The Competition Solution: The Bipartisan Secret behind American Prosperity

Published by EH.NET (September 2005)

Paul A. London, The Competition Solution: The Bipartisan Secret behind American Prosperity. Washington: American Enterprise Institute Press, 2005. vii + 227 pp. $25 (cloth), ISBN: 0-8447-4204-X.

Reviewed for EH.NET by Richard K. Vedder, Department of Economics, Ohio University.

Paul London, a Deputy Undersecretary of Commerce in the Clinton Administration and later a visiting fellow at the American Enterprise Institute, argues in The Competition Solution that rising competition and the end to stultifying monopolistic practices was the key factor in the rise in American prosperity between the 1970s and 1990s. His account is highly readable and sometimes incisive. Unfortunately, it suffers from two major flaws that detract somewhat from it becoming a major, enduring work.

London argues that the 1970s was a generally unsuccessful decade economically in America, suffering from high unemployment, high inflation, and sluggish economic growth. By contrast, the 1990s were a period of moderate inflation, falling unemployment, and higher economic growth. What caused the change? Rejecting the notion that monetary or fiscal policy was the leading determinant, London concludes that the commanding heights of the American economy became invigorated, largely because of a bipartisan political effort to end competitive restraints. The true heroes in London’s account are politicians of all political stripes, ranging from Ronald Reagan to Ted Kennedy.

More specifically, London singles out the automobile, steel, transportation, communications, financial services and retail trade industries for attention. In London’s view, in 1970 the American steel and auto industries were relatively inefficient oligopolies that were slow to innovate, to reduce costs, and meet customer wants. Given their importance in the economy, this dragged down growth and job creation, also aggravating inflation. Similarly, AT & T had an inefficient regulated telephone monopoly, while airlines and railroads were stifled from competing by government regulations imposed by agencies like the Civil Aeronautics Board and the Interstate Commerce Commission. Limits on branch banking, interest rates, and entry into new fields stifled financial services. Various laws, often imposed by the states, restrained price competition in retail trade.

I suspect most scholars agree that the deregulation of these industries positively impacted on the economy, probably materially. The assertion, however, that this is the dominant explanation of rising prosperity is more dubious. The author provides little hard evidence about the positive effects of increased competition in these industries, nor does he critically analyze in any detailed way alternative explanations for improved economic performance, such as more moderate inflation and increased monetary stability, a lowering in marginal tax rates, or even New Growth theory notions about increasing returns to scale, the cumulative effects of technological changes, etc.

First, to the evidence: We can use the misery index (inflation rate plus unemployment rate) as an indicator, and augment it by subtracting the annual rate of real GDP growth. Doing that for the 1970s yields a misery index of 13.62, and an augmented index of 10.39. The figures for the 1990s are 8.68 and 5.58, clearly much lower, supporting London’s point.

Yet the observed improvement is entirely due to a Phillips Curve shift to the left, which many economists believe reflects a dampening in inflationary expectations, which suggests that monetary and fiscal policies probably played an important role. Moreover, the oligopolies that London castigates (Big Steel, AT&T, New York banks, etc.), existed in the 1960s as well, when the misery index was lower than in the 1990s (7.33), and the augmented misery index was an extraordinarily low 2.90. In the bad old days of oligopoly in the mainline industries, we sometimes had economic performance comparing well with today. Thus a fuller look at modern macroeconomic history makes one somewhat skeptical that the enhanced competition in a handful of sectors alone explains most of the macroeconomic success of the 1990s.

Indeed, the rise in the growth in the money stock (M2) from a 7.05 percent average annual rate in the 1960s to a 9.67 percent rate in the 1970s is usually considered to be at least a significant factor in rising inflation in that decade, a period when, if anything, the monopoly power in the regulated industries actually declined slightly. Similarly, a fall in monetary creation in the 1980s (to 7.84 percent) and again in the 1990s (3.85 percent) most certainly largely explains falling inflation rates, and with that dampening inflationary expectations, and a better Phillips curve and misery index.

Another explanation for a robust 1990s could well be the reverse crowding out of private sector spending during the Clinton Administration. In 1992, the federal government spent (on a national income accounts basis) the equivalent of 22.79 percent of GDP; eight years later, that had fallen to 18.99 percent. The 3.8 percentage point shift in resources from a relatively less efficient public sector to a more efficient, market disciplined private sector could well be a major key to explaining the success of the 1990s.

The point I am making is that that there are multiple explanations of the improving economy over time, and London goes overboard in asserting that increased competition in some regulated industries was of paramount importance. He does not seriously evaluate alternative explanations. To be sure, London is no doubt correct in asserting that greater competition in these industries was important, and by emphasizing that and providing some details of the move to greater competition his book does provide a service.

Errors of omission are compounded by errors of commission, namely a number of factual misstatements. Three examples will suffice. Speaking of the 1990s, London says “unemployment fell to record lows, and no inflation appeared.” (p. 36). Actually, unemployment rates averaged higher than in several other decades (e.g., 1920s, 1940s, 1950’s, 1960s). The same in true with inflation — consumer prices increased every single year; it may have been low, but it did exist. Or, “Inflation did not becoming a significant problem during the Eisenhower years, but it was in the Kennedy-Johnson era” (p. 21). In fact, the annual rate of inflation during the three Kennedy years as president never reached two percent, and was lower on average than in the second Eisenhower term. Referring to Alan Greenspan, he said “In 1988 and 1989 … he tightened the money supply and raised interest rates from around 6 percent to over 9 percent” (p. 167). Interest rates on long term government bonds had not been as low as six percent in two decades, and the average rate in 1989 was only 14 basis points higher than in 1987 (and below 9 percent). Moreover, money supply growth actually rose in 1988. If he had said “there was a tightening of the money supply in 1989,” he would have been factually correct.

In the last chapter, London looks to the future, suggesting that competition could be extended further to promote growth, particularly in the fields of education and health care. While I happen to agree with him, I think as long as third party (governmental) payments are a dominant factor, it will be hard to fashion a competitive environment with true market discipline. Nonetheless, London correctly points out that 20 percent or so of the American economy operates in an inefficient, less than perfectly competitive environment.

London makes a valuable contribution in pinpointing the increased efficiency arising from increased domestic and international competition in a variety of important industries. He overstates his case, sometimes asserting things rather than marshaling evidence. Nonetheless, his book is a positive contribution to our understanding of contemporary American economic history.

Richard Vedder is Distinguished Professor of Economics at Ohio University. His most recent book is Going Broke by Degree: Why College Costs Too Much (Washington, AEI Press, 2004).