Uwe E. Reinhardt: Behind the Burden of Regulation Uwe E. Reinhardt is an economics professor at Princeton. "Over-regulated America" was the headline in the Feb. 18 issue of The Economist. "The home of laissez-faire is being suffocated by excessive and badly written regulation," began the accompanying article. Everyone who manages an American business corporation - be it for profit or not - is likely to agree with that headline. Having served in the past on the boards of two hospital companies, one a for-profit hospital chain and the other a nonprofit academic health center, I can sympathize with the headline as well. The question is why this regulatory burden is visited on Americans. Are we just victims of government, an alien force sent hither by some sinister, extraterrestrial creature - perhaps Darth Vader - tasked with suffocating us upright earthlings with mindless rules? Or should we seek the answer in the wisdom of Walt Kelly, the creator of Pogo, who is credited with the phrase, "We have met the enemy and he is us"? That thought occurred to me as I presented to my students in first-year economics a sketch of what economists call "constrained optimization": An investor-owned company, for example, is modeled by economists as seeking to maximize the wealth that the company represents to its owners, without violating the laws of the land. Management is assumed to pursue this objective, subject to the constraints of the input and output markets, technological constraints, legal (regulatory) constraints and ethical constraints. The ethical constraints imposed on this process are part of the company's ethical culture - some of it written down in its code of ethics. That culture is thought to be forged by the "tone at the top," that is, a management code of ethics. Another word for these ethical constraints might be "decency." What is legal is not necessarily decent. Although one should think that this is obvious, it increasingly seems to escape political and business leaders who, caught in dubious behavior, assert, "I did nothing wrong," and may well even believe it. By "nothing wrong," they mean that they did nothing that a high-priced lawyer could not defend as somehow legal in a court of law. I am reminded here of the exasperated lament of former Senator Fred Thompson, Republican of Tennessee, after Congressional hearings on the managerial, accounting and financial scandals of the late 1990s. "The real scandal here may be not what is illegal, but what is totally permissible," Mr. Thompson said, adding, "The system is clearly not designed with the interest of the general public or the investor in mind." There is a trade-off between the ethical and regulatory constraints that limit our actions in business, as elsewhere. The more pervasive the incidence of ethically dubious behavior, the more vigorously the rest of society will respond with ever more government regulations. As The Economist notes, "Governments of both parties keep adding stacks of rules, few of which are ever rescinded." To illustrate, the predictable response to the scandals of the late 1990s was the highly regulatory American Competitiveness and Corporate Accountability Act of 2002, commonly known as Sarbanes-Oxley. That bill was drafted by former Senator Paul Sarbanes, Democrat of Maryland, and Representative Michael G. Oxley, Republican of Ohio. It was passed by a Republican House and a Republican Senate and signed into law in 2002 by President George W. Bush, in spite that party's oft-stated misgivings of government regulations. Sarbanes-Oxley prescribes strict new accounting and governance standards for American corporations, some of which have been faulted as too burdensome, especially on small business. The much-criticized Wall Street Reform and Consumer Protection Act of 2010 - widely known as Dodd-Frank - was a predictable reaction to the ethically dubious practices that had crept into the financial sector in the preceding decade. That bill entirely is the handiwork of Democrats. As The New York Times reported on May 5, federal regulators are trying to prevent the financial disasters that arose out of interest-rate swaps sold to unsophisticated treasurers of municipalities, nonprofit organizations and school districts. Transactions in modern finance, just as in modern medical practice, must confront the problem of asymmetric information: one side of the transaction (e.g., the physicians or the sellers of financial products) has technically superior knowledge of the product being traded and could exploit that superiority to their financial advantage. Medicine's code of ethics forbids such exploitation. Should there be a parallel in finance as well? Finally, the myriad and often burdensome regulations imposed on our health care sector did not just rain down on a perfectly well-behaved industry. Act by act and regulation by regulation, they were regulatory responses to some sufficiently widespread mischief by members of a sector that had come to view public treasuries as a commons that could be grazed without inhibition. Pogo's dictum applies here, too. We are left with the question of why, if regulations are usually a legitimate response to mischievous games played by some parties in the private sector, these regulations are often so inchoate, if not outright silly. Lack of competence among the rule writers - especially unfamiliarity with the operations of those they seek to regulate - may be part of the answer, but probably not a large part. More important, in my view, is the gantlet that legislation and rule-making must run under our system of governance. Before an original bill passes Congress, it has been worked over ("marked up"), in each of the two chambers, by sundry committee fiefs whose members may be beholden to a variety of moneyed interest groups, each eager to steer the legislators" hands. The specific regulations called for in a bill, once passed, must also survive the scrutiny and influence of special interest groups, which typically work through members of Congress or the upper levels of the executive branch, whose affection they have acquired. Even the best-written original bill cannot emerge from that process in the form of a coherent set of rules. Many a rule may appear puzzling to straight-thinking people, and some even silly. Chances are they make sense to some interest group that had purchased it, so to speak.