Sunday, March 14, 2010

Regulatory Capture, Platonic Guardians, Eugenics, and Institutionalized Corruption


(Jacques-Louis David, Oath of the Horatii)

My friends, after a few weeks spent exploring some other topics, it is time once again for our favorite: free market triumphalism. Today's post will comment on a phenomenon that serves as a good point of entry for discussing many of the complications and distortions created when a small enclave attempts to steer or control an entire economy.

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I have always observed a singular accord between supercelestial ideas and subterranean behavior.
-Montaigne


I do not, gentlemen, trust you.
-Gunning Bedford of Delaware, Federal Convention of 1787


"Politics Without Romance": The Rise of Public Choice Theory

In the 1950s and 1960s, much of political economy teaching in the United States, to say nothing of Europe, was dominated by the idea that government existed to correct market failures, areas in which pure market outcomes would lead to injustice and/or negative externalities that injured third parties (those who did not benefit from the original, voluntary exchange-based transactions). The standard public-policy textbook was the highly pro-interventionist Richard Musgrave's Public Finance in Theory and Practice.

Musgrave put forth the thesis that public policy and regulations have three primary goals: 1) to provide public goods that the private sector cannot provide adequately (i.e., goods that have positive externalities which, because they cannot be captured by a profit incentive system, will be inadequately supplied by the market and must be subsidized or completely provided by government); 2) to create "social justice" by redistributing wealth; and 3) to stabilize the economy and protect it from the excesses of "unbridled capitalism" (from this point of view, capitalism has a tendency to provide too many goods and services that have "negative externalities", or negative spillover effects, and these must be heavily taxed or prohibited by coercive regulations).

The Musgrave argument, which has survived in many academic circles, requires that the net social costs of government action to correct market inefficiencies be lower than the costs of the market inefficiencies themselves. For quite a long time, this relatively frictionless concept of government intervention was just assumed to be true among many political economists---the pro-interventionist agitator enjoyed a "God of the Gaps" type of protection from skeptical attack (the "God of the Gaps" is a rhetorical gimmick typically used to attack Darwinian evolution. The Gap proponent looks for any holes or inconsistencies in the opposing side's position, then automatically claims them as victories for his own side and justification for his belief system. However, the Gap proponent wishes for his own position to be protected from analytical critique, and he does not hold himself to the same evidentiary standards that he holds his opponents to. Because it places the burden of proof on the opposition, the God of the Gaps argument is generally considered to be a flawed format unless one's position really has accumulated enough supporting evidence for it to serve as the default. In the case of government intervention, any weakness or negative outcome in a market-based economic system was considered a "gap" and provided with a solution that was immediately ascribed to government, ignoring the possibility that the government solution could make things worse).


(Public Choice economist James Buchanan receives the Nobel Prize)

James Buchanan and Gordon Tullock, both at the University of Virginia for many years, systematically dismantled many of the assumptions built into the Musgrave interventionist argument by simply adding this proviso: members of government are not omniscient, omnibenevolent entities who exist outside of the realm of consumers and businesses and who can only do good. They are, in fact, self-interested human beings like everyone else, given to the same rapacious appetites that other groups would enjoy satisfying if certain monopoly conditions were met. Adding this basic assumption has a number of fasciinating far-reaching effects, but today we will only focus on the pervasive problem of regulatory capture, which is most associated with the Chicago economist George Stigler.

Buchanan, Tullock, and Stigler are not true anarchists and none of them believe that a complete absence of all government regulation would be a desirable state of affairs. Rather, they tend to seek to emphasize very limited and constrained government programs (Nozick's "night watchman" state) which emphasize public goods that: A) benefit everyone roughly equally; and B) are paid for by everyone roughly equally (as a percentage of income, not in absolute terms). As we will see, a transfer schedule wherein benefits go to one party and are paid for by the population at large creates a host of perverse incentives, especially when the whole operation can be obfuscated.

Why the Inmates Will End Up Running the Asylum

The term regulatory capture refers to the persistent phenomenon of government controls being co-opted by the very forces that they are meant to regulate. Once captured, regulations are usually used to raise compliance costs in order to effectively block the entry of new players---domestic and international---into various industries. Not only does regulatory capture provide opportunities for corruption and economic rent-seeking, but, by providing leverage for special interest lobbying operations, the agencies that are "captured" end up doing far worse economic damage than a free market system would be capable of inflicting.

Regulatory capture is distinct from its cousin, outright regulatory failure. Regulatory failure is an "incompetence" problem that arises due to poorly conceived legislation---a law is passed that completely fails in its stated purpose, probably because said purpose was diseconomic to begin with (we will have to deal with this one separately). In a capture situation, in contrast, there usually is a politically competent force at work and a law which does meet its intended consequences, it just happens to be that the purposes are malevolent ones: capture means that a clear transfer of wealth occurs from one party to another. The transfer is made possible by the beneficiary party's control of a segment of government and ability to pursue its own desired pet projects, but shift the costs so that they are incurred by non-beneficiaries (preferably as large a group of non-beneficiaries as possible).

For a straightforward example of pure regulatory failure due to political lack of understanding about how complex systems operate, we can look to William Poundstone's discussion of misguided attempts to rein in CEO pay:

...Another benchmark is the ratio of American CEO pay to that of the average worker. In 2007, this stood at 275. It's changed a lot. It was around 50 in the Reagan era and 25 in the 1960s.

In the early 1990s, Senator Ted Kennedy led a chorus bemoaning the rise. (They argued that) average workers had just about kept pace with inflation in the previous generation, while CEO pay had about doubled. The U.S. Congress responded with a 1993 law eliminating certain tax deductions above the million-dollar salary threshold.

Instead of reining in CEO salaries, the million-dollar threshold seems to have functioned as an anchor. The law broadcast to the more backward parts of the corporate world that seven-figure salaries were possible, so "why not me?". In 1989, four years before the law, that ratio stood at 71. By 2000 it had surged to around 300. "In the hall of fame of unintended consequences," said Nell Minow of the Corporate Library, a management oversight group, "that has to rank near the top."


