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20 November 2000

Why Britain should jail businessmen

On Wednesday, Irwin M Stelzer, a deep-dyed US conservative, addressed a seminar at 11 Downing Street

By Irwin M Stelzer

It is increasingly clear that governments of all political stripes are reaching the outer limits of their ability to extract from their citizens a larger portion of their hard-earned money. It is deemed by all, save a very few, to be politically impossible to raise income taxes openly; and recent events suggest that indirect taxes are increasingly unpopular, and difficult to conceal. To the political difficulties, add the economic fact that capital and labour are increasingly mobile and willing to migrate, from jurisdictions in which taxes have become vexatious, to more hospitable climes.

So any government of the centre left must rely on economic growth to produce the sums in taxes that would satisfy the Treasury appetite. One is reminded of Queen Gertrude, whose appetite for the charms of King Hamlet increased “by what it fed on”. And rapid, inflation-free economic growth will, in the end, add more to the wealth of the nation and welfare of its citizens than any conceivable redistribution scheme.

That is why Gordon Brown has been so keen to couple his redistribution programme with one that raises UK productivity, and why he has taken as much interest in the details of how industry and commerce actually work (what is usually called micro- economic policy) as in the big picture of tax and spending.

When governments take an interest in microeconomic policy, their actions – a bit of taxation here, a bit of tax relief there, a subsidy or two, regulatory intervention, some exhortation to businessmen and workers – tend to be counterproductive, because ministers have to choose the economic priorities, and they nearly always get them wrong. That is not so if they adopt a vigorous competition policy. The reasons are as follows.

First, if a policy makes it difficult for businessmen to collude to fix prices, consumers will need to pay only the costs of producing the goods and services that they buy, plus a reasonable return on the capital committed to their production.

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Second, businesses will be under pressure to minimise costs so that they can meet or beat the prices of their competitors. This is one reason that competition policy has not been uniformly popular in Britain: it discourages overmanning and runs counter to several government policies, such as that designed to preserve jobs in the coal industry by preventing the construction of gas-fired power stations.

Third, a vigorous competition policy should maximise the rate of innovation and so deny what one economist identified as the greatest profit of monopoly: a quiet life. Economic literature expresses some doubts about this, because never-ending competition may deny innovators the fruits of their inventions, thereby discouraging expenditure on research and development. But consider, for example, the innovative services offered by the airline industry when competition replaced regulation. As another economist put it: “Competition seems very well in practice, but it is not so clear how it works in theory.”

Fourth, a vigorous competition policy provides a tool for judging which mergers are in the public interest, and which are not. The dividing line is simple: any merger that unduly reduces competition should be halted. The minister does not have to decide whether the merger will produce the anticipated savings (most do not); or whether football fans will be offended; or whether constituents in a marginal seat will be put out of work; or whether he regards the executives and directors of the acquiring companies as good chaps. All he needs to do is structure, fund and staff a competition authority, so that it can appraise the competitive impact of mergers.

Fifth, in most industries – the exceptions are those that have large elements of natural monopoly – an effective competition policy makes regulation unnecessary. That is not to deny the possibility that politicians will want to change income distribution or that they will want to protect particular groups or regions. But it is more efficient for societies dissatisfied with the way income is distributed to make the desired adjustments directly, by direct subsidies and income transfers, than it is to distort markets. Better to pay a fuel allowance than to distort electricity and gas markets by mandating artificially low prices; better to arrange direct income transfers, if a region is adversely affected by a merger that does not substantially reduce competition, than to prevent the merger.

Sixth, a proper competition policy produces desirable social effects – the diffusion of economic power and the maximisation of economic and social mobility. In an economy in which incumbent firms cannot create artificial barriers to entry, either by deploying their own market power or by colluding with others, fledgling entrepreneurs are likely to flourish. This is important not only to maintaining a high rate of invention and innovation – competitive entry, after all, inevitably destroys the value of existing investments – but to maintaining a society that is deemed by its citizens to be fair and open. In the US, the relative ease of entry has contributed to the mobility among income groups that has prevented the class warfare so common in other countries. But it is precisely this result of competition policy that creates opposition among those who want to stop arrivistes moving into and despoiling the neighbourhoods of those with “old money”, and among businessmen who fear that they will never recover undepreciated sunk investment if barriers to entry are eliminated.

