(This essay was published in Hong Kong Economic Journal on 2 November 2016.)


Although Milton Friedman is the most famous advocate of free market ideas in the second half of the 20th century, it was his colleague George Stigler of the University of Chicago who developed the theoretical arguments against government intervention in favor of free and unfettered markets. Stigler is best known for pioneering the economic theory of regulation, also known as capture theory, and was awarded the Nobel Prize in economics in 1982.


Stigler questioned why regulations exist. The standard economic arguments had been that they either correct market failures (for example, externalities like pollution) or pursue other policy goals (like income equality) in the public interest. The basic premise underlying these arguments is that government is motivated to do public good, and it can do so in an effective and cost efficient manner.


Stigler taught the profession to examine the scientific evidence based on consequences and not the premise – to look at the effects of government regulations and see whether they matched the stated intentions. If they don’t, is there a better alternative explanation for why governments regulate?


Stigler thought so. Using an evidence-based approach, he argued that more often than not industry incumbents have captured the regulatory process. Regulations are in fact often designed to benefit industries rather than the customers they serve.


He attributed this to the fact that regulatory processes are subject to consultation and vulnerable to stakeholder influence. Stakeholders who have large stakes and permanent interests in the industry are more likely to end up with the most influence. Producers, especially large ones, often have a disproportionate amount of influence because of their big stakes.


Stigler found that most regulations take the form of raising barriers to industry entry (for example, through licensing, quotas, and price control). These are usually introduced in the name of maintaining market orderliness and assuring standards of quality and performance. But he argued that the main result of such barriers is to limit competition among producers, especially from new entrants, rather than to protect customers.


On the other hand, consumers typically have very little influence and are often neglected by regulators that are supposed to advance their interests. Concentrated interests are politically more influential than dispersed interests. Stigler concluded the invisible hand of the market place is more often a better friend of the consumer than the visible hand of the regulator.


Advocacy groups have emerged to advance the interests of certain consumers. Some of them have become quite powerful in the political arena. This has to some degree offset the influence of powerful producers. But in gaining influence these groups have had to concentrate their focus on a single issue (or limited issues). The result is that they do not and cannot represent the full diversity of customer concerns.


Oftentimes their single mindedness results in other excesses as they seek to appease their own constituencies and pursue their own ambitions (both organizational and political). They too end up trying to capture the regulatory process in their favor and for their constituencies.


The rise of advocacy groups can in part be attributed to the rise of regulation. As government regulates industry, industry seeks to capture the regulatory process and advocacy groups appear to counter the influence of producers in response to consumer demand for redressing the imbalance. Regulations therefore tend to grow as society seeks to solve its economic issues through non-market processes.


George Stigler was concerned about such a development. While regulations are products of stakeholder lobbies and interest group advocates, every enacted regulation creates a constituency of beneficiaries that becomes the new vested interest. They too become part of the gridlock of organized lobbies and advocates that further complicate the policy environment. Hong Kong is in real danger of travelling down this path. Three aspects of our political arrangement are nurturing it.


First, under the Basic Law the government must not spend beyond its means. It has to balance its budget. Hong Kong is, however, beholden to many interest and advocacy groups. And the political system is also opening up. To accommodate some of these demands, the government will increasingly have to use regulation as a means to achieve some of its goals.


Regulation is a substitute for taxation, even if imperfectly so. It transfers resources from payers to recipients without going through the government balance sheet and is therefore politically and legally not taxation as such, but achieves some of the same results. But regulation is almost always an even more inefficient and wasteful means of redistributing the same amount of resources. It can be more detrimental for the economy and society.


Second, the present establishment coalition relies considerably on the support of organized interests. Not a few of these are heavily focused on narrow producer interests. They are not averse to using their influence to capture the regulatory process. Public policy therefore becomes prone to being fragmented and piecemeal.


Under British rule, the appointed colonial governor would try to balance these forces to create a coherent public policy.


Under the Basic Law, the balance has shifted in favor of the organized interests, which have become a formally institutionalized part of the political system. But, the Chief Executive of the ostensibly executive-led government is now elected. This obliges him to curry favor with all the powerful voices at the ballot box. All elections introduce non-trivial elements of opportunism and uncertainty into the continuity of policy over time (regardless of whether the selection is by the Election Committee or universal suffrage).


