24/5/18: America, the Medici Cycle and the Corporate Powers in Politics

A recent paper by Luigi Zingales of the University of Chicago, titled "Towards a Political Theory of the Firm" (NBER Working Paper No. 23593, July 2017: http://www.nber.org/papers/w23593) deals with the issue of rent-seeking behavior by monopolistic firms through political influence. "Neoclassical theory assumes that firms have no power of fiat any different from ordinary market contracting, thus a fortiori no power to influence the rules of the game," writes Zingales. "In the real world, firms have such power. I argue that the more firms have market power, the more they have both the ability and the need to gain political power. Thus, market concentration can easily lead to a “Medici vicious circle,” where money is used to get political power and political power is used to make money."

In his opening to the paper, Zingales notes 2016 report by Global Justice Now showing that 69 of the world’s largest 100 economic entities are now corporations, not governments. Using "both corporation and government revenues for 2015, ten companies appear in the largest 30 entities in the world: Walmart (#9), State Grid Corporation of China (#15), China National Petroleum (#15), Sinopec Group (#16), Royal Dutch Shell (#18), Exxon Mobil (#21), Volkswagen (#22), Toyota Motor (#23), Apple (#25), and BP (#27). All ten of these companies had annual revenue in higher than the governments of Switzerland, Norway, and Russia in 2015. ...In some cases, these large corporations had private security forces that rivaled the best secret services, public relations offices that dwarfed a US presidential campaign headquarters, more lawyers than the US Justice Department, and enough money to capture (through campaign donations, lobbying, and even explicit bribes) a majority of the elected representatives. The only powers these large corporations missed were the power to wage war and the legal power of detaining people, although their political influence was sufficiently large that many would argue that, at least in certain settings, large corporations can exercise those powers by proxy."

Despite this reality, economic theory largely ignores the issue of political power of the firms despite the fact that throughout modern history, "the largest modern corporations facilitated a massive concentration of economic (and political) power in the hands of a few people, who are hardly accountable to anyone." And despite the well-established fact (including through the precedent of the U.S. sanctions), that "...many of those giants (like State Grid, China National Petroleum, and Sinopec) are overseen by a member of the Chinese Communist party." Worse, as Zinglaes notes, "In the United States, hostile takeovers of large corporations have (unfortunately) all but disappeared, and corporate board members are accountable to none. Rarely are they not reelected, and even when they do not get a plurality of votes, they are coopted back to the very same board (Committee on Capital Market Regulation, 2014). The primary way for board members to lose their jobs is to criticize the incumbent CEO (see the Bob Monks experience in Tyco described in Zingales, 2012). The only pressure on large US corporations from the marketplace is exercised by activist investors, who operate under strong political opposition and not always with the interest all shareholders in mind."

So Zingales argues "that the interaction of concentrated corporate power and politics it a threat to the functioning of the free market economy and to economic prosperity it can generate, and a threat to democracy as well." Which, of course, is simply consistent with existence of the set of market-linked trilemmas, such as The International Relations (Order) Trilemma that implies that in the presence of perfect capital mobility, the nation states can either pursue a democratic sovereign political set up or an objective of international stability/order, as well as. (see more on these here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2786660).

Logically, thus, economics need to be asking the following questions, largely ignored in the neo-classical theory of the firm: "To what extent can the power firms have in the marketplace be transformed into political power? To what extent can the political power achieved by
firms be used to protect but also enhance the market power firms have?"

As Zingales notes correctly, "US economic patterns in the last few decades have seen a rise in the relative size of large companies," as also documented in a number of posts on this blog:
for example, the rise of monopolistic competition here:

• http://trueeconomics.blogspot.com/2018/03/20318-market-power-and-5-macroeconomic.html
• http://trueeconomics.blogspot.com/2018/03/28218-san-francisco-fed-research.html
• http://trueeconomics.blogspot.com/2018/02/7218-american-wages-corporotocracy-why.html 
• http://trueeconomics.blogspot.com/2018/02/9218-angus-deaton-on-monopolization-and.html; 

monopsonistic power here:

• http://trueeconomics.blogspot.com/2018/02/7218-american-wages-corporotocracy-why.html
• http://trueeconomics.blogspot.com/2018/05/23518-contingent-workforce-online.html

effects on regulatory enforcement efficiency here:

• http://trueeconomics.blogspot.com/2017/11/301117-efficiency-of-enforcement-vs.html

effects on democratic institutions here:

