Ongoing Disasters Show Why Business Regulation Needs Rethinking

Two recent catastrophes reveal that the U.S. government's approach to regulating business is deeply flawed. The BP (BP) oil spill in the Gulf of Mexico might have been prevented if the Mineral Management Service (MMS), the federal agency that was supposed to inspect the Deepwater Horizon drilling rig that exploded, had actually done its job. And of course, the recent financial crisis might never have happened if regulators had forced Wall Street to bear the long-term costs associated with its short-term gains. These flaws require nothing less than a deep rethink of how government regulates business.

While it's still too early to tell what actually caused the BP disaster, it's pretty clear that the various oil industry participants involved did a fairly thorough job of avoiding taking the blame when they testified in front of Congress last week. The Deepwater Horizon rig exploded April 20, killed 11 people, then sank. Oil has been gushing into the Gulf of Mexico for 27 days at a rate of thousands of barrels a day -- or possibly far more.

But the government didn't really do its job of inspecting the rig. According to the Associated Press, the actual number of MMS inspections of the Deepwater Horizon rig fell short of agency's own monthly standard. It turns out that the MMS collects billions in royalties from the very industry it's supposed to regulate. So if it interrupts the flow of oil and gas -- and hence cash from the industry -- the MMS cuts the value of its own royalty stream.

Complexity Beyond Human Understanding

It should come as little surprise, then, that despite some inspection reports that appear to have clearly foreshadowed what went wrong, MMS held up the Deepwater Horizon as a model, according to the AP. Yet, the news service found that Deepwater Horizon continued operating without documenting how it would respond, as the MMS regulations required, to "the exact disaster scenario that occurred."

Similarly, the causes of the financial crisis still seem to elude us, but it looks like Federal Reserve Chairman Ben Bernanke may be missing something more fundamental. According to the The New York Times, Bernanke cited the May 6 market plunge of nearly 1,000 points as an example of the financial system's complexity -- and the inability of humans to understand it. The Times quotes Bernanke as saying, "Our financial system is so complicated and so interactive -- so many different markets in different countries and so many sets of rules. I just think it's not realistic to think that human beings can fully anticipate all of possible interactions and complex developments."

When one considers that "flash traders," who account for perhaps 70% of daily trading volume, hold stocks for as little as 11 seconds, according to the Times, it's easy to agree with Bernanke about market complexity and the enormous challenge government faces in keeping it from careening out of control.

Independent Examinations

Despite uncertainty over specific causes, at the core of both failures is "regulatory capture" -- the notion that business gets cozy with its regulators and uses that coziness to limit independent regulatory oversight.

Meant to oversee the oil industry, the MMS gets paid billions by the industry it regulates. And the financial industry keeps its regulators from doing their prescribed jobs not just because Wall Street has become so complex that not even the Fed chairman understands what causes market volatility but because financial firms pour $500 million annually into Washington political campaigns and lobbyists' coffers. Making matters worse was a culture of deregulation that made it possible for analysts and ratings agencies to project independence to investors while getting paid by Wall Street.

A new approach to regulation would start with an independent examination of what causes so-called externalities -- unintended costly side-effects of business operations such as pollution and financial bubbles -- and shift the costs of cleaning up those externalities onto the people who make the decisions that cause them.

Set Up Bailout Reserves

What would this mean exactly? The answer would vary by industry. For the financial industry, it would mean some good old-fashioned post-accident investigation into what caused the financial crisis. That would involve running reams of statistical analysis of the correlations between different financial markets around the world to pinpoint the riskiest interconnections.

Having identified those, we could move to getting the players in those industries to set aside sufficient capital to bail themselves out in a worst-case scenario. I'd also require much greater transparency about which players are making which trades and why. And I'd find a more independent source of cash to pay for the regulatory apparatus required to make all this work. l'd apply a similar approach to the oil industry.

It's a tall order, but if we don't act to fix what ails the relationship between business and government, we're doomed to more catastrophes. And lacking a new regulatory approach, the folks who wind up paying will continue to be the victims of industry malfeasance rather than the companies that caused it.