We are at a watershed moment: the coronavirus Covid-19 is a catalyst fast bringing many long simmering problems to the boil. It is exposing the creaking financial systems around us and it will change the way economies function. Economic and financial pundits, however, have been focusing almost exclusively on the short-term effects of coronavirus and so are missing the much bigger themes at play.

Epidemiologists tell us that when it comes to the virus, we are looking at a once in a century event. It is highly contagious and highly lethal. Experts are not comparing Covid-19 to SARS or Swine Flu, but to the Spanish influenza of 1918 that killed between 50 and 100 million people worldwide.

We do not have good data on what the stock market did during the 1918 flu, but we do know that it led to a severe recession. The connection between influenza and recessions is well documented. Going as far back as the Russian flu in 1889-90, the Spanish flu in 1918, the Asian flu in 1957-58 and the Hong Kong flu of 1968-69 — they all led to recessions. This one will be no different.

But this recession will not only be driven by the economic loss of able-bodied workers, it will be helped along too by the steps political leaders take to avoid the spread of the coronavirus. In medicine, the immune system’s response can often be worse than the disease. When the body goes into septic shock, the immune system overreacts, releasing what doctors refer to as a cytokine flood, which can reduce blood to vital organs and lead to death. Sepsis is common and kills more than 10 million people a year. Today, the political reaction to Covid-19 is causing something akin to a septic shock to the global economy.

The recession is likely to be very sharp but brief. Recessions are self-regulating. De-stocking of shelves and warehouses leads to re-stocking. Collapsing low interest rates and oil prices eventually spur spending and borrowing. Government spending and central bank easing eventually feed through to the real economy. While there will be massive panic and bankruptcies today, there is little doubt that markets will be better in a year, and certainly will be in two to three years,

But the structural changes to how our economy operates, however, will be felt for decades to come. And this is in large part because we didn’t learn the lessons of the last crash.

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Over the years since the 2008 crisis, central banks have been trying to stamp out every single small fire that flares up (the European crisis in 2011-12, the Chinese slowdown in 2015-16, the slowdown last year); but suppressing volatility and risk only creates bigger fires. Risk is like energy and cannot be destroyed. It can only be transformed.

Forest fires are a useful analogy. California has infrequent, devastating forest fires; the Mexican state of Baja California has many small frequent fires and almost no major catastrophic fires. Both states have a similar climate and vegetation, yet they have vastly different outcomes. That’s because when there are very few small fires, underbrush grows, vegetation increases and creates greater kindling for the next fire. Suppressing small risks only makes them emerge eventually as very big ones.

In politics and economics, massive change events tend to happen not in orderly sequences, but in sudden spasms, like the Arab Spring, or the collapse of the Eastern Bloc. Watching events unfold is often like watching sand grains pile slowly on top of one another until a final, random grain causes the entire pile to collapse. People knew the Arab countries were fragile and that the Eastern Bloc might eventually fall, but predicting which grain of sand would do it precipitate either was impossible.

Further reading

2011 birthed the mother of all protests

By Christopher Rhodes

Physicists call these transitions critical thresholds. Critical thresholds are everywhere in nature. Water at moderate temperatures is disorganised and free-flowing, yet at a given critical value, it has an abrupt transition to a solid. It’s the same with the sandpile: one grain too many can trigger collapse — but which one?

In 1987 Per Bak, Chao Tang, and Kurt Wiesenfeld found that while sandpiles may be individually unpredictable, they all behave the same way. The critical finding of their experiments was that the distribution of sand avalanches obeys a mathematical power law: The frequency of avalanches is inversely proportional to their size. Much like forest fires, the less frequent they are, the more catastrophic they are.

It’s the same with financial markets and the economy. We will experience years of quiet, interrupted by sudden avalanche. Years of slowly adding grains of sand can end abruptly — to our great surprise. Today in financial markets, many unsustainable trends have been building, and the coronavirus is merely the grain of sand that has tipped the sandpile.

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It would be controversial to say that the stock market reaction to the coronavirus would not have been very big had we not been in the middle of an orgy of borrowing, speculation and euphoria. Of course, stocks would have fallen with coronavirus headlines, but it is unlikely they would have crashed the way they did without those exacerbating factors. Furthermore, without enormous underlying imbalances of high corporate debt, the prospect of poor sales would not have driven so many stocks to the verge of collapse.

This aspect of the current crisis has so far gone unreported. But not unmentioned. A few weeks before the crash, Charlie Munger, vice chairman of Berkshire Hathaway and Warren Buffett’s longtime business partner, issued a dire warning, “I think there are lots of troubles coming,” he said at the Los Angeles-based Daily Journal annual shareholders meeting. “There’s too much wretched excess.”

Speculative euphoria was at record highs. As Sir John Templeton once said, “Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria.” Investors were all on the same side of the boat, and it capsized, as happens in market crashes.

• Investors were buying a record amount of call options, or bets on stock prices rising further. According to SentimenTrader, by early February, “We’ve never seen this level of speculation before. Not even close.”
• Asset managers were betting in record quantities on stock futures, which are instruments to bet on underlying indices. Positioning in S&P futures hit a new high as of February 11.
• Hedge fund borrowing to buy stocks was at a 24-month high. They were highly confident markets would keep rising.

