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NRO’s domestic-policy blog, by Reihan Salam.

The Incomplete Neoliberal Revolution



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Ramesh Ponnuru’s latest column argues that the “tongue-depressor tax,” one of the lesser-known provisions of President Obama’s health system overhaul, might lead to the loss of jobs associated with the manufacture of medical devices:

In November, citing the new tax, Stryker Corp. (SYK), whose products include artificial hips and knees, announced that it would let go about 1,000 of its workers. Earlier last year, Covidien Plc (COV), maker of surgical instruments, said it would lay off 200 workers in the U.S. and move production to Costa Rica and Mexico. It, too, cited the tax.

Other companies in the field have announced similar measures — or plans to expand production overseas but not in the U.S. — without mentioning the tax. The sluggish economy is clearly part of the explanation, but the medical-devices industry had been a relative bright spot within U.S. manufacturing, losing only 1.1 percent of its employees during 2007-2008 while manufacturing as a whole lost 4.8 percent. A study done for AdvaMed, a trade association for the industry, claims the tax could ultimately cost more than 45,000 jobs.

Medical-device companies employ more than 400,000 Americans. Their wages are higher than the national average. The U.S. is a net exporter of medical devices.

The tax will change these numbers for the worse. It will be levied at 2.3 percent of sales; on average, profits make up less than 4 percent of sales in the industry. The AdvaMed study concludes, “The new 2.3 percent excise tax will roughly double their total tax bill and raise the average effective corporate income tax rate to one of the highest effective tax rates faced by any industry in the world.”

While the tongue-depressor tax raises legitimate questions of allocative efficiency — do we really have a good reason to single out the manufacture of medical devices for a punitive tax, even if we accept that the U.S. health system systematically overspends on medical devices? — Ramesh’s argument reminded me of a larger set of arguments. Since the 2008 financial crisis, calls for improving the incentives for firms to invest and hire have intensified, and they were already quite intense. I have been strongly inclined to embrace this push, as I think that our tax code is a mess that suppresses our growth potential. Yet these more recent calls have generally been for more focused efforts, like temporary employer-side payroll tax cuts, temporary investment tax credits, etc. Market conservatives have offered a by now drearily familiar and entirely correct case against tax temporary tax measures, on the grounds that they deepen uncertainty, they intensify lobbying activity (to delay the sunset), they simply don’t work as well as “permanent” reforms, etc. All of this is pretty sound.    

But let’s think about the mental model at work behind the case for incentives. Some months ago, I heard a few left-wing commentators guffawing about American business: “I mean, these guys are supposed to be capitalist individualist heroes, and here they are clamoring for little tax breaks. They just can’t do anything without a boost from the government. It’s kind of pathetic.” At the time, I found these remarks fatuous. Now, however, I think they expressed a deeper truth. As Ashwin Parameswaran has argued, policies aimed at achieving macroeconomic stabilization have turned large U.S. business enterprises into hothouse flowers:

The structural malformation of the economic system due to the application of increasing levels of stimulus to the task of stabilisation means that the economy has lost the ability to generate the endogenous growth and innovation that it could before it was so actively stabilised. The system has now been homogenised and is entirely dependent upon constant stimulus. The phenomenon of ‘rapid cycling’ explains a phenomenon I noted in an earlier post which is the apparently schizophrenic nature of the markets, turning from risk-on to risk-off at the drop of a hat. It is the lack of diversity that causes this as the vast majority of agents change their behaviour based on absence or presence of stabilising interventions.

Many observers have highlighted the investment deficit plaguing the U.S. and other advanced market democracies. Michael Mandel, for example, notes the following:

(i) Despite rebounding from its recession valley, net business investment as a share of net domestic product is still far below historical levels.

(ii) Household and institutional net investment as a share of net domestic product is at a 40-year low.

(iii) And perhaps most disturbing, government net investment is only 1% of net domestic product, a 40-year low.

Presumably, our left-of-center interlocutors will point to (iii) as a legacy of GOP obstructionism, and with some force. One could also argue, however, that it reflects the spending priorities of the president’s coalition and political imperatives, e.g., a Social Security payroll tax holiday was seen as more likely to yield short-term employment gains than a sustained increase in public investment that would yield less visible (and thus less politically salient) employment gains over time; the cause of “public investment” has been badly undermined by consumption-like spending on sustaining high employment levels in K-12, etc. 

