The Context of Light-handed Regulation

Introduction to a Fabian Society series on Light-handed Regulation, Wellington.10 September 2012

This is the first of five presentations on light-handed regulation. Its critics sometimes call it “light-headed” regulation, referring to the simple mindedness of the idea, or “light-fingered” regulation, referring to the way a goodly number used it to line their own pockets at the public’s expense. More formally light-handed regulation is the notion that the market can be left to self regulation by private interests with a minimum of public regulation through law and supervision.

This presentation begins by putting light-handed regulation in an historical and intellectual context. Then it goes on to explain why this is an issue again facing New Zealand, thereby preparing the way for the remaining lectures. The lectures are not regularly spaced but are scheduled to coincide with important events, including the release of a couple of pertinent Royal Commission reports.

It will be necessary in this overview to illustrate some of the general propositions from the areas of the other presenters. But each will have a much richer story to tell. I will be listening to them closely, because while the last lecture begins with the failures in the building industry, by this time we should have the report of the royal commission on the effects of the Christchurch earthquakes. But I shall finish off suggesting what needs to be done.

There are other examples of light-handed regulation which the series is not covering. The choices are some of the most currently prominent ones. There are others including alcohol policy, broadcasting, aspects of consumer policy, and employment relations under the Employment Contracts Acts. In each there has been a strong “anything goes” element with the market defining the outcome rather than being used to shape it..

To begin almost at the beginning, after centuries of slowly building up, the economic forces were unleashed in the nineteenth century which transformed much of Europe from an agrarian and rural society to an urban and industrial one. It was a period of economic, social and political turmoil. Perhaps the forces were instigated by science and the enlightenment, but the central economic drivers were money, capital accumulation and the market; the greatest of them being the market.

There were two sorts of interdependent responses. One we know as the Left-Right dimension. The Left wanted to use democratic institutions – and therefore collective ones – to respond to the new economy, while the right preferred to leave these matters to individual initiative which, of course, were biassed towards the rich. Paul Samuelson, in his famous textbook principles, nicely – and ironically – captured the dichotomy when he pointed out the market was a kind of voting system in which you use dollars rather than a ballot paper to determine outcomes. Some people have more dollars.

The other response dimension was a modernisation stance versus conserving traditional society. This was not just an issue for the right, which saw the replacement of the aristocratic land holding class with a capitalist one, not all of whom where the descendants of the aristocracy. But it also applied to the left as well. The French social anarchist Jean-Pierre Proudhon is an exemplar of the traditional left approach when he advocated returning to a rural agrarian Arcadia of an idealised eighteenth century. However many socialists did not think this was either practical or desirable. They were the modernisers.

Socialism was a both a critique of urban-industrial society and a program of how to respond to it. The critique had two major dimensions. One was a deeply moral response, something which the left expresses passionately to this day. But socialism was never only a moral crusade – although sometimes it appears to present itself as solely one. As an analytical critique it was also an integral part of the development of the emerging social sciences. Many of the great economists of the nineteenth century were socialists – John Stuart Mill, Alfred Marshall, and Karl Marx.

Marx’s significance has been lost in the misinterpretations of his followers. He said he was arguing for ‘scientific socialism’ in contrast to those he saw as traditionalists, who may have been moral but were nostalgic for the Arcadian idealised past. Instead, Marx argued, the drivers of industrialisation and urbanisation were unstoppable. Just being moral about it was like lying in front of a train. That is why Marx described his approach as “scientific”, for it tried to analyse what was happening and predict the future. Marx’s prediction had a cheerful twist. He accepted that there was enormous suffering and distress from the industrialisation but his theory said that ultimately the world would be a better place – he called it ‘communism’.

Marx’s prediction proved correct insofar as that we are better off on many measures today than our ancestors were in the nineteenth century. Even Africa – the poorest of all continents – has a material standard of living three times higher than at the beginning of the nineteenth century. (Ours is twenty times higher.) But his prediction was very wrong in that the world has not reached some communist nirvana ruled by workers. It is an interesting exercise to explain what was wrong with his economic model, but let us skip onto the next group of socialists who were modernisers without forgetting Marx’s central lesson – we need to analyse as well as moralise.