• http://trueeconomics.blogspot.com/2017/09/7917-millennials-support-for-liberal.html

As the result, Zinglaes calls "attention to the risk of a “Medici Vicious Circle.” The “signorias” of the Middle Ages—the city-states that were a common form of government in Italy from the 13th through the 16th centuries--were a takeover of a democratic institution (“communes)” by rich and powerful families who ran the city-states with their own commercial interests as main objective. The possibility and extent of this Medici Vicious Circle depend upon several non-market factors. I identify six of them: the main source of political power, the conditions of the media market, the independence of the prosecutorial and judiciary power, the campaign financing laws, and the dominant ideology. I describe when and how these factors play a role and how they should be incorporated in a broader “Political Theory” of the firm."

The driver for this 'Medici Circle' dynamic is market concentration or monopolistic competition. Product differentiation and market regulation can bestow onto a firm a degree of market power that translates into market concentration (rising and significant share of market activity captured by the firm). While in the environment of continued innovation, such competitive advantage generates only temporary abnormal profits, the degree of market power can be significant enough to provide the firm with substantial resources (profits) to engage in lobbying activities, corruption and other rent-seeking activities. There are also symmetric incentives for the firms to engage in rent seeking. As Zinglaes notes: "If the ability to influence the political power increases with economic power, so does the need to do so, because the greater the market power a firm has, the greater the fear of expropriation by the political power". This sounds strange, but it is quite intuitive: as a firm gains market power, it's prices rise above the marginal cost, yielding abnormal economic profits to the firm at the expense of consumers. The Governments can (and do) claim political mandate to limit these profits by taxing the market dominant firms' profits (either through regulation or direct taxation), thus expropriating part of the abnormal profits.

In simple terms, "Most firms are actively engaged in protecting their source of competitive advantage: through a mixture of innovation, lobbying, or both. As long as most of the effort is along the first dimension, there is little to be worried about. ...What is more problematic is when a lot of effort is put into lobbying. In other words, the problem here is not temporary market power. ...The fear is of what I call a “Medici vicious circle,” in which money is used to gain political power and political power is then used to make more money. ...In the case of medieval Italy, it turned Florence from one of the most industrialized and powerful cities in Europe to a marginal province of a foreign empire. At least the Medici period left some examples of great artistic beauty in Florence. I am not sure that market capitalism of the 21st century will be able to do the same."

Zingales relates the Medici circle concept to the modern day U.S. economy. "In the last two decades more than 75 percent of US industries experienced an increase in concentration levels, with the Herfindahl index increasing by more than 50 percent on average. During this time, the size of the average publicly listed company in the United States tripled in market capitalization: from $1.2 billion to $3.7 billion in 2016 dollars... This phenomenon is the result of two trends. On the one hand, the reduction in the rate of birth of new firms, which went from 14 percent in the late 1980s to less than 10 percent in 2014. On the other hand, a very high level of merger activity, which for many years in the last two decades exceeded $2 trillion in value per year... The market power enjoyed by larger firms is also reflected in the increasing difficulty that smaller firms have in competing in the marketplace: in 1980, only 20 percent of small publicly traded firms had negative earnings per share, in 2010, 60 percent did... Barkai (2016) ...finds that the decrease in labor share of value added is not due to an increase in the capital share (that is, the cost of capital times amount of capital divided by value added), but by an increase in the profits share (the residuals), which goes from 2 percent of GDP in 1984 to 16 percent in 2014. ...By separating the return to capital and profits, we can appreciate when profits come from (non-replicable) barriers to entry and competition, not from capital accumulation. Distinguishing between capital and share allows Barkai (2016) also to gain some insights on the cause of the decline in the labor share. If markups (the difference between the cost of a good and its selling price) are fixed, any change in relative prices or in technology that causes a decline in labor share must cause an equal increase in the capital share. If both labor and capital share dropped, then there must be a change in markups—that is, the pricing power firms to charge more than their cost."

And fresh from the presses today: "US IG Chart of the Day: Global M&A deal flow has doubled YTD for a total of $1.5 trillion of announced deals. US-only deals account for about 37% of the global total, for $555 billion of transactions."

