The Great Reversal

by Thomas Philippon

  We can go even further using the data we have at the country, industry, and year levels. We can use relatively advanced statistical models with our panel data. We can ask if concentration explains markups controlling for broad changes at the country level or for changes in global technology at the industry level. In all cases, there is a strong positive correlation between changes in concentration and future changes in prices.

  Finally, it is worth highlighting some interesting differences across European countries. The only country where we do not see a decrease in the markup is Italy. This is interesting because we know that the Italian economy has performed poorly over this period. This supports the idea that improving competition in the market for goods and services is important to macroeconomic performance.

  Yes, US Prices Are Too High

  Prices in the United States have increased 15 percent more than prices in Europe, but wages have increased only about 7 percent more than in Europe. Half of the relative price increase in the US comes from increasing markups. Moreover, we see that markups are systematically related, over time and across countries and industries, to the changes in concentration. The evidence strongly suggests that increasing concentration in the US is responsible for an excessive increase in prices by at least 8 percent over the past seventeen years.

  That is a big deal. Workers who do not own stock are 8 percent poorer than they should be. And that is not the end of the story; there are indirect effects as well. Higher markups reduce investment and therefore reduce the capital stock. With less capital, the economy is less productive. When we simulate the path of the US economy since 1990 (Gutiérrez, Jones, and Philippon, 2019), we find that aggregate consumption would be significantly higher today if competition had remained at levels found in 2000.

  What happened? Why have US policy makers let concentration increase so much?

  In the next part of this book, we will show that the changes come from different policy choices in terms of regulations, barriers to entry, and antitrust. But first there is more we can learn from Europe. We need to discuss what is perhaps the most surprising result in this book: how did European markets become more competitive than American markets?

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  a  The program collects price data for specific goods and then defines an aggregation methodology for each country. For the OECD and the rest of Europe, data for specific goods are collected every three years, and results were reported for 2005, 2008, 2011, and 2014. The level of detail available publicly is at the aggregate good level, which includes, for example, bread and cereals, milk, nonalcoholic beverages, transport, and so on.

  b  Which method should we use: PPP or market rates? It depends on the issue at hand. Financial flows should clearly be measured at market rates. Economic growth, human development, and poverty are more often assessed at PPP rates. The main drawback of PPP is that it is difficult to measure and is not readily available in real time.

  CHAPTER 8

  How European Markets Became Free

  The problem was to break up excessive concentrations in the coal and steel industries of the Ruhr … The Americans had been the first to tackle the problem, many months earlier. Their economic and political philosophy would not tolerate either the practice or the apparatus of domination, at home or abroad.

  JEAN MONNET, MEMOIRS (1978)

  THE UNITED STATES invented modern antitrust laws in the late nineteenth century. It deregulated many of its industries in the early 1980s and has been the champion of free markets ever since, to the great benefit of American consumers. The American free-market doctrine spread globally and, by the 1990s, a broad international consensus had emerged among policy makers in favor of US-style regulations for most markets. This was particularly true in Europe. The US retained its head start, however, and it had a longer history of independent enforcement. Given these initial conditions, one would have predicted that US markets would remain more competitive than European markets.

  But then something totally unexpected happened. Starting around 2000, profit rates and concentration ratios increased in the US but remained stable or decreased in Europe. Prices relative to wages increased by 8 percent more in the US than in Europe despite similar productivity growth. As US markets experienced a continuous decline in competition, European markets did not. Today many European markets appear to be more competitive than their American counterparts.

  How did that happen? How did Europe, of all places, become the land of free markets? Throughout its history, continental Europe often chose state intervention over private competition. What has changed over the past twenty years to convince Europeans to embrace free markets?

  The Freeing of European Markets

  European policy makers seem to have heeded the warning of economists Alberto Alesina and Francesco Giavazzi in 2006: “If Europe is to arrest its decline … it needs to adopt something closer to the American free-market model.” The European Union has streamlined its regulations to encourage entry and competition in many markets. Many indicators highlight these improvements, but let’s first consider the ease of opening a business. Figure 8.1 shows that the number of days required to start a business in the EU has steadily decreased and converged toward the US number.

  For example, it took fifteen procedures and fifty-three days to begin operating legally in France in 1999, versus three procedures and three days in New Zealand (Djankov et al., 2002). In 2016, it took only four days to start a business in France and one day in New Zealand. Over the same period, however, the entry delay in the US went up from four days to six days. In other words, opening a business used to be much faster in the US than in France, but it is now somewhat slower.

  This is not an isolated indicator. The OECD compiles a measure of regulation called product market regulation (PMR) indexes.a Figure 8.2 shows the various vintages of PMR indexes for EU countries and the US. In 1998, every EU country except the UK had more regulations than the US; in 2013, every EU country except Greece and Poland had fewer entry regulations than the US.

