We have a saying here in this company that penetrates the whole company. It’s a saying that our competitors are our friends. Our customers are the enemy.

—James Randall, former president of Archer Daniels Midland

CAPITALISM BRINGS INCOME INEQUALITY WITH IT. THE public generally accepts this inequality as long as it is not excessive, is seen as part of a system that benefits everyone, and, most importantly, is justified by a principle that a large fraction of the population considers “fair.” A competitive free-market system delivers all three of these things. Competition limits the possibility of earning extraordinary profits—and thus limits income inequality as well. Competition ensures that consumers enjoy the benefits of innovation. Competition creates a pressure toward efficiency and hence meritocracy, a system in which responsibilities are given to the people who can deliver the most and in which the rewards are then seen as the just prize.

Competition brings even more than this: it gives customers the freedom to choose. That customers can switch from one vendor to another not only protects them from companies that try to gouge them with high prices; it also ensures that their welfare is maximized. To keep their business, firms will offer customers the most favorable terms.

When a business gains excessive market power, so that it can increase prices indiscriminately, customers can seek protection through the political process. But when a business obtains both market and political power, escape becomes impossible. Under these circumstances, the system starts to resemble a socialist economy instead of a free market. In a socialist economy, the political system controls business; in a crony capitalist system of this kind, business controls the political process. The difference is slim: either way, competition is absent and freedom shrinks. Without competition, economic life becomes unfair, favoring the connected insider.

Competition is the magic ingredient that makes capitalism work for everyone. Most of the elegant results that economists have derived about the benefits of free markets are based on the assumption that markets operate competitively. But economists do not focus sufficiently on the goal of ensuring that the competitive condition is met in practice. The problem is not the temporary advantage that companies secure through innovation but, rather, the longer-lasting political power they can secure through their size and lobbying influence. When companies operate in a noncompetitive market and are run by managers accountable to nobody, we should stop thinking of them as parts of a free market and see them instead for what they really are: small, centrally planned economies.

The battle against crony capitalism is older than the nation itself. It started in Boston in 1773, when the American colonists rebelled against the abuses of British monopolies. In fact, these colonists, who threw overboard three shiploads of English tea, were revolting not against higher taxes but against a monopoly and British crony capitalism. The Tea Act of 1773 had lowered the taxes on American tea importers. But it also granted tax-free status to the East India Company, a firm so politically connected to the British government that the two were almost indistinguishable. The colonists despised this privilege and feared that government-created monopolies might extend to other goods as well. The American Revolution was a battle for political rights, yes. But it was also a battle for economic freedom against crony capitalism.

To many of today’s readers, fighting to establish or maintain competition might seem unremarkable. In 1773, however, it was something radically new. Throughout history, economic competition had been regarded as an evil to avoid at all costs. The guilds of the Middle Ages, for instance, were designed to restrict competition within a trade. The first modern corporations (the Dutch and English East India Companies) were monopolies that the Crown had granted. The long-prevailing economic doctrine, mercantilism, held that the state should help create, promote, and defend monopolies, which were considered the best way to organize economic activity. Even today, if you search for the term competition on the Internet, you will find it mostly associated with negative adjectives such as cutthroat, unfair, and hurtful.

When Adam Smith published The Wealth of Nations in 1776, he started a revolution at least as important as the one the American colonies began in the same year. Smith’s revolutionary idea was that competition was a force for good. Merriam-Webster’s modern-day definition of economic competition partly reflects this idea: “the effort of two or more parties acting independently to secure the business of a third party by offering the most favorable terms.” The notion that competition is welfare-improving was completely foreign before Smith. It turned out to be profoundly right, both in theory and in practice.

THE BENEFITS OF COMPETITION

Smith’s idea that competition leads profit-motivated firms to produce the goods that people want at the lowest possible cost was initially just an intuition. After the publication of The Wealth of Nations, economists tried to figure out scientifically whether what Smith called the “invisible hand” indeed guided markets. Finally, in the middle of the last century, Kenneth Arrow and Gerard Debreu were able to prove, under very general assumptions, that Smith’s intuition was indeed correct: competitive markets lead to an efficient allocation of resources (what economists call the first welfare theorem). The most important of those general assumptions is that economic agents are “price takers”; in other words, they act independently (i.e., they do not collude) and are sufficiently small in market size that they can ignore the impact of their actions on market prices. In most economic models, these conditions are just assumed. In reality, they need to be sustained, an important point I will return to momentarily.

