Escape from the Great Distress: The Role of Rules

The early part of my career was focused on the elusive notion of an idea and its economic power. I worked both at the theoretical level and the policy level in thinking through what we should do in our policies to take the full advantage of the power of ideas.

What makes ideas so remarkable is their capacity for shared use. A bottle of valuable medicine can heal one person, but the formula that is used to make the medicine is as valuable as the total number of people on Earth. Economists call this concept “non-rivalry.” Working through both the theoretical and policy implications of non-rivalry took up the first decade or more of my career.

There is a saying that you all know that we use to capture this character of non-rivalry: If you give someone a fish, you feed them for a day, but if you teach someone to fish, you destroy another aquatic ecosystem.

My new work really springs from this, from a recognition that progress, in the broadest sense, is a function not just of the development of new technologies, but also the development of rules that make sure that we use those technologies appropriately to make us all better off.

My goal is to explore this co-evolution of rules and technologies. In basic control theory, the distinction is made between control variables and state variables. The state variable could be the amount of water in the tank, and the control variable is the valve. The science policy community—and I certainly include myself in my early work—thinks of rules as control variables. We use legislative actions such as the Bayh-Dole Act to change the rules on patenting, or we make new rules about education subsidies to attract more people to science and engineering. If we just come up with a good rule and figure out how to get it implemented, that will have implications for the dynamics of technology.

The point I want to argue today is that we can step back and think of rules and technologies as state variables that influence each other and co-evolve. The deep control variables are something I am going to call metarules. The metarules are the rules by which we change the rules that we need to change on a day-to-day basis. In a dynamic world, we need to keep changing those rules all the time.

The Charter Cities initiative is an attempt on my part to propose a different metarule for changing the rules in developing countries, one that could, in some sense, circumvent many of the roadblocks that stop changes in rules. The underlying strategy behind Charter Cities is to use the power of a start-up in contrast to something like reform of an existing institution. The start-up firms are the way in which very important new innovations come into an industry. Perhaps, start-up political jurisdictions could have that same effect in the developing world. The Charter Cities Web site has information about the theory and its practical implications in Honduras, which is starting an entirely new political jurisdiction and city.

But my purpose here is not to address the political hurdles in developing countries but to examine the dynamic relationship between rules and technologies in the United States. To frame this, let me start with an example of a rule that we decided that we wanted to change decisively in the 1960s and 1970s: the rule that said that blacks should be treated differently than whites in the United States.

Calling that a rule highlights something that might not be obvious. Rules capture any social regularity. They can be created by legislation, regulation, and enforcement, but they can also be the result of social norms. Discrimination was the result of both of those processes.

The nation went about changing that rule in a variety of ways. One way was through the filing of lawsuits that eventually made their way to the Supreme Court. These lawsuits appealed to fundamental principles in the Constitution and led to the early steps in desegregation in schooling.

Another way was through congressional action that culminated in the Civil Rights Act of 1964. This legislation is enforced by detailed rules, issued by organizations such as the Equal Employment Opportunity Commission, that stipulate what steps an employer must take to implement an affirmative action program.

A third way in which the nation changed these rules is illustrated by the actions taken by the U.S. Army after the Vietnam War, when it sought to eliminate discrimination and achieve better racial harmony as it made the transition to an all-volunteer army. Charles C. Moskos, a Northwestern University sociologist renowned for his study of the military, tells the story of a cafeteria at Fort Hood, where all the black soldiers would regularly eat together at one table. One day, a white sergeant went over to the black soldiers and told them to go sit at other tables and that in the future there would be no table that would be considered exclusively for black or white use. Moskos observed that this type of rule enforcement, which was appropriate for the military, would not be effective on his college campus.

Even though many people might object to the military system of enforcing rules, the fact is that the Army has been the most successful U.S. institution at abolishing formal discrimination, reducing informal discrimination, and achieving thorough integration. We should be open to the possibility that there are different ways to go about changing, rules. The familiar paths of elections, legislative action, and formal judicial procedures are not the only viable and legitimate options.

Consider another example that is more recent and more familiar: stabilizing an economy in the face of a dramatic crisis. The nation has two systems of metarules for responding to a crisis. One is that Congress can pass special legislation, as it did in 2008 with the Troubled Asset Relief Program. The other is that the Federal Reserve Board has the authority to take unilateral action on many financial matters, just as the Army can in managing its troops. The Fed responded much more quickly and aggressively than did Congress, and arguably, it deserves the credit for saving the United States and the world from a disastrous global financial panic.

We need to keep an open mind about metarules and to be rigorously scientific in identifying goals and assessing the mechanisms for achieving them.

The power of metarules

Having articulated this framework of the co-evolution of rules and technologies and certain metarules that define how rules are updated, what does it imply for the nation’s response to the Great Distress, the coming 5 to 10 years of economic turmoil into which the United States is heading? Can an understanding of metarules make it possible to understand this period in a longer historical context?

One possibility is that the legislative and regulatory process that the nation uses to set many of the rules for its economy may not be producing the desired outcomes. In particular, they may be giving too much power to the hierarchical organizations that collect net income from the government. Consider a few examples and their connection to the Great Distress.