  There is a deep irony to this story. The idea that free and competitive markets work best is supported by much empirical evidence, and economists spread the gospel of free markets in large part because it had proven so successful in America. In their highly influential paper, Simeon Djankov, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer (2002) find that the regulation of entry is associated with higher levels of corruption, and that countries with more open and accountable political systems regulate entry less. Multilateral agencies such as the World Bank and the OECD provided similar advice around the world. In 1999, the OECD noted that the “United States has been a world leader in regulatory reform for a quarter century. Its reforms and their results helped launch a global reform movement that has brought benefits to many millions of people.”

  FIGURE 8.1  Number of days to start a business. Data source: World Economic Forum

  FIGURE 8.2  Product market regulation index. GRC = Greece; POL = Poland. Data source: OECD

  The irony is that Europe heeded this advice just as the US was starting to forget its own history of free markets. Note that I am referring to the markets for goods and services. I am not discussing labor market regulations, tax policy, or public spending. This is a deliberate choice. The theory I am going to present in this chapter explains why the EU project has an outsized influence on the market for goods and services, but has little effect on other markets. I am not arguing that the EU has become more competitive than the US in other areas. The US has better universities and a stronger ecosystem for innovation, from venture capital to technological expertise.

  Despite these caveats, my view is very much at odds with the common caricature of the EU as an overreaching bureaucratic beast. This view is sometimes true, but more often than not, it is a reflection of ignorance and laziness on the part of commentators. If you have nothing interesting or relevant to say, you can always take a jab at European bureaucrats. It’s the political e
quivalent of complaining about the weather: fundamentally useless, but substantive enough to hide an embarrassing void of interesting ideas.

  What is true, of course, is that EU policy documents are a reader’s nightmare. Policy makers in all countries have a terrible habit of coming up with pompous titles for everything they do, and the EU is no exception. In EU documents, the most basic idea is usually depicted as a grand, three-pronged strategy. It is annoying and painful to read, but it should not distract us from the fact that many of these initiatives are well-intentioned, and some are even successful. Technocratic jargon in Brussels might be unbearable, but one should not dismiss a child simply because her parents gave her an ugly name.

  Let us try and understand how competitive markets came to be such an important feature of the European integration. We will discover that the fight against market dominance has been part of the DNA of the European project from the very beginning.

  Churchill versus Monnet: A Brief History of the European Union

  The history of the EU is fascinating but often misunderstood, especially in America. If you remember only one thing from this chapter, let it be this: the EU was founded on the ideas of a Frenchman who admired British and American institutions and who, above all, wanted to get things done.

  The project of a unified Europe grew out of the ashes of World War II, and economics played an important role from the beginning. For deep historical reasons, the entire EU machine of economic regulations aimed to eliminate economic nationalism and excessive market dominance.

  To understand the process of European integration, we first need to travel back to 1914 in order to understand the process of European disintegration. World War I was a European civil war, a tragedy of unprecedented scale. Europe had always been a continent of wars. French president François Mitterrand joked, when he gave his last address to the European Parliament in 1995, that throughout its long history, France had fought every single European country except Denmark.b But World War I was worse than any war the world had seen until then. Europeans sleep-walked into civilizational suicide.c The American Civil War had already demonstrated the destructive power of industrial-age weapons, but few understood just how terrible these weapons could be. World War I put them on full display for the first time. The scale of the destruction, the decimation of an entire generation of young men, and the massacre of civilian populations created a demand for lasting peace in Europe. French soldiers returning from World War I coined the phrase “La Der des Ders” (the last of the last), which expressed the hope of an end to wars in Europe.

  It almost happened. US President Woodrow Wilson was the first to propose a League of Nations as part of his Fourteen Points plan for an equitable peace in Europe. The League of Nations came to be, but the US was never a member because many citizens and members of Congress wanted to keep America out of European affairs. Many German immigrants living in the US opposed the Treaty of Versailles, the acceptance of which was necessary for membership in the League.

  Europeans tried to keep Wilson’s idea alive despite the lack of American support. French foreign minister Aristide Briand proposed a unification of Europe in a speech at the League of Nations on September 5, 1929. His plan aimed at industrial cooperation and protection against the Soviet threat from the East. Unfortunately, German foreign minister Gustav Stresemann, the main supporter of the plan in Germany, died a month later, and the Great Depression soon plunged the world—and Germany in particular—into economic chaos.

