The Future of Capitalism

by Paul Collier

  So, the evidence on outcomes supports giving legal force to the representation of worker interests on the boards of companies. Nor is such a change impractical: in Germany, the legal structure of companies has long required worker representation. Far from this having generated disaster, German companies have been outstandingly successful. But what is to prevent the workers and owners of a company conspiring together to exploit those interests that are unrepresented; most obviously, the interests of users?

  THE HABITAT OF FIRMS: COMPETITION FOR SURVIVAL

  Companies exist within a habitat, and each one finds a niche within it. The struggle for survival in this habitat is the discipline that compels these companies to serve the interests of their customers. Translated from biology to economics, the habitat is the marketplace, and the struggle for survival is competition; the force of evolution, by which species come to be well-adapted to their environment, has as its counterpart the benign dynamics of capitalism. In struggling against each other to survive, firms try to make their product cheaper and better, and we are all the beneficiaries.

  The enemy of competition is vested interests. Vested interests use their power to build impediments to competition via a range of strategies. At the legal end of the spectrum is lobbying, which has grown into a huge sector that burns up resources in a quest for privilege. In the middle of the spectrum we find corruption: the abuse of public office to sell permits and court judgments, and to grant monopolies. Current revelations suggest that, in return for favours, former President Zuma of South Africa used his office to generate rents for the business empire of the Gupta family. At the extremity of the spectrum is the total capture of the state.

  The centralization of power inherent in communism eliminated accountability and so left vested interests rampant. Most people recognize this: the same surveys that find capitalism to be tainted by corruption find that corruption is even more strongly associated with communism. As the grotesque lifestyle of the three-generation Kim dynasty in North Korea illustrates, the all-powerful state is not a check on vested interests, but rather their ultimate triumph. Communist societies removed the habitat of the marketplace, and the result was so dysfunctional that, despite intense political repression, their people voted with their feet. ‘Build a wall!’ did not start with Donald Trump’s attempt to keep foreigners out, but with the desperate attempt of communist regimes to keep their citizens in. I grew up with images of people trying to climb over the walls, but younger people have no such memory: they can only learn it from books, and the books give priority to other parts of history. My ten-year-old knows about Hadrian’s Wall but not about the Berlin Wall: try it as a test on your children.

  Ever since markets began, powerful people have tried to limit competition to their own advantage. Vested interests know far more about the nature of their advantage than public officials can possibly know. Being narrowly defined groups, they find common action in their own interest easier to organize than the diffuse common interest that they oppose. Competition overcomes these obstacles. Since firms in the same business have similar information, once they compete the vested interests will lose their advantage regardless of whether public officials know about them. Once the common interest recognizes the principle of maintaining competition, it can use it to repel each specific vested interest heist. The opponents of competition plead that it is unfair, destructive and ignores some imagined benefit provided by the incumbent. Behind these arguments there lurks self-interest: it is motivated reasoning.

  It was the market, not public intervention that disciplined GM and Bear Stearns. But nevertheless, sometimes competition will not be sufficient. For these tougher circumstances, we need active public policies.

  While vested interests try to create artificial impediments to competition, in some sectors of the economy there are technological impediments due to atypically powerful economies of scale. Scale economies are most pronounced when the activity depends upon a network. The provision of electricity requires a network of wires, the grid; the provision of water requires a network of pipes; the provision of train services requires a rail network. Sometimes it is possible to detach the service from the network: train companies can compete on a shared rail network; electricity generators can compete on a shared grid. But the network itself is a natural monopoly. The emergence of the e-economy has created new network industries that can extend to global monopoly. These firms need very little capital as conventionally defined – the tangible assets of equipment and buildings. Their value is an intangible asset: their networks.8 Unlike tangible assets, these are very difficult for competitors to replicate; and, being immaterial, they have no fixed location subject to public policy. Facebook, Google, Amazon, eBay and Uber are all examples of networks that tend towards natural global monopoly in their particular niches. As unregulated, privately owned natural monopolies, they are highly dangerous.

  The same process is underway less dramatically in many other sectors of the economy. The steady increase in complexity inherent in rising productivity has introduced some network features into other industries.9 This, in turn, is enabling the top firms within each of these industries to become more dominant. Walmart has harnessed the new network features of logistics to retailing. The largest banks have reaped new scale economies in finance. The overall increases in productivity and corporate profits have become concentrated in such top companies.10 While not as extreme as the natural monopolies, the gains from scale enable them to receive a premium over the return on capital earned by their smaller competitors. Competition in the ownership of shares in these companies drives up their price, enabling the original shareholders to capture this premium on scale as a windfall.

