Why has regulation become a more important tool of governance over the past decades?
Introduction
Some phenomena are too complex to be explained in their entirety through the lens of a single approach. By looking at its temporal evolution in the Western world, this paper argues that although regulation can be interpreted as a functional response to past market shocks, ideas played important role in reinforcing the paradigm of regulatory policies after 2008. The point is that the resilience of dominant narratives in the economic policy-making debate, combined to the lack of viable alternatives, has contributed to place regulatory practices at the top of governments’ policy agendas in current times.
The first part of the essay addresses ontological problems and the emergence of regulation in relation to other tools of governance, with particular reference to the decline of the positive state (ADD FUNCTIONALIST APPROACH SOMEWHERE HERE). The second part delineates the boom of regulatory practices in the aftermath of the financial crisis and demonstrates that despite evident practical reasons, the rise of regulation as a more important tool of governance has to be understood in relation to the role that dominant ideas play in economic policy-making. The final part includes a brief summary and the conclusion.
IN SEARCH OF A COMMON GROUND
As mentioned above, this paper refers to regulation in the area of economic policy-making. The term itself, however, has been used across different subjects with no semantic rigor. The first step is therefore to clarify the meaning that regulation will have throughout the rest of this essay, and particularly find a definition that will allow to target the topic of the present discussion without sacrificing the general meaning of the word.
Selznick offers a very simple and straightforward definition of regulation, referring to it as “the sustained and focused control exercised by a public agency over activities valued by the community” (as cited in Noll 1985, 363). The merit of this definition is that it conceptualizes regulation as a procedure aimed at targeting activities desired in society. The constraints of regulation, therefore, are not imposed to eliminate certain practices, but rather to adjust the trajectory of actions that are regarded as beneficial to the public. Despite the resonance it had in the academic world, Selznick’s definition lacks a certain degree of specificity that is needed to follow the reasoning in this paper. As we particularly refer to regulation over economic activities, Selznick allows for too high a degree of generalizability, which might confuse the reader over the meaning of the word as it is used in the following argument.
Baldwin et al. (1998), on the other hand, add two more strands to the understanding of regulation. The first one extends the meaning of regulation to all the measures the state can use to steer the economy, which might well include instruments such as subsidizing and taxation (1998, 3). Other than being unhelpfully broad, this definition also works against the purpose of this paper since, as it will be explained further in the next paragraph, we want to characterize the emergence of regulation in relation to the decline of the positive state. The excessive inclusiveness of the definition does not allow for this distinction to be made and it will therefore be discarded. The second strand considers “all mechanisms of social control to be forms of regulation” (1998, 4). Black’s work (2002), in particular, elaborates on this line as she tries to escape the state-society relationship and formulate a decentred definition of regulation. Despite the compelling arguments she raises, her definition, quite similarly to Selznick’s, can be explained from the need to find principles valid across different subjects. As already mentioned, we are focusing on the developments of regulation in an economic sense and the second part of the essay will specifically look into the regulatory response to the financial crisis. We can therefore afford to sacrifice generalizability in favor of more specificity and set the conversation in a more defined context.
With this said, Koop and Lodge’s definition of regulation seems to serve our purpose. By digging out the underlying and often tacit consensus at the foundation of many definitions of regulation, they conclude that we can generally refer to it as the “intentional intervention in the activities of a target population, where the intervention is typically direct – involving binding standard-setting, monitoring, and sanctioning – and exercised by public-sector actors on the economic activities of private-sector actors” (2015, 11). The intentional and direct intervention of public actors on the economic activities of privates is an appropriate illustration of how regulation has been interpreted in policy-making debate over the past decades (MAYBE ADD REFERENCES), and we will therefore refer to it in this sense throughout the rest of the paper.
“MORE IMPORTANT” THAN WHAT?
Once the meaning of regulation is defined, we need to understand relatively to what regulation has grown more important over time. This requires to take a deeper historical perspective that will set the starting point of our analysis back in the middle of the 1970s.
