Monday, January 23, 2012

Romer on Regulation

I ran in to a lovely little paper on regulation, thinking about financial regulation, from Paul Romer.

In my thinking about financial regulation, I've been heading toward the idea that we should regulate assets, not institutions; that regulations should be few and simple; that regulations should be rules, not licenses for regulators to do whatever they want; that rights and recourse for the regulated are important limits on the abuse of even well-intentioned power; and that pre-commitment, limiting the power of regulators ex-ante to bail out ex-post is important.  That view is in an earlier blog post, and in an article in Regulation. More to come of course.

Paul comes to about the opposite conclusion, in a very thought-provoking way.

Paul cites Myron Scholes' law, "Asymptotically, any finite tax code collects zero revenue," to suggest that simple clear rules will never work. He cites the FAA's regulation of flight safety and the Army's  integration as successful examples in which regulators, given wide latitude but rewarded on results achieved. And he cites the OSHA as an example of the hopelessness of a rules-based approach. For example,
The height of stair rails shall be as follows:
Stair rails installed after March 15, 1991, shall be not less than 36 inches (91.5 cm) from the upper surface of the stair rail system to the surface of the tread, in line with the face of the riser at the forward edge of the tread.
Stair rails installed before March 15, 1991, shall be not less than 30 inches (76 cm) nor more than 34 inches (86 cm) from the upper surface of the stair rail system to the surface of the tread, in line with the face of the riser at the forward edge of the tread.
Paul comments:
 It is tempting to ridicule regulations like these, [you bet! -JC] but it is more informative to adopt the default assumption that the people who wrote them are as smart and dedicated as the people who work at the FAA. From this it follows that differences in what the two types of government employees actually do must be traced back to structural differences in the meta-rules that specify how their rules are established and enforced. The employees at the FAA have responsibility for flight safety. They do not have to adhere to our usual notions of legalistic process and are not subject to judicial review. In  contrast, employees of OSHA have to follow a precise process specified by law to establish or enforce a regulation. The judicial checks built into the process mean that employees at OSHA do not have any real responsibility for worker safety. All they can do is follow the process.
I'm not totally convinced. In part, I'm a pilot, aircraft owner, and flight instructor, so I have a slightly different view of the FAA than the average air traveler. Yes, commercial jet travel is remarkably safe. But it's not at all obvious how much of this comes from the FAA regulation, especially at the margin, and how much from technical progress in aircraft and pilot training.

The surest way to ensure flight safety is to make sure nobody takes off in the first place. That often seems to be the FAA's attitude towards the light aircraft that I fly.

For in fact the social optimum balances flight safety against the economic and personal advantages of flying. For commercial aircraft, the airline companies and the flying public are loud enough to be heard. For light aircraft, we are not. No FAA employee was ever fired for the number of flights that didn't happen, the number of pilots who gave up flying, the technical innovations that didn't happen under his watch.

And the Federal Aviation Regulations, plus the FAA's love of paperwork, can make the OSHA stair railings look positively simple. In fact, there are rules, there is right of appeal, and by and large the FAA does not have the authority to come out to your airport and shut you down if it doesn't like what you're doing. (It can, and does, dig in to the paperwork to find inevitable flaws.)  And these are good things!
Some of the FAA's "safety" regulation has the opposite effect. For example, automobile engines are now more reliable than light aircraft engines. But they and their parts are not "certified," a long and expensive process. So we use what's certified. Airplane-to-airplane collision avoidance systems have been on the market for several years that cost $1000, yet the FAA's system ("ADS-B") which will be much more expensive is taking years to come out.

I'll say this for the FAA: it's all much worse in Europe. And the FAA is not  corrupt. Wide latitude to make decisions as you see fit, and to selectively enforce a forest of rules, is usually a surefire recipe for corruption.

Looking forward to financial regulation, it seems inevitable that regulators, given wide latitude, and  charged only with "safety" and not "growth" will mistake the fortunes of the financial system with the fortunes of individual, existing, institutions, and will quash innovation and competition in the name of safety. The Fed's proposals to implement Dodd-Frank (comments here) seem already very clear in that direction

Scholes' rule is fun too, but the corollary is that any society will arbitrarily expand the complexity of its regulation and the deviousness of lawyers and accountants to avoid it, until nobody actually does anything anymore and the society grinds to a halt.

So, it's a great and thought provoking read, and it's making me think a lot harder, though I'm not totally convinced.


  1. "it seems inevitable that regulators, given wide latitude, and charged only with "safety" and not "growth" will mistake the fortunes of the financial system with the fortunes of individual, existing, institutions, and will quash innovation and competition in the name of safety."

