Martin Hellwig is the co-author (with Prof. Anat Admati) of the book Banker’s New Clothes, a book about finance that the Financial Times’ chief economics commentator Martin Wolf described as “the most important to emerge from the crisis.” Hellwig is also Executive Director of the Max Planck Institute for Research on Collective Goods and, among other things, a former head of the German Monopolkomission (Monopolies Commission).
The Monopolkomission in 2003 published a report entitled Competition Policy under Shadow of “National Champions” which is a most useful document from our perspective. It argues, as we have, that the pursuit of what we at FG call the Competitiveness Agenda tends to lead to restrictions on market competition. It also argued against creating a German “banking champion” – a position that earned it a dismissive rebuke from the government of Gerhard Schröder, which basically said all was safe and well regulated.
A couple of short excerpts from that document provide flavour and context, and the interview with Hellwig is below.
“The promotion of “national champions” is usually justified as a means of strengthening the competitiveness of the German economy. The image of a national economy that competes like an enterprise in the markets is striking but factually misleading.”
And it goes into further detail:
“The image of a national economy as a competitor stems from the political tradition of militarism. According to this tradition, countries are rivals and the “strongest” defeats the others, annexes their territory and expels or conquers their citizens. This image has nothing to do with economics. International trade is not about subjugating other countries or preventing the subjugation of the home country, but about capitalising on the universal benefits of exchanging goods and services.”
And he makes the point, as we have, that promoting one sector will tend to come at the expense of others:
“Government support for “national champions” in specific sectors, such as the building up of “Deutsche Post AG” into a world leading logistics company, impairs the competitiveness of German companies in other sectors, such as the car industry.”
Hellwig’s critique of the Competitiveness Agenda is compatible with the work of Martin Wolf and Paul Krugman (and, more explicitly, David Ricardo) — though it is in a different tradition from the work of others such as Mariana Mazzucato, Ha-Joon Chang or Bob Jessop, each of which argue in favour of certain kinds of government intervention in markets to support certain sectors, whether or not in the name of something called ‘national competitiveness’.
The interview with Hellwig, by FG’s Nicholas Shaxson, is below. We’ve added links of our own in a couple of places.
FG: How is the term ‘competitiveness’ used in the context of whole nations, particularly with respect to tax and financial regulation?
MH: I think that that kind of phrase involves a lot of doublespeak. The simplest version would be: I want to promote my country’s financial industry (or any other industry) at the expense of everybody else. But the second half of that ‘at the expense of everbody else” is usually left out. An alternative would be ‘I want to promote the financial system at the expense of taxpayers.’
“Competition is usually beneficial, but this has nothing to do with “competition between countries”. Here, I am a very uncompromising Ricardian. There is no such thing as competition between countries. There might be when you talk about war, and there might be when you talk about trying to attract talent.”
One possibility would be: you arrange your tax system and your tariffs so that, say, other industries find it hard to attract talent because the financial sector is attracting so much. For example, the University sector finds it hard to attract talent if the private sector attracts too much. It is an issue if you’re talking about fundamental research, which is important for the long-run growth of an economy.
If you think about physicists, or engineers, and who become involved in designing high-frequency trading programmes instead. Their brains are mainly used to develop better techniques for front-running, i.e. trading on news, even the news that someone else wants to trade. Such front-running is pure redistribution at the expense of someone else who will end up getting a worse price. Maybe these engineers and physicists would be better employed in doing research on something like the storeability of electricity. And then consider the real resources used to provide a completely straight line for fibre glass cable between Chicago and New York, drilling through mountains, just to gain a few microseconds that can be used for better front-running – from the perspective of society it is a pure waste.
FG: How are universities affected?
MH: Some of the hard sciences have seen a lot of talent hired away by the prospect of high salaries in the financial industry. To the extent that these high salaries are due to either redistributive activities such as front-running, or are due to firms’ taking risks at the expense of third parties such as taxpayers, the allocation of talent is distorted.
FG: Is there a relationship between high salaries and rent-seeking: are rent-seeking activities generally more remunerative than more productive ones?
MH: There are three reasons why such incomes can be extraordinarily high.
First, you may own a scarce resource that everybody needs, which is difficult to substitute. That’s basically Arab oil sheikhs, and the like.
