The Bear’s Lair: Playthings of the regulators

Volkswagen’s attempt to “game” the U.S. emissions control system and its abject failure to do so have put another industry, automobiles, to join banking, energy, education and healthcare in the hands of the world’s regulators. Massive fines will be imposed, shareholders will be robbed, and companies’ business strategies will be directed by the whims of an elite that is unelected either by the people or the shareholders. The system resembles feudalism rather than capitalism, and it is spreading across the global economy with alarming speed.

In the automobile industry as in several others, regulators have intervened without proper calculation of costs and benefits. The Corporate Average Fuel Economy standards, first imposed in 1975, wrecked the U.S. automobile industry and allowed the imported marques to become dominant – at a huge cost to a million auto workers, however much good it did to Japan’s balance of payments. The repeated tightening of the CAFÉ standards with the global warming hysteria of the middle 2000s has now imposed fuel economy demands that ratchet up to a level in 2025 that will be impossible for manufacturers to meet without appallingly dangerous compromises in automotive safety, as the unfortunate American public attempts to navigate superhighways in the equivalent of Fiat 500s.

In the emissions area similarly, U.S. standards on nitrogen oxide emissions are more rigorous than those in Europe, probably because the U.S. wishes to discourage rather than encourage diesel engines, not a strength of U.S. manufacturers, which are especially prone to emitting the genuinely mildly harmful nitrogen oxides, rather than the largely benign carbon dioxide. (Carbon monoxide is genuinely harmful, but has been reduced to very low levels by catalytic converters.)

Here Volkswagen’s arrogance and stupidity kicked in, and played a major role in turning an unimportant marketing problem (Volkswagen sells few diesels in the U.S. market) into a life-threatening corporate disaster. Being German engineers, Volkswagen’s top and middle management naturally had little regard for the competence of U.S lawyers, who sit on government bodies and ignorantly set emissions and fuel economy standards that are impossible to meet without hopelessly compromising German engineering designs that were the principal attraction of German cars for American buyers.

I have considerable sympathy for the Volkswagen engineers’ view of the EPA, and I believe the world economy would be in much better shape if regulators of their kind did not exist. However Volkswagen by resorting to cheap technological trickery to make a mockery of U.S. emissions regulations was asking for trouble. There was no chance that they could get away with it. Even though the EPA itself might have been incapable of figuring out that the engines being tested were in performance not those being sold successfully to the public, the United States is full of environmentalist engineers. It only needed one of those to spot Volkswagen’s software and the game would have been up.

If other companies have done the same thing to ensure their vehicles pass the EPA’s tests, they will equally have laid themselves open both to gigantic fines from the EPA and to huge lawsuits from environmentalist car owners who will claim “psychic damage” from driving a vehicle less environmentally virtuous than they thought.

Unless Volkswagen is absolutely alone in its malfeasance (in which case it will probably be driven into bankruptcy) the automobile sector will now be treated like the banking sector, with regulators competing with each other as to who can levy the most outrageous fines. Companies will only survive by the skin of their teeth; the great bulk of their annual profits will be diverted into regulators’ institutional pockets, or to filling small parts of the gigantic budget deficits now being run by nearly all governments.

Banking and financial services in general are already effectively wards of the state, at least at the top end. Fines imposed upon the big banks have exceeded $200 billion, almost none of them for genuinely troubling offences as indeed were committed in 2004-07 (like the Goldman Sachs “Fabulous Fab” synthetic CDO deal). Instead they have been imposed for matters like LIBOR and foreign exchange fixing shenanigans which were not considered offences at the time and merely reflected the failure of the LIBOR and FX fixing systems to keep up with the excessive business volumes generated by the derivatives market.

