 Welcome to Free Thoughts, a podcast project of the Cato Institute's Libertarianism.org. Free Thoughts is a show about libertarianism and the ideas that influence it. I'm Aaron Powell, a research fellow here at Cato and editor of Libertarianism.org. And I'm Trevor Burrus, a research fellow at the Cato Institute Center for Constitutional Studies. Today, we're talking about regulations gone wrong. Joining us is Peter Van Dorn, senior fellow at the Cato Institute and editor of Regulation Magazine. Peter, we had you on several episodes ago to talk about some problems with regulation. And one of the issues that emerged was that often regulations are the result of prices in the market not doing what people, regulators, politicians would like them to be doing. One of the examples I'll talk about today involve, well, in many regulated markets, what the regulation is designed to do is suppress price reality. And for whatever reasons, cultural or political, many prices upset people. And I'll start out with old-fashioned telephones, which are rapidly disappearing. But believe it or not, a lot of our internet and so-called net neutrality and other pricing issues regarding the internet actually all start with telephone regulation from the 30s, believe it or not. And that came in from the very beginning of telephones. They were already regulated pretty quickly, right? Well, the 1934 Telecommunications Act was the, yeah, so a long time ago. But the whole pricing issues about local versus long distance go back to a very famous Supreme Court decision, which I'll describe, which actually started the mischief rolling. And these are people, often people, they think the price would be too high or they don't understand what the prices are supposed to be doing and how they would create a system that maybe they don't like if you'd let them run naturally so they start getting in there and meddling and perverse things often happen. Correct. So tell us a little bit about the telecom. Okay, in the old copper-based landline system, there was a dedicated piece of wire from everyone's home to what's called an exchange. And it served one purpose and one purpose only, which is to connect your house to the exchange. So it was all fixed costs and no marginal cost. Every landline phone, every house had such a thing. In urban areas, they were a mile or two miles long. And in rural areas where I, there's one exchange in Northern New York where I grew up where the average loop link, the loop is the name used by telecom people to describe the copper wire going from a house to an exchange, the average loop link in this place in the Adirondacks was 27 miles long, right? So that's expensive. It's a lot of wire, yeah. And somebody has to pay for that. And way, way back when, long distance was expensive because you had a vacuum, so you had coaxial cable going from major cities to other major cities. And every 30 miles, there had to be vacuum tube-based amplifiers, right? And so access was expensive and long distance was expensive. So the question was arose, how should you price telephone service? So the fundamental fact that I just talked about was that access is generally more expensive than use. But ever since telephones were invented, that fact was contestable and suppressed. Because it seems like you would, I mean, bake the cost of the wire into the cost of construction of the house if you only have to build this thing once, right? But of course, then there's this national right, so urban areas get connected and then rural areas don't and because… And it's seen as unfair and they vote. And so the Senate over-represents rural areas, right? That's a good point. So regulated prices in telecom from the 30s onward were the opposite of the truth, which is that access was cheap. I mean, I grew up thinking local calls were free and long distance was something that where mom watched the clock and everything was very expensive. In fact, from the 30s onward, long distance was taxed to cross subsidize local service. Initially, this didn't have much economic mischief because long distance was only 3% of calls and most people didn't make them. So it was a small tax on something and it kind of worked out. But it turns out in 1931 in Smith v. Illinois Bell, the Supreme Court actually added to this perversity by mandating the cross subsidy that there are two fields I study. One is natural gas regulation and the other is telecom regulation where the thing that really made economic haywire were Supreme Court decisions. So I personally think that lawyers learning some economics and having more economic analysis in the legal community hopefully helps and will help court decisions in the future when it comes to regulation because they—anyway, this 1931 Smith v. Illinois Bell basically mandated that long distance be taxed and used to cross subsidize local service. So that local calls could be free. Well, not well. See free to the people. Right. Why is this a problem? I mean, it's all getting paid for. It's just the money's coming out of different buckets, I guess. Correct. And that's often a regulator's perspective, but the word economists always try to teach people is arbitrage, which is as long as there's no technological change and one cannot bypass the system and bypass the tax, then that's okay, from an economics point of view because non-bipassable taxes are efficient taxes. They're like head taxes. So— You can't get around them. You can't get around them. That doesn't distort behavior. Economists define efficiency. Thus, it's just as you said, it's just a way to collect revenue. But telecom demand turns out to be very concentrated. 