The really interesting story concerns net business investment. Getting cash-rich U.S. firms to invest is a serious challenge that has concentrated the mind of U.S. policymakers. There is an obvious hypothesis as to why U.S. firms are reluctant to invest in U.S. establishments. David Beckworth, citing Robert Gordon, writes the following

So over the next two decades Robert Gordon sees labor productivity growing at annual average rate of 1.7% compared to about 2.5% for 1995-2004. If his view is widely held then that means firms will expect lower returns to investment and household will expect lower incomes. Such lower expectations, in turn, would translate into lower investment and consumer demand today. This, then, may account for some of the prolonged slump.

Beckworth suggests that the anticipation of sluggish growth in the future is not the most important factor for firms, and he may well be right.

But let’s think about this for a moment. Imagine a world in which firms only ramp up investment when they think there is going to be a new wave of affluent customers eager to buy their wares. Wouldn’t you say these firms are pretty confident? That is, they’re taking survival for granted. In part, that could reflect the fact that they are sitting on mountains of cash. But they are presumably sitting on mountains of cash because, well, they’re not facing particularly stiff competition. If they were, those mountains of cash would be competed away.

The really threatening competition isn’t price competition. Price competition means that firms will invest more in scaling up their operations to drive down their price point. That is where monetary policy comes in, as Ashwin explains:

Business investments can typically either operate upon the scale of operations (e.g. capacity, product mix) or they can change the fundamental character of operations (e.g. changes in process, product). Investments in scaling up operations are most easily influenced by monetary policy initiatives which reduce interest rates and raise asset prices or direct fiscal policy initiatives which operate via the multiplier effect. Investments in process innovation require the presence of price competition within the industry.

But here’s the thing about investments in the scale of operations: they’re not likely to generate big employment gains across the economy. Part of the point of investments in scale is that you economize on labor. 

There is a big difference between this kind of exploitative investment (i.e., exploiting economies of scale) and exploratory investment. Ashwin again:

In a seminal article, James March distinguished between “the exploration of new possibilities and the exploitation of old certainties. Exploration includes things captured by terms such as search, variation, risk taking, experimentation, play, flexibility, discovery, innovation. Exploitation includes such things as refinement, choice, production, efficiency, selection, implementation, execution.” True innovation is an act of exploration under conditions of irreducible uncertainty whereas exploitation is an act of optimisation under a known distribution.

The assertion that dominant incumbent firms find it hard to sustain exploratory innovation is not a controversial one. I do not intend to reiterate the popular arguments in the management literature, many of which I explored in a previous post. Moreover, the argument presented here is more subtle: I do not claim that incumbents cannot explore effectively but simply that they can explore effectively only when pushed to do so by a constant stream of new entrants. This is of course the “invisible foot” argument of Joseph Berliner and Burton Klein for which the exploration-exploitation framework provides an intuitive and rigorous rationale.

Let us assume a scenario where the entry of new firms has slowed to a trickle, the sector is dominated by a few dominant incumbents and the S-curve of growth is about to enter its maturity/decline phase. To trigger off a new S-curve of growth, the incumbents need to explore. However, almost by definition, the odds that any given act of exploration will be successful is small. Moreover, the positive payoff from any exploratory search almost certainly lies far in the future. For an improbable shot at moving from a position of comfort to one of dominance in the distant future, an incumbent firm needs to divert resources from optimising and efficiency-increasing initiatives that will deliver predictable profits in the near future. Of course if a significant proportion of its competitors adopt an exploratory strategy, even an incumbent firm will be forced to follow suit for fear of loss of market share. But this critical mass of exploratory incumbents never comes about. In essence, the state where almost all incumbents are content to focus their energies on exploitation is a Nash equilibrium.

On the other hand, the incentives of any new entrant are almost entirely skewed in favour of exploratory strategies. Even an improbable shot at glory is enough to outweigh the minor consequences of failure. It cannot be emphasised enough that this argument does not depend upon the irrationality of the entrant. The same incremental payoff that represents a minor improvement for the incumbent is a life-changing event for the entrepreneur. When there exists a critical mass of exploratory new entrants, the dominant incumbents are compelled to follow suit and the Nash equilibrium of the industry shifts towards the appropriate mix of exploitation and exploration.

