Free Market Myth

The extraordinary financial collapse of recent months has been
commonly described as a testament to the failure of deregulation. The
events are indeed testament to a failure--a failure of public policy.
Blaming deregulation is misleading.

In general, political
debates over regulation have been wrongly cast as disputes over the
extent of regulation, with conservatives assumed to prefer less
regulation, while liberals prefer more. In fact conservatives do not
necessarily desire less regulation, nor do liberals necessarily desire
more. Conservatives support regulatory structures that cause income to
flow upward, while liberals support regulatory structures that promote
equality. "Less" regulation does not imply greater inequality, nor is
the reverse true.

Framing regulation debates in terms of
more and less is not only inaccurate; it hugely biases the argument
toward conservative positions by characterizing an extremely intrusive
structure of, for example, patent and copyright rules, as the free
market. In the realm of insurance and finance over the last two
decades, calls for deregulation have been cover for rules tilted
starkly toward corporate interests. And the recent change in bankruptcy
law, hailed by conservatives, requires much greater government
involvement in the economy.

False ideological claims have
circumscribed the public debate over regulation and blinded us to the
wide range of choices we can make. Without these claims, what would
guide regulatory policy? What kinds of choices would we have?

* * *

Patent
and copyright protection are good examples of government policies
obscured in the debate. They are forms of regulation, not elements of a
"free market."

It does not matter that we call patents and
copyrights "property" or even that we have a clause in the Constitution
that authorizes Congress to grant patents and copyrights. Suppose
autoworkers were given a property right to a job in the automobile
industry, a right they could even sell. Would anyone say that this
right to a job is part of the free market?

Patents and
copyrights are government-granted protections designed for a specific
public purpose, as stated in the Constitution: "to promote the Progress
of Science and useful Arts." But granting intellectual property rights
is one of many possible mechanisms for accomplishing this important
public goal. Whether patents and copyrights are the most effective
mechanisms for the promotion of the arts and sciences is an empirical
question. And the answer could be different depending on the specific
social and economic circumstances. However, we cannot have a serious
discussion of the relative merits of patents and copyrights until we
recognize that these are public policies and not intrinsic features of
the free market. Debates about both patent and copyright have been
hugely distorted by the failure to recognize this obvious fact.

In
the case of patent protection, policy disputes arise most frequently
with regard to prescription drugs. If drugs were sold in a competitive
market (i.e., without patent protection), the overwhelming majority of
drugs would sell for just a few dollars per prescription. Wal-Mart and
other major drug store chains now sell most generic drugs for less than
$10 per prescription--we know these drugs can be manufactured safely and
sold profitably at low prices.

The drugs available as
generics are not chemically distinct from their brand-name counterparts
that often sell for hundreds of dollars per prescription. The only
difference is that the latter, as a group, enjoys a
government-guaranteed monopoly. Patents constitute a government policy
that effectively raises drug prices by several thousand percent above
the free market price.

Recognizing this should be the
starting point in any policy debate. The next question is whether this
policy for supporting innovation is the best mechanism for financing
the research and development of new drugs. It clearly is not the only
one.

The government could, for example, support drug
research through a prize system in which it buys drug patents and then
places them in the public domain so that newly developed drugs could be
manufactured and sold as generics.

When we sweep away ideology, we see that it is a debate between two regulatory strategies for keeping drug prices down.

Alternatively,
the government could pay for the research upfront and make all research
findings and patents fully public. It already spends $30 billion a year
financing biomedical research through the National Institutes of
Health, an amount almost as high as the pharmaceutical industry claims
to spend on its research. NIH research is highly respected, with almost
all observers agreeing that the money is, on the whole, extremely well
spent. While the NIH focuses on basic research (it also does some
later-stage drug research, including clinical testing), there is no
obvious reason why the government could not simply double its
commitment to biomedical research in order to replace the research and
development currently supported by grants of patent monopolies.

But
the government may wish to use a different mechanism to encourage drug
development. It may choose to establish a small number of master
contractors, who would then contract out the awarding of research funds
so as to minimize the potential for political interference. Regardless
of the structure a particular program would take, expansion of direct
funding is clearly feasible.

There would also be large
public benefits in addition to lowering the price of drugs to their
marginal cost. Eliminating huge monopoly rents associated with drug
patents would take away the incentive for drug companies to push drugs
in cases where they may not be especially beneficial, or even
potentially harmful. Nor would there be incentive to conceal research
findings that indicate a drug's weak performance. Furthermore, by
placing all research findings in the public domain, so that scientists
can quickly benefit from the research done by others, the process of
drug innovation would likely accelerate.

