The Compliance Doom Loop

Why the rules keep growing

“The [Spanish] census of 1788 showed that almost 50 per cent of the adult male population was not involved in any form of productive work. The army, the Church and, above all, the vast nobility were a dead weight on the rest of the population.” — Antony Beevor

“We must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military–industrial complex.”  — Dwight D. Eisenhower

Europe is creating a new ruling class — but they don't make laws or deliver services. Instead, they check boxes and issue stamps of approval. These are the compliance officers  who ensure other people follow rules. From ESG reporting to sustainability audits, from data protection to supply chain verification, checkers and verifiers have become a fast growing segment of the economy. European business is increasingly governed by a group of rule-enforcers that, rather than create economic activity, shrink it.

The growing compliance economy

Consider the (many) new reporting obligations of companies that are currently coming into effect. The Corporate Sustainability Reporting Directive (CSRD) mandates 42,000 companies to adopt European Sustainability Reporting Standards  to track and report on environmental, social, and governance (ESG) issues. Under the rules, companies must prepare sustainability statements based on 1052 data points, of which 783 are mandatory, — compliance costs from €150.000 for non-listed companies to €1m for listed ones.¹ 

The reporting is fraught with risk, with vague obligations such as the “do not significant harm” principle. Each firm is  obliged to show in real time how sustainability concerns affect their business and how their operations impact the world, perpetually collecting data and preparing complex ESG reports. Companies will need new compliance teams, from data managers to sustainability experts and auditors.  A Danish Government cost analysis of CSRD estimates a minimum annual compliance cost of  €300.000 per company, €365.000 for the first year.²  The general secretariat of European entrepreneurs (CEA-PME) estimates initial cost for a French midcap at over €800.000 over two years. A study by the European Investment Bank estimates the compliance cost of CSRD for mid-caps at an astonishing (just one regulation!) 12.5% of the total investment volume.³ 

 The Deforestation-Free Products Regulation adds even more pressure. To prove supply chains are free of deforestation since 2020, companies must trace products like coffee beans back to individual farm plots and show that each acre was not deforested in the last four years. This requires setting up time-intensive systems to gather geolocation data and track each farm in detail. Staff must work closely with suppliers and outside consultants for verification.  A German official summarised:

 “I hear about firms that want to (continue to) import chocolate,  coffee beans, meat  into the EU, but cannot do so, as their traditional suppliers from Africa or Latin America cannot prove that the land they use to produce agricultural  inputs for such product was not cleared of woodland within the last I think 4-5 years.”⁴

The costs of the expanding compliance burden are enormous. In Denmark the number of applicable regulations, both Danish and European, for the average firm rose by 63% from 2001 to 2023.⁵ For the chemical industry, annual compliance costs for small and medium enterprises have almost doubled in 10 years from €332.500 in 2014 to €577.000 in 2023.⁶ To this cost we must add  GDPR compliance, at  €500.000 for SMEs to  €10m for large organisations.⁷

The stunning thing is that all this European legislation does not replace national legislation! This duplication, according to the Draghi report, costs another  €200bn per year due to complex procedures, excessive national requirements and unharmonized labelling standards.⁸

And all of these are only the directly measurable regulatory costs. Costs not included: beneficial innovations that have been made crowded out, or the devaluation of existing human and physical capital.  

 According to Auditor/Consultants KPMG, most companies worldwide are not ready for detailed ESG reporting: 

“[Only] 29% of companies feel they have the ESG policies, skills and systems in place to be ready for independent ESG data assurance”

 The problem is particularly serious for smaller businesses. 

“Obtaining appropriately skilled and experienced people is set to be a challenge for all given that so many businesses are looking for the same skill sets at the same time and also that the skills required are very specialised.”

 Of course, if this assessment is accurate, this means more demand for consultancy services by KPMG and other firms. 

Academic institutions are reacting to this growing trend. Wharton, one of the leading educators of our young managers, just announced two new majors: Environmental, Social and Governance Factors for Business (ESGB), and Diversity, Equity and Inclusion (DEI).

Readers in academia —particularly in the US— can intuit where this trend is going by looking at their own institutions, which have seen the same self-perpetuating growth of compliance classes. Below is the case of Stanford, which illustrates the broader story. Since 1996, the university has added 835 faculty and 11648 (!) administrators. The ratio of administrator-to-faculty has doubled in less than thirty years, from 3:1 in 1996 to 6:1 today. Think of the time you spent trying to get a reimbursement 15 years ago versus today, and you can figure out the cost for European SMEs.

The increase in compliance jobs in the private sector is just the tip of the iceberg.   Jobs are also being created in the public sector – in the supervisory agencies whose job is to stop economic activity from happening. Don’t get me wrong — many activities must be regulated. The problem is that, as we extend the regulatory state relentlessly, an increasing share of the activities we stop from happening are legitimate. As we said last week,

 “[Europe now has] a culture that rushes towards more regulation rather than less, even as it ends up with perfectly governed industries that don't actually exist”

Compliance is subject to increasing returns 

The heart of the compliance economy is that as it grows, the incentives to increase it increase. 

You could imagine that in a well-functioning economy there is a self-correcting mechanism preventing the compliance/regulatory sector from growing too much: if too many talented individuals move into compliance, there should be higher returns to talent in entrepreneurship. This should attract talent back into the productive sector and restore the balance between both sectors.

However, rent seeking activities, (e.g. compliance work) are subject to increasing returns. The mechanism was analyzed by Kevin Murphy, Andrei Shleifer, and Robert Vishny: 

First, as more talented individuals enter rent-seeking, they become more effective at extracting rents due to better coordination, shared insider knowledge, and greater influence over regulatory processes. Marginal returns to rent-seeking do not diminish but actually increase as more people engage in it. 

