DRI-445: Size Matters

For the umpteenth time, we awake to find Greece in the headlines. Her bickering political parties cannot form a coalition government – new elections are unavoidable. Capital is fleeing the country – almost $900 million worth on a single day. Greece will have to abandon the euro; the currency’s viability is in doubt. The European welfare state is imploding in slow motion, like a desolated high-rise public housing project condemned as uninhabitable.

The Wall Street Journal put its editorial finger on the problem. “The euro zone was conceived as a currency union…rather than …a fiscal or debt union…Trying to turn the euro into a larger political union has put the entire euro zone in jeopardy.”

For the last two years, governments of the European Community have applied one band aid after another to the debt-and-spending problems of its smaller, weaker members. Each application was accompanied by ostentatious public exhalations of relief and proclamations that fiscal peace in our time had been attained. None of the temporary fixes addressed the underlying problem, which is that Greece, Portugal, Spain and Italy have been supporting bloated, inefficient governments by overspending their budgets and borrowing the overage.

Eventually, creditors recognized the imminent danger of default and refused to play along with the charade any longer. Greece is the first country to face the choice that will soon confront the rest; namely, default on the debt – thereby shredding their credit rating and any hope of borrowing in the future – or leave the European Community and the euro behind.

The Eurozone can afford to lose Greece, but a protracted procession to the monetary exits would write finis to the euro as a currency. Consequently, the dominant member of the organization, Germany, has tried to impose a program of fiscal austerity on Greece. “Fiscal austerity” is shorthand for tax increases and spending cuts. Having ridden the governmental gravy train for most of their lives, Greece’s voters are in no mood to be thrown off by a prime minister – Angela Merkel of Germany – they didn’t even vote for. Instead, Greek political rallies feature posters of Merkel dressed in a Nazi uniform. Meanwhile, Spain offers a preview of coming attractions; mobs of protestors called “indignants” parade in opposition to austerity measures.

Economically, Ms. Merkel is right. After all, the only way to keep Greece and the euro both afloat is to bail the Greeks out, and German taxpayers are the only ones solvent enough to take on that job. Ms. Merkel is like the captain of a lifeboat currently holding its capacity of twenty souls who is importuned by another dozen shipwreck survivors. But politically, the protestors are right. When the citizens of a democracy surrender control over their tax and spending policies to a foreign power, they are no longer living in a democracy. How can such a stalemate possibly be resolved?

Free Trade and the Optimum Size of Government

The European Community is the successor to the old Common Market. Its purpose is to leapfrog the political borders that otherwise hamstring economic transactions. Its advent superseded thousands of rules, regulations, tariffs, quotas and barriers that previously made commerce between European nations a quagmire of cost and complication.

Now the economy of Europe resembles that of the United States. People, goods and services move freely across the political boundaries that separate the several states. Almost everybody benefits from this, the only exceptions being those that would reap large gains from excluding foreign competition. (Economists call these people import-competing suppliers of goods, services and inputs.)

It is not enough to eliminate the political impediments to trade across national boundary lines. Trade within the United States is lubricated by the use of a common currency that allows all prices and relative values to be expressed in terms of a common denominator. Failing that, the need for rates of exchange to facilitate trade involving different national currencies can impede trade nearly as much as political barriers. Problems arise because each government’s control of its own national monetary unit lets it create money for its own purposes. Money creation depreciates the value of the national money in the foreign exchange market, causing the exchange rate to rise. The price of goods is supposed to be based on supply and demand, but exchange rate changes cause the price of internationally goods to change for reasons unrelated to their underlying supply and demand. When people react to these camouflaged prices, the resulting changes in supply and demand falsify the real wants and needs of the people.

That is why the European Community created a common monetary unit – the euro – for its members. By affording all Europeans the luxury of a common currency, the euro made it possible to effectuate the ideal envisioned by author T. H. White, author of The Once and Future King. White felt that war and strife between nations could be avoided if we could somehow see the world as a bird did, from the air – without boundaries. The classical liberals of the 19th century agreed that free trade between nations was the best prophylactic against war. The great French economist Bastiat proclaimed that if goods did not cross borders, soldiers would.

But White was only half right. Political borders might be an economic nuisance, but they served a useful purpose. In their absence, the only alternative would be one gigantic, world government. The existence of political borders allows us to keep government small and manageable. Lord Acton, the English jurist and political philosopher, declared that “power corrupts and absolute power corrupts absolutely.” Unfortunately, the wider the scope of government, the more power is needed to enforce its dictates and fund its administration. The bigger is government, the harder it falls upon the heads (and wallets) of its subjects.

