Capitalisn’t: Who Will Regulate the Regulators—Stigler 50 Years Later

Speaker 1: Good morning from Chicago. We are excited to begin our two-day symposium commemorating the 50th anniversary of the publication of George Stigler’s seminal article, “The Theory of Economic Regulation.”

Bethany: I’m Bethany McLean.

Phil Donahue: Did you ever have a moment of doubt about capitalism and whether greed’s a good idea?

Luigi: And I’m Luigi Zingales.

Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.

Bethany: And this is Capitalisn’t, a podcast about what is working in capitalism.

Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?

Luigi: And most importantly, what isn’t.

Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.

Luigi: Have you ever heard the term “regulatory capture”? If you did and did not know where it comes from, you certainly want to listen to this episode, where we are going to provide you the excerpts of a very interesting conference that was organized recently by the Stigler Center to celebrate the namesake of the center, George Stigler, and the publication 50 years ago of the piece called “The Theory of Economic Regulation,” that really generated the idea behind the concept of regulatory capture.

Bethany: So, Luigi, this spring marks the 50th anniversary of the publication of George Stigler’s seminal article, “The Theory of Economic Regulation.” A central thesis of this paper is that, as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit. How would you summarize what his article said?

Luigi: Stigler tries to bring regulation inside the economic discussion. Regulation was seen as a way to fix problems created by markets, but it was not discussed as the product of a political process driven by politicians who have their own self-interest. He, in the paper, goes a bit extreme by saying that all regulation is simply acquired by the industry and designed with the interest of the industry in mind, so that regulation, instead of helping consumers, helps the industry block new entrants and make more profits.

But I think that the reason why his paper is so important is because a lot of economics used to be, “Oh, this is where the market fails, and if the market fails, you’re going to have regulatory intervention,” and no discussion was about, “Is this regulation functioning the way it is supposed to? Are there mistakes? Are regulators sometimes evil, sometimes good?” So, it brought the topic of regulation from a perfect fix into a part of the discipline. So, it was at the same time an enormous enlargement of the discussion and an enrichment of the discussion.

Bethany: Stigler’s insight changed the discussion in economics. Did it practically change the way regulation is enacted?

Luigi: That’s a very good question. I think that, yes, in the United States, for example, we started to see a deregulation trend in the late ’70s, and everybody associates deregulation with Ronald Reagan, but in fact, deregulation started under Carter.

Jimmy Carter: Bit by bit, we are chopping down the thicket of unnecessary federal regulations.

Luigi: And an economist, Alfred Kahn, who was very much influenced by all these ideas.

Alfred Kahn: We’ve made a good start on turning the gobbledygook of federal regulations into plain English that people can understand.

Luigi: And I think that without those ideas, probably the deregulation in trucking and airlines, and this is for the younger listeners, they don’t remember a time when prices of tickets were fixed. As a result, airlines were competing on quality.

Did you know, Bethany, that during the heyday of the regulated period, to fly from New York to San Francisco in first class, you would have a guy playing piano in first class, because the competition on quality was so intense? You were paying a fortune, but you had a piano bar in first class. That’s the time of regulation. And to send a truck across an interstate border, you had to ask permission for the price that you were paying. This is stuff that is hard to imagine today, especially hard to imagine in America. For foreigners, they always think America is free market, so, gee, this is anything but free market. That’s the kind of regulation that was eliminated, also thanks to Stigler’s insight.

Now, one application, already mentioned in the paper, is professional licensing. Actually, a former colleague of mine, who has now moved to Washington University in St. Louis, he’s an accountant, and he studied the accounting market. In the last two or three decades, different states started to increase the educational requirement for accountants. So, in order to get a state license to do accounting, you had to have, instead of four years, five years of college or equal education. He finds no effect of any improvement on the quality of accounting numbers, but you do find a significant increase in the wages of accountants. So, increasing educational requirements is a barrier to entry that reduces entry and increases the prices of the existing players, with a public interest in mind; we want to have better accounting, so we are going to increase the number of years they have to study.

Of course, surprise, surprise, the professors are all in favor, because that means more demand for accounting classes, more students and more money. So, you have the academic-industrial complex all pushing in one direction. It just turns out to be the wrong direction.