Consumers are the major beneficiaries of competition. On January 1, 1984, when AT&T’s local operations were split into seven independent regional holding companies and the market for long distance was opened to competition, the price of a one-minute call from New York to San Francisco (in 2011 dollars) was $1.90 and one from New York to Paris was $3.54.¹ Today, after you pay a small flat fee, domestic calls are free, while calls to Paris cost only 9 cents a minute.² Cell phones, formerly a luxury reserved for billionaires, are now common even in Brazilian favelas. Behind these enormous welfare improvements was no Samaritan, no benevolent central planner, no government subsidy. In fact, governments the world over raised billions of dollars auctioning off the radio frequency spectrum (thus saving taxpayers money).

Competition generates social benefits, too, by penalizing discrimination. In a competitive market, individuals who want to discriminate against others, refusing to trade with them, wind up worse off themselves. ³ For this reason, when the intensity of competition increases, discrimination diminishes. Recall that racial walls in America initially began crumbling in the highly competitive world of sports. Gender discrimination, too, has been reduced by competition. Between 1970 and 1995, as the banking sector became more competitive as a result of deregulation, the wage gap between men and women in that industry closed significantly, while the share of women in managerial positions increased by about 10 percent more than it did in other industries.⁴

Last but not least, competition gives people broader freedoms. I am reminded of a young colleague who recently went walking in the rain with a senior one. The latter, born in Europe, said jokingly (though certain jokes are not funny when stated from a position of power): “In Europe, the young assistant professors carry the umbrella for the senior ones.” My younger colleague quickly responded: “Why don’t you go to Europe?” What gave him the power and freedom to speak his mind was competition—in this case, among universities, since my colleagues and I at the University of Chicago had competed aggressively with many other schools to hire him. As a consequence, even as a young assistant professor, he was more “powerful” in some ways than the older one.

Competition may be a customer’s best friend, but firms like it much less. Companies do their best to hamper competition, because that makes it easier to make money. When I teach entrepreneurial finance, I tell students that in establishing a new firm, they would need to think about how to create barriers to entry for new competitors. Without any such barriers, a firm would operate in a perfectly competitive market: profits would be nonexistent. So it is only natural that entrepreneurs and businesspeople try to block competitors. If kept within acceptable limits, this is economically healthy. Without the hope of gaining some market power in the future, entrepreneurs would have little motivation to devote their lives to the success of their enterprises, and customers would be deprived of great new products.

Yet it is not easy to decide what constitutes “acceptable limits.” Developing a reputation for high quality, for instance, is one way of building a barrier to new entrants; it does not hurt customers and might even benefit them. Creating bugs in an operating system to prevent full compatibility with the application software of one’s competitors is another way, one that doesn’t benefit consumers. The most debilitating barriers to entry, though, are those that the law creates. The state has the ultimate monopoly: the monopoly on the legitimate use of violence. Accordingly, any other monopolies that the state protects are the most difficult to overcome.

To understand just how powerful and dangerous monopolies can be when government sanctions and amplifies their power, consider the East India Company—the firm against which American colonists revolted and at which Adam Smith leveled his cutting remarks.

THE EAST INDIA COMPANY

Adam Smith’s views were shaped by witnessing the corruption of the corporations of his time, in particular the East India Company (EIC), perhaps best known today in its fictionalized form in the Pirates of the Caribbean series. The Pirates movies make no claims to historical accuracy, but they are broadly accurate in their portrayal of the company’s efforts to control the export and import trade among the islands.

Founded in 1600, the EIC immediately received from the Crown a monopoly on trade with all countries east of the Cape of Good Hope and west of the Straits of Magellan (an area that includes the Caribbean). Initially, this monopoly right was granted for fifteen years. But thanks to its political influence (and the bribes it offered), the EIC was able to get the monopoly renewed until 1694. That year, the English Parliament, under pressure from other merchants, liberalized trade with India and a short time later granted a charter to one rival company: the English Company Trading to the East Indies.