Foundations of Regulatory Capture: Individuals and Groups Have Different Intensities of Preference for Political Program Options

The usual mechanisms for regulatory capture involve permitting, concentrated campaign contributions, subsidies, and specially designed legislation meant to make life difficult for targeted competitors. The exact murder weapon selected is less important than the robustness of the initial assumptions, which are remarkably easy to meet in the real world: for the process of regulatory capture to begin, all you really need is a situation in which the intensities of preferences for and against different legislative options varies from person to person and from group to group. If everyone feels exactly the same way about every issue, regulatory capture will never become a systemic threat. However, if some groups tend to have reasons to care a great deal more about particular government proposals than others do, the wheels begin to turn and the pressure for capture becomes very strong.


(public policy entrepreneur and regulatory capture enthusiast Milorad "Rod" Blagojevich served as Governor of Illinois)

Buchanan and Tullock found that the prevailing arguments for collectivist action and government intervention all were utopian and made the assumption that "vote trading" and special interest perversions were not major threats to the effectiveness of government programs.

Buchanan and Tullock:

The assumption of equal intensity of preference for all voters over all issues...seems anachronistic and sterile. ...When all individual preferences are assumed of equal intensity, simple majority rule will make sure that the summed "benefits" from (government-executed collective) action will exceed the summed "losses." However, if individual intensities of preference are not equal over all voters, this unique feature of simple majority rule disppears. If minorities feel more strongly on particular issues than majorities, than any rule short of unanimity may lead to policies that produce net "harm"...

"Logrolling": A Catalyst for Regulatory Capture


("We are lumberjacks and we're ok.")

Buchanan and Tullock relax the extremely unrealistic assumption that all voters care to the exact same degree about all issues, whether for or against, and then add a new component: time. By having different agenda items come up at different times, and making voting records public so that defectors from the corruption game can be punished, a new phenomenon---"logrolling", or the selling of votes for individual gain---emerges:

We note...that the introduction of a time sequence of political choices allows a market of sorts to be developed...If the individual participant recognizes the economic value of his own vote to others on certain issues and, in turn, recognizes the economic value of others' votes to him on separate issues, he will be motivated to engage in "trade." Moreover, if ways of "trading" can be found that do not clearly conflict with accepted standards of behavior, individuals will seek mutual advantages in this way. The possibility of exchanging votes on separate issues opens up such trading prospects. The individual may effectively, but imperfectly, "sell" his vote on a particular issue, securing in return the votes of other individuals on issues of more direct interest.

...Students of the political process, who adopt the view that, at base, political behavior is not motivated by economic interest, must explain such action in terms of aberrations from more orthodox behavior. ...There has been a failure to recognize that logrolling phenomena are much more pervasive than the more obvious examples would indicate. The phenomena surely occur at several levels of political sophistication.


By creating a market for votes and an infinite number of corruption opportunities, logrolling practices completely undermine the benevolent "Government of the Gaps" argument posed by Musgrave. Gordon and Tullock, after developing a functional model for expressing these concepts mathematically, reach a very unpleasant conclusion:

We do not want to preclude the possible existence of a system of human behavior which could effectively restrain logrolling, but surely the American behavior pattern contains no such restraints. Under our system open logrolling is normally publicly characterized as "bad", but no real stigma attaches to those who participate in it. The press describes open logrolling arrangements without apparent disapproval, and, in fact, all of our political organizations operate on a logrolling basis. Moreover, no stigma at all attaches to implicit as opposed to explicit logrolling...

It would appear that any government activity which benefits specific individuals or groups in a discriminatory fashion and which is financed from general taxation would fit our (corruption-heavy) model well. It is not, of course, necessary that the revenues employed in paying for the projects be collected equally from all voters, either in terms of tax rates or tax collections. The minimum necessary condition is that the benefits from public activity be significantly more concentrated or localized than the costs. This is a very weak condition, and many budgetary patterns seem to meet it. If the taxes are collected by indirect methods so that individuals cannot really tell how much they individually pay for each specific "public-service project", this accentuates the distortions described by our analytical model.


Thus, we have already reached a very discomforting, perhaps even depressing, point in our tragedy: rather than serving as some utopian check against negative spillovers and social injustice, government programs attract a new class of entrepreneur---the "public policy entrepreneur"---and create a new, non-transparent market for buying and selling access to political largesse. Of course any such initiative will be cloaked in patriotic, even moralistic rhetoric---for instance, the sugar industry argues that its subsidies are in the national security interest---and will attempt to combine a concentrated group of politically powerful, highly motivated beneficiaries with the largest possible tax base to fund the benefits (in this way, the fleecing of individual taxpayers can be kept as painless as possible).

The use of populist rhetoric to conceal the personal agendas of the beneficiaries is epitomized by the "Baptists and Bootleggers" scenario of the Prohibition Era: because both entrepreneurial criminals and religious zealots had a vested interest in regulations prohibiting alcohol sales, politicians were able to enjoy campaign contributions from the bootleggers and top-cover justifications provided by sermonizing from the Baptist groups.

The goal of the policy entrepreneur is simply to build support for his own pet projects---projects could involve genuine political agenda items of concern, the economic welfare of his friends, cathedral and pyramid construction, monorails, whatever---by trading his votes on issues that are less important to him for his colleagues' votes on issues that are more important to him.

Keep in mind that, in discussing logrolling, we are not talking about a market transaction in which a buyer and seller meet to exchange goods or services or cash. We are talking about a transaction in which a political operator seeks to gain economic rents (or some other personal consideration) by exploiting his regulatory position, and to do so he will effectively sell his vote on other initiatives that he cares less about, or at least is less informed about. He does not even necessarily need to be selling for personal gain and he does not need to personally be corrupt---he may have genuine feelings about, say, endangered species protection and prioritize this kind of legislation over, say, a loosening of internet gambling laws. In exchange for supporting the naturalist politician's endangered species and biodiversity agenda, however, a colleague who does represent internet gambling interests will expect support for his own policy goals and constituents. Rather than being a phenomenon that instantly corrupts the entire political process, logrolling is more subtle in its effects and works by a process of gradual moral decay.

Once again, all that is required is for the preference mixes to vary. Thus, the programs which will tend to thrive are those that benefit highly vigilant, concentrated special interest groups---who are prepared to "pay" the most for the votes of the political entrepreneurs and can do so credibly---at the expense of the general taxpaying public. The political operator may need some notional argument or patriotic justification for his actions, but only in the most outrageously criminal cases will these be difficult to generate.

