market power

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Structural Defects

The Bank for International Settlements issued its annual report yesterday.  Perhaps the central banks are feeling a little insecure, or perhaps they are a little more sensitive to economic reality, but the BIS felt compelled to use one third of its report to tackle inequality.  Here’s the summary as given in the report:

“Key takeaways

  • The long-term rise in economic inequality since the 1980s is largely due to structural factors, well outside the reach of monetary policy, and is best addressed by fiscal and structural policies.
  • Monetary policy can most effectively contribute to a more equitable society by fulfilling its mandate, which addresses two key factors causing inequality at shorter horizons. This requires keeping inflation low and limiting the incidence and duration of macroeconomic and financial instability, which disproportionately hurt the poor.
  • Central banks can also help mitigate economic inequality wearing their “non-monetary hats”, notably as prudential authorities, promoters of financial development and inclusion, and guardians of payment systems.”

Fairly bland stuff.

First:  That opening conclusion that the long term rise in inequality is more due to structural defects than monetary policy is spot on.  Sort of.  The near perpetual low interest rates maintained for the past decade and more have surely supported asset holders more than the rest.  In fact going some way back the prevailing focus of monetary policy seems to have had a decided bias towards the credit side of the ledger.  Rightly so, you might argue.  I suppose the central banks can argue that the seemingly bottomless willingness to support the financial system in moments of crisis is a necessity.  After all the general public benefits from a working payments system and access to credit.  That the financiers are never held accountable for the rest of what they do is left aside.  I will get to that in a moment.

Second: I think we can all agree that the avoidance of major economic cyclical damage is in the public interest.  So the BIS’s point about central bank mandates — to avoid inflation and limiting instability — are well made.  But insufficient.  That such instability hurts the poor more than the wealthy is surely blazingly obvious.  The evidence from the long slow recovery form the Great Recession is all we need in support of that argument.  What if, however, the central banks consistently undershoot their inflation target?  Who benefits from that?  Does too low a level of inflation benefit the poor?  No, it doesn’t.  The wording the BIS uses is carefully chosen: it elides the responsibility central banks have towards the support of labor markets.  Their recent record is not so strong on that front.  Labor market conditions are presumably subsumed into the “instability” fighting responsibility.  The recent record indicates that other aspects of instability prevention take precedent.  Like the endless focus on banking.

Third: I love that the BIS then adds a non-monetary policy factor: the regulation of finance.  Guardians of the payment system? Yes I get that.  Prudential authorities and promotion of financial development?  I don’t think the BIS ought crow too much about this.  The ease with which the banks manipulate and coax the regulators into a pro-bank stance was all too well evidenced by the crash.  Much financial innovation appears to be destructive and adding to that instability the BIS mentions.  Why is it tolerated?  The laxity and ineffectiveness of regulation has been exposed for all to see even in recent weeks here in the US, where the big banks all passed their “stress tests” and are now planning to shovel billions of dollars back to their shareholders.  This will deplete capital and divert resources to the wealthy, thereby exacerbating inequality.  This contradicts the feel-good story the BIS wants to convey.  The weakness with respect to regulation is in stark contrast to the devotion to duty displayed in the fight against inflation.  Consequently the central banks appear to be less neutral in their role than they would like us to believe.

For the record I have always advocated the separation of bank oversight from the implementation of monetary policy. The lines between the banks and their overseers blur all too easily.  The career carousel between overseer and the overseen is too easily ridden.  The intellectual independence that the central banks pride themselves on in their monetary policy making is hard to find on the regulatory side.  But this all might simply be me extrapolating from personal experience, so you can dismiss it is bias if you like.  It’s just that the heavy handed threat of rising interest rates to head off inflation contrasts rather starkly with the delicacy with which the big banks are treated.  Is that to do with the too frequent mingling of staff?  I leave it you to decide.

Back to structure.

I mentioned a little while ago that I had been reading Jan Eeckhout’s book “The Profit Paradox”.  I recommend it.  Whilst it might not be stunning news that market power has grown significantly in the past few decades, it is useful to keep its impact in mind when evaluating things like the BIS annual report.  Indeed the report lays it out there right at the beginning: “structural factors”, it says, are largely to blame for rising inequality.  Eeckhout’s data and analysis provide the justification for that statement.  What the BIS doesn’t say is that structural defects affect the efficacy of monetary policy.  It takes a lot more effort, and for longer, for policy to have the desired effect when its transmission is through a sticky mechanism.  Contra to the pristine economies that the policy makers model when making their decisions, the real economy is riddled through with jamming devices that slow down or contradict the messaging intent of policy.   Oligopolies work to rig the labor market, they limit output in order to manage revenue, and they over-price in order to maximize short term profit.  The consequent effects on employment and consumer welfare are all negative and create a downdraft backdrop for monetary policy.  Surely the BIS ought note this in its comments.