In the presence of a politically and economically powerful incumbent, it is not easy to introduce competition. An incumbent monopolist, strong in terms of financial resources and political connections, can easily buy out a single new competitor. It is only when market entry is completely free—and when there are therefore many competitors—that this approach becomes too expensive. Thus, we should not be surprised that the British Parliament’s bid to introduce competition for the EIC, by giving a charter to one other competitor, failed to work. Absent any antitrust law, some EIC stockholders bought enough shares of the one rival and forced it into a merger, thereby regaining the monopoly position. To seal the deal and prevent future competitive challenges, the EIC extended a £3.2 million loan to the Treasury, which, in exchange, again granted the monopoly of trade, allegedly only for three years. But repeatedly, when the monopoly expired, the EIC would lobby and pay bribes and get it extended—until 1813 for most goods and until 1833 for tea.⁵ That a fifteen-year monopoly right lasted 233 years is a harsh reminder of how dangerous the commingling of economic and political power can be.

Owing to geographical distance (at the time, a voyage from England to India and back took roughly two years) and the impossibility of long-distance communication, the East India Company’s managers were pretty much free to rule at their own discretion.⁶ In fact, it quickly became common practice to give the captains of EIC vessels up to twenty feet of deck space for their private cargos, so that they could do some trading on the side.⁷ Similarly, EIC employees, though paid little, could enrich themselves via “commissions” on the EIC’s procurements. This system of legalized bribes became the norm, contributing greatly to the culture of corruption that still plagues the Indian subcontinent.

It is difficult to imagine anything more distant from the invisible hand of markets. The outcome was predictably awful for all the parties involved, with the notable exception of some EIC managers and employees. Consumers back in England had to pay much more for tea and other spices than they would have in a competitive market, and EIC employees, despite their commissions, had to work for a deeply corrupt company. Adam Smith himself lamented the inefficiency of the EIC and similar organizations, observing that “they have, accordingly, very seldom succeeded without an exclusive privilege, and frequently have not succeeded with one. Without an exclusive privilege they have commonly mismanaged the trade. With an exclusive privilege they have both mismanaged and confined it.”⁸ This confinement meant that other merchants were prevented from operating or forced to conduct business illegally (and therefore inefficiently).

The EIC’s political power damaged British citizens even more. The EIC and the state became so thoroughly entwined that the interests of the British Empire were subjected to EIC interests. Even the American Revolution partly resulted from the EIC’s influence on British parliamentary decisions.

Worst of all, however, was the experience of the Indians, who endured ruthless and brutal treatment from the EIC. Probably the most nightmarish episode was the 1770 famine in the Indian territory of Bengal. By 1764, the EIC had become the de facto ruler of Bengal, where it established a monopoly in grain trading and prohibited local traders and dealers from “hoarding” rice (i.e., keeping reserves to shield the population from crop fluctuation). A year after drought struck in 1769, the EIC raised its already heavy tax on the land. The result was that one out of three Bengalis (more than 10 million people) died of starvation.⁹

Another of the EIC’s claims to shame involved opium. Having lost its monopoly of trade with India (except for tea) in 1813, the EIC aggressively promoted its export of Bengali opium to China. Despite Chinese authorities’ efforts to keep it out, by 1820 the EIC was exporting nine hundred tons of opium to China every year. To defend the EIC’s right to sell opium to China, the British Empire would wage two wars.

As the awful history of the EIC demonstrates, the profit goal by itself does not make private business superior to state ownership. A privately owned monopoly like the EIC can be even more destructive than a publicly owned one when it captures state power. While much of the history of European colonization is far from pretty, probably the two worst chapters were written by two private companies: the EIC and Leopold II’s Congo Free State, which I mentioned in Chapter 1. Both of these private monopolies were eventually broken up in response to the international uproar over the cruel conditions in which they kept local populations. If business remains a bad word in those parts of the world, much of the responsibility falls on these two monopolies.

