Historical watersheds are clearly perceived only in retrospect, but we can at least speculate that we are crossing one now. After two decades in which Anglo-Saxon political economy has been dominated by deregulation, privatization, and faith in the magic of the market, we may be entering a period when free-market wisdom is no longer conventional. If we are lucky, a new consensus may form around a slightly different principle: We will celebrate free competition rather than free markets, and we will recognize that promoting competition may frequently require departure from the principle of laissez-faire. If we are less lucky, we may face a more sweeping backlash against enterprise, with high costs to our prosperity.
The signs of this watershed are scattered, but they are too numerous to ignore. Abroad, we face a broad disaffection with pro-market reformism, which runs from disappointment at privatization and marketization in Russia to the return of leftist populism in Latin America. Within the United States, market advocates have been on the defensive, arguably, since the summer of 2000, when California’s first electricity blackouts called into question the deregulation of the energy sector. Around the same time, the telecommunications sector began its dramatic meltdown, culminating two years later in the bankruptcies of WorldCom, Global Crossing, and more than 150 less famous participants in the experiment unleashed by the 1996 telecoms deregulation law. The only healthy telephone companies — the heirs to the local Bell firms — face their own set of questions: Despite deregulation, they have managed to retain a stranglehold on the local residential market, with the result that the lower prices promised by deregulation have not materialized. Meanwhile the airline industry, deregulated with huge success in 1978, has faced periodic questions. Customer frustration with delays fueled calls for a passengers’ “bill of rights” in the late 1990s; mergers among airlines have caused some economists to fear for the price cuts that deregulation has delivered; recently the bankruptcy of U.S. Airways and United, along with the precarious finances of other airlines, has raised the question of whether further consolidation is inevitable. The health sector has faced calls for tougher regulation too, with state legislatures tying red tape around the health maintenance organizations that seek to restrain medical costs.
All that’s before you consider the twin shocks of terrorism and the outcry over corporate governance following the bankruptcy of Enron. In the aftermath of September 11, Americans turned instinctively to government for solutions — not just to hunt down al Qaeda but also to create the economic adjustments apparently required by the new circumstances. The airline industry, weak even before September 11 and now positively reeling, was immediately promised $5 billion in cash and $10 billion in loan guarantees by Congress. The responsibility for security at airports was transferred from the private sector to the government. The Bush administration advocated the creation of a government insurer to underwrite terrorism risks. There were efforts to strengthen government surveillance of all kinds of communication and mobility — emails, money transfers, commercial shipments across borders — to the point that some commentators wondered whether globalization might be threatened.
The aftermath of Enron brought a similarly broad response. After considering the string of failures that allowed the firm’s chief financial officer to steal $45 million from shareholders, Congress passed soup-to-nuts legislation that President Bush signed in July 2002. The new law strengthens government oversight of auditors. It ends seven decades during which auditors have been allowed to write their own professional standards. It regulates the kinds of consulting services that accounting firms can peddle. It obliges Wall Street’s stock analysts to declare the conflicts of interest created by their firms’ investment-banking activities. It increases the government’s power to pursue aberrant executives with criminal sanctions. It changes the dynamics of the corporate boardroom, requiring muscular and independent audit committees. What’s more, the July legislation may not represent the full extent of Congress’s appetite for new financial regulation. At this writing, members are mulling new rules for 401(k) pension accounts and for initial public offerings.
Moreover, these bursts of government activism have come not only from the left of the political spectrum. This is most strikingly true of the post-Enron reform wave. The chief author of the legislation was Sen. Paul Sarbanes, a Democrat, and its inspiration came partly from Arthur Levitt, Bill Clinton’s chairman of the Securities and Exchange Commission. But the legislation was enthusiastically endorsed by the former Fed chairman, Paul Volcker, and it was welcomed by Alan Greenspan, the current one. Greenspan’s position is especially revealing, both because he is the father and bellwether of Republican economic thinking and because of the way he explained himself. “My view was always that accountants knew or had to know that the market value of their companies rested on the integrity of their operations,” he stated; it followed that government regulation of accounting was “unnecessary and indeed most inappropriate.” But his faith in market incentives had been tested by successive corporate scandals, which demonstrated that, owing to weak oversight, rational accountants chose to forsake their professional standards, calculating that the risk of detection was minimal. In these circumstances, it takes stronger regulation to change accountants’ incentives, and thus to restore the integrity of the capital markets. And so the Fed chairman offered an atypical admission. “I was wrong,” he said.
