The Flawed Vision: Deregulation and Public Choice

The 1980s were rich with extravagant claims about the superiority of markets and the incompetence of government to make economic decisions. After more than a decade of the experiment in deregulation, however, the reality seems far more complex than this stylized vision. The environmental problems and savings and loan failures that now confront us were not averted by dismantling activist government. Indeed, the case for abandoning government's role in the economy was never as strong as its advocates claimed. It is time, therefore, to think again about how government can realistically improve our national well-being.

Support for the wave of deregulation that began in the 1970s came from liberal as well as conservative economists. But deregulation was pursued with single-minded vigor during the 1980s at least in part for ideological reasons. It embodied a political theory which justified the administration's distaste for activist government. That theory, called "public choice," was espoused by a group of market-oriented economists and lawyers who claimed to demonstrate two things: first, that an activist government is all but incapable of reaching efficient and public-spirited decisions, and second, that private markets do so routinely and automatically. According to public choice theory, regulatory policy results from a badly flawed political marketplace, which makes decisions based not on economic efficiency, but on the power of interest groups to use government to pursue private benefit at the expense of the general welfare.

This is no mere ivory tower conceit. Public choice theory played an important role in the economic policy of Presidents Reagan and Bush. The proposed balanced budget amendment, and other schemes to limit government or place it on automatic pilot, grow out of this body of theory.

And it may be with us for a long time. As the Supreme Court and the lower federal courts have grown increasingly conservative, they have begun to build public choice reasoning into judicial doctrine. In one very recent example, Justice Antonin Scalia, writing for the Court in City of Columbia, S.C. v. Omni Outdoor Advertising, removed from the reach of the antitrust laws monopolistic conspiracies between private parties and public officials, even when the official has used the power of his office to benefit personally from the deal. By recognizing no distinction between legitimate local regulation and blatantly self-serving betrayals of the public trust by local officials, Justice Scalia treats all local economic regulation the way the public choice model views it: as a simple rip-off of the public. And in the increasingly influential "textualist" approach to judicial interpretation, statutes and administrative regulations are read as narrowly as possible to ensure that the noxious influence of the legislature reaches no further than legally avoidable.

Where conventional economists acknowledged that market failure can justify selective government intervention, public choice advocates developed a general theory of government failure to justify a greater reliance on markets. They argue that the problems of newly deregulated industries exist, not because of the regulation that was removed, but because of the regulation that remains. The savings and loan debacle, for example, has been blamed not on the removal of regulatory safeguards, but on those still in place. Federal deposit insurance allegedly insulates bankers from market discipline when they invest their depositors' assets unwisely. Similarly, the problems of airline deregulation have been attributed to remaining federal regulation of airports and ground capacity.

Without this theory, decisions about which tasks to allocate to the public sector require careful case-by-case comparisons of the efficiency of unregulated markets with that of government regulation. With it, broad generalization seems possible. No matter how dubious the results of any particular deregulatory decision, the theory seems to suggest we should deregulate further, in the hope of reaching some holy grail of free markets, when the final miracle for private enterprise would be revealed.

As we shall see, however, public choice theory in fact has quite limited implications for public policy, even accepting the theory itself at face value. It makes no persuasive general case in favor of private markets and against activist government.

The Flight from Politics
In the public choice view, government regulation is fatally flawed because government means politics, and politics means trouble. Legislators do not serve the public; they serve themselves. Political advantage is said to flow from favoring the most powerful -- often the richest, most cohesive, and most vitally affected of their constituents. Smaller groups, in which each member is vitally affected by a governmental action, are likely to be more cohesive and politically effective than larger groups, like consumers or the general public. For example, occasional taxicab customers care far less about cab rates than do their drivers.

As a result, regulation often benefits the very industry it apparently controls. Governments may use regulation to limit the entry of new competitors into an industry, for example, and thereby convert it into a cartel, as with many of the licensed professions.

The form of political power available to larger groups -- the power of voting -- is often less effective than imagined, argue public choice proponents. Members of the broad, unorganized public have little incentive to vote: an individual can affect only infinitesimally the outcome of an election, yet bears significant costs in becoming informed and voting.

