Throttled by Compliance

Wednesday, March 2, 2011

On Sunday evening, February 27, 2011, Hoover Institution Senior fellow Scott Kieff and I addressed members of the Hoover Board of Overseers on a question that regrettably has risen to the top of the social agenda. What is to be done about the compliance culture—a culture born in response to excessive regulation—that now threatens to compromise the technological advances that have long spurred innovation in the United States?

Illustration by Barbara Kelley

This sad chronicle of relative decline takes place in three separate stages. The first involves the new mindset that too often finds harmful externalities and bargaining breakdowns in virtually all human endeavors. The second involves the bulky remedial structures that government puts in place to respond to these newly identified perils. The third stage involves the subtle alterations in the selection of the compliance culture: the rise government officials and key private officers and executives whose skills matter ever more in these more severe regulatory environments.

This three-fold progression is not specific to this or that industry, but applies across the board. In this essay, I shall discuss American’s compliance culture chiefly in land-use planning, drug development, and labor relations. Other industries could easily be added to the list.

Let’s start first with the issue of negative externalities. The traditional common law view used a narrow definition to cover negative externalities, those harms that were regarded as "cognizable"—those actions that should be met with a legal remedy. Topping the list of these actionable externalities were physical harms to the person and property of another individual. A sensible extension of that principle covered those nuisances like noises, odors, and pollution that damaged the lands of people.

Equally important is this: that somewhat mysterious word "cognizable" was intended to capture the critical notion that some human activities will cause certain types of harm to other people for which the law should provide no remedy. Most on that list where such common harms as blocking of views by new construction, building new structures that cast shadows over the lands of others, and constructing buildings that do not meet key aesthetic standards.

Note the difference between the two lists. The occurrence of common law nuisances is today a rare event that just about everyone thinks should be prevented. We should have confidence in this judgment because we know that when individual developers create subdivisions, their original deeds to new purchasers never allow them to engage in nuisance-like behaviors against people in the neighborhood. The clear implication of this uniform practice is that these harms always cause more harm than they do good.

Broad definitions of "external harms" and "bargaining breakdown" fuel superfluous forms of state regulation.

A second list of softer externalities is a harder nut to crack. These same developers often include covenants that are directed to protect interests like views, aesthetics, and light. The importance of these externalities to social welfare cannot therefore be denied. But the key point is that these restraints are put into place by developers who know that if they push too hard on these softer dimensions, the total value of the project will be reduced. Think of the system this way. With a uniform set of controls, each person is benefited and burdened in equal precautions. When the whole scheme is in place, either everyone or no one has to take the common outcome. Putting aside subtle differences, in general people who receive a benefit of $100 in protection from a common building scheme at a cost of $200 will reject the program, which is why it will not be offered in the first place. Hence, the dangers of private regulation by contract tend to be self-limiting.

Politically, however, this same game on land-use restraints plays out very differently when incumbent members of a local community are empowered to apply these restrictions to new entrants, while cleverly grandfathering their existing properties from those same set of restrictions. Consequently, the local boards and commissions will push far too hard since all the economic losses are now borne by outsiders who have either no say or only a limited say in the local political structure.

The upshot of this intervention is a vast increase in the regulatory apparatus. Precisely because these soft nuisances are so common, no one thinks that an endless array of private lawsuits supplies the best way to control them. It is of course too late to wait until the building is up before suing to take it down. So the broad definition of nuisance leads to the luxuriant growth of a permit process which has the ability to stifle development by drawing out the process with ever more expensive demands made by community members who dislike these unwelcome strangers.

Accordingly, the administrative process is geared up to allow for full participation by all interested parties, which now includes just about every protestor. Since the issues are so important, it becomes necessary to develop a peculiar mix of popular participation, technical expertise, and endless appeals. Ironically, a process of this sort also generates winners in the form of newly incumbent developers who try to raise the drawbridge to gain the extra monopoly returns by imposing restrictions on new entry. Virtually any regulation ostensibly advancing health and safety can easily be turned to anticompetitive purposes.