What explains these ideological reversals? We are of course dealing with a mixture of phenomena: The anti-market revolts that add up to the sense of watershed are as various in their origins as they are in their targets. War has expanded government repeatedly over the course of American history, so it isn’t really surprising that the “war” on terrorism should do the same. Stock market slumps have had a similar effect over the past century, so the end of the long bull market of the 1990s was bound to provoke a new regulatory appetite. But it may also be that something more is happening. Privatization, deregulation, and general enthusiasm for markets may have reached the natural end of their political and intellectual ascendancy.
The deregulatory era began with spectacular successes, the kind you get when you go out into the orchard and pick the lowest and shiniest apples. In Britain, Margaret Thatcher privatized businesses that had no reason to be public in the first place: British Telecom, British Gas, and British Airways. In the United States, where state ownership had always been more limited, Jimmy Carter deregulated industries where the case for government controls was flimsiest: airlines (1978), trucking (1980), and railroads (1976 and 1980). Thatcher’s privatizations were almost bound to look wonderful initially: They had the immediate effect of raising millions for the government, so permitting tax cuts; and the shares in the newly private companies were sold to the public cheaply, sprinkling millions of first-time shareholders with easy capital gains. Similarly, America’s early deregulatory initiatives were a triumph: The savings to American consumers from airline deregulation alone have been estimated at more than $20 billion annually; adding trucking and railroads produces total benefits of around $50 billion a year. These successes, on both sides of the Atlantic, turned what came to be known as Thatcherism/Reaganism into an ideology that spread globally, spurring impatience with sleepy government everywhere from Latin America to New Zealand to ex-communist Eastern Europe. Given the timing of American deregulation — and given that Reagan flirted with the idea of reversing trucking deregulation — the ideology might even have been called Thatcherism/Carterism. Still, as ideologies go, this one did a lot of good.
But there was always something fragile about this free-market ascendancy — flaws that suggested that one day it would go pop. For one thing, the case for deregulating prices of things like airline tickets never amounted to a case for rolling back regulation that protects health, safety, and the environment. Economists distinguish between two kinds of regulation: There’s the kind that controls which firms can enter a market and what they can charge once they’re in it, and there’s the kind that forces firms to “produce” public goods like cleaner air or safer roads. The deregulatory movement that began in the late 1970s was really an attack on the first kind of regulation — price and entry regulation — and not on the sort that addresses public goods. Everybody agrees that public goods will not be produced by the market, and most people agree that health, safety, and the environment are important; so a large amount of regulation in these areas is inevitable. Even supposed deregulatory hawks, such as John Graham, the head of regulatory oversight in the Bush administration, freely accept this; “the federal regulatory state is here to stay,” he declared in a speech recently. The existing stock of public-goods regulation imposes around $800 billion in costs on Americans annually — a sum larger than the discretionary federal budget. That’s a rather big qualification to the notion that sweeping deregulation of the sort envisaged in the Reagan/Thatcher heyday was ever really possible.
The second fragility in the free-market ascendancy was a tendency to exaggerate the private sector’s virtues. When conservatives talked of “getting government off people’s backs,” they assumed that unburdened citizens and corporations would naturally do good. But, left to their own devices, corporations do not necessarily seek profits by virtuously inventing new products and more efficient ways of making them; they also seek profits by colluding with one another to push up prices, by defrauding customers, and by lobbying the government for favors. The pharmaceutical industry is a good example. It invents life-saving drugs, and this is wonderful. But it also engages in legal maneuvers to extend monopolies on patented drugs beyond the time of expiration; and it has been known to pay generic drug makers not to market cheap versions of brand-name drugs that have gone off patent. These practices cost consumers billions — in fact, legal maneuvers to add 30 months to the patent protection of a single heartburn drug, Prilosec, are reckoned to have transferred $5 billion from the pockets of patients to AstraZeneca, the drug’s maker. It’s hardly surprising that the cost of drugs has become a political issue. To counter this less virtuous side of private-sector behavior, strong government — in this case, strong antitrust enforcement — is necessary. In August 2002 the chairman of the Federal Trade Commission, Tim Murris, announced plans for a newly vigorous focus on the machinations of the health industry.