To be clear, there is no doubt that the regulatory state originated many years before the 1970s. Glaeser and Shleifer, for example, observe that regulation became a prominent tool of governance in the US over the years of the Progressive Era (1887-1917), when regulatory agencies took the place of private litigation in resolving “social wrongs” (2003, 41). Nevertheless, for the scope of this analysis, it is not necessary to take such an extensive temporal perspective. As the rise of regulation has to be understood in relation to other tools of governance, the mid-1970s represent a good starting point. These years, indeed, marked the end of the positive state, which had been the dominant ideology among Western governments, and the consequent emergence of the regulatory state as a better alternative to define the relationship between government and economic sector. Thus, it can be said that it is in the 1970s that we see regulation become a more (if not the most) important tool of governance in directing the economy.
The dynamics through which regulation rose to the top of governments’ policy agendas can be explained with a functionalist approach, by pointing at the inadequacy of the Keynesian model to accommodate the needs of a changing market. Between the end of the 1960s and the beginning of the 1970s, the world economy entered a period of stagflation, characterized by high unemployment rates and low growth. Faithful to the teachings of Keynes, OECD countries fought the crisis by applying the same old remedies that had been successful when dealing with other types of economic shocks in the previous decades. This time, however, these remedies turned out to be ineffective (Veggeland 2009, 29). Under the guidance of Thatcher and Reagan, the UK and the US therefore departed from the model of state interventionism to resort to supply-side economic policies (Storper and Scott 1992). The period that followed is known as a period of liberalization, privatization and deregulation, which prepared the ground for the institutionalization of the regulatory state as a replacement to the positive, Keynesian state (Majone 1994, 1997; Veggeland 2009).
It is possible to say that regulation grew relatively to the positive state and because of the failure thereof. Indeed, although the period that followed (1980s-1990s) is generally referred to as the time when the state withdrew its powers from the economic sector (Winston 1993, 1263; but see also Stigler 1981), many point out that there is more complexity at play. Vogel says that the semantic confusion over the meaning of deregulation has led to misinterpretations of the role of the state, and that we should speak of reregulation combined with liberalization (1996, 3). That is, the creation of freer markets in fact resulted in more rules through which the government could control private economic actors (ibid.).
It is therefore in this context that we can understand the rise of regulation as a more important tool of governance. The decline of Keynesianism created opportunity for change, and the more reliance on regulatory practices in the years of liberalization settled regulation at the top of states’ policy-agendas. In the second part of the paper, we will see how a functionalist approach however cannot fully grasp the reasons why regulation has grown so important in current times.
NOT END OF THE POSITIVE STATE
Before proceeding with the second part of the argument, it might help to clarify some points that have been claimed so far. Although the previous paragraph examined the rise of regulation in relation to and because of the decline of positive state, this does not mean that some aspect of the Keynesian model are not still present in governments’ policy-agendas.
Taxation, for example, plays a big role in defining the relationship between the state and the economy. Tax burdens continued to be stable even during the significant cuts of the 1980s and 1990s, confirming that the government had retained some of its interventionist power (Swank and Steinmo, 2002). Moreover, some scholars have also analyzed the return of Keynesian models in economic policy-making (Bradley W. Bateman, Toshiaki Hirai and Maria Cristina Marcuzzo, 2010). The presence of forms of positive state, however, does not reject the general trend illustrated in the previous paragraph. On the one hand, indeed, even though countries, like France, have tried to return to more dirigisme, they were incapable of doing so because deprived of important state-led development institutions (Levy 2016). On the other, the boom of regulatory policies and agencies in the aftermath of the financial crisis confirms the increasing importance of regulation as a tool of governance.
In the next paragraph, I will argue that despite the fundamental insights of a functionalist approach, ideas played a crucial role in determining the increasing importance of regulation after the financial crisis.
AFTER THE FINANCIAL CRISIS
So far, the rise of regulation has been understood in relation to the Keynesian model, and particularly the failure of the positive state in dealing with the stagflation of the 1970s. The functionalist approach provides a good framework to explain the establishment of regulation as a dominant theory in policy-making. However, I will argue that it is the self-reinforcing paradigm of the regulatory ideology that ultimately explains the strengthening position of regulation as a tool of governance in current times.