Another involves inventions and innovation. Think about Bill Gates: there are some doubts as to who made the actual developments, but there is no doubt that much of his fortune was based on being at the core of a company that provided innovations that everybody ended up using.
In financial markets, you also have the element of innovation. When derivatives were first introduced, they made a lot of people very rich. In the initial stage, that had to do with something like the Bill Gates success: plain vanilla derivatives provided something that was really needed. The economy needs plain vanilla derivatives, such as interest rate swaps or currency swaps because the people or firms where the risks arise are usually not so good at bearing them. Using derivatives to shift them to someone else may therefore provide for an allocation of basic risks that is better. If you have hedging techniques that allow you to reduce the costs of assuming such risks from someone else, you may be able to earn a lot of money.
The problem with any innovation is, however, that, if imitation is possible, rents will be quickly competed away. This is why in some areas we have patents to protect against such completion.
Look at the history of derivatives markets since the late eighties. By around 1990, it was no longer possible to earn large profits from plain vanilla derivatives. The techniques were too well understood. New developments typically involved much more complicated new products that involved a lot of gambling and required a lot of salesmanship because they did not serve many existing basic needs. But then the small interest rate increase of 1994 in the US had dramatic effects because the recently developed, very complex derivatives generated enormous interest rate sensitivity, and many of the buyers had not understood what they would be getting into, for example the Treasurer of Orange County or the CFO of Procter and Gamble.
You had some of that again in the 2000s with European municipalities buying interest rate straddles or currency swaps from the likes of UBS or Deutsche Bank (US municipalities got wiser after Orange County). Some of them are now struggling with the consequences, most recently because the revaluation of the Swiss Franc made their debt go up by a lot.
You also have many derivatives in the second and third generation that are not really hedge-able. Credit default swaps (CDSs) are not really hedge-able and they should not actually be put in the same basket as plain vanilla derivatives at all: ultimately they involve someone taking speculative positions and betting that this won’t be a problem.
If a financial player sells a lot of credit insurance, he is exposed to risks from correlations. If the different credit contracts are independent, diversification may even out the overall portfolio risk, but if the risks are correlated, say because the borrowers’ repayments are driven by interest rate moving (under variable-rate contracts), the overall economy, or real-estate prices, the credit insurer will be in trouble. as AIG found out (or UK credit insurers around 1990).
So in the second and third generation of derivatives, innovation again enabled people to earn large profits, but then the risks ended up with taxpayers. High incomes based on such taxpayer subsidies are unmerited.
FG: Are there scenarios where one could say that rivalrous (or ‘competitive’) behaviour between countries can have beneficial outcomes?
Competition is usually beneficial, but this has nothing to do with “competition between countries”. Here, I am a very uncompromising Ricardian. There is no such thing as competition between countries. There might be when you talk about war, and there might be when you talk about trying to attract talent. But I don’t think that there is competition between countries in terms of products.
There is competition between firms and even between industries: firms and industries can find competition in the marketplace easy or difficult, depending not only on how efficient they are but also on public regulations, the legal systems and the like. So you want a legal and regulatory system that generates few distortions. I do not just mean distortions from taxation and regulation, but also distortions from externalities whereby some of the costs of an activity are borne by third parties.
Think of a company that’s polluting the river Thames, somewhere upstream from Oxford. The cost of the river being polluted for people in Oxford and people in London is part of the social cost of that company’s activity. If that doesn’t get priced, you will have too much of that activity. The externality creates a distortion that lowers welfare. The people working in this company might argue: ‘if we have to clean up the stuff that we dump into the river, then either we are not competitive in global (or even local) markets, or we have to lower our wages.’
Well, the answer is that it is inefficient to maintain activities on the basis that their social costs are not properly priced – no matter how proud we may be at “our champions’ winning in global competition”.
The point is obvious if the workers in question actually live downstream from the plant and would themselves benefit from preventing the pollution. If we think about their standard of living, we must consider the environmental effects as well as their wages. If they do not live downstream from the plant, they will not be affected, but someone else will be. In this case it is important to remember that nobody has a claim on earning money by harming others.