Bethany: Really interesting. So, I was struck by Cass Sunstein’s criticism of Stigler, and I’d love to know what you made of it. I actually thought one piece of his criticism was essentially implying that Stigler was a journalist, because he wrote that his original essay was more of a narrative than it was empirical science. I thought, “Aha, see, we journalists do have lasting impact through our narratives.” But anyway, I’m curious to hear what you made of that criticism, whether you expected it or whether it was unanticipated.

Luigi: Well, I expected Cass Sunstein’s criticism. I thought that, more to the point, Cary Coglianese added a very nice summary of what was wrong with the paper and also what was right with the paper.

Cary Coglianese: And so, I want to start by just highlighting a few weaknesses of the paper, but then go on to explain why, nevertheless, I think the paper has enjoyed so much impact.

Luigi: He went through a list of things, including that Stigler overclaims and that some of the key concepts are not well-specified.

Cary Coglianese: Even Stigler acknowledged the results were not very robust. He presented what he called “a modicum of evidence” for his theory.

Luigi: Then, he doesn’t cite enough of the existing work before him and all the stuff that we generally see in every referee report. Then, it concludes with the overclaiming of a key sentence, the sentence that people have repeated over and over again, as an example of his overclaiming. He said—

Cary Coglianese: “As a rule, regulation is acquired by industry and designed and operated primarily for its benefit.”

Luigi: So, there is no doubt that this is an overstatement, certainly based on the empirical evidence he had at the time. However, the interesting part that Cary pointed out, too, is that, to some extent, the reason why this paper made such a big splash is because, number one, it tells a dramatic story. He turns a hero, the public-interest regulator, into the villain.

Cary Coglianese: Any of you who have small children, you probably have watched the movie Frozen at least once. It’s a bit like Prince Hans, who at first seems to fall in love with Anna, but in fact is only manipulating her to try to scheme and take over the kingdom. That’s dramatic, and that’s part of, I think, what is so appealing about Stigler and so important, though, too.

Luigi: OK, and that is the Hollywood element of every good story, because it does have some real important element of truth.

Cary Coglianese: It’s actually capturing an important part of the reality of the regulatory process. Business interests simply do have a lot of influence, and the public-interest theory that held sway at the time Stigler was writing was indeed too pollyannish or naive.

Luigi: Then, the third point is that the paper, if you read the paper, not just the CliffsNotes version of it, the paper is much more subtle than it is given credit for. So, the nuances that are not in that statement are there.

Cary Coglianese: He recognized the industry was far from monolithic. He recognized that not every regulation was there to advance industry.

Luigi: But also, because academics and society were at the right time. One thing that Cary said that really struck a chord with me is, in 1964, the trust in the federal government was at its high.

Cary Coglianese: Seventy-seven percent of the public, when surveyed, said they had high levels of trust in the federal government.

Luigi: Then you had the Civil Rights Movement, Vietnam, Watergate. You had a dramatic drop in trust in government.

Cary Coglianese: By 1974, that level of trust was down to 36 percent or so.

Luigi: This paper was written exactly in that moment, and so it was easy to pick up for people who started to be suspicious of the government.

Bethany: So, I thought one way to think about Stigler’s work was, there is a line in his paper that I thought is still interesting today. He was talking about his insight as it applies to the field of banking, and he wrote, “The power to insure new banks has been used by the Federal Deposit Insurance Corporation to reduce the rate of entry into commercial banking by 60 percent.” A piece of data showing that regulation actually helped to protect incumbents in the banking industry.

I thought that maybe thinking about regulation of our banking industry through a Stiglerian lens is pretty interesting, because in some ways, to me, it shows the weakness in his theory and that clearly some regulations, particularly post the financial crisis, have been applied to banks that they don’t like and don’t welcome.

On the other hand, it has made new entrance into the field of banking quite difficult. We came out of the financial crisis talking about too big to fail, and we have too much bigger to fail now. And the question is, of course, what the rise of fintech and the rise of cryptocurrencies do to undermine that over time. I thought that banking is an interesting industry through which to think about Stigler’s insight.

