The Third Pillar

by Raghuram Rajan

  Most commercial poultry farms in the United States crowd chickens together in tight spaces, with little light or ventilation. This raises the risk of disease and contamination, which is why US chickens are disinfected by washing them in chlorine. The unscrupulous poultry farmer can also use chlorine to “freshen” up stale meat.

  In the European Union, minimum space and ventilation standards for poultry rearing reduce the risk of disease, and thus allow poultry farmers to achieve the applicable local health standards by washing chicken with only water. The European Union bans the sale of chlorine-washed chickens, even though there is no clear evidence that the chickens thus treated are a health risk.4 The ban serves two purposes. It reflects European discomfort with harsh rearing methods that create the necessity for chlorine washes. It also reduces the risk that improperly washed contaminated birds or “freshened” stale meat get into the European food chain. Clearly, the prohibition on chlorine-washed chicken can seem to be a protectionist targeting of US-produced chicken. Instead, it may reflect the genuine preferences of Europeans or the concerns of their food administrators.

  To avoid such situations, some countries have pushed for the harmonization of rules and regulations across countries to prevent the possible erection of nontariff barriers to trade. This will make it easier for corporations to traverse borders and do business everywhere. They want every country to feel and behave alike. Indeed, such harmonization can be taken to comic levels: European Commission Regulation No. 2257/94 required all bananas sold in stores within the Union to be “free of abnormal curvature” and at least 14 cm in length, and all cucumbers to be “practically straight” and bent by a gradient of no more than one-tenth.5 It is easy to imagine the anger of a Portuguese grocer, cursing foreign-imposed idiocy as she measured her vegetables with ruler and protractor. These regulations were eventually laughed out, but even when the attempt at harmonization is more serious, it is often a step too far, as emphasized, for example, by the economist and Financial Times commentator, Martin Wolf.6

  For one, it tramples over the preferences of citizens of small countries. When countries get together to decide whose rules will prevail, typically, the voices of small countries are drowned by larger and more powerful ones. Moreover, the views of negotiators from large powerful countries are shaped all too often by what will favor their largest corporations, rather than what can genuinely benefit their own country, let alone the world. This need not be because large corporations have corrupted their government’s negotiators. The reality is often more prosaic. Large corporations have smart specialized analysts who can understand the possible consequences of new rules and regulations, can figure out what configuration will benefit their corporation, and can feed the analysis in a persuasive way through lobbyists to their country’s official negotiators. Since these negotiators have little data or analytical support of their own, it is not surprising they will use what they are fed.

  The push toward lower tariffs is not complicated—lower is typically better for everyone for every good and service. By contrast, the direction in which to go to harmonize business environments across countries is less clear. Should one adopt the United States’s preferences on washing chickens or the European Union’s preferences on giving chickens space? And do the negotiators for the United States reflect the preferences of their people or of the chicken-producer lobby? Do the representatives of poorer countries have equal say in, or equal understanding of, the negotiations? Typically, the outcomes of these negotiations to harmonize regulations are profoundly undemocratic, both within nations and across the community of nations.

  Moreover, much of the benefit of a common global market can be had with low tariffs but without harmonization. If a common standard is of the essence to attract business, then countries will sign up to it without being coerced. Blatant attempts at protectionism through differentiated rules, standards, or regulations can be thwarted by taking the potential violator to an international dispute resolution mechanism like the WTO court. If the court rules that the ostensible violation was not primarily protectionist in intent, it should be permitted. That will preserve a country’s democratic space to be different.

  Indeed, differences in environment between countries simply mean that exporters have to work a little harder to address the market, not that they are shut out. American chicken producers who want to export to Europe will not be able to rear their poultry in the same crowded pens as they rear poultry for the American market—they will have to give the chickens intended for Europe more space and light. This is not entirely a bad outcome, since it can make their European consumers happier. Indeed, multinational companies do not assume consumer preferences in each country are the same—they alter their products, their marketing, and their financing to suit each market, even while drawing on their global economies of scale to address each market more cheaply. Why can’t they also adapt to differences in taxation or regulation? Put differently, what the world needs is predictable, low-cost access to markets in different countries. What is less important are harmonized taxes or regulations or safety standards. . . . Why should people not have more control over these issues, which might make them more willing to accept free trade?

  There is virtue to diversity. Often, we have no idea what production environment or standards will be best going forward. If we insist on uniformity across countries, we preclude the possibility of experimentation, which could throw up better alternatives than the current consensus. We also run the risk of coordinating on a set of rules that prove disastrous. Therefore, even if harmonization was driven with the best interests of the world in mind, it might still make sense to leave decisions to countries so that a variety of environments emerge, so that there is competition between environments, and the global system develops both resilience and better practices.

