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.

REGULATION OF BANKS AND FINANCIAL FIRMS

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.

MARKET REGULATION OF UTILITIES AND MONOPOLIES

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.

REGULATING INDIVIDUAL BEHAVIOR WITH CRIMINAL LAWS

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.

US National Security

Back in March of 2007, I wrote a list of nine areas that are critical to the future national security of the United States.

Now is the time to revisit the list, shown in order with the biggest threat listed first.

1. Political corruption - the government of the USA is corrupt. The legislative system requires that candidates raise money from rich interests to be elected; then the elected legislators grant favors to their campaign contributors.

The national security suffers when only money interests receive favorable laws.

2. Military/Industrial Complex - Contractors receive money from providing products and services to the armed forces. With that money they influence policy to encourage wars.

Our national security is damaged by public wars for private gain. Our military is corrupted when wars are started or encouraged by companies who profit from a war.

3. Energy - Oil interests damage the national security by promoting our dependence on oil.

We simply must reduce our oil dependence - there is no alternative.

A bill was proposed in 2007 in the House of Representatives to fund searches for oil alternatives. This is a good idea.

Here's another: let's treat oil like a public utility. After all, everyone needs it, just like water and electricity. So let's create a national oil commission that will plan for energy alternatives and regulate the price of oil so that oil companies can earn a reasonable rate of return but not any excessive profits.

Failure to deal with our energy problem will damage our future security.

4. Labor and Consumer Unions - Corruption favors business interests over workers and consumers. It is time to restore a more equal balance between labor and business and consumers.

Continued weakening of labor and consumer power will damage the working family, the backbone of America.

A case can be made that all the laws which favor capital creation should be weakened and all the laws which promote higher wages and more jobs should be made stronger. Our national security depends on a strong economy and the economy depends on consumers having enough income to buy products.

5. Income and wealth Disparity - we are becoming a two tier country; the middle class is becoming weaker.

Our idea has been that Americans are mostly middle class. Losing the middle class will damage our long term security.

6. Elections - The foundation of the American idea is that voters can change the government if it is unresponsive. But, if the voting process is manipulated for partisan purposes or private gain, our security is damaged.

7. Judicial Independence - Judges must be above politics to protect our values.

8. [Was 9] Financial Regulation [was Usury]

Unregulated banks have caused the current mess. We cannot tolerate cowboy capitalism.

9. [was 8] Trade Deficits - trade deficits reflect an economic imbalance that will eventually damage the American way of life.

A word about climate change - it is a global problem, not just a US problem, so is not listed here.

Obama's Economic Thinking

So far the thinking of the new economic team is seriously disappointing.

They are reported to have reached out to divergent economists who [wait for it..........] all agree that the stimulus is needed.

So, mainstream economists call other mainstream economists to solve a problem created by mainstream economics. That is just dumb.

The reason we are in this mess is that mainstream economic thinking is wrong. Even Bush understands the mainstream: 'Free people, free markets, free trade.' This is the same thinking that gave us the Great Depression.

It's also the thinking that gave us Enron, the mortgage meltdown and a severe recession tetering on depression.

Throwing money at the problem - - the Obama solution - without examining the framework is a prescription for disaster.

Even in mainstream, textbook economics, monetary policy - throwing money at the problem - does not work unless people want to borrow.

Nobody wants to borrow now and even the few who do want to borrow can't.

Here's the problem: everyone is convinced that the economy will become worse, not better.

Here's the solution: convince people that the economy will get better.

Here's how to do that: point by point, list each situation in the economic framework that has contributed to the problem, Then list each action to be taken and how it will correct that one particular situation.

For example:

Problem: bonds based on sub-prime loans have tanked and frightened bond buyers.

Solution: no bonds based on mortgages will be offered for sale without a rigorous examination of the mortgages which underlie the bond, with the examination's results published in the bond prospectus and verified by an outside regulator. This is not rocket science, it's very similar to the disclosure the SEC used to require for any security.

Problem: rising unemployment.

Solution: reconfigure national labor laws so that the creation of jobs is favored over the creation of capital. There is a real concern that there is already too much capital in the world and not enough jobs.

For details, see the discussion of the jobs theory of economic growth here: http://www.mkeever.com/apply.html

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Don't any of these people read economic history??