Mitch Daniels Uses Benefit-Cost Analysis to Teach his Daughter Ethics

This is the fourth and final article in a series of pieces discussing the claim by a Cato scholar at CIFA's recent meeting in Monaco that formal benefit-cost tests by economists were essential to prevent regulatory excess. The second column focused on a speech in 2001 by Mitch Daniels, then President Bush's Office of Management and Budget (OMB) director to the Competitive Enterprise Institute (CEI). http://www.whitehouse.gov/omb/speeches_cei_regulatory052202 Mitchell E. Daniels, Jr., Competitive Enterprise Institute Speech, 05/22/2002 Daniels is the nation's leading proponent of benefit-cost tests, and the purpose of his speech was to advance arguments in favor of OMB economists' use of benefit-cost tests to block the adoption of regulations. The column discussed Daniel's use of a “mistress metaphor” to explain why economists' formal benefit-cost tests are vital. Daniels warmed up his global warming denial audience (pun intended) with this joke, which he said he often shared with his daughter. Many of us who are parents look for these opportunities to mix family meals and an opportunity for moral instruction. This is how Daniels relates his efforts at teaching moral reasoning: 'If James Carville and Geraldo Rivera were both drowning, and you could only save one [laughter], would you read the paper, or eat lunch [laughter and applause]?' Altruism is, as Ayn Rand stressed, a grave error. To be a Good Samaritan, particularly to save the life of someone who disagrees with you, is not a mitzvah but an unpardonable sin. It follows that one should teach their children that the correct response to learning that a person is drowning and only they can save a life – is to let them drown – while noshing. The death of those who disagree with us is a cause for celebration [“laughter and applause”]. The substance of Daniels' talk was an effort to claim the high moral ground for OMB and CEI's efforts to block new regulations and kill new ones. Daniels began with a premise that illustrates, unintentionally, several classic abuses of benefit-cost tests. “We know with some degree of precision that, conservatively estimated, regulations on the books of federal government inflict 600 to eight hundred billion dollars in cost to the American economy every year. It's wrong to put it the way I just did, because such costs are not inflicted on abstractions like economies, but on each of us, on everyday citizens, with ultimately every dollar of that falling on a purchaser of a good or service, either in a direct cost, or the unavailability of that product or the loss of the freedom of our choice consequent to some regulatory restriction.” No, we don't know any such thing, much less with “precision” and the people who make these estimates are the most partisan theoclassical economists whose central dogma requires them to believe that regulation is unnecessary, harmful, and an assault on central freedoms. Consider the glaring flaw that Daniels is oblivious to – what happened to the benefits? They don't even require discussion – they don't exist and can't exist under Daniels' anti-regulatory ideology. The most basic and inexcusable error in benefit-cost analysis is to ignore either the costs or the benefits while stressing the other. Buying M1A2 tanks and Super Hornets is exceptionally expensive. Such costs are, under Daniels' reasoning, “inflicted … on each of us.” They are inflicted without our individualized choice. I may not want the U.S. operators of Predator drones to launch Hellfire missiles to attempt to assassinate American citizens in Yemen without trial. The answer is – tough luck. By a democratic process, U.S. representatives voted to procure roughly a trillion dollars annually in military goods and services and to use them as the Commander-in-Chief orders. But Daniels would never discuss only the costs of tanks, carrier-based high performance fighter-bombers, drones, or missiles and ignore the benefits. Can economists quantify in a rigorous fashion the benefits of the current U.S. military v. one with 80% or 120% of its existing capabilities? No. Usually they're smart enough not to try. Can economists quantify the net costs and benefits of trying to use Predators to kill Americans in Yemen who we suspect of being terrorists? No. If you understand the code, Daniels gives away his theoclassical blinders in this clause about the costs that regulation inflicts upon consumers: “the loss of the freedom of our choice consequent to some regulatory restriction.” Consumer regulation is inherently harmful to Daniels – he literally cannot conceive of any other outcome. Most people in the world, rightly, consider this dogma crazed – but neoclassical economists often embrace it. Indeed, many introductory microeconomics textbooks present this claim as if it were indisputable truth – for they present a graph “proving” the point. Here is the logic. Consumers vary in their desires and consumers are the best judges of their desires. Any regulation that changes a consumer's choice, therefore, must cause him to be worse off (he falls to a lower indifference curve in his utility map). Except, and even neoclassical economists would have to admit it if you cornered them, the opposite is true in a wide range of situations. The claim that rules harm consumers: 1. Is not necessarily true if the seller is a monopolist or the sellers are in a cartel. 