Luigi: I think one of the things that emerged very clearly at the conference is that one of the details of his idea, or the way he applies it, is that the way the industry captures regulation is by making it difficult to enter the industry. This was clearly true of the trucking regulation that he uses in his paper, and it is clearly true of licensing, but it’s not true for every regulation. We cannot think that every environmental regulation is in that direction, and so on and so forth. So, it’s important to recognize that it’s just a piece of a more general theory of regulation. It’s not the whole thing.

Jennifer Nou, a colleague at the conference, said something very insightful. She said that the title of the paper is not “An Economic Theory of Regulation,” but “The Theory of Economic Regulation.”

Jennifer Nou: Perhaps it’s best to appreciate Stigler’s work for what he told us it was, which is a narrow theory of economic regulation, as the title suggests, and maybe that’s limited to price controls, barriers to entry in established markets. To the extent it’s been marshaled as a citation to engage in public, rational choice as a whole, perhaps we just appreciate it as a mechanism for generating falsifiable hypotheses. That’s all it is.

Luigi: Stigler is very modest in his title, saying it’s a theory and of only one aspect of regulation, which is the regulation that applies to some economic aspects. So, it isn’t necessarily true for privacy regulation, if you consider this as noneconomic. It’s just applied when you enter the economic sphere, and I would say, of a particular type of regulation. I think it’s very valuable in places where regulation can block entry.

So, as you know, at Chicago we don’t write cases in general, but I did write a couple of cases. One of the cases I wrote and I still teach is a case about a commercial fintech in Chile called Cumplo that started basically as a peer-to-peer lender, in a market where consumer lending has stratospheric interest rates.

The reason why I love that case is because it’s a very nice example of a Stiglerian approach to regulation, because the founder, before starting the company, goes to an uncle and asks this uncle, who is a lawyer, do you think I am violating any law by starting this peer-to-peer lender? The uncle said, no, I don’t think that’s the case. So, he starts the company. Soon afterward, not only does he receive a notification, he receives a criminal indictment for basically taking deposits without having a guarantee for deposits. He tries to negotiate with the bank superintendent about how to get out, but he pretty quickly understands that the bank superintendent has been pushed there by the legal counsel of all the other banks enforcing that regulation to preempt entry.

That’s a very clear example of a case where some regulation has clear benefits, in the sense that you don’t want anybody to take deposits freely—and even in the United States, there are rules against that—but then the enforcement is prompted by the industry to defend the industry. So, the part where the Stiglerian message is more valid today is the extent to which the regulation is shaped over time by the industry, because they are also the only ones who have a real interest is monitoring it every day.

For a while, I was interested in financial regulation when they were writing Dodd-Frank, but I didn’t keep up with every norm. If you are paid a lot of money per hour, you can think about reading all the stuff. You don’t read that stuff for fun or for public interest . . . You read a little bit for public interest, but there is a limit to that. So, the only ones who know the financial regulation inside and out are the lobbyists who are paid to do that. That really has a gigantic influence. But certainly, some regulation is introduced for at least an alleged public-interest reason, not for just blocking entry.

Bethany: You mention the humility in Stigler’s paper, the nuance in it, and I love the idea that when you really think about the title of the paper, there’s a certain amount of humility implied just in the way he titled the paper. I think that’s really interesting.

I also think it’d still be really interesting for someone to look at financial regulation post the crisis and through the last decade through a Stiglerian lens and figure out how much has been at the industry’s behest, how much has been shaped by the industry, and how much actually has been against their kicking-and-screaming opposition.

But lastly, as you were talking, it made me wonder if there’s a new element particularly in financial-services regulation, but maybe in our talk about regulation of technology, too, which is just complexity. When you think about financial services and regulation today, or technology and regulation today, the complexity is exponential from thinking about regulation of trucking firms, right? In terms of the amount of knowledge that is required to even understand what they’re talking about in certain regulations. So, the possibility for very capable, well-intentioned regulators to be misled simply by sheer complexity is, I think, a new element.

Luigi: It is and it’s not. Clearly, the world has become more complex, but clearly, the amount of regulation has grown faster than the complexity in the world. I think that the experts have a big responsibility here, because, on the one hand, the experts are enamored with the details and the technical aspects. On the other hand, they benefit tremendously from it, because that’s where their expertise is required.