The financial sector in this country is regulated by legislation and regulations passed by agencies such as the Securities and Exchange Commission. Congress recently completed a reform process of legislation and some reorganization of these agencies because of the evidence that existing rules and regulations were not effective in preventing the recent financial crisis. The nation is making a serious effort to update its rules, but it is far from certain that the current approach will be effective.

Look at the healthcare sector, which has just been through a major round of legislation designed to reform its rules, a task that has been on the national agenda for decades. A movement to revise the relationship between national and state governments and their employees is gaining strength. Several states are trying to limit the range of items that are subject to union collective bargaining agreements. Many states and local jurisdictions have eliminated elected school boards and given control of the schools to a governor, mayor, or other official. In higher education, the rapidly expanding for-profit institutions are trying to influence the legislation and the regulations that influence their industry.

What is common to these activities? In each case, they are well-organized entities in some kind of a hierarchical structure that have the opportunity to have significant increases in net income if the government makes one set of decisions or to have reductions in that income if the government makes a different set of decisions. In all cases one can argue that they have been too effective in promoting their own self-interest with the result that the national interest has suffered. All of these attempts at reform are trying to redress the balance.

For decades now, a background theme in economic discussions has been the increase in income inequality. Although economists are engaged in a long-running debate about the details of how best to measure income, the underlying fact about which there is no dispute is that income inequality has been growing in the United States. Even if technology has been improving rapidly enough to raise average income, somehow the benefits of that are being distributed in a way that favors those on the upper rungs of the economic ladder so that median income is not growing.

Tyler Cowen of George Mason University interprets the underlying problem as a problem in technology. He speculates that perhaps technology is not coming in fast enough or maybe it is not the right form of technology.

An alternative perspective illuminates the importance of rules. The key factor is that finance and health, the two sectors where concerns have arisen about the quality and effectiveness of their governing rules, have captured a rapidly increasing share of GDP.

Finance has grown from roughly 6% of GDP in the 1970s to more than 15% today. Healthcare has grown from 5-6 to 12-13%. The data for government are provided for reference. This measurement of government is essentially the workers that governments hire and the buildings that they build. This is not a measure of taxes collected to then return to consumers in the Medicare program. That is treated as a transfer. It might surprise many Americans to learn that government’s share of GDP has actually decreased during this period when shares of finance and healthcare were growing dramatically.

If there is something wrong with the rules in finance and healthcare and if those rules in some sense have actually grown worse since the 1970s, and these sectors are becoming much larger fractions of GDP, it is conceivable that they are behind some of the broader measures of distress in the economy.

For example, compensation and returns in finance are highly concentrated among a very small number of people. Having even more of GDP going to finance and having that be very concentrated among a few people is clearly contributing to increases in income inequality. Some of the compensation in healthcare, especially among medical professionals, is also concentrated at the upper end of the income scale and thus also may be contributing to inequality.

The most interesting question, however, is not the details of the forces behind income distribution but what is happening to the quality of the rules that govern finance and health care. Has quality been deteriorating, and if so, what are the implications?

In the recent healthcare debate little mention was made of the fact that most U.S. healthcare providers, such as the Blue Shields and the Blue Crosses, used to be nonprofits. Then in the 1990s, the country witnessed a massive wave of privatization of those organizations. At the time, there was concern about whether private organizations would provide the same charitable care as the nonprofits had, but other than that, no one raised any concern about the broader implications of this change. Instead of having a healthcare sector that looks primarily like Kaiser or the Mayo Clinic, we have these very large corporate interests in both insurance and in hospitals. The insurance part actually shows up in the finance curve. The employees of the hospital would show up in healthcare.

The possibility here is that having corporate entities with executives whose personal compensation is dependent on corporate profits created political pressures to adjust at the margin any law or any piece of legislation at the national level that influenced the profits of these organizations. They created very strong incentives to tweak those items in the direction of increasing the compensation for people in this sector. Some of the resistance to national healthcare reforms and some of the very effective political action right now to undermine the most recent healthcare reform may, in fact, be the long-run consequence of having switched from a nonprofit organization in this sector to a for-profit system of organization.

Failure to pay attention to the dynamics of rule-setting and the nature of the operative metarules could have blinded us to what was happening in areas such as setting compensation levels for Medicare. It may have allowed us to make what could end up being the biggest budgetary mistake in our nation’s history. It is not something that will be easy to roll back.

Why might the for-profit entity be problematic here? Part of it is just because so much of its compensation comes directly from the government or comes in ways that are influenced by government action, such as tax subsidies for employer-provided healthcare. But part of it may be because we have a system of metarules for setting the laws and regulations that relies so heavily on legislatures.

Remember, we could have had a system like the military that sets the rules. We could have had a system like the Supreme Court. But what we have is a Congress that passes bills and then agencies that implement those bills with regulations. That legislative process may be too vulnerable to manipulation by very well financed entities with an enormous amount of wealth and income at stake. Every dollar of cost savings in healthcare means a dollar in reduced income for somebody in that sector.