Therefore, in this view, activist economic regulation by government is a nearly hopeless undertaking. Interest groups will use the power of government to reap special favors for themselves, and distort even genuinely public-spirited legislation by influencing the administrative agencies which administer those programs. Because government is almost inevitably venal, it must largely be abandoned. We should return to free markets, to the benign, reasoned, and non-political judge-made common law, and harmony will be restored. Or, at least, so goes the argument. The reality is not so simple.

Markets and Rules
Contrary to popular belief, there is no such thing as a free market. All economic transactions take place in markets structured by law. Because contracts are enforceable in court, businesses can rely on the commitments of customers and suppliers. Because property rights are legally recognized, businesses and individuals can make investments with some assurance that those investments are secure. The traditional rules of contract, tort, and property in our society regulate even seemingly unregulated markets. The ability of markets to achieve efficient results will nearly always depend on the desirability of the underlying legal rules.

However "efficient" markets may be in responding to incentives, outcomes can only be as good as the incentives themselves. Traditional economists have pointed to a laundry list of "market failures," in which perverse incentives justify government intervention in private markets. Public choice proponents have responded that if market failures exist, they have their origin in some failing of the legal system. But if we cannot count on common law courts to produce the right result, we can count on markets to produce economically wrong results.

For example, market prices do not always reflect the full costs and benefits to society of every private action. Pollution costs are not included in gasoline prices, so drivers are free to ignore the environmental effects of driving. The "invisible hand" works, if at all, only in the presence of legal rules that allow an individual to reap the benefits, and that require him to bear the costs, of his actions. Before we can be sure that markets will produce economically desirable results, we must ask what assurances exist that common law rules produce socially desirable incentives.

Misdirected skepticism about government falsely constrains our response to market failure. Public choice advocates argue that in the gritty real world of politics democratic government serves whichever interest group is most powerful, not some abstract conception of "the public interest." True or not, that problem lies with politics, not with government. A decision not to enact regulation, or to remove existing regulation, has its origin in the same political process. Though political decisions are far from infallible, activist government may still be a desirable solution to the failures of a market system.

Any policy which makes activist government less available as a political option will direct interest group activity into preventing government actions which do serve the public interest but which harm their own well-being. It will also redirect interest group activity into the courts, which are not immune to its pressure. Building barriers to activist government does not eliminate the harmful effects of interest group activity, but it does rule out an available tool for remedying the failures of the market system.

There remains a positive role for government in our economy. This conclusion arises not out of faith in the sober efficiency of government, nor out of a belief that the role of special interest influence in our system of government is so small that it may safely be neglected. On the contrary. Regulatory solutions to social problems must remain carefully considered alternatives, despite their frailties, simply because the alternatives are vulnerable to the same frailties, and because there can be no determination, except on a case-by-case basis, as to which allocation mechanism poses the least risk of distortion of the public's welfare.

Markets and the Common Law
The case for free markets rests on the assertion that, with proper incentives, private behavior will coincide with the public interest. Individuals will generally respond as swiftly and as accurately as they can to the incentives of the marketplace, more swiftly and accurately than could any centralized decisionmaker.

Central to the case for the efficiency of free markets, therefore, is the assumption that the legal system appropriately structures incentives in the marketplace so that private individuals are led to behave in ways that serve larger social goals as well as private interests. If legal rules are not appropriate, market incentives can be dramatically counterproductive.

The old common law doctrine of "privity" in tort, for instance, protected a manufacturer from liability if the consumer was injured by a product bought from a retailer. Because the consumer had not bought directly from the manufacturer, the courts held that the consumer was not "in privity" (that is, not in a direct contractual relationship) with the manufacturer, and thus could not collect compensation. Manufacturers did not have to bear the full social cost of hazardous products, because the law allowed them to shift risks to retailers or consumers. This led manufacturers to be less concerned about the safety of their products than they should have been, and to invest too little in making their products safe. A legal rule now generally held to be incorrect led the market to produce an undesirable and socially inefficient result.

Because any economic system is vulnerable to the weaknesses of the legal rules that govern it, advocates of totally free markets have made two arguments to reassure us that these rules do not undercut the attractiveness of market outcomes. These claims have enabled proponents to insist that rules, however clever or foolish, are largely powerless to change market outcomes.

