The Pathology of Privilege: The Economic Consequences of Government Favoritism
Despite the ideological miles that separate them, activists in the Tea Party and Occupy Wall Street movements agree on one thing: both condemn the recent bailouts of wealthy and well-connected banks. To the Tea Partiers, these bailouts were an unwarranted federal intrusion into the free market; to the Occupiers, they were a taxpayer-financed gift to the wealthy executives whose malfeasance brought on the financial crisis. To both, the bailouts smacked of cronyism.
The financial bailouts of 2008 were but one example in a long list of privileges that governments occasionally bestow upon particular firms or particular industries. At various times and places, these privileges have included (among other things) monopoly status, favorable regulations, subsidies, bailouts, loan guarantees, targeted tax breaks, protection from foreign competition, and noncompetitive contracts. Whatever its guise, government-granted privilege is an extraordinarily destructive force. It misdirects resources, impedes genuine economic progress, breeds corruption, and undermines the legitimacy of both the government and the private sector.
I. THE GAINS FROM EXCHANGE
It is helpful in understanding any pathology to begin by examining the characteristics of a healthy state of affairs. With that in mind, consider a market in which no firms enjoy favoritism: all are equal in the eyes of the law. In such a situation, free and voluntary trade results in gains for both sellers and buyers. Consider a simple trade: A offers B $6.00 in exchange for a sandwich. A must value the sandwich more than $6.00; otherwise he would not part with his money. Similarly, B must value the $6.00 more than the sandwich; otherwise he would not part with his sandwich. Though no new sandwiches and no new dollars have been created, the very act of exchange miraculously elevates the well-being of all concerned. (Figure 1 in the appendix describes the gains from trade using supply and demand curves.)
This simple idea—that voluntary exchange is mutually beneficial—is at the heart of modern economics. Indeed, a national economy, with all its sophistication and complexity, is simply a very large number of mutually beneficial trades. And a recession is nothing more than a collapse in the number of such trades. Moreover, as individuals expand the number of people with whom they exchange, they are able to consume a wider diversity of products while becoming more specialized in production. Specialized production, in turn, permits greater productive efficiency and allows us to do more with less. It is no exaggeration to say that the expansion of mutually beneficial exchange accounts for the lion’s share of human progress.
In a healthy market, there will be so much exchange that the gains from trade are maximized. This is more likely when markets are competitive. And markets tend to be competitive when property rights are well-defined, the costs of transacting (negotiating the terms of trade) are minimal, and—most important—there are no barriers to entering or exiting the industry. Markets can achieve competitive conditions with relatively few buyers and sellers. In a famous experiment, economic Nobel Laureate Vernon Smith showed that even when there are as few as four buyers and sellers, a market will tend toward the competitive equilibrium.
II. TYPES OF PRIVILEGE
In the next section, I will review the various ways in which government-granted privileges diminish the gains from exchange, threaten economic growth, and under- mine the legitimacy of government and the private sector. For now, consider the forms that privilege might take.
A. Monopoly Privilege
In April 2004, Chinese officials arrested Dai Guofang and sentenced him to five years in prison. Mr. Dai’s crime was founding a low-cost steel firm that competed with a number of factories backed by the Chinese government. The government, it seems, wanted to send a message: certain firms are privileged and it is illegal to compete with them. Monopoly privileges of this sort are more common in nations where governments direct large sectors of the economy. But monopoly privileges are not an artifact of the developing world.
The United States Postal Service is a case in point. While the U.S. Constitution grants Congress “the power to establish post offices and post roads,” it does not, like the Articles of Confederation before it, grant Congress the “sole and exclusive right” to provide these services. By the 1840s, a number of private firms had begun to challenge the postal service monopoly. Up and down the East Coast, these carriers offered faster service and safer delivery at lower cost. While the competition forced the postal service to lower its rates, it also encouraged the postal service to harass its private competitors: within a few years, government legal challenges and fines had driven the private carriers out of business. More than a century later, in 1971, the postal service was finally converted into a semi-independent agency called the United States Postal Service (USPS). Its monopoly privileges, however, remain. No other carriers are allowed to deliver nonurgent letters and no other carriers are allowed to use the inside of your mailbox.