There are three ingredients of a successful competition policy. First, the agency that enforces the policy must be staffed with able men and women: economically literate, free of biases against business, independent of the politicians who appoint them. That means quantity as well as quality. Even a conservative such as I, who believes that the best governments are those that govern least, recognises that a more vibrant competition policy warrants the expansion of the Competition Policy Division that took place in the UK this year. Good competition policy cannot be bought on the cheap, but pays for itself many times over.

Second, you need the right procedures. Here, the UK could benefit from the introduction of more adversarial techniques in its investigations of mergers and anti-competitive practices.

But third, and most important, the legislation must be properly drawn up. In Britain, although it is being reformed, it remains seriously flawed. Businessmen have all to gain and little to lose by violating the law. Fines – which may be up to 10 per cent of group turnover for up to three years – are paid by the shareholders, not by the executives who concocted the anti-competition schemes. So fines, no matter how big, are a less effective deterrent than short jail sentences. In America, it is the threat of a stretch as a guest of the government that keeps many an executive out of the proverbial smoke-filled room (although price fixers are now more likely to meet in the smoke-free environments of various hotel suites).

Britain has no such deterrent, which is doubly surprising now that your Home Secretary has decided that miscreants should be jailed only by day, and then let loose at night. Just as this will free burglars and muggers to pursue their trade after a day’s rest and three square meals at the government’s expense, so would this regime leave executives jailed for price fixing free to meet all their social and dinner commitments.

Nor will damage lawsuits, as provided for in the new legislation, be an effective deterrent. These cases are expensive, and the “loser pays” doctrine is likely to deter all save the best-financed firms from pursuing this remedy. Even if a plaintiff does prevail, the miscreant pays back his ill-gotten gains – and no more. Given that the probability of being sued is less than 100 per cent, and that the probability that the complainant will prevail is also less than 100 per cent, it pays for a potential conspirator or monopolist to chance paying such damages – nothing to lose, and all to gain. In the US, damages are trebled, so that a violator of the law might indeed lose a great deal if he is found to have illegally injured a competitor.

Such competition policies should apply as much to high-tech as to low-tech industries. Yes, we must protect intellectual property rights, so as to encourage rapid innovation. But we must also ensure rapid diffusion of those new technologies, and see to it that channels of distribution are not unfairly denied to new entrants. A firm with substantial market power (even power won fairly in the market place) cannot be allowed to tie other products to the one that it dominates. It cannot be allowed to use that power to bludgeon independent manufacturers not to deal with its competitors, or to impose a pricing system that accomplishes that same result. It cannot be allowed to deny access to its product, unless potential competitors agree to cede other markets to it.

These simple policy truths seem to me more, not less, compelling for industries in which waves of creatively destructive innovation are to be relied on as the principal engines of progress. In many such industries, dominant incumbents are threatened not merely with a loss of market share, but with extinction. Their incentive to fight hard and, if necessary, dirty is great indeed. Meanwhile, newcomers – the pizza-eating new graduate with a bright idea and a zero bank balance – rely on venture capitalists for the seed capital needed to take their idea from concept to marketable product. These venture capitalists are hard-headed realists. If they believe that an entrenched incumbent will be allowed to snuff out incipient competition by inducing manufacturers to boycott the new product – or by using technological legerdemain to tie its own competing product to its monopoly product – venture capitalists will suggest to the newcomer that completion of his doctoral dissertation or a job with the entrenched incumbent is his best option.

All this may be easily acceptable to a centre-left government. But I would make one final point.

We must recognise that macroeconomic policy, and most notably taxation, must not inhibit our ability to achieve the microeconomic goals of greater entrepreneurship, efficiency and productivity. High and rising taxes on what, to left-leaning politicians, seem like “high earners”; limitations on share option schemes; tax regimes so complex that no small businessman can hope to cope with them; taxes that discourage the lone entrepreneur working from home – all of these offset the beneficial effects of a vigorous competition policy.

Irwin Stelzer is an economics columnist for the Sunday Times and director of regulatory studies at the Hudson Institute, New York. This is an edited version of a talk he gave to a seminar sponsored by the Smith Institute