In terms of actual implementation, a very well-practiced logrolling technique is to simply add a particularly eccentric or otherwise questionable piece of special interest legislation to a large, complex legislative package. This is particularly effective if the larger package is time-sensitive, popular, or patriotic enough to be considered a very important bill. The logroller sells his vote on the larger package by demanding that his personal, special-interest legislation line-item be added to it. With the Oval Office unable to use a line-item veto (and possibly unwilling to use it even if one existed), even a fiscally responsible Executive Branch can be forced to accept an extraordinarily corruption-laden bill.


(the Hon. Representative Charles Rangel, D-NY)

This is almost certainly what happened when the embarrassing Charles Rangel---who repeatedly failed to report his own Caribbean-based "supplementary income" stream---was able to add clumsy legislation targeting offshore "tax havens" to a popular veterans bill. Rangel recently stepped down from his chairmanship of the House Ways and Means Committee---the body which writes federal tax legislation in the United States---amid a number of corruption charges, including his pursuit of a $10 million donation for the "Charles B. Rangel Center for Public Service" from imploded insurance-giant AIG at the same time that a bill imposing a 90% tax rate on AIG bonuses was being introduced in Congress.

Defenses Against Logrolling: Effective Checks and Balances

Gordon and Tullock do have some interesting suggestions for improvements, such as forcing officials to meet a supermajority standard before enacting tax increases. They also attempt, heroically, to deal with the incentive, waste, fraud, and abuse problems created by the pernicious logrolling process:

For example, suppose that the issue confronted should be that of providing some federal funds to aid the depressed coal-mining area of West Virginia. For such a measure the levy of special taxes on the citizens of West Virginia would be largely self-defeating. Nevertheless, it is easy to see that, if such aid is to be financed out of general-tax revenues, a veritable Pandora's box may be opened. Depressed fishing villages along the Gulf coast, depressed textile towns in New England, depressed automobile production centers in Michigan, depressed zinc-minining areas in Colorado, etc. may all demand and receive federal assistance. As a result, excessive costs will be imposed on the whole population.

One means of eliminating this sort of distortion, which may appear somewhat farfetched because it is novel, would be to require that all such projects be financed out of taxes levied on specific groups in the total population, although not on the same group securing the benefits. For example, if the funds designed for aid to West Virginia were to be collected from special taxes levied on citizens of Oklahoma only, then we could be assured that roughly balancing political forces could determine the final outcome. ...Through the (inevitable) logrolling process some solution would be reached, and this solution would more nearly reflect "the public interest" than the alternative one which requires general-tax financing.


Fuzzy logic pioneer and libertarian Bart Kosko has designed a new income tax form that would separate the federal budget into distinct areas and allow taxpayers to allocate their taxes favorably to those areas that have been independently audited for at least a modicum of logroll resistance.

Enter the Special Interest Group


(l to r: Nobel Laureates and free market champions George Stigler and Milton Friedman stand next to John Kenneth Galbraith. Despite being nearly perfectly opposed on ideological grounds---Galbraith was a liberal Keynesian "aristocrat"---the diminutive Friedman and the 6'10 Galbraith remained close friends and would share family events)

The theory of regulatory capture was primarily developed by George Stigler, a professor at the University of Chicago and a lifelong friend of Milton Friedman. Stigler was another of the individuals who made the economics department at Chicago the discipline's strongest academic powerhouse. Observing the power of the state to compel diseconomic outcomes and distortions, Stigler wrote:

The state—--the machinery and power of the state—--is a potential resource or threat to every industry in the society. With its power to prohibit or compel, to take or give money, the state can and does selectively help or hurt a vast number of industries.

Seeing this environment of resource and threat, Stigler despaired that government officials could first adopt the principles of a kind of Mafia protection racket, forcing contributions from those who they could threaten to regulate out of existence, as well as taking contributions from those who stood to gain the most from protection. The average taxpaying citizen would be unaware of much of this because of the wide disparity in information-gathering incentives that exists between an individual private citizen and a special interest group.

Rational Ignorance

To look at why special interest groups will come to dominate the influence and redistributionist-benefits market made possible by Buchanan and Tullock's apparently inescapable logrolling trap, let's imagine that I, as a private citizen, wish to be a better informed voter. I want to start by calculating the number of carrier battle groups that the United States needs, and then voting accordingly. In theory, I should be concerned about this issue as there are possible geopolitical scenarios in which having the correct answer to the carrier battle groups question could be very important to the United States. Unfortunately, we will soon see that I am personally better off not trying to be particularly well-informed on this or many, many other public-policy questions (i.e., I should avoid the expense and remain "rationally ignorant").



First off, I need to somehow compute how we determine the "needs" of the U.S., which (assuming the question even makes sense) is an extraordinarily complex undertaking rife with predictions about the future state of the world, risks to global trade and security, determinations about technological change, even long-range weather forecasts (for instance, the locks of the Panama Canal are filled with freshwater from surrounding lakes, not sea water, so rainfall patterns can affect the ability of this strategic waterway to accomodate global shipping).

Of course, I know that my assessment will ultimately have to be wrong on some level because, to make the problem tractable, I need to employ the fictious notion that the United States has one, overarching set of strategic needs, as if the U.S. is a single super-organism rather than a heterogeneous mix of people with different beliefs, tastes, risk tolerances, and foreign policy preferences.

After qualifying and quantifying the needs of the U.S., I need to somehow calculate the minimum number of carrier battle groups that would be necessary to support these needs, as well as determine how quickly new carriers and support ships can be commissioned or decommissioned in order to provide a flexible, adaptive response should future scenarios veer away from my predictions. If I were undertaking this study myself, I might also need to obtain five or six new graduate degrees first.

Suffice to say that I have no realistic way of making this determination, and even if I did put something sophisticated together the zone of uncertainty would be so great as to leave the study perpetually contestable. Indeed, the people who are experts on carrier battle groups---senior Surface Warfare and Aviation officers in the Navy---do not themselves actually know how many we "need." They can make a far better and more informed guess than I can, obviously, but then again they also have a vested interest in scaling up their final numbers. Imagine how much time the senior executives at, say, General Dynamics NASSCO and Northrop Grumman Shipbuilding spend on this kind of question, and how much they have at stake directly. How much time, effort, and money would I personally spend on researching this one issue and attempts to persuade public officials that my own assessments were correct? Not much. In contrast, consider how much time, effort, and money senior Navy and defense contractor leadership would spend on this issue and attempts to persuade public officials that their personal assessments were correct...

