Colombo Telegraph

Regulatory Capture: The Worst Public Enemy Imaginable

By W.A. Wijewardena

Dr W.A. Wijewardena

The banning of sand mining in rivers in Sri Lanka

In 2008, Sri Lankan authorities, supported by its Supreme Court, banned sand mining in rivers and internal reservoirs. The measure was well-intentioned as proclaimed by many experts on the subject. According to them, sand mining in rivers had caused irreversible environmental damage. Some of these damages had been documented and could not be ignored: Sand mining had caused sea water to seep inland through receded river mouths, destroyed the now fragile river banks and lowered the water table in adjoining areas making the land dry and unsuitable for cultivation. On top of this, rivers which are the main contributors to the natural formation of Sri Lanka’s sandy beaches by depositing the sand which they carry constantly could not do, according to experts, their job effectively without a sufficient quantity of sand available in them. Hence, the country faced the risk of faster sea erosion which had to be prevented through artificial means at great costs. Hence, despite the unaffordable increase in the price of sand which in turn raised the cost of construction, everyone hailed it as a public policy taken in the right direction. So the hope of the public that the measure would bring overall good to society ran very high and there was no doubt about its failure on any count.

The abuse of the good-intentioned public intervention

But the outcome of the measure as was unravelled subsequently was different. As had been predicted by economists a few decades ago, the good intentioned public policy had been captured by ‘captors’. The list of the captors in this case has been too long: Politicians, underground gangs, local officials, law enforcement officers and truckers. The result: Sand mining in rivers went on unabated, river sand was still supplied to those who could afford the new high prices which went up in multiple terms and many people who were strangers to this business made money out of the banned economic activity. But who paid those strangers who made money? They were the people who used river sand for constructing residential and commercial buildings on the one side and tax payers who financed the public construction programmes which have now been inflated due to the increases in costs on the other. Consequently, a good intentioned public regulation had gone sour.

Regulations are automatically captured by interest groups

The sad fate of sand mining regulation and of many other public regulations – from utilities to finance to banking to consumer protection and so on – is an undesired consequence of regulation which economists now call the ‘regulatory capture’. In fact, it was the Harvard University’s political scientist Samuel P Huntington who first came up with the idea that interest groups have incentives to influence regulatory agencies in a paper published in 1952. But the formal development of the concept in terms of economics was done by Chicago University economist and Nobel Laureate, George J Stigler, in 1971in a paper published in the Bell Journal of Economics and Management Science under the title “The Theory of Economic Regulation”. The term regulatory capture was not coined by Stigler, but by another political scientist, Marver H Bernstein, formerly at Princeton University and at that time President of the Brandeis University, in a paper published in 1972. In this paper titled “Independent Regulatory Agencies: A Perspective on Their Reform”, Bernstein said that “most familiar charge against independent commissions is that they develop an orientation toward the views and interests of their clientele and become ripe for capture” thereby giving birth to the term regulatory capture. Today, the regulatory capture theory in public policy is a well established proposition and it represents the main arguments presented for establishing the failure of the government. Hence, the need for eliminating the same in the public policy system is as important as eliminating bribery and corruption – another important source of the government’s failure.

Regulatory capture is a source of government failure

The regulatory capture means that the regulations imposed by governments for the benefit of the public are being captured by those who are to be regulated or by others who stand to gain out of regulatory mechanisms. For instance, a government, with all the good intentions, may impose regulations on, say drug companies. But the drug companies have all the incentives to get the regulation which is hostile to them turned to their advantage by diluting its intensity thereby defeating the purpose of regulation. For this, they start financing the politicians, physicians, researchers at the drug administration agencies and law enforcement officers and take the regulatory mechanism under their control. Since the regulations now serve not the public but those who are supposed to be regulated, the whole regulatory mechanism has been captured by them and that process is termed regulatory capture.

