29th January 2011
When is it legitimate for a government to regulate?
Libertarians argue that a government should not regulate at all. That is not what classical liberals claim. They agree that there is a small but valid role for government in the regulation of our daily economic activities. The following extract from Breaking Free of Nehru explains this issue in some detail.
Individual Ethical Failures in the Marketplace
For both parties of a trade to genuinely become better off, they must both conduct the trade in good faith. If one, or both, deceive the other, then that interaction amounts to cheating, or worse, it can’t be counted as a trade. The smooth flow of markets thus depends critically on our personal integrity as actors in each transaction. Some people claim that markets are moral since very few people renege on agreements in their interactions with others. That is true, but the problem with this view is that it implicitly assumes that immoral transactions are also part of the market. But immoral transactions are excluded from markets by definition – markets comprise only those interactions that are both voluntary and moral. Just like assaults and murder can’t form part of social interactions, markets must exclude cheating.
But problems of cheating do arise and we need to discuss them. Problems can arise if there are discrepancies between what was agreed to and what is delivered. In some ‘trades’ people could get injured or even die. In others, the buyer or seller, or both, pass on costs to those who were not involved in the trade. To solve such problems we must hark to the theory of justice, not to the theory of market failure found in economics.
Free societies require individuals to uphold their accountability voluntarily. If they do not close the loop of accountability (see Appendix 1 for a discussion), the state must step in to provide justice. No free citizen is entitled to cheat, hurt, poison, maim or kill others. Such things, as we have seen, are not ‘market failures’ but individual failures of freedom. The government’s job in such cases is largely limited to ensuring justice after the event.Thefailure must be punished, preferably proportionately. Where a strong argument for deterrence exists, punishment could potentially be disproportionate, noting that disproportion is, in principle, unjust.
However, this is not considered to be sufficient by some people. They want the government not only to dispense justice, but to prevent individual failures. A free society does not buy into such arguments. Preventing ethical failures is not the job of the government. Our ethical behaviour is an individual choice that each of us makes each day. The government is neither our master nor our nanny. Therefore a government is not required in a free society to establish an army of inspectors to detect individual failures before these occur. An inspection implicitly assumes that the organization being inspected is potentially riddled with ethical failures which the inspector has come to detect. While this may be true in a few cases, this is not so for the vast majority of businesses. Therefore expeditions by inspectors to fish around for potential ethical failures are unacceptable. Not only do they pre-judge normal law abiding citizens, they impose unnecessary costs both on the businesses inspected and also on tax payers who foot the bill for such fishing expeditions.
In a free society no law-abiding citizen or organization is inspectedrandomly. The onus is on the state to prove that an individual or business is potentially guilty before taking away even one minute of an individual’s life for questioning. We tend sometimes not to consider an inspection as a penalty, but it is one – an imposition on our time and hence on our life. Diminishing our life even by one minute is a penalty which should be imposed only if there are good reasons. Detailed inspections should therefore occur only after preliminary evidence of failure has emerged. The focus of an inspection would then need to be exclusively on finding the evidence relevant to a prosecution. If an inspection doesn’t yield a successful prosecution, then the concerned business or citizen must be compensated for his or her time, and the head of the inspecting agency dismissed (or at least asked to apologize and explain). That is the standard of regulatory excellenceexpected of a free state.
At the same time, as we have noted, the vastmajority of transactions are completed honestly and without incident. That is because a trader’s (whether buyer’s or seller’s) reputation is crucial to his business. A trader who wants to succeed has to focus on building his reputation and displaying good character,[i]
or else that business will collapse. Indeed, in developed markets like the USA and Australia, reputational effects are so strong that most large trading organizations and franchises routinely take back products they have sold, and fully refund the sale price – no questions asked – for up to a month or more from the date of purchase. This is done even though it may be obvious in some cases that the products being returned were negligently damaged by unethical customers. This good behaviour of businesses, arising largely because of fierce competition for customer loyalty, must surely confirm some of our ‘faith’ in markets.
