John “Eagle-faced” Raines had a simple goal in mind: put a big hurt into the evil saloon industry that was threatening the moral fabric of late 19th century New York State.  Low wage workers were spending huge chunks of their Sundays (for many, the only day of their weekend) tipping pints at dingy saloons, when they would have been better off spending that money on food and clothing for their families.

Raines could have pushed for New York to ban all alcohol sales on Sundays.  But that would have gone too far.  Many proper men of ample means were known to enjoy a drink or two on Sundays.  So Raines and his legislative pals came up with a clever solution: they banned Sunday alcohol sales at saloons but not at hotels.  (Technically, they allowed establishments to serve alcohol on Sundays if the establishment also served meals and had at least ten bedrooms.)  Well-to-do men, after all, primarily gathered in New York’s fancy hotels for their libations.  Daniel Okrent summarizes Raines’ intentions (in his marvelous book: Last Call) as “prohibition for the other guy, not for me.”  (See here for another post inspired by the book.)

But like so many government regulations, this one had unintended consequences.  Saloon owners were not going to lose their best day of business without looking for a way around the legislation.  So they adapted.  They began serving meals, or at least pretending to serve them.  Some saloons even mocked the Raines law by placing a brick between two pieces of bread “sat out on the counter, in derision of the state law.”

Even more cleverly, they created makeshift hotels, dividing back rooms into ten-bed hotels, each room divided by flimsy partitions.  With these beds now in place, the saloons had found a way not only to avoid the Raines law, but to even profit by it.  They turned their back rooms into whorehouses.

Perhaps Raines and his colleagues should have anticipated this consequence of their zealous and discriminatory regulation.  But sometimes regulations cause a chain of events that no legislative committee would ever be able to anticipate.  For example, when the Reagan administration implemented a new way to pay for Medicare hospital stays, the lump sum DRG system, they succeeded in slowing the rise of hospital expenditures.  Hospitals no longer had a fee for service incentive to prolong hospital stays in order to increase their Medicare payments.  Instead, they received a fixed amount of money for any given patient depending on that patient’s diagnosis.  That left them with an incentive to provide efficient hospital care, including timely discharge when patients were stable enough to go home.  The regulations slowed hospital expenditures, but it also had the unintended consequence of causing non-hospital medical expenses to rise.  Patients got discharged from the hospital earlier, and then incurred a larger number of outpatient expenses, expenses that could be billed on a fee-for-service basis.  In effect, the DRG regulation squeezed the healthcare cost balloon on the hospital side only to see it bulge out with the rapid growth of outpatient surgery centers, outpatient follow-up clinics and the like.

The fact that all regulations have unforeseen consequences is a reason to be cautious about any and all regulation.  It is why, all else equal, I favor non-regulatory solutions to social problems whenever possible.

But sometimes regulations are necessary.  For example, market forces often create externalities, whereby the market activity of one group harms another group without their consent or without reimbursing them.  When a riverside factory dumps waste into the water, people living downstream from the factory are harmed by the pollution.  When a few million Chinese people drive into Shanghai every morning for work, every resident of that city is exposed to that much more unhealthy air.  The free market does not have the ability, on its own, to deal with these externalities.  So we create environmental regulations.

More controversially, the healthcare system needs regulation because most developed countries have decided that society has a duty to provide healthcare to their citizens, regardless of whether any given patient has enough money to pay their doctor and hospital bills.  In the U.S., in fact, doctors and hospitals are required to provide emergency care to patients regardless of the ability to pay, a regulation passed during the Reagan administration.  Given that developed countries are not willing to leave the healthcare system totally in the hands of the free market, the system needs to be regulated.

If regulations are a necessary evil then, and if they inevitably have unintended consequences, good governing requires good follow-up.  When regulations get enacted, we need a government nimble enough to identify unintended consequences and revise regulations accordingly. If these revisions create other (hopefully less onerous) unintended consequences, we can decide whether these consequences are severe enough to warrant further regulatory adjustments.  And so on, and so forth.  Regulation, if it’s done right, ought to be a moving target, one that does not move so fast that people cannot keep up with the rules, but also one that does not remain fixed in the face of significantly harmful unintended consequences.

In the case of alcohol regulation, we had no such follow-up.  Instead we had prohibition.  Extremists on both sides of the debate could not find common ground.  The anti-alcohol crowd would not rest until alcohol was prohibited.  The pro-alcohol crowd would not admit that their product was wreaking havoc on many families, with women and children in particular suffering because the men providing for them were drinking away their hard-earned but meager earnings in Sunday saloons.

Intelligent regulation should be minimalistic.  It should also be bipartisan.  To make regulations more nimble, and to reduce the unintended consequences of regulation, we need to start by getting both sides of the aisle to agree that regulations are sometimes necessary, but always problematic.

**Previously posted on Forbes**

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