Whether a
patent-buyout system or direct public funding would be preferable to
the current patent system is obviously debatable; the point is that
patent is just one mechanism among many that could facilitate
prescription-drug research. And it is one that involves granting
monopoly rents to large drug companies.

It is important to
establish that patents are a form of regulation because there are many
venues in which the regulation of prescription drugs has been a major
issue, with those who would see prices fall cast as opponents of the
free market. For example, the ongoing push to have Medicare bargain for
lower prices for drugs bought as part of its prescription drug benefit
is widely viewed as interference in the free market. Even The New York Times
and other highly respected media outlets often present the argument
about Medicare-negotiated drug prices as a debate between proponents of
free markets and of government intervention. When we sweep away
ideology, we see that it is a debate between two regulatory strategies
for keeping drug prices down.

* * *

There is a
similar story with copyrights, although the economic waste is even
larger and the enforcement measures even more perverse. In the Internet
age, almost any printed or recorded material--music, movies, books,
video games--can be instantly transferred anywhere in the world at
almost no cost. However, rather than allowing the public to enjoy the
full benefit of this technology, the government has created a dizzying
array of new laws and restrictions designed to make it more difficult,
and legally more risky, to pass along material that is subject to
copyright protection.

As with drug patents, copyrights
serve an important public purpose. They provide an incentive to produce
creative and artistic work. But to protect copyright, the government
has imposed an aggressive sanction regime even for seemingly minor
offenses. In one case, a woman in Minnesota faced a fine of more than
$200,000 for allowing people to download music from her computer.
Universities have been told to police dorm rooms to ensure that
students are not downloading material in violation of copyright, and
they have been encouraged to conduct classes teaching that it is wrong
to make unauthorized copies of copyrighted material.

The
government has repeatedly prohibited the production of various types of
hardware until protections could be installed to prevent the
duplication of copyrighted material. It has banned the development of
software that can break through copyright protections. In one case a
Russian computer scientist was arrested by the FBI after a conference
presentation in which he described a way to get around a form of
copyright protection.

The list of extraordinary
government measures that have been developed to enhance copyright
protection is lengthy. Remarkably, these measures are never described
as forms of government regulation. They are treated as enforcement
measures necessary to protect copyright. However, just as patents are
not the only way to encourage innovation, a government-granted monopoly
with extensive rules and heavy-handed enforcement is not the only way
to promote creativity.

A vast amount of creative and
artistic work is already supported through mechanisms that do not
depend on copyright protection. Private foundations are a major
alternative source of support, as are the limited funds available
through public programs such as the National Endowments for the Arts
and Humanities. Colleges and universities are probably the largest
source of funding not dependent on copyright. Professors are expected
to do research and writing in addition to their teaching
responsibilities.

It is easy to envision mechanisms to
expand support for creative and artistic work outside the copyright
regime. For example, it would be possible to design a modest tax credit
for individuals who either support creative work directly or contribute
to organizations that support such work. The credit could be modeled
after the tax deduction for nonprofits or charities. Even a modest tax
credit (e.g., $100 per person)--which taxpayers could allocate to an
artist, writer, musician, or film producer of their choice--would likely
be sufficient to fund almost all of the work currently supported by the
copyright system.

To be fair, rarely
does either side argue against regulation as such. The real issue is
the structure of regulation and its impact on economic outcomes,
especially income distribution.

Alternatives to copyright are feasible and probably far
more efficient than the copyright system. And they would replace a
gigantic array of enforcement measures that can themselves be seen as
unnecessary forms of government intervention into the economy.

* * *

A
final example of excessive government regulation, never discussed as
such, is the bankruptcy-reform bill that passed Congress in 2005. This
bill substantially strengthened the conditions imposed on people
seeking bankruptcy protection, making such protection a much less
attractive option.

The public debate over the bill dealt in
liberal/conservative caricatures that completely misrepresented what
was at stake. The liberal argument relied on sympathy for the people
seeking bankruptcy; it drew on studies showing that the great majority
of people seeking bankruptcy had not been spendthrifts who deliberately
ran up huge credit card debts, but rather had fallen on hard times as
result of job loss, medical emergencies, or family breakup. The
opponents of stricter conditions argued that these people needed and
deserved the break that bankruptcy allows.

