What is to be Done about Light Handed Regulation?

Paper to the Fabian Society, December 14, 2012.

For Regulation and Leaky Buildings see http://www.eastonbh.ac.nz/?p=1686.

This lecture was originally advertised as illustrating the deficiencies of light-handed regulation by failures in the building industry, particularly leaky buildings and those not robust to earthquakes. The intention was the lecture would complement three earlier lectures in the series which illustrated other failures – on energy policy by Geoff Bertram, the financial sector by David Tripe and occupational health and safety by Hazel Armstrong.

But as the series progressed it became evident that the need was not just a matter of illustrating yet again what has gone wrong, but setting out what should be done instead. As the final thesis of Feuerbach says. it is not just a matter of understanding the world; the point is how to change it. The four examples are so diverse – I shall shortly add some more which extend that diversity – that it is not simply a matter of attending to this failure or that one. Light-handed regulation has been a policy framework, and it needs to be replaced with an alternative framework.

Although the term was not used until the early 1990s, ‘light-handed regulation’ first began appearing in New Zealand in the 1980s with the early flush of Rogernomics – New Zealand’s neo-liberal approach to the economy. Neo-liberalism is underpinned by an extreme distaste for state activity. It comes from a particular strand of American thinking,

However it is only a part of American thinking, often associated with the Chicago School of Economics with its project to minimise the role of the state. It has been rarely dominant in American economists’ thinking, although sometimes under Republican Presidents it was relatively more influential on policy. As we have seen in New Zealand, policies pursued by the conventional wisdom do not always reflect best practice.

Why did neoliberalism became so dominant in New Zealand, especially as the state has been an integral part of its development? One explanation is that it was reaction to the Muldoon era with its over-emphasis on the role of the oppressive state. Some people’s thinking jumped to the other extreme, not aware that there were options between the two.

A hundred years ago the French observer Andre Siegfried thought New Zealanders’ outlook “not too carefully reasoned, and no doubt scornful of scientific thought, makes them incapable of self distrust. Like almost all men of action they have a contempt for theories: yet they are often captured by the first theory that turns up, if it is demonstrated to them with an appearance of logic sufficient to impose upon them. In most cases they do not seem to see difficulties, and they propose simple solutions for the most complex problems with astonishing audacity.”

As I have put it, the New Zealand way is “bugger the analysis; let’s get on with the policy”. Certainly New Zealand’s Rogernomes were hardly affected by careful analysis. Instead they imitated American neo-liberal thinking, insensitive to the differences between the two economies and to New Zealand aspirations. As Siegfried might have said, the American logic was sufficient. They did not seem to see the difficulties, and proposed simple solutions for the most complex problems with an astonishing audacity.

Once the handful of Rogernomes were in power, practical New Zealanders – not too carefully reasoned, and no doubt scornful of scientific thought – were captured by the theory, relying on a confidence that the conventional wisdom was right. It was not, and over the following two decades almost all of the extremist policies of Rogernomics have had to be unwound – that is perhaps the proudest achievement of the Fifth Labour – Clark/Cullen – Government. The windback was not simply a matter of political taste; very few of the Rogernomes’ promises of greater prosperity and performance were fulfilled. Indeed, any realistic assessment of their policies suggest they broadly failed. As a result the majority of the elite no longer overtly endorse Rogernomics; many prefer to have their past enthusiasms overlooked, rather than forgiven. But, crucially, they still implicitly carry a lot of the Rogernomics baggage. They would be appalled to be told so, but the conventional wisdom knows of no alternative. Social democrats have notably failed to articulate an alternative plausible paradigm and get it into the public domain.

There is a deeper lesson here. The speed at which the elite adopted Rogernomics tells us, as Siegfried foresaw, that it is intellectually fickle and will seize on an alternative approach if the circumstances are right. At issue is that they are not yet offered an alternative.