The third weakness in the free-market ascendancy was the underestimation of the problems posed by “network” industries. Even if you set aside the whole area of public-goods regulation as beyond the reach of serious pruning, it’s still not clear that the other kind of regulation can be cut that far. Many important industries have a natural tendency to monopoly: It costs so much to create an electricity grid, for example, that competitors aren’t going to take on the incumbent by installing a whole new set of wires. These economies of scale for producers are matched in other cases by economies of scale for consumers: The value to customers of an instant messaging system or pc operating system depends on how many other people are using it or designing add-ons for it, so there’s a natural tendency to go with the industry leader. Both kinds of scale economy — for producers and for consumers — pose a challenge to believers in deregulation. If you let the market rip, the result may be monopoly and higher prices. The best course may be for government to force competition — for example, by demanding that the owner of the dominant instant messaging system allow its subscribers to communicate with friends who sign up for rival services. Or the best course may be for government to accept that a given industry is a natural monopoly — and to compensate for the absence of effective market discipline by imposing price controls.
These three weaknesses in the free-market vision — the need for public-goods regulation, the danger of private-sector rent-seeking and collusion, and the challenge posed by network industries — explain why one common view of the left/right debate is inadequate. That view is that the free-market right has had the intellectual upper hand over the past two decades, and that its failure to score clearer electoral and policy victories represented the inertia of the political system. According to this view, Newt Gingrich’s inability to roll back the state is no different from his failure to reform entitlements: Both efforts failed for lack of popularity, but both had powerful policy logic. Yet the truth may actually be otherwise. Entitlement reform is clearly necessary, and sooner or later it will have to happen. But rolling back government is different. Despite the intellectual assumptions that have dominated since the 1980s, government may not be shrinkable. And this is not just a matter of political inertia or the public’s incurable appetite for transfer payments. It reflects the market’s limited ability to function without government supervision. In the words of Alfred Kahn, the father of airline deregulation and an all-round cheerleader for market mechanisms, “successful deregulation rarely consists of total laissez-faire.”
Anti-market or pro-competition
There is no doubt what some on the left would like to do with this insight: Press for an indiscriminate expansion in the role of government. In the wake of Enron and its successor corporate scandals, John Sweeney, the afl-cio president, has railed against “the corporate crime wave that is sweeping our country”; he has denounced “profiteers,” citing not only Enron but also Microsoft. His purpose is to discredit freedom of action for all companies, even ones that operate in competitive industries where markets are the best discipline. “From his first days in office, President Bush advanced legal and regulatory changes to loosen controls on big corporations,” Sweeney says ominously, as though bigness alone is enough to merit regulation. American workers have “been had by the big corporations, the big banks and investment and accounting firms, and their big co-conspirators in the U.S. Congress.”
If this rhetoric has traction, then we are all in trouble: The labor unions’ vision of government is a menace. Many of Sweeney’s favorite causes — raising the minimum wage, blocking trade expansion — sacrifice economic growth in order to benefit members of his unions; in this sense, Sweeney is no different from corporate lobbyists who wring subsidies and favors from the government. A higher minimum wage raises the pay of poor workers but hurts the unemployed whose hopes hang on new job creation; it is a win for the poor and a loss for the very poor, as well as a growth-slowing tax on firms. Trade protectionism, similarly, is good for union members who work in threatened industries such as steel and textiles; but it comes at the expense of the rest of country, which could benefit to the tune of $200 billion annually if the world’s remaining trade barriers were eliminated (according to a study by Harvard’s Jeff Frankel). In sum, Sweeney’s intention is to use the real failings of markets as an excuse to push government interventions that have nothing to do with those failings — and everything to do with his desire to pick society’s pockets for the benefit of his constituents.