  Where big is technologically super-profitable, either because it leads to the extreme outcome of a natural monopoly, or to the less dramatic exceptional returns of dominant companies, competition becomes impotent. We need some more targeted instrument of public policy. The conventional options are regulation and public ownership. Each has its limitations.

  DO RULES RULE?

  However well-intentioned are boards of directors, sometimes regulation is essential. A rule can ensure that all firms follow the same policy, whereas leaving the matter to the judgement of boards would result in variation. For example, it would be inefficient and inequitable if some firms did much more than others to reduce their carbon emissions.

  However, when rules are used to address the problems of exploitative firms, the limitations are considerable. Regulation can aim either to break up natural monopolies, or to control the price they charge to consumers. Breaking up monopolies forces competition into the sector, but since the technological scale economies continue to push towards monopoly, policy intervention has to be sustained. Even then, by blocking the scale economies, policy imposes inefficiency. Price controls aim to restrain the company from exploiting the scale economies for its own benefit, forcing it to pass the gains on to consumers. Its limitation we have already encountered in a different context – asymmetric information. In its previous incarnation, it was about the gap between what the management of a firm knows, and what fund managers can find out. Now it is about the gap between what the management of a firm knows and what the regulator knows. The most spectacular asymmetries have been in financial markets, between the regulators and the banks, but the problem is endemic. The firm has far better knowledge of its costs and its market than can possibly be gathered by a regulator, and so the problem can never be fully resolved.

  Arguably, the best policy response to the problem is to combine a best-guess at price control with contrived competition, through auctioning the right to the monopoly. An example of the benefits of auctioning rights comes from the British government sale of the rights to the 3G mobile phone network. Initially, the Treasury tried to work out a reasonable price for the network based on available information of its likely profitability, concluding that a price of £2 billion would be its target. Fortunately, it was persuaded by academic economi
sts that the asymmetry problem was so severe that its estimate might be wrong, and so instead it put the network up for sale in an auction. The realized price was £20 billion. Evidently, whether the successful firm had paid £2 billion or £20 billion, it would have exploited the customers of the network to the maximum permitted extent, but at least this way what customers lost through monopoly exploitation was being captured by this windfall gain in government revenue.

  An impediment to this is the credibility of government commitments. When firms bid on such contracts they will make mistakes, albeit not as large as those that would be made by a regulator since they have much better information. If the firm bids too much it will suffer squeezed profits and, at the limit, renege on the contract through bankruptcy. It will only be prepared to take this downside risk if there is a corresponding prospect of gains on the upside. Moreover, if all firms underestimate the potential for profit, the winning bid will turn out to have been too low.* But politicians have short horizons imposed by elections, and so if a firm that has won a contract to run a monopoly utility is seen to be making high profits there is a temptation to overturn the decision of the regulator. The more that firms fear that such interference is likely, the lower will be their bids at auction and so the higher the profit that the winner will make, and the more likely is political interference . . . Low credibility is a vicious circle.

  If this were the only problem, the solution would be to shorten the length of the contract to match the political cycle; contracts would run from mid-term to mid-term to minimize the pressure from an impending election. But exploitative pricing is not the only dimension of company behaviour that matters. For a utility service such as water or electricity supply to be sustainable, the firm should use much of its profit to finance re-investment. But the shorter the horizon of the contract, the less inclined will the firm be to take socially desirable investment decisions. Potentially, the regulator can try to regulate investment, but this requires even more information than pricing: realistically, the regulator can have little idea as to which investments are desirable, nor how much they would cost. Regulation has its limits.

  The problems of regulation are vastly compounded in regard to the global e-utilities. Such regulation would often need to be global, whereas the capacity to regulate has remained overwhelmingly national. International co-operation is made more difficult because the e-companies are overwhelmingly American, and so the American government is at best ambivalent. Here is the assessment of a specialist antitrust lawyer, Gary Reback: ‘Will the EU ever succeed in using antitrust law to rein in the power of the dominant American tech companies? No . . . Their feeble antitrust enforcement efforts will never yield real results.’ Moreover, it would be easy for the companies to portray any regulation that did manage to be effective as being anti-American. Rules do not rule.