  There are certainly areas where a common global standard adds significant value. For example, common protocols may be necessary in communication networks to ensure interoperability. There is virtue in competition even here. If a set of standards is negotiated, it should be up to every country to decide whether to opt in, and no presumption that any country that does not do so will be excluded by everyone else. That will allow countries to experiment with alternative standards, so that a superior standard could emerge. Enforcing a monopoly here, as almost everywhere else, is bad.

  Finally, the alert reader might note a seeming inconsistency in my proposals. I argued earlier that communities should not be able to impose their own regulations to keep out goods and services from elsewhere in the country. I have just proposed that countries should have the right to impose regulations such as the ban on chlorine-washed chicken, so long as their primary purpose is not protectionist. The difference is that communities in a democracy can shape national regulation on the goods and services that can be sold. Once the national policy is set, though, communities should abide by them so that the national market is seamless, to everyone’s benefit. In contrast, international agreements, such as those on the harmonization of regulations, are rarely arrived at in a democratic spirit, as I have argued. This is why I believe countries should have a more bottom-up deliberative process on what they regulate and what they adhere to, and the ability to pick and choose in most such agreements.

  RACE TO THE BOTTOM . . .

  One concern countries have is a race to the bottom. If there is no harmonization of regulations, will countries that adopt the lowest standards benefit their firms, giving them a competitive advantage? This danger is emphasized, often by countries that fear their preferred position demands too much of their own firms. They prefer everyone to be disadvantaged by onerous regulations, rather than their firms alone. This becomes a way for powerful countries to create and export their bad regulations everywhere, and for everyone else to adopt unnecessary and inappropriate regulations.

  Take, for example, bank capital regulation. Banks do benefit from operating with little capital, especially
when markets are buoyant and financing is easy. For instance, before the financial crisis, some banks were operating at debt-to-equity ratios of 50 to 1 or more. This leaves very little room for error, as the financial crisis proved. Moreover, the leverage that is best for each bank’s profits may be excessive for the system collectively. Therefore, regulators have rightly seen a need to mandate minimum capital requirements.

  However, each country’s optimal minimum capital requirements for its banks may differ depending on its stage of development and the kinds of activities its banks undertake. If the banks in a country are sophisticated, can take on sizable, exotic risks, and are large relative to the country’s size—as for example in Switzerland and the United Kingdom—it is natural that those countries should impose higher capital requirements on their banks, because the risk to the country of the failure of these large banks is enormous. On the other hand, there is no reason why a small developing country with a fledgling banking sector should impose the same requirements on its banks. Nevertheless, the Basel Accords attempt to harmonize capital requirements across countries. While these accords do require more capital of large sophisticated banks, it is not clear that there is adequate differentiation allowed between countries.

  Moreover, under the guise of harmonization, countries or regions with special requirements try and impose them on everyone else. During the recent European crisis, European regulators worried that governments in southern European countries like Greece and Italy were pressurizing their domestic banks to buy domestic government bonds so as to ease government access to new financing. Given that the fiscal situation of these countries was far from healthy, there was a possibility the strapped governments would default on their bonds. The banks that bought more of their own government’s bonds were increasing the chances of their own default, and because Europe would eventually pay for the rescue, transferring the costs to Europe.

  One way to prevent such a problem recurring would be for European regulators to impose a higher capital requirement on any European bank that bought government bonds issued by distressed countries; Greek banks would quickly stop buying if they had to raise more equity capital for each Greek government bond that they bought. Yet, instead of agreeing to a European solution, European regulators tried to impose this across the world. Emerging markets would be at a particular disadvantage with this proposal since the bonds issued by emerging market governments are not highly rated, and would require their banks to hold more capital against them. The problem that Europe faces is not a problem for an emerging market. There is no one waiting to bail out an emerging market government, and no one it can shift costs to. If the European proposal were adopted, emerging market banks would hold costly additional capital for a nonexistent problem, even while these banks had other important financing needs they could not meet.

  It may be that Europe believed that by getting international agreement, it avoided a thornier negotiation within Europe. Moreover, once everyone was similarly disadvantaged, the costs to the southern European countries of agreeing would be smaller—at least so the thinking might go. It may be that this was a Machiavellian attempt by supporters of southern European countries to torpedo the entire move by escalating it to international levels. Regardless, the episode highlights the problems with harmonization—regulators cartelize and spread unnecessary and inappropriate regulation across countries, preventing competition between jurisdictions from highlighting the costs of such regulations.