THE TRADITIONAL VIEW OF MONOPOLIES

The most visible effect of a monopoly is higher prices. Competition drives companies to offer their products at a price close to their production cost. In a perfect and stable monopoly, this pressure is gone. When selling its tea in England, for example, the EIC could set the price that was most convenient to itself, realizing that lower prices would induce higher demand but that higher prices would yield a higher profit per unit. In deciding the optimal price level, a monopolist like the EIC will generally settle on a number that is above the competitive price. One might therefore think of monopoly as a tax that producers impose on consumers. But that conception isn’t always accurate. Imagine that the profit-maximizing price at which a hypothetical EIC sells tea is $10 per pound, when its cost of production and transportation is only $3. There are probably many people who are unwilling (or unable) to buy the tea at $10 but would be delighted to buy it at $5. Since 5 is bigger than 3, the company would be happy to sell to these customers at $5, if only it weren’t simultaneously lowering the price paid by rich customers. Many monopolists resolve the problem by segmenting the market and discriminating among customers. If they are unable to do so, however, they are forced to give up selling to thriftier consumers in order to preserve the high profit they get from higher-spending consumers. Notice that the profit lost on the nonbuying customers is not a transfer from consumer to producer, as we had just imagined, but a loss both for the consumers, who were willing to buy at $5, and for the producer, which could have sold at $5 what cost $3 to produce. This is an example of what economists call deadweight loss. Who should capture the difference between the $10 that the company charges and the $3 cost of production depends upon your view of who is most “deserving.” But the lost customers certainly represent a pure loss for society as a whole—a loss that, for example, patent law should try to minimize. This is the main reason why patent life is finite: the monopoly it creates (while necessary to motivate innovation) is inefficient, and there is a strong economic reason for it not to continue indefinitely.

The loss described above is not unique to monopolies. It occurs, albeit in a milder form, every time barriers to competition exist and firms have some market power over their customers. To address this problem, the United States developed antitrust legislation.

THE BENEFITS OF ANTITRUST LAW

Starting with the 1890 Sherman Antitrust Act, antitrust (or competition) law was introduced to oppose the coming together of entities—such as monopolies, cartels, or trusts—that could potentially harm competition. As is often the case, the motivation behind the act was suspect. Three months after proposing the law, Senator John Sherman sponsored the William McKinley Tariff, which restricted foreign trade and penalized consumers through higher prices. Some critics claimed that the Sherman Act was merely a scam to trick voters and introduce tariffs that severely penalized consumers. Regardless of the original intent, over the years the act and subsequent antitrust legislation have been used to reduce monopoly power and curtail business practices that set up detrimental barriers to entry. As the US Supreme Court has explained, “The purpose of the [Sherman] Act is not to protect businesses from the working of the market; it is to protect the public from the failure of the market. The law directs itself not against conduct which is competitive, even severely so, but against conduct which unfairly tends to destroy competition itself.”¹⁰

One of the main targets of antitrust actions has been mergers between competitors. There are several arguments in favor of mergers, including the fact that they improve efficiency by introducing economies of scale; this efficiency can be passed along to customers. Mergers also allow superior companies offering superior products to expand throughout the country. Consider Starbucks, which, in its expansion, bought out local coffee shops, presumably at least some of which had inferior fare or took too long to get customers in and out during rush hour. Without being able to acquire existing coffee shops, Starbucks would not have found it convenient to expand into markets too small to support multiple coffee shops. Old coffee shops, shielded from competition, would have had little reason to improve. The customers would have lost out.

To justify mergers, firms usually push the economies-of-scale argument. But economies of scale are no panacea—if they were, the Soviet Union would have had the most productive economy on the planet. The idea of a static trade-off between greater competition and greater economies of scale misses the gains that competition generates over time. The genius of capitalism is the continuous trial-and-error process it encourages. Without trial and error, it is exceedingly difficult to produce innovation and growth.

Accordingly, the purpose of an antitrust law is to prevent excessive consolidation, which deprives consumers of the benefits of innovation. But if antitrust enforcement helps keep an industry competitive, it also has two significant costs. The first is squelching some economies of scale. The second and more important one is massive government intrusion into the private sector—an intrusion that can be exploited for political reasons.

For this reason, antitrust law and its enforcement remain controversial among economists. Former Fed chairman Alan Greenspan has argued that consolidation will always benefit customers and that antitrust law is a waste of resources. In a 1962 pamphlet, he wrote: “The entire structure of antitrust statutes in this country is a jumble of economic irrationality and ignorance.”¹¹ He arrived at these extreme conclusions having started from the reasonable assumption that any monopoly that the government leaves unprotected is subject to the threat of competition from new businesses. In Greenspan’s view, the threat alone is sufficient to ensure that customers get most of the benefits of competition, even in the absence of actual competition.