Action to correct market failure leads to government failure

The regulatory capture theory throws light on a paradox in public policy. Public policy is justified and regulations are imposed in order to correct a situation which economists have identified as “market failure”. Market failure means that the market system does not bring about an ideal situation because of the presence of monopolies, self-interest driven businessmen who are more powerful than consumers, people causing harm to others without paying for their sins known as ‘external costs’, in the opposite people benefiting from the fruits of others without paying for same known as ‘external benefits’ and the need for producing and supplying of beneficial public services collectively known as public goods. Hence, it has been argued that societies cannot rely on markets and, in wider public interest, the governments should intervene in the markets through appropriate public policies. These policies involve the setting up of governmental agencies financed by tax payers and those agencies seek to achieve their objectives by imposing regulations on businesses or citizens. The underlying assumption is that the market failure has to be corrected by governments which are not supposed to fail in their enterprises. However, the regulatory capture theory suggests the opposite.

Tolerating market failure may be preferable to subjecting to government failure

Gary Becker, Nobel Laureate of Chicago University fame, in a paper contributed to the first issue of the Journal of Law and Economics in 1958 under the title “Competition and Democracy”, asked the question whether the existence of market imperfections does justify the governmental intervention. He went on to answer this question by saying “no”, if the imperfections in government behaviour were greater than those in the market. The regulatory capture theory suggests the imperfections in the governmental behaviour are greater because the governments are captured by interest groups including the politicians. Hence, by allowing these groups to run an economy, societies lose on two counts. Count number one is that the objectives of the regulatory mechanism are not realised and they simply become a waste of public funds. Count number two is the more stressful development: It says that the regulatory mechanisms, however much they are well-intentioned, create a class of people who prey as predators on the honest work of the members of the society. This class consists of politicians who are paid for by groups intending to capture the regulators, people on the regulatory agencies themselves and businesses and people who capture the regulators. This class thrives in a society and eventually emerges as monsters that cannot be tamed because they capture the political power as well. To support their monstrous activities, they bring under their control the regulatory agencies, media, the police and other law enforcement agencies and the judiciary as well. Eventually, society’s wealth is misdistributed in favour of the regulatory captors who have all the incentives to impose more regulations because they stand to gain out of them.

Self-interested politicians defeat libertarians

This is the crux of the battle between the libertarian economists and the centre to left economists in 1970s. The libertarian economists respected freedom to hold and develop private property for one’s benefit, act according to one’s conscience without the fear of being persecuted and participate in political processes as effective members of society. This calls for adherence to democratic principles at all levels. In the opposite, the centre to left economists argued that restriction to democracy is justified on the ground of providing greater benefits to some and correcting the perceived evils in the economic system. This battle was won at political levels defeating the libertarians and deciding in favour of the latter group of economists. They were supported by politicians, bureaucrats and public policy makers since they all stood to gain out of a regulated economy. The result was the inundation of economies with various types of public policies which were all introduced with good intentions but eventually captured by interest groups.

Hayek: Capitalism is needed for democracy to work

Nobel Laureate Friedrich A Von Hayek, in a publication as far back as 1939 under the title “Freedom and Economic System”, argued cogently for democracy and capitalism: He said in this book that “It is often said that democracy will not tolerate capitalism” summarisng the popular view at that time that true democracy requires the institution of socialism in a society to ensure a fair deal to everyone concerned. But Hayek said that capitalism means a competitive society based on a free disposal of private property and it is only capitalism which makes democracy possible. In his 1944 book, The Road to Serfdom, Hayek further elaborated his point by arguing that socialist type of economic planning and hence, economic regulations, lead only to make mankind serfs depending on the benefactor – handouts passed by feudalist aristocracies. Going by Hayek, Gary Becker in his article in 1958 argued that it may not be preferable to regulate monopolies. He said that it maybe preferable to suffer the ill-effects of monopolies rather than subjecting a society to the ill-effects of political imperfections. Hence, the government failure with all powerful politicians running an economy, according to these economists, is more costly than the perceived market failure.