If we accept this framework, the deeper cause behind insufficient business investment becomes clear. Incumbent firms aren’t as frightened of new entrants as they should be. 

Think about this across sectors of the economy. Sectors in which barriers to entry are relatively low are sectors in which firms are not stockpiling huge amounts of cash. Rather, firms are in a never-ending arms-race against rivals and potential rivals. They must engage in exploratory investment in order to maintain some (fleeting) advantage. 

But then a few things happen: incumbents find ways to protect themselves through the patent system, as Alex Tabarrok and Michael Heller have argued. And regulations designed to protect workers and consumers grow so onerous and complex that new entrants are stymied by them. 

This is what I mean by “the incomplete neoliberal revolution.” Ashwin’s take on this is brilliant:

By the late 70s, the pressures and conflicts of the system of “order for all” meant that change was inevitable. The result was what is commonly known as the neoliberal revolution. There are many different interpretations of this transition. To right-wing commentators, neoliberalism signified a much-needed transition towards a free-market economy. Most left-wing commentators lament the resultant supremacy of capital over labour and rising inequality. For some, the neoliberal era started with Paul Volcker having the courage to inflict the required pain to break the back of inflationary forces and continued with central banks learning the lessons of the past which gave us the Great Moderation.

All these explanations are relevant but in my opinion, they are simply a subset of a larger and simpler explanation. The prior economic regime was a system where both the invisible hand and the invisible foot were shackled – firms were protected but their profit motive was also shackled by the protection provided to labour. The neoliberal transition unshackled the invisible hand (the carrot of the profit motive) without ensuring that all key sectors of the economy were equally subject to the invisible foot (the stick of failure and losses and new firm entry). Instead of tackling the root problem of progressive competitive and democratic sclerosis and cronyism, the neoliberal era provided a stop-gap solution. “Order for all” became “order for the classes and disorder for the masses”. As many commentators have noted, the reality of neoliberalism is not consistent with the theory of classical liberalism. Minsky captured the hypocrisy well: “Conservatives call for the freeing of markets even as their corporate clients lobby for legislation that would institutionalize and legitimize their market power; businessmen and bankers recoil in horror at the prospect of easing entry into their various domains even as technological changes and institutional evolution make the traditional demarcations of types of business obsolete. In truth, corporate America pays lip service to free enterprise and extols the tenets of Adam Smith, while striving to sustain and legitimize the very thing that Smith abhorred – state-mandated market power.”

Minsky focuses on legislation that institutionalizes and legitimizes market power, a category under which excessive patent protection might comfortably fall, yet regulation of all kinds can protect incumbents. 

As Michael Mandel has argued, it is easy to imagine a scenario in which each discrete regulation is defensible, yet the cumulative impact of regulations create insuperable obstacles to exploratory innovation:

I’ve been using the metaphor of “throwing pebbles in a stream” to describe the effect of regulation on innovation. No single regulation or regulatory activity is going to deter innovation by itself, just like no single pebble is going to affect a stream. But if you throw in enough small pebbles, you can dam up the stream. Similarly, add enough rules, regulations, and requirements, and suddenly innovation begins to look a lot less attractive.

A new study entitled ”FDA Impact on U.S. Medical Technology Innovation: A Survey of Over 200 Medical Technology Companies“ makes this point very well. The study, supported by the Medical Device Manufacturers Association and the National Venture Capital Association, found lots of ‘pebbles’–inefficiencies and lags in the system of approval that added up to a big problem.

Note that we’ve come full circle. Ramesh is (rightly) concerned about how a new tax will impact incumbent medical device manufacturers. “Pebbles in the stream” are also a problem for these incumbents — and also for the would-be firms that never see the light of day because the cost of compliance is so high. 

