Interesting Exchange of Views Regarding the “Cost Disease”

Economist John Cochrane starts a recent blogpost by quoting a comment about the cost of regulation that appeared at Marginal Revolution (another economics blog). Here are some excerpts:

From my time in both the military and healthcare I can say that the biggest problem are the compliance costs. …

People worry that arcane institutions will somehow make off with lots of money and spend it either poorly or nefariously. Absent easily observed price and cost data in both sectors we began developing rules. These rules drive firms out of the market (e.g. we needed some light interior remodeling to comply with a regulation that specified inches between things, the contractor who has been most affordable and highest quality refused to bid because the hassle on his side was too great). Eventually the rules become too complicated and you start needing specialists to interpret them. Costs skyrocket and firms abuse rules to pad profits. Then the lawyers get involved and things get more expensive. Again, medical and military consumers become a captive market facing greater monopoly as fewer firms can navigate the thicket of rules to even try to make money.

Then we have the problem that people look at these sectors and say that it is public money. All public money should help with goal X (e.g. going “green”, affirmative action, boycotting South Africa/Israel, patriotism, “America first”) and then we become even more overly constrained. Find vendors who meet one hurdle is hard, finding ones that meet 30 is nigh unto impossible unless the vendor is engineering the firm to market solely to this niche – and charging monopoly rates as his reward.

Any single thing would not be too bad for prices, but the marketplace in general is diverging from military and healthcare. Even education is diverging with mandates in FERPA and political business constraints. We have pretty effectively restricted supply, why exactly would we not expect an increase in cost?

In response, Cochrane adds a few thoughts of his own, including:

It doesn’t take long to see in this post a reading of many contemporary economic ills. The perception of increasing monopoly power fits well. The decrease of small business formation and increasing size of businesses fits. And we can think of a number of industries that have the same problem. Banking is obvious. …

General aviation is a tiny, but clear example.  Go to your local airport, and contrast the ramp (where planes park) to the parking lot. The ramp is typically an excellent example of a Cuban used car lot. Lovingly maintained aircraft either from the 1950s or designed in the 1950s predominate.  Beautiful, yes, to nostalgic eyes, but not exactly practical. Small aircraft engines are much less reliable than automobile engines. Why? Well, they all must be FAA certified, and it’s not worth the cost to certify, say, a new model of spark plug. The parking lot is full of Teslas. Well, in Palo Alto. BMWs elsewhere. But stuffed with the latest technology. Planes are not inherently more durable than cars. They’re just regulated differently. …

The central point of the story is the interplay of new technology and regulation. Our technology has huge fixed costs.  Commercial off the shelf technology, usually “pretty darn good” is amazingly cheap and effective. Specialized technology written to constantly evolving regulation is nightmarishly expensive, and usually not very good. And leads to cronyism and monopoly. The cost of regulation is higher than you think. Make sure the benefits are appropriate.

And the comments that follow Cochrane’s post are also very good, including this:

I am a private sector PhD economist in banking regulatory compliance (model risk management). …

The end result of Dodd Frank is what we have now at my current employer. We churn out pages and pages of documents literally re inventing the wheel. …

There is a very real “fear of regulatory action” that the MBAs at the top go through, and combined with their ignorance on statistics, they tend to trust the quants that tell them they need to do things. So what do these ambitious managerial level quants want to do? Maximize the work! We write 100s of pages documenting work that is the equivalent of moving dirt from one place to another. If a quant really wanted to maximize the work (to have the most workers under them, all managers want to do this), they just say “we need to text all these things or else!”

As a result, I often see model risk management departments (I have been a part of 3) end up requiring 10% more each year from their model developers.

And this:

There is an interesting military analogy to your observation that private commercial aircraft lag behind regular automobiles and reliability and technical sophistication.

In recent decades, military aircraft have become hanger queens requiring greater numbers of hours of maintenance per hour of flight time. The F-22 requires 40 hours of maintenance for every hour of flight.

I look at my mini Mac, which is not failed in eight years of service, and has a computing power that a supercomputer used to have.

And this:

Notice too how this regulatory swamp doesn’t just reduce competition, it distorts the path of research and development. Engineers get paid not just to design better pegs, they get paid to fit square pegs into the round holes created by the regulators.

John’s right, most general aviation aircraft are exquisitely maintained antiques. But there is one exception, “light sport aircraft (LSA)” are designed and flown under a different set of rules. Not surprisingly, designers work to meet the rules, not to produce the best design. (For example, if you had to choose whether to make your aircraft safer or make it weigh less than 600kg, you would probably choose to keep things light and retain your LSA category.) Of course LSA’s are mostly toys for a handful of eccentrics but I’ve got to think the same thing happens in medical technology, defense technology and lots of other areas.

Jon Guze / Director of Legal Studies

Jon Guze is the Director of Legal Studies at the John Locke Foundation. Before joining the John Locke Foundation, Jon practiced law in Durham, North Carolina for over twent...

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