Asset Manager positioning in S&P futures hit a new high as of February 11 in both net contracts and value. S&P futures comprises the bulk of equity futures positioning by these funds.#SPX #NDX pic.twitter.com/OA744Dxzsc

— QF Research (@ResearchQf) February 14, 2020

It was not a coincidence that there was such euphoria. Retail brokerages had announced over the past few months that they were eliminating all commissions on trading activity. Buying and selling stocks was suddenly “free”. It was like pouring truckloads of kerosene on a blaze. At Charles Schwab, daily average trading revenue exploded 74% after the change.

In scenes reminiscent of the dotcom boom, stocks were doubling overnight. Virgin Galactic Holdings, with no revenue, was worth over $6 billion dollars. Tesla, which has never made money selling cars, had a market capitalisation greater than any other car manufacturer. Its stock price quadrupled in less than three months. The market was so stretched that it would have crashed due to its own absurdity — with or without coronavirus.

The source of this “free” trading came from high frequency trading firms that are supposed to act as market makers, executing buys and sells for clients. Except that they are not really disinterested middlemen; they are running their own trading strategies to make money off retail investors. They execute the order flow of so called mom and pop investors and profit from these “dumb money” retail traders, in the words of Reuters.

The brokerages which sell retail orders receive hundreds of millions of dollars in return from the market makers. This means that, essentially the market makers are bribing the brokerages to profit from retail traders. For example, E*Trade received $188 million for selling its customer order flow last year, while TD Ameritrade made $135 million in the fourth quarter alone. The market makers are willing to pay so much because they almost never lose money — they trade fast and know where the market is going.

As Warren Buffet once said, “As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’” Retail is the patsy.

Ken Griffin is the owner of Citadel Securities the biggest market-making firm, and his business is so profitable that he has gone on one of the greatest property buying sprees of all time. In 2015 Griffin paid $60 million for multiple condo units in Miami. He paid a U.S.-record $239.96 million penthouse in New York City, a $122 million mansion in London, and over $250 million in Palm Beach properties. Market making against “dumb money” is a fabulous business.

Further reading

The three myths about free markets

By Jesse Norman

As the mania deflated in late February, though, mom and pop were abandoned. As the crash started, market makers pulled back and provided less liquidity. Retail investors were left high and dry. It is no wonder prices fell so quickly.

The high frequency market makers have since been pleading for more capital, and rumors swirl that many are experiencing financial difficulties. The illusion of benign market makers looking after retail investors has vanished.

There are echoes here of the old problems from the Lehman crisis; but they have mutated into different forms. During the Lehman crisis, mortgage bonds were pooled together, and insurance companies and pension funds bought them. Today, retail investors have been buying popular funds known as Exchange Traded Funds (ETFs). These are easy to trade and cheap, but they have a fundamental problem. While ETFs have simple tickers like HYG, JNK, LQD that the average retail broker can trade on their screen, they are really holding hundreds of individual bonds inside of them that the investor is unaware of. These bonds are not easy to trade at a moment’s notice and are highly illiquid. But while the ETFs rose slowly and steadily, and investors poured more money in, lulled by a false sense of security.

While the ETF shares trade daily by the second, the underlying bonds are not easy to trade on their own. In the old days, insurers and pension funds bought these bonds, put them away in a drawer and never traded them. Today, though, investors expect instant liquidity from an illiquid investment. Liquidity mismatches are as old as banking itself (deposits and cash are highly liquid, while mortgages and loans are often completely illiquid); the problems of ETFs have been known all along, and the outcome has been inevitable.

As the coronavirus panic spread, the ETFs started trading at big discounts to the underlying value of the baskets of bonds. Markets are broken, and the gap is a sign of how illiquid the underlying holdings really are.

But these ETFs should never have been allowed in the first place. In the words of Christopher Wood, an investment strategist at Jefferies, “they commoditise equity and bond investing in an insidious way which ultimately creates a dangerous illusion of liquidity. True, ETFs are cheap. But so is fast food.”

While ETFs may appear technical and unrelated to the broader problems in markets, they share the same underlying problem. We have had the illusion of safety and liquidity for some time, and it is the coronavirus that has exposed the gaping holes in financial markets.

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The coronavirus won’t kill companies. But it will expose their bloated, over-leveraged balance sheets. Corporate debt in companies has never been higher and has now reached a record 47% of GDP.

Rather than encouraging moderation, central bankers and policy makers have been reloading the all you can eat buffet and persuading everyone to come back for third and fourth plates. The European Central Bank and the Bank of Japan have been buying corporate bonds, and central banks have kept funding at zero rates, which has encouraged a massive increase in indebtedness over the past decade.

Central bankers have long promoted high corporate leverage because they see it as a way to stimulate demand. Even now, many economists see no problems on the horizon. In the New York Times, Nicolas Veron, a senior fellow at the Peterson Institute for International Economics in Washington, was openly mocking anyone advocating prudence, “The prophets of doom who thought that more debt was more risk have generally been wrong for the last 12 years.” Like most central bankers for the past decade, he argued, “More debt has enabled more growth, and even if you have a bit more volatility, it’s still net positive for the economy.”

But while debt has encouraged growth, it has also introduced much greater financial fragility, and so the growth is fundamentally unsound. We are now finding out that less debt, rather than lower rates is better for financial stability.

