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Sunday, December 28, 2008

Corruption and Regulation

Originally posted October 2008:

Perhaps it was Karl Marx who predicted that the capitalist and communist economic systems would converge someday.

That day seems to be coming closer and closer with recent events trending toward increasing market and administrative regulation in the USA as a capitalist beacon and Russia as the former home of socialism.

In Russia President Medvedev is fighting corruption since he thinks that it hinders economic growth. In the USA, unregulated free market actions have created a financial panic that has created demands for stricter regulation from Democrats, Republicans, CEO's, the SEC and the general public.

Russian Sergey Vadimovich Stepashin, chairman of the Russian Federation Comptroller's Office, has proposed a comprehensive corruption elimination campaign, according to an interview article in the Rossiyskaya Gazeta, September 24, 2008 by Tatyana Panina.

He singled out Russian Law No N94-FZ "On Distribution of Orders for the Delivery of Goods, the Performance of Work, and the Rendering of Services for State and Municipal Needs" as providing opportunities for corrupt behavior.

In the United States, Christopher Cox the Chairman of the Securities and Exchange Commission [SEC] has blamed a lack of regulation for the current financial crisis. ['S.E.C. Concedes Oversight Flaws Fueled Collapse', By STEPHEN LABATON, New York Times Published: September 26, 2008]

The question naturally arises: What is regulation? It's an important topic that needs a lot of discussion.

I'll try to provide an overview from a layman's, i.e., not a lawyer, point of view. Perhaps a Western economic student's perspective will be useful - even though it may contain a few legal blunders.


In 21st Century economies, banks and financial institutions control part of the country's money supply. Thus, regulating them correctly is a national security matter - poorly or crookedly managed banks can harm the country.

Any firm which manages a part of the country's money supply should be examined regularly by the Central Bank or other appropriate institution to be sure it is being run soundly and honestly.

If the bank examiners conclude that the bank or firm has problems, the examiners should insist that the problems be corrected. Failure to correct the problems will lead to the bank being closed and its assets sold to another bank.

This is a case where separation of powers and extensive processes to ensure fairness to accused individuals can be compromised in the interests of the country.


In a market economy where most goods and services are provided by private, for-profit enterprises, sometimes firms are granted a monopoly by the state in providing a specific product or service. The economic justification for the monopoly is that the economies of scale compared to the size of the market dictate that a monopoly can be more efficient. In other words, the amount of investment to get the lowest cost is so high that a company will make the investment only if it can get a sufficient volume of business. This usually happens in utilities like electricity, garbage collection, sewer and water systems and so forth.

The economic problem is that any monopoly has an incentive to raise the price too high in order to make high profits. This then defeats the purpose of granting the monopoly in the first place.

Before some deregulations in the USA, many state governments created Public Utility Commissions [PUC's] which regulated utility monopolies. The basic idea is that before the firm can change any price or service level, it has to justify that change to its PUC. Failure to secure approval meant that the firm would be fined the total amount of the inappropriate price or service level. This took away the firm's economic incentive to cheat - what's the point in cheating if you will lose any gain to a fine?

The PUC's based their decisions on allowing a return on investment [ROI] sufficient to attract capital for expansion and no more. If a company needs to pay 10% on bonds or loans to get the money for the expansion, then the PUC allowed a price to be set which made a 10% ROI likely.

In exchange the firm received a safe and steady market but was prevented from risky and possibly more profitable ventures. Investors received a certain income with little growth possibilities. The system worked fine until deregulation.

Most PUC members were elected by voters under their enabling legislation.


Making regulation effective in preventing bad behavior by individuals requires that the rules are clear, specific and indisputable. After all, a person prosecuted under such a law stands to lose considerable wealth and/or freedom if convicted. He can be expected to mount a vigorous defense.

First Principle - Prevent Bad Behavior

Effective regulation tries to prevent specific behaviors, whether by individuals acting alone or for a company, bureau or government or behaviors by such organizations as a matter of organization policy.

Second Principle - Describe Bad Behavior

This creates a need for a detailed description of each behavior to be prevented. After all, how can a person or organization be accused of behaving badly if the behavior is not listed as prohibited behavior?

It is critical to describe the prohibited acts specifically so that there is little room for judgment. Such phrases as 'corruption' or 'bribery' are too vague to use in a law. Perhaps a phrase is useful such as: 'An individual employee granting an exemption to a legal requirement for an applicant in exchange for a payment of money or goods to the individual granting the exemption.'

In practice, this means that no behavior can be prohibited until that behavior is described and listed as prohibited. So, if taking a bribe for a favor is described and prohibited in a law passed on January 1, 2009, I cannot be prosecuted for taking a bribe on December 31, 2008. Of course, I can be prosecuted on January 3, 2009 for granting the favor that day, assuming that granting a favor has been described as prohibited behavior.

Third Principle - Describe Specific Punishments for Bad Behavior

The instrument which describes behavior as bad will also specify what is the punishment for the behavior. This may be a range of possible punishments, but the range of possible penalties should be specified. Failure to do so creates another problem where corruption can enter: negotiating or bribing away the punishments.

Fourth Principle - Separation of Powers

This is a Western approach; but, it seems to have merit in difficult areas like corruption.
Entities which participate in the identification and punishment of corrupt behavior should be different entities. For example, suppose a criminal law exists which states that a national government bureau employee who takes money or property and provides an exemption for an applicant to the bureau is guilty of a crime and will be fined a sum of money and be fired from the bureau.

Ideally, the national government's prosecutor prepares a case against the employee with all the relevant facts. The prosecutor's office then presents the case to a national government judge who listens to the prosecution and the defense, then makes a determination of innocence or guilt and assigns the punishment.

If the prosecutor's office also has the power to determine the guilt or innocence, the process is more likely to be viewed as corrupt and is also more susceptible to corruption since only one person has to be bribe.

Fifth Principle - Laws Conform to the Jurisdiction

The above example concerns a national or federal law, prosecutor and judge. If the case concerned a city law, then the prosecution would proceed under a city law with a city prosecutor and judge.

City judges cannot prosecute federal crimes and federal judges cannot decide offenses against city laws.

Sixth Principle - Separate Powers Chosen Separately

While one part of the prosecution process can be chosen by one part of the government, the other part should be chosen differently. For example, federal prosecutors can be appointed by the federal government directly, but federal judges should be either elected in a national election or appointed by the government subject to confirmation by the legislature.

Seventh Principle - Consumer/Worker Lawsuits

As an additional check on institutional abuses, consumers and workers are allowed to sue for damages. If this power is weakened, then regulations before the fact of abuse become even more important.

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