Archive for January, 2011
In the last couple of months, I wrote three posts [1,2,3] that tried to explain our recent economic experience as a consequence of the increased rent-seeking that goes along with a prolonged period of stabilisation. My analysis was restricted to the post-2008 period which has thrown up some anomalous patterns that cannot be explained by conventional macroeconomic theory (Keynesian or Monetarist). In particular, I focused on two patterns: the disconnect between corporate profitability and unemployment (highlighted by the rapid rise in labour productivity), and the fact that this increased profitability has so far only led to increased corporate cash balances and not to increased investment. Both these patterns, although unique, still possess an ancestral lineage that can be traced back to the Great Moderation. Recoveries have been becoming increasingly jobless since 1991 and the “corporate savings glut” has been a common feature since atleast the 90s in the United States, Europe and Japan. To some commentators (notably Michael Mandel and Peter Thiel) our current problems are the result of a prolonged innovation deficit, a view that has been expanded upon by Tyler Cowen in his excellent new book ‘The Great Stagnation’. In my opinion, this innovation deficit is atleast partly driven by increased Olsonian rent-seeking.
It’s difficult to prove that innovation has fallen due to increased rent-seeking. How can we measure the innovation that could have been in the absence of special interests? One approach is to look for industries where the developed economies of the United States, Europe and Japan are not at the forefront of innovation. Tyler Cowen correctly notes that much of the growth in developing economies comes from “catch-up” growth but this is not always the case. As the Economist notes, some of the best innovation in frugal healthcare is now coming out of China and India and much of this innovation has been slow to make its way into the developed economies. The Economist identifies the price-insensitivity of developed markets and regulatory red tape as reasons but this is an incomplete explanation. The same dynamic is visible in financial services where almost all the genuine innovation is taking place in developing economies (e.g. mobile banking in Africa and India), and although financial services has its share of regulatory red tape, it is certainly not price-insensitive.
A hint as to the real problem can be found in the unusually honest comment from a GE executive in the Economist article who admits that “the sales and distribution systems at firms like his, set up to sell $100,000 scanners, are ill-suited to sell versions at a tenth of that price”. As [amazon_link id=”0060521996″ target=”_blank” ]Clayton Christensen[/amazon_link] and James Utterback identified long ago, incumbent firms are almost never responsible for disruptive product innovations. These are inevitably originated by new entrants into the industry. As Christensen noted, disruptive innovations often result in worse product quality in the short term and drastically reduced profit margins that cannot sustain the incumbents’ cost structure. To expect an incumbent in this situation to take a leap on an uncertain innovation that at best will result in dramatically reduced profits is unrealistic. This highlights the damage done by the pervasive presence of special interests in any industry. Rent-seeking becomes the dominant niche that outcompetes all exploratory innovation by new entrants.
Despite this rather gloomy analysis, there is a silver lining. In the long run as the disruptive innovation becomes established, it is inevitable that the technology will spread even to the most rent-infested economies. This highlights the benefits of nation-level diversity in the global economy and the folly of pursuing homogeneity in global regulatory regimes. As Kenneth Boulding said: “If you have only one system, then if anything goes wrong, everything goes wrong.” As long as the “Olsonian cycles” of the major economies are not perfectly synchronised, the global economy may be able to maintain a healthy pace of innovation albeit in a stop-start manner.
In two recent posts [1,2], Scott Sumner disputes the role of financial rent extraction in increasing inequality. His best argument is that due to competition, government subsidies by themselves cannot cause inequality. A few months ago, Russ Roberts asked a similar question: “If banking is a protected sector that the government coddles and rewards, why doesn’t competition for banking jobs reduce the returns to more normal levels?” This post tries to answer this question. To summarise the conclusion, synthetic rent extraction markets are closer to an ‘Ultimatum Game’ than they are to competitive “real economy” markets.
Scott brings up the example of farm subsidies and points out that they only reduce food prices without making farmers any richer – the reason of course being competitive food markets. In my post on inequality and rents, I used a similar rationale to explain how reduced borrowing costs for banks in Germany (due to state protection) simply results in reduced borrowing costs for the Mittelstand. So how is this any different from the rents that banks, hedge funds and others can extract from the central bank’s commitment to insure them and the economy from tail events? The answer lies in the synthetic and rent-contingent nature of markets for products such as CDOs. The absence of moral hazard rents doesn’t simply change the price and quantity of many financial products – it ensures that the market does not exist to start with. In other words, the very raison d’être of many financial products is their role in extracting rents from central bank commitments.
The process of distributing rents amongst financial market participants is closer to an ultimatum game than it is to a perfectly competitive product market. The rewards in this game are the rents on offer which are limited only by the willingness or ability of the central bank to insure against tail risk. To illustrate how this game may be played out, let us take the ubiquitous negatively-skewed product payoff that banks accumulated during the crisis – the super-senior CDO tranche1. In order to originate a synthetic super-senior tranche, a bank needs to find a willing counterparty (probably a hedge fund) to take the other side of the trade. The bank itself needs to negotiate an arrangement between its owners, creditors and employees as to how the rents will be shared. If the various parties cannot come to an agreement, there is no trade and no rents are extracted. The central bank commitment provides an almost unlimited quantity of insurance/rents at a constant price. Therefore, there is no incentive for any of the above parties to risk failure to come to an agreement by insisting on a larger share of the pie.
In a world with unlimited potential bank stockholders, creditors and employees and unlimited potential hedge funds, the eventual result is unlimited rent extraction and state bankruptcy. The only way to avoid inequality in the presence of such a commitment is for every single person in the economy to extract rents in an equally efficient manner – simply increased competition between hedge funds or banks is not good enough. In reality of course, not all of us are bankers or hedge fund managers. Nevertheless, it is troubling that the evolution of many financial product markets over the past 30 years can be viewed as a gradual expansion of such rent extraction.
Although I’ve focused on synthetic financial products, the above analysis is valid even for many of the “real” loans made during the housing boom. In the absence of the ability to extract rents, many of the worst loans would likely not have been made. The presence of rents of course meant that every party went out of their way to ensure that the loans were made. It is also worth noting that although I have explained the process of rent extraction as a calculated and intentional activity, it does not need to be. In fact, as I have argued before [1,2], rent extraction can easily arise with each party genuinely believing themselves to be blameless and well-intentioned. The road to inequality and state bankruptcy is paved with good intentions.
- In some cases, the super-senior itself was insured with counterparties such as AIG or the monolines making the payoff even more negatively skewed [↩]