    Not only that, but through trying to make the system safer, the regulators paradoxically increase systemic risk since they cannot overcome the asymmetric information on the market.
    This is what happened to the financial sector recently, with the MBSs and the eurozone sovereign debt being denoted as safe assets serving as an obvious proof (here's my paper on the subject)

  2. Scholes law is wrong (why would you quote a guy who did not understand the difference between a simplistic model and the real world?) and so is your corollary.

    There is an element of Godel's incompleteness theorem at work in that any non trivial set of rules will necessarily be incomplete (not cover every conceivable circumstance) but rules can still cover the overwhelming number of circumstances. The fact that a system of rules cannot be complete is not a reason for having no rules and the fact that a given system of rules is incomplete is not a sufficient reason to switch to a different rule model since every non-trivial system of rules will be incomplete.

  3. I know nothing about light air regulations, but I disagree with Romer for a different reason: there are too many differences between OSHA and FAA to attribute the difference to their meta-rules.

    I agree with Cochrane that simple rules are preferable to discretion, especially for regulatory institutions that have recently been especially vulnerable to industry capture. Unfortunately, it is very hard to regulate effectively without providing the regulator with some substance-over-form discretionary, equity-based authority.

    One key is to try to place the regulatory authority in institutions that resist capture. A good example is antitrust. It's almost entirely discretionary in the U.S., and yet it's a fairly effective regulatory scheme. Some complain that it is over- or under-inclusive, but it's a lot better than the SEC has been over the past 20 years. That's because judges rarely depart the bench for private industry, and thus have no incentive to please their future employers.

    DOJ is also an effective federal agency because it largely resists capture. DOJ attorneys frequently depart for private practice, but they go to law firms where they are most valued for their lawyering skills. Their incentive is to develop and show off their legal skills, and impress the Big Law firms who will hire them on that basis.

    For all the fun people (justifiably, in some cases) have at lawyers' expense, there's an argument that regulatory agencies are better off when management throughout the organization is vested in lawyers.

  4. Airlines maintain and install on their aircraft only what is required by the CFR (Code of Federal Regulations).

    Airlines train and certify crew only to the standard required by the CFR.

    And no more.

  5. John, I'd have agreed strongly with you six months ago. But I've spent the last five in Mexico, where trivial regulation exists only as a means of collecting bribes. In that time, I've had more food poisoning than ever before---almost as if the restaurants serving me weren't interested in my return business.

    I now have a strong suspicion that many of these regulations are only required for the time necessary for the regulation to become a norm, and no more. Having worked in kitchens in Australia, I'm well aware that there it doesn't take regulation to encourage them to bleach every surface twice a day---it's just what's done. But in some industries, they may need a shove.

    1. almost as if the restaurants serving me weren't interested in my return business.

      Why, in light of the overwhelming evidence that markets don't work, do we have people who assert that they do?

      Why is it impossible to get an admission that human "shortcomings" are so forceful that we need both markets and regulation?

      Could it be--applying Munger's phrase--incentive caused bias?

      And then we have a proposal for a suicide pact ("limiting the power of regulators ex-ante to bail out ex-post is important."). We are to deregulate financial institutions (like our problem how is that we over regulate them) and pledge that if they again use weapons of mass financial destruction we will stand aside while they blow up the whole world?

  6. Great post, thanks alot.

    All that remains to be done then is that you write up your opposite view of the problem, then collaborate with Paul Romer on a unified model which shows (under appropriate conditions) regulating regulators is equivalent to regulating assets, or even precise what the tradeoffs are (presumably this will rely on Maskin and Myerson's work), and finally collaborate with someone else (me?) on which situations are nearly optimal, and then where exactly additional regulation can make a difference, and where on the contrary regulation cannot improve expected utility, because of feedback (and from there sensitivity to initial conditions/positive Liapunov exponent/chaos) bounding the regulators' control power.
    (In the FAA example the feedback/tradeoff is between utility of flight and utility of safety/life, and the regulator is subtly involved because as a human s/he is computationally limited exactly for being a product of evolution, being part of society, that s/he tries to model/control/regulate.)

    Finally we collect our Nobel prize. How does that sound?

    More seriously, thank you again for the post. These are fascinating ideas, the most pressing questions in economics and politics I think, which I look forward to reading your contributions to, and to which I hope to contribute myself.

    (And I do think it probable Romer and you will earn a Nobel prize.)

  7. regulating regulators

    like we don't do this already



    Senate confirmation of officers?

    What is also fascinating is the assertion that we can regulate regulators through the political process but we cannot regulate directly (remember all that Cato crap about gov't is bad,etc.) and the new CATO crap that we cannot be politically trusted to do stimulus (Bullard 2012)

    It is also fascinating to see Cochrane ridicule rules and regs from OSHA that work. I have abundant first hand experience on that score. It is no surprise that a Catoist would hate OSHA, for the rules work.

  8. I think you miss the distinction between rules-based and principles-based regulation. Once started down one of these two approaches, a regulator can find it very difficult to deviate. Great article.


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