The United States of Cartels

Tuesday, May 29, 2012

As the economies of both the United States and the European Union sputter along, political leaders continue to put forward the false choice between austerity and growth, without attending to the serious structural issues that have long plagued both of these major economies. In a previous DI column, I urged that the liberalization of labor markets was one key element of overall economic reform. Labor markets also play a critical role in understanding yet another overdue structural reform that deals with the distribution of power in both the U.S. and the EU: the need for dismantling long-standing cartel arrangements that cripple innovation and competition.

One distinctive feature of both the United States and the European Union is that they operate under a two-tier government structure. The U.S. federal system assigns responsibilities to both the federal government and the individual states. The EU does much the same thing. There are, of course, vast differences between the two systems. Most conspicuously, in the United States, no state has an independent voice in foreign affairs, as those issues are all controlled from the center. The European Union is far looser, given the long-standing national differences on foreign relations and military affairs among its member states. Accordingly, those issues remain safely beyond the control of the European Commission, which—operating out of Brussels—nonetheless exerts extensive control over economic operations within the EU.

 Illustration by Barbara Kelley

For all their differences, one striking similarity between the U.S. and the EU is the dangerous transformation in the relationship between the overarching government entity and its member states. To start with the United States, the original constitutional design had two key elements, which were associated with the power to regulate commerce. Recall that the commerce power, now under litigation in connection with the health-care mandate of the Patient Protection and Affordable Care Act, allows Congress to regulate commerce “with foreign nations, among the several states, and with the Indian tribes.”

That short command concealed a schizophrenic attitude toward trade. The control over foreign commerce, for example, was introduced, as Alexander Hamilton explained in Federalist No. 11, with economic protectionism as a key objective: “By prohibitory regulations, extending, at the same time, throughout the States, we may oblige foreign countries to bid against each other, for the privileges of our markets.” Yet at the same time, on the domestic front, the Commerce Clause was thought to allow Congress to pull down trade barriers in order to allow the U.S. to operate as a common market.

Ironically, Congress has not done much to achieve that end, but the U.S. Supreme Court has. By a set of decisions that are textually dubious, but economically astute, it has invoked the “dormant” commerce power to consistently strike down state restrictions on the flow of interstate commerce, unless those regulations are justified to guard against unhealthy or dangerous products. Under the constitutional arrangements as they stood until the New Deal Revolution of 1937, the federal government did not have the power to regulate productive activities—manufacture, mining, agriculture, even local transportation—within the states. These were subject exclusively to state regulation, which had the desirable effect of introducing a competitive federalist regime, whereby those businesses that did not like the regulatory regime under which they worked were free to move elsewhere.

Give them credit. The New Dealers knew how to put cartels together.

The right of any business to exit a hostile state was far from perfect. It did not, for example, protect landowners whose value in (immovable) real estate could be largely expropriated by local zoning rules. But it did put downward pressure on the efforts of state governments to create various barriers to trade to prop up cartels, which typically result in social dislocations, as the gains to participants are invariably smaller than the losses inflicted on consumers.

The great Progressive constitutional revolution of 1937 transformed the structure of the United States from a domestic free trade zone into a national market subject to the power of a single regulator to set prices in that market—i.e. a cartel. In polite company, of course, no one uses the word cartel because it has negative connotations. The euphemism for the cartelization of the market is “the stabilization of prices,” which has now become a national objective. By way of example, consider Justice Sandra Day O’Connor’s zombie-like recitation of the purposes of the Agricultural Marketing Agreement Act of 1937 in the 1984 case of Block v. Community Nutrition Institute:

In the early 1900's, dairy farmers engaged in intense competition in the production of fluid milk products. To bring this destabilizing competition under control, the 1937 Act authorizes the Secretary to issue milk market orders setting the minimum prices that handlers (those who process dairy products) must pay to producers (dairy farmers) for their milk products. The "essential purpose [of this milk market order scheme is] to raise producer prices,"), and thereby to ensure that the benefits and burdens of the milk market are fairly and proportionately shared by all dairy farmers.

