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Blame dysfunctional markets for our economic malaise

The slow recovery's lopsided gains show we ignore fundamental economic principles

October 8, 2014 6:00AM ET

America’s agonizingly slow recovery from the last recession is unlike any of the 32 previous business cycles of economic expansion and contraction, going back 160 years. We should be deeply troubled by the unprecedented and tortured path of recovery, which has left most Americans worse off than before the recession began almost seven years ago.

Past recoveries were faster and produced broad prosperity. But this recovery, which began in July 2009, has showered gains on the few at the top while the vast majority has lost ground despite a growing economy.  The 16,000 households at the very, very top — the 1 percent of the 1 percent — captured a third of all reported income gains in 2012 compared with 2009, whereas the bottom 90 percent suffered a loss of income.

If we resurrected Adam Smith, the father of modern economics, he could tell us right off the reasons for this stagnation. In fact, he warned us about them in his 1776 classic, “An Inquiry Into the Nature and Causes of the Wealth of Nations.”

What Adam Smith taught us is that the benefits of free markets depend on competition and removing government favors that tilt the playing field. The lopsided gains of the recovery reveal, among other important trends, the subtle but pervasive corruption in which markets and regulatory systems are rigged to favor the few at the expense of the many. Recent news reports from New York, Washington and San Francisco demonstrate this point.

Regulatory capture

Corporate profits have soared upward. The too-big-to-fail megabanks, whose reckless behavior crashed the economy, control a record share of banking industry assets. The five biggest U.S. banks — JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, and US Bancorp — control 44.2 percent of assets, up from 38.4 percent in 2007.

ProPublica reported last month on 46 hours of surreptitious tape recordings made by Carmen Segarra, a bank examiner who was fired for doing her job. The tapes show the regulators speaking of their jobs in terms of advancing the banks’ interests and protecting them rather than looking out for investors, borrowers and the public generally.

The recordings confirm what David Beim, a Columbia University finance professor, discovered when the New York Fed, whose duties include regulating banks, hired him to look into its role in the 2008 collapse.   After extensive interviews and examination of documents, he concluded that the Fed staff was so deferential to the big banks that “during the run-up to the recent crisis many potential issues were identified but did not ring alarms and were not acted upon.”

He said he was pressured to remove two words from his report: “regulatory capture.” The words refer to regulators’ being captive to the interests of those they are supposed to regulate. Beim refused.

“Regulatory capture” is the modern term for what Smith warned about — businesses seeking refuge from the discipline of market competition by getting government to act not as referee but as protector.

Electricity price gouging

In Washington the story concerns protecting electric market manipulation by seeking to close the Brayton Point electric power plant in Massachusetts — which is anticipated to reduce the supply of electricity in New England so much that prices have already soared.

The Federal Energy Regulatory Commission (FERC) asked for more information because “tight capacity conditions may allow suppliers who are aware of their pivotal role in the market to exercise market power. Under such conditions, we are concerned that the market mitigation provisions currently contained in the tariff may not protect customers against unjust and unreasonable prices for capacity.”

Our choice is between applying time-tested insights about the benefits of competitive markets or looking the other way as our democratic government helps the oligarchs pick our pockets.

However, the FERC ultimately found no reason to investigate, without explaining the basis for its conclusion.

FERC Chairwoman Cheryl LaFleur declared all is well with the New England electricity market. A former acting CEO of the electricity utility National Grid, she concluded that because no one reported rule violations, the latest auction prices must be “just and reasonable.”

Critics say the rules themselves are the problem because electric companies can easily manipulate them to drive up prices. In a statement LaFleur said that “to independently assess” whether the auction rules produce unfair results would be “inconsistent with commission precedent.”

Her words illuminate how institutionalized corruption works in the modern world. She is like a vice cop sent to check out a bordello who sips Champagne in a roomful of women in lingerie and watches them, men in tow, disappear behind closed doors. When someone suggests her job is to open those doors to see just what is going on, LaFleur declines because that would be inconsistent with precedent.

The results of the New England auction were so perverse that FERC Commissioner Tony Clark, a career utility lobbyist, wrote that an inquiry is mandatory because the auction rules “may lead to unjust and unreasonable results.”

When utility regulators like LaFleur ignore evidence of rigged rules — which means unfree markets — they help destroy the benefits of capitalism. As Smith taught more than two centuries ago, withholding supply artificially inflates prices:

Monopolists, by keeping the market constantly under stocked, by never fully supplying the effectual demand, sell their commodities much above the natural price, and raise their emoluments … The price of free competition, on the contrary, is the lowest which can be taken.

Such excessive prices act as a private tax on utility customers. They drain the accounts of customers, discourage investment in businesses that use lots of electricity, unjustly enrich power plant owners — all while creating deadweight losses that retard economic recovery. 

PG&E's latest scandal

Even more troubling is the story out of San Francisco, where emails show the hand-in-glove relationship between the office of Michael Peevey, the California Public Utility Commission president, and Pacific Gas & Electric, which serves most of Central and Northern California.

PG&E and Peevey’s chief of staff cooperated to steer a natural gas rate case to an administrative law judge thought to be favorably inclined to the utility. The chief of staff resigned, but Peevey, a former head of the utility holding company Edison International and its Southern California Edison utility, stays on.

PG&E voluntarily disclosed two sets of emails so damning that the company announced Monday that it expects to pay fines. In a chain of January emails a PG&E executive complained in earthy language that the judge assigned to the case “has a history of being very hard on us,” prompting Carol Brown, Peevey’s chief of staff to respond, “Would you rather have Long?” (a different judge).

Federal prosecutors are now investigating. They can issue subpoenas to examine the full trail of emails, phone records and other contacts, so we may see indictments once the full record is examined.

This investigation comes after a federal indictment of PG&E for obstructing justice in connection with a 2010 natural gas pipeline explosion that killed eight people and destroyed 38 houses in a San Francisco suburb.

Under Peevey the utility commission has repeatedly favored utility requests for more money and ignored or minimized evidence that smaller increases or none were justified.

The way to a faster recovery with robust benefits for everyone requires no new economic theory, only that we pay respect to the benefits of competitive markets that Smith articulated in the same year the Declaration of Independence was signed. George Stigler later built on these insights in his classic 1971 paper explaining regulatory capture —two words that, like Voldemort’s name in the “Harry Potter” books, should not be spoken, according to some bank regulators.

Our choice is between applying time-tested insights about the benefits of competitive markets or looking the other way as our democratic government helps the oligarchs pick our pockets.

David Cay Johnston, an investigative reporter who won a Pulitzer Prize while at The New York Times, teaches business, tax and property law of the ancient world at the Syracuse University College of Law. He is the best-selling author of “Perfectly Legal,” “Free Lunch” and “The Fine Print” and the editor of the new anthology “Divided: The Perils of Our Growing Inequality.”

The views expressed in this article are the author's own and do not necessarily reflect Al Jazeera America's editorial policy.

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