The New Tyranny: How the Regulatory State Threatens Your Freedom

THE UNITED STATES’ REGULATORY BUREAUCRACY has vast power. Regulators can ruin your life and your business very quickly, and you have very little recourse. That this power damages the economy is a commonplace complaint. Less recognized, but perhaps even more important, the burgeoning regulatory state poses a new threat to our political freedom.

What banker dares to speak out against the Federal Reserve? What trader dares to criticize the Securities and Exchange Commission? What hospital or health insurer dares to oppose the Department of Health and Human Services or ObamaCare? What business needing environmental approval for a project dares to criticize the Environmental Protection Agency? What drug company dares to challenge the Food and Drug Administration? Our problems are not just national. What real estate developer needing zoning approval dares to speak out against the local zoning board?

The agencies demand political support for themselves first of all. They are like barons in a monarchy to whom the King’s problems are secondary. But they can now demand broader support for their political agendas. And the larger partisan political system is discovering how the newly enhanced power of the regulatory state is ideal for enforcing its own political support.

The big story of the past 800 years of United States and British history is the slow and painful emergence of political institutions that constrain government power and guarantee our political liberty, institutions to which we refer broadly as “the rule of law.” The United States had rule of law for nearly two centuries before it had democracy, and its democracy sprang from the rule of law not the other way around.

This rule of law always has been in danger. But today, the danger is not the tyranny of kings, which motivated the Magna Carta. It is not the tyranny of the majority, which motivated the Bill of Rights. The threat to freedom and rule of law today comes from the regulatory state. The power of the regulatory state has grown tremendously, and without many of the checks and balances of actual law. We can await ever greater expansion of its political misuse, or we can recognize the danger ahead of time and build those checks and balances now.

The power of the regulatory state has grown tremendously, and without many of the checks and balances of actual law. We can await ever greater expansion of its political misuse, or we can recognize the danger ahead of time and build those checks and balances now.

Yes, part of our current problem is law itself, big vague laws, and politicized and arbitrary prosecutions. But most of “law” is now written and administered by regulatory agencies, not by Congress.

The use of law and regulation to reward supporters and punish enemies is nothing new, of course. President Franklin Roosevelt understood that New Deal jobs and contracts were a great way to demand political support. His “war on capital” hounded political opponents. The New Deal may not have been an economic success and likely prolonged the Great Depression, but it was above all a dramatic political success, enshrining Democratic power for a generation. Presidents John F. Kennedy and Richard Nixon tried to get the Internal Revenue Service to audit their political enemies. But the tool is now so much stronger.

Rule of Law: The Devil in the Details

“Rule of law” and “regulation” are slippery Big Vague Words. The rule of law is so morally powerful that the worst tyrants go through the motions. Stalin bothered with show trials. Putin legally convicted and jailed the punk rock band Pussy Riot for the crime of “hooliganism.” Even Henry the Eighth had trials before chopping heads. Is this not rule of law?

No, of course not, but it’s worth reminding ourselves why not as we think about bureaucracies.

“Rule of law” ultimately is a set of restrictions to keep the state from using its awesome power to force your political support. If you oppose Castro, you go to prison. If you opposed Herbert Hoover, could you still run a business? Yes. If you oppose the next U.S. President can you do so? If you oppose the policies of one of the regulatory agencies, now powers unto themselves, or speak out against the leaders of those agencies, can you do so? If you support candidates with unpopular positions, can you still get the regulatory approvals you need? It’s not so clear. That is our danger.

“Rule of law” is not just about the existence of written laws and the superficial mechanics of trials, judges, lawyers, and sentences. Rule of law lies deep in the details of how those institutions work. Do you have the right to counsel, the right to question witnesses, the right to discovery, the right to appeal, and so forth? As with laws, what matters about regulation is not the presence of written rules but their character and operation.

Regulators write rules too. They fine you, close down your business, send you to jail, or harass you with endless requests, based on apparently written rules. We need criteria to think about whether “rule of law” applies to this regulatory process. Here are some suggestions.

As with laws, what matters about regulation is not the presence of written rules but their character and operation.

Rule vs. Discretion? This is really a central distinction. Does the regulation, in operation, function as a clear rule? Or is it simply an excuse for the regulator to impose his or her will on the regulated firm or person? Sometimes discretion is explicit. Sometimes discretion comes in the application of a rule book thousands of pages long with multiple contradictory and vague rules.

Simple/Precise or Complex/Vague? Regulations can be simple and precise—even if silly. “Any structure must be set back six feet from the property line” is simple and precise. Or the regulation can be long, vague and complex, i.e.—“The firm shall not engage in abusive practices.”

Many regulations go on for hundreds of pages. Lengthiness, vagueness, and complexity are central features of regulations that appear to establish fixed rules while actually providing regulators wide discretion.

