In a federal system, such as the United States, we observe two forms of regulatory competition. Vertical competition when both the national government and some state government seek to regulate the same behavior. Horizontal competition occurs when states seek to regulate the same behavior.
The combination of the Supremacy Clause, the Supreme Court's expansive definition of what constitutes interstate commerce for purposes of the Commerce Clause, and the Court's cramped interpretation of the 10th Amendment means that the federal government will always prevail (assuming it has the political will) in competition with the states.
But suppose the federal government leaves an area to state regulation. We now have an opportunity, as Brandeis put it, for states to operate as laboratories of democracy. "It is one of the happy incidents of the federal system that a single courageous state may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of the country."
This sets up a dynamic in which states can compete: If State A tries an experiment that succeeds, people will move to it, giving it a higher tax base. In turn, other states will respond by copying the successful experiment so as to retain citizens. The possibility of exit (albeit at non-trivial transaction costs) thus tends to lead to Pareto optimal results.
On the other hand, however, if the rules of the game are such that one state can regulate transactions that occur anywhere in the country, competitive federalism can lead to a race to the bottom. In corporate law, for example, the internal affairs doctrine provides that disputes about corporate governance are governed by the law of the state of incorporation no matter where the shareholders live. If a Delaware corporation has its principal place of business in California and is sued by a California resident shareholder in a California court, Delaware law controls. Those who believe that state competition results in a race to the bottom believe that Delaware’s corporate statute is skewed to favor the interests of corporate managers rather than those of investors. As the story goes, because it is corporate managers who decide on the state of incorporation, Delaware caters to management, allowing them to exploit shareholders.
This background is necessary for evaluating a post by Ezra Klein on proposals to facilitate selling insurance across state lines.
Klein explains that:
Insurance is currently regulated by states. California, for instance, says all insurers have to cover treatments for lead poisoning, while other states let insurers decide whether to cover lead poisoning, and leaves lead poisoning coverage -- or its absence -- as a surprise for customers who find that they have lead poisoning. Here's a list (pdf) of which states mandate which treatments.
The result of this is that an Alabama plan can't be sold in, say, Oregon, because the Alabama plan doesn't conform to Oregon's regulations. A lot of liberals want that to change: It makes more sense, they say, for insurance to be regulated by the federal government. That way the product is standard across all the states.
Conservatives want the opposite: They want insurers to be able to cluster in one state, follow that state's regulations and sell the product to everyone in the country. In practice, that means we will have a single national insurance standard. But that standard will be decided by South Dakota. Or, if South Dakota doesn't give the insurers the freedom they want, it'll be decided by Wyoming. Or whoever.
In other words, liberals prefer vertical federalism with the federal government prevailing, while conservative prefer horizontal federalism. Klein claims this will inevitably lead to a race to the bottom:
The industry would put its money into buying the legislature of a small, conservative, economically depressed state. The deal would be simple: Let us write the regulations and we'll bring thousands of jobs and lots of tax dollars to you. Someone will take it. The result will be an uncommonly tiny legislature in an uncommonly small state that answers to an uncommonly conservative electorate that will decide what insurance will look like for the rest of the nation.
The trouble with this argument is that true races to the bottom are pretty rare. (See Ogus, Anthony. 1999. Competition between National Legal Systems: A Contribution of Economic Analysis to Comparative Law. International and Comparative Law Quarterly 48:405-18, at 414.) In corporate law, for example, state competition leads to a race to the top. According to this account, investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater excessively to management. Likewise, lenders will not lend to such firms without compensation for the risks posed by management’s lack of accountability. As a result, those firms’ cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors and, as a result, competition for corporate charters should lead to statutes that maximize shareholder wealth. Although some still contest the claim, I believe the evidence is quite convincing that state corporate law in fact races to the top. (See my article available here.)
Consider the sole example Klein cites; namely, the credit card industry. It is true that South Dakota has captured a lot of the credit card business. But so has Delaware. The migration of credit card operations to South Dakota and Delaware began with the Supreme Court's decision in Marquette National Bank v. First of Omaha Service Corp., which held that a national bank can charge all of its customers the maximum interest rate permitted by the law of the state in which the bank is chartered even if that rate would be treated as usurious under the law of the state in which some of its customers resided. Delaware and South Dakota responded by loosening usury restrictions and succeeded in attracting banks to charter therein.
So a race to the bottom? Well, only if you think usury laws are pareto optimal. Personally, I think usury laws prevent efficient transactions from happening and constitute a paternalistic restraint on trade:
The wonderful thing about voluntary loan transactions in the free market is that both the borrower and the lender benefit from such transactions. Loan transactions occur in the first place because borrows and lenders have different rates of time preference, and the fact that the agreed upon rate of interest is very high does not change that reality. (Link)
In sum, the automatic assumption that horizontal competitive federalism will automatically lead to a race to the bottom is simply unfounded. A national market will expose insurers to more competition, which will require them to compete successfully by offering terms and prices that are attractive to consumers. Insurers that congregate in the states envisioned by Klein will be at a competitive disadvantage.
In contrast, the liberal preference for vertical federalism is likely to be anti-consumer. Regulatory capture is a lot easier when you only have to capture one regulator instead of 50.