Perhaps New Zealand’s first outbreak of light-handed regulation was over competition policy. The Chicago School, for whom the state can hardly do anything right, concluded it was better not regulate monopolies. However the Fourth Labour – Lange/Douglas – Government largely ignored the argument when it reformed the Commerce Act in 1986. The Rogernomes persisted with their attempt to undermine it right through the 1990s, and even got cabinet to agree to an amendment which would have neutered its merger provisions; but it was never put to parliament. But there are other ways of neutralising legislation. Special legislation can ignore the principles of the promotion of competition.

Possibly the worst example was the privatisation of Telecom, which paid no attention to the fact that it was a monopoly, both by virtue of its ownership of the single line from exchange to the user’s phone, and because it had such a large share of the telecommunications market. The inevitable result was that the owners were able to exploit their monopoly power for high profits which they transferred to themselves, adding to New Zealand’s overseas debt. Moreover, without competitive pressures they were not particularly innovative and the New Zealand telecommunications industry got behind the rest of the OECD.

Fortunately, the Fifth Labour Government, led by minister David Cunliffe, began addressing the Telecom monopoly, which is the reason why telecommunications has not been a topic in this series. Instead, Geoff Bertram described what is happening in the electricity industry. It has a more complicated market structure – an oligopoly with a number of big players. The story which Geoff told of rising profitability showed that it is not properly competitive.

Given the nature of the electricity sector’s production it may well be that the most efficient form for our electricity generation system is a state-owned monopoly supplier subject to a regulatory framework and allowing feed-ins from private suppliers. Instead the government is proposing to privatise even more of the industry, without – you will not be surprised to be told – a careful review of the regulatory framework. What Geoff is suggesting is that the private buyers may make another mint, as they did in the case of Telecom.

The Rogernomes also promoted the privatisation of natural monopolies like seaports and airports. There was considerable local resistance, and not all have gone into total private ownership. However the chaotic form of port ownership has serious implications for economic efficiency, because they cannot be simply rationalised. The question of the charging of airports is an ongoing problem, with landing fees seemingly being hiked with little restraint.

Before finishing with these examples of a casual approach to monopolies and oligopolistic markets. I note that where some restraining measures have been introduced, it has often been at the behest of other businesses who are also paying for the high prices and suffering inferior services. It was they, not consumers, who pressured most effectively for a change of telecommunications regulation; it is the carriers who are resisting the landing charge hikes. Consumers are not well organised to deal with market power, which is why they need a Commerce Commission.

Having said that, I admit that our consumer protection laws do not seem to be as far behind international best practice. Even miraculously, the Consumer Guarantees Act was passed in 1993 by a National government. I attribute the success to an effective Ministry of Consumer Affairs, established by the Fourth Labour government, although I worry that it is becoming less effective as it is increasingly submerged into the new super-ministry for business.

Other early forms of light-handed regulation appeared in the 1980s. As David Tripe recorded, debate on the financial investment sector presaged a major failure 30 years later. In essence big investors claimed privileges relative to small investors, including that they wanted to paid more for their shares following a takeover and that there should be no restrictions on them practising insider trading. The privileging reflects the rarely mentioned fundamental feature of financial capitalism; one of the sources of the rich financiers’ profit comes from expropriating the savings of those lower in the hierarchy. We saw this again recently when the financial companies collapsed with substantial loss of the wealth of the small investors. Where did that go? The bit that was not lost in inefficiency ended up with the rich investors.

We had a Financial Services Commission from the 1970s, but it proved remarkably ineffective, because it got seduced by the rhetoric of light-handed regulation, with its assumption that small investors can largely look after themselves. Thus there was an institution which appeared to be helping them, but in the most important way it did not.

We were very lucky that from 2002 the Reserve Bank took a more rigorous approach to the banking sector for which it was responsible, so that the monetary system survived the Global Financial Crisis of 2008. For its pains, responsibility for the non-bank sector has been transferred to the Reserve Bank. However small savings will remain vulnerable to predation from the rich.

By the early 1990s, the notion of low state involvement in the regulation of business and market became consolidated in the rhetoric of light-handed regulation with its framework pervading public policy thinking. Had it not, the Financial Services Commission would surely have been more effective.