Further reading

The global economy has gone mad

By Peter Franklin

According to FactSet, 17% of the world’s 45,000 public companies haven’t generated enough cash to cover interest costs for at least the past three years. Debt has been used to finance more debt in a Ponzi fashion. The Bank for International Settlements looked at similar economic measures globally and found that the proportion of zombie companies — companies that earn too little even to make interest payments on their debt, and survive only by issuing new debt — is now higher than 12%, up from 4% in the mid 1990s.

Entire industries are zombies. The most indebted and bankruptcy prone industry has been the shale oil industry. In the last five years, over 200 oil producers filed for bankruptcy. We will see dozens if not hundreds more bankruptcies in the coming year. They were all moribund with oil at $50 dollars; they’re now guaranteed to go bust with oil at $30.

Only now, belatedly, are groups like the IMF waking up to the scale of the problem. In a recent report they warned that central banks have encouraged companies to pursue “financial risk-taking” and gorging on debt. “Corporate leverage can also amplify shocks, as corporate deleveraging could lead to depressed investment and higher unemployment, and corporate defaults could trigger losses and curb lending by banks,” the IMF wrote.

According to the IMF, a downturn only half as bad as 2008 would put $19 trillion of debt—nearly 40% of the corporate borrowing in major countries—at risk of default. The economic consequences would be horrific.

Corporate debt has doubled in the decade since the financial crisis, non-financial companies now owe a record $9.6 trillion in the United States. Globally, companies have issued $13 trillion in bonds. Much of the debt is Chinese, and their companies will struggle to repay any of it given the lockdown and the breakdown in supply chains.

We have not even begun to see the full extent of the corporate bond market meltdown. One little discussed problem is that a large proportion of the debt is “junk”, i.e. lowly rated. An astonishing $3.6 trillion in bonds are rated “BBB”, which is only one rating above junk. These borderline bonds account for 54% of investment-grade corporate bonds, up from 30% in 2008. When recessions happen, these will be downgraded and fall into junk category. Many funds that cannot own junk bonds will become forced sellers. We will see an absolute carnage of forced selling when the downgrades happen. Again, the illusion of safety and liquidity will be exposed by the coronavirus.

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The average family is encouraged to save money for a rainy day, in case they are fired, or they face hardship. Saving some money is considered prudent. It’s quite different for business. Companies pocket the profits in the good years and ask Uncle Sam to bail them out in the bad years. Heads shareholders win, tails the taxpayer loses.

Industry can’t be blamed for not expecting an act of God or force majeure, but in the past 30 years we have seen two Gulf Wars, 9/11, SARS, MERS, Swine Flu, the Great Financial Crisis, etc. Saving for a rainy day should only be expected in cyclically sensitive industries.

But rather than do that, companies have been engaging in a rather more reckless strategy: borrowing to buyback shares. This may boost their Return on Equity (ROE), but it is not remotely prudent and makes their companies highly vulnerable. Borrowing to prop up their own shares means they have less on hand when hard times come.

According to Barons, “Stock buybacks within the S&P 500 index totalled an estimated $729 billion in 2019, down from a record $806 billion in 2018.”

And then along came coronavirus.

Of those industries that are now seeking a bailout, none has saved for a rainy day. Boeing, the poster boy of financial engineering and little real engineering, bought back over $100 billion worth of stock over the past few years. Today it is asking the government for a backstop to its borrowing.

According to Bloomberg, since 2010, the big US airlines have spent 96% of their free cash flow on stock buybacks. Today, they’re asking US taxpayers for $25 billion.

Airline CEOs have been handsomely paid while not saving for a rainy day. Delta Airline’s CEO Ed Bastian made the most, earning nearly $15 million in total compensation. American CEO Doug Parker $12 million, while United CEO Oscar Munoz earned total compensation last year of $10.5 million.

Further reading

Corporate buyback culture is financial engineering not value creation

By Charlotte Pickles

The cruise liners were little different. Over the past decade, Carnival Cruises paid $9.2 billion dollars in dividends to its billionaire owners and bought back $6.7 billion of shares. Royal Caribbean, which is a smaller company, paid out $2.7 billion in dividends and $1.6 billion in buybacks. And the smallest cruise liner Norwegian Cruise Line spent $1.3 billion on share buybacks.

For years, the cruise lines have triumphantly proclaimed massive dividends and buybacks. For example, Carnival proudly announced in 2018. “In just three years, we have doubled our quarterly dividend and invested $3.5 billion in Carnival stock.”

Cruise lines have no real claim to any bailout. They pay no taxes due to a legal loophole, and all their vessels fly the flags of Liberia, Panama and the Marshall Islands. Furthermore, their owners tend to be billionaires with more than enough financial wherewithal to recapitalise their own businesses. Their shareholders are not among the 1%. They’re among the 0.01% of richest people in the world. In the worst-case scenario, the US has a highly efficient bankruptcy process. Bondholders of today become shareholders of tomorrow, and the companies can have a fresh start. Bondholders would only be more than happy to own the equity of these companies.

Banks, too, will inevitably be asking for bailouts before this is over. Banks have among the most aggressive stock buyback programs of any industry, with some repurchasing a staggering 10% of their outstanding shares annually. The eight biggest banks have announced they will suspend their share buybacks for the next two quarters due to the COVID-19 pandemic on the global economy. In 2019, the top eight banks bought back $108 billion of their own stock.

If any good can come of the current crisis, perhaps it is exposing the irresponsibility of share buybacks and lack of prudence of most companies.