But then there are bona fide errors that take place; namely, accidents. Such accidents happen to all of us; they are not, strictly speaking, ethical failures and should hopefully not undermine our ‘faith’ in markets. For example, we sometimes go back from a shopping trip and find a rotten egg among the dozen that we bought. Indian roadside egg-vendors will usually verify the quality of each egg they sell by eyeballing it, i.e. looking through the egg against the flame of a candle to confirm that its yolk has not curdled. If, after that inspection, one egg out of twelve turns out to be bad when we start cooking it, we don’t go asking for government intervention, and generally ignore that error unless this sort of thing has been happening too frequently with the same vendor. Indeed, on our next visit to the shop, if we mention this bad egg incident, the vendor will most likely give us an extra egg free of charge, quite readily.
At other times, a seller may inadvertently under-quote and find later that he will make a small loss because certain inputs turn out to be dearer than he had anticipated. The seller will most likely take a small loss in such a case, and move on without expecting us to pay more. In brief, small departures from what was agreed to and what is delivered do not make us lose sleep about capitalism and free markets. Statistically, these two types (honest transactions, and those with minor errors or mistakes) taken together probably comprise 99.9 per cent of our experience (999 out of 1000 trades).
* * *
Now to the problem found in 1 out of a 1000 cases; of deliberate cheating and serious accidental failures. Primarily, three types of such failures take place:
i) significant variation in promised economic value;
ii) unintended but preventable damage to human life and health; and
iii) damage to people not involved in the transaction.
For the most part, markets establish preventive solutions to these potential failures of individual accountability on their own. As far as the government is concerned, its best contribution to these problems is to dispense justice quickly and effectively. It may, however, also have a facilitative role in establishing preventive mechanisms in some cases. Let’s discuss these three so-called ‘market failures’ – but in fact ethical failures or accidents – one at a time.
Significant Variation in Promised Economic Value
Relatively large departuresfrom what was promised and what is supplied are of concern, whether these are accidental or deliberate. Freedom means each of us being held to account; no one can make the excuse that there was an error in not supplying what was promised, and get to walk away from a major discrepancy. Such situations can also lead to litigation and conflict and waste a society’s time and resources. A free society generally tries to minimize such discrepancies through its voluntary initiatives.
The role of a government in such cases is largely restricted to creating an efficient legal mechanism for compensation. But while some such failures merely need to be compensated such as through liability insurance, others could be deliberate fraud, being ethical failures. Slightly less than 1 per cent of the human race seems to suffer from significant shortcomings of personal character.[ii]
Such failures in character spill into the marketplace equally as they infect other interactions of such people, as in a marriage. In other words, these people cheat in markets equally as they cheat in their relationships. These are morally challenged people. They could be sellers, but also buyers who steal from shops. While we tend to focus on ethical failures of sellers, we should not forget that customers, or buyers, are required to be ethical too. Large department stores have to invest heavily in security because, given a chance, about 1 per cent of the buyers will steal.
Markets work hard to minimize such failures through self-regulation. Following is an illustrative list of actions that markets voluntarily put in place:
- Consumers ask others, or check the internet about what others are saying about a company they are contemplating to deal with.
- Businesses and customers record in great detail the specifications they have agreed to, so there is no confusion about what is being purchased. Similarly, at the time of delivery, all sorts of signatures are usually taken.
- Businesses send out surveys to get customer feedback so that bad practices or bad staff members can be weeded out.
- Businesses formulate voluntary codes of practice and establish standards to be adopted as part of good corporate governance. These include the standards of the International Standards Organisation, a non-governmental organization whose membership includes private companies.[iii]
- Businesses develop internal practices to comply with voluntary industry standards. These practices include internal audits and quality audits carried out by external parties.
- Businesses join voluntary accreditation systems. A psychiatrist who plays fast and loose with his vulnerable patients, or a company that manipulates the true picture of its accounts, can adversely affect the reputation of that entire industry. Therefore psychiatrists form associations which accredit only good psychiatrists. These associations then identify, warn and ostracize unsuitable members.