In the financial sector, you don’t get pollution of rivers, but you get pollution of the financial system through systemic risks. The welfare concerns are the same. In that respect, there is absolutely no difference between systemic risk and pollution.
FG: The word ‘competitiveness’ is used in the UK all the time to talk about the country. Is it the same in Germany?
MH: In Germany the rhetoric is similar but the financial sector is less prominent, so we hear it from other industries as well.
The term “level playing field” is used by every regulator and every banker: what they usually mean is that ‘if others don’t have a certain regulation then we shouldn’t have it.’ It’s like the electricity industry claiming that we should keep nuclear power as a source of electricity because other countries show no signs of abandoning it; not of course at the prevailing German safety standard but at the safety standard in Bratislava or Fessenheim [in France], because otherwise “we would not be able to compete”.
If German banks had been less competitive in acquiring toxic securities in the U.S. or in buying Greek government bonds, we all would have been better off.
In Germany a large part of the resistance to tighter banking regulation come from the public banks, local savings banks and at the regional level the Landesbanken. The local savings banks are very profitable but have trouble raising equity because they do not have access to the market and their public owners to not want to put up any money. The Landesbanken don’t really have sustainable business models at all. They have been using state guarantees to obtain funding at reduced costs. They have used the funds for a lot of gambling such as buying toxic securities in the years before 2007. This is not the kind of competitiveness that makes sense.
FG: Does the German model contribute to a different approach?
MH: In the 2004 bi-ennial report of the German Monopolies Commission, entitled Competition policy under the shadow of national champions, we took on the German government for its policy of national champions, which was much more mercantilistic than UK policies. At the time, the policy concerned mainly the recently privatised network industries, telecommunications, logistics, energy, with “national champions” Deutsche Telekom, Deutsche Post, Deutsche Bahn, E.ON and Ruhrgas. The idea was that these recently privatized “champions” should become global players, and that this objective warranted the exploitation of their German customers, for example by Deutsche Post using profits from its letters monopoly to buy up logistiscs companies worldwide.
At the time, Chancellor Schröder had also called for a national champion in banking, so we inserted two paragraphs [pp580-581] saying that this was a bad idea, which would generate Too-Big-To-Fail (TBTF) problems and moral hazard, an example of which could be seen in the 1931 banking crisis.
The government has to send a reply to these reports to the Bundestag. What they wrote was: to be sure, there’s a TBTF problem (this was 2004) but any comparison with 1931 is completely ludicrous, because we have a wonderfully functioning system of banking regulation and supervision, with Bafin (the German supervisor) and the Bundesbank cooperating to apply the law on banking regulation and the European Directive.
By now. of course, the government’s answer looks much more ludicrous than our warning.
The prominence of the national champions policy was reduced when Schröder left office, but you still find it here and there, most prominently whenever the automobile industry is involved, in particular, VW.
FG: Similarities with the Resource Curse – mineral-rich countries? A Finance Curse?
MH: I used to live in Switzerland. In Switzerland, the tourism industry is always complaining about the exchange rate, arguing that the central bank should dampen revaluations of the CHF. This is not just a problem with the revaluation this year, but has been an issue for decades.
“The key issue underlying the Ricardian logic which people often overlook, is that firms in any one sector are not just in competition with firms from the same sector in other countries, but also with firms from different sectors and in their input markets, in particular their own national or regional labour markets.”
The tourism industry emerged early in the 20th century, using a lot of cheap local labour in those Alpine valleys, where people were very poor and keen to get employment. Later on, in the 50s, 60s, 70s, with the development of the chemical industry in Basel, engineering companies in the central part of Switzerland, and the financial sector in Zürich, Basel and Geneva, and with large increases in mobility, these people no longer went to the local hotels: they went to the different industries to get jobs there. That’s part of the mechanism by which the more advanced industries have displaced tourism. Go to a hotel in the Swiss Alps , and most of the people working there are not Swiss any more.
The key issue underlying the Ricardian logic which people often overlook, is that firms in any one sector are not just in competition with firms from the same sector in other countries, but also with firms from different sectors and in their input markets, in particular their own national or regional labour markets.