Yet this argument is valid only under very special circumstances.¹² If Greenspan were right, companies would be unable to sustain prices above the competitive level even if they had made secret agreements with one another (also known as cartels). Sadly, we know that this is not always true. A good example, well known thanks to the movie The Informant, is the price-fixing scheme perpetrated by Archer Daniels Midland (and foreign competitors) in the market for lysine, an amino acid used in animal feed. ADM, a food processing conglomerate, was not new to price-fixing allegations. Between 1965 and 1998 it was accused of price fixing five times in markets ranging from bakery flour to monosodium glutamate (MSG).¹³ What makes the lysine case so striking is that, thanks to the informant who wiretapped the secret meetings, we can actually listen in as ADM conspires with four foreign competitors to raise the price of lysine from below 80 cents a pound to $1.20. “You’re my friend,” we hear ADM Corn Processing Division president Terry Wilson tell the foreign lysine makers in a secret meeting. “I want to be closer to you than I am to any customer ’cause you can make us money.”¹⁴ We also hear ADM president James Randall tell the group: “We have a saying here in this company that penetrates the whole company. It’s a saying that our competitors are our friends. Our customers are the enemy.” The price fixing lasted three years and—contrary to Greenspan’s claim—the threat of entry did not push prices to their competitive level. This is evidence of the benefit of antitrust enforcement.

Yet the most powerful argument in favor of antitrust law is one that is rarely made: antitrust law reduces the political power of firms. Most economists (including Greenspan) agree with the statement that the worst and most enduring form of monopoly is the one sanctioned by state power. The ability to obtain this state reinforcement, however, is directly proportional to the size of a firm (or a cartel)—the larger the firm, the easier for it to overcome the fixed cost of lobbying, and the higher the returns will be. The bigger the firm, too, the more likely it will be able to wield the power of the state to its own advantage. For all of these reasons, the monopoly costs traditionally cited are neither the only ones nor the most important.

OTHER PEOPLE’S MONEY

Writing in 1776, Adam Smith had the theft and graft of the East India Company fixed vividly in his mind. For him, this corruption was an indictment not just of monopolies but of all corporations that separated ownership from control. While his conclusion was too pessimistic—the corporate form has been extremely successful over the last two hundred years—his concerns were legitimate and remain valid today.

In the late 1990s, many Russian oligarchs enriched themselves by siphoning money from the companies they were running. For oil oligarchs, one of the most popular schemes was to sell oil at below-market prices to foreign trading companies that they themselves owned. To get a sense of the potential magnitude of this manipulation in transfer pricing, we can consult a report showing that in 2000, one Russian firm was selling oil to a foreign trading partner at just $2.20 per barrel, considerably below the average export price (net of export costs and excise taxes) of $13.50.¹⁵ The opportunity to channel profits toward a trading partner that the oil company’s managers personally owned, as was likely the case here, was enhanced by the opacity of Russian firms’ ownership structures.

Such episodes are not limited to foreign countries, of course, as the example of Enron can attest. Enron became infamous for its accounting fraud, which it perpetrated through a complex web of companies that did business solely with Enron. Enron’s chief financial officer, Andrew Fastow, who designed this web, had a financial stake in the companies, either directly or through a partner. He personally profited from many trades.

Nevertheless, despite some egregious examples, outright theft of this kind is fairly rare in the United States. But when competition is limited, the managerial corruption that Adam Smith feared can easily occur. In a competitive market, managers are unable to divert significant resources or pay themselves excessive salaries. Doing so, after all, would jeopardize the firm’s survival. By contrast, a firm with market power can earn more than it needs to compensate its workers and remunerate the capital invested. This extra return provides a cushion that top managers can easily exploit.

Consider the case of Ray Irani, the CEO of Occidental Petroleum. In 2010, he earned $76 million. His total compensation over the 2000–2010 period was a whopping $857 million. In these ten years, the company performed very well, but this performance largely resulted from a global surge in oil prices. The unhappiness of Occidental Petroleum’s shareholders about this compensation level was evident at the 2010 annual shareholders’ meeting. In a rare sign of lack of confidence, 54 percent of the shareholders voted against Occidental’s pay program. Yet it wound up going forward, because Securities and Exchange Commission (SEC) regulations ensure that these shareholder votes are only perfunctory—that is, inconsequential.

