Bill Totten's Weblog

Friday, February 13, 2009

Free Market Myth

Regulation is everywhere. Let's choose who benefits.

by Dean Baker

Boston Review (January / February 2009)

The extraordinary financial collapse of recent months has been commonly described as a testament to the failure of deregulation. The events are indeed testament to a failure - a failure of public policy.

Blaming deregulation is misleading.

In general, political debates over regulation have been wrongly cast as disputes over the extent of regulation, with conservatives assumed to prefer less regulation, while liberals prefer more. In fact conservatives do not necessarily desire less regulation, nor do liberals necessarily desire more. Conservatives support regulatory structures that cause income to flow upward, while liberals support regulatory structures that promote equality. "Less" regulation does not imply greater inequality, nor is the reverse true.

Framing regulation debates in terms of more and less is not only inaccurate; it hugely biases the argument toward conservative positions by characterizing an extremely intrusive structure of, for example, patent and copyright rules, as the free market. In the realm of insurance and finance over the last two decades, calls for deregulation have been cover for rules tilted starkly toward corporate interests. And the recent change in bankruptcy law, hailed by conservatives, requires much greater government involvement in the economy.

False ideological claims have circumscribed the public debate over regulation and blinded us to the wide range of choices we can make. Without these claims, what would guide regulatory policy? What kinds of choices would we have?

* * *

Patent and copyright protection are good examples of government policies obscured in the debate. They are forms of regulation, not elements of a "free market".

It does not matter that we call patents and copyrights "property" or even that we have a clause in the Constitution that authorizes Congress to grant patents and copyrights. Suppose autoworkers were given a property right to a job in the automobile industry, a right they could even sell. Would anyone say that this right to a job is part of the free market?

Patents and copyrights are government-granted protections designed for a specific public purpose, as stated in the Constitution: "to promote the Progress of Science and useful Arts". But granting intellectual property rights is one of many possible mechanisms for accomplishing this important public goal. Whether patents and copyrights are the most effective mechanisms for the promotion of the arts and sciences is an empirical question. And the answer could be different depending on the specific social and economic circumstances. However, we cannot have a serious discussion of the relative merits of patents and copyrights until we recognize that these are public policies and not intrinsic features of the free market. Debates about both patent and copyright have been hugely distorted by the failure to recognize this obvious fact.

In the case of patent protection, policy disputes arise most frequently with regard to prescription drugs. If drugs were sold in a competitive market (that is, without patent protection), the overwhelming majority of drugs would sell for just a few dollars per prescription. Wal-Mart and other major drug store chains now sell most generic drugs for less than $10 per prescription - we know these drugs can be manufactured safely and sold profitably at low prices.

The drugs available as generics are not chemically distinct from their brand-name counterparts that often sell for hundreds of dollars per prescription. The only difference is that the latter, as a group, enjoys a government-guaranteed monopoly. Patents constitute a government policy that effectively raises drug prices by several thousand percent above the free market price.

Recognizing this should be the starting point in any policy debate. The next question is whether this policy for supporting innovation is the best mechanism for financing the research and development of new drugs. It clearly is not the only one.

The government could, for example, support drug research through a prize system in which it buys drug patents and then places them in the public domain so that newly developed drugs could be manufactured and sold as generics.

When we sweep away ideology, we see that it is a debate between two regulatory strategies for keeping drug prices down.

Alternatively, the government could pay for the research upfront and make all research findings and patents fully public. It already spends $30 billion a year financing biomedical research through the National Institutes of Health, an amount almost as high as the pharmaceutical industry claims to spend on its research. NIH research is highly respected, with almost all observers agreeing that the money is, on the whole, extremely well spent. While the NIH focuses on basic research (it also does some later-stage drug research, including clinical testing), there is no obvious reason why the government could not simply double its commitment to biomedical research in order to replace the research and development currently supported by grants of patent monopolies.

But the government may wish to use a different mechanism to encourage drug development. It may choose to establish a small number of master contractors, who would then contract out the awarding of research funds so as to minimize the potential for political interference. Regardless of the structure a particular program would take, expansion of direct funding is clearly feasible.

