Don’t Bank on the Free Market for Competition

The latest upheaval emanating from the financial world with regard the ‘fixing’ of the Libor should leave only those with the most delicate of constitutions feeling scandalized as the reputation of the bottom feeders that stalk the trading floors of financial institutions are by now known to all save for those tasked to regulate them. Perhaps though, one should take a little time to feel compassion for the hapless multi-millionaires who oversee such organizations. For it is people such as these, who through no fault of their own we are told , that have been forced to pocket the benefits that derive from the miscreants that they were unfortunate enough to have employed and managed. If Mr. Diamond’s testimony to the Select Committee is representative of the self pity felt by others in his position it is apparent that the ‘Masters of the Universe’, though more accurately the ‘Directors of Disaster’, believe it is they that have lost the most in the litany of debacles that have occurred in the last 5 years. Where in simpler times such intellectual Leviathans were regarded with awe by grateful tax hungry governments we now find their success was not due to unfathomable brilliance but nothing more than the consequence of serendipity and the ability to locate your head firmly up the wrong end of your alimentary canal.

So gone are the days when the advocates of the free market could look to the City for their paragons. It is possible though the redemption of capitalism’s good name will be found in the more prosaic arenas that make up the manufacturing and service industries. If it is true a reshaping of our economic landscape which puts emphasis on these activities is highly over due then the propriety of such organizations will be the next to be brought in to sharp focus. Therefore if the honest brokers of capitalism are to be found within this cohort can long suffering consumers rest easy in the knowledge a fair deal can be obtained from the those that bring us baked beans and toilet rolls any more than the demi-monde realm of high finance?

To create market conditions unfettered by collusion as seen in the latest financial scandal as been a preoccupation going back to the18^thCentury where the revered economist Adam Smith saw the actions of cartel participants as an “absurd tax” and “a conspiracy against the public”. Certainly that is an opinion echoed by the founding fathers of the European Union and is most lately voiced in the 2009 Lisbon Treaty where there is a stated aim that the Union will establish ‘a highly competitive social market economy’ and ‘a system ensuring that competition is not distorted’ should be enacted to the benefit of consumers be they individual consumers or industrial participants in a market. Similar legal provisions in the via the Sherman Act also give vent to the notion that colluding to fix price and/or market share, the so-called ‘hard-core’ restrictions, is not to be tolerated for the sake of a free market that depends on competition for innovation and the efficient use of resources

The framing of legislation in the area of competition policy was a necessity due to a history of cartelization that has its roots in the nineteenth century. Prior to 1945 though the creation of cartels, outside the US at least, were not viewed with the same venom that future generations were to pour on them rather they were seen as a means of industry self regulation even if the producer’s needs were more highly regarded than the consumers. Some researchers estimate that 40% of world trade was controlled to one extent or another by cartels at the beginning of World War II as cartelization was seen by national governments as a means of waging economic warfare. Post World War II a less accommodating attitude to cartels was forthcoming as they were considered to be an enemy of liberalized trade and to democracy itself by some. It has though been argued that cartels were merely institutionalized by governments rather than abolished via nationalization and the creation of industrial national champions during the 1950’s and beyond.

Despite the change in the legal position motivations to collude or, depending on your point of view, self regulate are ever present. Take for instance the 2009 case of market sharing that came before the European Court of Justice involving household names in the energy industry Gaz De France and E.ON. The energy firms colluded not to sell gas in each others home markets from a pipeline that they had jointly financed. This agreement was found by the court to deprived customers of price competition and choices of suppliers with the subsequent innovation that this might bring and is an indication of why the EU and most other states in the developed world see the need for such prohibition.

The EU has also been fertile ground for cartels created by Taiwanese and Korean Liquid Crystal Display (LCD) manufacturers whose products end up in television and computer screens. Here the Court in 2010 found that six manufacturers, including well-known brand names Samsung and LG, had worked to fix prices and restrict output for four years and were aware of their illegal agreement evidenced by a document found during the investigation warning participants to ‘limit written communications’ between the parties. Similar collusion occurred in the markets with damages of $89 million awarded against Toshiba in June 2012 after the victims of the cartel found it necessary to bring a private action due to the authority’s refusal to prosecute.

Even if the harmony of purpose between the international business communities is to be admired and would put their counter parts in the United Nations to shame it must be acknowledged that the controlling minds behind these undertakings show an outrageous contempt for the customers that they purport to serve. But who can blame them for outside of a few members of the legal fraternity is anyone made aware of the extra expenditure that ‘we the people’ make to facilitate the burgeoning profits of these multi-nationals. An estimate by the EU in an Impact Assessment Report of 2008 shows that businesses and consumers were foregoing in damages, at the most conservative estimate, up to €25 billion annually due to the actions of cartel participants. Further to this, calculations by the OECD suggests that the mark-up of products can be up to 50% higher if an industry is fettered with a cartel. As this is far from being a victimless crime one may speculate why the guilty do not suffer more in the court of public opinion but as scant regard is given to such misdemeanors within the media or by our elected representatives maybe this is understandable.