Other left-wing statements have not been more encouraging. Robert Kuttner, the co-editor of the American Prospect, was quick to sense the coming of a new anti-market zeitgeist, but in a long article in August 2002 he put an alarming gloss on it. Seizing upon the corporate scandals and the stock market’s weakness, he offered a number of reasonable points about the shortcomings of markets (for example, that they don’t provide everyone with health care) mixed in with a lot of unreasonable ones (for example, that “market provision of health care is a disaster”). The voucher movement, in Kuttner’s estimation, is merely a “money-making scheme,” and the deregulation of airlines and telecoms were both equally misguided. And then you must accept that “the ultimate manifestation of the laissez-faire hegemony is the global free market, in which speculative money flows periodically wreck the economies of developing countries, undercut labor and environmental regulation in advanced democracies, and invite the creation of tax havens for the wealthy.” Like Sweeney, Kuttner is using the recent failures of deregulation to denounce market thinking more broadly. “Laissez-faire itself is the ultimate corporate fraud,” he asserts at the outset. “The entire set of free-market era claims are due for scholarly reappraisal and broad political challenge,” he says by way of a conclusion.
This overreaching from sections of the left is all the more reason why the rest of us need to rethink our outlook. In the face of setbacks for markets, from California’s blackouts to the corporate governance scandals, the case in favor of the market needs to be restated vigorously, but it also needs to be defined more carefully than it has been. Pro-market people need to distinguish between issues and industries where an aggressive deregulatory approach is justified and those where this will only backfire. They need to accept that the right policy is often not deregulation but rather smart regulation and that the goal isn’t to cut the number of government rules but to ensure that rules make sense. Above all, they need to focus their ambitions not on promoting markets but on promoting competition, a subtle shift in language that can strengthen their position wonderfully. It is competition, after all, that spurs innovation and keeps prices down; markets are merely a means to promote that competition. And competition can be fostered by other mechanisms as well, including various types of government action. Once the intellectual leap is made from being pro-market to being pro-competition, conservatives and centrists will no longer make the mistake of praising markets too lavishly — and then giving the left an opening when it becomes evident that markets have shortcomings. If pro-market people can become tomorrow’s pro-competition people, they will be free to choose flexibly between markets and government activism, recognizing each as means to the pro-competition end.
Being pro-competition leads to robust laissez-faire positions on a number of familiar issues. The whole point of trade protectionism is that it protects domestic industries from competition: This is clearly bad. The whole point of minimum wage laws is that they protect workers from the full rigors of the competitive labor market: This is bad too. Monopolies and cartels are anti-competitive, so these should be smitten; this goes for government services as well as private industry, so school vouchers are excellent. Government subsidies, which allow businesses to stay afloat even though they can’t survive through open competition, are generally wasteful: That means we should zero out most farm payments except those aimed at protecting the environment or promoting other public goods. Business lobbyists are a menace, because their raison d’être is to win profits for their firms by securing government favors. If you are pro-competition, it’s obvious that firms deserve profits only when they acquire them by competing, because it is only under those circumstances that profits reflect their success in improving the lives of consumers.
On the other hand, being pro-competition can lead you to advocate strong government action in other areas. The most obvious is antitrust enforcement — a violation of laissez-faire that can extend to the extreme step of breaking up a company. But there are other areas in which being pro-competition may lead you to be pro-government. Creating competitive electricity markets involves the big-government step of breaking up vertically integrated utilities, forcing them to surrender control of the transmission grid so that rival generating companies get a fair chance to sell into it. Creating electricity competition also involves recognizing that the transmission grid is a natural monopoly and that transmission prices therefore must be regulated. Likewise, promoting electricity competition involves a federal drive to standardize the workings of these grids so that electricity can be traded efficiently across regions. Moreover, electricity competition will only end badly unless it’s recognized that competitive electricity generators lack natural incentives to maintain reserve capacity — the extra power plants you need to keep the grid running when the weather hits extremes or when chance puts several big plants out of commission simultaneously — so you need a complex regulatory formula to require that reserve generation gets built. For all these reasons, the push toward electricity competition shouldn’t really be called deregulation. It should be called restructuring.