After this glowing account, she notes that the stabilization scheme had to be “approved by the handlers of at least 50% of the volume of milk covered by the proposed order and at least two-thirds of the affected dairy producers in the region.” Note how the logic of cartels is then backed up by an appeal to the political participation of farmers in the scheme. For the Roosevelt New Deal, these elections were a key element in distinguishing cartels from monopolies, the latter having no place for community participation.

What is overlooked in the constant refrain of stabilization and participation is, of course, the negative effects that these arrangements have had and continue to have on consumers: They must pay more because government backing eliminates the destabilization of cartels that would allow prices to return to their competitive level. Once prices are stabilized for the exclusive benefit of farmers, the inherent risk of variable agricultural prices (often controlled by the weather) is not magically removed. Rather, it is transferred by government fiat to the rest of society that bears the burden either in the form of higher taxes or higher prices. But Justice O’Connor concludes that consumers have no right to challenge the orders issued pursuant to the 1937 act, lest they bust up the cozy arrangement. The New Dealers knew how to put cartels together.

Why is the European Community dictating labor policies to its member states?

The EU has gone through a similar and equally destructive transformation. In its former incarnation as the European Community, the EC achieved most of the benefits of a free trade zone in goods and services, subject, of course, to the protectionist wall that was erected against goods and services from outside the EC. But with its weak powers, the EC did not have the ability to cartelize and regulate local industry. When the European Community became the European Union, it transferred a large amount power from its member states to the savvy bureaucrats in Brussels.

One key concept that drives cartelization is harmonization. Thus Article 136 of the EC Treaty takes as its mission “the promotion of employment, improved living and working conditions, so as to make possible their harmonization while the improvement is being maintained, proper social protection, dialogue between management and labour, the development of human resources with a view to lasting high employment and the combating of exclusion.” These “Fundamental Social Rights of Workers” were adopted in 1989. Thereafter, basic European institutional arrangements required both the EU and its member states to “implement” the directives that came from the center.

As is so often the case, the announcement of lofty ends presages disastrous results. “Harmonization” is another antiseptic term that masks coercion from the center: It lets Brussels set EU standards to which all member states have to comply. Harmonization has caused a similar transformation to take place in the EU as occurred in the United States after 1937. The EC did some good by opening up all member states to competition. The EU does the exact opposite by allowing the center to dictate labor policies for all of its member states. That maneuver will reduce cross border competition in labor regulations, for there are few—if any—instances in which the EU harmonizes down by saying to member states, for example, that they cannot impose anti-discrimination, minimum wage, or maximum hour laws.

The manifesto’s telling words—“proper social protection” and “combating exclusion”—represent an implicit rejection of the view that competition in labor markets represents the best way in which to secure the long-term social improvements that Article 136 hopes to introduce. There is no alternative world in which massive labor market rigidities are compatible with high levels of employment. Hence, the unemployment rate in the seventeen-nation Euro area rose last month from 10.8 to 10.9 percent, with Spain the worst offender at 24 percent, and Greece not far behind at 21 percent.

The overall situation would be far better if the EU just closed up shop on labor (and just about everything else). Member states should be happy to bear the costs of government regulation in the effort to create cross-border markets. But the balance of advantage shifts when harmonization through regulation displaces economic competition.

It is, of course, worth stressing that this basic framework has previously been on the books, both in the U.S. and the EU, so no one can point to these institutional arrangements as the sole source of the major dislocations. Clearly, other forms of government regulation have contributed to the overall malaise. But at the same time, it is worth noting that the pace of government regulation under national rule does not depend solely on the powers that are conferred on central governments. It also depends on their willingness to use them. On that score, the recent developments on both sides of the Atlantic point to an increased pace of regulation that only magnifies the effect of the major institutional mistakes in both areas.

The hard question is how to plot an escape from the descent into the quagmire of such regulations, as governments in both places face the strong temptation to double down on their protective policies; jingoist responses are all the rage in bad economic times. The necessary first step for any solution is recognizing the conceptual confusions that caused the problems in the first place. So long as we are content to use seductive and positive sounding terms like “price stabilization” and “harmonization” to cover up serious defects in institutional structure, no serious progress is possible. Instead, we shall continue to observe what everyone thought large supra-national policies would cure: higher levels of political polarization and social unrest.