The conservative
argument centered on individual responsibility. No one forced anyone to
take on debt; these people voluntarily chose to do so. Everyone knows
that bad things can happen. Those seeking bankruptcy protection should
have taken precautions.

This version of bankruptcy reform
undoubtedly resonated with those inclined to accept that people succeed
or fail largely as a result of their own actions, but, most
importantly, it obscured the real issue that the bill addressed: to
what lengths should the government go to collect unpaid bills? The
party seeking the aid of the government in this story is the creditor,
not the debtor.

Under the preexisting bankruptcy law,
creditors could lay claim to most of the debtors' assets and in some
cases place liens on future earnings. The new law hugely expanded the
creditors' claims on future earnings. This means that the government
will be far more involved in bill collection in the future than it has
been in the past, possibly monitoring the wages of millions of
individuals in bankruptcy who still have debts to creditors. (For those
who worry about the negative incentives caused by taxation, it is worth
noting that having money deducted from paychecks to pay creditors
provides the same disincentive to work.)

The
individual-responsibility line could have been applied just as validly
to the creditors in this story as it was the debtors. Part of being a
successful business involves knowing under what circumstances to extend
credit. No one forced businesses to extend credit to the people who
subsequently declared bankruptcy. They exercised bad judgment in
extending credit to people who were not good credit risks. Why should
the government step in to help businesses that fail to assess credit
risk? The ideological battle around the bill was a distraction. It was
an effort to get the government more actively involved in helping the
banks. It's that simple.

Other cases in which the
conservative position arguably requires more government involvement in
the economy than the liberal position abound. For years Ben and Jerry's
Homemade has fought attempts by state governments to ban labeling dairy
products as free of recombinant bovine growth hormone. Some pressure
groups associated with the dairy indutry argue that the rBGH-free label
implies that bovine growth hormones are harmful, which has not been
established by the Food and Drug Administration. Of course, Ben and
Jerry's Homemade is not trying to prevent its competitors from assuring
the public that their ice cream is safe. It is trying to make a
truthful claim about its own ice cream.

In the same vein,
the Department of Agriculture (USDA) recently prohibited a meatpacker
from testing its cattle for mad cow disease. The meatpacker had
intended to privately test all of its cattle, whereas the USDA tests
only 1 percent of cattle. But the USDA, arguing that full testing would
cause the public to question the safety of other meat, moved to prevent
it.

To be fair, rarely does either side argue against
regulation as such. The real issue is the structure of regulation and
its impact on economic outcomes, especially income distribution.

Let's
return to the financial crisis with this in mind. In the decades
preceding the financial collapse, regulations designed to protect the
public and to ensure the stability of the financial system were
considerably weakened, but the system was (and is) quite far from being
deregulated.

The key regulation that remained in place was
the "too-big-to-fail" doctrine. Essentially, the banks and other
financial institutions took enormous risks with an implicit guarantee
that their creditors could count on the protection of the U.S.
government if things went badly. For everyone except the creditors of
Lehman Brothers and the preferred shareholders of Fannie Mae and
Freddie Mac, this gamble proved correct.

This one-sided
giveaway was not deregulation. Had those setting financial policy over
the last three decades been committed to deregulation, they would have
assured financial markets that financial institutions making bad
investments would go out of business and that their creditors would be
out of luck. The Federal Reserve Board and the Treasury would have
warned that investors were acting at their own risk when they put money
in Bear Stearns, AIG, and the rest.

In the context of a
too-big-to-fail principle, the removal of restrictions on leverage
(investment banks were allowed to leverage their capital at a ratio of
forty-to-one compared to just ten-to-one for commercial banks) and the
relaxation of other prudential regulation (the nominal value of credit
default swaps, a new class of derivative instruments, grew to more than
$70 trillion in a nearly unregulated market) essentially gave the banks
a license to wager with taxpayers' money.

Banks did exactly
what economic theory predicts. They took huge risks, leveraging
themselves to the hilt with questionable assets, knowing that they
would gain as long as the housing bubble held up. And the banks did so
with willing accomplices among pension funds, hedge funds, and other
investors because these investors knew that the government would rescue
them if things went badly.