Now we reach yet another problem: even after all this Herculean effort, I probably will not be able to directly vote on the issue of carrier battle groups, anyway---public policy entrepreneurs will "pre-package" candidate platforms into jingoistic slogans and the line item for "Candidate X thinks we need 59 carrier battle groups" will probably be impossible to find. And even if it wasn't and candidates ran exclusively on competing carrier battle group hypotheses, my vote on the issue will count the same as that of the individual who determines the national security needs of the U.S. by watching G.I. JOE: The Rise of Cobra. Other than the enjoyment of the project as an intellectual self-improvement exercise, there is virtually no incentive for me to put in the countless hours of extra effort to become a genuinely informed voter---I am better off being "rationally ignorant" and leaving it to the professionals and "thought leaders" to figure it out for me.

The more complex the issue and the higher the costs of acquiring expertise, the less well-informed the vast majority of the voting public will be (rationally) and the more the center of gravity of the political debate will consist of emotional appeals and marketing gimmicks. The best thing to do, politically, may simply be to just offer blind hope and optimism, but over the long term this will risk creating a special type of regulatory capture problem that we will contend with shortly.

Regulatory Capture in Action: A Few Examples

There are extraordinary numbers of contemporary examples of distortions and poor economic outcomes that have been created by captured regulatory agencies serving special interest groups. Many of these may have begun as well-intentioned projects to prevent or solve a perceived "market failure", although others clearly were motivated by achingly ambitious politicians seeking to establish public recognition as moral crusaders and cynical special interest groups who lobbied for and received private benefits.

The tendency to backfire is well-established: increased SEC regulation of hedge funds, for example, raises compliance costs in a manner that favors the large and powerful existing hedge funds, who can more easily accomodate the increased burden of the regulations and pass them on to clients, one way or another. These hedge funds then can attract more capital and *may*, depending on how similar their strategies are, end up deploying this capital in more concentrated positions, which in turn are harder to liquidate during crisis periods.

In a somewhat similar vein, the Sarbanes-Oxley Act of 2002, which came in the wake of the Enron and WorldCom scandals and is meant to protect investors from accounting fraud, has had the effect of raising the compliance costs of smaller business and enterprises which are considering making initial public offerings to access equity financing in the capital markets. Rather than serving the interests of the public by curbing the excesses of powerful companies, Sarbanes-Oxley benefits "Big Business" interests, which are certainly annoyed but which can meet the increased compliance costs, at the expense of smaller ones.

Additionally, Sarbanes-Oxley may have had a secondary effect wherein its regulations have been effectively captured by trial lawyers, who use the difficult compliance requirements as a platform from which to launch class-action lawsuits. A serious concern is that this will cause "IPO migration" to offshore global market centers, most notably London.

The classic example of regulatory capture is the Interstate Commerce Commission, which was set up to regulate railroad freight rates in the 1880s. Railroad interests soon captured the ICCC and set rates in order to bar new entrants from effectively competing.

Milton Friedman:

It took about a decade to get the commission in full operation. By that time the reformers had moved on to their next crusade. The railroads were only one of their concerns…. For the railroad men the situation was entirely different. The railroads were their business, their overriding concern… And who else had the staff and expertise to run the ICC? They soon learned how to use the commission to their own advantage.

The first commissioner was Thomas Cooley, a lawyer who had represented the railroads for many years. He and his associates sought greater regulatory power from Congress, and that power was granted. As President Cleveland’s Attorney General, Richard J. Olney, a former railroad industry lawyer, put it in a letter to railroad tycoon Charles E. Perkins… only a half-dozen years after the establishment of the ICC:

“The Commission, as its functions have now been limited by the courts, is, or can be made, of great use to the railroads. It satisfies the popular clamor for a Government supervision of the railroads, at the same time that the supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things. It thus becomes a sort of barrier between the railroad corporations and the people and a sort of protection against hasty and crude legislation hostile to railroad interests… the part of wisdom is not to destroy the Commission, but to utilize it.”


Regulatory Capture and Real Estate Manipulation. The delightful Thomas Sowell, investigating localized housing bubbles, found that zoning boards had been "captured" by existing homeowners, who used the regulatory agencies to increase the value of their existing properties.

Sowell:

In Palo Alto, California, where home prices nearly quadrupled during the decade of the 1970s, there was not a single new home built during that decade, so this was simply a question of the same existing home selling for far more than before, and obviously had nothing to do with construction costs, since there was no new construction...in Salinas, California, about a hundred miles south of San Francisco...three-quarters of the county is legally blocked from development. With such a severe restriction on supply, high land prices were virtually guaranteed---and therefore also high prices for the housing built on the land.



How did the kind of building restrictions that send housing prices sky-high get started in the first place and then acquire such political momentum? Part of the answer is the heady but misleading concept of "planning." What is called "planning" in political rhetoric is the government's suppression of other people's plans by imposing on them a collective plan, created by third parties, armed with the power of government and exempted from paying the costs that these collective plans impose on others.

..Far from losing anything by housing restrictions, existing residents see the value of their property shoot up---and it is existing residents who vote on local housing restrictions that raise housing prices for newcomers. ...Another crucial insulation from free market forces has been having the government take over vastly more surrounding land than any or all of the existing homeowners paid for, in the name of "open space." Where thousands of acres of land are taken off the market around an existing community, that can mean millions---or even billions---of dollars' worth of land being made unavailable to others for the benefit of the existing residents of the community. Local residents do not need to pay for that land nor need the government unit that takes the land off the market. Merely by forbidding or restricting what can be built on that land, the government automatically lowers its value, often drastically.

Often the character of a community includes a bucolic setting or expansive views of the surrounding area which those who live there cherish...Political authorities in various jurisdictions began to take advantage of the erosion in property rights (which really took hold in the 1970s and included the landmark Petaluma case in 1975) to pass restrictive housing laws under a variety of politically attractive names such as "open space," "smart growth," and the like. Such restrictions have been especially prevalent in overwhelmingly upscale liberal communities such as those in coastal California, where concerns are often expressed for the poor, for minorities, and for children---all of whom are among those most often forced out of communities by high housing prices.