The modernising group I want to talk about are the Fabians who were around later than Marx, by which time Britain was highly industrialised and highly urban. They were deeply moral; they knew many lived in dreadful circumstances in late nineteenth century Britain. But they were also analytic. I read Fabian literature before I began studying economics. Many years later I reread The Fabian Essays, and was astonished at the quality of its economics. Of course they were not up to the latest economic developments of the times, but they were no further behind than, say, today’s New Zealand university’s economic departments. Their writings are a part of the great social science investigations of the times.

The Fabians accepted urban industrial society. Their program was to mitigate its worst aspects. They named themselves after the Roman general, Fabius Maximus, whose tactics against the superior forces of the Carthaginian army were of harassment and attrition rather than head-on battles. Yet, like the general, the Fabian socialist’s mitigating policies were intended to eventually win – to transform society in the long run. Theirs was evolutionary socialism but the ultimate goal was a revolution – a socialist society.

To what? In 1918 the British Labour Party adopted a motion about its goals, moved by the major Fabian thinker, Sidney Webb. It was to secure for the workers by hand or by brain the full fruits of their industry and the most equitable distribution thereof that may be possible upon the basis of the common ownership of the means of production, distribution and exchange, and the best obtainable system of popular administration and control of each industry or service.

Later it became the well-known and well-fought-over “clause four”: the goal of the public ownership of the means of production, distribution and exchange.

Many years later I was puzzled why if public ownership was the ultimate destination of a socialist regime; did we not want to nationalise corner dairies? In the 1960s some British left wing thinkers argued for a revision of clause four to ‘the social control of the means of production, distribution and exchange.

I found that enlightening. Democratic socialism has a central principle of “subsidiarity”, that decisions should be taken at the lowest effective level, as close to those who are affected as possible. The market is a means to do this because it is the individual who makes the decisions there, not big brother state.

A century ago the Fabians sought social control by public ownership. But in the subsequent hundred years, our increasing understanding of how markets work meant that we now know that, under certain conditions, market mechanisms are an effective means of social control, in the sense that they enable us to attain our social objectives better than any other way. The reason we do not nationalise corner dairies is that they do broadly what society wants from them under a properly regulated competitive market and we don’t know any better way.

How market transactions are regulated is, and has been, a central economic concern. It has also been a concern of modernising socialists. A question of terminology here. There are some who define socialists as committed to public ownership. If so, we might define those who focus more on social control as “Social Democrats”. I favour the broad church and try to eschew sectarianism. So I’ll refer to those who support social control also as socialists; if you are of a different mind you are welcome to substitute “social democrat” for “socialist” as I go along.

“Competition” and “proper regulation” are critical ideas. I am not going tonight say much about the notion of competitive market, except to encourage you to attend Geoff Bertram’s lecture in this series. We once had a rule of thumb that if there were five largish firms in an industry then it was near enough to being competitive for practical purposes. What Geoff’s work has shown that has not been true for New Zealand’s electricity sector; which has hiked prices at the expense of consumers.

He tells me he is going to talk about ‘workable competition’ which is how those 1960s socialists talked about the social control of strongly oligopolistic industries. It is an expression which has almost fallen out of use in New Zealand, and so has the analysis which goes with it. Geoff will reintroduce it. We need to. It is very rare that there are even four firms in many vital New Zealand industries.

The issue of properly regulated markets is the focus of the rest of this lecture, and – including workable competition – of the rest of this series. We begin by observing that the corner dairy is subject to various laws and regulations which cover food hygiene and consumer information and protection. Additionally – and importantly for later parts of the story – a wronged customer may be able to sue the dairy owner for damages. There are a plethora of these restraints over dairies. Market transactions which do not come under some legal restraints are extremely rare. The issue for those who favour social control is what are the relevant laws?

The notion of the market as a means of social control was not a popular view in New Zealand’s Left in the middle of the twentieth century. Its thinking had evolved out of the older economic tradition captured in the clause four approach to socialism. In any case, Labour had come into power in 1935 and had established a far more interventionist economic management than the social control approach subsequently suggested was necessary, although perhaps it reflected the economy of the times and its understandings.

