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GOVERNMENT’S ROLE IN A 21 ST CENTURY MARKET ECONOMY

GOVERNMENT’S ROLE IN A 21 ST 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

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GOVERNMENT’S ROLE IN A 21 ST CENTURY MARKET ECONOMY

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  1. GOVERNMENT’S ROLE IN A 21ST CENTURYMARKET ECONOMY John Kwoka Finnegan Distinguished Professor of Economics Northeastern University November 30, 2011

  2. 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.

  3. TYPES OF INVOLVEMENT Three broad types of government involvement in industries • Conventional industry regulation • Competition/antitrust policy • Industries in crises

  4. (1) INDUSTRY REGULATION • Conventional industry regulation where “free market” would mean monopoly power • Classic scenario involves “natural monopoly”

  5. (1) INDUSTRY REGULATION • Conventional industry regulation where “free market” would mean monopoly power • Classic scenario involves “natural monopoly”

  6. 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

  7. (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

  8. (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

  9. 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

  10. 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

  11. 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)

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. 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

  21. 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

  22. PROPER ROLE OF GOVERNMENT IN 21ST CENTURY

  23. PROPER ROLE OF GOVERNMENT IN 21ST CENTURY Man Controlling Trade

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