Financial and Monetary Systems

3 ways that regulation benefits economies

U.S. dollars and other world currencies lie in a charity receptacle at Pearson international airport in Toronto, Ontario, Canada June 13, 2018. REUTERS/Chris Helgren

Financial regulation is crucial for economic development, argues Professor Diane Coyle. Image: REUTERS/Chris Helgren

Diane Coyle
Bennett Professor of Public Policy, University of Cambridge
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Financial and Monetary Systems

One of the striking changes any rich-world traveler to low-income countries cannot fail to have missed during the past decade or so is the rapid spread of mobile phone use, followed now by expanding mobile Internet access. Mobile communications are playing the same role in social and economic development in Africa, Asia, and Latin America that the spread of fixed-line communications did in countries like France and the United Kingdom in the 1970s. Family and social connections, as well as business and educational opportunities, are being transformed.

A key contributor to this technological transformation was a mandatory EU technical standard enforced in 1987. The regulation created a continent-wide market for hardware and services, one large enough that the standard – called GSM, after the Groupe Spécial Mobile committee that had codified it – was adopted globally. By 2004, there were more than a billion subscribers to GSM services worldwide. The global reach of the regulation implied huge economies of scale in the manufacture of handsets and network hardware, so prices fell rapidly, and interoperability between networks and across countries was much easier to achieve.

Many regulations play this standard-setting role. Contrary to the simplistic view that regulation is inevitably bad for business, there are in fact three important channels through which regulation can benefit an economy.

One is the market-creating and market-growing role illustrated by the GSM standard. When there are competing technological approaches, such as the famous contest in the 1970s between the Betamax and VHS standards for videotape, consumers are better served if these contests between similar standards are settled promptly and decisively, to preclude the risk of spending money on a losing technology. When the standard is set by regulation in a large market like the EU, the United States, or China, economies of scale kick in quickly. The virtuous circle of falling prices, quality improvements, and growing demand is thereby established.

This is a powerful dynamic. It explains why British businesses are increasingly appalled by the prospect that the UK government will not deliver continuing post-Brexit regulatory alignment with the EU. After consulting thousands of its members, the Confederation of British Industry (CBI), the country’s biggest business organization, recently called for “ongoing convergence” with EU rules for goods, services, and digital standards. The scale of the accessible market is immensely important to growth prospects.

Regulation can also benefit an economy by enabling competition. This seems counter-intuitive, and indeed some forms of regulation serve to enable rent-seeking behavior. Businesses in oligopolistic sectors often complain about the burden of compliance; but they clearly rely on regulation as a barrier to market entry by new competitors. The cost of their regulatory burden is a fee they pay for market power.

The regulation of some of these sectors, like finance, is an example of what not to do. Officials imagine that consumer protection requires another regulation whenever something goes wrong, resulting in thickets of rules that protect incumbents and lead to all kinds of unintended consequences and complexities. As the new regulations prove ineffective (not surprising, given the overabundance of scams and mis-selling in finance), a vicious circle is set in motion, with additional regulation resulting in further failure – and more regulation.

That is why smart regulators charged with ensuring healthy competition, like the UK’s Financial Conduct Authority, use a “sandbox” approach to enable testing of new technologies and business models without a crushing burden of regulation. The FCA is proposing to make its regulatory sandbox method global.

Moreover, there is some safeguard against complex regulatory thickets if new rules need to undergo a cost-benefit analysis. But such assessments are only incremental, whereas what is needed is a periodic assessment of the regulatory framework as a whole. Major disasters are often the result of a failure to think in such terms, as evidenced, tragically, by the fatal Grenfell Tower fire in the UK.

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In new sectors, or those with a real possibility of new entrants with new technologies, regulation actually helps to create a market. For example, by removing information asymmetries about innovative products – asymmetries that are larger the more technologically advanced the products – regulation facilitates a level playing field between large incumbents and new entrants, enabling innovation to take root. And by providing assurances about the safety or effectiveness of new products and services, and setting minimum mandated standards, regulation gives consumers the confidence to try something new.

The third way in which regulation is good for an economy is precisely in its protection of consumers. If this means businesses earn a lower short-term profit, so be it. A society’s welfare is not identical with the profitability of its businesses, or with the growth rate of GDP. In the CBI’s conversations about post-Brexit regulation, the sectors most interested in regulatory divergence were waste and environmental services and water. Tough EU environmental standards impose high costs on these businesses, which might mean they grow more slowly than they otherwise would. But it is well known that GDP growth does not account for environmental externalities.

All of this underscores the importance of how regulators regulate. Their actions can – and often do – harm competition and growth, while failing to protect consumers. But that need not be the case. Recognizing the potentially large economic benefits of regulation might encourage a more sophisticated debate that moves beyond political pantomime and focuses attention on the crucial issue of regulatory design.

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The views expressed in this article are those of the author alone and not the World Economic Forum.

Related topics:
Financial and Monetary SystemsEconomic Progress
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