1% of users make 50% of the calls in their businesses. And thus, businesses had large incentives to try to figure out how to avoid the tax. Well, along comes something called microwave. All right. So remember, my story started with coaxial cable from cities where you had vacuum tube amplifier repeaters and there was no other way to transmit data and communications between cities. Microwave was invented and then put into use after World War II. And along comes network television, the biggest user of microwave at that time. And the network television didn't want to use the AT&T coaxial lines. It would be very, very, very expensive. So microwave made long-distance telephone calls and long-distance transmission much, much, much, much cheaper. But telephone regulation and rates didn't change to reflect the tax. You mean, so this is microwave, they're using that to transmit. So coaxial cable for long-distance calls basically goes out of use. And then from, so inter-exchange calls, i.e., local long-distance or long, long-distance calls start in the 1950s to be transmitted by microwaves through line of sight, big towers that are located every sort of 40 miles and you've all seen them. So did this, so the tax affix just to coaxial use? No. And that's the problem where it did affix to long-distance in general? The latter. Okay. So the legal term long-distance was never altered to reflect the technological change which changed the cost structure. And then guess who arose to try to arbitrage around this? And it's the famous MCI, Microwave Communications Incorporated. And they went to corporations and said, gee, we'll provide long-distance service between all your offices and we won't use the long-distance AT&T network and we'll charge much less It sounds like using Skype or VoIP or things of that. It's the same kind of... The telecom, I mean, people still have landlines, I guess, but they start complaining that this is a loophole because it allows someone who is not being regulated to provide things for people with lower costs and, you know, that's an evil that needs to be now extinguished via... And again, remember the key in this discussion today, often the word regulation is another word for tax, right, across subsidies. So regulation per se is one thing, but actually, in effect, long-distance call prices were not lowered to reflect the lowered cost of microwave transmission relative to coaxial cable. The surplus from all that excess long-distance revenue was used to cross-subsidize local loops and let me give you some of the numbers. From 1967 to 84, local rates only went up 114 percent. Now that may sound like a lot, but remember inflation was very... This is nominal, not real. And the CPI went up 311 percent during the same time period. So the real cost of local service was cheaper by a third, right? It went down a third or two-thirds in real terms. And so businesses, in effect, got sick of being taxed for all this, and they formed their own private microwave networks that went to a series of Supreme Court decisions. AT&T said, you've got to shut this down, and the Supreme Court said, no. And so then that's an arbitrage loophole big enough to drive reform through and the deregulation of long-distance rates and all the telecom turmoil that has occurred in my adult lifetime is all the result of A, a 1930 Supreme Court decision, 31 Supreme Court decision, which put the cross-subsidy system in effect in the first place. And then 50 years later, Supreme Court decisions basically unravel the whole... And now we don't have that stuff that when we were growing up, the long-distance rates were... They were commercials. Well, that's when I was young. Every two minutes about how... I mean, we've definitely changed how we call. I mean, it used to be... 10, 10, 3, 2, 1... Yeah, exactly. And when I was younger, right, long-distance was 17, 20 cents a minute. And then basically from 80 through the mid-'90s, we went down to... I mean, they're now three cents. And there's no... Is there any real difference in cost now with cell phones? Do you know if in terms of does it cost more to actually make a long-distance call for the... At the point of service or is it... Well, again, what's interesting is the last vestige of the old system is still... For those who have landlines in their house, there's still a dedicated copper wire going from that house to the exchange, i.e., the place where all the wires come together. And then communications between exchanges is now fiber-optic if it's in urban areas local or then microwave if it's long-distance. And even there may be some fiber-optic communication even between long-distance and exchanges, but I haven't read much about that. So we learned this... The lesson we learned here is you create a cross-uptodization because you think that certain local calls should be free or cheaper than the political wins will allow. So you cross-uptodize them, but you have a small group of people who are taking up that cross-uptodization, which means they have a lot of incentive to work around the cross-uptodization. And then you create a different organization that even in this weird way innovation occurs because of the regulation to get around the regulation possibly was incentivized to create microwave transmission. When a small group of people pay a large tax, it sharpens the mind. And now we... I don't think we... I mean, microwave actually came out of research in World War II and it wasn't people trying to avoid the tax, but once it was invented, then people said, what could we do with this and the rest as we say is history? And you also had something about the banking, was it the next thing we were going to do? Okay. So demand deposit banking is kind of like it's a miracle, I mean, or impossible depending on your point of view. At its heart, what banking does is what's called duration mismatch. I mean, you have something called demand deposits, a passbook savings or demand deposits and checking accounts. I mean, that's just a term for saying you can get your body back on demand. In effect, the contract between the funder and the institution says you can get your money back at any time. Well, what does the bank do with that money? Well, it loans it out. Can the bank get the loan back at any time? Well, no. So the miracle is that this ever works. Most of the time it does work, but when it doesn't work, it really doesn't work. And those are called bank runs. So when everyone tries to get their money out at the same time, then it's just not there. And it's not there. So the history of U.S. banking