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Monetary policy was one of the mechanisms employed in response to the last crisis, in the hope its effects would trickle down to the unwashed masses. Central banks bought vast amounts of treasuries and mortgage bonds to tighten financial spreads for banks and borrowers, but none of it went directly to households. It was all intermediated by the financial system and those who had access to capital.

The absurdity of the policy was perfectly illustrated recently in Europe. The European Central Bank has been busy buying bonds, and recently it bought bonds from LVMH, the luxury conglomerate owned by the world’s richest man Bernard Jean Étienne Arnault. The bonds had a negative yield, meaning that the ECB was paying LVMH to borrow. LVMH used the ECBs money to buy Tiffany.

If rates are now so low that billionaires are being paid to borrow, monetary policy has reached the limits of its usefulness.

Investors own stocks because their bond portfolios have acted like a hedge. Whenever stocks have fallen, bonds have gone up. In every downturn since the 1980s, central banks have cut rates, but most government bonds now have close to zero yields.

Extremely low interest rates and high valuations mean that any small change in interest rates will make portfolios much more volatile. If interest rates were to rise even slightly, they would vaporise many bond and stock portfolios. The margin of safety in bonds and stocks has diminished rapidly as rates have approached zero.

The world is now upside down. Many investors now buy stocks for current income and buy bonds to trade given how volatile they have become. Things cannot hold.

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What do high frequency market making, share buybacks and high corporate debt have in common? They are supposedly tools to make trading, growth and returns on capital more efficient and cheaper, yet they have made the system more fragile and less resilient. Perhaps returns on capital and cheapness of market orders and ETFs are less important than stability and anti-fragility, i.e. designing systems that are robust in the face of stress.

We have seen the fragility in supply chains in the recent crisis.When the coronavirus struck in China, suddenly companies everywhere found out that outsourcing all their manufacturing and even medicines and face masks to China might be a problem.

Manufacturing has become less robust, more fragile, even if the returns on capital are better for those companies that outsource everything to China in pursuit of share buybacks.

The lessons of history are instructive. Although planting a single, genetically uniform crop might be more efficient and increase yields in the short run, low genetic diversity increases the risk of losing it all if a new pest is introduced or rainfall levels drop.

Further reading

Have we been played by China?

By James Kirkup

The Irish Potato Famine is one such cautionary tale of the danger of monocultures, or only growing one crop. The potato first arrived in Ireland in 1588, and by the 1800s, the Irish had used it to solve the problem of feeding a growing population. They planted the “lumper” potato variety. All of these potatoes were genetically identical to one another, and it was vulnerable to the pathogen Phytophthora infestans. Because Ireland was so dependent on the potato, one in eight Irish people died of starvation in three years during the Irish potato famine of the 1840s.

The lessons from nature are dire. In the 1920s, the Gros Michel banana was almost wiped out by a fungus known as Fusarium cubense, and banana shortages became a growing problem. The widespread planting of a single corn variety contributed to the loss of over a billion dollars worth of corn in 1970, when a fungus hit the US crop. In the 1980s, dependence upon a single type of grapevine root forced California grape growers to replant approximately two million acres of vines when the pest phylloxera attacked.

Today, China is manufacturing’s monoculture.

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Against this dangerous backdrop of volatility and uncertainty, the coronavirus will now achieve the impossible. For the past few years, two ideas have floated around on the political fringes of the Left, but they have been dead on arrival. No one has seriously thought they might become government policy. Today, the Left and Right in the United States and Europe are embracing them.

Andrew Yang, a former tech executive from New York, ran a quixotic, obscure presidential campaign in the United States based on the idea that every citizen should receive a Universal Basic Income (UBI). He advocated a “Freedom Dividend”. This would be a form of universal basic income that would provide a monthly stipend of $1,000 for all Americans between the ages of 18 and 64.

Today, Trump, Pelosi, Romney and others are fully backing Yang’s idea. Respected think tanks such Brookings and Chatham House have advocated UBI. But once it is implemented, there will be no going back. Handouts will start small and grow.

The other big idea has come from Stephanie Kelton, who advised Bernie Sanders and advocates for Modern Monetary Theory (MMT). Kelton argues that in any country with its own currency, budget deficits don’t matter unless they cause inflation. The government can pay for what it needs by simply printing more money — no reason to borrow by issuing bonds. Helicopter money.

Further reading

Could free cash fix the economy?

By Peter Franklin

Her ideas were widely criticised across the Left and Right, ranging from Paul Krugman to Warren Buffett to Federal Reserve Chairman Jay Powell.

Yet today, the two ideas have come together. There are no atheists in foxholes. Even libertarians on Twitter are now calling for government intervention. Investors and politicians of all stripes are calling for UBI financed by MMT money issuing.

This is an epochal turning point, a great reset. The coronavirus is the grain of sand that will cause the avalanche.

For once the taboo of printing money to pay citizens is broken, we can never go back. Governments will spend money with few constraints, aided by central banks. It’s a strategy that has not worked well in emerging markets, and it did not work well in the 1970s — which has conveniently been forgotten.

Undoubtedly, the government must compensate citizens from mandatory curfews and quarantines. The short-term impacts of the lockdowns must be mitigated, but temporary policies must not become permanent political expedients.

