GOVERNMENT’S ROLE IN A 21ST CENTURY
MARKET ECONOMY
John Kwoka
Finnegan Distinguished Professor of Economics
Northeastern University
November 30, 2011
OVERVIEW
 U.S. is fundamentally a market economy
 1-2% of GDP from government enterprises
 post office
 municipal services
 3-4% substantially regulated industries
 95% private, but still subject to
 antitrust laws
 environmental and safety regulation
 Much less government ownership, regulation than other
economies
 Much less than in the past in the U.S.
TYPES OF INVOLVEMENT
Three broad types of government involvement in industries
 Conventional industry regulation
 Competition/antitrust policy
 Industries in crises
(1) INDUSTRY REGULATION
 Conventional industry regulation where “free market” would
mean monopoly power
 Classic scenario involves “natural monopoly”
(1) INDUSTRY REGULATION
 Conventional industry regulation where “free market” would
mean monopoly power
 Classic scenario involves “natural monopoly”
REGULATORY POLICY
 Regulated natural monopoly industries:
 local telecom (but not long distance)
 electricity distribution (but not generation)
 pipelines
 Nature and degree of regulation change over time
 Regulation now more flexible (“light handed”)
 Degree of regulation varies with needs of time
 size of natural monopoly sectors
 emergence of competition
(2) ANTITRUST POLICY
Antitrust enforces rules of competitive game
 It is reactive to specific types of problems
 Examples
 Conspiracies to raise price
 Cartel of flat panel display manufacturers
 Use of monopoly power to deter entry
 “Reverse payments” by drug companies
 Control over mergers for market power
 AT&T - T-Mobile
(3) CRISIS POLICY
 Other need for government involvement derives from
companies and sectors in crisis
 Excesses and imbalances
 Transformations and dislocations
 Examples of such industries
 S&Ls in 1980s
 Airlines after 9/11
 Auto industry after 2008
 Banking and financial institutions
REGULATORY CYCLE S IN HISTORY
 Regulation has significantly increased at certain times
 Then tends to recede until new cycle starts
 Late 1800s saw rise of railroads and national markets
 Prompted concern over monopoly abuses by large railroads
 Let to increased oversight and involvement
 Interstate Commerce Commission
 Also, Sherman Antitrust Act
 Over time, as problems eased and more competition emerged,
some retreat of regulation
THE CYCLE REPEATS
 Retreat tends to unleash forces that cause next round of excesses,
imbalances
 Thus cycle repeats itself
 Thus, stock market crash, Great Depression on 1920s-1930s
 Those crises predictably led to greater involvement by government
 Utility abuses led to Federal Power Commission
 Telecom monopolies prompted Federal Communications Commission
 Securities abuses led to Securities and Exchange Commission
 High water mark of regulatory involvement during 1960s-70s
 10-12% U.S. economy either public or heavily regulated
PUSHBACK AGAINST REGULATION
 Extensive regulation prompted free market critique in 1960s-70s
 Spearheaded by laissez-faire economics of Chicago School
 Argument was that market can discipline itself
 Led to successive rounds of deregulation
 First round began in 1970s-80s with “easy” cases
 Airlines, trucking, natural gas
 In 1980s-90s moved on to more challenging cases
 Telecom, railroads, depository institutions
 Considerable benefits from much of this deregulation
 Generally lower costs and prices, greater choice
 Some problems (e.g., railroads, S&Ls)
THE LATEST CYCLE
 Deregulation movement of 1990s-2000s focused on new industries
 Electricity
 Banking and financial institutions
 These were hardest cases due to tricky underlying circumstances
 Electricity required on-going coordination and interconnection
 Banking and finance required good information, correct incentives,
good governance
 Early warning signs of trouble
 Electricity crisis in California
 Accounting abuses at Enron, WorldCom, Tyco
 Collapse of Long-Term Capital Management
 Then collapse of major financial institutions in 2008
GOVERNMENT IN CRISIS ECONOMY
 Financial crisis of 2008, followed by Great Recession swept up
several sectors:
 Banking and financial institutions, of course
 Also autos, housing, and others
 Result was again massive government intervention
