In the early 1970s, there was no euro, Greece could print as many drachmas as it wanted, and the notion of a common European fiscal policy would have been dismissed as sheer fantasy by all but the most ardent proponents of a “United States of Europe”.
Exchange controls were still in force in a number of developed countries. By most measures, the international economy had still not regained 1914 levels of financial integration. Inflation loomed as a serious problem in many developed countries, including the US and UK.
In an effort to quell inflation, US President Richard Nixon launched an ambitious programme of price controls in an effort to break inflation on 15 August, 1971. Phase I – a wage and price freeze – was followed by Phase II, Phase III, Phase III 1/2 and Phase IV.
The last of the controls would not be dismantled until Ronald Reagan was president and the last of the litigation over them would not end until the 1990s. Phase II of the controls, in effect from 14 November, 1971 to 11 January, 1973, was administered in part by the Price Commission, an independent agency governed by a seven member board.
After the Price Commission was dissolved, its chair, Southern Methodist University Business School Dean C Jackson Grayson, Jr, wrote a thoughtful analysis of his experience, Confessions of a Price Controller (Dow Jones Irwin, 1974). Grayson raises a number of points important for those regulating today’s far more complex international economy to consider.
Lesson one: Regulating well isn’t easy
The first is that regulation is quite tricky to do well. Here’s Grayson’s description of the problem of regulating the price of groceries under the “customary initial percentage markup” rule that allowed firms to use invoice prices for supplies to set their current price.
Does the regulation apply on a firm-wide basis, such as, for all Kroger stores or for individual stores? Does it apply to departments or to individual items within departments – the entire meat section or sirloins, rib eyes, T-bones and so on? Does it apply to all products by general categories or by brand – all peas sold, or Del Monte peas, Libby’s peas and others?
“Whatever your customary business practice was!”
But it still wasn’t that easy.
What was the customary business practice in the base period? For one thing, the practice might have been changed since the base period. Could we force a firm to go back to a discarded system? Or perhaps the firm had a mixed pricing system – some items priced on an “aggregate” mark-up (items grouped together, such as the canned vegetables department), and some are priced on an “item-by-item” basis (such as Del Monte peas).
Some food chains, as it turned out, don’t set prices at all; instead, store managers are given gross margin targets, and there is no control over individual products.
What Grayson found was that this sort of complexity was almost impossible to deal with as a regulator. As a result, the price control enforcement agents (on loan from the IRS) “tried to push” firms toward an item-by-item pricing system so they could easily check the price history on each item when searching for violations. Grayson concluded that:
“This is a good illustration of how a control program can gradually remove degrees of freedom in order to achieve standardization and enforcement, thereby altering the normal patterns of business practice. Slowly the economy shapes itself around the convenience of the government rather than the influences of the market. Innovation is naturally suppressed because of its inherent ’difference’.”
As the OECD, US and EU continue to press for greater global financial regulation, it is important to avoid giving regulators impossible tasks. The temptation is strong – as Grayson noted,
“It sounds more ordered and rational. It is comforting to think that some intelligent Olympian-like men have the facts, the techniques, and the wisdom to relieve us of the burden of chaotic decision making.”
In fact, it is extremely difficult. Regulatory interventions must therefore be carefully designed and limited in scope to avoid this shift. The close cooperation between OFC governments and businesses through consultation over regulatory efforts gives those jurisdictions an advantage in achieving that balance that larger jurisdictions often lack.
Lesson two: Regulating is costly
Grayson observed growing distortions in the markets he was regulating as the controls displaced the price mechanism and concluded: “The longer controls are in effect, the harder it is to discern real from artificial signals. No matter how cleverly any group designs a control system, distortions and inequities will appear.”
Thus, for example:
“lumber controls were beginning to lead to artificial middlemen, black markets, and sawmill shutdowns. Companies trapped with low base-period profit margins were beginning to consider selling out to those with higher base periods, sending their capital overseas, or reducing their efforts. Instances of false job upgrading – which were actually raises in disguise – were reported on a scattered but increasing basis. To keep away from profit-margin controls, companies were dropping products where costs, and thus prices, had increased. And shortages of certain products, eg molasses and fertiliser, were appearing because artificially suppressed domestic prices had allowed higher world prices to pull domestic supplies abroad.”
Financial regulations are not exempt from these difficulties. We hear a great deal about the risks regulators want to protect us from with laws like Dodd-Frank. We hear less often about the risks such regulations themselves cause.
