Cato Online Forum

Fighting the Crony Capitalist Alliance

By James Pethokoukis
November 2014

Even though deep recessions are frequently followed by equally strong recoveries, that hasn’t happened this time around. Indeed, the 2013 median income was 8 percent below where it was back in 2007. Now it would be almost comforting if we could blame everything on the Great Recession and its unique characteristics—a financial crisis accompanied by a housing crisis. If that’s the case, then perhaps the economy just needs a bit more time to finds its legs. Eventually the New Normal will begin to more closely resemble the Old Normal.

This seemed to be the theory of the Obama White House, which arrived in power just as the recession was hitting bottom. Its economists repeatedly predicted a strong recovery to be just around the corner. In August 2009, the White House predicted GDP would rise 4.3 percent in 2011, followed by 4.3 percent growth in 2012 and 2013, too. In its 2010 forecast, the White House said it was looking for 3.5 percent GDP growth in 2012, followed by 4.4 percent in 2013. In its 2011 forecast, the White House predicted 3.1 percent growth in 2011, 4.0 percent in 2012, and 4.5 percent in 2013. While Democrats will argue that the White House didn’t count on a debt ceiling crisis or fiscal austerity (including the income tax hikes Obama himself demanded in 2013), they forget that the White House made those predictions also not assuming extraordinary and unconventional monetary stimulus that offset the austerity.

Although the economy finally appears to be picking up some steam in the fall of 2014, there is no indication of the kind of accelerated growth needed to make up the lost ground of recent years and put the economy back on its pre-recession trend line. And along with the growth gap, there is a job gap. The current job market recovery has been a historically slow one. It was only in March that private-sector employment surpassed its former peak reached in January 2008, or 51 months from its February 2010 nadir. During the 1981-82 recession by contrast, it took private-sector employment just 10 months to surpass its old high. If the current jobs recovery had been as robust as the ones during the Reagan and Clinton years, we would have around 6 million more private-sector jobs right now.

But the problem isn’t just the quantity of jobs created, but also the quality. Today there are nearly two million fewer jobs in mid-and higher-wage industries than there were before the recession took hold, while there are two million more jobs in lower-wage industries. Service-providing industries such as food services and drinking places, administrative and support services, and retail trade have led private-sector job growth during the recovery. These industries, which pay relatively low wages, account for 39 percent of the private sector employment increase over the past four years. As Susan Lund of McKinsey Global Institute has put it: “Where are the middle class jobs? U.S. job growth post-2008 is in skilled professions and low-skill, part-time jobs.” Thanks to both automation and globalization, jobs in the middle that can be “scripted, routinized, and automated” continue to disappear. What’s left, as MGI puts it, are those—both high and low skill—that involve “complex problem solving, experience, and context (e.g., lawyer, nurse).”

So yes, the Great Recession and its aftermath have taken a terrible toll on the economy. But pull the camera back and you see America’s economic woes have roots far further back. There is something deeper and more structural going on, something that predates the financial crisis of the Bush years and the multiple policy mistakes since then. McKinsey Global Research notes increasingly lengthy “jobless recoveries” after recessions. From the end of World War II through the 1980s, labor markets snapped back quickly after each downturn. It took an average of just six months to return to pre-recession job levels. But recovery times have grown ever longer over the past three decades. And when labor markets do normalize, the share of mid-wage jobs after the recovery is below where it stood before the recession.

Since 1999, real GDP growth has averaged just 2 percent. Instead of year after year of 4 percent growth as Wall Street predicted back in 2000, the U.S. has experienced just seven individual quarters of growth that fast versus 38 combined in the 1980s and 1990s. Never in the history of the United States has there been such a persistent period of weak economic growth. Such anemic economic growth has helped translated into weak job growth. Nearly 50 million net new jobs were created in the 1980s and 1990s versus fewer than 10 million in the 2000s.

So what’s wrong? Perhaps what we are seeing is the economic calcification of the U.S. economy, resulting in less dynamism and growth. As JPMorgan economist Mike Feroli has put it: “The churning that has long characterized the U.S. economy, the frenetic creative destruction of firms rising and falling, has become less frenetic recently. New business creation has trended lower, as has the normally-massive amount of labor market reallocation. This reduction in economic dynamism has taken place over the course of the last few decades. Less churning in the economy can have beneficial consequences, but the reality is that the negative effects likely outweigh the positive effects. The symptoms of reduced churn look similar to Euro-sclerosis.”

Indeed, economists Ian Hathaway and Robert Litan have found that if you look at startups as a share of all firms, that rate declined from about 15 percent or so in the late ’70s to about 8 percent in 2012, Other research, co-authored by Hathaway, also found a sharp drop since 2000 in the number of technology firms age five and younger – i.e., the fast-growing “gazelle” firms that generate a large share of America’s innovation and new job creation.