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The most powerful of these arguments emerged more than thirty years ago when Ronald Coase, an economist at the University of Chicago Law School, wrote a pathbreaking article titled 'The Problem of Social Cost." This article, which launched the modern "law and economics" movement applying economic reasoning to law, offered a startlingly original insight: Legal rules do not affect the allocation of resources at all, so long as the affected parties can negotiate a mutually satisfactory deal at no cost. The factory owner whose pollution afflicts his neighbors, for example, can be persuaded to clean up his factory's smoke by the lure of money. Whether the neighbors must pay him to reduce the smoke, or whether by law he must pay them for his right to contaminate the air, the amount of pollution and the factory's output will be the same.

This insight, now widely known as the Coase Theorem, made it possible to argue that mistakes in the legal system are of no consequence, so long as parties are allowed to negotiate their way to mutually satisfactory positions. As powerful a defense of the market as this is, it is vulnerable to the failure of its crucial assumption: that it is costless to negotiate. Without that assumption, markets will fail unless judges find the proper legal rules, allocating liabilities to the party best able to avoid or reduce the relevant cost. If a property right is assigned by the courts to the wrong party, negotiation costs will unnecessarily burden efforts to reach a mutually satisfactory deal, so not all desirable deals will be made and the market will not be as efficient as it could be.

Moreover, the Coase Theorem, like the entire structure of classical economics on which it rests, is vulnerable to the attack that it takes for granted the existing distribution of income. The claim is often heard, in court and out, that some contract terms should not be enforced, because they result from an inequality of bargaining power. Paying a monopolist to surrender his advantage is not a socially defensible outcome, even though it preserves the formal "efficiency" of the economic model. The law and economics model has paid little attention to the distribution of income.

A second defense of the common law and of the "unregulated" market, less logically compelling but powerfully appealing to many law-and-economics scholars, came more than fifteen years after Coase's paper. Richard Posner, now a U.S. Court of Appeals judge, was a law professor at the University of Chicago in the mid-1970s when he demonstrated that many common law rules were consistent with economic efficiency. This magisterial effort to explain vast areas of the common law in terms of a single theory seemed to indicate that something -- no one quite knew what -- drove the common law towards efficiency. A number of economists and lawyers, strongly influenced by the "invisible hand" conception at the heart of modern economics, leapt to a explanation: that an invisible hand mechanism inherent in the processes of courts also guided judges to efficient solutions, just as Darwin had argued that a kind of invisible hand led species to their ideal forms. The various arguments and speculations of these legal Darwinists, though not all consistent with each other, had this reasoning in common: the most efficient rules would survive the repeated scrutiny of courts, while less efficient rules gradually would become as extinct as dinosaurs.

Miracle of miracles, the common law could be relied upon to evolve over time to the best of all possible legal systems, and had already done so to an important degree. Even Judge Posner has acknowledged this argument is not fully persuasive, but at least it has this virtue: It has allowed the faithful to continue to believe that markets, if not always perfect, are nearly perfect and in the process of becoming more so.

Both the Coase argument and the evolution argument are clever and persuasive efforts to insulate the case for free markets from corruption by faulty legal rules. But neither is satisfactory. Let us explore the evolution argument, and then return to Coase.

Survival of the Efficient?
If, as Posner and other legal evolutionists argue, legal rules tend towards the ideal over time, then there is little reason to worry about those that are still less than perfect: they'll change. Rules that result in many injuries will also result in many court cases, providing opportunity for judges to change the law. If Ford Motor Co. is held not liable for injuries inflicted by defectively made Pintos, Ford will have little reason to improve the design. But when courts stumble onto a policy which results in fewer accidents, there will be fewer cases, and that new rule is more likely to survive, hi this way, courts supposedly blunder in the direction of rules that minimize the number of accidents. Since most legal problems have recurred for years, if not centuries, Posner would argue that the legal precepts which address those problems are reasonably likely to be right.

However, this logic fails careful scrutiny. Accidents may be costly, but reducing accidents is costly, too. The number of accidents and court cases will be smallest when safety expenditures are at a peak. In principle, one could expend infinite resources to minimize the risk of any injury. A truly efficient rule would not eliminate an accident if the costs of avoiding that accident were too great; rather, it would equilibrate cost and benefit. Therefore, the rule that results from an evolutionary process of simply minimizing the number of cases is obviously the wrong rule.