These kinds of massive salaries resemble those that the top officers of the East India Company were paying themselves. After the victory at Plassey, Sir Robert Clive, an officer of the EIC, awarded himself £234,000—a staggeringly high sum at the time. So a lack of competition penalizes ordinary citizens twice. It leads to higher prices and lower availability of a service or product, and it generates unjustified (and thus excessive) incomes, undermining consensus for the economic system as a whole.

CRONYISM

Raised as I was in Italy, I know a few things about nepotism. In its origins, the term is a euphemism: historically, the “nephews” receiving favors were in fact natural children of a pope (Alexander VI), who—being a Catholic pope—was not supposed to have children.

It is no surprise that nepotism was born in Rome, in the Catholic Church. Historically, the Church enjoyed tremendous market power. When that power was not won through the superiority of the Church’s message, it was obtained through the use of force. Repression, intolerance against heretics, and, ultimately, the Inquisition—all were aimed at preventing competition. It was precisely these barriers to entry that allowed the popes (and other members of the Catholic hierarchy) to wield—and often abuse—enormous power, including that of placing their children and cronies in positions of influence, regardless of merit.

This problem has not existed for Protestant churches, which are smaller and tend to compete with one another aggressively; thus they have little scope for favoritism. In these churches, appointing the wrong minister or the wrong treasurer can easily result in the disappearance of a congregation: room for error is scant. The same holds true for business. In a truly competitive market there is no room for cronies. The “room” arises when there is slack—that is, when a company can dominate a market. Cronyism, then, is another major cost of monopoly.

Unfortunately, it’s a cost that compounds over time. Once an incompetent “nephew” or stupid crony finds himself in a position of importance in a company, he tends to hire only subordinates of equal or lower quality, since he will feel threatened by people smarter or more talented than he is. After a few years of such cronyism, there is no easy way back. The human capital of the firm will become so eroded that it won’t be able to compete in the marketplace without some form of protection. Faced with any future threats to its own survival, should they somehow arise, the firm will then resort to lobbying, since it has forgotten how to compete. The more protection it is able to gain from government, however, the greater the available scope to continue the nepotism, which in turn makes protection even more necessary. A vicious circle is created that, once in motion, will drag down even the most successful economy.

THE POLITICIZATION OF DECISIONS INSIDE FIRMS

Firms and markets operate differently. Let’s say there’s a manager who wants to have a simple task done—photocopying, for instance. In a market transaction, the only information needed is the market price of this service. If the price is less than his assessment of how much the copies are worth, he will have the copies made; otherwise, he will not. He does not need to know the value of the possible alternative uses of the employees who work at the copy center, or the cost of the wear and tear on the photocopying machine. A single price saves him a lot of thinking. This is one of the great advantages of a market-based economy.

Consider now the same transaction within a firm. If the manager asks an assistant to make copies, the assistant will do the task (or risk getting fired). Within firms there is no contractual freedom: employees follow orders. There are also no prices involved. On the one hand, this makes things simpler: there is no need to haggle over how much any single task costs. On the other hand, the manager’s decision becomes tremendously more complicated. Not knowing the price, he must think about the alternative use of the assistant’s time and the alternative use of the copy machine. This can be done only within the context of an overall plan in which time is allocated to tasks and each task is given a value. In short, firms are small command-and-control economies, small socialist economies. What makes them so efficient (and keeps the capitalist economy vibrant) is the fact that they operate in a competitive environment. Once they acquire market power, however, they increasingly resemble their socialist cousins.

