Cato Online Forum

Restrain Regressive Rent-Seeking

By Steven Teles
November 2014

America today faces three great challenges. Inequality, driven in particular by a spike in incomes at the very highest end, is threatening the public’s belief in the justice of our economic system. Innovation in products and services that actually add to human flourishing and produce meaningful employment, driven by new firm formation, appears to be stagnating. Finally, Americans both on the right and left increasingly believe that our political system is rigged to benefit organized insiders, while critical public problems remain unaddressed.

All three of these critical national problems derive from the same source. We often talk about the last third of a century as an era of deregulation and the expansions of markets. And in certain areas that is certainly true. But the most important market rigidities that have been eliminated have been those that protected those from the middle class on down. In fact, the great paradox of the last third of a century is that we have actually had an explosion of regulation in this “supposedly deregulatory” era — but regulation that has the effect of redistributing, sometimes dramatically, upward.

A few examples will suffice to make the point. Intellectual property protections, especially patents and copyright, have been expanded dramatically over this period, both in time (through patent and copyright extensions for existing IP) and across space (by using trade agreements to push American IP principles into foreign law). While there is an argument that this expansion has actually reduced innovation, there is no doubt that it has allowed existing firms to use the force of law (rather than the market) to enrich themselves by reaching further into the pockets of consumers.

The same period has seen a transformation of occupational licensing, from a marginal force in our economic organization to one that is increasingly ubiquitous. According to Morris Kleiner, in the 1950s only one in twenty Americans needed some form of government permission to work in their chosen occupation, wheras today nearly a third do. With every passing year, more and more parts of the labor market cease to be characterized by free entry, with the licensing regime extending even to areas like interior decorating and flower arranging. The metastasizing licensing regime places barriers in the way of innovation (think of the way that the taxi license system has stood in the way of Uber and Lyft, or the way that medical licensing presents obstacles to health care reforms like shifting work from doctors to nurses), reduces economic opportunity (by making it harder for outsiders to enter licensed occupations and undercut incumbents), and by reducing competition allows insiders to raise their incomes at the expense of consumers.

Finally, the incredible growth of the financial sector, which has created a concentration of wealth that the United States has not seen for nearly a century, and which helped bring the economy to its knees just a few years ago, also finds its source in government-derived rents. By allowing for the consolidation of the financial sector (through financial deregulation and the all-but-abandonment of antitrust enforcement), the government helped create a set of firms so large that they were “too big to fail.” That is, they had an implicit government guarantee, one that became explicit in 2008. At the same time, by allowing a huge securitized housing finance market to develop (which had previously been primarily in savings and loans), and by pushing more and more of American retirement savings into actively managed 401ks and IRAs (which collectively produce negative value for savers) the government created the greatest pool of rents in the history of mankind. The result has been economic instability, a diversion of talent from innovation to financial engineering, hyper-inequality, and pervasive suspicion of our democratic political system.

A focus on rent-seeking allows us to look at the American inequality problem with a different lens than is typical in our public debate. On the left, there has been a tendency — accelerated of late by the publication of Thomas Piketty’s Capital — to see the expansion of inequality as a natural product of capitalism, one that can be disrupted only by war or depression. The solution, in this account, must take the form of enormous redistribution through taxes and transfers. In the center, there has been an account of exploding inequality that puts it at the feet of the increasing returns on skills and education, driven by the shift of the economy to cognitively-demanding tasks. If this is true, then the only response can be almost unimaginable improvements in the quality of education. Finally, most on the right continue to see American inequality as a relatively unproblematic result of a market economy, especially one where the scale of markets is global and where (in some of the darker accounts) society has effectively sorted itself into culture- and intelligence-based classes.

There is something to almost all these explanations. But the problem with all these accounts is that, peculiarly enough, they all insist on describing the United States as if it was a basically pure market economy, with the results one would expect. But as the short descriptions of the glaring exceptions to market logic described above would suggest, that description is, in fundamental ways, wrong — and especially wrong in the economy’s upper reaches. While there are certainly large parts of the 1 percent made up of entrepreneurs and innovators, the image of the U.S. as a free-market paradise is hard to square with the presence in the top income strata of people like car dealers (protected by regulations against the consolidation of car sales), doctors (protected by medical licensing and extensive educational requirements), lawyers (with a limited supply of lawyers and a government that produces outsized demand for their services), government contractors (including private prison managers, defense contractors, for-profit colleges and others whose almost exclusive dependence on government revenue raises question about whether they are “private” in any meaningful sense), and property developers (who in many urban areas can exploit government-constrained ability to build—which drives up prices — and political connections to generate oversized profits). Add in finance, licensed occupations, and sectors with lots of intellectual property, and you’re looking at a sizeable chunk of the 1 percent.