The neoliberal revolution was incomplete because, as Ashwin suggests, it emphasized the invisible hand without placing sufficient weight on the invisible foot. Last year, I briefly wrote about the two kinds of deregulation that occurred during the height of neoliberal reform. The following is from Monica Prasad:

To call Breyer and Kennedy’s participation in deregulation an indication of their underlying conservatism or eclecticism is a misreading of history, in light of what deregulation became. In the early to mid 1970s, deregulation was not a conservative idea, but a liberal populist one, against big business and in the interest of consumers. That Breyer himself saw the issue in these terms — and not in conservative terms of getting the government out of industry — is apparent in two memos that he wrote for Kennedy in 1974, urging Kennedy to push deregulation of the airlines. …

Although it has emerged on the Left as a pro-consumer issue, by the end of the 1970s deregulation had become a free-market issue pushed most heavily by the Right. In particular, the meaning of deregulation had changed: instead of economic deregulation (deregulation involving agencies that regulate one industry in the interest of preventing monopoly but have become “captured” and are giving unfair advantages to that industry) deregulation now referred to social deregulation (deregulation involving agencies such as the EPA and OSHA that regulate all industries in the interest of consumers, workers, and the environment).

I think it is fair to say that Prasad sees “social deregulation” as less defensible than “economic regulation.” Yet “social deregulation” might also be seen as an effort to clear away “pebbles in the stream” for new entrants.

And it turns out that while the neoliberal revolution proved somewhat successful in reducing onerous taxes, it utterly failed to reverse the progressive increase in regulatory barriers. James Gattuso of the Heritage Foundation suggests that the George W. Bush and Barack Obama administrations have seen a rapid increase in the regulatory burden. (Virginia Postrel wrote on a related theme back in 2004.) 

Two concluding thoughts:

(1) One gets the strong impression that the pro-market right has placed far too much emphasis on taxes and far too little emphasis on regulation. Interestingly, Mitt Romney represents an exception. The most detailed and convincing section of his much-criticized jobs plan was the section on regulation while he conspicuously failed to engage in an effort to outbid his primary challengers in a game of “who can offer the biggest tax cut.” Rick Santorum, in contrast, promises to eliminate the corporate income tax for manufacturers, which will presumably lead to interesting hair-splitting regarding what actually counts as manufacturing.  

(2) There has been a revival of interest in regulation on the left. In the context of the financial markets, this strikes me as defensible, though encouraging the rise of new entrants in this space (e.g., making it extremely easy to charter “narrow banks” and to limit deposit insurance to narrow banks) might be the better way to go. More broadly, however, the pro-regulatory push might actually contribute to an extremely fragile macroeconomy dominated by powerful incumbent firms. The results have been grim — back to Ashwin for a moment:

This tilt towards exploitation/cost-reduction without exploration kept inflation in check but it also implied a prolonged period of sub-par wage growth and a constant inability to maintain full employment unless the consumer or the government levered up. For the neo-liberal revolution to sustain a ‘corporate welfare state’ in a democratic system, the absence of wage growth necessitated an increase in household leverage for consumption growth to be maintained. The monetary policy doctrine of the Great Moderation exacerbated the problem of competitive sclerosis and the investment deficit but it also provided the palliative medicine that postponed the day of reckoning. The unshackling of the financial sector was a necessary condition for this cure to work its way through the economy for as long as it did.

It is this focus on the carrot of higher profits that also triggered the widespread adoption of high-powered incentives such as stock options and bonuses to align manager and stockholder incentives. When the risk of being displaced by innovative new entrants is low, high-powered managerial incentives help to tilt the focus of the firm towards a focus on process innovation and cost reduction, optimisation of leverage etc. From the stockholders and the managers’ perspective, the focus on short-term profits is a feature, not a bug.

So long as unemployment and consumption could be propped up by increasing leverage from the consumer and/or the state, the long-run shortage in exploratory product innovation and the stagnation in wages could be swept under the rug and economic growth could be maintained. But there is every sign that the household sector has reached a state of peak debt and the financial system has reached its point of peak elasticity. 

This is not the economy the left actually wants. But it is the economy that flows from excessive regulation. Ashwin is optimistic that a more “micro-fragile” economy, that is, an economy in which incumbents are more threatened by a constant flow of new entrants, would lead to higher employment levels. If he’s right, it seems clear that the left and the right have a shared interest in removing the pebbles from the stream.



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