The Third Pillar

by Raghuram Rajan

  Perhaps the most important regulatory agency of our time was set up in the Progressive era, somewhat ironically, because of the public-spirited actions of private individuals. In 1907, the failure of the Knickerbocker Trust Company set off a panic, which was arrested only when J. P. Morgan (and John D. Rockefeller) invested money along with other New York bankers to support the financial system. Conscious that the nation’s financial system had become overly dependent on one banker, and aware of the potential for abuse, Congress passed the Federal Reserve Act of 1913. It brought the monetary system of the United States under the aegis of the Federal Reserve Board. The Populist anger with large Eastern banks was, however, only fully propitiated in 1933, with the passage of the Glass-Steagall Act, breaking up the large banks and forcing them to divest their investment banking arms.

  The third element of the package to contain big business was taxation. This was perhaps the least-important piece, for there was really no desire to tax big business out of existence—after all, scale might be a source of efficiency and could reduce costs of production. Instead, following increasing public concern about large inherited fortunes and conspicuous consumption, taxation emerged as a tool to limit excessive concentration of business ownership, especially in the hands of individual inheritors. In the 1890s, fifteen states instituted taxes on large inheritances; more than forty states had inheritance taxes in place by the 1910s.46

  Each of these ways of containing big business has limitations. As Adam Smith recognized, regulatory bodies often become subservient to the powerful among the regulated—in which case, paradoxically, regulations become a tool with which to protect the powerful and stifle competition. Once again, democratic vigilance can prevent an excessively cozy relationship between the regulator and the regulated—the balance is critical. Both the Populist and Progressive movements managed to push through important reforms that prevented large corporations and trusts from shutting off business opportunity or abusing the public. They set limits to laissez-faire, and far from killing the market, preserved competition and thus its vibrancy.

  CONCLUSION

  As the state became constitutionally limited through Parliament, which was dominated by the propertied interests, these interests no longer needed feudal protections against it. Free of the fear of expropriation by the state, the markets flourished, but sometimes to the detriment of the community. The fight for suffrage was, in many ways, a fight by the community for some of its lost power. As it regained power, the community helped restore the balance.

  This was necessary because, in the absence of any restraints, the new robber barons who emerged from the initial frenzy of market competition preferred to secure their positions by eliminating competition. The tendency toward monopolies that was so apparent in feudal times emerged once again, this time blessed by a corruptible government. The balance was in jeopardy. Fortunately, important elements of the public, coordinated by parties, associations, and a competitive press, pressed democratically for transparency and reform.

  Politically engaged largely self-governing communities were a natural unit of organization, and facilitated organized protest. Common economic causes could then bring them together in a movement across the United States, as with the Populists and Progressives. The sense that the system had worked earlier gave the movements confidence that they could reform it and therefore did not need a revolution. Chance also helped. The tragic assassination of the pro-business president William McKinley and his replacement by a reform-oriented Theodore Roosevelt conspired to empower the anti-monopoly movement in a timely way.47 These democratic movements pushed back against the system’s natural drift toward cronyism.

  In the next chapter, we will see that the reverse is also true. By creating a healthy competitive private sector, competitive markets also help keep the state’s authoritarian tendencies in check, and democracy vibrant. Thus, markets and democracy could be mutually supportive. I emphasize “could” because there are circumstances where the voting public is apathetic to public policy, and others where it might actively turn against private wealth and competitive markets. This is why democratic protest works best when it is timely, before people believe the system is beyond reform.

  4

  THE COMMUNITY IN THE BALANCE

  In a modern country, there are very few powerful actors that are independent of the government. Some elements of the state such as the judiciary or the central bank can be structured to be quasi-independent, but since their members are appointed by the government, a government with sufficiently long tenure can mold these institutions into its way of thinking. The power of promotion is another powerful tool. Within every state organization, no matter how seemingly independent, there are a spectrum of views. By promoting sympathizers over opponents, the organization’s views can be aligned with the government, more so if opponents understand that to sympathize is the only way up. A determined party in power can shape many of the organs of the state toward its own preferences, given enough time.

  An independent private sector is therefore important in a democracy, for it lies outside the state apparatus and embodies tremendous potential power. It is an essential source of funding, both for the parties in government and the political opposition as well as for nongovernmental organizations. Its intent may not solely be to lobby for regulations that enhance its profits, it may also be more public spirited—we will discuss later in the book whose views it might represent. The private sector also provides platforms for, and sometimes orchestrates, public opinion. Recall it was the muckraking press that was instrumental in breaking up Standard Oil as well as bringing regulation to the meatpacking industry. The Washington Post, a family-owned newspaper, effectively led the investigation that resulted in President Nixon’s resignation after the Watergate break-in. The private sector can also take positions with its business activities that have a political or social slant, and attempt to nudge reforms.