The Muldoon government was the apogee of this approach. Of course Muldoon did not use the economic powers available to him for the purposes the Left desired, and there were many who saw the solution was to take over the same powers as Muldoon but apply them for other purposes. This overlooked the way that with affluence and complexity the economy was becoming increasingly difficult to control directly. In any case why neglect using the powerful mechanism of social control that the market offered?

The Labour government which came to power in 1984 sort-of realised that the regime that Muldoon managed could not continue. It did not, though, have much idea about how to replace it. It remains a mystery how the Fourth Labour government got captured by those who were pro-market but not from the Left and went on to abandon most of their socialist aspirations. One explanation was that they were modernisers and their Labour supporters were not, so they turned to the only group whose approach seemed to be addressing the problems which Muldoon’s management exposed.

That cannot be quite true. Many Labour supporters were economic traditionalists, but there were also a group of modernisers committed to traditional social values but who had thought about how to use the market for social control. The left wing modernisers saw the value of using the market as an instrument for social control in the pursuit of higher social ends; in contrast the right wingers saw the market as an end in itself.

Why did the Labour government not turn to the leftish modernisers for assistance, instead of letting its right wing advisers repress them? Again we do not know; such memoirs as we have avoid such issues. Certainly the neo-liberals saw this alternative as the greatest threat to the implementation of their agenda, and repressed them while the traditional left also turned their back on them. The repression set back the left for a quarter of a century; this Fabian Society is an attempt to re-establish the analytic approach of the left modernisers.

One factor may have been that the Labour traditionalists did not trust the Labour modernisers. Tony Judt accuses the left of being conservative. I think what he means is not only that they wish to preserve old values, but that they also want to preserve the institutions which they created in the past. Modernisers of the left or right threaten those institutions, albeit the left group may be progressive trying to adapt them for the evolving circumstances; while the right group – the neo-liberals – may be in favour of abandoning them. The Labour Traditionalists could not distinguish between the two, and so never turned to the Labour Modernisers for help against the neo-liberals.

(To illustrate the point, consider the social welfare record of the recent Labour Government. Its main advisers were essentially traditionalists, and with the occasional exception little was done to update the welfare state except at the margin. National has come in and tried to adapt the system for fundamental social change in the last forty years. In my opinion they are not doing it very well, but at least they recognise there is a problem. The traditional left is up in arms – as well they might be, given what amounts to pig ignorance and miserliness – but it is a conservative reaction which is hardly addressing the problems the social welfare system faces, just as they failed to do when they were in office.)

The fourth Labour Government did not implement the full neo-liberal program. As Roger Douglas wrote in the early 1990s there remained “unfinished business”. As we used to say before the Fourth Labour government was elected, the neo-liberals would not be satisfied until they abolished dog licences.

Initially the National government elected in 1990 determinedly pursued the agenda, never quite getting to the dog licences. To give it credit, the Fourth Labour government had put in some consumer law, which has been subsequently strengthened. There was also some worker protection law. Rather than repealing it, National’s neo-liberals undermined it by providing insufficient funding to enforce the law or weakening the institutions that were needed to make it work; as Hazel Armstrong will show, you cant have effective work safety in a dangerous work place without effective worker representation.

As a part of its approach this National government promoted the notion of light-handed regulation, where businesses were largely left to regulate themselves. The current government still does to some extent; a minister argued that it was unnecessary to impose particular regulations over the state owned assets they were trying to privatise, because the private sector would act in a socially responsible fashion.

Three broad reasons were advanced as to why private businesses would behave responsibly:

First, they would want to maintain their reputation in the community, to consumers and among workers. But reputation is of little value if the irresponsible behaviour leads to the firm’s demise. What is the Pike River coal mine’s reputation worth?

Second, there was the legal possibility of facing damages (preferably, if you were a neo-liberal, through the use of common law). Awareness of the possibility of damages would deter – it was said – businesses from misbehaviour. The reality is that it did not deter the building industry from constructing buildings which were not resilient to earthquakes nor ones that did not leak.