policy and is all about trying to deal with this fundamental difficulty. And then on top of that, we've created different kinds of banks for different kinds of loans, right? We used to have something called savings loans. We thought housing was special. We create these banks whose were by design took in demand deposits and then they couldn't loan to businesses or they were restricted to making mortgages within 50 miles and only 50 miles of their locations. I see where this is going. So why did – Concentrated risk. But why did we create – was it that other banks weren't giving enough mortgages out? The political perception was we need to create something to funnel monies into housing. And why would I as a regular person use a – put my money into a savings and loan that's then going to put it out in mortgages as opposed to using the same banks I had always been using? Well, one thing is that savings and loans could offer higher interest rates slightly. In fact, I'll go on. They actually were – they didn't have interest rate controls whereas commercial banks did and you can – again, we're going to go through an arbitrage story here that all breaks down. So you have these SNLs within 50 miles radius of mortgages? They were restricted to having a portfolio of assets that was within 50 miles of location. In addition, because of all the restrictions on banks in general, we didn't have interstate banking. You weren't allowed to – some state law said you couldn't locate across county lines. So again, think of these as really non-geographically diversified real estate portfolios. One tornado would really make that a problem or hurricane or earthquake or – Well, worse. But what happened more often was regional economic shocks of the negative sort, i.e., sector and region-specific recessions and we're going to get there by the end. In return for these restrictions, savings and loans were treated specially by the corporate income tax. They got lower rates than commercial banks, et cetera, et cetera, et cetera. So the net effect – When did that start? 50s or before? Oh, before. Yeah. So when I was growing up, all middle-class boys and girls were taught to open up a little account of the savings and loan. That was just the good thing to do and you funneled money into your community. And I just – I mean, I grew up thinking of this as normal. They're banks for other loans and they're special kind of banks for housing loans. So why do we start out with this? We're currently in a big discussion ever since the 07 Great Recession about Fannie Mae and Ginny Mae and Freddie Mac. And no one goes back far – I mean, in popular press discussions, people don't realize that these things were created because of the geographical restrictions on savings and loans. Right? So SNLs were where housing was from the 30s on through – up through the 70s. And then why do you have Fannie Mae, Ginny Mae, and Freddie? Where do these come from? And the answer is we've got growth in the West and people still in the East. And the savings is restricted under SNL rules to go to housing for the 50 miles of where the savings is. But that means all that New York savings and Jersey savings and DC savings can't go to the West. So in effect, the whole securitization game of turning real estate loans into securitized bonds that were backed by Fannie and Ginny and Freddie, it all comes about because we have – That restriction. We have these restrictions. So we don't – no other country has Fannie, Freddie, and whatever because they have national banking systems. Without that kind of localized restriction there, et cetera. So now what's ironic is given what's happened in banking and with the regulation that happened in the 90s and all the restrictions on interstate banking are gone, we don't need Fannie, Freddie, and because we now can – there are branches of banks all over the place and a bank can have a national and international distribution of mortgages if it chooses. But of course, whether or not you need a government entity is usually not a determinant of whether or not it will continue to exist. But this is often the case. I'm a bit disappointed in the press and much academic – even academic discussions of Fannie and Freddie somehow just start with Fannie and Freddie in 1970 and say they forget what the – I mean, there really was a problem and it was – rather than fix the problem, I mean geographically non-diversified real estate portfolios, instead of just opening up and deregulating the market for banking services, we added on this whole other apparatus rather than solving the fundamental problem. And even now, current – if you read the Post and the Times, current discussions about Fannie and Freddie seem to be a historic. They don't go back and say, well, why did we come down this road in the first place? This all sounds like the classic crime novel plot, which is like you make – these couple of guys make one stupid mistake at the beginning and then rather than just fixing it, they're like, I'm going to fix it this way and it just gets worn until you can't and then everyone – Yes. Basically, these little stories I'm telling today all have that character, which is lack of historical policy knowledge, lack of institutional memory, and lack of economic understanding on the part of legislators and lawyers who create much of this stuff just leads to trouble. Yes. I mean, this is always the – that we get accused of deregulation this conversation. They just want to deregulate or they just want to regulate this very black and white type of political issue for people in the free market. Going back and saying, well, these regulations, especially the old ones, they reformed the world around them, right? This is the reason why the world looks – and many of these regulations, the world looks this way because 50 years ago, the government put a thumb on the scale or they slightly changed incentives or prohibited something and now we're in a different mess. Again, much most all, political discussion seems to take place at a rather abstract team tribalism level. So our side says, I'm for markets, the