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April 30, 2007
Free markets and the law
This post is really just part III in a discussion of free markets on this blog. If you haven't yet, you might want to read the first two parts, with the comments to the second one. (Part I) (Part II)
Discussion with cactus (of Angry Bear) and others in the comments to my second post has been vigorous. To summarize, cactus's first question was why you don't see on-line markets or communities that operate without any rules (other than U.S. law). That is, why do discussion boards need monitors. Why does EBay have so many policies? And so forth.
That question is fairly easy to deal with because community rules, whether they are written down or simply part of the ethical custom of a group of people are not really regulations or laws. These are private entities with their own goals, objectives, expectations, etc. As such, they can set the house rules for people who want to participate. The fact that different entities exist with different policies (such as the contrast between EBay and Craigslist) means that in fact a vibrant market exists for these different systems. Some people choose one; some choose the other. Far from being a puzzle, this is what one would expect in a relatively free market for on-line communities. When you choose which community to use to sell your old futon, you are choosing what set of rules will govern your activity.
Later, cactus asks why these on-line communities (or indeed any marketplace, stock exchange, or the like) operate in the U.S. when they could go off-shore to avoid the burdensome regulations and laws of the U.S. government?
This is an obvious challenge to the "free market" position. If operating off-shore is a viable option, why isn't it more common? There must be some benefits to operating under U.S. law. If so, this looks like a victory for cactus's side--maybe we need those laws after all.
Not so fast. There are firms that locate off-shore away from U.S. laws. One of the best known categories of these firms would be gambling sites. So the question really is: why do gambling sites go off-shore while others remain subject to U.S. law?
One determining factor may be the amount of interaction you expect to have with the U.S. legal and financial systems. If you want to go public on a U.S. stock exchange, you will need to file papers with the SEC. You might as well just stay on-shore. If you want the protection of the U.S. court system in the event of a dispute with customers or vendors, you might as well stay in the U.S.. Gambling sites probably aren't looking to go public on the NYSE, and for the type of business they do, perhaps the advantages conferred by the U.S. court system are minimal. By the same token, there are compelling tax and regulatory reasons for them to leave. So kiss them good-bye.
Consider this related question: why do so many firms incorporate in Delaware? It started with certain favorable laws. But today an equally compelling reason is the network externalities that come from being part of that system. There are many corporations incorporated in Delaware. That means there are a lot of corporate lawyers. It also means that the state court system has a lot of case law related to corporations. In a sense, the state of Delaware specialized in the types of legal services that make things hospitable for corporations. Because of the history of corporations in Delaware, this equilibrium could probably sustain itself even if the laws of the state became marginally less favorable. There are so many other good reasons to be there.
The same is undoubtedly true for the U.S. as a whole. The usual set of complaints aside, the American legal system has a fairly sizable set of benefits, by virtue of its history of case law, the availability of quality legal advice, and the advantages of coordinating with other agents in that system. In other words, it's not that the various regulations affecting business do not have a cost--they do; and if a firm could get around those costly regulations, they would. But doing so also means turning their back on a valuable network of ancillary benefits. The more important those benefits to the firm, the more likely the firm accepts the cost of staying under the authority of U.S. law.
This could still be true even if it is technically possible for the firm to have access to U.S. capital markets or U.S. courts even while located off-shore. To maintain that access, the firm will have to subject itself to certain laws and regulations. The only reason to locate off-shore is to escape regulation of your activities that don't involve U.S. capital markets or courts. As cactus put it in a comment at Angry Bear discussing what activities are subject to U.S. regulation:
Ford's tapping of the American bond fund market, yes. Ford's activities in Brazil, no.
I would venture that a firm like EBay would have more interactions with American entities than with entities in an off-shore location where they might alternatively locate. So why bother? The comparison to Ford in Brazil is not very apt. Ford goes to Brazil to sell cars to Brazilians. That's a whole other question from where this started.
Gambling sites interact mainly by taking your money in exchange for offering you the privilege of playing games of chance and strategy. They don't need a network of lawyers and bankers to give them access to American legal and financial institutions. For them, the regulatory burden is much worse than the benefit those institutions confer.
Let me finish with a response to a comment from cactus:
...I did suggest that EBay could write its own rules - rules better designed to facilitate things for itself and its users. I also suggested they could write those rules and operate under them at what is to them a very low cost, and thus avoid all the superfluous US laws completely.
The fact that it doesn't is a sign that these useless laws and regulations (i.e., those that exist in the US body of law, but that if EBay were to list its needs from scratch, it would not include) clearly have attached to them some value.
They do write their own rules. Potential customers choose among communities with different rules. This was covered earlier in this post. This is entirely compatible with the free market position.
But could they go off-shore and write their own rules, operate under them, and do better? Not necessarily, for reasons detailed above. They can write their own rules for their community (i.e. policies that tell buyers and sellers how to interact in the community), but they cannot compel other entities outside that community to live under those rules. To the extent that they interact with agents in the U.S. legal and financial system, they have to abide by U.S. rules for those interactions anyway. Furthermore, there may be important network effects that could add to the incentive to remain in the U.S. system.