That’s why the danger is not today or even a year from now, it’s five to ten years away, when the crisis has past, along with the reason for UBI and monetary easing. What politician will be disciplined enough to stop spending? What central banker will raise rates when it is unpopular to do so?

Today we are reaping the whirlwind of the last financial crisis. Rather than pursue lower leverage, less debt and more robust institutions and more responsible corporate behaviour, investors and companies instead learned that they would be bailed out in a crisis.

Central banks became enamoured of their own success as fire fighters, and they have busily been trying to put out fires by encouraging reckless behaviour, prizing low volatility above a robust financial system, viewing “risk management” as preferring no financial corrections ever.

They should accept that sometimes putting out every single fire creates greater conflagrations. They should be humbler about the extent and limits of their power.

It looks like they’re about to learn the hard way.

Patents give drug makers a period of time with no competition where they can be rewarded for their innovations, encouraging drug companies to invest in costly research and development that might take years to pay off. The logic behind patents is sound, and drug companies devote billions of dollars to find extraordinary cures that extend our lives.

But intellectual property, once an unremarkable area of law, has exploded since the 1980s. From 1900 to 1982, the number of patents increased by around 138%. After 1982, the number of patents extended increased by an astounding 416% by 2014. Not only did the number of patents explode, the areas they cover has expanded in ways the Founding Fathers never intended.

Over the past few decades, copyright protection has been extended to unpublished works, the requirement to register one’s copyright has been dropped, and copyright terms have grown from 28 years to the life of the author plus 70 years. This is the dark side of patents, when they are often used as a tool to gouge customers. In the case of drug companies, patents allow them to rip off patients. The longer the drug lacks competition, the longer companies can charge extortionate prices.

The cost to society is immense. The United States spends over $3 trillion annually on health care, and 10% is spent on drugs. The average American spends more than $1,000 a year on prescription medications, 40% more than the next highest country, Canada, and double what Germany spends.

Further Reading

Clash of the Titans: Amazon takes on big pharma

By Nigel Cameron

The broadest study done on the reasons for the increase in costs appeared in the Journal of the American Medical Association: “The most important factor that allows manufacturers to set high drug prices is market exclusivity, protected by monopoly rights awarded upon Food and Drug Administration (FDA) approval and by patents.” Generic drugs are the main reason why drug prices have fallen, but access to them is generally delayed by numerous business and legal strategies.

When patents are about to expire, for example, the pharmaceutical industry seeks endless extensions through ‘reformulation’ of their drugs or minor modifications to the methods of delivery. Reformulation involves changing the drug just enough to obtain additional patent protection, while keeping enough characteristics the same, so that previous clinical testing results can be relied on to obtain FDA approval. There is no new innovation, no new discoveries or any greater benefit to patients, yet companies can continue to charge high prices.

For example, the Orphan Drug Act of 1983 regulated the approval of drugs for rare diseases and gave a drug companies even greater exclusivity. In theory, this would encourage drug companies to find cures for diseases that might not have a big market. The problem is that Orphan Drugs are not in fact rare. They make up 20% of all global prescription drug sales. Incredibly, 44% of new drugs approved in 2014 had orphan status, and due to pricing they are almost all the most expensive drugs. Now pharmaceutical companies are taking advantage of these incentives to gouge patients, insurers and the government.

Even once patents expire, regulations and bureaucracy provide another even greater barrier to entry for challengers who might want to bring new medicines to market. All new drugs are approved by the FDA to make sure that they work and are not harmful. This is an essential job. Generic drugs, though, are not new or unknown. They are identical to a brand name drug that is off patent in dosage form, safety, strength, route of administration, quality, performance characteristics and intended use. Yet the current FDA approval process for generics is extremely onerous.

Further Reading

The cosy relationship between big pharma and doctors is killing people

By Charlotte Pickles

Drug makers can charge what the market will bear because the magic of competition is missing. On average, a generic takes between three and four years to be approved. Given how long this process takes, it is no surprise the FDA’s backlog of generic drugs stands at an all-time high. In 2014, nearly 1,600 applications for generic drugs were submitted to the FDA. By the end of the year, not a single drug was approved due to a backlog of over 4,700 generics from previous years. Fast-forward to July of 2016, and 4,036 generic drugs awaited FDA approval, yet very few were even processed.

The bipartisan Creating and Restoring Equal Access to Equivalent Samples Act (CREATES), which has been submitted to Congress, should remove roadblocks to the approval of lower-cost generic drugs. However, lobbying – the industry spends millions of dollars a year – means it has almost no chance of passing and has failed every time it has been introduced.

The ugly truth about regulation is that while big businesses often complain about regulation, they tend to benefit from it. Regulations that are burdensome enough kill small companies but not enough to kill large ones are, in fact, ideal. To big companies, startups are like a horrible cancer attacking them, and they are willing to put up with anything painful that will kill them.

Further Reading

Only lateral thinking can save us from economic stagnation

By Peter Franklin

You can compare its effect with cancer treatment. Chemotherapy has the capacity to kill nearly every cell—tumor or normal. The most common way it does so is to damage DNA, the genetic blueprint of the cell. The damaged cells do not die right away—only when they try to replicate with the damaged DNA do the cells die. Sometimes replicating with damaged DNA triggers cell suicide, called apoptosis.