As a lawyer, I love to write very sophisticated sentences and also sneak in some loophole that I can then use later on by being a consultant on the other side. So, this complexity is really part of the tricks of the trade. And I’m not just criticizing lawyers. I criticize economists, too. I think that we love our sophisticated models that, of course, require our sophisticated advice. That’s the reason why, in my 2012 book, I said we should make an effort to keep regulation simple, even if we give away a little bit of efficiency on the regulatory side. Why? Because we benefit tremendously on the political and monitoring side.

My example, and you can certainly relate to this, is think about the Volcker Rule versus Glass-Steagall. Glass-Steagall was mandating a separation between investment banking and commercial banking. It was very rough, and any graduate student worth anything can write a paper showing that this is inefficient, that you can have the most sophisticated mechanism to separate one or the other to reach the same objective. The problem is that once you make that distinction, a big nuance, then it’s very easy to lobby and very difficult to monitor. So, the Volcker Rule was the idea—

Barack Obama: Banks will no longer be allowed to own, invest or sponsor hedge funds, private-equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers.

Luigi: Which doesn’t mean you have an explicit mandate. It means that when you buy, in your mind you’re buying for a customer and not for yourself. Now, short of an FMRI, I don’t think you can determine intent. My claim is that the Volcker Rule was adopted precisely because it was unenforceable. Tim Geithner was between a rock and a hard place. He was between the rock of the banking industry to say, no F way, we don’t want the separation, and the public at large that said, we want Glass-Steagall.

So, he said, let’s do a complicated version of Glass-Steagall that has the most respectable name in the industry, Volcker, so we can pass it as a new Glass-Steagall, and we can let the industry do whatever they want, and in the process, full employment for lobbyists and lawyers. From the expert point of view, that’s the best of all worlds. I admit in the book that I changed my mind. I was initially not so keen about Glass-Steagall, and I changed my mind and said, I actually want short and sweet, even at the cost of being slightly economically inefficient, because it’s easier to enforce and easy to monitor.

Bethany: That is a cynical take on the Volcker Rule, but I have to admit I’m 100 percent in agreement with you, because, if you talk to anybody inside of a financial-services firm, they’ll say, distinguishing trading for your own account versus trading for a customer is next to impossible. But I think what you’re saying is that the most dangerous of all situations is when you have an already-complex industry, and we respond to that with really complex regulations that only the experts can understand.

Luigi: This could be applied to a lot of areas. Think about, in the digital world, you can have a sophisticated scheme to separate the various businesses of Facebook, or you can break up Facebook. And I say, I actually tend to lean towards the breakup, because it’s simple and clear rather than all this in between.

And, by the way, in this I’m 100 percent Stiglerian, because when he writes this paper in 1952, of course, he doesn’t talk about digital platforms, because they didn’t exist, but he talks about big business, and he says, breaking up big business is not only the right thing to do, it’s also the conservative thing to do. Wait a minute, what is conservative about breaking up big business? Oh, because the alternative is to regulate all the details, and those are extremely complex, extremely intrusive. At least if I break them up, it’s once and for all, and then we move on.

Bethany: That actually provides a really great, modern way to interpret or think about Stigler, which is that much of the regulation being advocated for in Congress by the big tech companies, now when we hear it, seen through a Stiglerian viewpoint, it’s because they believe they can shape that regulation to their advantage and keep out other players and help reinforce their power, rather than actually diminish it. I think that’s a very apropos insight, a very timely insight for today.

Luigi: Yeah. And actually, if I may say, what I would like to add, one of the speakers at the conference was an emeritus colleague, Sam Peltzman. He was a student of Stigler and wrote an important paper afterward, “Toward a More General Theory of Regulation,” in which he was the first one to open up a bit to this political game. He said, look, there are competing interests that are trying to influence the politicians or the regulators, and regulation is the result of competition among these interests.

Sam Peltzman: Once you have the regulation, you have a political process, and the public-choice elements can’t be avoided. All of them, the collective action, the information, they imply interest competition. The organized and informed group will always include the industry. And I don’t think there’s been any serious challenge to that aspect of the story.