While firms require market power to acquire political power, access to political power is required to protect abnormal profits arising from market power. Which, in a highly polarised society (aka, the U.S. system of politics dominated by two mainstream parties) can result in political representation concentrated in the hands of minorities (e.g. Trump Presidency, gained absent major corporate support), and in ineffectiveness of lobbying monitoring (As Zinglaes notes: "Even when it comes to lobbying, the actual amount spent by large U.S corporations is very small, at least as a fraction of their sales. For example, in 2014 Google (now Alphabet) had $80 billion in revenues and spent $16 million in lobbying".) Which is, of course, quite ironic, given that the ongoing Robert Mueller probe of the Trump campaign is focusing almost exclusively on the violations in the legal or declared channels of lobbying, instead of the indirect forms of political influencing.


I will quote Zingales' conclusion almost in full here, for it is a powerful reminder to us all that we live in a world where corporatism (integration of State and corporate powers) and monopolisation / concentration of the markets are two key features of our environment, not only in the economic sense, but in the political / democratic domains as well.

"In a famous speech in 1911, Nicholas Murray Butler, President of Columbia University, considered the practical advances made by large corporations in the late 19th and early 20th century and stated: 'I weigh my words, when I say that in my judgment the limited liability corporation is the greatest single discovery of modern times, whether you judge it by its social, by its ethical, by its industrial or, in the long run, ...by its political, effects.' Butler was right, but this discovery of the modern corporate form – like all discoveries – can be used to both to foster progress or to oppress. The size of many corporations exceeds the modern state. As such, they run the risk of transforming small- and even medium-sized states into modern versions of banana republics, while posing economic and political risks even for the large high-income economies. To fight these risks, several political tools might be put into use: increases in transparency of corporate activities; improvements in corporate democracy; better rules against revolving doors and more attention to the risk of capture of scientists and economists by corporate interests; more aggressive use of the antitrust authority; and attention to the functioning and the independence of the media market. Yet the single most important remedy may be broader public awareness."

The latter bit is still woefully lacking in the Fourth Rome of Washington DC, where the usual, tired, unrealistic narrative of American Exceptionalism reigns supreme, and where the U.S. flags at the 4th of July picnics are still confused for meaningful symbols of the U.S. meritocracy and the American Dream, the native entrepreneurialism and the social mobility. Wake up, folks, and smell the roses.

20/3/18: Market Power and 5 Macroeconomic Puzzles: Rotten State of the ‘Competitive Markets’

Washington Centre for Equitable Growth has recently published a new modified version of the neoclassical model attempting to explain a number of empirical facts. A paper by Gauti Eggertsson, Jacob A. Robbins, Ella Getz Wold, titled “Kaldor and Piketty’s Facts: The Rise of Monopoly Power in the United States” (February 2018: http://equitablegrowth.org/working-papers/kaldor-piketty-monopoly-power/) departs from the empirical observation that the empirical facts of the real economy can be reconciled with in contrast to the traditional neoclassical models. Specifically, per authors:

• “(P1) An increase in the financial wealth-to-income ratio despite low savings rates, with a stagnating capital-to-income ratio.”
• “(P2) An increase in Tobin’s Q to a level permanently above 1.” So that stock market value of assets exceeds productive value of assets.
• “(P3) A decrease in the real rate of interest, while the measured average return on capital is relatively constant.” So profit margins on investment rise.
• “(P4) An increase in the pure profit share, with a decrease in the capital and labor share.” So shareholders get to carry away more in returns, while capital suppliers and workers get less.
• “(P5) A decrease in investment-to-output, even given historically low borrowing costs and a high value of empirical Tobin’s Q.” In  other words, low investment, even as the interest rates (cost of investment) fall.

Table 1: Factor shares. 5-year moving averages

The paper then modifies the standard neoclassical model. The authors introduce a market concentration distortion: “an increase in monopoly profits, [coupled] with a decrease in the natural rate of interest”.

To justify this, they, first, “depart from perfect competition, and posit that market power allows firms to make pure profits”. Second, authors assert that “there are barriers to entry, which prevent competition from driving these profits to zero.” This is consistent with the proposition that we are witnessing increased pressure of monopolistic and oligopolistic competition in the U.S. economy, as covered by me in a range of previous posts and articles.