Conglomerates tend to be more socialist still. Before it merged with Exxon in 1998, Mobil Oil was not just an oil company; it was a large conglomerate. When oil prices plummeted in the mid-1980s, Mobil cut investments in all its divisions—not only in oil explorations (a decision that made sense, given the reduced price of oil) but also in its Montgomery Ward department-store business (quite unrelated to oil). Mobil even reduced its investment in its petrochemical divisions, the investment prospects of which should have benefited when oil prices fell, since they use oil as an input.¹⁶

This is an example of a well-documented fact: investment behavior within conglomerates deviates significantly from what similar firms that aren’t conglomerates but that are in the same line of business do. One could argue that such deviation is understandable, since the reason conglomerates are created in the first place is precisely to manage resources in a way that is different from what markets do. For example, a conglomerate may provide financing to information-sensitive projects, which cannot raise the necessary funds in the marketplace without revealing their valuable secrets. Interestingly, though, the more the investment behavior of a conglomerate differs from that of the market, the less valuable the conglomerate becomes.¹⁷ The same seems to be true of salaries. A student of mine, having looked at the patterns of salaries in conglomerates and compared them with the salaries for similar jobs in single-segment firms, has found that when one division in a conglomerate is in a sector that pays high salaries, all of the other divisions receive higher salaries, too.¹⁸

These tendencies are a manifestation of the conflict (which I discussed in Chapter 2) between efficiency and redistribution. To maintain consensus, companies and conglomerates tend to redistribute resources from the haves to the have-nots. By “taxing” the winning divisions and employees in order to subsidize the losers, this redistribution tends to reduce the incentive to work hard. Furthermore, it gives workers an incentive to lobby the managers, who have the power to affect redistribution, so as to grab a larger share of the existing pie.

Economists call such lobbying rent seeking to distinguish it from profit-seeking behavior. In seeking profits, companies or individuals engage in mutually beneficial transactions. In seeking rents, they spend resources trying to influence the division of a given pie. This behavior not only fails to create value (it basically steals from Peter to give to Paul) but actually destroys value, since time and effort are wasted in the process. Rent seeking is one of the greatest costs of bureaucracies, with talented individuals diverting large portions of their working day to efforts to influence the decision-making process in their favor.

Most economists distrust government because government enterprises are the ultimate form of monopoly and, as such, extremely inefficient. But as all these examples show, private companies untrammeled by the need to compete are also highly inefficient. Firms are socialist islands in a free-market ocean. The smaller the market power of these islands, the more the system conforms to Adam Smith’s ideal; the larger it is, the more it resembles its socialist alternative. If one big firm controlled the entire economy, would a capitalist system differ from a socialist one?

MODERN-DAY EAST INDIA COMPANIES

For the invisible hand to work best, firms must be small enough that they cannot manipulate prices. Even when they do, free markets work pretty well as long as the firms’ market power is limited. The larger their market power, the larger the distortion. The worst outcome is a scenario in which firms’ market power transcends the industry they operate in and becomes political power. The state, as noted earlier in this chapter, has the ultimate monopoly—the one on the legitimate use of force. When the power arising from this monopoly merges with the market power arising from the economic dominance of a sector, the results are invariably disastrous—whether a government-owned firm is given market power (as with Fannie Mae and Freddie Mac) or a private monopoly takes over government power (as with the East India Company).

A modern-day version of an EIC and its negative consequences on a country are represented by Silvio Berlusconi. He won multiple electoral campaigns on his promise to run the government like a business. Unfortunately, he ended up running the government as his own business. Even when he did not bend the rules in his own favor, competitors bowed out for fear of government retaliation. Not since the East India Company has such a corrupt intermingling between government and business been seen. Berlusconi was prime minister for eight of the ten years between 2001 and 2011, during which time the Italian per-capita GDP dropped 4 percent, the debt-to-GDP ratio increased from 109 percent to 120 percent, and taxes increased from 41.2 percent to 43.4 percent of GDP. During the same period, Italy’s score in the Heritage Foundation’s Index of Economic Freedom fell from 63 to 60.3 and in the World Economic Forum Index of Competitiveness from 4.9 to 4.37. By capturing (or, more precisely, purchasing) the free-market flag the way one might acquire a business brand, Berlusconi has likely destroyed the appeal of the free-market ideal in Italy for a generation.

Unfortunately, Berlusconi is not the only example of a modern-day EIC. Under the Andreas family’s reign, ADM was another. In addition to its participation in price-fixing scandals, ADM has been the most prominent recipient of corporate welfare in recent US history.¹⁹ The libertarian Cato Institute Policy Analysis estimates that in 1995 at least 43 percent of ADM’s annual profits were tied to products heavily subsidized or protected by the American government.²⁰ Between ethanol subsidies and a cane-sugar tariff protecting its high-fructose syrup, ADM has made billions of dollars over the years in subsidized profits at the expense of customers and taxpayers.