Ironically, those who push for these outcomes usually also claim that the unaffordability of local housing is the result of "market failures" that need to be corrected by centrally-planned "affordable housing initiatives", like the clever ones that recently caused the Federal Reserve to have to absorb approximately $1.5 trillion in toxic structured credit products that had been generated by the now-under-conservatorship Fannie Mae and Freddie Mac.

I actually quite like the idea of "green space" and restrictions on development in some areas; the problem is that these goals are not being accomplished through a free market pricing mechanism that allows buyers and sellers to both try to benefit. Instead, the coercive power of the state is used to artificially sweeten the deal for one side or another. Real estate values in some areas are lowered by zoning restrictions, if not outright "eminent domain"-based seizures by the local government, in order to create artificial scarcities and boost the values of other, more politically influential property holdings.

The result is a race to the bottom, where Option A is to pay full market value for a piece of property in order to take it from the market and set it aside as an attractive natural amentity, while Option B is to bribe a (usually quite small and concentrated) group of local politicians, either directly or through campaign contributions and special patronage of pet projects, and then to have the piece of property rendered undevelopable or severely restricted. Since the $ Cost (Option B) < $ Cost (Option A) in almost all circumstances, this game is played all over the country. In fact, the game may have gone so far out of control that it has even backfired on some of its originators: a recent Supreme Court decision, Kelo v. City of New London, confers on local governments the legal authority to condemn private property by eminent domain and provide it to other private interests (politically connected developers). I can only imagine that this must have caused Sowell, who was already very concerned about the corruption opportunities created by property rights erosion and local government zoning regulation capture by vested interest groups, to become apoplectic.

"At last the Dodo said, 'everybody has won, and all must have prizes.'"
-Lewis Carroll




I think that we would all enjoy employing the force of collectivized general taxation---a force backed by violence---to pursue our own amusements. We could all come up with personal interests and projects that could be fulfilled by becoming pigs with first access to the public funding trough.

In my case, I would sip Clicquot-spiked mimosas and enjoy Hemingway first editions and massage therapy while waiting for fresh, exotic orchids, bespoke pinstripe suits from Norton & Sons of Savile Row, and walnut-stocked, engraved .500 Nitro Express Krieghoff double rifles to be delivered by specially-recommissioned SR-71 to my government-supplied Balinese beach/waterfall-panoramic-view fortress. Even if we didn't fund the Pritchard Comfort System through the printing press, each individual American taxpayer would only have to face a very small addition to his or her tax bill; certainly a few pennies and nickles here and there would be a small price to pay in order to bring me great joy. I'm not even acting selfishly: the program would make some shop owners and their employees very happy, so the PCS would have a counter-cyclical Keynesian fiscal stimulus effect and bring about a corresponding increase in aggregate demand. What would possibly be the harm...?



Grey Area: The Creative Commons

The issue of intellectual property rights seems to be one in which it is far more difficult, at least for me, to determine the true "free market" way forward. Some artists that I respect, including the author Mark Helprin (his Memoir from Antproof Case was mentioned in another blog post) and the band Metallica, have been very concerned about the erosion of IP rights made possible by various digital media and pirate sensibilities (Helprin wrote a book called Digital Barbarism to discuss his position).


(author Mark Helprin, shown here with part of his library, was educated at Harvard, Princeton, and Oxford, and served in the Israeli Army, Israeli Air Force, and British Merchant Navy)

On the other hand, there are independent writers and musicians who believe that this is a case of regulatory capture, wherein the entrenched artists and those controlling the traditional distribution channels (music labels, publishing houses) fear being disintermediated. In order to maintain their position of extracting economic rents, this "Creative Commons" argument goes, the entrenched powers wish to try to restrict, or at least slow, the proliferation of decentralized internet file-sharing technologies.

The argument presented against the file-sharing technologies then counters by emphasizing how pirate software does hurt the currently successful artists, who work hard and deserve to earn a good living, and also destroys incentives for new artists to pursue the (very uncertain) creative life.

I don't have a strong opinion on this, because good, satisfying cases have been made on each side of the debate. If pushed, I would normally believe that the erosion of IP protection was dangerous, but the technology economist Arnold Kling did have this comment, which I found quite interesting:

The amount and variety of music being produced today is expanding. There is no sign that musicians and composers are finding Internet file-sharing a deterrent to creative activity. On the contrary, there seems to be a blossoming of independent talent. At least one veteran artist, Janis Ian, has pointed out the advantages that Internet-based distribution gives to the vast majority of musicians who are not superstars:

"In the hysteria of the moment, everyone is forgetting the main way an artist becomes successful---exposure. Without exposure, no one comes to shows, no one buys CDs, no one enables you to earn a living doing what you love. Again, from personal exprience: in 37 years as a recording artist, I've created 25+ albums for major labels, and I've never once received a royalty check that didn't show I owed them money. So I make the bulk of my living from live touring, playing for 80-1500 people a night, doing my own show. I spend hours each week doing press, writing articles, making sure my website tour information is up to date. Why? Because all of that gives me exposure to an audience that might not come otherwise. So when someone writes and tells me they came to my show because they'd downloaded a song and gotten curious, I am thrilled! Who gets hurt by free downloads? Save a handful of super-successes like Celine Dion, none of us. We only get helped."


The Most Dangerous Form: Large-Scale Regulatory Capture, Government Bankruptcies, and Debt Abuse

One might think from my examples that the only scenarios in which regulatory capture takes place involve relatively small groups of beneficiaries who, through the political process, are able to direct the coercive power of the government to redistribute wealth towards them and away from the general populace. However, there are other forms that are far more dangerous because of the sheer numbers of players involved in the game.

This form of regulatory capture can occur when government subsidies prevent the price mechanism from passing on important, accurate information about resource scarcity to very large groups of consumers/voters. The result is a tragedy of the commons scenario that can, and has, cause governments to go bankrupt. Current consumers have, in effect, "captured" the regulatory agencies involved, but the victims will be either: A) those who have purchased that government's debt and who live outside of the benefiting communities, or B) generations of future taxpayers who are currently too young to vote, but who will be saddled with the debt created by the malfunctioning subsidy programs.

We will extend this model to discuss the coming crisis in entitlement programs, specifically some proposed health care programs, at a future date, but let's start with a more localized example. While the ramifications of this ultimate form of capture have not yet been felt in the US Treasury market, where buyers of U.S. debt could come to realize that large-scale U.S. government debt monetization through the printing press may be almost inevitable, we have certainly been able to bear witness to cautionary tales in the forms of state government failures or near-failures.