Economics says to eliminate political borders. Politics says that the more political borders we create, the smaller government is and the freer and more prosperous we become. We can have our cake and eat it by keeping governments small and numerous but simultaneously allowing free trade to cross political borders.

The problem is that officeholders have an incentive to make government as big as possible and oppose free trade across national boundaries. In other words, the incentives facing government are perverse – they tend to produce the opposite outcome to that desired. The only way to overcome that is by imprisoning government in a constitutional straitjacket that forces it to allow free trade while severely limiting its scope for growth.

The Size of Companies

Nobel laureate Ronald Coase saw transactions costs as the raison d’être of businesses. When households migrated away from self-sufficiency and toward specialization, why didn’t each one simply purchase the other goods it consumed direct from the specialist household? Coase believed that the transactions costs of providing goods and making them widely available in trade demanded the efforts of a firm organized to incur those costs efficiently. Thus was born the business firm.

The more efficient businesses became, the larger they grew. The greater the number and variety of production operations businesses could perform efficiently, the larger they became. In some cases, physical laws created “economies of scale” or greater-than-proportional increases in output resulting from proportional increases in all inputs. One such law is the so-called “two-thirds rule,” a functional relationship of cost to surface area and throughput to volume in various structures and processes like oceangoing cargo ships and pipelines. Since area tends to increase as the two-thirds power of volume, this means that the larger the structure, the lower will be the unit cost of a given output. This gives firms a powerful incentive to grow as large as possible.

No matter the source of the increase, it cannot not persist indefinitely. That is, no business could grow infinitely large without encountering some factor limiting its optimal size. In a free-market economy, the limiting factor always finds expression in the profit earned by the firm.

Perhaps the firm eventually grows so big that it cannot monitor product quality well enough. What constitutes “well enough” and how will firm managers know when the critical point is reached? Consumers will let them know by reducing their purchases of the product, thereby lowering the firm’s profits. Maybe the firm’s size loosens its grip on purchasing decisions. This will cause its costs to rise, thereby reducing its profits. Maybe the firm expands so far and so fast that spending on research and development falls, thereby depressing its rate of innovation and dropping its productivity. This will drive its costs up and its profits down. It might be as simple as just losing touch with the needs of its customers or with the pulse of the market. Whatever the cause, the symptom is the same – lower profits.

Note the difference between government and private business. Both face incentives to grow, but may grow too large. The profit motive is an inborn, inherent governor on the growth propensities of business. Government contains no such automatic, inherent restraint. The only restraining forces on government are exerted at the ballot box or in the streets.

Elections are an uncertain means of reducing government growth. The two watershed elections in recent Western industrial history – the elections of Ronald Reagan as U.S. President in 1980 and Margaret Thatcher as British Prime Minister in 1979 – succeeded only in slowing the pace of government growth in their respective nations. Revolutions, whether violent or peaceful, can be more transformational but are also riskier and potentially more costly.

Why the Left is Wrong About Company Size

One would be hard put to reconcile the foregoing with the picture of business painted by the left wing. The Left’s favorite villain may be the corporation. They use the word “corporate” as an adjective to modify a pejorative noun. “Corporate greed,” “corporate welfare,” “corporate cronyism,” “corporate profits” – even “corporate culture” takes on a pejorative cast.

If there is one connotation invariably and immutably associated with the corporation by the Left, it is bigness. Yet there is no necessary connection between size and the corporation. Economic historian Robert Hessen pointed out that almost every member of the Fortune 500 started as a small, closely held corporation whose stock was owned by a tiny group of owner-operators. When convinced of the firm’s potential, investors became willing to supply investment capital.

Eventually, the potential to reach national and international markets justified “going public” – selling equity shares to the public at the cost of relinquishing management control of the firm to the board of directors hired to safeguard the shareholders’ interests. It is actually this “separation of ownership from control” that is the single defining characteristic of the corporation, even more so than the limitation of investor liability.

The joint stock companies organized to explore the New World beginning in the 15th and 16th centuries were gigantic by the standards of their time. They had to be. But they weren’t corporations in the modern sense, merely companies organized to aggregate capital. Today, limitation of liability is inseparable from corporations and other forms of business organization. But the concept didn’t firmly attach itself to the corporation until the late 19th and early 20th centuries. Andrew Carnegie’s steel companies were structured as limited partnerships, while John D. Rockefeller built Standard Oil using the trust, a vehicle designed to facilitate expansion by merger and acquisition.

It wasn’t the corporate form itself that gave rise to big business, but rather the economic imperatives of the marketplace – economies of scale and scope, increasing market size, reductions in transport costs and all the rest. And they carried with them their own inherent, automatic limitation. Profit served as the trouble light on the instrument panel that served to warn owners and investors that growth had reached its natural limits.