Privately owned firms, including local cable operators and many publicly regulated utilities, may enjoy legal monopoly protection as well.
B. Regulatory Privilege
While it is relatively uncommon for U.S. firms to enjoy legal monopoly status, many firms do enjoy regulatory preferences that give them a measure of monopoly power. Until recently, for example, regulations governing banks, broker-dealers, and money market funds effectively required them to hold securities that had been rated by one of only a handful of private credit ratings agencies that had been blessed with a seal of approval from the Securities and Exchange Commission. This regulation may have resulted in more costly and less reliable credit ratings, but it was a boon to the three ratings agencies: Moody’s, Fitch, and Standard and Poor’s.
Though business leaders and politicians often speak of regulations as “burdensome” or “crushing,” the example shows that sometimes it can be a privilege to be regulated, especially if it hobbles one’s competition. This insight prompted consumer advocates Mark Green and Ralph Nader to declare in 1973 that “the verdict is nearly unanimous that economic regulation over rates, entry, mergers, and technology has been anticompetitive and wasteful,” and that “our unguided regulatory system undermines competition and entrenches monopoly at the public’s expense.” It also prompted bipartisan support for deregulation or partial deregulation of airlines, trucking, telecommunications, and finance in the late 1970s and early 1980s.
But in many industries, barriers to entry remain. Thirty-six states, for example, require government permission to open or expand a health care facility. Thirty- nine require government permission to set up shop as a hair braider. In the 1950s, less than 5 percent of the work force needed an occupational license; the number rose to 18 percent in the 1980s and it now stands at 29 percent.
While barriers to entry impose costs on all firms, the costs are more burdensome to newer and smaller operators. This is why existing firms often favor regulations. University of Chicago economist George Stigler won the Nobel Prize in economics for showing that regulatory agencies are routinely “captured” and used by the firms they are supposed to be regulating.
In the nineteenth century, the Interstate Commerce Commission (ICC) was famously captured by the railroads it was supposed to regulate. While the commission had been created to force railroad shipping rates down, railway men soon found that they could influence the commission and get it to force prices above what the competitive market would bear. In 1892, U.S. Attorney General Richard Olney explained this point to his former employer, a railway boss:
The Commission. . . is, or can be made, of great use to the railroads. It satisfies the popular clamor for a government supervision of the railroads, at the same time that that supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things. . . . The part of wisdom is not to destroy the Commission, but to utilize it.
As the ICC case makes clear, regulations can be especially useful to firms if they give the appearance of being anti-business or somehow pro-consumer. Regulations are often supported by strange bedfellows. Bruce Yandle of Clemson University has studied the phenomenon extensively:
The pages of history are full of episodes best explained by a theory of regulation I call “bootleggers and Baptists.” Bootleggers. . . support Sunday closing laws that shut down all the local bars and liquor stores. Baptists support the same laws and lobby vigorously for them. Both parties gain, while the regulators are content because the law is easy to administer.
The moralizing arguments are often front and center in regulatory policy debates, while the narrow interests that stand to benefit from certain regulations are much less conspicuous.
1. According to Occupy Wall Street activists, “Corporations . . . run our governments . . . have taken bail- outs from taxpayers with impunity, and continue to give Executives exorbitant bonuses.” New York City General Assembly, “Declaration of the Occupation of New York City,” http://www.nycga.net/resources/ declaration/ (accessed April 30, 2012). And according to the Tea Party Patriots, “The Tea Party movement spontaneously formed in 2009 from the reaction of the American people to fiscally irresponsible actions of the federal government, misguided “stimulus” spending, bailouts, and takeovers of private industry.” Tea Party Patriots, “About Tea Party Patriots,” http://www.teapartypatriots.org/about/ (accessed April 30, 2012).
2. In an interview with James Buchanan, F.A. Hayek once remarked, “[The First Amendment] ought
to read, ‘Congress shall make no law authorizing government to take any discriminatory measures of coercion.’ I think that would make all the other rights unnecessary.” Quoted in James Buchanan and Roger Congleton, Politics by Principle, Not Interest: Toward Nondiscriminatory Democracy (Indianapolis: Liberty Fund,  2003), vii.