  The private sector cannot be independent when it is largely reliant on the state for profits—when the state controls entry through regulations or licensing; elevates industry profits through protectionist tariffs; directs substantial military or government advertising contracts to favored firms; or turns a selective and convenient blind eye to the takeovers and predatory practices that lead to monopolization of industry. It might seem that a private sector that is cozily in bed with the state has the upper hand. After all, it controls the purse that pays the governing party’s bills. However, the owners of the largest enterprises are rarely secure in such a society, for they become dependent on the state. Much like Rockefeller, the monopolist may initially be efficient and capable of withstanding competition. Over time, though, without competition to keep them on their toes, monopolies or oligopolies typically become lazy and inefficient. Unable to compete any longer, they now fear competition from imports or new domestic challengers, and become dependent on government protection for their survival. The state thus steadily gains power over the private sector. Dependency breeds further dependency.

  Therefore, the main source of private sector independence in a country, and thus also property rights protection, is the private sector’s productive efficiency, which comes only through constant competition. A second source, though, is numbers. When a few giant firms dominate the private sector in a country, it is easier for the state to enter into cozy arrangements with them all, especially when each one dominates a specific sector. When activity is dispersed among many firms, their interests are often opposed, and it is harder for the state to capture them all. Those left out have strong incentives to expose the unfair arrangements entered into by those on the inside. Dispersed rather than concentrated production is thus an additional source of independence. This certainly is the lesson that emerges from the power of the gentry in Stuart England.

  The danger when the private sector is entangled with the state in a crony capitalist society is that the state can rapidly turn authoritarian. An opportunist d
emagogue, elected on a platform of rooting out corruption, no longer needs to solicit contributions from business in return for erecting protective regulations and barriers—she can demand tribute just to keep the existing protections and to not expose the cozy past deals to the public. For it is easy for the state to turn public opinion against private business when business is both monopolistic and inefficient. People see the swamps in the capital city filled with lobbyists and reeking of cloyingly sweet deals, even while they experience the high prices and bad service directly. They are primed to believe the worst of business.

  More worrying, she can use her anti-corruption campaign to demand fealty from the wealthiest in the economy. Fights against corruption led from the top are rarely attempts to reform the entire system. Instead, because almost everyone is usually implicated in shady deals, the leader intends the campaign to send a message. Periodically one of the wealthy, usually the least pliant, will be crushed publicly, both to satisfy voters that the anti-corruption campaign is alive and to provide a cautionary example to the wealthy about the dangers of stepping out of line. The public applauds the strong leader’s action, not seeing that in praising the act, they help her reinforce the message to anyone else who might think of rebelling. The public, however, rarely has the means to distinguish systemic fights against corruption from targeted moves against the ruling establishment’s political enemies until too late. Crony capitalism does not always stay benignly corrupt—it risks turning authoritarian.

  In contrast, a transparent competitive market system produces winners who have important characteristics that allow them to be a check on the government. They are efficient, so they are not dependent on continuing help from the government to make money. They thus have the confidence to be independent from it. They are usually many and varied, so it is hard for the government to do side deals with all of them. The state cannot coerce each one quietly, and any attempt by the state to strong-arm a number of them publicly will inspire the collective resistance of many others. The government can tax their efficient production and therefore the people benefit from their ownership—replacing the efficient with the inefficient comes at a significant cost in reduced output and reduced taxes, as the government of Zimbabwe discovered when it expropriated experienced white farmers and replaced them with politically connected greenhorns. Moreover, the people are more likely to be sympathetic to the property rights of the efficient if their position is arrived at through fair competition (not the case, though, with white farm ownership in Zimbabwe, which often stemmed from the previous expropriation of African lands). Competitiveness in markets engenders private-sector independence from the state, offers vibrancy to democracy, and, in turn, draws support from the community. Vibrant markets and engaged democracies are mutually reinforcing.

  We ended the last chapter describing two democratic movements in the United States that contained the overly strong markets pillar and its corrupt collusion with the state, and created a balance, even if temporarily. In this chapter, we will start by describing three situations when the community does not push for competitive markets—when market players or practices are deemed illegitimate and the strong state offers an alternative, when the state is weak and the community is bribed easily to stay apathetic, and when neither the state nor the community offer people the capabilities and the support they need to participate in volatile, changing markets. That will take us to how mechanisms to provide people capabilities and support evolved, and complete our discussion of the elements of the balance needed to sustain a liberal market democracy.

  THE PERCEIVED LEGITIMACY OF MARKET PLAYERS

  Property rights in a democracy are a social construct. While we have seen they are reinforced by the economic efficiency of the property holder as well as the collective power of similar property holders, in a democracy they also depend on public approval for enforcement.

  PROPERTY AS THEFT

  The more that the rich are seen as idle or crooked—as having simply inherited or, worse, gained their wealth through cozy government contracts, monopolies, or theft—the less voters care when the state turns on the rich. In Russia today, for example, property rights of the fabulously wealthy are not seen by the voting public as legitimate because so many of the very rich acquired their wealth through dubious means. They grew rich because they managed the system, not because they managed their businesses well.

