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AUTHOR
Picture of Raghu Rajan

Raghu Rajan

Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago Booth School of Business.

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Raghuram Rajan is the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago Booth School of Business.

Dr. Rajan is also currently an economic advisor to the Prime Minister of India. Prior to resuming teaching in 2007, Dr. Rajan was the Economic Counselor and Director of Research (in plain English, the Chief Economist) at the International Monetary Fund (from 2003). Since then, he has chaired the Indian government’s Committee on Financial Sector Reforms, which submitted its report in September 2008.

Dr. Rajan’s research interests are in banking, corporate finance, and economic development, especially the role finance plays in it. His papers have been published in all the top economics and finance journals, and he has served on the editorial board of the American Economic Review and the Journal of Finance.  He has written Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press) which won the Financial Times/Goldman Sachs Business Book of the Year 2010 award. He has also co-authored Saving Capitalism from the Capitalists with Luigi Zingales .

Dr. Rajan is a senior advisor to Booz and Co, on the academic advisory board of Moodys, and on the international advisory board of Bank Itau-Unibanco. He is a director of the Chicago Council on Global Affairs and on the Comptroller General of the United State’s Advisory Council. Dr. Rajan is the President (elect) of the American Finance Association and a member of the American Academy of Arts and Sciences. In January 2003, the American Finance Association awarded Dr. Rajan the inaugural Fischer Black Prize, given every two years to the financial economist under age 40 who has made the most significant contribution to the theory and practice of finance.

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November 14

Destructive Creation

Many economists are advocating for regulation that would make banking “boring” and uncompetitive once again. After a crisis, it is not uncommon to hear calls for limiting competition. During the Great Depression, the head of the United States’ National Recovery Administration argued that employers were being forced to lay off workers as a result of “the murderous doctrine of savage and wolfish competition, [of] dog-eat-dog and devil take the hindmost”, and called for a more collusive business environment, with the profits made off consumers being shared between employers and workers.

 

Concerns about the deleterious effects of competition have always existed, even among those who are not persuaded that government diktat can replace markets effectively, or that intrinsic human goodness is a more powerful motivator than monetary rewards and punishment. Where the debate has been most heated, however, concerns the effects of competition on incentives to innovate.

 

The great Austrian economist Joseph Schumpeter believed that innovation was a much bigger force for human betterment than ordinary price competition between firms. As a young man, Schumpeter seemed to believe that monopolies deaden the incentive to innovate, especially to innovate radically. Simply put, a monopolist does not like to lose his existing monopoly profits by undertaking innovation that would cannibalize his existing business.

 

By contrast, if the industry was open to entry, potential entrants, with everything to gain and little to lose, would have a strong incentive to unleash the waves of “creative destruction” that Schumpeter thought so essential to human progress. In a competitive industry, only paranoid incumbents – those constantly striving for betterment – have a hope of survival.

 

As an older man, Schumpeter qualified his views to argue that some degree of monopoly might be preferable to competition in creating stronger incentives for companies to innovate. The rationale is simple: If patent protection were limited, or if it were easy for competitors to innovate around intellectual property, a firm in a competitive market would have very little incentive to invest in pathbreaking R&D. After all, the firm would gain only a temporary advantage at best. If, instead, it held back spending and simply copied or worked around others’ R&D, it could survive perfectly well – and might be better off. Knowing this, no one would innovate.

 

But if the firm enjoyed a monopoly, it would have the incentive to undertake innovations that improved its profitability (so called “process” innovations), because it would be able to capture the resulting profits, rather than seeing them competed away. A “boring” bank, shielded from competition and knowing that it “owns’ its customers, would want to go the extra mile to help them, because it would get its pound of flesh from their future business. Customers can be happy even when faced by a monopoly, though they would grumble far more if they knew how much they were paying for good service!

 

An analogy may be useful. A monopoly is like running on firm ground. Nothing compels you to move, but if you do, you move forward. The faster you run, the more scenery you see – so you have some incentive to run fast.

 

Competition is like a treadmill. If you stand still, you get swept off. But when you run, you can never really get ahead of the treadmill and cover new terrain – so you never run faster than the speed that is set.

 

So which industry structure is better to get you to run? As economists are prone to say, it depends.

 

Perhaps one can have the best of both worlds if one starts on a treadmill, but can jump off if one runs particularly fast – if the system is competitive, but those who are particularly innovative secure some monopoly rents for a while. This is what a strong system of patent protection does.

 

But patents are ineffective in some industries, like finance. The overwhelming evidence in this industry, though, is that competition promotes innovation. Much of the innovation in finance in the US and Europe came after the industry was deregulated in the 1980’s – that is, after finance stopped being boring.

 

The critics of finance, however, believe that innovation has been the problem. Instead of Schumpeter’s “creative destruction,” we have had bankers engaging in destructive creation intended to gouge customers at every opportunity, behind a veil of complexity that shields them from the prying eyes of regulators (and even top management). Former US Federal Reserve Board Chairman Paul Volcker has argued, somewhat tongue-in-cheek, that the only useful financial innovation in recent years has been the ATM. Hence, the critics are calling for limits on competition to discourage innovation.

 

Of course, not all of the innovations in finance have been useful, and some have been outright destructive. By and large, however, innovations such as interest-rate swaps and junk bonds, have been immensely beneficial in allowing a variety of firms to emerge and obtain finance in a way that simply was not possible before. Even mortgage-backed securities, which are at the center of the crisis, have important uses in spreading home and auto ownership. The problem was not with the innovation, but with how it was used – that is, with financiers’ incentives.

 

And competition does play a role here. Competition makes it harder to make money, and therefore it depletes the future rents (and stock prices) of the incompetent. In an ordinary industry, incompetent firms (and their employees) would be forced to exit. In the financial sector, the incompetent take on more risk in the hope of hitting the jackpot, even while the regulator protects them by deeming them too systemically important to fail.

 

Instead of abandoning competition and giving banks protected monopolies once again, the public would be better served by making banks easier to close when they get into trouble. Instead of making banking boring, let us make it a normal industry, susceptible to destruction in the face of creativity.

 

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