There would also be large public benefits in addition to lowering the price of drugs to their marginal cost. Eliminating huge monopoly rents associated with drug patents would take away the incentive for drug companies to push drugs in cases where they may not be especially beneficial, or even potentially harmful. Nor would there be incentive to conceal research findings that indicate a drug's weak performance. Furthermore, by placing all research findings in the public domain, so that scientists can quickly benefit from the research done by others, the process of drug innovation would likely accelerate.

Whether a patent-buyout system or direct public funding would be preferable to the current patent system is obviously debatable; the point is that patent is just one mechanism among many that could facilitate prescription-drug research. And it is one that involves granting monopoly rents to large drug companies.

It is important to establish that patents are a form of regulation because there are many venues in which the regulation of prescription drugs has been a major issue, with those who would see prices fall cast as opponents of the free market. For example, the ongoing push to have Medicare bargain for lower prices for drugs bought as part of its prescription drug benefit is widely viewed as interference in the free market. Even The New York Times and other highly respected media outlets often present the argument about Medicare-negotiated drug prices as a debate between proponents of free markets and of government intervention. When we sweep away ideology, we see that it is a debate between two regulatory strategies for keeping drug prices down.

* * *

There is a similar story with copyrights, although the economic waste is even larger and the enforcement measures even more perverse. In the Internet age, almost any printed or recorded material - music, movies, books, video games - can be instantly transferred anywhere in the world at almost no cost. However, rather than allowing the public to enjoy the full benefit of this technology, the government has created a dizzying array of new laws and restrictions designed to make it more difficult, and legally more risky, to pass along material that is subject to copyright protection.

As with drug patents, copyrights serve an important public purpose. They provide an incentive to produce creative and artistic work. But to protect copyright, the government has imposed an aggressive sanction regime even for seemingly minor offenses. In one case, a woman in Minnesota faced a fine of more than $200,000 for allowing people to download music from her computer. Universities have been told to police dorm rooms to ensure that students are not downloading material in violation of copyright, and they have been encouraged to conduct classes teaching that it is wrong to make unauthorized copies of copyrighted material.

The government has repeatedly prohibited the production of various types of hardware until protections could be installed to prevent the duplication of copyrighted material. It has banned the development of software that can break through copyright protections. In one case a Russian computer scientist was arrested by the FBI after a conference presentation in which he described a way to get around a form of copyright protection.

The list of extraordinary government measures that have been developed to enhance copyright protection is lengthy. Remarkably, these measures are never described as forms of government regulation. They are treated as enforcement measures necessary to protect copyright. However, just as patents are not the only way to encourage innovation, a government-granted monopoly with extensive rules and heavy-handed enforcement is not the only way to promote creativity.

A vast amount of creative and artistic work is already supported through mechanisms that do not depend on copyright protection. Private foundations are a major alternative source of support, as are the limited funds available through public programs such as the National Endowments for the Arts and Humanities. Colleges and universities are probably the largest source of funding not dependent on copyright. Professors are expected to do research and writing in addition to their teaching responsibilities.

It is easy to envision mechanisms to expand support for creative and artistic work outside the copyright regime. For example, it would be possible to design a modest tax credit for individuals who either support creative work directly or contribute to organizations that support such work. The credit could be modeled after the tax deduction for nonprofits or charities. Even a modest tax credit (for example, $100 per person) - which taxpayers could allocate to an artist, writer, musician, or film producer of their choice - would likely be sufficient to fund almost all of the work currently supported by the copyright system.

To be fair, rarely does either side argue against regulation as such. The real issue is the structure of regulation and its impact on economic outcomes, especially income distribution.

Alternatives to copyright are feasible and probably far more efficient than the copyright system. And they would replace a gigantic array of enforcement measures that can themselves be seen as unnecessary forms of government intervention into the economy.

* * *

A final example of excessive government regulation, never discussed as such, is the bankruptcy-reform bill that passed Congress in 2005. This bill substantially strengthened the conditions imposed on people seeking bankruptcy protection, making such protection a much less attractive option.

The public debate over the bill dealt in liberal/conservative caricatures that completely misrepresented what was at stake. The liberal argument relied on sympathy for the people seeking bankruptcy; it drew on studies showing that the great majority of people seeking bankruptcy had not been spendthrifts who deliberately ran up huge credit card debts, but rather had fallen on hard times as result of job loss, medical emergencies, or family breakup. The opponents of stricter conditions argued that these people needed and deserved the break that bankruptcy allows.