Deregulation can be a principled
position held by true believers in a free market. But Wall Streeters
all wanted one-sided regulation that provided them with an enormous
government security blanket without any costs or conditions. None of
the Citigroup, Goldman Sachs, J.P. Morgan crew ever went to lobby
Congress for an explicit repeal of the too-big-to-fail doctrine. And
while many on Wall Street lost their jobs when the bubble burst, the
tens or hundreds of millions of dollars that banking executives earned
during the good times are theirs to keep. Even with the market
collapse, the vast majority of them are almost certainly better off
than they would have been had they done honest work over the last
decade.

* * *

If the real debate is over the
type rather than extent of regulation, then why is it always framed as
the latter? For conservatives, the answer is obvious. Many Americans
embrace the idea of free markets and hold a deep aversion to
government. Faith in government ebbs and flows, even in the most
liberal times. It will almost always be advantageous, then, to
associate a political position with support of the free market.

It
is less apparent why liberals would be so eager to accept such a
disadvantageous caricature of their position. The answer requires
digging a bit deeper into what their position implies about the nature
of the economy and economic outcomes.

Like conservatives,
liberals generally acknowledge that people get ahead as a result of
their skills and hard work, with some luck thrown in. The main
difference in the liberal and conservative views of the economy is that
liberals are more likely to believe that many people face serious
impediments to their success and do not get the same chance as people
from wealthier backgrounds. Liberals are also likely to feel guilty
about the difference in opportunities and therefore support political
measures that will reduce the gap and help those at the bottom.
However, most liberals still accept the proposition that the
distribution of income is fundamentally determined by the market rather
than political decisions embodied in regulations such as patents,
copyrights, and bankruptcy law.

But what if we accept a
view that virtually every facet of the economy is shaped by policies
that could easily be altered? Investment bankers get incredibly rich
because the government gives them the shelter of too-big-to-fail but
doesn't impose any serious prudential regulation in return. Bill Gates
gets incredibly rich because, through copyright and patents, the
government gives him a monopoly on the operating system that is (or
was) used by 90 percent of the computers in the world.

Doctors
are well-paid because, unlike less politically connected workers, they
enjoy protection from international competition. The same is true for
lawyers and other highly paid professionals. The six-figure salaries
depend less on skill and hard work than on being able to structure
labor markets in ways that autoworkers, textile workers, and cab
drivers cannot.

Deregulation can be a
principled position held by true believers in a free market. But Wall
Streeters all wanted one-sided regulation that provided them with an
enormous government security blanket.

There is a long list
of professional licensing requirements (many of which have nothing to
do with maintaining quality standards) that make it difficult for
foreign professionals to work in the United States. While trade
agreements such as the North American Free Trade Agreement have been
designed explicitly to eliminate institutional barriers that obstruct
investment in developing countries and the free flow of manufactured
goods back into the United States, there has been no comparable effort
to reduce or eliminate the barriers that obstruct highly educated
professionals in the developing world from practicing their professions
in the United States. Many ambitious professionals from the developing
world do manage to overcome these barriers, but professionals in the
United States still enjoy a far greater level of protection from
international competition than less highly-educated workers.

* * *

The
less-versus-more framing of regulation supports the premise that there
is in principle an unregulated market out there and that some of us
wish to rein in this unregulated market while others would leave it
alone. This is consistent with the idea that large inequalities in
income distribution just happen as a result of market forces. But as
the above examples illustrate, no one is really talking about an
unregulated market--rather we are all just talking about whom the
regulation is designed to benefit. Distribution of income has never
preceded the intervention of government.

The
government is always present, steering the benefits in different
directions depending on who is in charge. Accepting this view provides
a political vantage point much better suited to the case for
progressive regulation. After all, conservatives want the big hand of
government in the market as well. They just want the handouts all to go
to those at the top.

This expansive view of regulation puts
everything up for grabs, including the six-figure salaries of many of
those arguing the liberal position. Do liberals really want everyone
asking if we can have the same economic benefits by removing trade
barriers in physicians' and lawyers' services that we gain by removing
barriers to clothes and cars? Liberals, too, are invested in the
obfuscation that less-versus-more provides.

Even so, the
catastrophe produced by the one-sided deregulation of the financial
industry, coupled with a long list of regulatory failures in other
areas, will almost certainly lead to a serious rethinking of regulatory
policy in the years ahead. It remains to be seen whether this
rethinking will go beyond the familiar debate. We know that when we
emerge from the current crisis the economy will be extensively
regulated. The questions is, to whose benefit?