In fact, a close look at many of the industries that have been “deregulated” over the past quarter-century shows a surprising amount of residual regulation. From a pro-market perspective, the residue might seem troubling, since it offends against the principle of laissez-faire. But from a pro-competition perspective, the residual regulation may or may not be worrisome, depending on how much of it serves the essential goal of promoting competition. In the case of electricity, the government functions described above are essential to competition, but that’s not true of all the roles that regulators continue to play in electricity. The clearest example of bad residual regulation is the control of retail prices, a practice that became notorious during California’s blackouts. By controlling what consumers paid for electricity, California muffled the price signals that would have prompted consumers to economize during times of scarcity. As a result, the only means of limiting consumption was to ration it: that is, to impose blackouts. Moreover, California’s retail price controls put its utilities in the position of buying power at unregulated and therefore volatile prices while selling at regulated fixed ones. When the wholesale price went up, the utilities went bust.
Or consider the airline industry. If we are clear that the aim of deregulation is to promote competition, it becomes easier to sift the various complaints from politicians and consumer groups, distinguishing the reasonable ones from the nonsense. It is ridiculous, for example, to complain that deregulation has produced smaller seats on airlines, since the smaller seats merely reflect airlines’ competitive efforts to meet the demand for lower prices. It is ridiculous, similarly, to complain that deregulation has produced bewildering price discrimination, since the low fares charged to nonbusiness passengers who are willing to fly at off-peak times and stay over for a Saturday represent consumer-friendly discounts. On the other hand, it’s fair to worry about airport congestion and late takeoffs, but here the remedy is less regulation, not more of it. Airports should be freed to auction off their takeoff slots so that busy slots become more expensive. The resulting price signals will drive some commercial passengers and many private jets to take off at other times of day or from other nearby airports.
There are, however, some things in the airline business that government needs to fix. Alfred Kahn, the father of airline deregulation cited earlier, points out that a laissez-faire approach to this industry is liable to produce unwholesome concentrations of power. An airline that controls a large share of the flights at a particular airport has a big incentive to capture still more of them, since pretty soon local passengers will be forced to pay whatever rates it charges. Because of this incentive, a strong airline would rationally pay more for a landing slot at its hub airport than would an upstart challenger that lacks its pricing power. This logic creates a situation in which some airports are indeed dominated by particular carriers; in which airlines have merged together; and in which airlines have an incentive to engage in predatory pricing to wipe out competitors. As a result, at least some pro-competition economists believe that antitrust enforcement should have been stronger in the airline business than it has been. And, despite his anti-regulatory instincts, Kahn has proposed government action to head off the threat of predatory pricing. In his elegant formulation, an airline that cut its prices and then saw a competitor withdraw would be required to maintain those low rates for two years — enough to deter the elimination of rivals through loss-making prices. Again, the same principle guides this call for government intervention: Competition matters more than deregulation.
Or consider the telephone industry. To promote competition, it has been necessary to adopt an aggressive regulatory stance toward the “Baby Bells,” the incumbent local monopolies. This aggression, admittedly, has met with mixed success. It has worked in spurring the quick diffusion of the internet: The Bells were prohibited from charging extra to internet users or providing dial-up internet connections themselves, so hundreds of internet service providers sprang up and consumers got rock-bottom prices. In the early stages of the process, internet access cost about a fifth of the rate charged in Europe, where national phone companies were allowed to dominate the business; not surprisingly, the takeup rate in the United States was roughly twice as high as in Europe. On the other hand, the regulatory effort to force voice telephone competition in the local market has worked less well. Rather than forcing the Bells out of this business (which would have been extreme, since it is their core business), the strategy was to allow the Bells to stay in it but to require them to rent out their lines to rivals who wanted to compete for the Bells’ customers. Not surprisingly, the Bells refused to shoot holes in their own feet; they devised subtle ways of keeping competitors off their lines, with the result that the Bells still control more than 90 percent of local retail customers and (because of this prolonged monopoly) prices have not fallen. But whatever this failure, it’s likely that some form of regulation of local telephone services is necessary — either the sort that attempts to force competitive discipline into this monopoly market or the sort that accepts the monopoly as given and regulates its prices. Laissez-faire is not an option — except perhaps in urban areas where wireless phone services are in a position to challenge the Bells’ monopoly.