Second, as rent-seeking talent grows, they impose more regulations and barriers (a negative externality) that hamper the productive sector. Increased regulation raises the cost of doing business, reduces innovation, and lowers overall productivity. This makes entrepreneurship less attractive because the potential profits from productive activities diminish.⁹

Consider this example. Spain does not have any frontier AI companies. But the country rushed to establish the first AI agency in Europe — the Spanish Agency for the Supervision of Artificial Intelligence (AESIA). The organisation will have a president, a director, two subdirectors, a secretary general and 10 departments. It includes offices with names such as the “Department of Instrumentation of Mechanisms for Trend Identification and Impact Assessment”, and the “Department of Awareness, Training, Dissemination, Promotion and Consciousness-raising”. Readers in the US are familiar with competitions between cities to host companies. In Spain, León and A Coruña fought over the decision of where to establish AESIA — the regulator for an industry that does not exist!

Picture yourself as a bright young Spanish STEM graduate in 2024 with two job offers:

• Option 1: Join a startup. The hours will be long, the future uncertain. You fear your daily life will be consumed by filling reports and dealing with the regulator. 

• Option 2: Join AESIA. The pay is fine, the career path is clear, and the hours are wonderful.

Since the returns to rent-seeking are increasing, and to entrepreneurship declining due to regulatory burdens, talented individuals shift away from entrepreneurship.

This creates a poverty trap. As more resources and effort are wasted on unproductive activities, economic growth slows. The success of rent seeking reinforces itself, drawing even more resources from productive sectors.

Breaking the Loop in Europe

Every time we add a new reporting requirement or compliance burden, we're not just adding a cost to business—we're shifting the incentives for where Europe's talent goes.

The most concerning aspect of Europe's regulatory explosion isn't the legitimate goal of reducing carbon emissions - it's how this urgency has been exploited as a Trojan horse for an ever-expanding web of regulation. What started as a focused mission to combat climate change through emissions reduction has morphed into an all-encompassing ESG framework that touches every aspect of business operations. Environmental activists successfully pushed their entire agenda under the cover of emissions reduction, while other activists jumped on the bandwagon, adding layer upon layer of social and governance requirements. 

The result is a regulatory framework that goes far beyond its original climate mission, creating an unprecedented burden of reporting, compliance, and verification requirements. The EU's Emissions Trading System (ETS) already provided a simple, market-based solution for reducing emissions. Instead of extending ETS, we've ended up with a byzantine system of rules that diverts talent and resources away from genuine innovation and productivity.

For Europe right now, the path forward, to me, is evident: we need a regulatory pause. We have had a regulation explosion over 5 years due to the Green Deal, and its opportunistic expansion from climate to a broad degrowth agenda. Europe needs to pause, reconsider all the legislation, streamline it and, where necessary, eliminate it. The EU institutions, post Draghi report, must target at least two laws for fast elimination from the books: CSRD and the premature and badly thought out AI Act. 

During this regulatory pause, the EU must adopt good practices for the future: 

• Implement sunset clauses for regulations to force periodic review.

• Set simplification targets alongside new rules.

• Adopt one-in-one-out policies for regulatory requirements.

The Stakes Are High

This isn't just about companies hiring more lawyers. It's about where the next generation of European talent spends their careers. We're building an economy that rewards people for increasing complexity and rent-seeking, rather than reducing it.

This does not need to make us less climate compliant. Europe has an effective, price-based alternative to these huge proliferation of rules to fight carbon emissions: the Emissions Trading System (ETS). By leveraging market mechanisms, the ETS can reduce emissions without the heavy compliance burden that stifles innovation and diverts talent.

We need to balance the necessary pursuit of sustainability with the imperative to grow innovation and productivity. As long as the compliance economy syphons away our best minds, our companies will struggle to compete on the global stage and our citizens will get poorer. 

References: 

Acemoglu, Daron. "Reward structures and the allocation of talent." European Economic Review 39, no. 1 (1995): 17-33. 

Baumol, William J., "Entrepreneurship: Productive, Unproductive, and Destructive," Journal of Political Economy, XCVIII (1990), 893-921

Draghi, Mario. 2024b. "EU Competitiveness: In-depth analysis and recommendations" EU Commission. https://commission.europa.eu/topics/strengthening-european-competitiveness/eu-competitiveness-looking-ahead_en

Murphy, Kevin M., Andrei Shleifer, and Robert W. Vishny. "The allocation of talent: Implications for growth." The quarterly journal of economics 106, no. 2 (1991): 503-530.

Murphy, Kevin M., Andrei Shleifer, and Robert W. Vishny. "Why is rent-seeking so costly to growth?." The American Economic Review 83 (1993): 2.

1. Draghi Report (B), p.318.

2. Draghi Report (B), p.318.

3. Draghi Report (B), p.321.

4. John Cochrane’s blog: “https://www.grumpy-economist.com/p/stagnation-and-hope?utm_source=substack&utm_medium=email&utm_content=share.

5. Draghi Report (B), p.318.

6. Draghi report (B), p. 312.

7.  Draghi report (B), p 319.

8. Draghi report (B), p. 317.

9. Baumol (1990) and Murphy et al. (1991) study the allocation between the two activities (entrepreneurial and rent-seeking). Acemoglu (1995) and Murphy et al. (1993) introduce the idea as rent seeking increases, the returns to both rent-seeking and entrepreneurship, and hence, the possibility of multiple equilibria when the return to entrepreneurship falls faster than the return to rent-seeking. In this case, rent-seeking exhibits relative increasing returns.