Writing about the California energy crisis of 2000-2001, in which government-controlled utilities had to pay exploding wholesale prices for electricity but could not pass these prices on because the retail prices that they were allowed to charge consumers had been "captured" and capped by regulation (please consider current health care proposals as you continue), the economist Richard McKenzie had these observations:

Electricity waste has been a way of life in California. As the (energy) crisis began to fester in December 2000, the nearby international headquarters of the Trinity Broadcasting Network, whose religious television sets drip with ornate gold leaf props, had its multi-acre campus ablaze in with what appeared to be several million Christmas lights. Throughout the Chrismas season, Fashion Island, the shopping center where we ate, turned on nightly the "World's Largest Decorated (and Lighted) Christmas Tree." Because the tree was so massive, 110 feet tall, they had to hang Christmas lights the size of soccer balls, and you can bet there were lots of them.

It's transparently clear that electricity is relatively cheap in the state, given the widespread use...I've spent many hours with fellow economists talking about the "tragedy of the commons" that emerges when prices are not allowed to seek their market-clearing level. Typically, the talk is about how, say, cattlemen will invariably overgraze pastures when the property is held in common, meaning no one owns the property and no charge is exacted for access. The "tragedy", underfed cattle because of the overgrazed pastures, is an outcome none of the cattlemen wanted.

If there ever was a tragedy of the commons, I stood witness to its making. The electricity tragedy was man-made by those who were least suspected. Few consumers (or policy-makers) seemed to understand that every time they turned on a light, they "overgrazed" the power grid and increased the junk debt of the local power distributors, and the "overgrazing" continued because the retail price of electricity remained regulated, capped throughout the crisis, while the deregulated wholesale prices of electricity rose. Who cares? Ineed, it just struck me that by writing about the crisis in the midst of it on my power-gulping computer, I was adding to it, and the electric power companies' indebtedness (and the threat of their bankruptcy), but by so little that I need not have changed my writing plan. Therein lies the source of a real-life commons tragedy...

The state rapidly ran through billions of tax dollars to subsidize all the energy waste I saw around me. They only belatedly came to realize how their actions to hold the retail price of electricity down, in the face of the mounting shortage, eliminated any incentives to conserve electricity use all the more.


Much has been made about the behavior of Enron and other natural gas and electricity traders to push wholesale prices up. Deregulation has frequently been blamed, although California's energy demand had surged and supply had dropped for many other reasons. However predatory the traders were, the treasure chest was opened because the normal market price discovery mechanism---which would have passed the higher prices on to consumers---had been destroyed by regulatory capture. The true "winners" were those who used the most obscene amounts of electricty, since it was being heavily subsidized.

Stan Goff, who we met in the Haiti discussion of several weeks ago, argues for a greater role for collectivist government programs. In my opinion, he should be very concerned that attempts to create an even stronger concentration of power---in Goff's case, this would be in order to prevent imperialistic, profit-driven wars overseas---could end up simply leading to the Department of Defense itself suffering "regulatory capture", and working for the special interests of those that the government is supposedly meant to regulate. In fact, this form of capture is exactly what Goff's fellow traveler Smedley Butler describes in his book War Is A Racket.

Regulatory capture is where the attractive, idealized Hegelian notion of Big Government regulatory bodies providing an effective counter to the predations of Big Business starts to break down, as one quickly finds that the needs of both Big Government and Big Business become aligned. The best way to check the abuses of Big Business is to create a climate in which the forces of creative destruction---entrepreneurial innovation---are very strong, and no one agency or firm can take its dominant strategic position for granted.

Blame Plato and Hobbes: Philosophical Justifications



Given the demonstrable costs and risks that political and economic distortions such as logrolling, powerful special interest groups, concentrated taxing authority, and regulatory capture pose, particularly when combined as they so often seem to be, we must somehow explain why these perils are not more widely appreciated, and why calls for increased regulation and central control continue to be so popular.

Regulatory capture is made possible because of the existence of a regulatory state, and the existence of a regulatory state is made possible by the conviction that a significant percentage of the population must be given a large number of rules. Whether the common elements of society require these rules because the members are too stupid or because they are too evil to operate without them is a secondary concern, but the thrust of this argument is that individualism is dangerous in the wrong hands.

Much begins with Plato. Plato, favoring a tightly-regulated state with highly concentrated power, explicitly believed that a small number of people in society were fit to rule, and designed a social system in which these people---the philosopher-kings of which we must assume he included himself as a member(as Marx also did in his power-concentration cerebral masturbations)---would exert totalitarian control. His justifications essentially are similar to those of many others who feel that centralized, top-down planning simply must be superior to the highly individualistic, grassroots structure of a market-based system (to be fair, we must take into consideration the historical context in which The Republic was written, a time when markets and the price discovery mechanism were not well understood).

In achieving their benevolent ends, the philosopher-kings were authorized to use both complete regulation-based authority and something that Plato termed "the Noble Lie." The Noble Lie is a broad-based, deliberately cultivated illusion that keeps the dirty masses in a state of bliss (rational ignorance?), since the regular people lack the deep training in philosophy and critical thinking, as well as the native cognitive, psychological, and even aesthetic sophistication levels, to be able to handle the truth. These people are judged to be better off operating under a comforting illusion. What we essentially find in Plato is a cynical view of humanity that is analogous to the relationship between the shepherd (representing the cognitive elite) and his flock of domesticated sheep (representing the stupid, defenseless masses).

Plato has long been a favorite of those who want to find classical philosophical justifications for the concentration of power, but his works mostly recently found a home with the "Neoconservatives" embedded within the Bush Administration. Many of the leading Neocons were direct or indirect students of Leo Strauss, a humanities professor at the University of Chicago whose interpretations of Plato led him to conclude that a small group of golden people were intellectually capable of being "illuminated", and it was the duty of those who achieved such understanding to defend the polis, the state, against its enemies. The unwashed masses would be entertained by the equivalent of bread and circuses while the cognitive elite went about the dirty-but-necessary business of protecting the polis by any means necessary. The result would be a kind of covert or clandestine totalitarianism operating behind the scenes and focused primarily on foreign policy, or external threats to the state.