Luigi: He writes in 1976, so it’s still a pretty black box, but I think that the theory of regulation we need now is a theory that includes the public pressure. So, now there is a big backlash against Big Tech, so there’s a huge popular demand for some form of regulation. The industry sees the writing on the wall, and rather than fighting, they join the crowd, trying to direct in a way that is most convenient to itself. I think that’s where the Stiglerian point is very powerful and very strong.

Bethany: I wanted to close by asking you, was there anything that came out of the conference that made you reevaluate your views on Stigler, that made you say, “Aha, this is something I hadn’t thought of before, or this is a new way to think about this giant in this field that hadn’t occurred to me”?

Luigi: One thing that Andrei Shleifer said that I thought was quite interesting is that in emphasizing that regulators can be involved in an exchange between some benefits for the industry with some public interests, actually, Stigler opened up the possibility of a discussion about corruption in economics.

Andrei Shleifer: And so, much of the economics of corruption, which has actually become quite a significant industry in research and economics, with, as you can imagine, a great deal of empirical evidence, is based very much on this Stiglerian idea of exchange between politicians and firms, which is to say, much of what some of what politicians get in return for favorable policies is bribes.

Luigi: What is very surprising, and I think that’s, if I may say, very puritan of the United States, corruption was not a major item on the agenda until the late ’80s. And I remember that a colleague of mine, who not surprisingly is Brazilian, wrote a paper about privatization, in which she was explaining how managers of state-owned companies could be compensated—translate bribed—by the bidders to have more information and win the auction in the privatization phase. And one of our professors at MIT said with scorn, “Oh, but that’s a model of bribing,” like this is absolutely indecent that an economist should study this.

The world has changed a lot since then in many ways, thanks to Andrei Shleifer and the impact of his work. But I think that, in a sense, Stigler legitimized the study of these aspects that are not particularly pretty, but are incredibly important around the world, but also increasingly so in the United States.

I think that this puritan view of the United States is kind of self-defeating, and I have to say that, over the years, I realized that coming in with my cynical Italian view, most of the time I’m right.

Bethany: Luigi, are there solutions to this issue?

Luigi: We discussed that at the conference. There was some interesting back and forth, especially with Jennifer Nou, who is an administrative lawyer, and she thinks that, for example, career civil servants could be a good deterrent to capture.

Jennifer Nou: These career civil servants are not only more insulated from capture, but I think that, to draw on public-administration work, there is a real culture of thinking about their own institutional roles as serving the public interest.

Luigi: And so are judges.

Jennifer Nou: Regulations, or the market for regulations, probably are more immune to capture because of the fact that we have Article III judges that are tenure protected, salary protected, and therefore will strike down the efforts of industry groups. For example, when the Chamber of Commerce challenged the Bipartisan Campaign Reform Act in 2003, the Supreme Court in McConnell v. FEC upheld the Bipartisan Campaign Reform Act, despite the best efforts of industry groups.

Luigi: With all the complaints we have about judges in the United States, we know that they tend not to be captured by one industry or the other. So, I think it is possible, but that method is not perfect either. Coming from a civil-law country with a lot of civil servants. I’m not exactly enamored of a bureaucracy, but I do see the tradeoff between political appointees that, especially in the United States, go back and forth with the industry very quickly, and civil servants.

But one point I would like to conclude with, because I think it’s very important, related to how capturable a sector and industry are, I think that the differential wage with the private sector is incredibly important and something that people have not paid enough attention to. Thirty or 40 years ago, for example, a judge was making probably either equal to or more than a law partner. Today, a judge makes one-fifth, one-sixth of what a law partner makes. Many regulators used to do maybe 30 percent, 40 percent less. Now, they make one-tenth of what they do in the industry.

I believe that a lot of people have a lot of good in their heart, and they want to help the public good, and they’re more likely to do it if it doesn’t cost them a fortune. So, you are willing to give up 20 percent of your salary to serve the public good, but you are not likely to give up 90 percent of your salary for the public good. We have forgotten that.

Bethany: It’s a really interesting observation, and when I’ve discussed with people as well about another pernicious impact of widening income inequality, and the increased gap between those at the very, very top and everyone else, which is this perverse notion that it actually also decreases effective regulation, because you end up with the best and the brightest, due to the incredible economic rewards of being in the private sector, not serving as regulators, whereas in a different day they would have. Precisely your point.