After 2008, Western governments enacted a regulatory crackdown on the financial sector. The reckless behavior of banks that many blamed for the world economic disaster was fought with more regulation both at the national and international level. In July 2010, President Obama signed the Dodd-Frank Act into law, which, as Chairman Gensler put it, had the purpose to subject swap dealers to robust oversight (CFTC 2010). On the other side of the Atlantic, the European Commission set up three new supervisory bodies (the EBA, ESMA and EIOPA) to ensure better capitalization of banks, more caution for insurance companies, and full reliability on credit agencies’ rating systems (European Commission 2014). At a more global level, in November 2010 the G20 leaders endorsed another package of reforms, the Basel III, demanding “new capital and liquidity standards” (Bank for International Settlements 2014). What seems to be clear, therefore, is that the failure of the banking sector in 2008 has set regulation at the forefront of governments’ agendas by reinforcing the role of public agencies as scrutinizers of private economic actors (Pagliari 2012). The question that remains unanswered is why.
It is easy to understand these processes from a functionalist perspective, and this surely should be the case, as many responses were directed to the practices responsible for the crisis. More independent and public institutions, for example, worked as a counterforce to self-regulation, whose dominant presence in international standards had already raised concerns in the past (Underhill 1995). Stricter regulatory policies, on the other hand, were aimed at ending the “light-touch” regulatory policies promoted in both British and American markets until 2008 (Helleiner 2011, 73). Nevertheless, some regulatory measures were of questionable efficacy and the automatism with which they were applied suggests that there are more complex mechanisms at play. First, among the many reforms adopted, the Dodd-Frank Act eliminated one agency, the Office of Thrift Supervision, to create two new ones, the Financial Stability Oversight Council and the Office of Financial Research. As much as more people can always look better after each other’s work, the old “Quis custodiet ipsos custodes?” (“Who will watch after the watchmen?”) still holds, with agencies still vulnerable to regulatory capture. But more importantly, it is unclear why governments precipitated to increase the number of regulators instead of asking, for example, for more accurate models of risk assessment that regulators and banks could apply (Spence 2015). Second, the Basel III required higher liquidity standards, but the impact of capital requirements on banks behavior is ambiguous (Koehn and Santomero 1980; Buser et al. 1981), and it may sometimes lead to the opposite effect (Caprio 2013, 22). Third, more regulation on credit rating agencies did not really solve the problem at the core of their conduct. The “issuer-pays” model is indeed still common practice among the majority of rating agencies (Foley 2013). Although understandable at first glance, it seems that governments’ decisions have been driven by some unreflective automatism that makes us question the conclusions of a functionalist approach. Many regulatory policies, in fact, did not tackle the problems at the roots of the financial crisis. What can be suggested at this point is that ideas might have played a relevant role.
In the 1970s, governments were unable to acknowledge the failure of the Keynesian model. The McCracken group reported, “We reject, however, the view that existing market-oriented economic systems and democratic political institutions have failed” (1977, 14). It seems clear that some similar pattern can be found in the decision-making process after 2008. Indeed, many claimed that it was not the failure of the regulatory state, rather it was the “bad regulation” of the years prior to the crisis that led to catastrophic economic results (Ferguson 2012, but also Caprio 2013). If the decades of the 1980s and 1990s had witnessed few regulators and soft regulation, then it was now time to fix this with more regulators and stricter rules. With the decline of the positive state in the 1970s, regulation had become the dominant ideology in policy-making, and dominant ideas are resilient even to financial crises.
GOOD INTENTIONS BUT LACK OF ALTERNATIVES
It therefore seems that governments’ decisions were influenced by the ideological prominence of regulation in economic policy-making. Surely, governments resorted to new regulatory policies with good intentions. The aim was to prevent another financial disaster to happen in the future, but the fact that some policies were redundant or of dubious efficacy hints to the role of ideas. In particular, it also suggests that this enthusiasm for regulation might have spurred from the lack of viable ideological alternatives. The failure of the positive state had in fact left regulation as the most influential ideology in the policy-making debate.
Conclusion
In this essay, I argued that although a functionalist approach offers invaluable insights to understand the rise of regulation as a tool of governance, ideas contribute to understand why regulation has consolidated itself over time, and particularly after the financial crisis.
In the first part of this essay, I discussed the meaning of regulation and explained its emergence in relation to the positive state. I argued that the regulatory state has replaced the Keynesian model because of the failure of the latter to respond to stagflation, and that this has placed regulation at the forefront of policy-making. I then examined the consolidation of regulation after the financial crisis, claiming that the insights of a functionalist approach have to be integrated with the role of ideas. As much as regulation can be interpreted as a corrective force to economic shocks, the automatism with which governments have turned to regulation after 2008 suggests that dominant ideologies exercise a powerful influence on the decision-making process.