The conservative argument centered on individual responsibility. No one forced anyone to take on debt; these people voluntarily chose to do so. Everyone knows that bad things can happen. Those seeking bankruptcy protection should have taken precautions.

This version of bankruptcy reform undoubtedly resonated with those inclined to accept that people succeed or fail largely as a result of their own actions, but, most importantly, it obscured the real issue that the bill addressed: to what lengths should the government go to collect unpaid bills? The party seeking the aid of the government in this story is the creditor, not the debtor.

Under the preexisting bankruptcy law, creditors could lay claim to most of the debtors' assets and in some cases place liens on future earnings. The new law hugely expanded the creditors' claims on future earnings. This means that the government will be far more involved in bill collection in the future than it has been in the past, possibly monitoring the wages of millions of individuals in bankruptcy who still have debts to creditors. (For those who worry about the negative incentives caused by taxation, it is worth noting that having money deducted from paychecks to pay creditors provides the same disincentive to work.)

The individual-responsibility line could have been applied just as validly to the creditors in this story as it was the debtors. Part of being a successful business involves knowing under what circumstances to extend credit. No one forced businesses to extend credit to the people who subsequently declared bankruptcy. They exercised bad judgment in extending credit to people who were not good credit risks. Why should the government step in to help businesses that fail to assess credit risk? The ideological battle around the bill was a distraction. It was an effort to get the government more actively involved in helping the banks. It's that simple.

Other cases in which the conservative position arguably requires more government involvement in the economy than the liberal position abound. For years Ben and Jerry's Homemade has fought attempts by state governments to ban labeling dairy products as free of recombinant bovine growth hormone. Some pressure groups associated with the dairy indutry argue that the rBGH-free label implies that bovine growth hormones are harmful, which has not been established by the Food and Drug Administration. Of course, Ben and Jerry's Homemade is not trying to prevent its competitors from assuring the public that their ice cream is safe. It is trying to make a truthful claim about its own ice cream.

In the same vein, the Department of Agriculture (USDA) recently prohibited a meatpacker from testing its cattle for mad cow disease. The meatpacker had intended to privately test all of its cattle, whereas the USDA tests only one percent of cattle. But the USDA, arguing that full testing would cause the public to question the safety of other meat, moved to prevent it.

To be fair, rarely does either side argue against regulation as such. The real issue is the structure of regulation and its impact on economic outcomes, especially income distribution.

Let's return to the financial crisis with this in mind. In the decades preceding the financial collapse, regulations designed to protect the public and to ensure the stability of the financial system were considerably weakened, but the system was (and is) quite far from being deregulated.

The key regulation that remained in place was the "too-big-to-fail" doctrine. Essentially, the banks and other financial institutions took enormous risks with an implicit guarantee that their creditors could count on the protection of the US government if things went badly. For everyone except the creditors of Lehman Brothers and the preferred shareholders of Fannie Mae and Freddie Mac, this gamble proved correct.

This one-sided giveaway was not deregulation. Had those setting financial policy over the last three decades been committed to deregulation, they would have assured financial markets that financial institutions making bad investments would go out of business and that their creditors would be out of luck. The Federal Reserve Board and the Treasury would have warned that investors were acting at their own risk when they put money in Bear Stearns, AIG, and the rest.

In the context of a too-big-to-fail principle, the removal of restrictions on leverage (investment banks were allowed to leverage their capital at a ratio of forty-to-one compared to just ten-to-one for commercial banks) and the relaxation of other prudential regulation (the nominal value of credit default swaps, a new class of derivative instruments, grew to more than $70 trillion in a nearly unregulated market) essentially gave the banks a license to wager with taxpayers' money.

Banks did exactly what economic theory predicts. They took huge risks, leveraging themselves to the hilt with questionable assets, knowing that they would gain as long as the housing bubble held up. And the banks did so with willing accomplices among pension funds, hedge funds, and other investors because these investors knew that the government would rescue them if things went badly.

Deregulation can be a principled position held by true believers in a free market. But Wall Streeters all wanted one-sided regulation that provided them with an enormous government security blanket without any costs or conditions. None of the Citigroup, Goldman Sachs, J P Morgan crew ever went to lobby Congress for an explicit repeal of the too-big-to-fail doctrine. And while many on Wall Street lost their jobs when the bubble burst, the tens or hundreds of millions of dollars that banking executives earned during the good times are theirs to keep. Even with the market collapse, the vast majority of them are almost certainly better off than they would have been had they done honest work over the last decade.

