Deregulation's darkening effect


Three apparently disparate events - the Enron debacle, the chaos of the California governor recall and the blackout of the Northeast quadrant of the country - could be called the Bermuda Triangle of system dysfunction.

The common factor is deregulation. What started with trucking and airlines during the presidency of Jimmy Carter has expanded to almost every part of the economy once controlled by the government. It's why your bank is now part of a national conglomerate. It's why dozens of companies beg you to sign up for their long-distance telephone service.

Deregulation has come to areas once far removed from the frenzy of competition, such as supplying electricity. Enron went from a small pipeline company to a Wall Street behemoth by pioneering the trading of electricity in the newly deregulated environment. Much of California Gov. Gray Davis' troubles can be traced to that state's energy crisis of 2001, which was caused in large part by its clumsy deregulation of electricity. And many point to deregulation as the villain in the this month's 2003 blackout: Freed of their public service overseers, electric utilities pursued the quick buck instead of investing in maintaining and upgrading the grid, critics say.

The intellectual underpinnings of this appeared in the late 1960s and early 1970s when the reign of ideas credited to John Maynard Keynes was replaced by those influenced by economists like Milton Friedman. They argued that government needed to back off and unleash the power of the free market.

"There is a rule of two," says economist Steve Hanke. "It costs about twice as much for the public sector to provide a good or service as the private sector. That's true right across the board."

Hanke, who has been at the Johns Hopkins University since 1969 and served on President Ronald Reagan's first Council of Economic Advisers, was an early and eloquent proponent of free markets. He says that much of what is now considered the public infrastructure in the United States - roads, waterworks, public transportation, the electric grid - was originally developed with private money.

"That went out with the Progressive Era," he says, referring to the late-19th- and early-20th-century reformers. "There was lots of government regulating and meddling and price controls that essentially strangled the private provider by making it impossible to make any money. As a result, the quality of service in many cases went down."

Increased productivity

Hanke says that the deregulation movement of the past quarter-century is responsible for the growth in U.S. productivity, allowing it to outpace the more regulated economies of Europe.

But others argue that the deregulation movement has gone too far.

"All markets are not like all other markets," says Robert Kuttner, co-editor of The American Prospect magazine and author of the 1997 book Everything for Sale: The Virtues and Limits of Markets. "Commodities like electricity, health care, airlines, telephone systems and such really do not fit the free-market model. ... You can tick off all the standard things that make free markets work and electricity violates all of them. It's a natural monopoly. In order to have some aspects of it competitive, you need a ton of regulations to make sure the Ken Lays of the world don't have their thumbs on the scale."

Kenneth L. Lay was head of Enron, which, among its many sins, has been charged with manipulating the California market in a way that led to the 2001 spike in energy prices.

Kuttner notes that competition cuts the profit margin on selling electricity so low "that the game is to control enough of the market to have an influence on price. A study done in California concluded that all you need is a 3 percent market share to control pricing power. ... The nature of electricity is such that you are going to get bottlenecks. And when you get those bottlenecks, you have pricing power. It's not like a grocery store where you can go to another one across the street. It's just not comparable."

But Hanke says that the problem is that there is not enough deregulation in electricity, at least of the right kind.

"Like so much deregulation, it's been half-baked," he says. "In this latest blackout, we are all focused on the hard infrastructure. That's off-base. The problem is in the soft infrastructure. We need to design a set of rules that allows for a market-based, competitive result." He believes that private companies would maintain the grid just as any company takes care of its production facilities.

Hanke says the problem in California was a botched deregulation. "It was never really deregulated. It was the hokiest affair, that would never work. ... Anybody could see it was a disaster waiting to happen."

He says government's role in the electric grid should be limited to setting reliability standards, and that once those are met, the market should do its work.

Kuttner contends that is having it both ways. "If you have a regulator you trust setting standards, then you are saying the market cannot do that. Once you concede that, you ... have a mixed system and the debate becomes what kind of mixed system? I'd say one with more regulation and [Hanke] would say one with less."

Kuttner says free-market advocates assume those working for the government will not do a good job. "But if you go and visit these people, you find that they really believe in what they are doing. Civil service staffs, public utilities commissions, they are full of people who actually believe in doing the public good."

David Sicilia, an economic historian at the University of Maryland, College Park, notes that the civil service arose from the same progressive movement that put in place many early business regulations.

The civil service was a response to the patronage systems of the big-city boss. The business regulations were a reaction to the unprecedented concentration of wealth. "When you had someone like [John D.] Rockefeller earning the equivalent of 2 percent of the gross national product, that disturbed people," he says. "They saw it as a failure of the marketplace, a breakdown of capitalism."

The Progressives were willing to pay a bit more to break up that system. "Some of these trusts did actually get 90 percent or more market share, but they were tremendously efficient. [Rockefeller's] Standard Oil sold kerosene and gas cheaper than anyone else."

This first wave of regulation, Sicilia says, was followed by controls on banking and investment during the New Deal and then by the social regulations of the 1970s that focused on consumer protection, worker safety and the environment. But it would be a mistake, he says, to think that before the late 19th century, America was a totally free, open market.

"Controls that were in place back in the Colonial Era would boggle the mind of even the most left-leaning person today," he says. "It was a highly structured marketplace."

Social costs

Sicilia says decisions as to what was provided by publicly owned utilities and what by private companies were haphazard and anecdotal. Problems with bad water from one private system led to most water systems in this country being in public hands, while railroads, electricity and telephones were generally developed by private companies that became regulated utilities.

"In the current wave, the direction since the '80s is clearly toward expanding the sphere of private activity," he says. "The rest of the world is going along with that. In most cases, this is more efficient, but you also pay a social cost with that. It is up to each society to decide whether it is worth paying the social cost."

Sicilia points out that in the case of electricity, there is a zero tolerance for failure, but failure is an endemic part of capitalist competition. "Americans like competition, but they don't like anyone losing," he says.

"Or what if a company that is dominating the market and getting a 6 percent return decided that it could get an 8.5 percent return putting its money somewhere else and said it was shutting down tomorrow. That would be a rational business decision, but would people tolerate that?"

There is another cost associated with the increasing free market - the time and energy spent making decisions.

"Economists call this the information problem," Sicilia says. "However infinitely expandable information is, our attention spans remain finite. Do we really want to spend a good part of our attention deciding what phone company to choose?"

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