2. Is not necessarily true if information is asymmetric – and marketplace information is typically asymmetric. 3. Is not necessarily true if there are substantial externalities to the transaction, and externalities (and transaction costs) are common. (Significant transaction costs are pervasive, so Coase's theorem supports the prediction that externalities will typically cause a market failure.) 4. Is not necessarily true if the transaction involves an asset whose value has been largely determined by the creation or collapse of a bubble. 5. Is not necessarily true if consumers have material, deleterious biases due to the factors studied by behavioral economics and finance scholars. 6. Is not necessarily true if the consumer demand is generated by the seller, e.g., through advertising. 7. Is not necessarily true if the good is psychologically or physically addictive. 8. Is not necessarily true if the restriction reduces fraud or theft. Such rules directly aid consumers and provide essential gains to honest sellers by breaking the perverse Gresham's dynamic that would otherwise cause dishonest sellers to gain a competitive advantage over their honest competitors and allow the dishonest to drive the ethical sellers out of the marketplace. The loss of honest sellers harms consumers. 9. Is not necessarily true if the purchaser or seller is coerced. 10. Is not necessarily true if the purchaser is a child, mentally ill, or has seriously reduced cognitive abilities. 11. Is not necessarily true if the contract being restricted should be void as against public policy, e.g., a contract to commit a crime. 12. Is not true if the rule creates the foundations that facilitate transactions, e.g., rules requiring one to drive on the right (or left) restrict choice in ways that are essential to creating effective choice. In the absence of traffic rules in a major metropolitan area the result is gridlock circumscribing everyone's ability to drive. 13. Is not true if the rules create creating appropriate uniformity. Technological advances, e.g., AM stereo broadcasts, may require broadcast standards in order to produce viable goods and services. 14. Is not likely to be true if the rules restrict odious discrimination against consumers . Appropriate anti-discrimination rules may make some consumers worse off, for a time, but net they make consumers better off. 15. Is not true with regard to rules requiring common carriers to publish fares and not discriminate against particular customers. Such rules make customers better off. The typical microeconomics course treats these market realities (which, collectively, are the norm) as if they were curious theoretical exceptions to a grand norm of market perfection. The typical microeconomics text ignores many of these market imperfections. It is common for the professor to either not get to or rush through in the last week a small subset of the imperfections that dominate real markets. Consider the interaction of only a few of these common market failures in a context relevant to the current crisis and Daniels' April 2002 speech to CEI. Daniels made specific his claim that OMB and CEI captured the high moral ground when they prevented or removed regulation. Because consumer protection regulation inherently harmed consumers, it followed that any actions that OMB and CEI took to prevent consumer regulation protected consumers. Daniels' lead-in sentence to the paragraph of his speech about the cost of regulation that I quoted above was: “regulatory review is consumer protection in its purest form.” No, it isn't, particularly as Daniels practiced it. It is not consumer protection in any form to be captured by a dogma that is contrary not only to real life, real markets, and real economics (as I have just detailed). A theoclassical economist whose dogma requires him to believe that rules designed to protect consumers impose only costs will harm consumers. Daniels is not describing “regulatory review” by OMB to protect consumers – he is describing an assault on consumers by ideologues. Daniels gave one specific example of consumer protection regulation in his speech. The passage in which he describes it provides the fuller context for the clause I have just been discussing. “Think back with me, if you will, to 1978, when a seven- or eight-year campaign ultimately failed in its bid to