In the UK, you have had significant de-industrialisation between the 1970s and 1990s. At the same time, you got exorbitant growth of the financial sector in the South of England. I’m pretty sure that the financial sector in the South of England did not just recruit young people from the South, but also many well qualified people from the Midlands, Wales, and further north, who decided to move to where the money was.
FG: Dutch Disease: is the exchange rate factor of oversized finance not a factor?
MH: The exchange rate is not the only relevant factor. In fact, devaluations can provide for temporary relief, but usually not for permanent relief. For example, the effects of the 1967 devaluation of the pound were quickly neutralised by high wage settlements, so the increase in competitiveness was lost again.
The term “competitiveness” is used a lot these days, for example in the context of Greece, or of the Mediterranean countries altogether, or Ireland for that matter. There people say that real wage rates must go down, to create more ‘competitiveness’.
To assess such arguments properly you need to know something about the underlying mechanisms and the potential distortions they cause. If you worry about the effects of real labor costs on competitiveness, it is not enough to think about the exchange rate. You also need to think about wage setting and about competition between sectors.
The purely macroeconomic approach, which talks about competitiveness in th entire economy must really focus on savings. If a society wants to save a lot, like German society does because of its demographic structure, one way to do so is to run a current account surplus and accumulate foreign reserves and foreign assets. To achieve that you may need relatively low wage rates and high competitiveness in many sectors. Equivalently, a country that wants to dis-save may do so by running down its foreign assets or by borrowing abroad. Some of the countries that I just mentioned in fact did precisely that in the runup to the euro crisis.
The resulting current account imbalances are not in and of themselves good or bad. The question is whether the system in which decisions are taken involves significant incentive distortions. For example, in the German case, whether high saving rates and high current account surpluses are properly informed about low rates of return and even waste in the financial system’s investing funds abroad (those toxic securities). In the Greek case, whether low saving rates and high current account deficits are properly informed about the amount of borrowing involved. To the extent that such information is not taken into account, some policy corrections may be called for.
Given the macroeconomic nature of these problems, there is a temptation to address them at the macro level. That may however be problematic. For example, Greece has very special export industries. The most important are shipping and tourism. In talking about the competitiveness of the country one must take into account sectoral developments. Unfortunately hardly any of the policy reforms that have been undertaken in Greece have taken account of the fact that international shipping has been in a deep crisis since 2008. They don’t earn margins in shipping any more, even to cover fixed costs. And the other export industry, tourism, is one where exports take place inside the country, so in contrast to all other exports, tourism is directly affected by changes in the value-added tax. Increasing this tax, which was imposed to promote fiscal consolidation automatically harmed the competitiveness of Greek tourism relative to, say Turkish tourism.
FG: Are you with Paul Krugman on banishing the word competitiveness from economics?
MH: Certainly in macroeconomics and international trade. In fact, the 2004 report begins by saying ‘when I was a student I was saddened to read that five percent of all prime numbers die within three years of their birth, usually from a typhoid fever. The idea was that, except in very special circumstances, talking about the competitiveness of an economy is just as nonsensical as the quoted sentence – grammatically correct but meaningless in substance. The notion of competitiveness of an economy doesn’t make sense. It is a semantically nonsensical use of the term.
FG: Which sectors use this word most actively, and where in the financial sector is it most often used?
MH: That varies by country. I was giving the example of tourism in Switzerland, I could also give the example of manufacturing in Germany, including cars, I’m reasonably sure that in the UK it must be the financial sector.
In the UK, the Vickers report does use the argument with reference to the City and uses competitiveness concerns to justify a privileged treatment of investment banking and the City relative to retail banking. In our written comments on the interim version of the Vickers report, Anat Admati and I indicated that this distinction between investment and retail banking did not convince us. Lehman brothers was an investment bank, so the notion inherent in the Vickers report that taxpayers have to worry about retail banks but not about and investment banks is invalid.
FG: Anything else you’d like to add?
MH: I was very much struck by the speech that the governor of the Bank of England gave on the occasion of the 125th birthday of the Financial Times, in which he put forth a vision of substantial additional growth of the industry becoming larger than ever before. I thought that it’s strange for the governor of a central bank, an institution which is also involved in financial stability policy, and by now again in financial supervision, to be articulating industrial policy objectives in such a prominent and dramatic fashion without even mentioning the risks to society.