Nowhere is the impact of market power more obvious than in the banking industry itself where a few ultra-large organizations now dominate most markets.  Since the steady consolidation of banking has taken place right under the noses of the central banks armed with regulatory oversight of that consolidation, I think the BIS might usefully reflect on the role its members have had in allowing those structural defects to accumulate.  It is one thing to palm the rise in inequality off on non-monetary policy issues like structural factors.  It is another to be complicit in the formation of those factors.

Perhaps the BIS can opine on how to untangle the finance industry and break up the big banks in its 2022 report?  After all, the central banks oversee the industry.  Don’t they?

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Power Shifts, or Not?

Power can flummox even the best economist.  A typical explanation of events in an economy makes scant reference to the way in which power distorts the wondrous smooth motions that so obsess the discipline.  It’s almost as if human relationships don’t exist in those wonderful models they are all so proud of.  For the rest of us, power is central.  It takes little time to realize that establishing an imbalance can have all sorts of advantages.  They most notable being that it defeats or undermines the consequences of the classic impersonal marketplace.  Fair is out.  Asymmetry is in.

Not that the existence of asymmetry ought surprise anyone.  The real world is an awfully lumpy place.  Resources, information, people, and everything else exist in clumps.  Without those clumps there would be no exchange.  There would be no trade.  There would be no markets.  But the world is lumpy, hence all of the above.  This paradox, that economists study idealized worlds whose features eliminate the very phenomena that are the supposed object of study, is one of the more endearing aspects of economics.  Building theories about made up worlds is a whole lot more fun and easier than inventing them to explain the real world.  But, hey, let’s be fair: as long as we all know that we are theorizing about our fantasies in order to extract useful nuggets about the real world, we should go for it.  Unfortunately, and I think this is fair criticism, the way in which economics is taught often elides this.

One of the odd things about our emergence from the pandemic and the sudden prospect before us of a robust economy is that the more conventional analysts are all bleating about inflation.  Something terrible is about to happen, they argue, unless we correct for all that money sloshing about as a consequence of governments trying to bail out their respective economies.  The ghosts of the 1970s are everywhere.  Strange things are afoot.  Are massive purchases of government debts by central banks properly called monetary policy?  Or are they a sort of fiscal policy?  Are we in an era of well-anchored inflation expectations?  Or are we adrift about to take on water?  And the difference between forecast and outcome based policy setting is keeping some analysts awake at night.

It’s enough to confuse even the most adroit of us.

There are so many puzzle pieces on the table it’s difficult to send the outline of the picture we need to paint.  So let’s look for a straight edge.

That’s where power comes in.

It might be passing, but at the moment workers here in the U.S. have the upper hand.  For the first time in decades they are able to extract higher wages from prospective employers.  And the employers aren’t liking it.  Nor are the financial media types and analysts brought up in an era of shareholder value dominated business strategies.  All those consultants whose existence is to give intellectual cover to the suppression of the workforce despite all their screeds on employee “engagement” and “human capital” are perplexed.  What is a cost-cutter to do when the source of the largest single cost in most businesses gets less supine?  Heck management might even have to pay the workforce more.  Hell is freezing over.

Power is shifting.  At least temporarily.

How temporarily will be affected by the ability of business to re-assert its oligopolistic hold on the economy.  This is why a new book by Jan Eeckhout is so timely.  It is called “The Profit Paradox”, although the subtitle “How Thriving Firms Threaten the Future of Work” is far more telling.  It is somewhat disappointing to find a book in 2021 whose main thesis is the shift in the balance of power away from labor to capital.  Surely we all knew about this a long time ago.  Has it really taken this long for someone to take a good look at why?  Of course not.  Others have ventured here before.  What I find interesting about Eeckhout’s ideas though is that he ties the individual firm’s pursuit of self-interest — via the infamous shareholder value proposition — to the general decline of economic performance.  It’s an inversion of the famous Smithian view that the result of self-interest is to produce a socially beneficial result.  Clearly when we examine firms rather than individuals that is no longer true.