illicit side, I'm not. I don't tend to traffic in that and I tend to just – I know a lot about and teach about the details of what markets were like, what struggles were going on, what led to political concern about them. We can then have a discussion of whether there was any normative or factual basis for that fussing, then talk about the intervention, what did the intervention do? And so I deal at that kind of detail. The actual facts and not the primitive one. Yes. And so I have come to the conclusion of being mostly against regulation, not because of some overarching ism that I know, which I – it's rather if you study the details, in most markets you get very cynical and very upset by the sort of lack of match between the intervention and the problem and the lack of recognition of how the intervention creates side effects, which in turn can't be undone unless we go back to the beginning. And so one of the side effects of the savings and loans was the savings and loans crisis. So keep going forward, right? So what economic shock hit the United States to make the SNLs have their own bubble? The 87 stock market crash? Well, let's go back first. It's the oil price increase of the 70s. And that means Texas is awash in money. And what can the money do? The money goes into savings and loans and then goes into Texas real estate. Texas real estate, if you look back then, rose tremendously in value. House prices. I have a friend who taught at University of Texas at Austin. And then – well, then what happened in 1985? Oil prices went down. Oh, my goodness. So all this Texas real estate is underwater, i.e. the mortgages are greater than the value of the real estate. That's the SNL crisis, right? Briefly, we bet on real – in effect, the regime forced a bet on real estate in one particular region of the United States that had a positive income shock, then it had a negative income shock, oil boom, oil bust. And the SNL bailout was simply that in a nutshell, even despite all the discussion of it, and the rise of the role of Fannie and Freddie and Ginny actually came about because of the demise of the SNLs. Yeah, because they don't really exist anymore. Not really, no. That's – they do, but they don't. And so the takeover – the institutions that filled the gap for housing for the United States after the demise of the SNLs were Fannie and Ginny and Freddie. Interesting. Even more on banking, just interest rate controls. So again, we've got these – so we've got demand deposits and savings accounts, and we had something called what's called regulation Q, which the Fed enacted and said, we're not going to have market rates of interest on savings and checking accounts. Well, first of all, you couldn't have interest on checking at all. That's another arbitrage story. Ginny had savings accounts, and that rate was regulated. And then comes the Vietnam War and Vietnam War inflation. And then people realize, oh my god, they're losing – I mean, in effect, inflation starts to exceed the interest rate that's allowed on 90% of American savings. So they're losing money. So they're losing money. Remember, I told you in the SNLs, SNLs did not have price controls. So the initial arbitrage story that occurred was all the money goes out of commercial banks, commercial savings accounts, goes into SNLs. Bankers don't like – so then in 1966, the Fed put price controls on SNLs. Okay. Just so they couldn't take all the customers away from the regular banks. Rather than just releasing price controls on the banks. Correct. Double down. Double down. In 1970, the minimum – all right. So then what do people do? Well, they buy T-bills because T-bills are a way to preserve your money and get a market rate of interest because they were sold at auction. 1970, the government raised the minimum T-bill purchase amount from $1,000 to $10,000. So ordinary savers can't tap into that market. So then what happens? Well, money market funds arise. All right. So when I was in graduate school, people took government student loans at 3% and then we're investing them in money market funds at 20%. Right? In 1980, inflation was 13%. Wow. Okay. And my graduate student stipend was fixed and nominal terms. I was losing – I mean, just losing money all the time. And I had friends who were loaning money and then putting it into the early money market funds. Sounds like a good idea. Well, it was. But again, this is this – so you've got price controls allegedly to create banking stability and then a shock hits called inflation and then innovation occurs and the system keeps trying to patch everything together and SNL crisis, Fannie and Freddie, et cetera. And then we believe that the great 2007 recession, again, was the shadow banking system failed and that was arbitrage around the regulated bank. What do you mean by the shadow banking system? In 2007, most Americans don't realize that the overwhelming majority of credit being supplied to us, our car loans, our student loans, our home mortgages, weren't actually being held by banks. They were in what were called structured investment vehicles, which sold debt on an overnight basis called overnight repose, overnight repurchase asset agreements. And that was not insured by FDIC or anybody else. And that money did not have to be renewed. So since so much of that money was in effect invested in real estate through all those loans that were securitized all outside the banking system, that money then ran and it ran to treasuries and the September 08 crash was basically entirely within the shadow banking system. The 30s where consumers lined up to get their checking and savings from banks, what happened is institutional investors, large corporations, have been sitting on a lot more cash than they used to and they invested it in these overnight repurchase agreements outside the banking system. And basically there was more money in that than there was in the regular banking system. And we're now figuring out that all that existed and nobody really knew about it much, didn't study it. So again, banking regulation is a never-ending history of an attempt to solve the