Inside Story

How the public interest went missing in action

Books | Is the US economy suffering from an overriding malady — and could Australia become infected?

Carmela Chivers 22 January 2018 1043 words

In the grip of rent-seekers? The Capitol Building in Washington, DC. vgm8383/Flickr

The Captured Economy
By Brink Lindsey and Steven Teles | Oxford University Press | $39.95 | 232 pages

Economic textbooks have long claimed that policy-makers face a trade-off between efficiency and equity — they can increase the size of the economic pie or they can ensure it gets shared more fairly. Yet America today faces the worst of both worlds: inequality has grown and the economy is stagnant. What’s gone wrong?

In this important new book, Brink Lindsey and Steven Teles point the finger at rent-seeking. Their core premise is that markets function best when supported by a state that can enforce the rules of the game in the public interest. When the balance is wrong, markets are less dynamic, less efficient and less productive — wealth begets wealth, and inequality is entrenched. When the balance is right, innovation, growth and social mobility flourish.

Lindsey and Teles argue that American policy-makers have upset the balance by creating regulations that protect the wealth of powerful special interests. This happened because government regulation allowed rent-seeking to proliferate: “To the extent that rent-seeking holds sway, the invisible hand of capitalism degenerates into the grasping hand of crony capitalism, and the lofty pursuit of the public interest devolves into a feeding frenzy of special interests.” Given that more Australians than ever before tell opinion pollsters that government is “run for a few big interests,” theirs is a timely warning for those of us who wish to avoid following America’s path.

In economics, “rents” are extra payments received by productive resources (such as labour, land or capital) simply because they are scarce. They are by no means always bad. The most common example of an acceptable rent is the extra profit firms earn when they invent a useful new product. While other firms work to catch up (or to make an even better product), the inventors can charge more for their innovative idea. Importantly, these rents are temporary — they should erode under the pressures of a competitive market.

Problems arise when the promise of rents encourages continuing activity that hurts the public interest. Remember the infamous case of the pharmaceutical company that raised the price of a sixty-two-year-old life-saving drug from less than $20 to more than $700 a pill? The company could get away with it because the market for the drug was small, and because US regulations made it difficult and costly for other firms to start producing the drug and compete on price. There was no internal mechanism in the market to wind back the rents accruing to the company, or to protect the interests of patients. It was a classic case of harmful rent-seeking: regulatory loopholes were exploited to boost profits by creating artificial scarcity in the market.

Figuring out where to draw the line is tricky. The risk of regulating is that rent-seekers will find ways to extract profits at the expense of the public good. According to Lindsey and Teles, firms may find it is more profitable to engage in an “on-going negative-sum scramble for more favours” when regulations go wrong. This distorts the economy — and political processes — to the detriment of all.

The authors use four case studies — from finance, intellectual property laws, occupational licensing and housing — to make their point. They argue, persuasively, that the economy and society suffer when government policy looks after special interests better than the public interest. But the focus on regulations going bad can make their case studies feel one-sided. The next step would have been to give the reader an idea of how we should weigh the benefits of regulating against the costs. A good example of this tension comes from the housing chapter.

Here, Lindsey and Teles argue that zoning and land-use controls (which govern how people can build new housing) are skewed in favour of the people who already live in an area. Zoning advantages existing homeowners at the expense of potential buyers, they argue, because these regulations protect the value of already-built homes in desirable locations by restricting supply and pushing up house prices. The regulations therefore come at a cost for people (and governments) seeking affordable housing.

These findings are important for the ongoing debate about the impact of housing supply on house prices in Australia, and they back up the argument that rezoning could be one of the most effective levers available to Australian governments concerned about housing affordability. But to convince the reader, the authors should have made more of an effort to weigh the community benefits against the costs. Frustratingly, doing so would have strengthened their argument: estimates suggest that land-use controls in America cost the economy between 2 and 13 per cent every year. It’s hard to imagine that the benefits of zoning could be that big. Unfortunately, the housing chapter was a missed opportunity to make that case.

The final chapters of The Captured Economy argue that rent-seeking is most successful (for the rich and powerful) when political processes prioritise the voices of the few over the voices of the many. These chapters suggest that combating the problem requires “hearing the other side of the story” by encouraging debate between disparate groups. The idea is to give equal airtime to everyone who might be affected by a policy change, and thereby ensure that special interests don’t gain too much sway over the final outcome.

It’s a novel idea, but the argument feels incomplete. For one thing, Lindsey and Teles may be overly optimistic about the prospects of rational debate in the American political arena: politics there has rarely been more polarised. More broadly, the rise of far-right populism is creating an “us versus them” feel to politics in many Western democracies.

More importantly, The Captured Economy doesn’t say much about what well-designed regulations look like. It fails to give adequate weight to the fact that if governments don’t regulate, the public still suffers. Though the book starts by proclaiming the importance of a “strong state” to balance the strength of the market, there seems to be an implicit assumption that the less regulation, the better. The reader is left wondering — why regulate at all?

The Captured Economy is a valuable book; it earnt its place on the Grattan Institute’s Summer Reading List for the Prime Minister. It does a very good job of diagnosing a problem. The solution, however, remains elusive. ●