Regulating regulators: government vs. markets.

• Author: Baetjer, Howard, Jr.
• Position: Essay

Quis custodiet ipsos custodes?

--Juvenal, Satires

Regulation by market forces works better than government regulation. It does so because of the way each process is itself regulated, or not. Government regulatory agencies are in practice unregulated monopolies unaccountable to the public in any meaningful way. By contrast, the process whereby market forces regulate industries is itself effectively regulated by market forces.

To regulate is to make regular and orderly, to hold to a standard, to control according to rule, as a thermostat regulates the temperature in a building. Market forces do this continuously as competing businesses offer what they hope will be good value, customers choose among the various offerings, competing businesses react to those customer choices, and then customers choose again. That process is the market's regulator.

The public seem unaware of this regulation by market forces. In the semantics of the day, "regulation" means "government regulation" only. It means restriction by statute. When people complain that we are overregulated, they don't mean that we have an excess of the desirable aims of regulation: regularity and predictability in markets, and decent quality and reasonable prices for the goods and services we buy; they mean that government agencies impose too many restrictions and mandates on us, and that we chafe under the burdens they impose.

Yet because the public, blind to the market regulation all around them, believe government regulation to be the only means to attain the desirable ends of regulation, they grudgingly accept a vast array of meddlesome, wrongheaded, and often counterproductive government mandates and restrictions we would be better off without.

Government regulation is not the only kind of regulation. We should stop talking about regulation versus deregulation, about regulated markets versus unregulated markets. There are no unregulated markets, because market forces regulate. We should start talking about the choice we face between government regulation and regulation by market forces. And we should notice and show others that regulation by market forces works better. What follows explores why. (1)

Market Forces Regulate

Most of the regulation that occurs in a market economy is regulation by market forces. To take the most obvious example, market forces regulate market prices. In healthy industries, market forces are the only regulator of prices. The terms of exchange offered by some restrict the terms of exchange others can offer in any realistic hope that they'll be accepted. If the Giant supermarket near my home is charging $2.00 a pound for red peppers, the nearby Eddie's Market will not be able to charge a whole lot more than $2.00 a pound and still sell many peppers. Neither will other grocery store chains or the farm stands that open nearby in the summer. All will charge nearly the same price. There is strong regularity to the prices of red peppers at any place and time. This regulation is accomplished by each seller's reaction to the actions of his customers and competitors. In short, market forces regulate prices.

The same goes for quality. Customers won't buy peppers that aren't fresh and firm as long as they think they can get better peppers at another store. Grocers might wish they could sell peppers that are getting soft, but customers, along with the self-interested actions of other stores, won't let them. Their customers' choices and competitors' actions constrain--regulate--even the quality of produce they can offer for sale--let alone actually sell--because discerning customers spurn stores whose produce is consistently shabbier than that offered nearby. Stores in competitive markets cannot afford to put off these customers, so they maintain decent quality, even if they would prefer not to. In this manner, market forces regulate quality.

The example demonstrates a key fact: there is no such thing as an unregulated market, so long as the market is competitive and market entry is legal. Markets, by their nature, can never be unregulated. They are inherently self-regulating. The actions of every market participant constrain and influence the actions of other market participants in ways that make actions more or less predictable.

Thus, we face a choice not between regulation and deregulation, but between distinct categories of regulation: government regulation and regulation by market forces. The question naturally arises: Which process serves us better? That in turn depends on which of these processes is itself better regulated. Government regulation and regulation by market forces have quite distinct, and in some ways diametrically opposed, processes for their own regulation.

The process of government regulation is itself poorly regulated, because government regulatory agencies are legal monopolies, regulated by political bodies which are, in turn, poorly regulated as well. This political process of regulation, in which ultimate accountability is to the public as voters, is ineffective at assuring the quality of regulation itself. The process of regulation by market forces, by contrast, is itself well regulated because the enterprises that set standards of quality and safety in this process are themselves regulated by market forces. This market process of regulation, in which accountability is ultimately to the public as consumers of the regulated goods and services, is much more effective at assuring the quality of regulation.

Government Regulatory Agencies Are Unregulated, Unaccountable Legal Monopolies

Government agencies that regulate quality and safety are legal monopolies. Those they regulate are required to abide by the regulatory agencies' decisions; the regulated have no freedom to use different quality-assurance services from some competing entity instead. Government regulatory agencies are thus free of regulation by market forces and therefore not directly accountable to the public they are supposed to serve. They are indirectly accountable to the public through the political process, but that process puts such distance between the public and the government regulator as to leave that regulator effectively unregulated.

Consider some examples:

* Taxicab service is regulated by public service commissions (PSCs). Taxicab and limousine companies may not decline to follow the standards set by the PSCs and sign on instead with alternative enterprises with different standards of quality and different methods of quality assurance; the PSCs face no competition as they impose their standards, be they sensible or silly, cost effective or wasteful. The PSCs have a monopoly on the service of assuring the quality and safety of taxicabs and limousines.

* Bank capital is regulated by a web of agencies including the Federal Reserve ("the Fed") and the Federal Deposit Insurance Corporation (FDIC) Banks may not decline the attentions of the Fed and FDIC and instead choose to be inspected and certified as safe by, say, independent associations of banks that mutually guarantee one another's deposits. Hence the Fed and FDIC face no competition as they impose their standards, good or bad, systemically stabilizing or destabilizing. They have a monopoly on the service of assuring the soundness of banks and the safety of depositors' money.

* Drugs are regulated by the Food and Drug Administration (FDA). Pharmaceutical companies may not choose any other agency to test their products and certify their safety and effectiveness (at least for on-label use). The FDA faces no competition in setting these standards, even though the standards it imposes and the processes it mandates are excessively strict, time-consuming, and expensive. It has a monopoly on the service of assuring the quality and safety of drugs.

* Government schooling is regulated by boards of education and state departments of education. Government schools may not set their own standards for curriculum and teacher performance, nor embrace a different kind of curriculum, such as the Montessori approach. They may not choose to be accredited by some independent enterprise maintaining different standards. School boards face no competition in standard setting for government schools. They have a monopoly on the service of assuring the quality of K-12 (government) schooling.

Of course, the regulatory agencies discussed above do not have monopolies in the sense that no other provider of quality assurance is allowed to operate. For example, some taxi companies may distinguish themselves by enforcing particularly high standards of cleanliness and punctuality; banks could join associations that certify their exceptionally large capital cushions; and name-brand drug manufacturers try to distinguish their products as better than generics. In all these cases, however, the government regulator is the only quality assurer to whose standards all the enterprises in the industry must by law conform. Additional, optional requirements over and above what the government requires are allowed, but the government's requirements are mandatory for all. In this sense government regulators have monopolies.

The legal monopoly status of government regulatory agencies such as the PSCs, the Fed and FDIC, the FDA, and school boards is a problem. It means that when and if these agencies do a bad job of assuring quality in their industries, the public is stuck, because there are no systemic forces to improve the agencies' performance or replace them with better quality-assurance providers. And, often, the government agencies do a very poor job indeed.

First, consider taxis and other city ride services. Entrepreneurs have recently used smartphone and GPS technology to create new city ride services. All one must do to summon an Uber car is to push a button on one's smartphone. The Uber software signals the nearest available Uber car and shows it approaching on a smartphone map. The rider gets in, gives the driver...