fundamental problem which is taking short-term deposits and matching them to much longer-term investment opportunities and basically that doesn't work. But it works most of the time but when it doesn't work it really doesn't work and that's what happens. And so the regulations were meant to fix this problem of it really not working. When it fails periodically, we patch it up and the only way to make it work actually is to have banks be all equity and no debt. So the way I'm thinking about this is if you are not going to have all the money on hand all the time, as you said, so anyone who can get a deposit back at any time then there's some risk of what they're investing in and those risks can be subject to shocks, especially exogenous shocks whether it's the dust bowl or the Great Depression or things that suddenly make that money not be on hand for demand deposits and then the House of Cards. Well, it's not really House of Cards. Well, the contract says you get your money back but then if you worry in a game theoretic sense that it might not be there then your neighbors, then everyone worries and then we all try to get money that isn't really there because it's actually all invested. So banking is kind of this miracle where you have to develop somehow something economists call a confidence equilibrium where we all believe that it's actually good investment and as long as we all believe that it is and we don't take your money out then it all works. But when it doesn't work, boy, it doesn't work. Interesting. And we had what was the next one energy that we're going to do, electricity. Electricity. Again we have a pricing problem. So electricity is priced as an average. Early in our discussion you said, well, if all the money coming in equals all the money going out doesn't that just sort of work and it does accept when the marginal costs of some kinds of output are much, much higher than others and then we average it then the question is, well, notice that if you pay average but some of the stuff you consume really costs a lot more than that but you don't know it, it's not priced that way, then there's this secular tendency for that kind of demand to rise relative to the cost. This is sort of a Jeven's paradox in the sense that, well, in the sense that you don't know, so you're paying an average, you're paying a kilowatt hour average but sometimes you have. You pay eight or 10 cents but on a summer's day at noon it really costs 50 cents. And you don't see that in your bill. And nobody sees that. So everyone is overusing energy so there's no congestion pricing, no variance on that. So this stylized fact that electricity demand in the United States rises blah percent per year, it's not natural. The reason that is a stylized, I mean it is a true fact up until the Great Recession but the reason that occurs is because the highest cost stuff isn't priced that way. So of course demand rises because if it's eight cents a kilowatt hour and you turn on your air conditioner in the summer afternoon, it's still eight cents to you, it's costing the power company 20, 25, 30, 35 cents. Is this really just that you're not seeing it because you are paying eventually for all the electricity that you use? Is there a set, right, that the revenue from consumers equals the total costs and more? Right. But I mean like if I, in the summer when I run the air conditioning all day, I see a much, much higher bill. But not as high as it really costs. Okay. And then in winter, right, and then in winter you're actually paying more than it costs and at night you're paying more than it costs. So economists have called for real-time pricing and so that maybe you would chill a bunch of water all night from midnight to 6 a.m., store it in a big tank underground, and then that chilled water would actually supply your air conditioning in the daytime, not actually using any electricity, right? So if we had real-time pricing we'd have… Efficiency is created like that, yeah. Entirely different way of heating and cooling our houses just as an endogenous response to pricing. So how does the regulations come into that, yeah? Well, I mean so, okay, so we set up this average price system. Was the average price system, was that market or the company's determined to that or was the average price system from regulation? From regulation. Okay. Yeah. I mean plus peak demand as we now talk about it is really a recent phenomena mainly resulting from air conditioning. So prior to the mass cooling of homes with central air in the United States, if we look at a 24-hour cycle of power use in a household, yes, it used to vary, and yes, from midnight to 6 a.m., it was not very much. But the sort of daytime peak that we now talk about is a post-1980 phenomenon. So would it have not come in in the, this is not the system that would have been adopted in the absence of the regulation because I'm thinking of other things that we pay for today that do have this kind of averaging. So streaming music would be an example where the company that I stream these songs from is paying some number of cents per song. But I'm paying, so if I listen to a ton, they have to pay a ton and if I listen to almost nothing, they have to pay almost nothing. I pay a flat, so average, eight bucks a month or whatever, but there's no regulation causing that. It just is the most efficient system for them. Probably. Again, the only, I mean, again, digital, right, the marginal cost of output doesn't rise with use. Now, there are- Well, they have to pay to the artists, so they're paying out. But it's flat. Yeah. I mean, it's, the only analogous issue in internet discussions is this whole business of video, right, the high, the Netflix type of stuff, right? There's this video really makes demands on the internet system and- It's about 30% ever, or maybe more than- It's the majority of traffic or a bandwidth at certain times, yeah. Well, it's 30% of primetime internet use is now not just video. The claim is that it's Netflix. Just Netflix. So if you add up even- Yeah. There's other video other than Netflix that would even add to that. And