If the damage to a brand and a company’s reputation is not deterrent enough to stop errant behaviour the financial consequences for a company found guilty of such practices although not paltry should be put into context. The punishments given to E.ON and Gaz de France were fines of €552 million each for their market sharing cartel and are the second highest fine ever given under EU law. However when the turnovers of these undertakings are both well over €60 billion perhaps the lesson is that the reward is worth the risk. Further succor is given by the men of power within the EU as Competition Commissioner Joaquin Almunia has stated ‘no fine would push a troubled business off a cliff’. This assurance from the law makers allows for moral hazard to be a feature of competition law as what court could ignore the social and political dimensions of a decision that penalized a company to the extent that it would lead to plant closures or job losses.

This fact may explain that cases involving collusion have stayed stubbornly high. It is reported that within the EU between 1995 and 1999 10 decisions were found against cartels involving 60 companies but between 2005 and 2009 this had jumped to 33 cases involving 205 companies. Although this increase was due in part to improved investigatory powers given to the Commission and a system that allowed whistle-blowers to have reductions in their financial penalties it is further evidence that giving cartel membership a go is a worth while business strategy.

When presented with the fact that many familiar company names have a flagrant disregard for the rule of law at the expense of the consumer it is tempting to fly in to a fit of justifiable indignation. It is though necessary to explain to ourselves why such cooperation is apparent between profit maximizing, win at all cost undertakings. Surely this does not fit the economic model that neoliberal political theorists would have us believe is the natural world order. If the most vibrant and effective markets are those where regulation is at its lightest, or not present at all, why do companies that are free to act independently seemingly unionize to voluntarily regulate their price, output and limit their geographical markets? Certainly this smacks of the planned economy that is an anathema to those who speak on behalf of the capitalist system.

The answer can be found in economic theory that is as old as capitalism. Augustine Cournot a 19^th Century economist observed direct competition on price would be suicidal for an industry and for this reason is to be avoided. The classical example of such a situation is where the market is an oligopoly, that is to say there are a few market participants, the cost of entering the market is prohibitive to potential new entrants and, generally speaking, the output of one company is indistinguishable from that of another. This describes the market structure of numerous industries that are bed rock of an economy such as oil refining, silicon chip manufacturer and steel production. To compete on price in these instances would lead to each manufacturer taking the price charged for its product down its cost of production as a war of attrition ensued and is obviously to the disadvantage of all in the industry. If however output levels are chosen that are most cost effective for the plant capacity that each market participant has at its disposal, with the price then set so that that the aggregate production of the industry can be sold; this will inevitably lead to higher profits for all. These actions do not need any illegal collusion as in a cartel just tacit cooperation via self imposed quotas that are inevitable due to the production capacity that each company has chosen to maximize its profits.

This is the reality of the situation in the oil refining industry in the US. The prohibitive cost of building a refinery, in the region of billions of dollars, limits the increase of new capacity from industry outsiders and this coupled with the existing oil refiners’ persistent refusal to increase supply turned a low margin moribund trade in to a new . An article in ‘The New Yorker’ from 2006 reports US refiners enjoyed year on year profit growth of over 30% around this period with petrol prices in California up 48% despite only a 17% rise in crude oil.

Despite evidence to the contrary the predominance of cartels in a market is thought by some distinguished commentators to have a benign influence. They point to the fact that competition is present but regulated by the agreements between the parties and are in essence no different to the strictures put on industries by the state. What this propensity to cooperate does illustrate is that there is no contradiction between the free market, if such an entity exists and regulation. As market participants behave as a collection of individuals in a social network it is inevitable that the ‘rules of the game’ become the social contract that binds them and stops a descent in to a state of nature that a free market would allow. The realization of this has been a historical and constant feature of trade since the industrial revolution had its beginnings and conceivably there is a Darwinian inevitability to business structuring itself in this ecosystem which becomes the natural conditions of many markets.

Since the Reagan-Thatcher accord that was a feature of the early 1980’s, be it in the financial sector or in manufacturing and service industries, the argument has been won by those with a neoliberal agenda that market regulation is to be avoided. Consequently governments for the last 30 years in the Western economies have been contented enough to go along with the mantra that the market knows best whatever the misanthropic consequences that there might be. What the market knows however is that to operate effectively regulation and co-ordination is a standard operating procedure that is hard-wired in to the system for its own sake. During the good times the satisfying of share holder self interest by a power elite is a situation most people grudgingly acquiesce to but these are far from good times. The economic maelstroms of the last 5 years has reduced the slice of the pie for many to crumbs therefore for the relevance of the democratic process to be maintained it is to be hoped that governments and regulators will realize the need to preside over markets for the sake of a wider set of stakeholders than the current situation provides for.

Alan Norman, 30/07/2012