  Finally, what about the race to the bottom? Regulators agreed to common bank capital requirements in the various Basel Accords because they feared that if given the flexibility, some regulators might impose inordinately low requirements on their banks. Yet this fear is questionable. If higher bank capital reduces risks, why wouldn’t the bank regulators in each country internalize the need to set capital requirements for their domestic banks at adequate levels? Moreover, if regulators feared competition in their markets from inadequately capitalized foreign banks, they could always require that such banks operate domestically through entities that meet domestic capital standards.

  There is one other plausible reason for a harmonized international capital standard; the fear that each country’s regulators, left to themselves, will not be able to set an adequate capital standard domestically—the domestic bank lobby will be too powerful for them. By meeting in Basel, far from domestic lobbies and democratic pressures, regulators can set capital requirements closer to the level they feel comfortable with. Arguing, then, that their hand has been forced by the international bargains they have had to make, they avoid the need to justify the standard at home. If so, regulators are essentially asking their people to trust them to get it right. But such agreements are not free of perverse influence, and they reinforce the popular belief across the world that too much is decided far away behind closed doors. International agreement and pressure on tariff reduction is warranted because the objectives are transparent and the outcomes generally beneficial to all. Few other technocratic international agreements meet these standards. They should be used sparingly given the democratic tolerance for such agreements is narrowing. Domestic democratic oversight, flawed as it may be, is better than the alternatives.

  WORKER RIGHTS . . .

  Another area where there is often talk of harmonization is worker rights. Some countries, especially developing ones, do not have strong unions and adequate worker protections. The concern, then, is that this allows firms in that country to underpay workers or to underinvest in their working conditions, thus giving them a competitive advantage. The proponents of harmonization argue for keeping out the country’s exports until it improves its treatment of workers.

  One problem is that the low pay of workers in developing countries may reflect their low productivity, not exploitation by owners. If those firms are required to pay significantly more, they may be forced to fire their workers and close down. Similarly, worker-safety regulation is naturally better in advanced countries. While developing countries should work continuously to improve worker safety, if owners are suddenly required to implement safety measures at rich country levels, they may find production uneconomical once again. More generally, given their circumstances, a steady job and the accompanying income may do more for worker health and well-being in a poor country than workplace safety measures. Having both jobs and safety would be even better, but the country may be forced to choose. Is it not in the best position to make this choice? In short, could insistence on harmonization of worker pay or worker rights risk turning into protectionism?

  Some argue that instead of focusing on specific worker-friendly measures, countries should harmonize their treatment of worker organizations like unions. Once unions are in place, they can figure out what is best for their members. This form of institutional harmonization is both impractical and intrusive—impractical, because developed countries treat unions and protect union rights very differently. Scandinavian countries place unions on a much higher pedestal than, say, the United States. Indeed, even in the United States, the eastern states offer a far more union-friendly environment than the “right-to-work” southern ones. Whose standard should be applied? And will application of these standards not be intrusive? Don’t developing countries, even ones that are not fully democratic, have the sovereign right to decide what environment they create domestically?

  All countries should, of course, respect universal human rights, including refraining from using slave labor or child labor. Consumers in developed countries should be free to pay more for fair-trade coffee or to boycott clothing produced by exploited labor elsewhere. Multinational firms should also feel free to set better standards for their operations than local requirements. Should powerful countries additionally impose their preferences on others through internationally determined rules? Probably not.

  INTELLECTUAL PROPERTY

  Yet another area where harmonization has been controversial is intellectual property. Historica
lly, countries have been more lax on protecting intellectual property until they developed enough creativity of their own.7 Nearly every developed country, in the early stages of its development, appropriated intellectual property from elsewhere. Like the power to levy taxes, the right to define what is property is a sovereign power. Property rights in intellectual property ought to be determined by each country, deciding what it wants to define as protectable intellectual property, and how long it wants to protect it.

  While countries should certainly pay for the intellectual property they use, the more contentious question is the duration and breadth of intellectual-property protection. Countries that generate intellectual property, such as the United States, obviously want to apply the long duration and extensive protection granted in their own countries everywhere else. The argument is that such protection will give innovators greater profits and therefore greater incentive to innovate. As we have seen with the debate over patents, it can also reduce innovation by others in the industry, whose way is blocked by earlier patents.

  Such problems are accentuated in developing countries. Domestic firms in developing countries primarily consume intellectual property as they try to catch up, and their ability to innovate would benefit from wider availability of intellectual property. Josh Lerner from Harvard University finds, after examining the patent policy of 60 countries over 150 years, that an enhancement in patent protection in a country enhances patent filing by foreign firms while reducing filing by domestic firms.8 The absence of any positive effect of strengthening patent protection on patenting by domestic firms is particularly pronounced in developing countries, suggesting they benefit little from such laws, which may deter domestic innovation.