create a Consumer Protection Agency for the United States. Well thank goodness it did. Two years later, by Executive Order, the organization we now know as OIRA got full authority to become a central clearinghouse and review agency, a second opinion source on major federal regulations, would-be regulations emanating from the various departments of the federal government. And those two otherwise unrelated events are linked in my mind because I would assert, if done properly, regulatory review is consumer protection in its purest form.” OIRA is the section within OMB that conducts benefit-cost tests. Remember the time period of Daniels April 2002 speech to the CEI. All hell has broken loose. The FBI had transferred 500 of its agents specializing in white-collar crime investigations to national security in response to the September 11 attacks. Most of the remaining FBI agents, and probably the great bulk of those they considered most effective, had been working since 2001 to investigate the massive accounting control frauds (Enron and its ilk) who had failed in 2001-2002. The FBI requested permission to hire agents to replace the transferred white-collar specialists – the Bush administration, and that means then OMB Director Daniels, refused. The FBI was left with fewer than 100 agents to investigate a developing “epidemic” of mortgage fraud that by the time of Daniels' CEI speech was still small enough that it could have been stopped by vigorous prosecution of the largest fraudulent lenders. The FBI was unable with that grossly inadequate number of agents to investigate any of the major fraudulent lenders making the hundreds of thousands of fraudulent liar's loans. Daniels' response as OMB Director to the FBI's critical resource limitations to respond to the developing “epidemic” of mortgage fraud and the Enron-era accounting control frauds was to deny the FBI the resources that were essential to prevent the fraud epidemic and the developing financial crisis. It is inconceivable that Daniels' decision to deny the FBI the resources could have passed any benefit-cost test. Allowing fraud epidemics and financial crises is catastrophically expensive. Bush's nickname for Daniels was “the blade” because of his role in cutting expenditures in programs and rules designed to protect the public. The concept that an effective OMB director must be to find areas of excessive, ineffective, and inadequate expenditures was foreign to Bush and Daniels except in the context of inadequate expenditures on national security. OMB's function is supposed to be to ensure rational budgeting. Given the September 11 attacks and the very large transfers of FBI white-collar specialists to national security, the staggering size of Enron-era accounting control frauds, and the rapidly growing epidemic of mortgage fraud it was certain that the national interest required a substantial increase – not simply restoration – in the number of FBI white-collar specialists. Focus closely on Daniels' rhetoric and claims about “consumer protection in its purest form.” He says “thank goodness” that the efforts to create an agency to protect consumers were killed by the financial industry's lobbyists and he sees this as, while “unrelated,” also “linked” to the decision to make OMB a super-regulator entitled to second-guess and overrule the decisions of agency experts, after analyzing the industry's comments on the proposed rule, that the adoption of a particular rule is in the public interest. We can agree that the decisions were “linked” – the industry, particularly the financial industry, was eager to prevent the adoption of rules to protect the public and killing the consumer protection agency and using OMB to prevent the adoption of rules to protect the public. Daniels is wrong about both anti-regulatory actions being “unrelated” – they were generated as part of the same anti-regulatory lobbying effort. History ran a real world test of Daniels' assertions that blocking rules to protect consumers is the purest form of consumer protection. The genius of free exchange is that it can, in many circumstances, lead to Pareto optimal exchanges – both parties are made better off. I have discussed above a number of the circumstances in which voluntary exchange will not necessarily make consumers better off. The crisis tested the Daniels/Greenspan/Fischel theory that financial consumers are better off if regulations that are designed to protect consumers are removed. Consider only the intersection of accounting control fraud and asymmetrical information. The typical nonprime borrower and lender from 2005 to 2007 suffered large losses. Both principals were made worse off, particularly if the loan was fraudulent. The typical “liar's” loan was fraudulent and the lenders and their agents typically put the lies in the liar's loans. Many working class Americans had their limited wealth wiped out