It isn’t so much that the rent is too high, it is that firms are earning too much of it from political influence and too little from innovation.
The decades-long upward march of US corporate profit margins and with them company valuations to historically high levels raises questions of how much is derived not from genuine wealth creation but rent-seeking, the extraction of profit through some monopoly-like advantage.
Not all rent-seeking is odious: build a better mouse trap and until the competition catches up you make extra profit and the world loses extra mice. But in economics Nobelist Robert Shiller’s classic example of political rent extraction, when a feudal lord puts a chain across a river to extract a toll he creates no value, only slowing trade and enriching himself.
James Bessen, of Boston University School of Law, finds in a paper published last month that about half of the rise in profits and valuations is traceable to political gamesmanship.
“Much of the growth in corporate valuations and profits since 1980 can be accounted for by growing investments in intangibles, especially investment in R&D. But it appears that an even larger share of the rise in valuations and profits can be accounted for by factors associated with growing regulation and political activity, especially after 2000,” Bessen writes in the study.
In other words, innovation is paying off, but not on the same scale as politics.
The study, which looks at non-financial companies, thus excluding the banking industry which is a battleground of claim and counter-claim over the impact of regulation, profit and social utility, found that companies are earning a rich reward for their spending on lobbying, on regulation and political campaign spending.
And what’s more, the more regulation, the more incumbents within an industry tend to benefit.
“Causality flows from regulation to higher corporate valuations. Nor does regulation tend to reduce profits by burdening firms with compliance costs,” Bessen writes.
The costs, or benefits depending on which side your bread is buttered, are huge. The study found that regulation corresponds to a US$2trn higher valuation among the publicly traded firms in the study, which were able to mark up prices by about an extra 1%.
That’s a US$200bn annual transfer of cash from consumers to companies.
The “rent-seeking” sector
This is all a rather large problem. Beyond issues of fairness and the extra money extracted from consumers, money spent on gaming the regulatory process acts as a dead weight on economic growth, diverting capital from more productive and creative areas.
Joseph Stiglitz, another Nobel-prize-winning economist, attributes a substantial portion of the growth in inequality in the US to rent-seeking.
Bessen identifies what he calls a “rent-seeking sector” – a group of industries in which the link between regulation and profit is especially strong, and which tend, in a chicken vs egg puzzle, to be particularly politically active and powerful.
“Among non-financial corporations, most of the effect is accounted for by just five industries: pharmaceuticals/chemicals, petroleum refining, transportation equipment/defence, utilities, and communications,” Bessen writes in the Harvard Law School Forum on Corporate Governance and Financial Regulation.
“For example, the pharmaceutical industry has actively stymied efforts to address problems of patent trolls that affect many other industries.”
Historically, some major efforts at regulatory control and reform have created what amounts to a devil’s playground which have almost precisely the opposite effect to how they were initially advertised.
Congress in 1992, reacting to cries of outrage over rising cable television subscription costs, passed the Cable Television Consumer Protection and Competition Act, a name which in retrospect is rich in irony. Supporters at the FCC argued prices would fall by 10% but instead cable companies responded to complex regulation with ever more complex pricing and package matrices. The value of publicly traded cable firms far outpaced the growth of the rest of the stock market in following years.
We should not take this as either a counsel of despair on regulation or as the final word in explaining the puzzle of high corporate profitability. Corporate profits have fallen recently, and some argue that changes in trade patterns and demographics, not to mention politics, may increase the power of labour. That would lead to a long-lasting decline in both margins and valuations.
As for regulation, the link between complexity and rent-seeking seems strong.
We might want to favour the simple and robust over the complex and clever in regulation. Who knows, companies might even start to spend more on research and development.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