Third, it was said that the businessman and women would behave morally. It is hard to argue that happened in our finance sector, some members of which not only failed to behave morally, but broke the law to the point that they have been incarcerated. But their fraud is the tip of an iceberg. Consider all the so-called independent financial advisers who failed to mention to investors that they were paid by the businesses they were recommending investing in. In my view not indicating a conflict of interest – especially when it was as great as this – is immoral. (Observe that neither loss of reputation nor the threat of being sued had much effect either.)

The purpose of the three reasons – reputation, retribution and morality – was to justify light-handed regulation. The real reason neo-liberals supported it was that they had no confidence that the government could do any better. This was not the result of a careful assessment of the alternatives that a left moderniser might make. Rather it was part of a sweeping ideological belief that the government was always a part of the problem, never a part of the solution.

Alan Greenspan acknowledged the foolishness of such a universal condemnation, following the Global Financial Crash. He was a follower of Ayn Rand whose objectivist philosophy is an extreme form of neo-liberalism – Paul Ryan, the US Republican candidate for vice president is another follower of Rand. In the almost 20 years in which Greenspan was Chairman of the Federal Reserve of the United States he managed the stock of money – as Friedman advised. But he neglected regulating the American financial system, instead practising light-handed regulation. The practice contributed to the magnitude of the Global Financial Crisis.

Not long after it began, Greenspan was questioned by a congressional committee. Referring to his free-market ideology, he said

“I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.”

He was pressed to clarify what he was saying. A congressman remarked:

“In other words, you found that your view of the world, your ideology, was not right, it was not working.”

To which Greenspan replied

“Absolutely, precisely. You know, that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.”

To give Greenspan credit, he admitted he was wrong. Few of our practitioners of light-handed regulation have so fessed up. I’ll leave David Tripe to illustrate the failure in the New Zealand finance sector but allow me to insert a comment about our Reserve Bank.

I do not know how much objectivism influenced Don Brash who was its governor for the 14 years to 2002. His strategy broadly followed that of Greenspan, controlling the money supply but a hands-off approach to financial regulation other than by requiring public disclosure of the financial accounts. His successor, Alan Bollard who almost certainly knows about workable competition, took a more interventionist approach to regulating the banking sector. Almost certainly the measures he introduced moderated the impact of the Global Financial Crisis on New Zealand. However the Reserve Bank was not then responsible for the non-banking part of the financial sector. As David will report, that was regulated under light-handed principles and it failed miserably.

We should not conclude that light-handed regulation always leads to disaster. Where the threat of a loss of reputation or of being sued for damages are effective. business may be more easily left to itself. (I doubt one can rely on the morality of business in a capitalist system.) Typically that happens where a wrong may be identified reasonably shortly after the transaction. However where it takes time, the outcome can be catastrophic for the gulled consumer or investor.

Let me round off the political story with what happened under the Fifth Labour Government headed by Helen Clark and Michael Cullen. They were elected on a platform of reversing the extremes of the neo-liberal era; in many areas they did. You might say they were Fabian modernisers even if the neo-liberals saw them as reactionaries.

Very often they failed to complete the job. I am not sure of all the reasons but surely a key one was that the earlier repression of the left modernisers meant that the Clark-Cullen government lacked the fire-power to address some issues. This is no better illustrated than in the area of market regulation. When they came to power they established three reviews of areas where there were sharp problems..

To review monetary policy they chose a Swedish economist who supported the status quo; not surprisingly we got little from that report. While I have the greatest admiration for Alan Bollard, he leaves the job as governor this month with monetary policy still requiring an overhaul. It is not likely to happen until a new government is elected. Hopefully next time they will select their advisers a little more carefully.

The reviews of the telecommunications industry and the electricity industry did only a little better. Neither review team seemed to know much about workable competition. Fortunately, as far as telecommunications were concerned, there were officials who were practical and we have been slowly getting that sector under social control. Electricity has been even less successful, but I’ll leave Geoff Bertram to tell that story.

One thing you should notice is that in each case there were powerful business interests favouring reform. Exporters were suffering from the exchange rate consequences of monetary policy (still are). Suppliers of telecommunications services were finding themselves overwhelmed by the Telecom monopoly; their persistence may be why there has been progress here. As well as households, businesses consume electricity and they also they thought were getting a rough deal. But before you draw the lesson that the Fifth Labour government was not as sensitive to the interests of ordinary people, it did progress consumer protection legislation. I look forward to Hazel Armstrong assessing its contribution to safety in the workplace.