Strauss also used Plato to create a model for at least the conceptual underpinnings of regime-change operations, since his applications of Plato would allow a policy-maker (provided he had a strong classical education, of course) to predict the future behavior of other sovereign governments. This is a very subtle issue, but I will simplify by suggesting that the Straussian analyst believes that he can solve a political forecasting problem by looking at the state's current ruler in terms of personal behavior and ambitions, and extrapolating from this individual's conduct to predict how that state itself will behave, eventually, in the foreign policy arena ("L'Etat C'est Moi"---"the State is Me"). Thus, one can assume that a kleptocratic despot who behaves very badly on the domestic front will, eventually, seek to behave in a similar manner on the international stage. Pre-emption is less risky than it would be in another model because an important, thorny scenario-construction issue---assigning probabilities to different scenarios---has been solved.

I do think that the focus on the behavior of the individuals in power for predictive purposes is a worthwhile approach, but the Straussian model does not appear to have been tested for robustness and accuracy. In contrast, the political scientist and game theorist Bruce Bueno de Mesquita has developed a much more sophisticated methodology for making foreign policy predictions by using extrapolations from the utility-maximizing incentives of individual leaders.

The philosopher Karl Popper was so disgusted by Plato's elitism that he listed the ancient Greek as the number one enemy of the freedom-loving "open society" model that Popper espoused.

Popper:

What a monument of human smallness is this idea of the philosopher king. What a contrast between it and the simplicity and humaneness of Socrates, who warned the statesmen against the danger of being dazzled by his own power, excellence, and wisdom, and who tried to teach him what matters most - that we are all frail human beings. What a decline from this world of irony and reason and truthfulness down to Plato's kingdom of the sage whose magical powers raise him high above ordinary men; although not quite high enough to forgo the use of lies, or to neglect the sorry trade of every shaman - the selling of spells, of breeding spells, in exchange for power over his fellow-men.


(the philosopher of science Sir Karl Popper was lifelong friends with F.A. Hayek and is the intellectual hero of Nassim Taleb)

Another of the great philosophical authorizations for a tight-regulatory state was the one issued by Thomas Hobbes in his Leviathan. Hobbes felt that the state of unregulated man was one of eternal conflict, bellum omnium contras omnes ("war of all against all"). Human nature, left unchecked by a totalitarian sovereign, descended from a state of prehistory in which lives were, as he famously put it, "solitary, poor, nasty, brutish, and short."

Of course, the overwhelming majority of biologists now agree that man is descended from a particular group of highly social primates, a common ancestor of our modern African great apes. There was never a period when we were truly solitary creatures, our social intelligence developed in small groups in which trust was critical, and repeatedly-confirmed experiments (employing fMRI scans and a cooperation/defection test called "the Ultimatum Game") have revealed that we are hardwired for cooperation, even in contrived situations in which cheating and greed would go unpunished.

This is not to say that sociopaths and other pathological non-cooperators are absent from the population, but the interesting thing about them is that concentrated political power and coercive authority are absolute aphrodisiacs to such people, while communities composed of benevolent cooperators are going to want to largely experience the world through voluntary social arrangements, minimal use of coercive force, and protected toleration of individual diversity and differing opinions. In modern times, the Hobbesian advocacy of a totalitarian "leviathan" state creates the seeds of its own destruction because it is based on initial assumptions about human nature that are not substantiated, but it still seems to be a popular one among liberal "elites" for reasons that I will propose in another post.

Elitism, The Regulatory State, Eugenics, and Forced Sterilization

A serious discussion of this should also be saved for another day, but there are unavoidable connections to be made between the Platonic notion of a cognitive ruling class of philosopher-kings, standardized testing for intelligence and other desirable traits, and the eugenics movement. I am not saying that an interest in eugenics necessarily follows from a view of the role of of the state that favors tight regulations of private conduct and tries to select an elite group of policymakers who can direct or steer markets, but I will claim that the beliefs are quite compatible on a logical basis, and that the beliefs have often come packaged together on a historical basis.

For those new to the topic, I will simply define eugenics as the study of how "superior" genetic branches of humanity can be created by special, controlled breeding programs ("positive eugenics") and the inferior branches can be controlled by forced sterilization of the unfit ("negative eugenics"). At the public policy level, eugenics can be conceived, if it is ever implemented, as a form of regulatory capture in which those who fit a given dominant-class trait definition---probably based on IQ testing, since eugenics and IQ standardized exams are closely linked historically, althought fitness criteria could also be based on race, tribal membership, religious preferences, sexuality, or something elese---are able to exploit a political advantage and promote programs that celebrate their traits and punish those in whom the trait is absent.

I will try to resist ad hominem attacks on John Maynard Keynes, because I do admire the man in many ways, but I want readers to understand that the same individual who distrusted free markets, espoused government intervention (the printing press was, to Keynes, the equivalent of Plato's "noble lie"), and who has become a darling of the economic left was also an extreme intellectual elitist who believed strongly in a society that was stratified by IQ levels. A Director of the British Eugenics Society for years, Keynes wrote before his death that "Galton’s eccentric, sceptical, observing, flashing, cavalry-leader type of mind led him eventually to become the founder of the most important, significant and, I would add, genuine branch of sociology which exists, namely eugenics."

Rather than being some eccentric coincidence, I believe that the interest in eugenics is a logical, if somewhat extreme, extension of the interest in a tightly-regulated economic and political climate, controlled by a small group of illuminated individuals with exceptional intellectual gifts.


(extremely bright and persuasive, J.M. Keynes became something of a cult figure)

Lest we fall victim to the belief that American intellectuals were somehow insulated from the appeal of eugenics, I will quote Oliver Wendell Holmes, the widely-cited Supreme Court justice and legal theorist, who, explaining the sinister Buck vs. Bell decision---which authorized forced sterilization of the "unfit" and led to perhaps 60,000 Americans, mostly women, being involuntarily sterilized---wrote that:

It is better for all the world, if instead of waiting to execute degenerate offspring for crime, or to let them starve for their imbecility, society can prevent those who are manifestly unfit for continuing their kind. The principle that sustains compulsory vaccinations is broad enough to cover cutting Fallopian tubes. Three generations of imbeciles are enough.

