Regulation by rules versus regulation by values

John Kay

Mr Mole runs a service station on the outskirts of Manchester. Petrol is on sale there for approximately twice the normal price. There is nothing exceptional about the petrol or the facilities provided by Mr Mole. It is unlikely that any customers visit his service station more than once. But on an arterial road on the fringes of a major City, there is sufficient passing trade to keep Mr Mole in business.

There are three responses to the story of Mr Mole. The free market approach is reluctant to interfere with his freedom to trade. People buy petrol voluntarily from Mr Mole (in a sense). Who are we to distinguish between Mr Mole and the trader whose petrol is of such outstanding quality that everyone agrees that it is easily worth twice the price? This answer is self-evidently ridiculous. But in understanding why it is ridiculous we see that the problem posed by Mr Mole is more difficult than it appears at first sight.

My inclination is to think that in modern Britain action to deal with Mr Mole is not worth the trouble. But there are economies - like those of Nigeria, Haiti, or parts of the former Soviet Union - where behaviour like that of Mr Mole is endemic rather than exceptional, and this is the main reason why such economies are poor. In these places we need to confirm the precise contractual terms of trade before we engage in even the most trivial of exchanges. In these places we find that we can only ensure that our expectations are met if we are able to enforce the terms of contracts. We can use the Courts, but we will often find it easier to use our fists. The result is that the cost of doing business is so large that very little business takes place. And, much of the business that does take place is at the fringe of fraud and illegality.

If there were more than a few garages like that of Mr Mole most of us would conclude that in future we would only buy our petrol from stations operated by companies like Shell and Esso, whom we expect would not trade in this way. But that solution imposes substantial economic costs. It creates an environment in which it is difficult for genuine local entrepreneurs to succeed - how is such a person to distinguish himself from the myriad of Mr Moles? And it is difficult and costly for Shell and Esso to maintain their own high business standards in such circumstances. Often, they will conclude that the effort is not worthwhile. They would rather operate in Britain, the United States and Singapore. This is not a purely theoretical problem. It is a central problem - perhaps the central problem - of underdeveloped economies.

The second approach is to frame rules designed to restrict the activities of Mr Mole. But this is hard. Mr Mole's customers simply take for granted that petrol will be sold at a fair price. Mr Mole thinks that it is fair game to make profits from consumer misinformation. So do the cowboys who persuade old ladies that their drives must be expensively resurfaced; the financial institutions which sell complicated trading strategies to gullible corporations and public authorities: and the betting shops whose naive and luckless punters return every afternoon. Which of these do we think should be out-lawed! And how?

There are already rules on how service stations must display their prices and these could, no doubt, be tightened. It would be necessary to prescribe the size and perhaps the typeface of the sign; the units of measurement in which the information is conveyed. We will need to specify how often the sign is to be cleaned, and to stop Mr Mole from planting a tree in front of it. We know that what world is like. It is the world of fussy, bureaucratic regulation. It gets in the way of honest, sensible business and it is rarely adequate to block the activities of Mr Mole.

The third solution - and, I think, the only practical solution - is to live in a world in which business values are not those of Mr Mole. And that is a world in which people like Mr Mole find it hard to trade. They cannot obtain petrol from reputable sources. Equipment manufacturers will not supply them. The local bank manager and accountant want none of their business. In describing these mechanisms, we can see how they are breaking down. They are breaking down in the face of a widening of markets, in which trade is inevitably more impersonal. But they are also breaking down under the pressure of a belief that it is certainly unnecessary, and perhaps even wrong, for us to behave in these judgmental ways in our commercial lives.

But it is necessary to have these sanctions. The problem is that while opportunistic behaviour is an essential part of the spirit of successful market economies it is equally capable of destroying them. The attempt to write rules that would discriminate between desirable and undesirable opportunism is obviously and inevitably doomed to fail. Yet few of us have much difficulty in distinguishing, at least at the extremes, one type of activity from the other. We can see the difference between Mr Mole and the man whose petrol is twice as good as other peoples. We know that the innovations of Drexel Burnham Lambert are not valuable but those of Merck are. Market economies actually depend on the social sanctions which come from these perceptions, and the understanding that not all profitable activities are equally valuable.

There are those who advocate that the economic role of government is to lay down rules, and that firms should then be free to trade within them as they wish. In doing so they have fallen victim to the same fallacy as those who thought they could run the Soviet Union from Moscow. If that kind of state would work, then socialism would have worked. Would utility prices be higher or lower, and the companies concerned more or less profitable, if boards were simply required to set prices that were reasonable, rather than engaging in protracted and acrimonious negotiations with their regulator to fix a price cap?

The notion that social objectives can best be achieved by allowing agents to operate freely within a centrally defined, but specific and comprehensive, framework of regulation, is a fallacy common to both left and right. For the left, it manifests itself today in the belief that government can decentralise through contracts and targets. It cannot, because if you know enough to write the contracts and define the targets you would already in effect be managing the business, the school or the hospital. For the right, it manifests itself in the hope that you can align the interests of chief executives with the goal of wealth creation through generous incentive payments and prescriptive accounting standards.

Under both extreme socialism and extreme capitalism, the outcome was tragedy and farce. Investment bankers explained how the genius of men such as Ken Lay of Enron and Bernie Ebbers at WorldCom had changed the rules of the competitive game. Slater's statisticians similarly recorded and applauded the heroic endeavour of individual Soviet workers, such as Alexei Stakhanov, the apparently superhuman Siberian miner. Together they produced a rich tapestry of imaginary feats and bogus figures.

The standard reaction to these exercises is to demand more rules. But the better alternative is a return to a more balanced conception of the nature of business. A world in which senior executives earn salaries. Great businesses - like Merck, Procter and Gamble, Shell and Marks and Spencer - were not built in the three to five year timescale of a so-called long term incentive scheme for managers. The massive shareholder value they generated was a by product of their competitive strengths, not the object of the business itself: and for that reason was sustainable for long enough to deliver our pensions. Henry Ford - no mean creator of shareholder value - wrote that a business run only for profit would die because it had no long term reason to exist. He might have been talking about Enron and WorldCom.

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