When the Rules Are the Real Risks. Robert W. Hahn and Robert E. Litan.  October 2004.

This week, Wim Kok, the former Dutch prime minister, is expected to release recommendations for reviving the Lisbon Agenda. That agenda aims to make the EU the "most competitive and dynamic knowledge-based economy in the world" by 2010. To make headway, Mr. Kok and company are going to have to attack the European regulatory juggernaut head-on. EU policy makers should consider jump-starting this process by borrowing a page from the American regulator's playbook.

We refer to the common-sense approach the United States uses for regulating the private sector. Increasingly, federal and state governments have stopped regulating prices and rights to enter an industry where there is little or no evidence of monopoly. Consumers have reaped tens of billions of dollars of savings in the process.

But there still is good reason to regulate private firms and individuals where the actions they take can hurt someone else, or where individuals may not be aware of the risks. That is why American policy has limited environmental pollution, regulated workplace safety, put restrictions on toys for children, and changed the design of automobiles.

The costs of such regulations are substantial -- running in the hundreds of billions of dollars annually. But so, too, are the benefits. The challenge is to design each regulation so that its benefits exceed its costs. Although this simple principle still attracts criticism in some quarters, it is also common sense. If government regulators attempted to eliminate all risks, they could easily gobble up much, or even all, of a country's gross domestic product.

Not all of America's regulatory statutes permit regulators to balance benefits against costs, though regulators routinely do so implicitly. Indeed, the past seven U.S. presidents, over a span of more than 30 years, have attempted to make sure that the agencies they control do their analytical homework. Each has required regulatory agencies to tote up benefits and costs as best they can before setting new rules that could impose costs of over $100 million on the economy. And since 1997, lawmakers have required the White House budget office to issue annual reports on the total costs and benefits of regulation along with recommendations for how to fix what is broken. These reports give the public some idea of the benefits it receives in return for the higher prices and lower wages that can result from regulation.

Contrary to popular impression, cost-benefit analysis, properly applied, neither favors nor penalizes regulation. It just ensures that those regulations that are implemented make sense. For example, the decisions to phase out lead in gasoline and significantly curtail the use of chlorofluorocarbons were both based on hard-headed cost-benefit analyses. More recently, White House economists encouraged U.S. environmental regulators to toughen their standards on diesel emissions from off-road vehicles because of evidence that the benefits of doing so outweighed the costs.

And the U.S. government is even using cost-benefit analysis proactively, to get regulators to do things that aren't on their radar screen. In the past three years, the budget office has issued twelve "prompt letters" -- encouraging agencies to address new risks through regulations that could save thousands of lives and improve health at a reasonable cost. Examples include better food labeling to encourage heart-healthy diets and installing defibrillators in the workplace to reduce the risk of death from heart attacks.

There are lessons in all this for Europe, especially as it continues its effort to develop a pan-European set of domestic policies that improve its ability to compete in world markets.

First, we suspect there are several opportunities -- air transport being a prime example -- where further deregulation of prices and entry barriers across Europe could save consumers billions of euros in lower fares and other costs. Consumers could also reap substantial benefits if strict regulations on large stores and opening hours were relaxed, assuming politicians were willing to take the heat.

Second, regulations governing Europe's labor markets need to be revisited. It is no accident that unemployment remains high in many EU states. While we would not necessarily advocate an "American model" for Europe, even a modest reduction in the cost of hiring and firing employees could have a positive impact on employment.

Third, the EU and its member states could benefit from a re-examination of its precautionary principle, which in essence says "it's better to be safe than sorry" when deciding whether to allow a new drug, genetically modified food, or a whole host of other products, to be marketed.

The problem with "better safe than sorry" is that it is not a practical guide to decision-making, except in its extreme form, which would be to ban anything that entails a risk of harm. By that logic, we'd never have electricity, the automobile, the Internet, or countless other inventions that allow our modern society to function (but each of which has risks).

But if the precautionary principle is not to be applied in such a strict way, then where and how should decision makers draw the line between what to allow and what not to? We do not believe there is any principled way to do so without balancing costs against benefits. In some cases, this may be relatively easy to do. In others, it may be especially hard to quantify the benefits -- as in the case of regulations designed to protect against terrorism. But even these hard cases should not excuse decision makers from at least toting up the costs of various options.

For the fact is, even in the case of terrorism and other hard cases, societies cannot afford to seek totally risk-free environments. Hard choices must be made. The precautionary principle does not help one do so in a nonarbitrary way. Balancing costs against benefits -- even though sometimes difficult and fraught with uncertainties -- at least offers a principled approach for making these tough decisions. We do so in our every day lives; we should ask our political leaders to do no less.

Finally, we believe that the EU should create a strong centralized regulatory oversight unit to review and help standardize the preparation of analyses before new regulations are set. In addition, states that do not have such units should consider creating them. A more effective oversight system at both the EU level and within member states could help to reduce inefficient regulations and promote regulations that do more good than harm.

Messrs. Hahn and Litan are the co-founders and directors of the AEI-Brookings Joint Center in Washington, D.C., which focuses on regulation and antitrust. We would like to thank Rohit Malik for research assistance.

This article appeared in the Wall Street Journal-Europe on November 1, 2004.