Knowable Rules vs. Ex-Post Prosecutions? Is the rule book knowable ex ante? Or is it, in application, simply a device for ex-post prosecutions. Insider trading rules are, at present, a good example of the latter. The definition of “insider” varies over time, and there is really little hope in finding a coherent rule book that tells you what is and is not allowed. Much better to stay on good terms with the regulator.

stocks-BPermission or Rule Book? In one kind of regulation, there is a rule book. If you follow the rule book, you’re OK. You go ahead and do what you want to do. In much regulation, however, you have to ask for permission from the regulator, and that permission includes a lot of discretion. Environmental review is a good example.

Plain Text or Fixers? Can a normal person read the plain text of the rule and understand what action is allowed? Or is the rule so complex that specialists are required to understand the rule and the regulatory agency’s current interpretation of the rule? In particular, are specialists with internal agency contacts or specialists who used to work at the agency necessary?

Enforced Commonly or Arbitrarily? Regulations that are seldom enforced but then used occasionally to impose enormous penalties are clearly more open to political abuse. If Americans commit three felonies a day in “conspiracy,” internet use, endangered species, wetlands, or employment, and immigration regulations (just to start), but one in a hundred thousand is ever prosecuted, then the power to decide who gets prosecuted is obviously ripe for abuse.

The Right to Discovery, See Evidence, and Challenge Decisions. Do you have the right to know how a regulatory agency decided your case? Step by step, what assumptions, calculations, and interpretations did it use? The objects of agency actions often do not, even in high profile cases.

The Right to Appeal. In law, the right to appeal is central and means the right to have your case heard by an appellate body distinct from the prosecutor and first judge. In regulation, however, the right to appeal often means only the right to ask the same agency that made the decision to reconsider. The Supreme Court’s Chevron doctrine sets a high bar for courts to second-guess agency interpretations of law. That severely limits your ability to appeal regulatory decisions and the regulations themselves.

Insulation from the Political Process. There are many structures in place whose purpose is to ensure the “independence” of independent agencies. But we live in a democracy, so independent agencies can’t be too independent if they have great discretionary power.

The purpose of these structures is to prevent the regulatory state from being used for explicit party politics. They are less successful at limiting the bureaucracy’s use of its regulatory power to prop up its own separate fiefdom. They are also less successful at limiting unwitting political cooperation. When vast majorities of the bureaucracy belong to one political party, when government employee unions funnel unwitting contributions to candidates of that party, and when strong ideological currents link decisions across agencies, explicit cooperation is less necessary.

And, though it was ever thus, the enormous expansion of the size, power, and discretion of the regulatory state makes the insulation structures more important, just as they are falling apart.

Speed vs. Delay. The regulatory process can take years, and a canny regulator need not explicitly rule against a political foe. Delay is enough. The Internal Revenue Service, for example, didn’t deny tax-exempt status to conservative groups in 2012. It just repeatedly delayed the approvals until the election was over.

Consultation and Consent of the Governed. Congress writes empowering legislation that is usually vague and expansive. The agencies undertake their own process for rule writing. They usually invite comment from interested parties, but are typically free to ignore it when they wish.

The Regulatory State in Action

Do we really have reason to be afraid? Let’s take a tour of the regulatory state of affairs. As we do so, think of how well the current regime represents “rule of law,” how well it respects your freedom to speak, your freedom to object, your freedom to oppose the regulator and regulatory regime. Think how insulated it is against the strong temptations of our increasingly polarized, winner-take-all, partisan political system to use regulatory power as a means of enshrining political power.

Systemic Means What We Say It Means

The Dodd-Frank Act is a 2,300-page law that, among other things, gives regulators the power to designate certain firms as systemically important financial institutions (SIFI). Such designations put firms under stringent regulation by the Federal Reserve. But the law does not define what a SIFI is. Subsequent regulations have not defined it either. When the insurer MetLife challenged its SIFI designation in court, the Financial Services Oversight Council responded by opining that a failure by MetLife could threaten the broader economy. This setup makes a SIFI designation nearly impossible to fight.

dodd-frank-bombThe act has given rise to tens of thousands of pages of subsidiary regulation, and much more still to be written. The Volker rule alone—do not fund proprietary trading with insured deposits—runs now to nearly a thousand pages. To call this Talmudic is to insult the clarity and concision of the Talmud.

The result is immense discretion, both by accident and by design. There is no way one can just read the regulations and know which activities are allowed. Each big bank now has dozens to hundreds of regulators permanently embedded at that bank. The regulators must give their OK on every major decision of the banks.

The “stress tests” that have become a cornerstone of the Federal Reserve’s regulatory efforts are a case in point.

There is no way one can just read the regulations and know which activities are allowed. Each big bank now has dozens to hundreds of regulators permanently embedded at that bank. The regulators must give their OK on every major decision of the banks.

