Regulation – The Hidden Curse

Regulations are nearly always introduced with the best intentions. In financial services, they aim to stop unscrupulous brokers and banks from ripping off the public through bad practices. Manufacturers are banned from making products which are dangerous to children, the environment, or which might fail through shoddy workmanship. However, state intervention in commercial matters is based on shaky grounds, consistent with denial of the role and workings of markets, and an overriding desire to interfere.

This contrasts with a true understanding of why free markets work, and the control the consumer exercises over prices and choice, subordinating them to his subjective decisions. Consequently, regulation is based on an unreasoned belief that the individual needs state intervention to ensure standards are maintained, and that bad practices will be eliminated. The incorrect assumption is that free markets encourage unscrupulous manufacturers and service providers to defraud the consumer, when in fact, reputation becomes the paramount relationship in trade.

Because private sector regulation tends towards monopoly practices, the state naturally sees itself as the independent arbiter to ensure fair play. But the state, having initially imposed regulations, finds it very difficult to stop there, with political pressures always to modify and intensify bureaucratic control. Furthermore, unintended consequences of earlier regulations are never corrected by abolishing them. Instead, more layers of regulatory control are introduced in an attempt to address ensuing problems. We therefore drift into greater and greater regulation, without being aware of the true economic cost.

Anyone who favours regulation needs to explain away Germany’s post-war success. Her economy had been destroyed, firstly by the Nazi war machine, and then by Allied bombing. We easily forget the state of ruin the country was in, with people in the towns and cities actually starving in the post-war aftermath. The joint British and American military solution was to extend and intensify war-time rationing and throw Marshall aid at the problem.

Then a man called Ludwig Erhard was appointed director of economics by the Bizonal Economic Council, in effect he became finance minister. He decided, against British and American misgivings, as well as opposition from the newly-recreated Social Democrats, to do away with price controls and rationing, which he did in 1948. These moves followed his currency reform that June, which contracted the money supply by about 90%. He also slashed income tax from 85% to 18% on annual incomes over Dm2,500 (US$595 equivalent).

Economists of the Austrian school would comprehend and recommend this strategy, but it goes wholly against the bureaucratic grain. General Lucius Clay, who was the military governor of the US Zone, and to whom Erhard reported, is said to have asked him, “Herr Erhard, my advisers tell me what you have done is a terrible mistake. What do you say to that?”

Erhard replied, “Herr General, pay no attention to them! My advisers tell me the same thing.”

About the same time, a US Colonel confronted Erhard: “How dare you relax our rationing system, when there is a widespread food shortage?”

Erhard replied, “I have not relaxed rationing, I have abolished it. Henceforth the only rationing ticket the people will need will be the deutschemarks. And they will work hard to get those deutschemarks, just wait and see.”

The US Colonel did not have to wait long. According to contemporary accounts, within days of Erhard’s currency reform, shops filled with goods as people realised the money they sold them for would retain its value. People no longer needed to forage for the basics in life, so absenteeism from work halved, and industrial output rose more than 50% in the second half of 1948 alone.

Erhard had spent the war years studying free-market economics, and planning how to structure Germany’s economy for the post-war years. It goes without saying that his free-market approach made him a long-standing and widely recognised opponent of Nazi socialism, a fact that enhanced his credibility with the military authorities tasked with repairing the German economy. He became an early member of the Mont Pelarin Society, a grouping of free-market economists inclined towards the Austrian School, founded in 1947, and whose first President was Hayek.

Erhard simply understood that ending all price regulation, introducing sound money and slashing the burden of taxation, were the basics required to revive the economy, and that the state must resist the temptation to intervene and had to reduce its role in the economy. He remained a highly successful finance minister for fourteen years, before succeeding Adenauer as Chancellor in 1963.

Erhard not only allowed unfettered free markets to rapidly turn Germany around from economic devastation, but being publicly credited with this success he presided over the economy long enough to ensure that bureaucratic meddling was kept at bay subsequently. His legacy served Germany well, despite the generally destructive actions of his successors.