Hazel Armstrong showed the consequence for work and safety. Workers died. Not just at Pike River; Hazel showed they died on the railways too, until the Fifth Labour Government took action. No doubt close attention to other industrial sectors would find similar instances. Apparently our death and injury rate among workers is about double the OECD average.

There are at least two further lessons from the Pike River disaster. The first is that the legislative weakening of unions meant that worker safety concerns were not properly represented.

The second was there is a national habit of quarantining a systemic failure to the particular instance and not seeing it as an example of a wider phenomenon. The Department of Labour has belatedly responded with its High Hazards Unit, but there is insufficient attention to the wider problem of inadequacies of our occupational health and safety system.

This fallacy is repeated in the leaky building fiasco. Historically, the construction system was based on a prescriptive regulation which described how buildings should be constructed. By the 1970s there had been increasing concern that the prescriptive regime was preventing the introduction of new – higher productivity – building technologies.

So the regulatory system was switched over from a ‘prescription-based’ approach to a ‘performance-based’ one. No longer were particular house building methods and material specified. Instead structures were required to last 50 years, the cladding 15 years, and the walls and roofs were to be impermeable to water. Nobody seems to have thought much about what happens if the cladding falls off after 14 years. Would the builder, architect or materials supplier be around, could they afford the remediation?

Let me not go through the detail of how the regulatory system for housing construction was inadequate, but mention that there were also some related issues such as the deskilling of the sector, the introduction of technologies without a proper understanding of their import while the reorganisation of the local government sector undermined many of their building sector services. Suffice to say they all greatly contributed to the leaky buildings disaster, which may have built 110,000 seriously damaged houses plus more commercial and public buildings, at considerable cost for remediation and much family hardship, including suicides.

In many ways, given the introduction of new technologies, some failures were inevitable. What is concerning is that when the problem became apparent in the 1990s, very little was done and we just kept constructing leaky buildings. I am told they still may be being built or, at least, there are still buildings being constructed which eventually will prove as faulty. Moreover, where the failures have been identified there proved to be no simple (and cheap) remediation process. (Incidentally here is an example of where consumer protection legislation – the Consumer Guarantees Act – does not apply, because a built house is not legally a single product.)

The regulatory failure in the construction industry has not been confined to leaky buildings, as demonstrated by the collapse during the Christchurch earthquakes of commercial buildings constructed in the last quarter of a century. While some of the failures were the result of a general lack of technological knowledge, in at least some cases there were failures due to poor quality construction. Why was it allowed to happen? More fundamentally there must be similarly poor quality buildings elsewhere in New Zealand just waiting for an earthquake to demolish them.

Once more we have quarantined the problem. We ignore a general problem of regulating the construction industry better, focussing on the specific problem of leaky homes. We admit there were some badly built offices in Christchurch, but since they have fallen down, it is now no longer a problem.

I want to go a step further. There is not just a general problem of regulating the construction industry, and not just a problem of price gouging by electricity generators and firms in concentrated markets, and not just a problem in occupational health and safety, and not just a problem in small savers getting a fair deal. There is an overarching problem of failure to regulate private markets. It applies in other markets too. Among the others are the supply of alcohol and gambling services, and some environmental areas – “dirty dairying” is a slogan associated with the failure of relying on industry monitoring its water pollution.

Each of these problem areas could be tackled separately but it will be in a context in which there is a bias towards light-handed regulation. As Pierre Bourdieu, the French sociologist and intellectual, observed in his seminal work Outline of A Theory of Practice, the way that an elite typically stays in power in almost any society is both by controlling the means of production, and also by shaping the social discourse (that is, the way a society describes the world around it). What matters not just what is discussed in public, but what is not discussed because those topics are considered boring, irrelevant, taboo or just unthinkable. He wrote: “the most successful ideological effects are those which have no need of words, but ask no more than a complicitous silence.”

Yet, some topics about which silence would be preferred are so compelling that they cannot be ignored and so there is a backup strategy of quarantining them by not exploring generalisations, inter-relationships and linkages.