* * *

If the real debate is over the type rather than extent of regulation, then why is it always framed as the latter? For conservatives, the answer is obvious. Many Americans embrace the idea of free markets and hold a deep aversion to government. Faith in government ebbs and flows, even in the most liberal times. It will almost always be advantageous, then, to associate a political position with support of the free market.

It is less apparent why liberals would be so eager to accept such a disadvantageous caricature of their position. The answer requires digging a bit deeper into what their position implies about the nature of the economy and economic outcomes.

Like conservatives, liberals generally acknowledge that people get ahead as a result of their skills and hard work, with some luck thrown in. The main difference in the liberal and conservative views of the economy is that liberals are more likely to believe that many people face serious impediments to their success and do not get the same chance as people from wealthier backgrounds. Liberals are also likely to feel guilty about the difference in opportunities and therefore support political measures that will reduce the gap and help those at the bottom. However, most liberals still accept the proposition that the distribution of income is fundamentally determined by the market rather than political decisions embodied in regulations such as patents, copyrights, and bankruptcy law.

But what if we accept a view that virtually every facet of the economy is shaped by policies that could easily be altered? Investment bankers get incredibly rich because the government gives them the shelter of too-big-to-fail but doesn't impose any serious prudential regulation in return. Bill Gates gets incredibly rich because, through copyright and patents, the government gives him a monopoly on the operating system that is (or was) used by ninety percent of the computers in the world.

Doctors are well-paid because, unlike less politically connected workers, they enjoy protection from international competition. The same is true for lawyers and other highly paid professionals. The six-figure salaries depend less on skill and hard work than on being able to structure labor markets in ways that autoworkers, textile workers, and cab drivers cannot.

Deregulation can be a principled position held by true believers in a free market. But Wall Streeters all wanted one-sided regulation that provided them with an enormous government security blanket.

There is a long list of professional licensing requirements (many of which have nothing to do with maintaining quality standards) that make it difficult for foreign professionals to work in the United States. While trade agreements such as the North American Free Trade Agreement have been designed explicitly to eliminate institutional barriers that obstruct investment in developing countries and the free flow of manufactured goods back into the United States, there has been no comparable effort to reduce or eliminate the barriers that obstruct highly educated professionals in the developing world from practicing their professions in the United States. Many ambitious professionals from the developing world do manage to overcome these barriers, but professionals in the United States still enjoy a far greater level of protection from international competition than less highly-educated workers.

* * *

The less-versus-more framing of regulation supports the premise that there is in principle an unregulated market out there and that some of us wish to rein in this unregulated market while others would leave it alone. This is consistent with the idea that large inequalities in income distribution just happen as a result of market forces. But as the above examples illustrate, no one is really talking about an unregulated market - rather we are all just talking about whom the regulation is designed to benefit. Distribution of income has never preceded the intervention of government.

The government is always present, steering the benefits in different directions depending on who is in charge. Accepting this view provides a political vantage point much better suited to the case for progressive regulation. After all, conservatives want the big hand of government in the market as well. They just want the handouts all to go to those at the top.

This expansive view of regulation puts everything up for grabs, including the six-figure salaries of many of those arguing the liberal position. Do liberals really want everyone asking if we can have the same economic benefits by removing trade barriers in physicians' and lawyers' services that we gain by removing barriers to clothes and cars? Liberals, too, are invested in the obfuscation that less-versus-more provides.

Even so, the catastrophe produced by the one-sided deregulation of the financial industry, coupled with a long list of regulatory failures in other areas, will almost certainly lead to a serious rethinking of regulatory policy in the years ahead. It remains to be seen whether this rethinking will go beyond the familiar debate. We know that when we emerge from the current crisis the economy will be extensively regulated. The questions is, to whose benefit?

Related Articles

This article is part of a special issue on Fixing the Economy, which also includes:

Jeff Madrick, No New Tax Cuts

Robert Pollin, Tools for a New Economy

Copyright (c) 1993-2009 Boston Review and its authors. All rights reserved. Do not reproduce without permission.

Bill Totten


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