Of course those responsible for the systems should have updated them, and regulators should have imposed a tiny “Tobin tax” to suppress trading volumes and keep the markets under control. However given the failures of market authorities and regulators, the imposition of huge fines on banks for the natural activities of their traders is pure looting. What’s worse, the proceeds of the fines are mostly being used for nefarious purposes, such as setting up ever more elaborate regulatory systems or fulfilling left-wing social agendas, none of which have been properly authorized by voters and all of which almost certainly do damage far in excess of their monetary cost.

Banks are now mere wards of the regulators; they can engage only in activities permitted by the regulators (or, an even more egregious barrier, understood by them.) Their profits are artificially boosted by crazed, hugely damaging monetary policy; then those profits are looted arbitrarily through fines which are used to boost the complexity of regulations or fulfil the regulators’ social goals. This bears no relation to the free market; it bears much more relation to feudalism, in which the lords allowed their tenants to make money through oppressing the peasantry, then seized part of their tenants’ loot for their own share. Needless to say, there is no evidence whatever that this system results in optimal resource allocation, a particularly important consideration in financial services, through which resource allocation for the entire economy is conducted.

The financial regulators have now dreamed up a new wheeze which will bring us all under their thumb. Bank of England chief economist Andy Haldane’s scheme to abolish cash will force us to see arbitrarily large portions of our wealth scooped off by the financial system to reward hedge fund operators, speculators and others with political pull. So blatant a return to the Dark Ages would never have received even a respectful hearing if we had not been conditioned by two decades of funny money to believe that central banks are all-powerful and should be given the right to seize our assets arbitrarily in pursuit either of their distorted Keynesian fantasies or of sheer public sector plunder.

Other sectors of the economy have had resource allocation so distorted by the public sector that market mechanisms to restrain them no longer work and they have grown to bloated behemoths that threaten to swallow up altogether the remaining healthy economy. In the United States, the two most notable examples of this are healthcare and education. Not all the distortions in healthcare are left-wing; the patent system for example grants companies monopolies on rare drugs on which they can capitalize by charging arbitrarily large amounts to those forced to rely on them. Adam Smith strongly disapproved of the monopoly element in patents, and in the pharmaceutical sector there is no question that his worst fears are being realized.

The solution is probably to abolish exclusivity in patent grants, allowing competitors to manufacture the patented drug on paying a royalty of say 25% to its inventor. That way, some drugs would be more profitable than others, and some research would prove barren, but egregious rip-offs of the consumer would be impossible, because by charging more than a 25% premium over cost plus a reasonable profit margin the drug’s inventor would invite in competitors. This reform would however tip matters too far the other way if regulators were allowed to delay approval arbitrarily, or demand arbitrarily expensive and repetitive testing; this could be solved by government reimbursement of costs imposed by its regulators, removing the regulatory risk (but not the development risk) from new drug discovery.

Most excess cost bloat in both healthcare and education is imposed by the government itself through regulation and ill-directed subsidies. In education, the cost-bloating effect of a blizzard of regulations has been worsened by the effect of subsidized student loans. This is incidentally the one sector where the regulated welcome more regulation and devise new cost-bloating measures for themselves without the government imposing them. Market discipline desperately needs to be applied to the professoriate, where it would do most good.

In healthcare, two factors stand out: the enabling of the trial bar, by which unbounded legal costs are loaded onto the system at every level and the 1986 mandate for hospitals to give emergency care without reimbursement – which then loaded cost onto the unfortunate middle class consumers and their insurance companies (who were able to avoid much of it.)

When you add it up, and include the direct costs of government, far more than half the economy is in these neo-feudal sectors, where market disciplines barely exist and incentives to bloat cost and produce unwanted output are paramount. Little wonder that U.S. productivity growth is almost zero. Unless there is a quick reversal, overall output will shortly go into a death-spiral and the decline in U.S. living standards, already quite substantial, will become terminal.

It is already likely, indeed obvious that for Americans the twenty first century will be poorer than the latter half of the twentieth. Really the only question remaining is whether U.S. living standards will revert to the nineteenth century – or the tenth.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)