so, it's analogous that the, we've got used to flat rate internet pricing and now we're in a big discussion of whether, in effect, heavy demanders that create extra- It's like a super high, I mean, in effect, Netflix is creating a peak demand problem on an infrastructure and probably not paying the marginal costs of all the congestion it creates. If Netflix didn't exist, the fixed price access system probably would work much better, right? They've now made an agreement, actually, if you've noticed, with Comcast and got the net neutrality advocates all in a tizzy because, oh boy, I mean, something that the new techies love, something called Netflix, has now sold out and done the bad thing, right? It's going to- Pay more. Pay more to ensure access. That sounds like a good thing, though, generally. It's something we would generally- Well, not only, I mean, again, it's not that Netflix is paying, you know, attacks to Comcast. It's that Comcast is really having to, has real infrastructure issues to be able to deal with this client. So why don't we, I mean, with the electricity or with Netflix or whatever else, why don't we just, you pay for usage? So if I stream a ton of Netflix, I'm going to pay more for my internet access? People don't like that. I mean, in its infancy, a price structure was developed for business reasons. Again, and I could explain why, which is if you go back to, you remember when Washington, D.C., dug up all the streets under Mayor Williams to put in fiber, 98? We weren't here at that time, so we don't remember that, but we'll take your word for it. D.C. was dug up and it was a mess and the rationale was, you've got to have fiber everywhere, right? Post 2000, we had a glut of fiber. I mean, so there were all these discussions of, you know, we, how much would, we couldn't imagine how much internet use would actually grow and actually start to use all that, but for a while, we actually thought there was no possible way that demand could ever arise to use all this fiber that had been stuck and sunk in the ground. But that doesn't seem like a very wise, people will fill that demand, I think. We're looking backwards now. Looking forwards is always harder. At that time, why not price things in fixed terms? I mean, there was no, there's no, there's no possible, there's so much available that nobody could conceive of the issues we're now confronting. And so the fixed price model arose. A whole generation, i.e., your age and younger, grew up thinking this was the law and the reality and now imagine trying to tamper with it, which is what the net neutrality discussion is about. And as best I can tell, everyone under the age of 35 thinks of free fixed cost, unlimited internet access as the 20 whatever amendment to the Constitution. The 28th amendment, yeah, there has to be this. And so the defector, right, the company that goes first and says we've got a problem and we're going to do something about it, it just gets tart and feathered and beat to death. So how did this happen with electricity? It's the same thing, yeah. Go back to the early 90s and we have basically two different ways of producing electricity. We have something that's very capital intensive with low marginal costs. We have something that doesn't involve much capital and has much higher marginal costs. The first that's capital intensive are called nukes. The second that are very little capital and much higher marginal costs would be natural gas. And coal would be somewhere in between. So electricity streamed to you is actually a product of those three kinds of ways of making things which have very different marginal costs. Now in any market, the highest marginal cost thing determines the marginal cost of the product by definition. Yes, yes, yes. Okay, so I could do farmland, right? So farmland in Iowa is very productive, farmland in Arizona is not. We need some farmland that's dry and whatever just to meet market demand. That means their rents are excess profits so that very high cost land sets the market price for the product. Farmers with much better land get rents. They get economic rents, what economists call excess profits. Farmers in turn are capitalized into the value of the land in Iowa. Okay, go to electricity, same kind of thing one can imagine which is when you have peak demand and you need natural gas fired power, that sets the market price for electricity. But that means there's excess profits to the nukes and coal. Well that doesn't sit very, so that's where regulation comes in was to say we're going to suppress excess profits to the inframarginal producers, we're going to do it through rate regulation, blah, blah, blah, blah, blah. So that leads to tariffs and tariffs is cost recovery, you're going to amortize that plan over 40 years and we're going to get 1 40th of the capital in a nuke plant. Then you get a glut of electricity in the late 90s, mid to late 90s because natural gas prices go down and suddenly you can produce, so suddenly that higher marginal cost electricity is way less. Well, businesses in the northeast are stuck with the tariffs that pay for the nukes and they don't like it. Those tariffs are put on to electricity bills that you're saying? By tariff I just mean rate regulated. That is you have to pay this much and this recovers the cost of all these plants over their economic lifetime, usually 40 years. National electricity deregulation took place in 92 at the wholesale level, so there suddenly can be trading between firms in the grid at the wholesale level, but not to retail customers. Businesses in the northeast that are stuck paying off the nukes suddenly want access to the cheap natural gas-fired stuff that's elsewhere and they demand deregulation. Actually, electricity deregulation like the telephone deregulation, it's again an arbitrage around a rate regulated system and then we get to California. Yeah, in the brownouts. Let me describe briefly what went wrong there and it was instead of having wholesale and retail rate deregulation, what California had is wholesale deregulation combined with a retail rate reduction and a