Normal tissues can repair damage because they have the resources and DNA blueprint to repair damage, even if it means slowing growth. Cancers, on the other hand, grow at the expense of any DNA repair. When they try to grow with damaged DNA, they then undergo cell death, through apoptosis or necrosis. Hence, the basis of selectivity of chemotherapy.

Bigger companies favour regulation because, like the normal tissues, they can divert energy to repair and maintenance (lawyers, compliance officers, lobbyists, etc). Big companies are not in the exponential phases of growth like many startups are. (Interestingly, most toxicity in normal tissues come from tissues that grow rapidly: intestines, skin, hair, bone marrow.) These smaller companies need to grow and do not have the budgets to hire an army of lawyers and compliance officers. These fixed costs are a bigger drag on the profitability of small firms than large firms. Hence excessive regulation selectively kills off the small startups attacking big corporations. It is a formidable barrier to entry for any industry.

Today, small businesses are feeling the scorching heat from the chemotherapy of regulation. US companies in 2016 were subject to 104.6 million words of regulation. (The King James Bible comes in around 783,137 words.)

Further Reading

'Government Sachs' keeps adopting policies that favour Wall Street

By Reihan Salam

Researchers have found that a 10% increase in the regulatory restrictions on a particular industry is associated with a decrease of about 0.5 % of the total number of small firms within that industry, with large firms mostly unaffected. The correlation between regulation and higher profits holds across countries. The economist Fabio Schiantarelli looked at OECD countries, and found that high barriers to entry contributed to higher markups. It also explains the loss of dynamism in the economy with fewer startups.This is exactly what has been happening in the US, as industries have concentrated.

If you doubt that regulations can effectively kill any new entrants, consider what has happened to the banking industry. The extensive new regulations introduced with the Dodd-Frank Act have created a protected class of financial firms, with only seven new banks formed between 2009 and 2013. Jamie Dimon, the CEO of JP Morgan has said that Dodd-Frank creates a “moat” around the big banks, while doing nothing to break up America’s largest banks or end the status of banks that are too big to fail. Instead, it has simply kept lawyers, accountants, and consultants busy while choking off competition.

For big businesses across many industires, it’s exactly as one Goldman Sachs lobbyist told Politico in 2010: “We are not against regulation. We’re for regulation. We partner with regulators.”

This is the third of three extracts from “The Myth of Capitalism: Monopolies and the Death of Competition” a new book co-authored by Jonathan Tepper and Denise Hearn.

Shockley was as close to a rock star as it got in the science world. Having won the Nobel Prize for co-inventing the transistor, many people thought he had gone mad when he moved to Palo Alto to found the Shockley Semi-Conductor Laboratory. But he had his reasons. He had grown up in the area, and he wanted to return home to help his ailing mother.

Shockley hired an all-star cast to join him – experts in physics, metallurgy and mathematics, they abandoned the East Coast to work on the commercialisation of the transistor. Robert Noyce, one of the hires, said getting the call from Shockley was like picking up the phone and talking to God.

Read the series

When competition ends in conspiracy

By Jonathan Tepper

Shortly after arriving, however, they discovered he was an erratic and difficult boss. He was a genius, but a jerk, and not just your ordinary, run-of-the-mill jerk. He was an epic egomaniac – and had tried to claim sole credit for the invention of the transistor. Later in life, he spent his time espousing a racist eugenics agenda, promoting a high-IQ sperm bank, and losing all contact with his children. He was, by most accounts, a horrible boss.

Within a year of joining Shockley, the new hires decided to leave and found a new company – Fairchild Semiconductor. Later dubbed the ‘Traitorous Eight’, they signed one-dollar bills in place of formal contracts – a symbol of nonconformity.

Many consider this act of employee treachery as the definitive moment of Silicon Valley’s creation. It set a precedent of ‘can-do’ entrepreneurialism and loyalty to lofty ideas, rather than individual firms and egos.

Noyce, only 29 at the time, was the ringleader and the group’s transistors expert. Eventually, Noyce and his colleague Gordon E. Moore outgrew Fairchild, and again poached employees to start Intel. In 1971, only three years after founding Intel, Noyce made history yet again with the invention of the Intel 4004, the world’s first microprocessor. He had invented the beating heart of the modern computer.

Suggested reading

Time to topple the technopoly

By Charlotte Pickles

Silicon Valley owes its success to many things – access to capital, proximity to Stanford (one of the best universities in the world), and access to a vibrant Pacific hub in San Francisco. But what helped make it the innovation capital of the world is rarely discussed: California is one of the few states where non-compete clauses in work contracts are completely non-enforceable. In other words, employees have full rights to leave and work for a competitor.

In many other states, employees may be asked to sign a non-compete agreement as a condition of their employment. The terms vary considerably, but the basic idea is that if you are fired or quit your job, you cannot work for a competitor within the same industry for a certain period of time. These clauses make it difficult for workers to leave jobs and bargain for higher wages elsewhere.

Back in 1872, California made it illegal for employees to be bound to a specific employer. This state law is still in effect nearly 150 years later, and the lack of non-competes has proven a powerful factor in the Valley’s success. To this day, Boston lags Silicon Valley in the commercialisation of new technologies.

Imagine where the Valley would be today if Noyce had been prevented from defecting? What if Wozniak had never left Hewlett Packard to join Steve Jobs? Where we would be if Nikola Tesla were prevented from leaving Thomas Edison?