  Briand’s plan had failed, and it would take another world war with an even greater death toll, including the highest death toll from genocide in history, before Europe could finally agree on a peaceful union.d The devastations of World War II, together with the increasing threat of encroachment by the Soviet Union, created powerful political pressures for unity in Europe. Shortly after World War II there were several visions of what a unified Europe might look like. At the risk of oversimplifying, let’s call them the Churchill view and the Monnet view.

  In September 1946, Sir Winston Churchill, twice prime minister of the UK, argued that Europeans “must build a kind of United States of Europe. In this way only will hundreds of millions of toilers be able to regain the simple joys and hopes which make life worth living.”e Churchill had a geopolitical perspective on the European project. Like most leaders at the time, he was concerned with peace and security. He wanted a reconciliation between France and Germany. He always viewed the role of the UK as outside of a unified Europe, not inside. In 1930 he explained, “We see nothing but good and hope in a richer, freer, more contented European commonality. But we have our own dream and our own task. We are with Europe, but not of it. We are linked but not compromised. We are interested and associated but not absorbed.” We can only wonder how he would have analyzed the Brexit debate.

  Churchill’s vision was grand, but it had little to do with how the EU was actually built. The spiritual father of the EU was a less well-known and less charismatic figure, a Frenchman named Jean Monnet. Monnet’s vision focused on economic and industrial cooperation. Monnet was a fascinating character and immensely influential as an adviser to the French and other European governments, but he never ran for office. The New York Times wrote in its obituary, “in many respects Mr. Monnet could be readily identified as a Frenchman. Spruce, well-groomed and with a neat, close-cropped mustache, he talked logically and precisely. But in other ways he was un-French, for he admired (and practiced) British and American pragmatism and scorned parochialism and political narrowness.” Monnet did not oppose the political union that Churchill alluded to, but he focused on more tractable economic issues. He was convinced that “once a Common Market interest has been created, then political union will come naturally.”f

  Monnet’s admiration for British and American institutions and pragmatic attitude were reflected in his proposal for European integration, which came to be known as the Schuman Plan. Robert Schuman was the French foreign minister from 1948 to 1952. The Schuman Declaration of 1950 was a milestone in Franco-German cooperation and led to the creation of the European Coal and Steel Community, which later became the Common Market.

  Movement toward political unity soon followed. In 1963 Konrad Adenauer, the first chancellor of West Germany, and French president Charles de Gaulle signed a historic treaty of friendship between the two countries. Adenauer was committed to postwar reconciliation with France. Political visions matter, but to understand the EU, one must keep in mind that economic integration came first. It is not because economics is more important, but because economic solutions can be used to create incentives for peace and cooperation.

  The Fight against Market Dominance

  The US established the parameters for modern antitrust law with the Sherman Act of 1890, which was motivated by the growth of large-scale businesses during the Industrial Revolution, and the Clayton Act of 1914, which dealt with anticompetitive mergers and acquisitions.

  The history of EU antitrust law is more recent and uncertain, but the fight against market dominance has been at the core of EU policies from the very beginning. In Memoirs (1978), Jean Monnet recalled that “In a note written for the Committee of National Liberation in Algiers on August 5, 1943, I had said: There will be no peace in Europe if States re-establish themselves on the basis of national sovereignty, with all that this implies by way of prestige policies and economic protectionism.” In exile in Algeria in the middle of World War II, he knew that the postwar order should fight against “economic protectionism.” He was thinking of “a system whereby the former Reich would be stripped of part of its industrial potential, so that the coal and steel resources of the Ruhr could be placed under a European authority and used for the benefit of all the nations involved, including a demilitarized Germany.”

  After the war, Jean Monnet made it clear that it was in France’s interest to prevent excessive concentration of market power in the coal industry, especially among the large German Konzerne (trusts) of the Ruhr region.
The way Monnet saw it,

  The problem was to break up excessive concentrations in the coal and steel industries of the Ruhr, where the Konzerne or trusts, which had underlain the military power of the former Reich, were quite naturally being rebuilt. The Americans had been the first to tackle the problem, many months earlier. Their economic and political philosophy would not tolerate either the practice or the apparatus of domination, at home or abroad. They insisted that the German coal-selling organization … should lose its monopoly, and that the steel industries should no longer own the coalmines. (Monnet, 1978)

  But how and why would Germany give up the ability to shape its industrial policy? In December 1949, Chancellor Adenauer agreed to an authority that supervised the mining and industrial areas of Germany, France, Belgium, and Luxembourg. The key point was that the International Ruhr Authority was independent. It would not be controlled by France or any other country. This was also the basis of the Treaty of Paris (1951) establishing the European Coal and Steel Community (ECSC). Monnet had an ambitious vision “of the High Authority’s independence. It should, I argued, have its own revenue, drawn from a levy on coal and steel production, and not depend on government subsidies to finance its administration and its operational work.”