All this, and much more, happens on its own, without the free society’s government getting involved in any way. Where businesses do not voluntarily act to minimize failures of accountability, and frequent instances of deception are found to occur, a government may have to consider a more active, temporary strategy:
- It may be productive use of the taxpayer’s money in some cases (very rarely, though!) to pay business associations to develop the capacity to self-regulate and undertake self-monitoring processes. They could also be subsidized initially to educate their members on best-practice.
- It may sometimes be productive use of a government’s time to get involved by providing comment on an industry’s self-regulatory practices to ensure consistency and alignment with community expectations. The goal in such cases is to maximize the quality of industry self-regulation.
- If an industry is demonstrably incapable of self-regulation despite such support, governments may need to directly regulate and establish ‘rules of the game’ temporarily; things like mandatory best-practice prudential norms or self-audit standards. A paper trail of compliance with these rules can then unerringly help to identify the specific person or persons within a business who has or have perpetrated a deception. Setting these norms would not necessarily require a government to conduct preventive inspections. For instance, the annual audit of company accounts to an agreed standard by chartered accountants should suffice to identify economic crime.
- Direct preventive government inspections may become necessary in order to enforce regulation where there is a very high likelihood of proven ethical failures. An instance may be the currently unregulated area of political party accounts in India. The political industry in India has failed to self-regulate. So a government could potentially not only impose regulatory requirements on the industry but also establish a limited program of inspections – with advance notice and focussing on high risk issues. Penalties for default would have to be high as well.
The last two regulatory approaches are getting increasingly heavy-handed and should be scrupulously avoided until absolutely necessary. As far as action after the incident is concerned, where the matter is significant, consumers can be asked to appeal to the business first, and if that doesn’t work, apply to the government to remedy the situation. The justice system then needs to kick in immediately and deliver effective punishment and compensation.
On the other hand, where the compensation will be less than the cost of obtaining justice, consumers can be encouraged to accept the loss and move on, noting that this does not preclude seeking justice where a person feels strongly about it. This situation can be remedied also by lowering the cost of providing justice. In both such cases, consumers can also dent the reputation of the business by denying future custom to the business and by telling others about the incident. Publishing the bad-incident story on the internet or writing letters to editors is also a good idea. This can make such accidental or ethical failures really costly for the business, and act as deterrence.
Unintended but Preventable Damage to Human Life and Health
A second type of major failure in in individual accountability takes place when a trader (buyer or seller) compromises the life or safety of another party through actions that are preventable with due diligence, caution and knowledge. Life is the ultimate yardstick of value – the most important thing of all. If someone has the knowledge or access to such knowledge on how to prevent a potential physical injury or death either in the workplace or during a trade, but does not diligently act to prevent such injury or death, then this category of harm is best treated as criminal negligence.
The wages that the owner of a coal mine pays to miners are for the services they render by digging up coal; the wages are not payment for the miners’ lives. If the owner has access to knowledge that can potentially prevent a coal miner’s death but either does not seek that knowledge or, having sought and obtained it, does not apply it adequately, thus accidentally killing the miner, then we must conclude that there has been an abuse of the employer’s freedom of action to engage the services of the miner. Accountability will then fall squarely on the owner of the mine, and require severe punishment. While there may have been no intention to kill, no one is free to be negligent when human lives are at stake.
While workplace safety or consumer safety can be enhanced through self-regulation, the fact that lives are potentially at risk calls for a higher focus on prevention. As the purpose of our having a government is to preserve our lives (preserving our freedom is only a consequential or derivative purpose), the government can place reasonable restrictions on our actions to prevent us from negligently injuring or killing others.
Examples of good self-regulation do exist in this area. For instance, large food companies generally maintain very high internal standards for food handling and storage. Given that I keep getting hit by diarrhoea germs even at relatively expensive restaurants in India, I prefer to stick to the much cheaper but hygienic McDonald’s or Nirula’s restaurants. Another example would be the International Safety Management Code developed by the International Maritime Organisation (IMO). While its content is periodically vetted by member governments of the IMO, and to that extent it is not exactly self-regulation, the implementation of the Code is largely left to the industry.