I find it quite plausible that for all but the simplest transactions (such as taking your money to play an on-line game of chance), the protection and standardization of the Uniform Commercial Code is a pretty good reason to stay in the U.S. legal system. As an aside to illustrate the value of coordination, keep in mind that laws relating to business are mostly state laws, but most states (with the exception of Louisiana because of their heritage of French civil law as opposed to English common law) have standardized (with some exceptions) a set of fairly simple laws mostly relating to sales and methods of payment. As a pragmatic free marketer, I see little reason to try to reinvent that wheel. The benefits from coordination on that set of laws are quite compelling.
And so in conclusion, it is not a fair question to ask why a given firm chooses not to locate in a low regulation or zero regulation environment when its competitors and the entities with which it interacts are located in an established but more regulated financial and legal system. The advantages are not the regulations themselves, but the institutions that have evolved to deal with them (case law, legal advice, etc.). Things would look very different if you started with a tabula rasa. However, given the current environment, relatively few firms would voluntarily step outside the established system if they would have to interact with agents remaining in the established system.
A pragmatic free marketer can come up with several reasons why a given firm would choose to remain in a regulatory environment. Thus it can be consistent to believe that a national economy could benefit from less (but perhaps not zero) regulation even though the firms chose to locate there rather than in lower regulation countries. Other costs and benefits besides simply the direct costs and benefits of the regulations must be considered.
Posted by William Polley at April 30, 2007 11:49 PM
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Comments
People are going to use publicly-known rules to structure their interactions with each others.
The issues are: to what degree can a community be self-regulating, on a voluntary basis and at what point does legitimate coercion ought to come in? What institutional form should that coercion take? Moreover, are there benefits that coercion deny, beyond the freedom-as-value-in-itself perspective?
If coercion wouldn't have its disadvantages you could just say, let's coerce everyone into our perfect vision of the world. But there are issues with that. Political economy, Public Choice and so on abound with them.
To conclude, since our menu of rule sets (of countries, worlds, etc.) is limited, and that moving from one option in the menu to another is costly, it's pretty clear that no one lives in a world with the perfect balance of rules, by their subjective standards.
I would love to be an US citizen, caeteris paribus, but I can't afford to move. Is this proof that Romanian over-regulation is good?
I would also love to finance an anarcho-capitalist experiment on a Pacific island. But I don't have the $$$. Is this proof that I'm a hypocrite?
You sometimes settle with the (over-regulated) second-best. This doesn't legitimizes the status quo.
I think that Nozick's thought experiment is useful here. In certain situations maybe both I and cactus would settle and choose the same world, because we need each other in a way. This doesn't mean that we couldn't imagine better worlds, less/more regulated.
Posted by: Gabriel M. at May 1, 2007 05:33 AM
Bill & Gabriel,
You can't be for the institution and against the regulation that developed along side it. The two things are not inseparable.
In the US, for the past past six years, we've enjoyed an experiment in deregulation. The administration has chosen not to enforce rules and regulations that had been enforced earlier. End result... weaker institutions, and less respect for those institutions.
Posted by: cactus at May 1, 2007 06:41 AM
One other objection... a lot of hedge funds have located off-shore. A number of telecom funds as well. Most of these do most or all of their business in the US with US customers, and one can argue that legal protections may be more important when one is talking about the sums involved in a hudge fund than when one is talking about the purchase of some sort of a small gizmo on EBay.
Posted by: cactus at May 1, 2007 06:52 AM
Cactus,
It is more than the traditional "institutions" (the banking system, the court system) though they are important. It is the entire network of people and firms that have specialized in making it work. Again, its why many corporations still incorporate in Delaware even though states like Nevada have responded with favorable laws. There is a network of people AND institutions that is perceived as valuable.
Whether I am for the institution (construed broadly to mean the entire network as described) is irrelevant. The fact is that a given individual firm may find it undesirable to unilaterally turn its back on that institution (and network) when all of its competitors, vendors, and customers remain a part of it.
As for whether the regulatory structure and the institutional network are inseparable, I beg to differ with you. A lawyer who is admitted to the California bar but not the Delaware bar is of little help to you in navigating the Delaware court system. These things are, to a large extent, specific to a legal jurisdiction.
As for the hedge funds, that fits right into my framework. You're talking about investors with a lot of risk capital. The major players likely know each other by reputation. The costs of regulation likely exceed the benefits. But at the other end of the spectrum, who's going to want to invest in an IPO of an unknown widget maker in some far-flung unregulated off-shore market? Knowledge, information, and reputation are all very important in determining what types of entities will seek to avoid government intrusion into their business.
It is a cost/benefit problem that each entity must solve for its own situation. Some will move off-shore, some will willingly subject themselves to being under U.S. law. But the fact that some entities would find it NOT in their best interest to move off-shore unilaterally, does not imply that they would benefit from less regulation if it applied to ALL players in the market. I say again, the network effects matter enough that a firm may choose to accept a little extra regulation to be a part of that network.
No one entity can create that network on its own.
Posted by: William Polley ![[TypeKey Profile Page]](http://www.williampolley.com/blog/nav-commenters.gif)
at May 1, 2007 01:15 PM