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Broken System? Tweak it, They Say

By: Louis Uchitelle
New York Times, June 28, 2002

Going back two centuries, economists have worried about what Adam Smith described as the tendency of chieftains in a market system "to deceive and even to oppress the public." When the grasping got out of hand a century ago, government regulation made a great leap forward in the Progressive Era. There was another leap in response to the excesses of the 1920's. And now regulation is again on the agenda.

For the first time since the Carter administration began deregulating in the late 1970's, the process has halted, and the winds are pushing in the opposite direction. The spreading damage to people's lives from plunging stock prices and disappearing pension savings has made regulation acceptable again. In a Harris Poll of 1,010 people this month, 82 percent supported "tough new laws" to reduce or prevent corporate fraud.

The House and the Senate, in response to the outcry, approved last week the first stab at renewed regulation a bill that would punish chief executives with jail for hoodwinking the public and would erect obstacles to future hoodwinking, particularly by accountants. President Bush says he will sign the bill quickly.

But regulation is likely to stop there, or slow to a trickle. Republicans and Democrats are resisting a second act, arguing in effect that this one piece of legislation may be enough to repair the system, along with a bit more action to improve accounting for stock options and to protect pension savings. Or as Senator Carl Levin, the liberal Democrat from Michigan who wants these extra steps, said in an interview, "I do not think anyone here lusts to regulate."

Similar reluctance showed up in interviews last week with mainstream economists, even those who 25 years ago were leery of too much deregulation. In the growing debate over the government's role in the rocky, post-boom economy, the views of economists are important. They are the experts who would provide the rationale, and the cheerleading, for a new era of regulation, just as they have provided the reasoning and crucial support for deregulation. So far, the broad middle ground in economics is wary of reversing course.

"I want thoughtful regulation and not an inadequately thought-out regulatory response to the problems of the moment," said Janet Yellen, an economist at the University of California at Berkeley who was an adviser to President Bill Clinton. Ms. Yellen offered a caution repeated often in the interviews. "It slightly worries me that when people find a problem, they rush to judgment of what to do," she said. "We have to be careful of ill-considered regulation."

If stepped-up regulation is unlikely, so is more deregulation, even the proposal to let individuals invest some of their Social Security contributions in the markets. The deregulation wave appears to be suspended, and that in itself may be a historic turning point. The deception uncovered in recent scandals has elevated deregulation into a national crisis, by punching many holes in a process that had seemed to function as long as it was confined to particular industries and the players were more or less honest.

POLITICIANS and many economists now appear to hope that by monitoring the accountants and punishing errant executives, as the new Congressional legislation is intended to do, deregulation will become acceptable again. But there would be a greater emphasis on fine-tuning and occasional government intervention as problems arise.

For all the mayhem of recent weeks, most mainstream economists say they still hold to the theory that unfettered competition, achieved through deregulation, tends to lower prices and promote efficiency and innovation.

"If you go around asking academic economists, `Do you think we should reregulate the airlines or trucking or any other deregulated industry?' you would get no votes," said Alan S. Blinder, an economist at Princeton and a Clinton adviser who served briefly in the 1990's as vice chairman of the Federal Reserve.

There are dissenting voices, however, among some economists slightly to the left of the mainstream. James K. Galbraith of the University of Texas at Austin argues for balance between regulation and deregulation in an economy that relies for prosperity as much on the public sector as the private sector. And Robert Kuttner, co-editor of the American Prospect magazine, contends that mainstream economists are caught in a bind.

"You have a whole generation of economists who have devoted their careers to supporting deregulation," he said, "and now they are twisting themselves into intellectual pretzels to deny that they are recanting on deregulation."

Instead of giving up on deregulation, many economists are proposing ways to fix it; that is, to tweak it so it works better. At times they are also calling for a regulation or two that would be narrowly focused on a particular problem that, in their view, is distorting markets that in other respects are efficient and competitive.

The nation's academic economists are nearly all members of the American Economic Association, which has added only one session on regulation to the already-prepared agenda for its annual meeting in January. That session, titled "Lessons from Enron," will include a paper by James Poterba of the Massachusetts Institute of Technology that will examine the dangers when employees are required to invest a large portion of their 401(k) accounts in their employer's stock, a practice that wiped out the retirement savings of many Enron workers when that company's stock collapsed.

To address this problem, Mr. Poterba favors portfolio diversification. But what if the price of diversification is an unwillingness by the company to contribute very much at all to a 401(k)? Companies often consider stock contributions much more affordable than cash subsidies. Should regulation go a big step beyond diversification and require a minimum pension subsidy, in cash, from the company?

There Mr. Poterba is not willing to go. "If contributing to pensions gets too expensive," he said, "companies will just not do it."

A similar preference for sticking with the current degree of deregulation, with repairs, pervades the thinking of the nation's economists.

Consider the airline industry. Deregulation started with the airlines in the Carter administration, which lifted federal restrictions on routes and on fare changes. The goals were to lower fares through competition, and to admit more new airlines to the industry.