The contrast with Britain’s economic performance was stark, where rationing was not finally lifted until 1954, and her post-war socialist, anti-market government was nationalising key industries. The contrast between Germany’s revival and Britain’s decline could not have been more marked.

The point is that free markets are demonstrably more successful than regulated markets as a means of ensuring economic progress. The same phenomenon was observed in Hong Kong, where John Cowperthwaite succeeded in stopping his own local officials and London’s Colonial Office from imposing regulations on the island’s economy in the post-war years. Cowperthwaite was roughly contemporary with Erhard, retiring as Hong Kong’s Financial Secretary in 1971. Yet despite this indisputable evidence that free unregulated markets actually work best, the political class can never resist the compulsion to regulate.

Regulations are intended to take risks out of life, an objective at which the state demonstrably fails. Established businesses are happy to collude with the state in setting regulations, partly because they get to influence their scope, and partly because it allows them to disregard the emphasis they otherwise have to place on their reputations in a free market.

I will always remember a lunch I had with the managing director of a well-known spread-betting business before spread-betting became regulated in the UK. When I enquired of him if he saw proposals to regulate his business as an imposition, he replied to the contrary. He was looking forward to the legitimacy that regulation by The Securities and Futures Authority, which was the regulator at the time, would give to his business. And to this day, spread-betting and similar products remain regulated as investment products. It is a legitimate mainstream financial activity, instead of a casino for financial products.

A regulated business clearly does not have to trade on its reputation, since its customers are theoretically guaranteed by the regulations. The intention is that ordinary people no longer have to consider whether this or that broker, or bank, is safe to deal with. Equally, the broker and the bank no longer views the client or customer as their uppermost consideration. That relationship is with the regulator.

Clients and customers are now so used to regulation they find it hard to imagine how things would work without them. Who wouldn’t want the protection of a government regulator to ensure fair play? Well, there are some who have become disillusioned. Ask those who entrusted their money to a regulated Bernie Madoff, or those who found their margin deposits lost in a black hole called MF Global.

Doubtless there will always be those who suffer from business failures, when they thought they had the protection of the state. Of course, we cannot know the counterfactual, how many failures there would be in an unregulated financial services industry, but we do know that state regulations routinely fail to protect the public.

Regulations have also become extremely complex and costly, and to a large extent regulators have to trust regulated businesses to work within the spirit of the regulations. How naïve is that. It suits big businesses very well, because they can easily afford the lawyers to advise them how best to work the regulations they themselves drafted to advantage.

Smaller competitors, the principal threat to established businesses in free markets, are practically excluded from setting the rules. Take the arcane subject of the EU Biocide Directive. Manufacturers using elemental silver for the last twenty years have been required to work towards gaining EU-wide approval for its use as a biocide, despite this safe non-toxic use being already thoroughly proved and established. The legal and bureaucratic processes have required the businesses affected to spend roughly €1m each so far, and counting. Small beer perhaps to members of the silver task force such as Dow Chemical and BASF, but wholly disproportionate and unaffordable for smaller competing enterprises.

The battle between a business establishment that games regulation to the disadvantage of its less powerful competitors is the same underlying principal that governs relations between governments in the advanced and developing nations. Complex and costly regulation has long been a handy deterrent against cheaper, foreign competition. But uncompetitive practices only work for a time, and foreign upstarts, based in more efficient, unregulated or lightly regulated markets, have become too powerful for the western bureaucrats to deter. The same free-market dynamics that benefited Germany and Hong Kong in the post-war years are today exploited by a whole host of countries, notably led by China, Russia, and now India.

This is the underlying reason the west faces economic failure, while the newly-industrialised nations are so dynamic. The old world is sinking into a quicksand of bureaucratic, anti-competitive regulation, while the new order is based on the firmer ground of free markets.

Future historians recounting the relative decline of the EU, America and Japan will have some easy copy, assuming they make the connection between economic success and lack of regulation, so plainly demonstrated by Ludwig Erhard and John Cowperthwaite.

Alasdair Macleod

HEAD OF RESEARCH• GOLDMONEY