 Provides opportunity to reflect on government’s role
 Also to see how this fits into regulatory/deregulatory cycle
TALE OF TWO BAILOUTS
 Consider U.S. auto industry
 Problems pre-date financial crisis
 Root cause was lack of competition among domestic “Big 3"
 Results were progressive losses of jobs, retirement protections
 Also market shares, profits, shareholder value
 And then the credit crisis and recession of 2008 hit
 Sales dropped by 50-55%
 Clearly unsustainable
AUTO INDUSTRY BAILOUT
 Auto industry prompted vigorous political argument
 Free market advocates contended companies should be allowed to fail
 Pragmatists contended that economic and social consequences huge
 Bush Administration authorized interim loans in 2008
 Obama Administration announced its plan in March 2009
 Involved several assistance programs
 Supplier Support Program
 Warranty Commitment Program
 Director of Auto Recovery
 Total cost about $35 B
STRINGS ATTACHED
 Government forced both GM and Chrysler into bankruptcy
 Took equity position in both companies, providing capital
 But companies were forced to make fundamental changes
 Plants had to be closed, products eliminated
 Chrysler told it had to find partner–and it found Fiat
 GM told it would have to cut divisions–and it did
 UAW told it would lose jobs, take pay cuts–and they did
 Dealers told that many would close–and many were
 Bondholders and stockholders lost money
 Executives responsible for condition of companies removed
 CEOs of GM, Chrysler fired
 Long-time passive board members replaced
AUTOS: THE “HARD” BAILOUT
 GM and Chrysler have now recovered in marketplace
 And at same time, government funds largely repaid
 By any reasonable definition, auto bailout successful
 Important lessons of this bailout:
 (1) Take firm control of companies
 (2) Hold people responsible
 (3) Transform companies
 (4) Get out ASAP
 Save the institutions (if worth saving), but ensure that the
responsible individuals do not benefit or get to repeat
BANKS: THE “SOFT”BAILOUT
 Crisis of 2008 prompted need for massive government
intervention and bailout of banks, financial institutions
 Sector had been turned loose by deregulation
 Result was to unleash incentives without oversight or penalty
 Included largest mortgage company in country
 Also, largest insurer in country
 And some of largest banks in country
WHAT DID AND DID NOT HAPPEN
 Might expect government to step in and rescue companies
 Then control bad behavior via regulation, restructuring, removal
 Government did step in with massive amounts of taxpayer money
 But there was no substantial regulation, restructuring, removal
 No substantial re-regulation
 Dodd-Frank being compromised
 No restoration of Glass-Steagall
 Volcker rule inadequate
 No systematic holding of companies accountable
 Overturning of SEC deal with Citigroup is notable exception
 No breakup of major banks
 Now larger than before
 No systematic removal of bad actors
 Executives never changed
RESULT OF BAILOUT
 Banks now even larger, more concentrated
 Top 10 banks now have 58% total banking assets
 Up from 44% in 2000, 24% in 1995
 Top 6 banks have assets totaling 63% of GDP
 Up from just 17% in 1995
 No economic evidence largest banks need to be so big
 But clear evidence of their potential dangers: “systemic risk”
 Individuals not held fully accountable
 Head of Countrywide cashed out 100s of millions in stock
 Paid $67M to settle SEC charges without admitting guilt
 Head of AIG who earned $150M over six years
 Settled SEC charges for $15M without admitting guilt
 Head of Goldman Sachs earned $54M in 2007
 Still there
BANKS VS. AUTOS
 Incentives for bad bank behavior have not been controlled
 Structure, incentives, even some personnel remain in place
 Predictable that banks, financial institutions will do this again
 Early evidence from MF Global
 Contrast autos, where companies, products, executives changed
 Scarcely recognizable compared to pre-bailout
 This is the fundamental flaw of a Soft Bailout
 Institutions have been saved, but behavior unchanged
 Regulatory cycle where tough regulation follows excessive
deregulation has not happened
PROPER ROLE OF GOVERNMENT IN 21ST CENTURY
PROPER ROLE OF GOVERNMENT IN 21ST CENTURY
Man Controlling Trade