Hazel, and indeed the others, will draw attention to ongoing failures over the last two decades. The list is long. I am going to list some of the most appalling ones. It is not accidental that these are largely recent. Light-handed regulation works best in the short term. Long term problems accumulate and so they can be much more difficult to deal with when they become visible.

I begin with seven examples where the failure of light-handed regulation has led to greater direct regulation when the failure became evident.

1. Telecom, the dominant supplier to the telecommunication market, was privatised without any consideration of the regulatory environment. The government-owned business had been directed by the government to limit some of its monopoly behaviour; those practices were immediately abandoned by the new private owners. In recent years there has been increased intervention, including a telecommunications commissioner in the Commerce Commission and specific directions by him on how the industry should organise itself. The most important change has been the separation of line from other telecommunication businesses – the division into Chorus and Telecom. It probably should have been done when the firm was privatised in 1989; it was not even considered. For over two decades Telecom used the privilege of its monopoly position to prevent effective competition and gouge consumers – as its exceptional profitability shows – but there was also a cost that we got behind the rest of the rich world.

2. Because market competition in electricity supply has not always been effective, there is a supervising Electricity Authority and restrictions on the degree of vertical integration. Even so, as Geoff Bertram has reported and will report, electricity prices seem to have risen faster than they would have if there was real competition.

3. The finance industry is now regulated by the Reserve Bank of New Zealand following widespread business collapses in the 2007 to 2010 period, in part the result of inadequate supervision by the Securities Commission which practised light-handed regulation.

4. The investment advice industry now has an investment advisers’ act following its poor quality – indeed immoral – performance in the run up to the Global Financial Crisis, when many investors lost wealth.

5. In early 1998 the Auckland CBD suffered a blackout when the cables delivering electricity overheated and failed. This may not be quite as much a regulatory failure as the other examples, but it reflected a downgrading of engineering supervision with greater attention to commercial imperatives, similar to that which has occurred in some of the other examples. The board of the company consisted of business people none of who were competent engineers; it was an engineering matter when the cables failed.

6. Evidence to the Royal Commission inquiring into the Pike River Coal Mine disaster suggests that there had been inadequate levels of mine safety supervision. In August 2011, the Department of Labour’s head of health and safety policy, James Murphy, agreed that the department had taken a hands-off attitude to the detail of mine safety ‘and we are now thinking that actually we were too hands-off.’ A few days later, the Government announced it was setting up a High Hazards Unit, doubling the number of safety inspectors for the mining and petroleum industries.

7. The highly ideological Employment Contracts Act was introduced in 1991 with the effect that workers and their representatives would have reduced roles in regulating the work place. It has been replaced in 2000 by the Employment Relations Act. While the replacement act could be argued to reflect the changes of political power following the election of a Labour Government, there has been no strong reversal following the election of a National Government in 2008, although there is a weakening of some of its provisions. It is another example of neo-liberal innovation which has been repealed because the experience it did not work.

In each case light-handed regulation failed to the extent that the regime was replaced. But the costs were not just reduced economic performance and equity. Here are five examples where there was a loss of lives.

8. In April 1995 14 young people died and others sustained severe injuries when a platform overlooking Cave Creek collapsed. In his report on the incident, Judge Graeme Noble found one of the causes of the failure was inadequate supervision by the Department of Conservation. Behind the failure was the 1989 closure of the Ministry of Works and Development which meant their high standards of regulatory supervision of such constructions lapsed. Noble concluded ‘I am left with the overwhelming impression that the many people affected – victims and their families, department employees and their families, and others closely associated with the disaster – were all let down by the faults in the process of government departmental reforms.’ This might be thought of as a precursor of leaky buildings, where workers without the requisite expertise took on a construction task beyond them.