The life cycle of a regulatory agency

Marver H Bernstein in his 1955 paper has presented a life-cycle for a regulatory agency and according to that life-cycle a regulatory agency has to die one day. This resembles the law of nature relating to natural phenomena: Every natural phenomenon has a birth, existence and eventual death.

Gestation: Regulator lives in the past

Similarly, Bernstein said that every regulatory agency will pass through four stages, namely, gestation, youth, maturity and old-age. According to his observations relating to USA, within about 20 years all regulatory agencies complete this cycle. In the gestation period, the regulatory agency which is created as a solution to a crisis starts growing into a regulator, but based on a statutory structure which is out of date by the time it is enacted. Hence, the agency lives in the past forever. To justify its existence and funding by the tax-payers, it focuses on short-term issues rather than thinking of long-term sustainability of an economy.

Youth: Desire to be a crusader

The youth of the agency is marked by an era characterised by desire to act as a crusader in a conflict-infested environment. Hence, it is guided by vague objectives and to make the matters worse, it lacks experience and knowledge. This makes the agency more vulnerable to interest groups which are more knowledgeable and experienced. It starts losing public trust and support from politicians because those who had earlier established the agency have now retired from political life. The new occupants to the political office do not have the same vigour of continuing with the agency’s work.

Maturity: Reactive instead of being proactive

The agency goes through the maturity period by developing a passive outlook and apathetic approach to issues. It usually reacts to events instead of being proactive and hence, its interventions are too short and too late. It starts to maintain good relations with those who are to be regulated and therefore, the intensity of regulation gets diluted substantially. With inefficiency creeping in, a backlog of cases accumulates and the agency fails to perform its job properly without hiring additional staff which is resisted by Treasuries on the ground of controlling public finances. The result is the agency becoming less and less active in its field.

Old-age: As good as being dead

The old-age is equal to the status of a retiree from the public service: No longer interested in keeping the knowledge base updated, unwilling to change, declared commitment to maintain status quo and becoming irrelevant in the eyes of those who are being served. The staff increases in number but declines in quality since the old-hands are promoted to high position without regard for ability or efficiency. Thus, the management becomes poor and the agency sets to have a cordial working arrangement with those who are to be regulated. Increasingly, it comes under pressure from politicians who do not allocate funds for its modernisation unless it becomes servile to their interests. Overall, the agency becomes senile with debility built into the whole organisation and is as good as a dead man.

The public succumbs to crafty propaganda of politicians

Thus, good public policies which are introduced with so much of hopes at the time of introduction become perverse to the society over the natural life span of a regulatory agency by allowing itself to be captured by interest groups. Though this is known, the demand by politicians and the public is for more and more public policies and regulations. The politicians do so because they stand to gain. The public does so because they are made to believe that regulations are for their benefit through effective propaganda aiming at arousing patriotic, nationalistic or religious feelings.

How to limit the regulatory capture?

After the bad experience with regulatory capture in the last century, an independent think-tank called The Tobin Project based in Massachusetts in USA implemented a special project on regulatory capture in 2009. Its report titled “Preventing Regulatory Capture: Special Interest Influence and How to Limit It” is to be released shortly by the Cambridge University Press. However, the papers in the volume have been released to the web for free use by the interested scholars (available here ). The papers have argued that to limit the regulatory capture, consumer groups have to be empowered to check on the influence of the industry on regulators, the court system should be strengthened to review the regulatory action and declare whether it is legal or illegal and a central review system of the regulatory action should be established with powers to look at the regulatory work from both prospective and retrospective points of view.

The rule of law and an independent judiciary a must

Since the consumer groups, judiciary and central review agencies can also be manipulated by the special interest groups, especially all powerful political authorities, the whole issue boils down to three basic requirements to be put in place. They are the observance of the Rule of Law, the preservation of the independence of the judiciary and respecting the work done by both formal and informal institutions that have dedicated themselves to eliminate the possible regulatory capture by interest groups.

*W.A Wijewardena can be reached at waw1949@gmail.com 

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