The third step in the process deals with the new type of people who are drawn into this vortex. On the government side, the level of discretion brings forth a wide group of public-minded citizens, who too often are determined to defend their communities against outside developers. These bodies are then readily lobbied by a set of activists of all persuasions who are intent on drawing out the process as long as possible.

Virtually simultaneously, the individuals drawn into the process change with each shift in programmatic emphasis. Hire people who know how to design, build, or market new construction? Of course. Beyond them, the big money goes to those talented impresarios who master the permit process that has come to overshadow the remainder of their business. The key constraints on new construction deal with aesthetics, affordable housing, handicap access, green technologies, and exterior design. These multiple layers interact in unforeseen ways. As the compliance culture grows, the innovative culture necessarily lags.

The second half of this jeremiad deals with the bargaining breakdown that is said to lead to market failure. Here again we have both the broad and narrow accounts of what counts as a bargaining breakdown. The narrower view stresses force, fraud, concealment, and undue influence. These events tend to lead to imbalanced exchanges where one side wins and the other loses in the negotiation. But these are infrequent in established business relationships, and where they crop up they are in general stopped by strong reputational constraints or by individual actions brought after the fact.

The broader accounts of bargaining breakdown turn on ideas of imperfect information and inequality of bargaining power, which have the same ubiquitous qualities as soft externalities based on appearance, shadows, and views. Yet gaps in information can be filled by many sources, from the internet, to brokers, to advisors. The alleged differences in bargaining power are best ignored altogether, because people of different wealth levels should always be able in competitive markets to make exchanges that benefit both.

Excessive regulations cause private firms to displace creative officers and entrepreneurial executives with the dull masters of compliance.

Yet once these two types of imperfections are elevated to social problems, the law gravitates toward an ex ante regulation that suffers from massive overkill. Constant systems of disclosure are the norm for dangerous drugs and securities transactions. The difficulties of overwarning are often suppressed. The legal system then makes matters worse by refusing to allow for safe harbors, so that standard warnings for standard products—whether pharmaceuticals or tobacco—can always be attacked on an ad hoc basis after the fact by individuals whose harm is all too easily said to follow from some narrow warning imperfection. For these people, fears of bargaining inequality have ushered in the rise of labor unions in the name of leveling the playing field. Yet that shift to a monopolistic collective bargaining model represents a huge transfer of power and wealth that has laid low many strong private firms and has put serious financial pressures on public unions.

These changes in legal rules lead to changes in social culture. The government intervention in markets opens the door for the enthusiasts that populate the Department of Labor. Third party interest groups try to exploit gaps in the legal system. As the regulatory noose tightens, the gains from entrepreneurship must be sacrificed to let persons who can work in a compliance culture take center stage. Securities registration statements become such exercises in caution that sensible people look elsewhere for information. Drug warnings are often so cluttered that people depend on their pharmacists to pass on a simple warning that reminds individuals not to take certain drugs with grapefruit juice. Union organizational drives and bargaining sessions become exercises in grammar and tone as firm managers must constantly beware that permissible predictions do not slide over into illegal threats. The types of people who are good at these regulatory tasks are not necessarily good at launching new companies, developing new drugs, or forging solid employee relations.

No one should be so reckless as to claim that these forces operate in all cases in all ways. We still have our wonderful success stories. Yet by the same token, no one should be so naïve as to think that these forces have no role to play in the loss of innovation and competitiveness in this country, a loss felt in both absolute and comparative senses. This loss has become an ever-larger feature of the modern United States.

There are some welcome signs that people are more alert to the risks posed by new rounds of regulation. It is now equally imperative that they beware of the flawed intellectual arguments that for too long have driven the downward cycle. Broad definitions of external harms and bargaining breakdown fuel extensive forms of state regulation, which in turn lead private firms to displace creative officers and executives with the masters of compliance who batten the hatches in the face of a storm. This rising culture of compliance bodes ill for America.