The implication of the Left’s sinister portrayal of the corporation is that small business is somehow pure, noble, untarred by corporate pitch. In practice, of course, this is pure hooey. The relationship between big business and small business is symbiotic.

Virtually all big businesses start small – in that sense, the former couldn’t exist without the latter. Less teleologically, big corporations rely on small businesses for raw materials, supplies, recruiting needs, equipment purchases and servicing. But the flow of influence also runs in the opposite direction. Big business serves as the training ground in which entrepreneurs learn their trade; indeed, the standard advice to the would-be entrepreneur is to take a job working for wages in his or her chosen industry. Oftentimes, that job is corporate – either a salaried position at a major corporation or perhaps ownership of a franchise, where the owner can “paint by the numbers” using a proven operational and marketing plan in order to learn the ropes of running a business.

Much is made of the fact that the bulk of job growth comes from small business. This is not the result of virtue or the small-business mentality or even superior agility, so much as simply economic and arithmetic logic. Big businesses are, by definition, big; this means that a preponderance of them have approached, attained or (occasionally) surpassed their optimum size. They have little or no room for growth in income and employment. Small businesses, being small, have more “room” for growth. While some of them will remain small, the ones that thrive will grow. Some will grow a little, some quite a bit, a few will grow enormously. The outcome of this is that small business naturally generates most of the new job growth.

The Mixed Economy – the Case of Banks

As an intermediate case between growth in government and free-market growth in private business, we have heavily regulated private firms. On the one hand, regulation is conducted by government bureaucrats within the framework of government. On the other hand, its ostensible purpose is to replicate, replace or fine-tune the competitive process in cases where competition is either absent or impracticable. To which of these polar extremes will the outcome of regulation tend?

Banks are a locus classicus of business regulation. Although banks were regulated in the 19th century, thoroughgoing regulation began during the New Deal and the Great Depression. Widespread bank failures are cited by just about everybody as an important cause of the Depression. It is striking that our next-door neighbor, Canada, suffered next to no bank failures compared to the hundreds we endured.

At the time, branch banking was illegal in the U.S. but legal in the U. K. Various monetary theorists have suggested that Canadian branch banks protected their parent companies against risk by diversifying the company’s asset base geographically, resulting in better offset to region-specific loan losses. This is a case in which restrictive U. S. regulation kept our banks from growing large enough to neutralize the risks borne in their local environment.

The opposite case unfolded in the 1980s and persisted for the following four decades. A philosophy gradually developed that the larger a bank grew, the greater were the number and strength of its ties to other firms. If the bank failed, it might take many of these connected firms with it. The term for this interconnectedness problem was systemic risk. Fear of systemic risk gave rise to the doctrine known as “too big to fail.” Some banks, or financial firms generally, were considered too big to be subject to the risk of failure. This mindset is widely thought to underlie the massive bailouts of late 2008 and early 2009.

The most striking feature of the “too big to fail” doctrine is its effect on the size of banks. Clearly, banks have a huge incentive to get as large as possible in order to qualify for this kid-glove, hands-on treatment. More generally, the incentives confronting banks under regulation tend to be perverse, motivating them to do the wrong thing – not diversifying the bank in the 1930s and growing to improve eligibility for bailouts in the 2000s.

One of the most perverse features of bank regulation was that the biggest banks adopted policies that were quite unfriendly to their own customers. For example, financial commentators remarked that one mega-bank apparently had sought to induce its depositors to overdraw their accounts in order to incur large fees. In a competitive market, a bank would never take such a punitive stance toward its own customers, for fear of losing them. Under regulation, mega-banks apparently take a heads-I-win, tails-I-get-bailed-out attitude.

Size Matters

There is no doubt that, as elsewhere, size matters in politics and economics. Free markets feature an automatic mechanism that regulates business-firm growth and size; namely, the firm’s rate or level of profit. Increasing profits encourages continued growth, while reduction in profits suggests that the firm pull back from growth. Governments find it difficult to cut back on their own size and growth because they lack this warning sign telling them when to cut back on growth and when to embrace it.

Regulatory behavior is actually perverse in its effects on banking firm size. The “too big to fail” doctrine nudges firms toward gigantism, where they may win favor for a bailout. It also promotes neglect of customer service – a failing that would come back to haunt a competitive practitioner.

There is a countervailing hypothesis that it is not size per se that matters, but the use to which any size is put. Free markets make the best of things by encouraging businesses to reach their optimum size. Instead of regulating firms with discretionary orders issued by human bureaucrats, markets appoint consumers as the regulatory czars. The profit motive becomes the tool to impose regulatory discipline on businesses.