3. This point is not disputed by economists. See, for example, the microeconomic textbooks by Paul Krugman (of the left) and Gregory Mankiw (of the right). Paul Krugman and Robin Wells, Microeconomics, 2nd ed. (New York: Worth Publishers, 2009); Gregory Mankiw, Principles of Microeconomics, 6th ed. (Mason, OH: South-Western, 2012).
4. See, for example, Matt Ridley, The Rational Optimist: How Prosperity Evolves (New York: Harper Collins, 2011).
5. There are exceptions. In some markets, up-front or fixed costs are so great that the competitive price is not high enough to make the venture worthwhile (think of a new drug, which can costs millions in R&D). In this case, the gains from trade are maximized when the industry is monopolized.
6. These characteristics appear in one form or another in most microeconomic textbooks.
7. Vernon Smith, “An Experimental Study of Competitive Market Behavior,” Journal of Political Economy 30, no. 2 (1962): 111–137.
8. Daron Acemoglu and James Robinson, Why Nations Fail: The Origins of Power, Prosperity, and Poverty (New York: Random House, 2012), 437–438. See also Richard McGregor, The Party: The Secret World of China’s Communist Rulers (New York: Harper Collins, 2010), 220–223.
9. See, for example, “The Rise of State Capitalism: The Emerging World’s New Model,” The Economist, January 21, 2012,http://www.economist.com/node/21543160.
10. Kelly B. Olds, “The Challenge to the U.S. Postal Monopoly, 1839–1851,” Cato Journal 15, no. 1 (Spring/ Summer 1995).
12. In addition to these perquisites, the USPS pays no taxes and is exempt from local zoning laws.
13. Some of these firms have significant fixed costs, which suggests that the market might only support one or two firms in any event. This possibility does not imply, however, that there is an economic case for outlawing competition. See George Stigler, “Monopoly,” in The Concise Encyclopedia of Economics, ed. David Henderson (Indianapolis: Liberty Fund, 2008).
14. The privilege grew out of a 1975 Securities and Exchange Commission rule that designated the big three agencies as “Nationally Recognized Statistical Ratings Organizations.” Over the next 25 years, only four additional firms qualified for this designation. By the end of 2000, however, mergers had reduced the number to the original three. Lawrence J. White, “A Brief History of Credit Rating Agencies: How Financial Regulation Entrenched this Industry’s Role in the Subprime Mortgage Debacle of 2007–2008,” Mercatus on Policy 59 (Arlington, VA: Mercatus Center at George Mason University, 2009).
15. Mark Green and Ralph Nader, “Economic Regulation vs. Competition: Uncle Sam the Monopoly Man,” Yale Law Journal 82, no. 5 (April 1973): 871–889, 881.
16. Ibid., 871.
17. On the benefits of this deregulation, see Clifford Winston, “Economic Deregulation: Days of Reckoning for Microeconomists,” Journal of Economic Literature 31 (1993): 1263–1289.
18. National Conference of State Legislatures, “Certificate of Need: State Health Laws and Programs,” http://www.ncsl.org/issues-research/health/con-certificate-of-need-state-laws.aspx (accessed May 2012).
19. Valerie Bayham, A Dream Deferred: Legal Barriers to African Hairbraiding Nationwide (Arlington, VA: Institute for Justice, September 2006).
20. Morris Kleiner and Alan Krueger, “The Prevalence and Effects of Occupational Licensing,” British Journal of Industrial Relations 48, no. 4 (2010): 676–687.
21. Rajan and Zingales argue that large incumbent firms invest in political influence in order to lock in the status quo, which preserves their dominance. Raghuram Rajan and Luigi Zingales, Saving Capitalism From the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity (New York: Crown Business, 2003).
22. George Stigler, “The Theory of Economic Regulation,” Bell Journal of Economics and Management Science 2, (1971): 3–21.
23. Milton Friedman and Rose Friedman, Free to Choose: A Personal Statement (New York: Harcourt Brace Janovich, 1980), 194–203.
24. Ibid., 197.
25. Bruce Yandle, “Bootleggers and Baptists: The Education of a Regulatory Economist,” Regulation 3, no. 3 (May/June 1983): 12–16.