Why is this important and concerning? Innovation is what drives long-term economic growth and improvement in living standards. And key to generating innovation is creating an economic ecology of maximum competitive intensity where the most innovative and dynamic company wins. Startups and the threat of failure they bring to incumbent firms are critical to the Schumpeterian “gales of creative destruction” that drive innovation. A lack of competitive intensity, however, results in stagnation and decline. And right now there are several ways government is throttling the economy’s dynamism, competitive nature, and startup culture. Investment taxes, regulations, and immigration laws are frequently mentioned as impeding innovation, but one mentioned less often is our highly concentrated and interconnected, Too Big to Fail financial system, which gives a competitive edge to megabanks—an advantage that Dodd Frank extends and worsens. Since just before Dodd-Frank’s passage through the third quarter of 2013, according the Mercatus Center, the United States lost nearly 10 percent of its small banks. Moreover, small banks’ share of U.S. banking assets and domestic deposits has decreased by nearly 20 percent and 10 percent, respectively, with the five largest U.S. banks absorbing much of this market share. The megabanks not only suck assets away from their smaller rivals thanks to their TBTF status, but the biggest banks can also better deal with Washington’s tidal wave of regulations.

Now this is critical: Smaller banks are crucial to small business creation. As an AEI paper last year noted, community banks provide nearly half of small-business loans issued by U.S. banks. Big banks, on the other hands, are incentivized to focus on taking risk of the sort the Fed and regulators care about, risk that would sink the broader economy such as investing in mortgage-backed securities and complex derivatives. The attractiveness of this strategy has meant that banks shunned lending exposed to non-macroeconomic idiosyncratic risks such as lending to small businesses or new firms.

One possible solution would be to substantially raise the capital requirements for Too Big To Fail banks and apply it to all assets. But how much capital? Some in Congress would force megabanks to comply with a 15 percent leverage ratio, meaning they could borrow only 85 percent of the money they lend versus 94 percent or 95 percent under new preliminary U.S bank rules. As AEI scholar Charles Calomiris has pointed out, a capital cushion of that size allowed all the large New York City banks of the time to survive the Great Depression. What’s more, such capital requirements might well nudge the biggest banks into shrinking themselves or breaking up. Assets would be more evenly distributed among financial institutions, and smaller banks would not have to contend with Dodd-Frank regulatory flood.

Not only do we need to end the bailout culture on Wall Street and create real financial competition, but we must also dismantle the regulatory and legal barriers more directly eroding America’s startup culture. There should be as few government hurdles as possible between a person with a good idea and the transformation of that idea into a small business with the potential to become a high-growth gazelle. As Adam Thierer writes in Permissionless Innovation, “Experimentation with new technologies and business models should generally be permitted by default. Unless a compelling case can be made that a new invention will bring serious harm to society, innovation should be allowed to continue unabated and problems, if they develop at all, can be addressed later.”

One big way government intersects with the world of ideas and innovation is through patent and copyright law. But U.S. copyright and patent laws have evolved into cronyist protection of the revenue streams of powerful incumbent companies that hampers innovation and entrepreneurship. And that protection, a type of regulation, hampers innovation and entrepreneurship. Indeed, patent and copyright laws have become a key manifestation of the long-term corporatist turn of the U.S. economy that works against startups, economic dynamism, and creative destruction. As Nobel Prize-winning economist Edmund Phelps writes in his book Mass Flourishing: “But now the economy is clogged with patents. In the high-tech industries, there is such a dark thicket of patents in force that a creator of a new method might well require as many lawyers as engineers to proceed … Copyright has only recently seen controversy. The passage by Congress in 1998 of the Sonny Bono Act lengthening copyright protection by 20 years—to author’s life plus 70 years—prevents wider use of Walt Disney’s creations and prevent wider use of performances copyrighted by the record companies. The length of the copyright term may be be deterring new innovation that would have had to draw on products at Disney and EMI. Members of Congress have a private interest in lengthening copyright and patent protections since they can expect to share in the big gains of the few without paying for the small costs borne by the rest of society.”

The 2014 paper “Intellectual Property Rights, the Pool of Knowledge, and Innovation” by Joseph Stiglitz outlines the problem in a similar way: “We have shown that tighter intellectual property regimes, by reducing the newly available set of ideas from which others can draw and by increasing the extent of the enclosure of the knowledge commons, may lead to lower levels of innovation, and even lower levels of investment in innovation, as a result of the diminution in the size of the knowledge pool.” In short, an overly strict patent and copyright regime benefits existing players, not new ones.

With an aging population and slowing labor force growth, America will need to be more innovative than ever just to grow as quickly in the future as in the past. The U.S. economy will need a higher level of competitive intensity and dynamism to avoid Euro-sclerosis and Japan-sclerosis. But that won’t happen if big government and big business keep teaming up in a crony capitalist alliance to prevent the next generation of dynamic and disruptive competitors from ever existing.


The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on reviving economic growth.

James Pethokoukis is a columnist and blogger at the American Enterprise Institute.