Competition Cures Crony Capitalism and Drives a Meritocratic Economy

Big businesses that don’t need to deal with competition develop not only flab but a corrupt culture, in which managers advance workers not by merit but cronyism and nepotism.

Finance Minister Moshe Kahlon and Histadrut secretary-general Avi Nissenkorn, December 2015.
Olivier Fitoussi

Until the mid-1970s, U.S. regulation protected American banks by banning competition between the states. Banks were prohibited from opening branches in other states and many became local monopolies. In 1975, a lengthy process of deregulation began, with states repealing the ban one after another, opening the way for competition in U.S. banking.

The slow transition from a monopoly industry protected by the regulator to a competitive one gave researchers a unique opportunity to study the monopolistic dynamic: What happens to workers in an industry that the regulator protects from competition? At the start of the millennium, Profs. Sandra Black and Philip Strahan – economists from California and Boston, respectively – set out to check.

The first result of their research was unsurprising: When shielded from competition, banks transferred part of their monopolistic rents (the surplus they charged customers by virtue of having no competition) to their workers, even though they weren’t unionized. Although wages in the financial system rose in general, the situation was complicated – in places where competition did exist, the bankers’ pay dropped.

Economists had long known that monopolies and companies protected by the state share the spoils they reap from consumers and taxpayers among their shareholders and workers. The interesting part was Black and Strahan’s analysis for gender-affected pay: Competition led to a 13% drop in pay for male bankers, but just 3% for women. Also, at banks exposed to competitive market forces, the number of female employees in management positions grew.

Economists aren’t sociologists or organizational experts and tend to shy away from multidisciplinary explanations for such things. But here is one possible explanation: Big businesses that don’t need to contend with competition develop not only flab but a corrupt culture, in which managers advance workers not by merit but by cronyism, nepotism and loyalty.

The main skill required of managers at companies like this is to keep the gravy train rolling; to use their monopolistic power to crush potential competition; and to leverage the monopolistic power in the industry to compete unfairly in auxiliary industries. If a company isn’t threatened by small, talented companies, its managers aren’t threatened by the market and can appoint their friends and family – even if they lack talent. And if there are monopolistic spoils to be shared among loyal workers without fear that the company will lose market share and the manager be fired, it’s no surprise that male managers prefer to appoint other loyal males as their subordinates.

All that is jargon for what’s known as the Old Boys' Club.

Narrowing the gender gap

Competition turns out to be a cure not only for monopolies and crony capitalism, but a driver for a meritocratic economy. And competition that empowers the skilled at the expense of sweetheart deals is also, it turns out, a way to narrow the gaps between men and women, and shatter the club of men in positions of power who take care of their buddies.

That study came to mind two weeks ago, when the Taub Center published its superb annual report analyzing productivity in Israel. Productivity (output per hour of labor) is a hot topic – especially in the United States, where the data of recent decades shows that most of the value created by increases in productivity goes to “capital,” while the bargaining power of workers lessened due to their unions weakening, globalization and job losses to other countries.

In Israel, the productivity picture is even bleaker. Even before the division of income between capital and manpower, a lot of industries suffer from low productivity compared with other developed nations. And the gap has been growing.

Taub Center economists Eitan Regev and Gilad Brand wanted to see which industries were dragging Israeli productivity down.

First off, they verified the claim that Israeli productivity is lower than the global average because of the long working hours in Israel. But in recent decades, the gap in working hours did not widen, while the productivity gap did.

Second, most of the increase in the gap between Israel and the West concentrated in five industries: wholesale trade; retail trade; food; business services; and telecommunications. All supply their services mainly to the domestic market and can be divided into two categories – those boasting higher productivity than the rest of the economy, like telecommunications and finance; and those with relatively low productivity.

Israel’s telecommunications and finance industries ostensibly deliver higher productivity than the other domestic sectors – but still fall short of international levels. The Taub economists show these sectors are bigger than in other OECD countries, and suggest they may have become bloated with manpower over decades because of the absence of competition, and transferred their rents to the workers and shareholders.

Sectors with high productivity that are not lagging behind the world in recent years are the export ones, led by high-tech. It’s pretty obvious – only an industry with high productivity can compete in the world.

Concentration and wide margins

So, the interesting part of the analysis is the explanation for the relatively high productivity in local terms, which is competition by imports. Regev and Brand show that the industries exposed to international competition narrowed their productivity gaps with the West.

One surprising finding is that wholesale trade alone was responsible for about 30% of the increase in the productivity gap between Israel and the OECD during the period studied (1995-2009).

