How to make episodic deregulation work
Business Standard, 17 February 2025
There is a lot of concern about government interference in the lives of the people. In the Budget speech, the Union finance minister announced a high-level committee to examine deregulation in the non-financial sector, and a work programme at the Financial Stability and Development Council to do similarly for the financial sector. The new Reserve Bank of India (RBI) governor, Sanjay Malhotra, threw new light when he said just like there are no free lunches, regulation to enhance stability and consumer protection too is not devoid of costs. There are tradeoffs between stability and efficiency. In the United Kingdom there is optimism about a new `regulatory innovation office'. In the United States there is less optimism about a new `department of government efficiency'.
Foundations
Reasoning about regulation involves comparing the costs and benefits. Full freedom allows the people to pursue economic efficiency. This, in turn, generates growth in gross domestic product (GDP) through innovation and rational firm design. Every government intervention reduces economic efficiency and hampers GDP growth. Government intervention is justified only when the societal gains from regulatory compliance outweigh the societal costs.
The environment of pure economic freedom suffers from some market failure (ie situations of market power, externalities, asymmetric information, and public goods). A good regulation is one that surgically addresses market failure, does not have unintended consequences, and imposes the lowest cost upon society. That is, it yields an acceptable outcome on addressing market failure while imposing the least possible adverse impact upon economic efficiency, innovation, and GDP growth. India's state capabilities are limited. Therefore, it is often wiser to tolerate some market failures than to harm economic dynamism through poorly designed or implemented interventions.
Real-world governments are shaped by public-choice theory: Officials and politicians respond to incentives and pursue their self-interest. State personnel enjoy having, threatening, and wielding coercive power against private persons. Hence, government intervention often has no connection with market failure. It needs to be identified and removed.
This understanding guides the script to use in episodic deregulatory projects. For each piece of state intervention, deregulatory projects should run through the following steps.
Question 1: Why was the intervention put in place at the outset?
The documents on each intervention need to show the objective and to demonstrate that this objective is grounded in market failure. When an intervention does not clearly show its objective, it is good to immediately reverse it. As an example, the candid preamble to the present payments law says that the objective of the law is to have the RBI regulate the business of payments. This objective has nothing to do with market failure.
When an intervention makes claims about the market failure that it seeks to address, these should be sceptically analysed. There is considerable bait-and-switch in the workings of government: A monster in Tibet is shown to justify an intervention in Kerala. Hence, critical thinking is required in reading the founding documents about an intervention (which articulate objectives) and verifying that the legal instruments connect up with the text correctly.
Applying these two tests — (1) whether an objective is stated when designing the intervention, and (2) whether that objective addresses a market failure — would significantly streamline the Indian state.
Question 2: Did it work?
The regulations that survive Question 1 are those that were introduced in the past, were motivated by a market failure, and articulated an objective. Now we must ask: Did the intervention deliver? Were the objectives met? Many interventions fail to deliver on their objective and should be reversed. Good intention in public policy is useless. What matters is getting things done.
Question 3: Did the costs exceed the benefits?
Government intervention curbs possibilities for private persons, who respond by innovating less and investing less. The third stage of deregulatory projects consists of sceptically looking at successful intervention (those that articulated an objective, where the objective was indeed addressing market failure, and those that genuinely won in achieving their objective). Now, we must ask: Yes, the regulation was a success, but at what cost? A regulation that imposes minimum equity capital requirements comes with the cost of blocking entry by smaller firms and reducing competition. A regulation that forces private persons to waste land imposes economic harm by driving up the capital required by firms, and hampers economic efficiency in land utilisation.
There are direct costs of compliance. More important, there are invisible costs of an adverse impact upon the innovation, creativity, and investment of private persons. In the limit, the Indian central planning system forces entire private industries to behave like public-sector undertakings, where all important decisions are made by the government. The RBI controls products and processes in private banks, much like what is done with government banks.
A regulation that imposes high costs (in terms of innovation, growth, and dynamism) that are not commensurate with the benefits (in terms of addressing market failure) should be reversed.
Rules vs. deals
It is always important to look beyond the de jure (text of the law) and at the de facto (the way state intervention actually operates). When powers are amassed by the Indian state, these interact with the lack of rule of law. Powerful government organisations in India have arbitrary power. This fear holds back private persons from commitment to activities in India. Alongside the deregulatory agenda, solutions also involve improving the rule of law.
Conclusion
This analysis shows us how to run episodic deregulatory projects, and also gives us insights into why these generally work poorly. It is very hard to master one sector (eg aviation or financial derivatives), to build a team that has the intellectual capacity to process the above three questions, and to challenge entrenched government organisations that crave power. In addition, none of this is a root-cause solution because the state's faulty structures, which put out new state interventions every day, are purring away. The daily flow of new kinds of harm overwhelms the possibilities from episodic deregulatory projects. What is needed is a root-cause analysis that will change how regulators work. The field of regulatory theory in India knows how to do this.
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