Around the beginning of the year, Obama made an appeal for government consolidation and to reorganize the bureaucracies in a more logical manner. At first pass, this seems like a reasonable approach. But we must beware of what Karl Smith calls "liberalization failure". While current regulation might be frustrating, badly done deregulation can result in even more finger pointing instead of actual work. Perhaps we can draw a lesson from an interesting anecdote about Sichuan river hydropower stations.
Hydropower ventures are interesting to regulate because they do carry an externality. Besides changing the distribution of water, the dams carry a risk of collapsing. When this happens, any tunnels downstream can get flooded and, in severe situation, workers are killed as their houses are destroyed. As a result, before 2000, the construction of the dams was regulated by both a commerce agency and a water resource agency. The first would determine whether a dam could be built, while the second inspected the dams to make sure the engineering was of good quality. The collapse externality is the market failure. The inspection regime is the non-market based solution, and can be thought of as the government failure.
So where's the liberalization failure? To give you an idea of the problem, Sichuan dams are supposed to be inspected within three years of construction. Only after the inspection can they officially start producing commercial electricity. But in the past 10 years, of the over 4000 new hydropower stations constructed, a considerable number of them have never been inspected. Yet they have been "testing" their generators and selling the electricity on the market. Sichuan is one of China's largest hydropower provinces; why does it have so many regulatory problems?
A lot of the problem boils down to what the government tried to do starting in 2000 to liberalize the development of dams on the rivers. Remember the commerce and water resource agencies? In 2000's, the commerce agency took over the supervision of basic engineering from the water resource agency. But this transfer of power took place without any transfer of real resources. While the water resource department had over 150 people working on the issue of supervising construction, the commerce agency only had a few. Although their was a joint memo discussing inter-agency cooperation, was steadily ignored over the years. By 2003, the water resource agency gradually lost all of its regulatory power to the economic development agency, but still had to bear the burden of fixing engineering problems when they threatened the public safety. An official for the water resource agency summed up the problem very nicely:
"If we try to regulate, we're not the right agency. If we try to not regulate, they come and hold us responsible for the accidents on the river"
There were accidents aplenty. In 2006, because of a half-done shoddy job by a contractor, a dam broke, flooding workers houses with over a thousand cubic meters of water, killing eight people and injuring six. The manager of the dam skimped on some safeguards, jeopordizing the stability of the plant. Many of the contractors were uncertified, and there was never a third party inspector to make sure the work met standards. In 2011, large floods interrupted dam construction and flooded work tunnels, trapping thirteen workers and killing all but one of them.
And who's responsible? In the 2011 case, the government noted that better engineering would have saved the workers, but ended up putting all the blame on a "natural disaster". Even when the government takes responsibility, it is incredibly vague. A translation from a 2012 policy paper titled "Suggestions for increasing engineering and design oversight for hydropower plants of less than 25 megawatts"
After many years of hard work, hydropower plants have become a primary energy source for Sichuan's rural counties, especially for the minority and mountainous areas, and they hold the potential to support the province's economic and social development as well as its citizen's livelihoods; however, in this process of development many problems have been revealed, especially in the areas of regulatory coordination, inspection procedures, engineering oversight, environmental protection, as well as other areas that are still pending increased attention and improvement.
Note there's not a single line on who is doing this work. Agencies are hinted to later on in the paper, but not with any specificity. Merely that building safety issues should be taken up by all relevant agencies". This is especially problematic when "inspection procedures, engineering oversight, and environmental protection" are all divided over rmultiple agencies that are governed over many levels of government. Some are local, whereas others are run by the province, and even others are run by the central government.
As a result, the locus of liberalization failure centers around this problem with agency responsibility. Responsibility is never clear, and work is not delegated efficiently across the agencies. This is a key point about deregulation and attempts to make policy more "market friendly". What you may end up with is an incomplete transfer of power, thereby giving people the regulatory power but not the expertise, or vice versa. The separation of these powers may not result in check and balances; rather, it can create perverse systems of incentives in which the mistake of one agency is paid for by the work of another. In the Sichuan case, the water resource agency has to bear the burden of the commerce agency's engineering mistakes. The commerce agency could pursue their goal of economic development without too much concern, because if they went overboard it was the water resource agency's problem to solve. So in the regulation of an externality, the institutional structure actually promotes externalities within the government.
Another more philosophical note is that the government can never be truly thought of as a unified entity, but rather is better conceptualized in terms of individual agencies. These entities have their own missions, own internal incentive structures, and own responsibilities to outside agencies. As Mankiw's principles remind us, incentives matter, in both private and public life. And this is the sad truth on why the dam deregulation is likely to stay dammed. The incentive structure for change is not there, as those with the power have to shoulder none of the responsibility.
While the above may just be a small story of a small power industry in Sichuan, the power of two "I's", institutions and incentives, should never be underestimated. Failed partial liberalization can corrupts the first; failed regulatory regimes can arise from the bad design of the second. This process is incredibly important for the design of microeconomic issues, and appears to be a fruitful investigation for the future.