Deregulation vs. restructuring
In sum, there aren’t many industries where it’s enough merely to cut redundant red tape, then wait while prosperity advances. Some of the early deregulations may have been a bit like that: The pioneers who busted the old trucking cartel had the satisfaction of seeing the number of firms in the business shoot up from 10,000 to 450,000 over the two ensuing decades. But the easy harvesting of the first low-hanging fruit did not mean that the next round would be simple. In most industries, it turns out, cutting back one kind of government regulation requires installing a different kind in its place. “Deregulation” turns out to be a less accurate term than “restructuring.” And the test of its usefulness is the extent to which competition is enhanced.
If this sounds obvious, it is in a way; regulatory experts have been making variations on this point for years. Yet the distinction between being pro-market and pro-competition is frequently lost in the debate in Washington, where countless political struggles are cast as battles between the forces of the market and the forces of big government. Almost as often, losing sight of the pro-market/pro-competition distinction has placed centrists and conservatives on the weaker side of policy arguments. This is what seems to have happened during the recent battle over financial regulation following Enron.
From a pro-competition perspective, the issue at stake in that battle was the competition to raise capital. This can take place efficiently only if companies make reliable financial disclosures, allowing savers to make judgments as to which firms will use their money most productively. If companies can get away with false disclosures, they may attract more capital than they deserve, allowing them to buy up rivals that might be better run; in this way, skewed competition in the capital market can smother fair competition in the goods market. For this reason, it’s important that financial disclosures be fair; but, as Alan Greenspan conceded, there is no market mechanism to ensure that fairness. The auditors who are supposed to do the job get paid by the managers whose books they oversee; they have little incentive to blow the whistle on them. It’s therefore essential that government look over the shoulders of auditors to make sure they’re doing their job; and, because such oversight can never be perfect, it’s important to prohibit practices that increase the auditors’ incentives to be soft on management, such as the practice of collecting consulting fees from those same managers. Equally, it’s essential to transfer the job of writing audit standards from the auditors’ own lobby to an independent regulator; otherwise auditors will fill the standards with vague phrases and loopholes, making regulatory efforts to enforce them more or less meaningless.
And yet, for some reason, it took many market supporters a long time after the Enron collapse to accept that pro-competition principles point to tough regulation of auditors. Greenspan’s support for reform came only on the eve of its passage; until then, he had argued that markets could largely be trusted to correct auditors’ shortcomings without action from Congress. The Bush administration, similarly, shied away from serious reform in the first half of 2002; only when the momentum of successive scandals swept the reform movement to triumph in Congress did the administration declare itself a convert. The same early resistance to reform was even more pronounced among several Republican heavyweights in the Senate, notably the former economist Phil Gramm; in May, Gramm and his allies attempted to drown the Democratic bill by proposing 123 amendments to it. In the House, the Republican caucus lined up behind a much weaker reform proposal that would, among other things, have left auditors free to preserve the loopholes in their professional standards. At the Securities and Exchange Commission, likewise, Republican-appointed chairman (since resigned) Harvey Pitt came out in favor of limited reform. The Chamber of Commerce, one of the principal lobby groups for market causes such as freer trade, utterly lost touch with its senses. Its president, Thomas Donohue, put out a letter accusing the Senate reformers of a “knee-jerk, politically charged reaction” to the Enron scandal and of posing a threat to “informed market decision-making.”
In all these cases, pro-market forces seem to have missed the possibility that government activism might be the best way to promote vigorous and open competition. That failure, more than any other single episode, animates the argument of this essay. The post-Enron reform battle gave a huge boost to the anti-market skeptics of the left, whose arguments menace our prosperity; it was a boost that might have been avoided if conservatives and centrists had been quicker to embrace a robust government response to the Enron crisis. But many in the economic mainstream were slow to realize this because their initial reaction was to fall back on an instinctive belief in markets and hostility to regulation. It is that instinct that must be reexamined, both in light of the Enron experience and in light of the natural limits to the deregulatory ambitions of the Reagan/Thatcher period. That reexamination, I suggest, will resolve itself in a few simple ideas. Markets are only one means to competition, and there are others. Markets work sometimes, and other times not. But competition is always to be desired. For competition is a constant spur: to innovation, to invention, to ever more efficient techniques of production, and therefore to prosperity.