9. In April 2008, a coolstore in Tamahere, Hamilton exploded killing a fireman. The manager of Icepak told the inquest that his company operated without knowing it was putting people at risk, and had no one on staff with electrical or refrigeration expertise. Instead they relied on outside experts. A safety inspector said that an inspection three years earlier had found some safety issues, but there was no obligation for that to be followed up; it was the owners of coolstores who were to make sure plants complied with the law, because the industry was self-regulating. The company, the associated refrigeration company and the managing director pleaded guilty to charges of breaching health and safety employment regulations. Their fines plus reparations to the injured firemen and their families amounted to almost $400,000.

10. I have already mentioned the explosion of the Pike River Coal Mine as instigating a reversal of light-handed regulation. A factor was that 29 men died. The Royal Commission has yet to report, but the evidence to the enquiry suggested that had there not been the reductions in the frequency of mine inspections and the standard of mine safety supervision, the disaster may not have occurred.

11. The leaky building syndrome is an exemplar of the economic failure of light-handed regulation. The failure involves significant resource costs. The estimates depend on assumptions; currently the lowest is NZ$11.3 billion (i.e. 6% of annual GDP), with them going up to $33 billion (18 % of annual GDP).These estimates do not include the costs of similar failures in commercial buildings and public buildings such as parts of hospitals and schools. Moreover there has been severe personal and financial stress which has contributed to marriage breakups and suicides.

12. While much of the destruction from the Canterbury earthquakes was inevitable and some of the deaths unlucky, it is clear that the 115 deaths at the CTV building were the consequence of poor design and construction techniques which could have been avoided had there been adequate public and private supervision. We await the report of the Royal Commission of Inquiry.

This is a selective list, albeit one which highlights some of the worst catastrophes. But think of the number. Oscar Wilde’s Lady Bracknell famously said that to lose one parent was a misfortune but to lose two was sheer carelessness. When it comes to this number the carelessness is outrageous. What has to be done is not just to treat each instance as it occurs. Rather we need to see the regularities across a wide range of instances and address the mind-set of light-handed regulation.

The current policy stance seems to be that we practise light-handed regulation until we get caught, and then respond on an ad hoc basis. What is needed is a approach which is sufficiently worked out that the sixth Labour government, when it is elected, is committed to it and in a position to act comprehensively. If we don’t there will be more; we may not repeat leaky buildings but the likelihood remains there will be other construction disasters. Worker safety will remained compromised unless we tackle the issue holistically.

I am now going to set down some principles at the meta-level, those that set out a context for regulating an economy. I apologise that they are not as brief and elegant as Webb’s 1918 statement. The economy has got a lot more complex and our understandings are greater.

What I am setting down here is, of course, tentative. If someone offers a better set then I am happy to gracefully withdraw these (although I reserve the right to criticise alternatives if they are too complicated, inelegant, or prescriptive.) They are very much in the spirit of the left modernising approach.

Principle 1: The purpose of the economy is to contribute to higher social goals (which need to be set out, but not solely by economists). It is not the higher goal.

Principle 2: Businesses have a critical role in pursuing this economic purpose, irrespective of their form of ownership. This role should be respected, but it is one where business is the servant of society, not its master.

Principle 3: The government has a role to ensure there is social control of the means of production, distribution and exchange. (The modernised version of Clause Four.)

Principle 4: There are numerous ways of exercising social control including public ownership and regulation of private business. There is no prior preference for a particular approach. The test is what works, and the configuration of interventions will depend on the particular circumstances.

I am going to stop here because we are moving from the meta-principle level to how we might go about designing a system of social control. I have not yet made my mind up. I shall be listening very closely to Hazel, David and Geoff over the next three lectures. In my final contribution to this series I shall draw on their lectures and what I have learnt from the failure of regulation in the building industry to conclude by suggesting what a set of principles to regulate the economy might look like in today’s conditions.

We can use them as the basis for a discussion on the sort of approach the next leftish government might implement. Hopefully it will be a left modernising one.

The rest of the series are as follows:

  1. Light-handed Regulation and Work Safety, presented by Hazel Armstrong on Monday 8 October;
  2. Light-handed Regulation and the Finance Sector, presented by David Tripe on Wednesday 31 October;
  3. Light-handed regulation and the Energy Sector, presented by Geoff Bertram on Monday 12 November; and
  4. Light-handed Regulation and the Building Sector, presented by Brian Easton on Thursday 22 November.

All will be at Connolly Hall at 5:30pm.