The only element that maintains continuity of policy is a civil bureaucracy that functions according to established rules and procedures. These formal processes preserve continuity of past policy goals, but on occasion they appear as unthinking intransigence in the face changing circumstances.


All too often policy is muddled through, which means overlaying more regulations on top of existing ones in a piecemeal fashion. This satisfies the most powerful and loud voices in the short term. But the piling up of more ad hoc regulations creates more new beneficiaries in an increasingly complex system of regulations. The myriad of constituencies makes it even more difficult to make coherent policy choices. As regulations become more and more complex, reform of the regulatory system also becomes increasingly difficult.


Third, given a constitutional arrangement where the legislators have curtailed powers and opposition parties are unlikely to capture government power, the opposition members no longer have to be accountable for the delivery of solutions to policy problems. They merely have to be accountable for their campaign platforms.


This usually means promising to hold government accountable and to stake out their position on political reforms. Taking government to task rather than working out a solution to policy problems becomes a sufficient condition for becoming elected or re-elected. As a consequence, the legislature has become increasingly a political advocacy platform.


Moreover, for a variety of opportunistic historical reasons the elections system has been designed to allow minority opinions to be over represented. The proportional representation election rule gives an exaggerated voice to narrow minority interests. As a result, extreme radical views have gained representation among opposition voters. This has ended up polarizing and fragmenting political positions.


It has become increasingly impossible to make political choices that have budgetary implications, and regulatory interventions have become the norm, some of which do not require legislative approval. This leads to an even more divided political landscape, where decisions become an outcome of opportunistic chance and coincidence.


Bold decisions of the past that advanced Hong Kong’s economic development – such as buying back the franchise to open up the international telecommunications market and terminating the interest rate agreements to open up banking competition – have become almost impossible to imagine in today’s political environment.


The deregulation of industries to open up markets and unlock entrepreneurial capacity will be an important driver of economic productivity. Financial technology, education, medical and health care are obvious areas where considerable gains can be achieved.


Land, property and housing are markets that are highly regulated and where there are externalities. But how they are regulated and how property rights are restricted or facilitated has a huge effect on how much value will be unlocked and made available for use. Current rules could be liberalized to increase supply in a way that would avoid creating market disorderliness and improve efficiency, transparency, and equity. Such measures would go a long way towards promoting growth with equality.


The selective deregulation of immigration to enhance our population quality would also promote growth with equality. Attracting more skilled individuals will be crucial to Hong Kong’s future. Professor Liu Pak-Wai’s recent report on Hong Kong and Mainland economic relations argues that selective opening of immigration is especially important in the face of Hong Kong’s rapidly ageing population – one of the most rapid the world.


Some one-fifth of our population arrived within the past 40 years, but most are relatively unskilled and came through family reunion, mostly cross-border marriages. On the flip side, Hong Kong has also lost 850,000 residents to emigration since 1980. This has created enormous tightness in the labor force for skilled individuals.


Women today already make up 44.6% of the labor force. In 1971, they were only 33%. The number of men in the labor force has not grown since 1996 when it reached 1.92 million. Since then the number of women in the labor force has grown by about 400,000, rising from 1.14 to 1.55 million.


Hong Kong has a huge talent pool working overseas. According to official reports from the OECD in 2000, there were 335,993 persons from Hong Kong working in member countries, of which 251,407 were highly skilled. More updated numbers are not available, but they should obviously be even higher today.


A larger, more skilled workforce would not only be a gain for economic productivity, but would also improve wage inequality because unskilled labor would then constitute a smaller fraction of the workforce. It would narrow the rising relative wage gap between skilled and unskilled workers.


All too often, people are hostile to freer markets mostly because they are not aware that when markets are not free, far more problems are usually in store. George Stigler defended freer markets not for ideological reasons, but on empirical and scientific grounds. He showed that for the most part, they have had a good track record. Stigler passed away 25 years ago, but his capture theory is alive and well.

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