“Third, claims to the (nonzero) pure profits of firms are traded and priced, and the ratio of the market
value of firms (which includes the rights to pure profits) to the replacement value of the productive capital stock is permanently above one; this ratio is commonly known as “empirical Tobin’s Q”.” Note that the tradability of pure profits of the firm (as opposed to rents on capital) is a distinct part of the model. Traditionally, we think of stock markets valuations as reflective of economic rents, not pure profits. That is so, because we assume that over the longer run, pure profits are driven down to zero. However, if/when pure profits are non-zero, stock market valuations are reflective of both: capital rents (low, due to extremely low cost of credit), plus pure profit (high, due to the transfers from interest rate subsidy from labor and technology logical capital to financial capital via pure profit monetisation, plus, dare I say it, the monetary policies excesses of the recent past).

CHART 1

Now, the authors confine their explanation for market power perpetuation to the following: “Because of the barriers to entry, the assets which hold the rights to the pure profits are non-reproducible: unlike productive capital, individuals cannot recreate these assets through investment, they must instead purchase them from others.” Personally, I would agree that barriers to entry - formal ones, e.g. via licensing and regulation - are one part of the problem. But there is a more direct problem arising in the American economy as well: concentration driven by pure monopolistic differentiation (see buy post on this here: http://trueeconomics.blogspot.com/2018/03/28218-san-francisco-fed-research.html, and here: http://trueeconomics.blogspot.com/2018/02/7218-american-wages-corporotocracy-why.html, and here: http://trueeconomics.blogspot.com/2018/02/9218-angus-deaton-on-monopolization-and.html.

The authors simply ignore this consideration as if it represents an uncomfortable truth about the state of the modern American society and economy. Instead, they create a marginal wrap-around argument to explain these dynamics: “This produces an interesting result: returns to assets that receive the rights to pure profits are significantly riskier than the returns to productive capital.” Why would returns to pure profit assets be riskier? Because the authors want to explain the differential between the returns to pure profit (higher) and the returns to productive capital (lower) by something ‘organic’, related to traditional financial theory. In other words, they need to show that pure profits returns bear additional risk and are paid additional risk premium over and above the returns to productive capital.

Here’s the authors’ argument: “The reason for this result is closely connected to the non-reproducibility of the assets which hold the rights to pure profits. When the economy is shocked, the price of these assets show large fluctuations, because their supply is fixed. In comparison, there is less fluctuation in the price of productive capital, since the supply is not fixed and it can be produced through new investment; the variance of the price of productive capital is determined in our model by the level of capital adjustment costs. As the economy transforms from one in which the majority of assets by market value are productive capital into one dominated by pure economic rents, this generates an endogenous increase in risk premium.”

CHART 2: Average return on capital

I do not buy this argument AT ALL. Let me explain. Non-reproducibility of these assets is a pure, unadulterated nonsense. We used to have Microsoft (a monopoly) and then we got Google (another monopoly), then we got FAANGS (more monopolies), and so on. If anything, rising concentration of the S&P 500 at the hands of larger, monopolistic issuers strongly suggests not only that the monopolistic assets ARE reproducible, but the our financial markets are solely preoccupied with reproducing them. Behold the ‘unicorns’.

The real driver for the abnormal (pure profit-linked) returns is the very existence of that pure profit, driven by: (a) regulatory barriers to entry (think banks), (b) state subsidies (think Tesla), (c) market macrostructure (think Google and Facebook), (d) rampant rent-seeking (think all), (e) outdated anti-trust regulations (think the U.S. system dominated by only one consideration, that of the material harm to consumers, that ignores the fact that modern ICT services are NOT your typical transactions, and involve a barter-type set of transactions between consumers and, say, Google). Majority of these drivers are reinforced by the selectively ultra-low cost of funding for the monopolistic competitors, available courtesy of the rounds and rounds of global risk-mispricing, aka, QE.

Despite the above shortcomings, the paper is an important one. Its conclusions are succinct and far-reaching. “There are a number of reasons why we argue for this hypothesis (i) there is a wide variety of confirmatory evidence that concentration, profits, and markups have increased over the time period, while the natural rate of interest has decreased (ii) it is parsimonious, in the sense that we use two data series (markups and interest rates) to explain the movements of 5 separate trends (iii) our model does not generate counterfactual implications.”

“In this paper, we argue that these trends can be explained by an increase in market power and pure profits in the US economy, i.e., the emergence of a non-zero-rent economy, along with forces that have led to a persistent long term decline in real interest rates.” Whatever your views on the causal factors might be, the dangers inherent in this systemic dismantling of the competitive, open, entrepreneurial model of the American economy of the past is a major source of future risks, uncertainties and social risks.