The standard image of how our economy works, and where the wealth of a good chunk of the 1 percent comes from, is wrong. The really important question, if we want to put our economy on a trajectory of greater productive innovation, less inequality, and more political legitimacy, is what explains this explosion of upward redistributing rent? How did this happen at a time that all of the political conversation was about the wonders of markets? How, if at all, might we actually restructure our politics to make it possible to claw back these rents, thereby liquidating unjust politically-protected fortunes, creating space for greater economic opportunity, and unleashing greater innovation?

If one were to consult only the economists who pioneered the idea of rent-seeking, the answer would be terribly depressing. Starting with Mancur Olson, economists have traced the political success of rent-seeking to the unbalanced incentives to organize of rent extractors and those whom they seek to exploit. While those with concentrated interests have a strong incentive to invest in political activity, and to engage in surveillance over political actors, those with diffuse interests do not. Thus rent extraction is a natural law of democratic political systems, limited only by constitutional constraints.

The good news is that Olson’s account of democratic politics was wrong. Diffuse interests — like those opposed to rent seeking — are not always unorganized. As Jack Walker first argued, democratic politics since the 1960s has been pervasively populated by “public interest organizations” funded by third parties (those who do not primarily benefit from the organization). That suggests that rent-seeking might be constrained by public interest organizations, but only if there was sufficient philanthropic interest in creating countervailing power. Second, political scientists like Frank Baumgartner and Bryan Jones have emphasized how much rent-seeking policy monopolies depend on supportive institutional structures and attractive “policy images” to protect what policies that would be very difficult to defend publicly. When those protective structures are skillfully attacked, they appear much more vulnerable than public choice might have us believe.

Such attacks depend on the existence of space and time on the public agenda, intense and informed media scrutiny, and public interest groups willing to challenge rent seekers, sometimes for decades, before getting their break. In some ways, rent seekers have exploited problems in all of these areas, for example by shifting their activity away from places with sophisticated media and an active public interest community, to state governments, obscure agencies, and arcane laws and regulations — all of which maximize their resources, and minimize those on the other side.

Putting a dent in rent seeking, therefore, requires that someone be willing to subsidize “third party” political activity, and for good or ill that must start with deep-pocketed donors willing to use their money to compensate for the imbalance of organization and attention that is the lifeblood of rents. Such activity is not pie in the sky, for we can look to two examples, associated with the right or left, to see how potent such anti-rent-seeking mobilization can be. On the left, donors in the late 1960s and 70s poured huge sums into getting a broad range of environmental organizations off the ground. Pollution can be profitably understood as a form of rent, since it produces additional profits for those who engage in it by extracting uncompensated benefits from those who pay its costs in the form of despoiled air and water. Polluters had effectively captured government agencies in the years before the institutionalization of the environmental movement, but donor-subsidized counter-mobilization helped make agency rule-making more pluralistic, and repeatedly damaged the reputation of polluters in the public sphere. The result was a correction in the political marketplace that allowed for a surge in environmental regulation.

Equally potent has been the enormous investment in the cause of education reform over the last two decades. As Terry Moe argued in Special Interest, the politics of education policy in most school districts is dominated by teachers’ unions, which have captured school board elections and defended their professional interests behind the popular belief that their actions are aligned with the welfare of children. A wide range of organizations funded by large foundations and individuals have started to correct this organizational imbalance, from think tank programs at Brookings and AEI to state-based organizations like 50CAN and Stand for Children and leadership pipelines like Leaders for Educational Equity and Students for Education Reform. This broad range of third-party-supported education reform organizations has at least partially evened the playing field in education policy, to the point where at least some observers are starting to worry that it is the reformers who have captured the political system.

If the broader phenomenon of upwardly redistributed rents is to be effectively addressed, these examples of subsidized anti-rent-seeking mobilization need to be multiplied. Funders need to make sure that there are organizations in every state that can give testimony when professions seek to expand the web of licensing, and to aggressively push back the boundaries of licensing where it is already in place. The very small network of organizations working on financial regulation need to be ramped up considerably, and they need to be given the resources to hire sophisticated analysts capable of understanding the complex businesses that regulators oversee. And more broadly, funders need to invest in journalism and research across the board that can bring to light the stories of rent-seeking in real time, when it is still possible to rally public interest and make public officials worry that their upward transfers will be exposed.

It may be impossible to organize a broad, deeply mobilized grassroots coalition against upward-redistributing rent seeking. But in most cases, equaling the manpower and resources of the rent-seekers isn’t necessary — just making sure that there is someone on the other side can make a big difference. Perhaps perversely, it may be that the only answer to the problem is for the wealthy themselves to bankroll organizations that would change the political calculus that makes acceding to the demands of rent-seekers logical for politicians.

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.

Steven Teles is an associate professor of political science at Johns Hopkins University.