freeze. Oops. You mean they reduced how much you could have to pay for electricity on the retail side? Retail customers got a rate reduction. What California didn't tell them is that they could have actually had lower rates if they were market-based because there really was an electricity glut in the west at that time. Market rates were lower by having a frozen retail rate above a market rate that created a tax which was used to cross-subsidize the wealth losses for the nukes and the coal-fired plants, not many coal in the west, but mostly the nukes that were afraid of losing all their capital if we go to true market which wouldn't pay them off. Then we have a hydropower shortage because of a drought and then you need natural gas-fired power in the winter in 2000 and 2001. So the wholesale price rises above the fixed retail price. That's where the blackouts came from was this not true market deregulation but rather a crazy wholesale system mixed with a disguised tax and a price freeze in a complicated political way. The sad result is it discredited something called electricity deregulation. Since that happened, we have not seen no further deregulation electricity in the United States. In fact, many states have repealed their statute and gone back. One is California and another is Virginia. So Maryland is now deregulated and Virginia is not even though they're in the same wholesale area and sadly until – so electricity is now off the political – I mean you don't hear about it. You don't read about it. People like me know about it because we study it but basically it's now the California debacle until a generation gets old and retires and forgets it, we're not going to have any market innovations in electricity because of that failure to in effect deregulate correctly. And the way that this all should have worked in the first place from an economic standpoint is to not have an average rate and let people pay for what they're using. Well, the difficulty with peak pricing is that we had meters that were capable of measuring when you used electricity. So we actually had to change, have to and are changing all the meters in the country. So they can figure that out. And then Maryland, my meter got changed a couple years ago. Basically that got funded through some of the Obama recessions. The change of all meters in the United States to real-time capability is being funded by taxpayers. But that seems like setting up to actually do this at some point and people are going to get very angry that they think that average pricing for electricity is a basic human right or something. My guess is states, so in Maryland right now they still have average prices and rate regulation even though all the meters are fully capable of pricing literally by the minute. So we'll see what happens. It just seems odd that psychological connection, the bond that people have to these average prices or fixed prices when they're so uncommon in our lives in the sense that we don't buy food that way and we all kind of acknowledge that it would be nuts if we did. If you go into the grocery store and you pay by the pound or you get as much as you want for 50 bucks a month or something, that would be crazy. In the argument that we need rate regulation on something called necessities, again your food is a necessity and so I'm surprised that people are so adamant about something called electricity and cable and not about food. It is interesting, but of course you see it. I mean egg prices and all these things that are volatile that are important to us. And you see it, I mean when people are asked to change anything about how they're paying for something, air travel has been changing so much in the last 10 years that people are having to pay for things on the plane and paying for drinks and paying for all these things that used to be free and people are getting very upset that they have to do this even though it makes economic sense to some. But economists watch how people behave not what they say and notice even these airlines that I think are bizarre like spirit airlines to pay for everything, right, pay for the bathroom. Well, not quite, but they're now, a frontier is charging for overhead access and it's like, okay, so I mean spirit is profitable and so people are mouth and off and flying. Yeah, and that's okay, they can be, and if you think about before deregulation of the airlines, they got so many things for free because that was the only way they could possibly compete, right, to give you slippers and everything because they couldn't compete on price and now they compete on price and they'll see how far that can go until consumers are kind of over it. Correct. So the last thing we're going to talk about is healthcare. One of Peter's rules is never mandate a ratio. I remember that, but I need a little bit of filling in here. It's a regulatory rule. Lots of people often say without knowing it, they're mandating that something called a ratio be at a certain level and they fail to think about that. What they're always thinking about is the numerator and they fail to think about how the denominator can be altered and so let me, I know that's very abstract, let me, what I'm going to talk about is the New York State mandate about the reporting of outcomes in cardiac surgery in New York State and there's a movement in healthcare and it was started by this called report cards and it seems perfectly reasonable, right? Lots of policy things are mandated because they do well on the stump, right? You can make a speech to people and you make an analogy to something that's common in their lives and they say, well, that sounds right. If I have report cards in school, I'd have a report card at my doctor. Now the underlying analytic issue is the information conveyed to consumers about healthcare is pretty murky. It's not, I mean, you can learn a lot more about cars and everything else we buy but try to learn about your doctor's capabilities and the outcomes that occur from his treatment and what happens to people that go into Hospital X versus Hospital Y if you have choices in your area. So Obamacare