For example, in May 2006 National Finance fell over. The public reaction was this was a one-off rather than indicative of some underlying problem. Then more finance companies fell over. Each case was treated as a one-off. There were 40 failures up to July 2008, just before the Global Financial Crisis hit. The list is currently 67 involving $9 billion of New Zealanders’ savings. It is hard not to conclude there was a systemic failure. But even here there is a tendency to quarantine by suggesting the failures are the result of criminal behaviour. Of course some has been, but the problem is more fundamental: incarcerating financial criminals does not provide a remedy for the small investors, nor recover the associated economic waste.

More generally, do you really think that failures from light-handed regulation stopped on, say, 14 December 2012? Do you think there will not be more – even disasters as big as those that have already happened? Hasn’t our approach been patching up again and again a Heath Robinson machine in the hope that this will be the last one. It hasn’t been and it won’t be.

The conclusion from Bourdieu is that in order to prevent these repeated failures we have to change the discourse – both the explicit one which a society describes its world, but also to expose that which it is silent about. In particular we need to replace the belief in light-handed regulation with an account of the world – a discourse – in which the state has an active responsibility for enabling markets to pursue the social good.

What we need is an alternative policy framework, one of those higher conceptual notions which Siegfried says we are not very good at. Let me illustrate this with the report out this week on child poverty commissioned by the Commissioner for Children. It is right to say there is widespread child poverty and that it compromises the nation’s future. It has also some worthy policy recommendations. But before we get overwhelmed with the latest report – for over forty years there have been many such reports – we need to ask whether something is missing for ultimately the report does not explain why there has been this continuing failure.

Suppose we looked for an overarching principle. The report does not have one. It might be that we should have a child-centred approach to child policy, a simple notion, but it challenges the conventional wisdom. Observe that the Bennett changes to the treatment of social security beneficiaries is hardly child-centred – many will make children worse off. And if the changes are not child-centred, what are they? I leave that answer to another venue. To offer a conceptual framework as to why child poverty occurs, and why we dont address it is a far cry from the ‘bugger the analysis, let’s get on with the policy’ approach in the Commissioner for Children’s committee’s report. For tonight’s purposes it sufficient to point out that because the committee was superficial, failing to challenge the conventional wisdom – offering an alternative view – it will have very little impact.

Similarly, it is insufficient for those who want to dismiss light-handed regulation to have only a list its failures; they have to offer a coherent alternative policy framework. I am going to devote the rest of this lecture to beginning to elaborate one.

(Before doing so I need to deal with the immediate objection from the elite’s conventional wisdom. This is not to go back to the Muldoon era. As I explained in my previous lecture, Muldoon’s regulatory framework was as much an anathema to social democrats as is the current one. There is spectrum of options between the two extremes.)

I begin by insisting that the purpose of an economy is to maintain and increase the wellbeing of its members. It is not simply to maximise output (GDP), a point to remind economists that per capita output is not the ultimate purpose of the human condition.

A social democrat pursues this goal by the social control of the means of production, distribution and exchange. Observe it does not argue that public ownership is necessary, accepting that sometimes transactions can be better left to the market – a properly regulated market. On the other hand it does not rule out public ownership as a means of enhancing social control.

The reason why we use the market is that a fundamental principle of social democracy is ‘subsidiarity’, that decisions should be taken at the lowest effective level, as close to those who are affected as possible, thereby avoiding the oppressive state. The market is a means to do this. Just as the state should not be in the bedrooms of the nation, it should stay out of private economic intercourse as much as possible.

One way of thinking about the market is that it is a voting system, except instead of being one-person one-vote it is one-dollar one-vote. To work properly we must ensure that everyone, or their guardians, has the right number of votes. Distributional policy belongs to another occasion, but once there is a fair distribution of the dollar votes, we allow people to exercise them with a minimum of state involvement.

However markets do not always operate effectively. They typically need a framework of laws and enforcement to work effectively.

1. To work really well, markets require many suppliers and purchasers. Where there are only handful, the resulting competition is likely to be inefficient and to involve price gouging. In such circumstances we need what economists call workable competition.

Social democrats are is not afraid of monopoly; in some circumstances they will use it because it gives the best outcome. A particularly chaotic market is the provision of health care. This is a topic in its own right, but let me just note that there is a very wide international consensus that it works best with a single dominant public funder.

