Kling’s line is very simple:
1. Ideal regulatory systems can be modeled as games.
2. Regulators *try* to solve problem by creating regulations.
3. The regulated participants *try* to circumvent regulations by following the letter of the law, avoiding the intent.
4. In any system where there is enough money involved, there is no contest…the regulated participants necessarily win.
5. Letter-of-the-law regulation is therefore *guaranteed* to fail in high $ industries like finance.
6. This is a big problem, insofar as we can agree that an unregulated finance industry is undesireable.
Seems all true and obviously so. The difficult part is that Kling continues:
Therefore we should try a different form of regulation: PBR
… In roughly all cases, the identification and analysis of the problem is the high-value part of the discussion. The solution almost always sucks. This is because solutions are hard, and if you haven’t tried it, you’re almost always wrong.
Great post.
READER COMMENTS
Greg G
May 24 2012 at 1:09pm
It is a great post. There is no regulatory system that can’t be messed up by a bad regulator just like there is no business that can’t be messed up by a bad CEO. The devil is always in the details.
MikeP
May 24 2012 at 1:21pm
Just as common law is superior to legislation in virtually every way, I would expect principles based regulation to be superior to rules based regulation in virtually every way.
Sonic Charmer
May 24 2012 at 1:48pm
Let’s use a concrete example. (*The* concrete example, I would think.) Here’s the problem everyone’s angsty about nowadays, which has spawned this “PBR” stuff: The Volcker Rule embodies a simple and good-sounding ‘principle’, but seems to get kludged when translated into a ‘rule’.
Your answer (I guess?): “PBR”. Keep it a ‘principle’ and let just regulators fine banks when ____ occurs. (I have no idea how that blank will get filled in, and I guess, neither do you, but you like it that way?)
My answer: The kludge is telling us something. It’s telling us the ‘principle’ was flawed. Ergo: don’t have a Volcker Rule. Try to solve that problem (whatever it is – is there one?) some other way.
In other words, I’m just trying to point out that when frustration at regulatory failure seems to tempt you towards “PBR”, it could be that the principle behind the regulation requires re-examining – not better, cleverer regulatory implementation.
Mike Lorenz
May 24 2012 at 1:51pm
“PBR” is also used as an acronym for Pabst Blue Ribbon. I have used PBR as a short-term solution for many problems, but in the end, nothing has really improved.
mdb
May 24 2012 at 1:52pm
This strikes me as very similar to FDA cGMP regulations. I do not like these regs and feel industry spends a lot of money over complying – because you never really know – and as such the bar is continually raised for regulations. So regs always ratchet up, compliance costs always ratchet up and barriers to entry always ratchet up. I will say you don’t really see gaining in the pharma industry, but you also have a lot of stagnation.
stephen
May 24 2012 at 2:03pm
I wanted to criticize your post at first glance, but decided to wait. After reading Aretae’s (usually) top notch remarks I was glad I did. That said, I am still on board with Sonic.
Publius The Lesser
May 24 2012 at 2:22pm
My challenge to Arnold is to provide an example of a “principle-based” regulation and how it would be enforced. Right now, my understanding of “principles-based regulation” is that the regulatory body issues a vague “principle” and decides after the fact whether you’ve violated it or not. If that’s the case, it’s pretty much incompatible with the United States’ legal system, and I don’t think the changes necessary to make it compatible would be a good idea.
As to “rules-based” regulatory systems being subject to gaming, its not as if the financial industry is the only group to game the rules. I doubt if Arnold, or anyone, would want to live under a “principles-based” taxation system, wherein the IRS issues guidelines about what constitutes taxable income and what you can deduct, and then decides after the fact whether you’ve paid enough.
Jehu
May 24 2012 at 2:29pm
PBR systems are just as subject to gaming. If you don’t believe that, I bet you’ve never run a complicated advanced roleplaying game. The gaming just takes a different form. What happens is that your application of Principle X becomes used by clever sophists to argue why you should allow them to do Y and you, the regulator, get tied up into knots over time. Only a metarule for participants—i.e., don’t be a system-gaming prick—works for such games, and that metarule only works when you can self-select your participants. Obviously you can’t do that for any meaningful industry, God forbid, the finance industry, where participants are selected based on their ability to game systems.
Floccina
May 24 2012 at 3:33pm
This also seems related to welfare. Some people really need help and some need a kick in the butt. It is exceedingly difficult to write laws that differentiate between the 2 groups correctly. For example I have known a few able to work people undeserving on SS disability and yet there are some deserving people who cannot work who cannot get SS disability.
I once tried to think up a scheme to solve the problem and I came up an idea of having groups of people elect a benevolence person to spend their benevolence taxes. People could join the group of their choice. It would be like mandatory charity.
gR
May 24 2012 at 5:23pm
@Publius The Lesser; I would argue an example of PBR is US GAAP. US GAAP standards are set by the financial account standards board (FASB) and are based on a series of principles, assumptions, and constraints (historical cost, matching, going concern, conservatism, etc.). FASB pronouncement’s are clarified and more clearly defined through interpretations, opinions, and technical bulletins by the FASB, the AICPA, or the SEC. The SEC enforces the principles by requiring public companies to follow GAAP.
Gaming still exists, such as in areas where mark-to-market has replaced historical cost, but any regulatory system is open to gaming. The expectation in PBR is that new interpretations are continuously meeting new issues as they arise. For accounting, it takes time for changes to be made to the ASC, but professionally lit does a decent job of staying at the front of the knowledge curve and carries weight when issues haven’t been directly addressed by FASB.
Jeff
May 24 2012 at 8:01pm
Excellent.
Handle
May 24 2012 at 9:36pm
A relevant PBR comment I left over at Foseti’s.
andy
May 25 2012 at 2:33am
In one anti-trust case here the ‘fact’, that the company was a monopoly (and therefore the behaviour they engaged in was forbidden), was found out by the court after-the-fact; the company could not know, if they were a monopoly before-the-fact, and their being the monopoly (on a particular bus-line) actually depnded on a bad marketing by their competitors and decisions of their customers (they were accused of bellow-cost pricing; funny is the rail-‘competitor’ did the same, but because they were unable to ‘steal’ customers from the bus-operator, they were said not to be part of ‘relevant market’).
Seems to me the same with pbr; regulation ceases to be something you should comply with; instead, it becomes an unpredictable tax. It doesn’t change your behaviour in many cases, because you have no idea it could happen.
Ari T
May 25 2012 at 5:46am
Dr. Kling,
You might want to read up on Brazil. Apparently they made finance industry CEO’s responsible with their personal property in case their company would fall to government hands. And I’ve heard they’ve had little financial crises for past few decades.
J.D.
May 29 2012 at 4:53pm
I get where this is trying to go, but the courts would never allow it.
Rules without punishments for rulebreakers is pointless, and the legal doctrine of lenity means courts would either whittle those rules down to the narrowest possible meaning, or completely toss the rule for vagueness.
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