The government favors derive from the Andreas family’s political connections. In addition to contributing millions of dollars to both political parties, Dwayne Andreas, the family patriarch, has provided personal assistance to politicians. He bought Jimmy Carter’s peanut warehouse for $1.2 million²¹ and sold Bob Dole and his wife an apartment at the Sea View Hotel in Bal Harbour, Florida.²² He was not shy about his political influence. As he declared to a journalist: “There isn’t one grain of anything in the world that is sold in a free market. Not one! The only place you see a free market is in the speeches of politicians. People who are not in the Midwest do not understand that this is a socialist country.”²³ As the Cato Institute Policy Analysis correctly points out, “Andreas has exerted his influence in Washington to ensure that the U.S. form of ‘socialism’ resembles 1930s’ Italian corporate statism: the government plunders the citizenry for the benefit of politically connected corporations.”²⁴ The conservative National Review labeled him a modern robber baron.²⁵

ADM bought support through the media as well. For a company that does not sell consumer products, it has wielded a massive TV advertising budget. Its ads in the past have inundated political talk shows. From January 1994 to April 1995, ADM spent $4.7 million on NBC’s Meet the Press, $4.3 million on CBS’s Face the Nation, and $6.8 million on PBS’s MacNeil-Lehrer Newshour, and it was the primary sponsor of ABC’s This Week with David Brinkley.²⁶

Fannie Mae and Freddie Mac are likewise modern-day EICs. The conservative press has often described them as government entities pressured by politicians to make bad loans. A better characterization is private monopolies, which use their political connections to make money at the expense of taxpayers. Their operations are so massive that one could describe them as a state within the state. They have become so crucial to the US economy that they cannot be allowed to fail. They are so politically influential that reform becomes a Herculean task.

The political might of large financial institutions is not much smaller. Consider Citigroup’s effort to change the Glass-Steagall Act, which severed the economic ties between investment banking and commercial banking. In 1998, Citigroup acquired Travelers (an insurance company), even though the law prohibited banks from merging with insurance companies. At the time of the merger, Travelers’ CEO, Sandy Weill, explained why the companies were moving forward in spite of an apparent conflict with the law: “we have had enough discussions [with the Fed and the Treasury] to believe this will not be a problem.”²⁷

At that time, the head of the Treasury was Robert Rubin, who worked very hard to convince his fellow Democrats to change the law. Rubin left the Treasury in July 1999, the day after the House passed its version of the bill by a bipartisan vote of 343 to 86. Three months later, on October 18, 1999, Rubin was hired at Citigroup at a salary of $15 million a year, without any operating responsibility. It is hard not to see a connection between these two events.

Both Citigroup and Rubin acted within the law. But so did Berlusconi when he had the law changed to benefit himself and his own businesses. The legality of such commingling of business and government does not make it right. In a healthier state of affairs, one can use the resources created by private business to resist the grasping hand of the government or use the power of the state to restrain the abuses of private monopolies. But when private monopoly controls the power of the state, remedies vanish.

CONCLUSIONS

In the Introduction to this book, I mentioned that 51 percent of Americans agree with the statement “Big business distorts the functioning of markets to its own advantage.” This conviction is shared not only by those who distrust free markets but also by those who agree that “the free market is the best system to generate wealth.” The distinction between a promarket agenda and a probusiness one has not escaped the attention of a majority of Americans. While the two agendas sometimes coincide—as in the case of protecting property rights—they’re often at odds. A probusiness agenda aims at maximizing the profits of existing firms; a promarket agenda, by contrast, aims at encouraging the best business conditions for everyone.

Adam Smith was promarket rather than probusiness, as all economists who believe in his principles should be. Free and competitive markets are the creators of the greatest wealth ever seen in human history. But for markets to work their magic, the playing field must be kept level and open to new entrants. When these conditions fail, free markets degenerate into inefficient monopolies—and when these monopolies extend their power to the political arena, we enter the realm of crony capitalism. Unfortunately, as the Citibank example suggests, one industry in which crony capitalism has gained a tremendous amount of influence in the last decade is finance, which deserves a separate analysis.