How would this show up? When Congress was at a budget impasse in Spring 2011 and in danger of shutting down, it managed to pass a bill at the very last minute. One measure in that complex legislation repealed a provision of the healthcare reform bill that provided free-choice vouchers even though these vouchers have no effect on the budget. Someone, and we don’t know who, inserted this repeal measure at the last minute.

There was also a rollback of $2.2 billion that had been set aside in the healthcare reform act to support the creation of a few private health cooperatives, which were designed precisely to rebuild some of the nonprofit providers in the healthcare sector that had been wiped out in the 1990s. But the funding for those was also wiped out as part of this budget compromise.

Healthcare interests, which have a huge stake in this area, managed to catch the government at this point of maximum vulnerability and extract a few key concessions for the industry. I think you can anticipate that we will see this scenario repeated in each of the next few crises that will take place in the Congress in the months to come.

Another example involves the for-profit higher education sector. Many of these institutions enroll large numbers of students who depend on government-guaranteed loans to pay their tuition. But students who attend these schools default on their loans at a higher rate than those who attend nonprofit institutions. Experts attribute this high default rate to the for-profits’ aggressive recruiting techniques that attract many unqualified students who do not pass their courses and therefore have trouble finding jobs or who find that the education they receive does not make them more employable.

The Department of Education is trying to promulgate regulations that would force disclosure of employment prospects for students, prohibit certain dishonest marketing tactics in recruiting students, and threaten a cutoff of the access to guaranteed student loans for institutions that have the worst default rates. Even though these regulations would clearly save the government money, a hundred members of Congress signed a letter to President Obama stating their disappointment that the budget legislation did not include language prohibiting the Department of Education from implementing its regulations.

This issue will not go away. We may be in the early stages of a shift toward for-profit provision of education, analogous to the 1990s shift to for-profit provision of healthcare. The budgetary and other social effects could be significant.

The one point to make about government employee unions is that this is not a left/right issue. These unions have a very big stake in net income from the government. Some observers worry that the unions have been able to use contract provisions such as defined-benefit retirement programs and disability benefits designed to extract payments that were not fully disclosed or that circumvented the usual accounting and budgetary mechanisms.

All of these examples go beyond the left and the right, Democrat and Republican. It is a general reflection of the vulnerability of legislative-like mechanisms to manipulation by these kinds of interests. A mayor, a governor, or a president is understood to be individually responsible for the outcome of decisions and policies, but members of elected bodies are able to elude this direct responsibility.

Rewriting the rules

So what are the possible responses to this? One that is fascinating is a move to change the role of the Congress. In the case of the Base Realignment and Closing Commission, Congress delegated a group of people to make the tough decisions and develop a comprehensive plan that would then receive an up or down vote. This insulated members of Congress from the back office negotiations, special deals, last-minute insertions, and other opportunities for organized special interests to exert undue influence.

One of the most important measures in the healthcare reform act is the Independent Payment Advisory Board, which will provide this kind of function for proposed cost reductions in the Medicare program. It will be very interesting to see if this survives the next few budget crises. If it does, there is a chance that it could lead to real change in how we make rules in the healthcare sector. The Greenspan commission was supposed to perform a similar function for Social Security, and the recent debt limit legislation creates a special congressional group to develop a budget plan that will be submitted for a simple up/down vote by the full Congress. Thus, we may see an evolution of the legislature to emphasize its investigatory functions and its up/down vote functions, but to have it much less involved in the detailed crafting of the legislation that influences the dollars that come in and out.

Another option is to try to rebuild the nonprofit sector in healthcare or to take steps to protect the nonprofit sector in higher education. It will be very interesting to watch how official policy goes in this direction.

One final point that is worth emphasizing is that top U.S. public officials are very poorly paid compared with their counterparts in other countries. The top civil servant in any department in Singapore receives a base salary of $1.5 million a year with the possibility of bonuses of as much as $500,000. There are promotion tournaments for the people who aspire to achieve those top positions. That means there is a serious financial incentive for talented people to stay in the government and work their way to the top.

An agency such as the Securities and Exchange Commission (SEC) has to deal with pressure from the financial sector for regulations that let them earn profits at the expense of stability of the economy. If the SEC staff included people capable of earning millions of dollars in the private sector but who had devoted their entire careers to government service, the agency might have been better positioned to resist a very well organized campaign to adopt regulations that served the interests financial industry.

The critical point is that in trying to change the metarules we should not limit ourselves to the obvious paths of judicial action or legislative reform. The Army acts differently. The Fed acts differently. (And if these ill-conceived proposals to abolish the Fed succeed, the economy will encounter disasters we cannot even imagine.) All of these approaches have costs and benefits. Our responsibility is to be objective and scientific about what the goals are, what the data say, what the theory suggests, and to be willing to ask broader questions about what would be a good way to organize ourselves.

If we do that, we will make better progress. Progress there will be much more important for helping us get back to what we think of as the golden era in the United States than measures designed simply to speed up the rate of technological change.