Careful assessment of the impacts of regulatory efforts – particularly in response to real or perceived crises – is indispensible in minimizing such distortions. The greatest danger is ending innovation. Financial services innovation is critical to the continued success of the world’s economy – it was innovation that got us hedge funds and captive insurance, for example
OFCs know both the upside and downside of such distortions. The first round of post-World War II OFC activity was often driven by distortions in rules introduced by onshore economies. As Craig Boise and I argued in our analysis of Curacao’s rise and fall between the 1960s and 1980s, the “Antilles sandwich” was a product of the structure of the US withholding tax.
When the tax went away, so did the sandwich. Bad regulations in onshore economies create business opportunities for offshore jurisdictions, but exploiting others’ mistakes is not a sufficient long-term strategy for growth.
The OFCs that are successful in today’s market have found ways to add value by innovating in business structures, providing laws and courts superior to those available in competitors, and focusing regulatory efforts on solving specific problems in a cost-effective way.
Lesson three: Special interests go where the power is
There’s an apocryphal tale that American bank robber Willie Sutton responded to a question about why he robbed banks with “that’s where the money is”. (Sutton never actually said that, although he did entitle a book Where the Money Was in a nod to the alleged quote.)
Shifting important decisions from the market to the government means people will invest resources in seeking influence over those decisions through the political process, as certainly happened with the 1970s price controls. Grayson noticed that distortions came about because controls led businesses to refocus their attention on the regulators rather than the marketplace.
“They inevitably come to the same conclusion, summed up by one executive: ‘We know that all of our sophisticated analysis and planning can be wiped out in the blink of a Washington controller’s eye.’”
Note that Grayson is not arguing that the price setting process was particularly subject to political pressures. Indeed, one of the most surprising things about Grayson’s memoir is the degree of autonomy the Commission received from the Nixon Administration.
Indeed, Grayson’s description of the Price Commission’s operations is almost straight out of a civics textbook – a committed band of smart, well-meaning individuals who threw themselves into a difficult task for the good of their country, accomplished their mission and returned to their private lives. This may have been aided by the temporary nature of the task and the start-up atmosphere of the Commission.
But the Price Commission’s success actually suggests the problem is even more difficult than merely deterring corruption. If despite all its virtues, the Price Commission observed a diversion of attention from competing in the marketplace, imagine the impact of permanent bureaucracies.
OFCs have an important advantage over onshore jurisdictions in avoiding these distortions: They don’t have to regulate for several hundred million people at the same time. Yale Law Professor Jonathan Macey and Anna Manasco Dionne have argued that regulatory competition among OFCs and onshore jurisdictions has led to a race to appropriate regulation3. In part, that appears to be due to places like Bermuda, Cayman, Guernsey, Hong Kong and others finding a way to focus attention on important problems and not succumb to the temptation to try to do everything.
In 1974, Grayson concluded his memoir of his time as a price controller by warning, in italics, that:
“My view is that we are increasingly regulating the market system to the extent that it is being burdened and regulated beyond its power of endurance, and to where mere differences in degree are becoming differences in kind.”
Nearly forty years later, those 1970s regulations appear almost childishly simplistic compared to today’s tax codes, Dodd-Frank, Sarbanes-Oxley, Savings Directives I and II, and Basel I, II, III, etc.
An optimist might conclude that Grayson must have been wrong – that the market system had more endurance than he thought. A pessimist might conclude that Grayson’s prophecy has come true.
To the extent that it has not, much of the credit goes to the OFCs and financial and legal professionals who have kept regulatory competition alive. The question is, how much longer will they be able to do so?
- For those ready with a quick “but what about the toxic MBS” question,
there’s a strong case to be made that a large part of the problem was
the years of loose money caused by central banks around the world. But
that’s another column.
- Craig M. Boise & Andrew P. Morriss, Change, Dependency, and Regime
Plasticity in Offshore Financial Intermediation: The Saga of the
Netherlands Antilles, 45 TEXAS INTERNATIONAL LAW JOURNAL 377 (2009).
- Anna Manasco Dionne & Jonathan Macey, Offshore Finance and Onshore
Markets: Racing to the Bottom, or Moving toward Efficient? in OFFSHORE
FINANCIAL CENTERS & REGULATORY COMPETITION (Andrew P. Morriss, ed.,
AEI Press 2010).