Raising Rival’s Costs and Reform in the Public Interest

How can we achieve reform in the public interest when the public is rationally ignorant and unorganized while the special interests are informed, organized and well funded?  Matt Yglesias draws some interesting lessons and hope (!) from my paper on The Separation of Commerical and Investment Banking: The Morgans vs. the Rockefellers (pdf).

Yglesias offers a brief summary of the paper:

The basic story is that the Depression led to a lot of public outrage about the financial system and the outrage was—as outrage tends to be—a little bit inchoate and not really focused on the fine-grained details of public policy. Meanwhile, the Rockefeller family and the Morgan family had some longstanding business conflicts between their respective empires. And the Glass-Steagall bill was essentially an effort by the Rockefellers to channel that inchoate public outrage in a direction that would harm the Morgans:

More than anyone else, Winthrop Aldrich, representative of the Rockefeller banking interests, was responsible for the separation of commercial and investment banking. With the help of other well-connected anti-Morgan bankers like W. Averell Harriman, Aldrich drove the separation of commercial and investment banking through Congress. Although separation raised the costs of banking to the Rockefeller group, separation hurt the House of Morgan disproportionately and gave the Rockefeller group a decisive advantage in their battle with the Morgans.

He then draws an interesting conclusion:

Tabarrok notes that when this kind of regulatory strategy is pursued in a given industry “the industry as a whole will shrink” even while one firm gains an advantage over its rivals. And here we have actually an answer to a question that’s troubled me for years: How, given political realities, can the financial sector ever be brought to heel?… It shows a way that smart and savvy would-be regulators can find ways to undermine sector-level political solidarity. Not just in ways that favor one firm against another (which would be pointless) but even in ways that shrink the sector as a whole.

Here’s the big picture. Under certain conditions, free markets channel self-interest towards the social good – that is the meaning of the invisible hand theorem. Unfortunately, there is no invisible hand theorem for politics. There are institutions, such as democracy, checks and balances and an independent judiciary, which help to channel political self-interest if not to the public good then at least away from the public evil. Even given the right macro institutions, however, breaking the iron triangle of politics is difficult. Industry self-interest and the public interest will typically align only accidentally. Universities are not less self-interested than any other actors but support for basic research is (arguably) in the public interest. The usual situation, however, is that industry self-interest pushes well beyond the point of alignment with the public interest. At current spending levels, lobbying by defense firms does not benefit the public even if national defense is a public good.

Yglesias is interested in the most difficult case when the public interest favors not a larger but a smaller industry. Will industry self-interest every align with a smaller industry? Rarely but if public anger against an industry is high then some industry participants may see that a smaller industry is consistent with their self-interest if their share of the industry grows enough as the industry shrinks–a bigger share of a smaller pie. This is the theory of raising rival’s costs that I argue led to the Glass-Steagall Act. Other examples of raising rival’s costs are firms like Costco, that already pay high wages advocating for increases in the minimum wage.

Could we apply this strategy to the provision of other public goods? Here’s an idea. The best political strategy to combat global climate change may be to bring the cleaner parts of the energy industry into a coalition with environmentalists to support a carbon tax. That means bringing the environmentalists together with the nuclear, hydro-electric and fracking part of the energy industry in a play to raise the relative costs of coal and foreign oil. Could this happen? It is unlikely but not inconceivable. As Yglesias says it would take “a smart and savvy” regulator and, I would add, a public-interested regulator (a small but let’s be charitable and say not a zero intersection) to bring the coalition together. You can see why I am less optimistic than Yglesias that the theory can be used to support the public interest but no one said that smart, savvy, public interested regulators would have it easy.


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