On January 30, 2017, President Trump issued an executive order entitled: "Reducing Regulation and Controlling Regulatory Costs."1 Known as the "One-In, Two-Out" rule, it calls for dramatically reducing the regulatory burden upon the US economy. This executive order may do more for the US economy than any other economic proposal by the Trump administration, perhaps even far more than any enacted tax cuts.

There is no doubt regulatory reform is needed. From anecdotally looking at the effects upon particular industries (e.g., Dodd-Frank's impact on preventing new community banks from opening), to the number of pages in the Federal Register, to estimates of lost man hours and direct expenditures from the Congressional Budget Office: the degree of the regulatory burden is clear. The US economy has never suffered to this extent.

How did it get this bad? Three primary reasons exist. First, unlike fiscal or even monetary policy, the burden imposed by regulations is more difficult to quantify and assign causality. Second, regulations exist and have increased in number by benefiting two primary constituents: entrenched businesses using regulations as a barrier to entry, and their politically connected lobbyists. Third, and of most significance, mainstream economists agree that without regulation, planes would crash in the sky, the food supply would be contaminated, and working conditions would degenerate to Neolithic-period levels. The acceptance of regulations is as widespread as the supposed underlying rationales are numerous.

Of all the rationales proffered, perhaps the strongest argument for regulations concerns the perceived "market failure" of negative externalities. If the justification for the regulation of negative externalities proves faulty, then the rationale, form, magnitude, and/or existence of all regulations should also be questioned. Analyzing the history of negative externality analysis provides insight into the "justification" of regulation.

Negative Externalities Defined and Pigou's Recommendation

Externalities exist when costs are imposed (negative externalities) or benefits are realized (positive externalities) by parties other than the economic actor performing or participating in the action creating the costs or benefits. Pollution is a classic example of negative externalities: a power plant operating alongside a cold river may discharge warm water which interferes with a downstream brewery's similar need for cold water.

The economist A.C. Pigou in his treatise The Economics of Welfare provided the classic and still widely accepted solution: tax or regulate the negative externality.2 Either assess an impactful tax on the warm water discharge from the power plant, or regulate the amount, nature, and timing of this pollution (or ban it altogether). Either way, the effect of warm water upon the downstream brewery and other river users would be lessened.

Coase Counters, But Misses the Solution

Ronald Coase's classic essay, "The Problem of Social Cost," challenged the traditional Pigou solution to negative externalities.3 While Pigou saw only liability with the creator of negative externalities, Coase assumed blame to be ambiguous:

The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A?