Preventive intervention by government on health and safety matters can focus on two main areas:
- Disclosure:Failure of disclosure of harm is a major ethical failure. Where businesses fail to voluntarily disclose the details of harmful effects of their products, it may become necessary to mandate such disclosure. This is particularly important as such information is generally not in the public domain. The onus must be on businesses to disclose harmful effects as soon as they discover them, with heavy penalties if it is found later that the businesses deliberately hid such information. Cigarette companies knew for long that cigarette smoking is related to significantly increased risks of lung cancer but did not disclose this information, killing millions of people in the meanwhile. It bears repetition of the fact that freedom is not license to kill.
- Mandatory duty of care: Employers must do their very best to prevent the accidental injury and death of their employees. Doing so cannot be optional. The government of a free society can therefore set performance standards, mandatory prudential rules[iv] as well as audit standards that will unerringly point to culpable negligence if and when it occurs. Such an imposition on our freedoms is acceptable particularly if it is tailored appropriately to the level of risk and achieves the safety outcomes efficiently. In other words, regulations relating to traffic safety,[v] public health and occupational health and safety, that seemingly restrict our freedom, are the standards we agree upon as a free society to protect our lives and, thus, our freedoms. These standards ensure that not only is accountability clearly specified, but accountability can easily be traced to the responsible person where failures occur. These regulations must, of course, be supported by a very effective criminal and civil justice system.
Damage to People not Involved in a Transaction
A third type of failure in accountability occurs when either the buyer or the seller or both – either through collusion, ignorance or negligence – pass on significant costs to others not involved in the transaction. This is the well known case of externalities (correctly, negative externalities) which has become increasingly more important with mounting evidence of the adverse impacts of mankind’s actions on the environment. The seller or consumer need not have knowingly harmed others. Even accidental pollution imposes real costs, as the greenhouse gases predominantly emitted by Western societies since the early years of the Industrial Revolution have imposed.
Do these greenhouse gases actually impact global climate? Yes, they do, though perhaps not to the extent suggested by most scientists.[vi]
The science of global warming has not been perfected yet. The impact of CO2
being logarithmic, there is likely to be a narrower upper bound, of around 2 degrees, on increase in global temperature irrespective of CO2
emissions, even as polar areas heat considerably more. Many species of life living in icy cold conditions will be adversely impacted. People who live there will also be adversely affected along with those living in low lying areas.
Since freedom is not a license to harm others, such damage must be compensated. Unfortunately, the problem of justice becomes complex in this case. The party, or parties, who engage in such harmful transactions often do not voluntarily disclose their polluting activities to others since both parties may have colluded to pass on costs to others. The affected parties may, of course,complain, but if the people affected are poor, as is often the case, their voice may not be heard. In some cases entire societies pass on costs to future generations knowing that these parties can’t complain at all, not yet being born! Each of these kinds of externalities is an injustice. A free society does not tolerate attempts to pass on costs to others.
The problem is that we are all guilty, to a lesser or to a greater extent, of such violations of justice. Our collective neglect of the environment has now created a situation where many animal and plant forms are seriously threatened, apart from the damage caused to millions of other human beings. As an example, each time we buy products made from a tree that has not been fully replaced, we pass on at least the following (small) costs to others:
- the cost of increased flooding and damage to topsoil is passed on to those who live downstream of the forest from which the tree was culled;
- reduced opportunity to make a living by those who make a living off the by-products of trees, such as tendu leaves used to make bidis (that bidis are themselves a cause of an externality is a separate matter);
- slightly less oxygen to breathe for all for all citizens of the world; and
- slightly higher temperature and excessive climatic variation consequent to the reduced absorption of carbon dioxide – faced by all citizens of the world.
In addition, there is a loss to the food chain in the wild, as well as loss of habitat provided by that tree to birds, bees and other animal and plant life. While I leave out the interests of plants and animals in the discussions here, these should not be ignored in a free society since our lives are intricately bound by the continuing success of all other species of life.
We note in this example that most affected parties are not likely to complain. More problematically, it is not practical for a government to identify the individuals who perpetrated this negative externality. It may, in any event, not be sensible to punish someone who may have purchased, say, only a few reams of paper in a year.