Fares did come down, although often not by much, and certainly not for most business travel. As an alternative to lower fares, airlines lured travelers with frequent-flier miles. Some economists consider frequent-flier miles a deregulation flaw and would fix it by getting rid of these lures. Frequent-flier miles would presumably lose their appeal if the Internal Revenue Service ruled that the awards were income, subject to tax.

Or consider telecommunications, which Congress deregulated in 1996. Havoc followed. With the stock market bubble offering encouragement, telecommunications companies overexpanded, built up huge debts and engaged in ruinous price-cutting in a futile attempt to make use of idle networks. As the shake-out proceeds through mergers and bankruptcy, the odds grow that a few surviving companies will acquire enough pricing power to raise rates for the telephone, Internet and television cable services that so many Americans feel they must have.

That would give the survivors the sort of monopoly power that AT&T enjoyed until the courts broke up the company in the early 1980's. In the absence of competition, government had set rates and operating standards, a regulatory practice that many economists said stifled entrepreneurship and innovation.

But now that the telecommunications industry is shrinking to fewer companies, the new danger is too much pricing power. As a result, price regulations still in effect for local service may have to remain, said Eli M. Noam, a Columbia University economics professor.

"There was the expectation," he said, "that these tariffs would phase out through competition, but now that no competition is expected, the regulated rates are not likely to go away."

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Or consider electricity. Deregulation got into a lot of trouble in California in the summer of 2000. The electric utilities had sold off generators and power stations and were buying electricity for customers on the open market, presumably at competitive prices. But in 2000 the suppliers spiked prices, partly because of power shortages but also through manipulation. That led to some fixes even before corporate scandals and plunging stock prices awakened much broader public interest in repairing deregulation.

California began to buy electricity under long-term, fixed-price contracts on behalf of the utilities, thus averting price spikes. And the federal government imposed price caps. Now Severin Borenstein, director of the Energy Institute at the University of California at Berkeley, offers another solution for fixing a basic problem in electricity deregulation: inelastic demand, which means that households do not turn off lights and appliances or even cut back in the midst of a price spike.

Big commercial users, however, can quickly ration use, Mr. Borenstein contends. He would install computerized meters in their operations that keep the owners informed of the fluctuating cost of electric power through the day as their utilities buy it. When the price became too high, the commercial establishments would cut back or shut down for a while. Demand would realign with supply and prices would soften for everyone ・in theory, at least.

But for all his enthusiasm for this proposed fix, Mr. Borenstein does not recommend the installation of the meters elsewhere in the country until Californians try them first, to make sure they work.

Electricity deregulation has been proceeding state by state, and as Mr. Borenstein observed, "what happened in California has given everyone else pause."

"The states that have not deregulated are not going to start now," he said. "The ones that are moving toward it are putting it on hold. And the ones that have deregulated are grappling to fix deregulation."

From the 1970's until Enron, deregulation had mainly focused on specific industries: airlines, banking, trucking, electric power, financial services. The savings and loan crisis in the late 1980's produced some backtracking to deal with the shady and destructive lending that deregulation had allowed. Then with Enron came the quantum leap. Deregulation, it turned out, had fostered widespread greed.

A similar surge of bad behavior had brought on the Progressive Era with Theodore Roosevelt and, in the 1930's, the New Deal ・periods in which America "cleaned up its act" through regulation, as Claudia Goldin, an economic historian at Harvard, put it.

Regulation flourished in those eras in step with the public's suffering. Now the damage is limited; in the Harris Poll, only 25 percent said they had been hurt by the fraud and accounting problems.

Regulation, as a result, is making itself felt only in accounting reform and new jail penalties for executives, Mr. Kuttner of American Prospect argues. Still largely untouched are the next rungs: stock options and the conflicts inherent when a company is allowed to operate a commercial bank, a brokerage house and an investment bank. The Glass-Steagall Act separated those functions in the 1930's, but Glass-Steagall was repealed in 1999.

Whatever the differences, a common thread runs through the corruption fostered by the robber barons in the late 19th century, the stock kiting and fraud of the 1920's and the scandals today. In economics, that common thread is called asymmetric or imperfect information, which means in effect that one party in a transaction knows more than the other party and can take advantage of the second party.

Corporate executives, for example, know more about their companies' circumstances than shareholders, lenders and even employees, and can use that knowledge to swindle the others and loot their companies, by selling stock perhaps, knowing that it will plunge in value when misdeeds surface.

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Two modern-day economists, George A. Akerlof at the University of California at Berkeley and Joseph E. Stiglitz at Columbia, incorporated asymmetric information into economic theory and won a Nobel last year for their efforts. Now Mr. Akerlof sees much greater enforcement as a necessary response to the misbehavior that has flourished in recent years.

But like most mainstream economists, he shies away from more regulation. Instead, he would greatly increase enforcement by the Securities and Exchange Commission and other agencies to discourage insiders from taking advantage of their privileged information.

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