In “stress tests,” Federal Reserve staff make up various scenarios and apply their own computer models and the banks’ computer models to see how the banks fare. However, the Fed does not announce a set scenario ahead of time. The Fed staffers make up new scenarios each time. They fear that if banks know the rules ahead of time, then the clever MBAs at the banks will make sure the banks all pass. And billions of dollars hang on the results of this game.

The Fed staffers playing this game that I know are, for now, completely honest and apolitical. But how long can the Fed resist the temptation to punish banks that have stepped out of line with a stress test designed to exploit that bank’s weaknesses? Is it any wonder that few big banks are speaking out against the whole regime? They understand that being an “enemy” is not the way to win approvals.

And the stress-test staff are getting handsome offers already to come work for the banks, to help the banks to pass the Fed’s stress tests. Ben Bernanke himself is now working for Citadel.

If this sounds like the cozy world of “regulatory capture,” however, remember the litany of criminal prosecutions and multibillion-dollar settlements. These are instigated by the Attorney General and Department of Justice, with much closer ties to the administration, but they revolve around violations of securities regulations. Is it a coincidence that Standard & Poor’s, which embarrassed the administration by downgrading U.S. debt, faced a $1.4 billion settlement for ratings shenanigans, while Moody’s, which only later downgraded U.S. debt, did not? Pay up, shut up, and stay out of trouble is the order of the day.

John J. Mack, Morgan Stanley’s ex-chairman, explained Wall Street’s mentality today when he told The Wall Street Journal: “Your No.1 client is the government.”

Statistics Say You’re Guilty

In 2013, the Consumer Financial Protection Bureau (CFPB) and the Department of Justice charged Ally Bank with discrimination in auto lending and extracted a nearly $100 million settlement. Ally provides money to auto lenders. Lenders negotiate interest rates. Nobody is allowed to collect data on borrowers’ race. But DOJ ran statistical analysis on last names and zip codes—Bayesian Improved Surname Geocoding—to decide that minorities are being charged more than they should, essentially encoding ethnic jokes into law.

Why did Ally pay? Sure, it might have won in court. But nobody wants to be branded a racist. And DOJ and CFPB have many more cards up their sleeves. CFPB now can disapprove any retail financial arrangement it deems “abusive” and put Ally out of business.

Note that there was no charge or evidence of discriminatory practice or intent. The case was purely about DOJ and CFPB not liking the statistics of the outcome.

More importantly, was this a knowable regulation or a bill of attainder? Did CFPB or Justice make available the Bayesian Improved Surname Geocoding program on their websites, and tell financial institutions: “Please download the BISG program, make sure you run loans through it, and that they come out with the right statistics”? Obviously not. This was an unknowable regulation. Ally had no way to make sure it was lending to the right last names.

The Affordable Care Act You Can’t Afford to Refuse

Puppet B copyThe Affordable Care Act created massive new health care entitlements, funded those with a complex array of fines and taxes, and imposed rigorous regulations on the design of health insurance plans. The bill is 2,700 pages long, and the subsidiary regulations are so convoluted that there is an active debate on their page count. Justice Antonin Scalia invoked the Eighth Amendment against cruel and unusual punishment as protection against actually reading it.

The Heritage Foundation counted 1,327 waivers to various provisions of the law that the Department of Health and Human Services has issued. Clearly, someone needing a discretionary waiver shouldn’t be a big critic of HHS or the law.

The ACA is almost a textbook case of corporatism: The big hospitals, doctors, and insurers get a protected small cartel in return for political support for the law, HHS, and state exchanges. As the ACA is itself an intensely partisan question, that support leaks into major party politics.

The ACA is almost a textbook case of corporatism: The big hospitals, doctors, and insurers get a protected small cartel in return for political support for the law, HHS, and state exchanges.

Speaking about the consolidation of health insurance into two or three big companies, Aetna CEO Mark Bertolini told The Wall Street Journal that federal regulators “happen to be, for most of us now, our largest customer,” adding:

So there is a relationship you need to figure out there if you’re going to have a sustained positive relationship with your biggest customer. And we can all take our own political point of view of whether it’s right or wrong, but in the end-analysis, they’re paying us a lot of money and they have a right to give us some insight into how they think we should run our business.

United Health wanted to join the California exchange Covered California. Many areas of California have only one or two insurers now, so competition and choice are clearly needed. But participation in the exchange needs prior regulatory approval, and United Health was denied. Why? The Los Angeles Times reports:

Peter Lee, executive director of Covered California, said established insurers shouldn’t be free to come in right away. Those insurers, he said, should not be allowed to undercut rivals who stepped up at the start and made significant investments to sign up 1.2 million Californians during the first open enrollment. …

We think the health plans that helped make California a national model should not be in essence undercut by plans that sat on the sidelines.