A particular reason for a poor market structure is economies of scale. Not only does that often mean there is only a sole supplier – a natural monopoly – but it is difficult to get a sensible pricing structure. A relatively new form of natural monopoly occurs where there are networks. Often the best way of handling it is by public ownership – Transpower is but one such example. Almost always natural monopolies require very close supervision.

2. Markets do not serve us well where decision-makers do not take into consideration any of the important impacts of their actions. Economists refer to these as ‘externalities’. Such market failures are most evident in the way we interact with the environment. But there are many such others – for instance, excessive drinking rarely involves the abuser thinking about the consequences to others or to her or himself in the long run.

One of the ways of dealing with this failure is to incorporate the economic resource into a market framework. That is why we have a Individual Transferable Quota scheme to sustain the stock of fish, and why I support one for water.

But you cannot always do this. A nice example is that future generations may have an interest in the current resource usage, but they can no direct say. That is one reason why the Resource Management Act has a requirement for sustainability – in effect the it gives the future a vote in the current resource decision.

3. Joe Stiglitz argues that information asymmetry is a crucial market failure and argues that it was the cause of the Global Financial Crisis. The logic of his argument applies more to overseas financial institutions but clearly we need to ensure that ours are transparent, and it may be necessary as, say, the Volcker report argues, to separate the various function of banks so that in the next financial collapse the protect the payments system without having to bail out every investment failure.

Informational asymmetry is more pervasive than just banking. Much consumer protection law aims to reduce the informational advantage that the seller has over the consumer. This occurs up front by requiring the supplier to provide better information, and after sales via the Consumer Guarantees Act.

Provisions to reduce conflict of interest – when the adviser may not be operating independently, but is pretending to be – is another example where the state intervenes to reduce the asymmetry of information.

4. Another crucial asymmetry in the market is the asymmetry of power in a transaction. That is why it is common in most democracies for the law to privilege unions in an attempt to reduce the advantage a corporation has relative to the individual worker.

5. Related to informational asymmetry is the fact that sometimes individuals make economic decisions which they subsequently regret. A social democrat does not generally favour the paternalistic state, which is not well placed to make decisions on others’ behalf, but there are instances of intervention which allow the individual to modify a hastily taken decision. The cooling off period for door-to-door sales is a well known one. One dimension of alcohol control policies is to help people make wiser drinking decisions.

There are occasions in which the state has to be paternalistic because common sense says that the individual may not make good decisions. Children are an obvious case. Our practice is to leave the guidance in the hands of guardians –usually their parents – but the state may set standards – as in compulsory schooling. And the courts have the right to over-rule the parent where the guardian manifestly fails. Another example, yet to be addressed, is that in my opinion children should not have irreversible cosmetic surgery without a careful screening by the medical profession supervised by the courts. Fortunately breast enlargement for early teenagers is not common in New Zealand, but in American it is claimed that some girls get it for their fifteenth birthday. Notice that the question of reversibility is critical here. We’ll come back to that in the tenth reason.

Even though we reject the paternalistic state, we may accept that there are merit goods, which require some extra intervention in order to promote them. Education is perhaps the most important merit good. John Stuart Mill famously said it was better to be an unhappy philosopher than a happy pig. Regrettably the market tends to promote piggish ambitions.

6. Related to making decisions which are subsequently regretted is the so-called ‘nudge’ approach. What behavioural economists have found is that the way a question is asked affects the response. If you ask whether to opt in to an organ donation scheme – as the Austrians do – few offer their parts after death. On the other hand if you ask them to opt out – the German practice – most people say ‘yes, of course use my body parts’. A New Zealand instance of this was in the Kiwisaver scheme where new recruits have to opt out.

How such questions are framed is thought to be sufficiently important for both the Obama government in the US and the Cameron government in Britain to have a unit addressing the issue. It has not occurred to the New Zealand government that there is even a problem.