  So, given these inherent problems of regulation, the currently fashionable alternative is public ownership.

  PUBLIC OWNERSHIP

  Currently in Britain there is so much dissatisfaction with the regulated private utilities that large majorities favour nationalization to bring rail, water and electricity companies into public ownership. This is ironic since all the utilities were originally publicly owned monopolies, and the impetus for turning them into commercial companies was public dissatisfaction with their performance. However, the public memory of the inadequacies of public ownership is a decade more distant than memory of the Berlin Wall. Under public ownership, the utilities suffered from capture by their employees, reflected in a very high incidence of strikes, and politicized underpricing of services that caused under-investment. Current discussion has polarized around ideology: ironically, the left wants nationalized industries, but not a sense of nationhood; the right wants a sense of nationhood, but not nationalized industries.

  In reality, some industries have worked better run by private regulated firms, and others worse, consistent with wide variations in the extent to which information is asymmetric. On reasonable measures, the railways are better, whereas water is worse. The evidence that rail is better under private management comes most clearly from usage: however much they grumble, people have voted with their feet. Rail usage declined every year in the decades of public ownership prior to privatization in 1998, and has increased, strongly, every year since. The evidence that water is worse comes primarily from the very high profits extracted as dividends.

  SO, WHAT CAN WORK?

  Since both regulation and public ownership have severe limitations, are there any other approaches that have not been considered? Here are three.

  Taxation

  In those sectors in which big is naturally more productive and more profitable, the exceptional gains from scale are a form of ‘economic rent’. Such rents are an important concept in economics that will be central when I turn to the divergence between the metropolis and broken cities. What economists mean by the term is the return on an activity beyond what is needed to attract the workers, finance and enterprise on which it depends. If the rents evaporated, whoever has been capturing them would be worse off, but the activity would be unaffected. The private monopoly gains economic rents; so, less obviously, do the largest firms in those industries in which being the biggest implies being exceptionally productive. The future of taxation is to do a better job in capturing these rents. Unlike other taxation, by definition this does not discourage productive activity; instead, it is capturing something that has not been earned by the effort of work, the delayed gratification of saving, or the courage required for risk-taking.

  In those industries where to be the biggest has come to imply the most productive, there is a case for differentiating rates of corporate taxation by size. The same data that academics have used to show that in some sectors big is more profitable could be used to design differential tax rates. The purpose would not be to discourage economies of scale, but to capture some of the gains for society. Ironically, we already differentiate taxation by size, but perversely: the new network monopolies such as Amazon benefit massively from being tax scams, avoiding the taxation of their terrestrial equivalents. Since the effects of taxation cannot be fully known in advance, the smart approach would be step-by-step, starting with modest new tax rates on size and evaluating the consequences. One consequence is predictable: the big companies will lobby vigorously against it.

  Representing the public interest on company boards

  Many of the decisions of boards have consequences that extend beyond the firm but are not well suited for regulation, which is a crude sledgehammer that could easily do a lot of damage. An example is the bias of CEOs towards spending too little on investment: a regulation requiring firms to invest a certain proportion of their profits would replicate some of the worst features of Soviet economic planning. A wise investment decision depends upon a wealth of detailed evidence and judgement that cannot be reduced to a few regulations.

  The best way to overcome these limitations is not to strengthen regulation, but to put the public interest right in the engine room where decisions are being taken: the public interest needs direct representation on the board. This does not mean that companies should be run as charities, sacrificing the interest of the company for whatever cause some representative of the ‘public interest’ takes a fancy. Although the overarching purpose of a company should be consistent with long-term benefit to society, the primary means by which it can do that is to focus on its core competence. But it does mean that board decisions should not sacrifice a clear and substantial public interest for a small benefit to the firm.

  How can the public interest best be incorporated into the board? The law could be changed to make due consideration of the public interest mandatory for all board members. Being legally liable, if board members chose to ignore an important aspect of the public interest, they could face civil or criminal challenge in the courts. The law could be framed in such a way that the company would not be expected to bear large losses for small public gains, but wh
ere there was a reasonable presumption that large public losses were being inflicted for small corporate benefits, a court case could be brought. Knowing this, it would be a rash board that did not bother to hold a board-level discussion on such decisions, and summarize that discussion in the minutes. Case law would gradually build up from early judgments, and if the outcomes looked to be tilted too far in one direction or the other, the law could be revised.