We note that the mere existence of such difficulties does not automatically create a role for the government. When the affected parties are mutually identifiable, externalities can be often resolved by the affected parties negotiating with each other. This suggestion was first made in 1960 by Ronald Coase in his The Problem of Social Cost
For a wide range of negative externalities, however, the government is best placed to ensure accountability and provide justice. It can do so in the following manner:
- First, obtain compensation for the damage caused. Where possible, a government can tax the parties that are likely to cause the damage and apply the tax towards compensating those affected. This method of securing justice is known as a Pigovian tax, named after the economist Arthur Pigou (1877–1959) who first discussed externalities. In the example cited above, a tax can be levied on each product made from trees that have not been fully replaced. The total tax should (proportionately) add up to the amount that the government would pay to those affected to clean up for the damage from flooding and to replenish oxygen in the atmosphere through subsidizing new tree plantations. We note that each tax has its own cost of administration and enforcement, so there has to be a judgement made about which product is taxed and which is not.
In the Online Notes
I have argued against the concept of excise duty or other product-based taxation in favour of taxation of incomes and wealth. However, where negative externalities have been identified in relation to a product, Pigovian taxes on products ensure that the buyer and seller will, together pay the true cost of the product. These taxes are best seen as a part of the system of justice,
not part of revenue generation for public goods.
- Second, where it is not possible to identify the parties that caused the damage, or to levy a Pigovian tax, or if the damage done exceeds the net value of the original transaction, then it could become necessary for the government to prohibit such transactions altogether.
An example of this sort would be the prohibition on smoking in bars. In such cases, the small damage potentially caused to bar workers by second-hand smoke from individual customers adds up cumulatively to precipitate lung cancer among some workers. Because particular individuals cannot specifically be held liable for such cancer, therefore there is a sound case to prohibit smoking altogether in bars.
- Third, there is the much more difficult case where damage is caused to a person or persons by people living across an international border.
Countries which were the first to make technological advances in the use of coal and oil products are ‘guilty’ of having (unwittingly) caused the emissions of large amounts of greenhouse gases. It is true that they are similarly ‘guilty’ of making the technological advances that have saved the lives of hundreds of millions of children across the world and helped to extend human longevity. The difference between these two, however, is that the West has been paid through the market for its scientific advances; and those transactions are therefore ‘complete’. In the case of externalities, though, the external costs imposed by the West have not been absorbed by the West. While we are not in a position to pursue an individual’s family for justice on behalf of a guilty dead person, nations, which are living associations of people, do not ‘die’ in that sense unless they are completely restructured. Therefore countries that have polluted the globe in the past are accountable for their actions and must step forward to compensate the rest of the world for this negative externality. This is particularly important given that the effect of increased CO2 emissions is logarithmic, meaning that most of the damage is caused by the early emitters.
The problem is that there are no cross-border governments. Social contracts do not run across nations. Consequently, neither compensation nor a reduction in the current level of emissions can be enforced. Compensation in such cases depends critically on good faith. But when large groups of people such as nations compete with each other, they sometimes lose sight of their own larger self interest. Various models have been proposed, such as the global trading of carbon emissions within agreed caps, but each solution works only to the extent that most (if not all) countries participate in these programmes.
My view on this type of externality is that advanced Western countries must abide by the principles of justice and freedom they themselves espouse, and show good faithin compensating the rest of the world before asking others to join them in a global emissions trading order. That will bring about the desired good faith response from countries like China and India. Absence of compensation is likely to make this a tit-for-tat race to the bottom and will expose the weak underbelly of the concept of nation states.
Where would such compensatory funds come from, for money surely doesn’t grow on trees? The answer is fortunately very simple: from funds currently deployed as foreign aid
. There is simply no basis for Western countries to continue with their extremely misguided concept of foreign aid[ix]
(see Box 1). Funds deployed in foreign aid should be almost completely stopped and diverted into greenhouse gas emission compensation.