Suggested reading

Google, Amazon, Facebook: It's time to smash Silicon Valley monopolies

By Nigel Cameron

Silicon Valley’s history demonstrates that respect for worker talent was prized above strict company loyalty. This led to a malleable ecosystem, where good ideas spread quickly from company to company and innovators were free to choose their own fates. Professor AnnaLee Saxenian, author of many books on the tech industry, points out that, “In the early days engineers would say, ‘I work for Silicon Valley.’ And the idea was that they were advancing technology for a region, not any single company’s technology.”

If Noyce thought Shockley was God in the early 1950s, Steve Jobs idolised Noyce in the 1970s. When Apple was starting, Noyce was already a legend with Intel. “Bob Noyce took me under his wing,” Jobs said. “He tried to give me the lay of the land, give me a perspective that I could only partially understand.” Jobs continued, “You can’t really understand what is going on now unless you understand what came before.”

Although Jobs worshipped Noyce, he failed to give his own Apple employees the same freedoms that allowed Noyce’s best innovations to flourish. In 2014, it came to light that Jobs had been preventing employees from moving to other companies. Silicon Valley was founded on freedom of mobility for workers, but the tech giants – Apple, Facebook, Google, Adobe and many others – were caught in “gentlemen’s agreements” to not poach each other’s employees. Staff brought the case forward claiming that these pacts made it difficult to market their skills and that they also suppressed their salaries.

Suggested reading

What government can do about the winner-takes-all economy

By Peter Franklin

As part of the lawsuit, emails came out in court between Steve Jobs and Eric Schmidt, the CEO of Google, “I am told that Google’s new cell phone software group is relentlessly recruiting in our iPod group. If this is indeed true, can you put a stop to it? Thanks, Steve.” In another email, Larry Page from Google sent a distressed message saying Steve Jobs had threatened war if a single one of his staff were hired.

In the end, the agreement not to poach went out across Silicon Valley. Google, Adobe and others developed Do Not Hire lists. This was clear collusion, and the tech firms were forced to pay a $324.5 million fine for their illegal non- compete pact.

Further Reading

Marxist McDonnell has a plan to save capitalism

By Daniel Haynes

The non-compete problem did not end there. These contractual arrangements are now spreading like an epidemic across the entire economy and hurting the poorest the most. Today non-competes cover almost 18% of the entire American workforce and nearly 40% have signed one in previous jobs. Only California and three other states (Montana, North Dakota and Oklahoma) ban non-compete agreements in the US.

Lawyers sometimes argue that these clauses help protect trade secrets, but is there any good reason to ask camp counselors, janitors, and personal care workers to sign them? There are already federal laws dedicated to protecting Intellectual Property and today even those who clearly do not possess trade secrets are made to sign them, including 15% of workers without a four-year college degree and 14% of people earning less than $40,000.

These employment clauses are found in a staggering percentage of America’s largest fast-food chains with minimum wage employees. Chains like Burger King, Carl’s Jr., Pizza Hut and, until recently pressured in 2017 to drop them – McDonald’s. These no-hire rules affect more than 70,000 restaurants – more than a quarter of the fast-food outlets in the US – according to Alan B. Krueger, who is an economist at Princeton University.

Suggested reading

The collapse of unions is corrupting capitalism

By Denise Hearn

If you’re wondering what Pizza Hut has to lose if one of their store workers decides to work for another Pizza Hut across town, the answer is simple: the fewer options workers have, the less freedom they have to find a company that might pay a higher wage. The only function of these rules is to limit worker mobility and diminish their ability to bargain for wage increases. This is modern day feudalism, and workers have become vassals to corporate lords.

The truth is that non-competes only help firms that want tight control over employees. They do little for a given industry at large or for the economy. They harm workers and are disastrous for workers’ wages.

Often employees do not realise they are signing away their right to work somewhere else, as firms are not legally obligated to disclose non-compete clauses in almost all states. According to a study by economists Matt Marx at MIT and Lee Fleming at Harvard University, barely 3 in 10 workers were told about them in their job offer, and in 70% of cases, they were asked to sign them after they had already accepted the offer and turned down any alternatives. Half of the time, non-compete agreements were presented to employees on or after their first day of work.

Further Reading

Could Mill's model mend capitalism?

By Victoria Bateman

Barring workers from moving in search of better opportunities only works in an environment where firms have all the power. Because of industrial concentration, a number of firms now have monopsony power – that is, they are the only buyers of labour. A monopoly means there is one seller, and a monopsony means there is only one buyer.

In a monopsony, workers have little choice in where they work and have little negotiating power for wages with employers. In a healthy economy, many firms would be competing equally for workers and would be incentivized to entice new hires with higher wages, better benefit packages, and few restrictions on their next career moves. But monopsonies make it easier for firms to depress worker wages. The classic example of this is a coal-mining town, where the coal plant is the only employer and only purchaser of labour. Today, in many smaller towns, Walmart is the new coal plant – and is the only retail company hiring.

With burdensome occupational licensing, forced arbitration, and increased industrial concentration thrown into the mix, American workers are now faced with pressure on all sides. Without a strong union movement to provide a countervailing power, American workers are left to fight alone.

This is a toxic cocktail. The hangover from increased corporate power is real, with many struggling to meet basic needs. This is not the free capitalism we need or the hope that drove the ‘traitorous eight’ in Silicon Valley decades ago. Workers deserve better.