Besides, there is little reason to think that the rules most often implicated in extensive litigation are likely to change. A great many cases involve corporate law, for example. Does that mean the legal rule granting limited liability to shareholders is likely to change? Conversely, poor rules firmly adhered to by the courts are more likely to induce parties to settle their lawsuits than to press a futile challenge. Some criterion other than the frequency with which the rule is challenged seems to determine which rules are changed and which are not.

* * *

In historical fact, the evolution of the common law is rather erratic in its sense of direction. Tort liability evolved for decades, roughly since the 1940s, towards making tort cases easier for plaintiffs to win. Recently, however, many critics have become conspicuously unhappy with those changes, and some judges and state legislatures have reversed them. Over several decades, the states have reversed course more than once on basic issues of tort law.

The common law has also demonstrated an inability to adjust successfully to new problems outside the traditional framework of private law. The common law was largely unsuccessful in protecting the environment, for example, despite the significant social costs of environmental degradation. Prior to the major federal initiatives of the early 1970s, state common law proved largely unable to deal with modem environmental problems. The experience of federal regulation must be evaluated, not against some abstract ideal, but against the common law as it actually evolved.

Often, problems such as environmental injury simply cannot be solved in the traditional framework of litigation. Environmental injuries far distant in time and place from the injurious activity pose unusual difficulty for demonstrating cause and effect. It is extremely difficult to identify, years after the fact, the particular plaintiffs injured by exposure to asbestos or Agent Orange, or which of several manufacturers sold DES, an anti-nausea drug found to cause cancer in the daughters of women who took the medication, to a plaintiff's mother. Reliance on legal evolution in such novel settings necessarily subjects economic actors to uncertainty about the extent of their future liabilities. Efforts to assign liability in such cases have placed great stress on the liability system, and have had undesirable effects on the incentives facing insurers and manufacturers subject to indiscriminate liability.

On the other hand, a refusal by the courts to confront such difficult cases would leave injured plaintiffs uncompensated and would wrongly give manufacturers reason to ignore the long-distant effects of their actions. No remedy now in the purview of the courts appears adequately to address the problem.

Administrative remedies can be far more effective in dealing with such problems. By their nature, they define in advance the actions that should be taken by private parties, avoiding the need to assign after-the-fact liability. Administrative agencies can arrive at integrated policies which courts, by virtue of their necessarily reactive role, cannot. Courts are able to deal only with the case before them, and cannot establish rules for cases which have not yet happened. While agencies may choose not to exercise these abilities -- for example, in recent years, the federal health and safety agencies have been limited in their effectiveness, in part because of the political direction they have been given -- courts have nevertheless long respected the superior abilities of administrative and legislative bodies in arriving at such policy decisions, and have tried to avoid decisions which infringe on these "legislative" functions.

Furthermore, courts make mistakes. The broadening of tort liability over the last several decades was motivated in part by the desire to find "efficient" legal rules, yet has evoked intense protests by affected interest groups and their apologists. Now the courts, which are not entirely immune to political outcry, may be backing away from these changes. Hence, the dilemma: If we freeze the common law at the rules arrived at by the "old" courts, we surrender whatever efficiency gains are still in the process of evolution. If, instead, we allow the "new" courts to discard traditional rules and concoct new ones, we might as well let legislatures do the same; there's no telling which will be the less bad.

* * *

Efficiency may be a factor in determining legal outcomes, but it is far from the only factor. As many critics of regulation have pointed out, small, cohesive, and intensely interested lobbying groups have organizational advantages in pursuing their group interests which often overwhelm their more numerous but less effective opponents. These groups' advantages, however, do not cease at the boundaries of the political arena, but extend to the legal arena. As any client of any major law firm will testify, good legal advice is expensive -- and also very valuable. Whether pooling funds to finance legal battles through trade associations, or adopting a joint litigation strategy to press their common viewpoint, organizationally efficient groups will have the ability to pool resources more successfully than their opponents: after all, they are the very groups able to do so successfully in the political context.