Rather than belabor the point let me quote from page 75 of his book:

“This is the central thesis of the book.  We tend to accept that when firms do well, the economy does well.  Competing firms that make profits create jobs and work benefits.  Alas, currently dominant firms exert market power and do the opposite.  They generate excess profits because they face too few competitors and make consumers pay too high a price for a bottle of beer or for their grandmother’s prosthetic hip.  Therefore they sell fewer units, as fewer people can afford to buy.  Market power is now so widespread, from tech to textiles, that it lowers production and the demand for labor.  Instead of creating jobs, profitability due to market power lowers wages and destroys work.  That is the profit paradox.  Only a competitive marketplace where firms sell at low prices brings benefits for workers and restores a healthy economy.”

The entire book is an explanation of how market power is created and protected.  The consequences are lower economic growth, lower wages, and fewer jobs.  It is an interesting thesis and well worth getting to know.

Okay: I cheated a little.  Eeckhout doesn’t actually mention shareholder value.  I assume that’s because it has become such an institutional piece of management technology that it is subsumed into the reality we deal with.  No one appears to question it much.  So I thought I would add it into my narrative to remind us that the rise in market power Eeckhout describes so well is a consequence of the strategic decision-making of firms driven by the perceived need to maximize shareholder value.  That “need” is, of course, not a need at all.  It is a choice.  It is ideological.  It has deep roots in neoclassical economic thought.  But let me give Eeckhout credit.  He touches briefly on the issue when he talks about cost-cutting in his chapter on technological change.  One of the great technological innovations in management is the development of supply chains that stretch around the globe.  The objective is to cut costs.  They could not exist without the enablement of the digital information flows and the development of super-sized carriers to make transport cheap.  The words “supply-chain” and “logistics” were hardly used a few decades back.  Now they are talked about obsessively in management circles.  In this context, Eeckhout even hints at what he seems too think of a business school education:

“That is possibly the success of a business school education.  MBAs have learned finance, how to act strategically, and how to minimize expenses.  This cost-cutting cult achieves lower costs for the firm, higher profits for the shareholders, and lower prices for the customer … [but] Cost cutting that results in such market power is not entirely beneficial to the customer because the dominant firm does not pass the entire cost reduction to the customer, and keeps part of those savings in their own accounts as profit.”

Business school education is exactly about how to create excess profits.  It is about how to undermine all the standard economic arguments for a free market.  Firms seek power to undermine the market.  That us what Eeckhout points to as a major, if not the main, cause of our recent stagnation both in the economy at large and in wages in particular.  Reducing his entire thesis to one short sentence: business strategy [and therefore all MBA education] is an attempt to suppress the workforce in favor of shareholders.  It is about power.

And here we are.  It has taken a pandemic to create the space within which workers can challenge that power.  Given that our economy is now so riddled through with oligopoly it seems hard to see how workers can maintain this space for themselves.  As an aside: Eeckhout reminds us to use the word oligopsony rather than monopsony when we discuss the wage suppression big business espouses.

Perhaps all the inflation hawks out there haven’t been paying too much attention.  They appear to have missed the role of power in wage rate setting.  Instead they all seem hell-bent on providing intellectual cover for the continuation of wage stagnation.  After all we can’t have those pesky workers getting too much of a pay raise.  Even after decades of near flat wages a significant pay raise would rock the establishment boat too much.  Look at the inflation it all would cause!   We can’t have that.  Who ever heard of workers having power?

Oh, as an an addendum: let me say I was surprised to learn, via Larry Summers, that savings could be a cause of inflation.  I had no idea.  None.  I thought the detrimental effect of excess savings was through its reduction of demand.  Larry, though, added the existence of the “excess” savings created by all those government support payments as one of his potential causes of inflation.  Anyway, I assume he means that once those savings are no longer savings but turn up as demand they then become pernicious.  That would imply he thinks we would have demand in excess of supply.  Which, kind of, gets us back to market power and Eeckhout’s argument: one of the major effects of oligopolistic market power is in the under-supply of product.  It pays dominant firms to reduce supply in order to build excess profits.

As I said: power can flummox any economist.  Even someone as smart as Larry Summers.  Maybe he needs to go to business school to get an understanding of how the economy is actually run?  No!  That’s not our answer.  We need to re-think the MBA, not advocate it!