The main problem wholesale faces, Regev tells me, isn’t regulatory barriers or manpower bloat. “The industry’s main problem seems to be the structure of the market, by which I mean concentration and the wide margins,” he explains. “In agriculture, for instance, labor productivity in Israel is significantly higher than in the OECD, yet we hear about a lot of farms going broke and closing down. The main reason seems to be the margin gaps and monopolistic power of the big wholesalers over the farmers. Unsurprisingly, the food and retail sectors are responsible for a large part of the increase in the productivity gap. These three industries – wholesale trade, retail trade and food – are linked and together are responsible for 50% of the gap’s increase. The wholesalers buy from the farmers at rock-bottom prices and charge the retailers much more (reducing the volume of activity and productivity of wholesale trade).

Blocking agricultural imports on the grounds that local farmers will suffer is mainly an excuse to block competition, in Regev’s opinion: like in many other areas of Israel’s economy, interest groups are using weaker groups as a “shield” to deflect competition.

“Over the years, cynical use has been made of the claim that opening the food industry to imports would decimate local agriculture, which is already barely surviving,” Regev says. But the real reason for the farmers’ difficulties is that wholesalers are paying low and charging high because they don’t face competition, including from imports. “That does not mean opening the food industry to imports would immediately benefit the local farmers, but it would certainly boost competition in the wholesale sector, benefit the consumer, and increase activity volumes and productivity in wholesale trade, retail trade and the food industry,” continues Regev. “In parallel, the wholesalers’ margins and their excessive power over farmers has to be handled.”

The data Regev and Brand present is another example of the Israeli system, wherein powerful interest groups block reforms for efficiency, competition and imports, chattering on about social issues, while the main beneficiaries of the protection against competition are small groups in the private and public sector.

Look at the recent wage negotiations between the Finance Ministry and the Histadrut labor federation. Finance Minister Moshe Kahlon and Kobi Amsalem – the ministry’s wages director – decided this was a good opportunity to call the federation’s bluff. It draws its power and status from a number of large monopolies, and therefore its achievements for workers over the last 20 years have been confined mainly to a number of small, aggressive groups in the public sector, leaving most other workers lagging behind. The silence of the Histadrut on subjects such as the natural gas plan and economic concentration committee, and its support for the squandering of billions of taxpayer shekels by giant government companies, is not surprising. It is not an inclusive union of workers, but a lobbyist organization for a number of powerful interest groups.

This doesn’t mean war

Kahlon and Amsalem went in the right direction, but only one step. If they were trying to really handle the massive flab in the public sector, which leads to poverty, gaps and poor service, and if they insisted on transferring tens of billions to the weak, it would be war. Only after a protracted strike – a process essential for economy recovery and, especially, to expose the real data to the general public – could an agreement be reached. The speed at which Kahlon and Histadrut leader Avi Nissenkorn shook hands on a deal shows that the powerful are satisfied with the outcome and with the bones they’re throwing to the weak to demonstrate their “social” chops.

Wage gaps in the public sector will remain gaping even with this agreement. The State Revenue Administration’s data on real estate is a painful demonstration of this: A huge chunk of the people buying properties for investment in recent years are employees of those monopolies, municipalities, the defense establishment, millionaire pensioners from the army, and top people working in the public service.

The combination of absolute tenure, free time and noncontributory pensions have turned tens of thousands of them into real estate investors. They are courted by the mortgage banks and have the power to negotiate, while hundreds of thousands of other public-sector workers, including contract workers, are busy just surviving.

Studies in Israel and the world prove the power of competition in propelling the economy forward, and the economic and social damage caused by concentrated, inefficient structures. The interest groups will always fight against efficiency, competition and imports, using the weak as a human shield to block reforms and structural changes.

Uncompetitive markets – such as those that exist in most of the public sector and in concentrated private sectors – concentrate power in the hands of the few. Political power is translated into economic power, and vice versa. Thus, they entrench their power, using “social” slogans to gain social legitimacy.

The interest groups cooperate among themselves, too. The Histadrut never attacks the tycoons and bankers, and they in return don’t attack the Histadrut. Power is drawn to power because together they have more power – instead of protecting the general public, which may be large in number but is disorganized and has no real influence. The majority remains without representation.

What information is the general public given about this state of affairs? Which media groups dispel the smokescreen that hides the interest groups, and which serve them? Journalists often face this quandary: Whether to serve the rich and powerful, in the hope that one day they will help them, or to serve the reader. It is time for the media to decide who it wants to represent.