Contrary to the "efficiency by evolution" view, a legal rule will be reexamined only when someone has the incentive and ability to bring it to the attention of the courts. Organizationally effective groups have greater ability to sustain continued assaults on legal rules than do groups less able to defend their interests. Laws with powerful and effective enemies are surely as vulnerable to evolutionary pressure as rules which are inefficient.

The fact that some law firms consistently charge substantially higher fees than others, and that their clients willingly pay the premium, means that high-powered legal services are deemed worth the cost. Expenditure therefore will often correlate with result. Groups better able to muster resources will succeed more frequently in establishing favorable legal rules, just as they seem more likely to succeed in the political context.

In sum, the "efficiency by evolution" hypothesis simply takes far too rosy a view of the legal process and the court system. There is reason to doubt that the rules chosen by the legal system evolve toward some efficiency standard, or are clearly better than the rules chosen by legislatures.

Is the Law Irrelevant?
The Coase Theorem offers no more reassurance than the legal evolution view. According to that argument, the legal regime really doesn't matter anyway as long as the parties are free to settle their differences out of court. If the courts give factory owners the right to pollute, victims may offer payment sufficient to persuade them to change their behavior. If factory owners are not allowed to pollute, they may buy the right to do so by paying potential victims enough to compensate for the injury the smoke will inflict. If the costs of reaching agreement are negligible, the Coase Theorem tells us it doesn't matter which side has the benefit of the law: the parties will reach an agreement that allows the same amount of pollution in either case. Most important, whatever the legal rule, the outcome will be efficient, in that the parties could not be made better off by further negotiations; that result, however, is held to be less likely with regulatory remedies.

But we have what we might call experimental data on the implications of the Coase Theorem. Negotiation under the common law is hardly costless. Recent experience with tort law reform suggests that changing legal liabilities have had dramatic effects on resource allocation.

* * *

Over the last few decades, many state courts have dramatically extended tort law to reach defendants more easily, to expand the size of damage awards, and to permit more plaintiffs to file suits. "Strict liability" has replaced negligence standards in many contexts, making a defendant liable for his actions even if the defendant took all reasonable precautions to avoid harming the plaintiff. That makes life much easier for plaintiffs than the negligence standard, which, by contrast, holds the defendant free of liability if he can show that he took reasonable precautions.

Defendants are also liable for a much broader range of actions than they once were. For example, the doctrine of tort privity has been largely abandoned. Standards of proof have relaxed, making it easier for plaintiffs to assign liability to defendants. Both jury damage awards and settlement amounts have risen on average, and very large awards have become much more common. And the volume of tort litigation has expanded significantly in response to these incentives.

These changes in the legal regime have had significant effects on the activities in which potential defendants engage, and on the willingness of liability insurers to provide coverage. There is some indication that insurance companies have refused to offer coverage for environmental liability, such as for the cleanup of toxic waste sites. Hazardous waste management facilities apparently have closed because they have been unable to obtain insurance. Pollution control firms have refused to undertake toxic waste projects. Doctors and hospitals also have changed their practices, responding to the increased frequency and severity of medical malpractice awards. Some doctors have stopped providing certain services, or have withdrawn from practice altogether, in response to increased legal exposure.

Indeed, both contract and tort cases necessarily involve significant transaction costs. Such dramatic implications of changing legal rules for resource allocation are simply inconsistent with the Coase hypothesis that legal rules are irrelevant, or costless. What may well be the wrong set of tort liability rules may have dramatically distorted the behavior of persons providing inherently risky services, and of the insurers which once protected them. Changes in an integrated body of legal rules, contrary to Coase, have had substantial effects on the allocation of resources. This seems to suggest that legislative intervention can sometimes improve on the way the common law resolves complex legal disputes.

One must conclude that the legal regime is frequently relevant to market outcomes. The possibility of incorrect legal rules suggests that decisions about public intervention in markets cannot be resolved a priori, but only by case-by-case analysis of particular market problems and proposed regulatory remedies.

Democracy and Its Dangers
Neither the evolutionary argument nor Coase's legal irrelevance argument can assure us, then, that the common law will work in perfect harmony with efficient markets. It should come as no surprise that the law made by human judges is not always completely perfect; that it is influenced by the resources that litigants are willing or able to spend. And if judges make mistakes, then there is at least the possibility that even an imperfect legislature can on occasion promulgate better rules.