in fact involves some report card mandate reporting. I mean, who could, everyone is for mandating the supply of information, even right-of-center people often to head off more onerous regulation agree that something called the reporting of information sounds as American as apple pie, I mean, it's sunshine, it's America. Best disinfectant, yeah. So the New York State mandated that information about the outcomes of cardiac surgery, i.e. angioplasty and stents and things like that, be reported by practitioner and hospital in New York State. The goal was to allow the market to work so that consumers would steer towards the better providers obviously and punish the worse providers. Now again, the thinking behind this was that something called the denominator would be constant because of the intervention. So the good news, so there have been a bunch of economic in the journals, articles by good economists evaluating the outcomes of this report card system. So the ratio is going to be how many performed versus how many errors or how many successes is that weird? It's basically mortality rates, which is how many people die at the hands of Surgeon X and Hospital Q. So your denominator is 3700 angioplasty and stents. It's the population of people who receive services and the numerator is bad outcomes. Okay so the trick is here that everyone without thinking thought that the denominator would be constant, i.e. that the set of people operated on relative to the population of people possible would be in sickness terms the same. But I'll tell you what happened and why that didn't turn out to be the case. So the good news is the results from the New York State report card were that sicker patients went to better doctors and better hospitals. So that's what they thought would happen, but here's the counterintuitive thing that happened. What did the bad docs and the bad hospitals do? Stop performing at all. They started operating on healthier people. Right if your income was threatened, I've been a teacher my entire life. So if I were evaluated on the basis of the outcomes of my students, what kind of students would I like in my classroom? Smarter students. Exactly. So even they were doing operations that weren't necessary? Correct. No, it's a judgment call because the person doesn't need it then you can be pretty sure that it's going to work out. So the bad news is the bad docs responded by operating on much healthier people to reduce their fatality rate. The weakest patients that really needed help were shunned because you don't want them. You don't want a bad score. Looks what happens with standardized school testing, which is if you've watched what the states do, everyone tries to game the system by playing with a denominator. I call this Peter's Right. Don't ever mandate ratios because you think that they're going to deal with a numerator, but in fact what they're going to do is play with a denominator because the incentives are to do that. If you're trying to keep your batting average up, you may want to sit down against Justin Verlander for a day if one of the best pitchers in the game and so it changes your actual plate appearances if your actual goal is just a... So the notion that the denominator is fixed is wrong, i.e. endogenous reaction to the rule makes the denominator change. Again, from a moral point of view, this was designed to help the worst people, but what actually happened is the weakest patients, no one would operate on them because... Here's your livelihood is... Well, and so we're in this with Obama, which is the med-cent, the urban medical schools that take the six people in part because they learn from and train residents and whatnot. We're into now risk adjustment, which is running regressions to try to make sure that comparing hospitals gets the population of patients to be the same in a statistical sense. So there's now a whole consulting operation funded by us. By taxpayers. To design methodologies to risk adjust so that Obama payments that go to the best practitioners and best hospitals will, in fact, not be gained. Anyway, so it's great for smart people. It leads to jobs and estimating regressions, but so Peter's rule stands, which is don't mandate ratios. They're trouble and full employment for economists. Okay, so aside from Peter's rule for the regulators who are listening to this now, what's the overall takeaway? What's the lesson that they should learn from all of these stories you've told us? After many years of studying markets, I'm convinced mostly on average they work. There are very few market failures. What mostly people object to and leads to political discussion and intervention in markets are what are appropriately thought of as distributional issues, i.e., all our stories. We want phone calls to be cheaper. We want electricity to be cheaper, right? So it's not that the market isn't working. It's that the result, the resulting price, the resulting impact on ordinary people with ordinary incomes is thought to be too high relative to some philosophical conception of appropriate burden that falls on a population. Okay, if Cato would not believe in this, but if you do, then the appropriate thing is to have an explicit tax, raise revenue, and then distribute it to people in question. Because Americans are rather skittish about these kinds of things, where tend to be less tax and transfer oriented than other modern industrial societies, the political resistance to the appropriate treatment of these problems is probably not there. So if you want to get this through, what you do is enact cross-subsidies in a disguised way through market regulation, which as I'm in market after market after market, I tend to find that it eventually blows up, it doesn't work. Thank you for listening to Free Thoughts. If you have any questions or comments about today's show, you can find us on Twitter at Free Thoughts Pod. That's Free Thoughts P-O-D. Free Thoughts is a project of Libertarianism.org and the Cato Institute and is produced by Evan Banks. To learn more about Libertarianism, visit us on the web at www.libertarianism.org.