I suppose that the argument could be made that the eugenics movement should be, like Plato's tiered society with its Guardians, placed in a proper historical context---while our modern stomachs may churn at the thought, we should consider that eugenics "seemed like a good idea at the time" (even "rugged individualists" like Teddy Roosevelt voiced opinions in favor of it). My counter to the relativistic claim would be the following observation: if an activity that most of us would now consider monstrously evil---it is not a far leap from forced sterilization to the camps of the "Final Solution"---seemed like a perfectly good idea at the time, then it means that we should trust regulatory authorities even less unless said regulations protect timeless humanistic values and protections for minority groups.

In my opinion, the problem with men like Keynes (and Plato, we could probably safely surmise) is that: A) they truly are extremely intelligent men, far outside the normal range in a variety of cognitive domains; B) they are aware of item A; and C) as a result of items A and B combined, they genuinely feel the world would be better off if those like themselves were in charge. It seems to me that part of the enduring appeal of the regulatory state to many intelligent individuals is that the move from A and B, which may be correct, to C, which in my opinion is not, is so natural and intuitive. I think that there are a few fields of study which can help to form a wedge of humility between A and B (A and B just make someone a bit vain about his or her cleverness) and C (which is the point where a lot of mischief can begin).

Keynes, Aesthetics, and Messianic Mythology

When you read accounts of Keynes from his contemporaries, you get this sense of awe that makes you realize how confident and persuasive the man was, and how this was combined with a both a ferocious quantitative/analytical capability and the ability to think in terms of holistic systems. I am reminded of accounts of the magnetic personality of the philosopher Ludwig Wittgenstein, who so mesmerized a generation of students that years after his death they were still attempting to copy his mannerisms and accent. The combination of charisma and genius made Keynes potentially a cult object---one breathless Canadian politico, after watching Keynes speak, said, "I am spellbound. This is the most beautiful creature I have ever listened to. Does he belong to our species? Or is he from some other order? There is something mythic and fabulous about him. I sense in him something massive and sphinx like, and yet also a hint of wings".

Keynes and Plato both were aesthetes. Plato's idealization of "perfect" forms is well-known and his proposed society met his standards for aesthetic beauty, harmony, and a certain geometric quality---these are classic hallmarks of architecture and design-exaltation being applied to social engineering. Keynes was both an important collector and patron of the arts and a member of the elite Bloomsbury Group that included Virginia Woolf, E.M. Forster, Vanessa Bell, and Lytton Stachey. The Bloomsbury Group drew great inspiration from G.E. Moore's Principia Ethica, and in Moore's work are some passages that would seem to authorize Plato's employment of the Noble Lie and the existence of a cognitive and aesthetic elite in society.

Perhaps as a result of his love of the beauty of mathematical expressions and symmetry, Keynes incorporated the famous IS-LM model that uses simultaneous differential equations to show how a depressed economy can become "stuck" at an equilibrium level with high unemployment (and this of course helps to authorize massive government intervention to apply positive aggregate demand shocks and shift the economy to a new, higher equilibrium level). We need to be very careful of how applied mathematical techniques that promise precision can authorize totalitarian behavior---Keynes himself apparently did not wish to excessively rely on closed-form mathematical solutions, but even so his use of differential equations implies a clockwork, deterministic economy with levers and dials that can be "tuned" by a small group of specially-trained macroeconomic technicians (a group very similar to the philosopher-kings that Plato proposed).

When I read Keynes, I personally sense an amused genius playing chess with himself. For instance, the same man whom in his General Theory advocated wild use of the printing press to keep interest rates down at "zero percent" as a monetary policy goal, and who offered "pyramid building" as a suggested fiscal stimulus technique also had this to say about inflation:

Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

For me, the interest in eugenics reveals that, given how things can go so horribly wrong, even with highly intelligent men involved, we should scale the role of government to the most pessimistic scenarios, rather than to assume that omnibenevolent and omniscient demi-gods will be in charge. Mutual fund investment manager Peter Lynch once said that he wanted to "buy a company that an idiot could run, because eventually one will." Popper himself said, "The vital question is not 'Who should rule?' but 'How can we minimize misrule?" Unfortunately, I think that there is little chance of the dangers of regulatory capture---to say nothing of regulatory incompetence---being properly appreciated, because central planning seems to have two lasting psychological appeals that are deeply rooted in the human psyche.

.....................................

In the next post, I will finish up on this theme by talking about the two major appeals---the Appeal to Intuition and the Appeal to Ambition---that seem to make the regulatory state, even after this pernicious "capture" problem has long been identified in the literature, an enduring feature of general political thought. The "bionomics" (ecosystem) concept of the economy will be discussed as an explanatory model that could potentially provide a counterweight to these appeals. I will also give my own take on the lonely, difficult plight of the educated free-market libertarian, who is very reluctant to join organized political movements, but who also, perhaps painfully, sees the center of gravity of the debate tending to shift towards interventionist proposals that have a contrived, populist basis to their attractiveness.

2 comments:

  1. I love the Montaigne quote--I wish I hadn't given away my copy of his complete works years ago...

    I know this doesn't have much to do with the overall direction of the post, but I couldn't help but think how well this quote describes many private sector environments just as well as it does government:

    "The goal of the policy entrepreneur is simply to build support for his own pet projects---projects could involve genuine political agenda items of concern, the economic welfare of his friends, cathedral and pyramid construction, monorails, whatever---by trading his votes on issues that are less important to him for his colleagues' votes on issues that are more important to him."

    In the private sector, the solutions to this seem often to involve a high degree of business transparency and tight feedback loops between firms, customers, and shareholders (if applicable).

    As a denizen of one of the less transparent areas of the private sector (hedge funds), do you think this assessment is correct? If so, do you think there's any realistic way to apply this to such behemoth, slow, conflicted, and sprawling organizations as national governments?

    (This also ties back to one of your earlier dev econ posts; I recall that Collier talks about business transparency as being the highest priority for a nation that is caught by the "natural resource trap".)

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  2. Jay, good point about the feedback system's importance in moving information around so that participants can make better decisions.

    Re: governments and feedback. Maybe if programs had very specific and measurable performance targets, and if failing to meet a target meant that the program was cut...? Some kind of selection pressure needs to be there to make agencies more responsive. As it stands, it is difficult to say if a program has failed because it was just a bad idea or if a program has failed because it wasn't properly funded, and of course this creates an opening for all kinds of mischief.

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