It is worthwhile to remind oneself again that negative externalities are ethical failures
, not ‘market failures’. We therefore need to build systems and mechanisms to ensure that everyone is held to account. Freedom is intimately related to good governance; without it no country can hope to be free.A brief word on regulating the regulators. There is compelling evidence – including from the experience of India’s history over the past six decades – that regulatory bodies created by governments to protect us often end up protecting entrenched business and political interests instead, being ‘captured’ by them. In India, policy was often designed, if not tailored, to meet the anticompetitive needs of specific businesses which had bribed these regulatory bodies. The scarcity of goods and services that India faced during the peak years of socialism stemmed from the government’s preventing competition through its licensing and quota schemes. The poorly paid and ill-trained inspectorate in India is also often bought out by businesses, nullifying the purpose of their existence. Such regulatory bodies merely increasethe cost of goods and services apart from squandering taxes without providing a commensurate benefit of risk reduction or product disclosure.[x]
The free society therefore has learnt to keep its regulators in check. It does so by asking for greater disclosure of outcome indicators from regulators, scrutiny by Parliament and seeking contestability of policy advice. The regulator is not to be the provider of policy advice to government, merely a stakeholder. At the most basic level, though, good governance cannot be provided without good political representatives, which, unfortunately, we don’t have in India. Ensuring good governance is a major task cut out for us. I discuss some ways to meet this challenge in chapters 4 to 6.
Wrong Reasons to Regulate Markets
We can define markets that are minimally regulated in the manner discussed above, as ‘free markets’. This is what was meant by the qualifier ‘almost free’ used in relation to markets in the beginning of this section. In other words, governments provide post-incident justice and minimize individual ethical failures through regulation. In addition, there is a role for the government to specify the locations where markets can be established; this would be related to the zoning of towns and cities. This entire package creates highly disciplined free markets and generates the maximum possible wealth in a society. Regulating beyond the ‘free-market level’ of regulation has a great downside. It can only lower a country’s wealth potential without providing any additional benefit to the people.
In particular, there is no justification for intervening in markets on two commonly cited grounds: promoting perfect competition and promoting equality. Unfortunately, these reasons are cited even by most relatively free Western societies, and this approach holds them back from their maximum potential.
Daniel B Klein shows how ‘A habit of deceit is a mark of bad character, and bad character has a way of revealing itself no matter how cunning the individual. Deceit is both bad karma and bad business. I am inclined to agree with Montesquieu, Adam Smith, and Friedrich Hayek that commerce elevates manners and probity’, in Klein’s ‘Trust for Hire: Voluntary Remedies for Quality and Safety’, Reputation: Studies in the Voluntary Elicitation of Good Conduct, University of Michigan Press, 1997, pp.97–133. Information on an individual’s character is spread through a range of modes of communication including gossip, newspapers and electronic media including chat groups and blogs on the internet, legal case law, or even information that we pay for such as the magazine Consumer Reports in the USA.
Economists generally assume that we all possess a mild version of this ‘deceptiveness’ or ‘cleverness’ ‘opportunism’. They assume that we may short-circuit strictly ethical behaviour if there is no risk of detection. I cannot say that I have never pirated software, for example, or never used my official work hours for some personal business. The vast majority of us are not saints, but equally we’re not rascals. We are what is called ‘human’.
E.g. Standards Australia is a company limited by guarantee, with 72 members representing a range of industry groups, unions, professional associations and others.
Such as the obligation of the mine owner to spend time and resources to fully understand the risks to the safety of employees, and to exhaust all current knowledge on ways to prevent injury.
Traffic safety is not a market-related regulation generally, being a ‘rule of thumb’ of convenience, but there are elements in motor safety, such as seat belts, that may legitimately ‘impinge’ on our freedom (or more broadly, on markets) in the interest of safety.
In the Journal of Law and Economics
, October 1960. Copy available at
I have put forth more arguments at [http://sabhlok.blogspot.com/2007_01_01_archive.html]. I will also discuss this issue in more detail in my forthcoming book on the history of freedom.
This area of economic study is well researched and documented with George Stigler
, in 1971, leading the way. In his paper, ‘The Theory of Economic Regulation’, Stigler found that ‘as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit’.