There is, after all, no law of nature that the groups which oppose government action must be weaker or more virtuous than the groups which support it. Cases surely arise where the opposite pattern holds. Interest groups have much to fear from an activist government and surely organize to oppose government action. As a result, the defeat of a proposed governmental action is not necessarily less "special interest" in nature than its victory. Politicians, lobbyists, and activists have long pointed to the power of special interest groups in op posing regulation. One would expect at least some cases in which the absence of government, rather than its presence, indicated special interest influence.

For example, tax cut legislation giving favorable treatment to a group is quintessential special interest legislation, though it reduces government's role in the taxed activity. Consumer protection legislation in the 1970s was defeated because business lobbyists saw it as a threat to their interests. That legislation would have allowed consumers injured by defective products to file class action lawsuits against the manufacturer, enabling consumers to share the otherwise prohibitive costs of a lawsuit, and thereby making available to a "class" the same relief the legal system would have provided to an individual litigant.

Labor law reform in 1975 would have strengthened federal protection for unions in representation elections. Business groups organized a campaign against the bill. Hundreds of business lobbyists worked against it, spending an estimated $5 million, and successfully defeated it. In what sense was the defeat of the bill less "special interest" in nature than its passage would have been?

Why, indeed, should deregulation have succeeded politically, as it did, if regulation so well served the powerful interest groups which allegedly dominate our politics? The success of deregulation implies either that those groups can be defeated (in which case regulation at times will serve the public interest), or that deregulation came to serve the interest of those very groups that previously had sought regulation (in which case self-serving interest group politics can result in smaller, less activist government). Either conclusion is inconsistent with the policy prescriptions of the public choice school.

Special Interests and Common Law
Interest groups can direct their energies to the preservation of market imperfections from which they benefit. Each market failure develops a constituency that benefits from the continued existence of the market failure, and therefore has an incentive to oppose a governmental remedy. Members of cartels, or monopolists generally, prefer market failure to efficient but competitive rates of return because the market failure is the source of their monopoly profits. Similarly, the failure of the courts to assign liability to the appropriate party, or to assign property rights completely, is likely to call forth opposition to legislative correction of the error. The classic remedy, a tax on an externality-generating activity such as the output of a polluting factory, obviously would be opposed by the party on whom the tax would fall. Alternative remedies to externalities present similar problems.

* * *

Suppose property rights in the environment could be assigned to one party or the other; absent strategic efforts to deceive by either party, this could correct the externality. Nevertheless, the assignment of a property rights will be opposed by the group to be denied the right. The property right may be inappropriately assigned to the wrong party or may fail to be assigned altogether. In any case, if courts have not assigned property rights completely though they should have done so, what appeared to be a failure of the market is a failure of the common law. In either case, a legislative remedy is necessary.

Because lobbyists do at times find it in their interest to oppose government actions, efforts to limit special interest politics by imposing judicial or constitutional constraints against activist government can only be self-defeating. Lobbyists working in this changed environment would note that the probability of success in opposing government action had become higher. Opposition to action therefore would be a relatively more certain investment than it is now. This would reduce the likelihood that desirable legislation would be enacted and raise the odds that government will fail to act even when it should.

Because common law rules can be critical to the efficiency of a market economy, and because policies which diminish the ability of government to act affirmatively can redirect interest group activity into the common law, there is a risk that such policies would increase the distortive effects of the common law by raising the role of interest groups and diminishing considerations of efficiency in the formation of common law rules.

Posner has argued that interest groups will have no advantage in court, because the judge, enjoying life tenure and subscribing to a code of judicial ethics is beyond the influence of the kind of virtual bribery that public choice theory routinely ascribes to the legislative process. However, the power of organizationally efficient groups is not limited to the public choice concept of buying votes legislatively.

Interest groups can also overwhelm their opponents by the infusion of resources into a court battle. The legal process can be manipulated by bringing repetitive cases, forcing one's opponent to defend in multiple jurisdictions, infusing attorney resources into the development and researching of multiple issues

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