The Great Reversal: How America Gave Up on Free Markets

by Thomas Philippon

When you read an author or commentator who tells you something is obvious, take your time and do the math. Almost every time, you’ll discover that it wasn’t really obvious at all.

The debate on growth versus inequality hinges on the idea of incentives. When economists talk about incentives, they mean a motivation for material (monetary) gains. People work hard because they expect that their efforts (their investment) will increase their income. For the economic system to work, there needs to be a connection between (ex-ante) effort and (ex-post) income. Does that mean that some degree of inequality is necessary? Does that mean that more inequality always creates better incentives? The answers are probably yes and no, but the link between incentives and inequality can be subtle.

Making an investment decision therefore requires a complicated discounting of uncertain future cash flows and a comparison with the current cost of buying new capital. How can these decisions be made for the whole economy, with thousands of businesses, hundreds of billions of dollars of cash flows and investment costs? How can predictions be made not only one year ahead, but two, five, ten, or twenty? It sounds like a daunting task, and it is. But if you think about it the right way and make some assumptions, you can see that accountants, together with stocks and bonds traders, have done it for us. This was the brilliant insight of Nobel Prize winner James Tobin. The measure that “looks at it the right way” is called Tobin’s q and is explained in Box 4.1. Tobin’s insight is that the market value of the firm encodes all we want to know about the firm, at least as far as classical investment decisions are concerned. If accountants do their job properly, then we can measure the replacement cost of the firm’s fixed assets. If investors do their job properly, then we can measure the market value that the firm creates from these fixed assets. The difference between the market value and the replacement cost is the NPV of the firm. Tobin’s q is the ratio of the market value to the replacement cost. If q is more than one, the firm should scale up because each additional $1 of capital expenditure is worth q dollars. Tobin’s q contains a lot of information. In particular, Tobin’s q c...

Money influences politics everywhere. What sets the US apart is therefore not that money seeks to influence politics; it is rather the scale of the money involved that is exceptional. If differences in lobbying expenditures between the US and the EU are large (a factor of two, or three for corporate lobbying, as we saw in Chapter 9), differences in campaign contributions are staggering. Figure 10.5 shows total campaign contributions for federal elections in the US and total campaign expenditures for several European countries, normalized by GDP. The sample of European countries is primarily based on EU Parliament in 2015 and was chosen to be representative of the European economy. Campaign contributions in the US are fifty times larger than those in most European countries.

For every useful innovation in online banking, there are several mostly useless or even harmful ones.

At the aggregate level, therefore, monopsony and monopoly have the same implications for workers’ standard of living. It does not matter whether firms mark up their prices by 50 percent or whether employers push down wages by 30 percent. In both cases the purchasing power of workers is 30 percent lower than it should be.

We have always known that competition lowers prices and increases real wages and standards of living. But the evidence also shows that competition is good for investment and suggests that it fosters innovation and productivity growth. In theory, however, competition can be excessive. We should expect, then, to find at least some industry at some time period in some country where competition has had a negative impact on innovation. But we find hardly any. Why is that? This is the story of the dog who did not bark. I have seen and discussed many papers showing that competition is good for growth (Buccirossi et al., 2013). I have not seen a paper that convincingly shows that protecting incumbents through patents, barriers to entry, or any other stratagem leads to an increase in productivity. It is highly unlikely that no researcher would have found this effect if it was in the data. The dog did not bark; that is the key piece of evidence. But why is it so difficult to find any such example? I think the answer is actually quite simple. The standard theory is incomplete because it ignores the political incentives of incumbents who lobby to weaken competition and erect barriers to entry. They often succeed for the wrong reasons, and this is why free markets are fragile. But in the rare instances in which their arguments have merit, their success is almost assured. As a result, the empirical distribution of industries is biased toward insufficient competition, and we almost never...