  Many of today’s Russian oligarchs got their lucky break when the cash-strapped Yeltsin government effectively auctioned off prized state-owned enterprises at bargain-basement prices. A few connected insiders, such as Mikhail Khodorkovsky, who bought a 78 percent share in oil company Yukos worth about $5 billion for only $310 million, became fabulously wealthy.1 That he had never seen an oil field before winning the bid suggests that he was not necessarily the most efficient owner.2

  The public was enraged, but could do little about it. Yet the dubious circumstances of the acquisition also meant property rights were insecure. Indeed, with many of Russia’s largest companies being commodity extractors, it did not take management genius to run them profitably, which meant ownership could always be seized easily by the state and transferred. It was only when some oligarchs like Khodorkovsky developed political interests and decided to take on the government that they realized how weak their property rights, without public support, really were. Khodorkovsky was imprisoned and Yukos was seized by the government. The outside world seemed to be sympathetic to his cause, but many Russians believed he had gotten his just deserts. Few protested on his behalf, and the oligarchs, having received the message, swung into line behind the increasingly authoritarian government. Invariably, the behemoth that thinks it can control the leviathan gets swallowed by it.

  SWEET DEALS

  Even if the people do not question the provenance of the private sector’s property, they might not have much faith in a private sector that is tied by the umbilical cord of sweet deals to the state. This could leave them open to a demagogue who promises to drain the swamp and bend the private sector to the will of the state.

  In Germany, the links between the state and industry emerged under the Iron Chancellor, Otto Von Bismarck, in the last few decades of the nineteenth century. Bismarck wanted to insert a wedge between industrialists and landowners, so as to prevent a concerted move by the propertied, supported by the citizenry, to limit the state.3 He co-opted industry by nationalizing industries like the railroads, by erecting tariff barriers to foreign manufacturers, and by allocating lucrative contracts for military supplies to favored industrialists. As Germany militarized under Bismarck, continuing into the First World War, there were few checks on the imperial government.

  In the interwar period, the close ties between government and industry reemerged. In his study of the rise of Nazis in Germany, Columbia political scientist Franz Neumann observed that Germany never experienced an anti-monopoly movement against trusts and cartels like the Populist and Progressive movements in the United States. The Marxist labor unions in Germany acquiesced to the growing concentration of industry because they were persuaded of the wastefulness of competition and the inevitability of monopoly in the final stages of capitalism.4 Unlike the Progressives, the German middle class did not also protest, perhaps because they had been ejected from the ranks of the confidently comfortable by the 1923 hyperinflation that robbed them of their savings.5 They certainly were open to the kind of strong government that the Nazis promised. In this vein, a study by political economists Satyanath, Voigtländer, and Voth suggests that people in communities in interwar Germany that had stronger community engagement, as evidenced by the greater presence of local clubs and associations, were more likely to join the Nazi Party and help its electoral success.6 They were especially supportive in regions with greater instability of the state government, suggesting a desire for a strong hand there. Communities may not always make the right choice, especially when the pillars are imbalanced!

  The concen
tration of business thus proceeded unchecked. Concentrated business, mindful of its own dependence on government and aware of the many subsidies it enjoyed, especially as the world moved into depression in the early 1930s, did not oppose the authoritarian controls imposed by the Nazis.

  CRONY DEMOCRACIES AND CAPTURED POLITIES

  Apart from the misguided conviction that change is in the right direction, communities may be bystanders because of apathy. If state capacity is weak, the people may not see any value to pressing for reforms. Instead, they may not care, as in the Italian village of Montegrano that we encountered in the Introduction, or opt for patronage, thus turning a blind eye to cronyism. The latter situation, prevalent in many developing countries around the world, is one reason we see illiberal democracies, a felicitous term used by Fareed Zakaria.7

  A member of parliament (MP) in India represents a parliamentary constituency of over ten million people.8 Do his constituents worry about the government’s economic performance, its reform plans, or its social agenda? Except for the rare occasion when they are influenced by a popular national wave, for the most part most voters do not really care about public policy. What they want is help with their daily lives, help with filling the holes that a stretched state with limited capacity cannot address.

  Therefore, for example, they want him to procure a birth certificate for their child, who was delivered in their shack in a village far away from any medical clinic. The birth certificate is essential for the child to be admitted to the free government school, and no government officer will provide it without suitable gratification, because he has no official document to rely on. The poor do not have the money to bribe so they plead for a call from the MP’s office, which will set the wheels of bureaucracy rolling. Once the child is in the local school, the child becomes the MP’s responsibility. When she graduates from high school, the MP has to find a college that will admit the student if her grades are modest, and when she gets a degree, he has to persuade some government office to give her a respectable secure job. And when she gets married, he will be invited to the wedding and be expected to give a suitable gift.