Sunday, October 14, 2012

Regulation and Complexity

@timharford's article So Many Numbers, So Little Time yesterday prompted me to think about the causal relationship between regulation and complexity

There are at least three contrasting ideas about this relationship.

1. Red tape directly causes complexity. The solution to complexity is therefore to cut red tape. See for example the OECD document Overcoming Barriers to Administrative Simplification Strategies: Guidance for Policy Makers (pdf, 2009).

2. Conflicts of interest and mutual mistrust create complexity. The response to this complexity manifests itself in complicated forms of contractual negotiation, governance and regulation, which is the outward symptom of the intrinsic complexity of the situation. See for example my discussion of the Oil Industry example in my post Beyond Multiview.

3. Regulation triggers complex behaviour. In his article, Tim Harford suggests that it isn't always economic complexity causing regulatory complexity: in the financial industry, the causation often runs the other way. (Chester Spatt made a similar point in a keynote address earlier this year. Complexity of Regulation, HBLR June 2012.) Every attempt by the regulators to introduce greater complexity into market controls, in the hope of regulating the market more effectively, prompts an increase in the complexity of market behaviour.

Complex rules invite complex rule-bending, says Tim Harford. If at least some of the market players are more agile than the regulators, then they can always escape real regulation by shifting market operations to a higher complexity than the regulators can control. In which case it is not really the regulators who are controlling the market but the market players themselves. So what price Requisite Variety?

There is another twist to the story. Bad behaviour by large companies (Enron, WorldCom) has prompted legislation such as Sarbanes-Oxley, which turns out to be more burdensome for small companies than for larger companies. There seem to be significant economies of scale in such areas as compliance and tax avoidance: large companies can afford armies of accountants and lawyers and lobbyists and PR companies, some of the largest and most profitable companies pay practically no corporation tax. So who really benefits from all this red tape?

(In consequence, many start-up companies are designed to be acquired by a large company rather than undergo the massive administrative costs of a public flotation. Some commentators suggest that this tendency reduces the contribution of start-up companies to the macroeconomic goals of growth and full employment.)

See also Requisite Variety and Wall Street Regulation (May 2012)

(updated October 15th 2012)


R Gilyead said...

Interesting article in today's Guardian re contrast between Starbuck's declared earnings (and tax bill) and the statements they make to analysts about profitability. Perhaps regulators should concentrate on macro outcomes rather than internal rules?

Richard Veryard said...

Thanks Richard. But the Guardian missed a good headline here - the Independent asked if we could attribute Starbuck's tax avoidance to Good Bean Counters?