by nonprime loans. Virtually all of the nonprime lending specialists failed – they all suffered tremendous losses. The “unfaithful agents” – the lenders' and loan brokers' senior officers, the employees placed on compensation systems that created incentives to make fraudulent loans, the appraisers who inflated appraisals, the audit firms and the rating agencies that blessed the massive overvaluation of the assets and the grotesquely inadequate allowances for loss reserves were often made wealthy. The fraudulent lenders created the perverse incentives through their compensation systems that produced these “echo” epidemics of fraud among the agents by deliberately generating “Gresham's” dynamics in which bad ethics drove good ethics out of the markets and professions. The nonprime mortgage market – well over a trillion dollars – was based on reverse Pareto optimality. Both parties to the transaction were typically made worse off. The often fraudulent nonprime loans drove the hyper-inflation of the bubble, particularly in 2005 and 2006 and delayed the collapse of the bubble into 2007. This caused millions of prime borrowers and their lenders to suffer enormous losses. Accounting control fraud causes exceptionally large negative externalities. A consumer protection agency that banned “liar's” loans would have prevented the bubble from hyper-inflating. Banning liar's loans would have caused the bubble to collapse far earlier when it would have caused far smaller losses. A consumer protection agency that banned perverse compensation systems that generate Gresham's dynamics would prevent “echo” fraud epidemics and greatly reduce losses. Note that this would aid not only consumers but also honest businesses. George Akerlof explained this point in his famous 1970 article on markets for “lemons” (which led to the award of the Nobel Prize in Economics). Appropriately designed consumer protection regulation and prosecution of control frauds is essential to ensure that honest businesses, not cheaters, prosper. “The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.” As OMB director, Daniels got wrong all the important OMB decisions that contributed to the developing financial crisis. He could not conceive of the vital need for the OMB to insist that the federal banking regulatory agencies regulate and enforce the laws effectively to protect consumers. He stood by and cheered while: • “Chainsaw” Gilleran – who worked chainsaw-and-pruning shear with the leading bank lobbyists and the FDIC to destroy effective financial regulation • The administration completed the process that cut the FDIC staff to one-quarter of its peak • The FDIC adopted MERIT examination in 1982. The acronym stood for “Maximum Efficiency, Risk-focused, Institution Targeted.” It was “efficient” because it was examination-lite. It was anti-“risk focused” because it instructed examiners that they generally did not even have to review files on bad loans. Vigorous examination is essential to financial regulatory success, so this process guaranteed failure. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aLEW..mshRA4 • The federal regulatory agencies' only display of zeal was in “preempting” state efforts to protect consumers from fraudulent and predatory mortgage lenders • During Daniels' watch, Fed Chairman Greenspan refused to use the Fed's unique authority under HOEPA to regulate the fraudulent and predatory nonprime lenders that were not subject to federal banking regulation • During Daniels' watch, the federal banking agencies made virtually no criminal referrals despite a developing surge of mortgage fraud that the FBI would soon label (in September 2004) an “epidemic” of mortgage fraud • During Daniels' watch, the Office of Thrift Supervision (OTS) “won” a spirited “race to the bottom” contest with its sister federal regulators. OMB cheered the results. Does the fact that most important government and corporate decisions are made without relying on formal benefit-cost analyses conducted by economists mean the military does not think about costs and benefits of different missions, equipment, and doctrine? No. Economists produce one variant of benefit-cost analysis – a variant that is not remotely universally useful for analyzing the most important issues a government faces. Indeed, very few business decisions are made on the basis of formal benefit-cost studies conducted by economists. There is no logical or experiential basis for making OMB a super-regulator. It lacks substantive competence and, as Daniels' exemplifies, it is driven by unconscious biases that cause it to make consistent errors that would prevent rules with strong net benefits. Its methodology, benefit-cost analysis, is not universally (or even generally) useful even in theory and in practice OMB uses it in a biased fashion due to politics and ideology.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.