You can’t ask for a clearer example of a regulator using discretionary power to cartelize an industry, protect incumbent profits, and punish a business for failure to support his political objectives. He said nothing about United Health’s ability to serve California customers or to abide by any regulation.

Nice Internet You Have There

The Internet is the central disruptive technology of our time. So far it has been “permissionless”—unlike just about every other activity in the contemporary United States. You do not need prior approval from a regulator to put up a website.

But pressure for regulation has grown under the reasonable-sounding banner of “net neutrality.” At stake is the right of businesses to pay extra for faster delivery of their content. “Net neutrality” means outlawing business class on the internet. The Federal Communications Commission, a supposedly independent agency, studied the issue and found no reason to regulate the internet.

Then, in November 2014, President Obama surprised the FCC by announcing his support for regulating the internet as a public utility. The agency duly followed the President’s lead and proposed new rules.

The result is the full telecommunications regulatory regime circa 1935. In particular, the FCC will have the power to determine what rates are “reasonable.” The FCC announced it will “forbear” to use that power along with its right, under the regulation, to impose content restrictions—yes, to tell you what to put on your website—and the “fairness doctrine.” But forbearance is discretionary. So, a company thinking of investing money in fiber-optic lines had better invest in good relations with the FCC and the administration that apparently drives its decisions.

Your Political Speech Papers Are Not in Order

Campaign finance law and regulation is all about restricting freedom of speech and altering who wins elections. So one should not be surprised about its political use to restrict freedom of speech and alter who wins elections.

Still, the recent trend is more troubling than usual.

Lois Lerner, director of the IRS Exempt Organizations Unit, famously derailed applications for nonprofit status from conservative groups ahead of the 2012 presidential election. Her main tactic was endless delay. And the goal was achieved. Many conservative groups sat on the sidelines rather than talk about their issues.

The tangle between Wisconsin Gov. Scott Walker and Milwaukee County District Attorney John Chisholm is similarly renown. Chisholm launched “John Doe” probes of Wisconsin conservative issue advocacy groups that, as The Wall Street Journal describes them, “blanketed conservatives with subpoenas, raided their homes and put the targets under a gag order.” The gag order prevented the targeted individuals from even revealing the fact of the investigation. It came to light, and the investigation was eventually ended by a court order, but not until well after the recall election. Walker won anyway, but he might not have.

The Obama administration has been pushing since 2010 to force nonprofits to disclose all donors, as campaigns must disclose contributors. It sounds innocuous: “Disclosures?” Who can be against that? Shouldn’t “big money” contributing to politics be public information?

Not when the vast power of the regulatory state can come down on whomever it wants to. Tyrannies always start by making lists. Nixon at least had to compile his own enemies list.

A Magna Carta for the Regulatory State

The power of the regulatory state has increased steadily, and it lacks many of the checks and balances that give us some “rule of law” in the legal system. The clear danger we face is the use of regulation for political control. In that scenario, industries get carved up into a few compliant oligopolies, and the threat of severe penalties, with little of the standard rule-of-law recourse, keeps people and businesses in line and supporting the political organization or party that controls the agencies.

The power of the regulatory state has increased steadily, and it lacks many of the checks and balances that give us some “rule of law” in the legal system. The clear danger we face is the use of regulation for political control.

We’re not there yet. The Koch Brothers are not on the EPA’s “crucifixion list.” The DOJ, National Labor Relations Board, Equal Employment Opportunity Commission, Occupational Safety and Health Administration, and so on and so on are not investigating every Koch plant. The Hoover Institution retains its tax-exempt status despite writings such as this one. A free media still exists, and I can read all my horror stories in the morning Wall Street Journal, and the free (for now) internet.

But we are getting there. What stops it from happening? A tree ripe for picking will be picked.

The easy answers are too easy. “Get rid of regulations” is true, but simplistic like “get rid of laws.” What we learned in the 800 years since Magna Carta is that the character of law and the detailed structures of its operation matter. Law is good, as it protects citizens from arbitrary power.

Magna Carta-B copyIt is time for a Magna Carta for the regulatory state. People need the rights to challenge regulators—to see the evidence against them, to challenge decisions, to appeal decisions. Yes, this means in court. Everyone hates lawyers, except when they need one.

People need a right to speedy decision. A “habeas corpus” for regulation would help: If any decision has not been rendered in six months, it is automatically decided in your favor.

A return to economic growth depends on reforming the regulatory state. And so does preserving our political freedom.

Mr. Cochrane is a Senior Fellow at the Hoover Institution, a Distinguished Fellow of the Booth School of Business at the University of Chicago, and an adjunct scholar of the Cato Institute. A longer version of this article first appeared at his website, The Grumpy Economist, on August 1, 2015, and is available at johnhcochrane.blogspot.com/2015/08/rule-of-law-in-regulatory-state.html.