7. The state can make the market work better by reducing transaction costs. A simple example is the small claims court, thereby avoiding lawyers’ fees which would overwhelm the settlement. Standardising consumer information makes it simpler for consumers to choose. The crux of the Woodhouse revisions for the reforming of the old fault-based accident compensation was that it was chewing up forty percent of levies in litigation. Switching to a no-fault system reduced those costs to 10 percent.

8. Sometimes the market fails to supply sufficient of a good or service because it cannot price properly or generate sufficient revenue. Certainly we should try to introduce pricing as much as possible. I would favour metering vehicle use of roading if there was a cheap and effective means to do it. There are many other instances where a subsidy is required because there is no effective pricing regime. An orchestra may be worth more to its audience than what they pay, but the logic is to keep the price of seats down to use them all including attracting those who are not the regular customers.

9. One strength of the current scheme is that it gives a strong incentive to the ACC – the monopoly provider – to campaign to prevent accidents. Remediation for failure may sometimes be necessary but prevention is often a better strategy, especially where the remediation is expensive, erratic and unfair.

10. Sometimes there is simply no remediation, no means of reversing a profound regret. No one can bring back those who died in the Pike River Mine nor in the CTV building in Christchurch, or in many other instances. (Extinction of a species is forever.) We cannot prevent all deaths through misadventure but good regulatory design can reduce them. It should not be a matter of pride that we have so many who die on the job.

From this list of ten reasons for intervening in the market you may well conclude that the market is not a very good way at delivering what we want. Many of the interventions are minimal – so sensible that no one contests them (other than extreme right wingers). Given the trillions of market transactions that occur it is remarkable how few transactions are really problematic. Such are the strengths of the market that a social democrat, knowing their weaknesses, designs any intervention to be as consistent with market principles as possible.

On the other hand, the interventions should not be used for doing things that they are not capable of delivering. As a general rule, dont use these market interventions to affect the income distribution – such as trying to lift people out of poverty. The best way to assist the poor is usually to gave them cash. (The caveat occurs because free health care and education and training may be helpful). There is a tendency to say that we cant do this or that because it would make the poor worse off. If it does, supplement their incomes to compensate them.

How to go about replacing light-handed regulation? First, it is necessary to redirect the public rhetoric by emphasising that the old ways have too frequently failed, that the failures are not isolated but they are systemic, and that there is a better way. It is sad that some of the failures have been so catastrophic to people’s welfare, but the least we can do to honour those who have died is by offering a better way for the future. The approach needs a short snappy phrase. I am not into marketing, and at this stage can only suggest ‘social markets’ with its references to the Europ4ean social democrat tradition. .

Second, the rhetoric of ‘social markets’ needs to be underpinned by some practical proposals for an alternate regulatory regime. Are we really satisfied with the current alcohol consumption outcomes, do we have to put up with further building failures? Effective design of alternatives is not easy. It is important to be sensitive to people’s ambitions. It would be very easy to design an alcohol regime which was onerous upon moderate drinkers. It is also important to be humble. An effective alcohol regime will not eliminate all abuse – certainly not in the medium run; no matter what one does there will be building failures – the aim is to reduce their number and the magnitude of the resulting damage and to respond quickly when there is a failure.

Changing the public rhetoric and offering alternative approaches can be pursued while Social Democracy is in opposition. One hopes that by the time its politicians get to power they will be committed to the alternative approach. They should establish a social markets unit whose focus is better market regulation and which supervises and co-ordinates the myriad of government agencies involved in regulating the market.

(Let us be clear that often there will be considerable resistance to the change from industry who sees its interests being compromised. I am not opposed to industry self-regulation but it does not apply everywhere. The record is it did not prevent a single leaky building.)

New Zealanders do not want the failures of light-handed regulation – deaths, suffering and economic waste – to be repeated in other arenas. They desperately desire a leadership to enable them to attain their goals.

A social democrat knows that the state is not perfect but neither is the market. An integration of the two does not give perfect outcomes either. But they can be better than the extremes of Muldoonism or the neoliberals. The challenge social democrats face is getting that balance right. In today’s circumstances that is a commitment to strengthening the role of the state, while respecting a properly functioning market – and yet maintaining a scepticism toward each of them. That is what workable markets is about.