This is the second of three extracts from “The Myth of Capitalism: Monopolies and the Death of Competition” a new book co-authored by Jonathan Tepper and Denise Hearn.

When Americans think of businessmen getting together to fix prices, they generally think of Matt Damon in The Informant. The movie tells the story of Mark Whiteacre, the highest-level corporate mole in FBI history, who helped break the Archer Daniel Midland (ADM) lysine price fixing scandal. ADM never met a price it didn’t want to fix. Like a Mob family, they met with competitors to restrict Lysine, an essential amino acid, as well as citric acid and high fructose corn syrup. In a document that came to light in court, an ADM executive wrote, “Our competitors are our friends. Our customers are the enemy.”

ADM were no outliers, either – the estimated annual cost of price fixing by cartels is up to $600 billion worldwide. And collusion doesn’t even need to be so explicit. In fact, you don’t need for players to talk to each other at all to get collusion. Many firms that have been caught continue to collude even after they no longer speak to each other. Tacit collusion can lead oligopolistic firms to achieve monopolistic outcomes, leading to reduced output, higher prices, and lower consumer welfare. This is known as the ‘oligopoly problem’. By allowing extreme industry concentration, the government has essentially guaranteed oligopolies can act like monopolies and encouraged outright and tacit collusion.

Suggested reading

Is capitalism immoral?

By Victoria Bateman

This unusual phenomenon can be explained by an idea known as game theory, which can be applied to almost any interaction. Everyone has seen A Beautiful Mind, in which John Nash, played by Russell Crowe, has an epiphany at a bar with his friends as they are trying to pick up women.

There is a group of women: one blonde and a few brunettes. All the men want the blonde woman, and one of Nash’s friends remarked that Adam Smith would have encouraged competition, and the best strategy would be for them to all go and speak to her. But, Nash points out, this would be a really dumb strategy. If they did that, none of them would get the girl. She would feel pressured and then the others would be offended that they were the second choice. The optimal strategy is for the group to cooperate — no one talks to the blonde and instead they all talk to the less attractive friends.

Nash’s key idea was that among different players, they might all choose tacit cooperation rather than face competition. The solution to the problem of competition is called “Nash Equilibrium”.

Nash didn’t create game theory, but he developed it. His idea was a direct descendant of John von Neumann’s Minimax theory. The idea is that players of a game won’t seek to achieve the highest pay-out but will try to minimize their maximum loss. The easiest way to understand this is the example of a parent who allows their two children to divide a cake. The most equal division will happen if one cuts the cake and the other chooses the first piece. Each kid doesn’t seek a theoretical bigger piece – he tries to minimise the chance he ends up with a really small one. Firms will often collude to avoid competition and minimise their maximum loss. That’s what Nash was describing in the film with the blonde.

Suggested reading

Corporate fat cats are abusing their power

By Michael Jacobs

But there is much more to game theory than talking to a blonde or dividing a cake.

The most famous example is The Prisoner’s Dilemma. If two prisoners are caught by the police and interrogated separately, they each have a difficult choice to make: to snitch or not to snitch. If they both stay silent and don’t rat on each other, they will both achieve the optimal outcome. However, if one of them wants to improve his own lot, he might talk to the police and betray his friend. He might walk, and his friend will serve a longer sentence.

There is no right answer to the Prisoner’s Dilemma. If you only play the game once, you are highly motivated to betray your partner. However, completely different solutions begin to emerge if you play the game many times.

In 1984 Robert Axelrod invited mathematicians, economists, and computer scientists to submit strategies for playing Prisoners’ Dilemma. What he found surprised him.

Suggested reading

Capitalists – not socialists – are killing capitalism

By Victoria Bateman

Strategies in the competition could either cooperate with each other or try to punish each other, but rather than play once, they had to play repeatedly until a victor emerged. The computer programs could not speak to each other or know each other’s intentions. All they could do was observe what the other program did in the previous games. Most strategies were sneaky and tried to get away with punishing their partners any chance they got. Other strategies economists submitted were very complicated with all sorts of rules for cheating or cooperating.

It was completely counterintuitive, but none of the complicated strategies won. The simplest, least elaborate strategy emerged victorious; the strategy was Tit for Tat. If the opponent cheated, Tit for Tat cheated. If the opponent cooperated, Tit for Tat cooperated. It was that simple. The program generally elicited cooperation, yet if others cheated, it punished the opponents and didn’t let them take advantage of Tit for Tat’s kindness.

If you only play one game, punishing your partner might make sense. You can get away with it once. But if you’re in a repeated game, things work differently. The dominant strategy of any iterated interaction is Tit for Tat, which leads to cooperation.

The lessons from Tit for Tat for industries is that if you’re in a cozy enough industry with very few players, selling to the same customers day in and day out over many years, the optimal strategy is always to cooperate.

Suggested reading

What government can do about the winner-takes-all economy

By Peter Franklin

Most industries are involved in repeated ‘games’ where they can observe their competitors’ actions, and much like the strategy Tit for Tat they have an incentive to cooperate the greater the number of interactions they have. They know competition can be punished in the future with price wars, and they know that tacit collusion can lead to higher margins.

For decades Anheuser-Busch got its rivals to cooperate by not lowering prices. Generally, everyone else followed, and if they didn’t, Anheuser-Busch played Tit for Tat. They signalled to competitors that if they lowered their prices, they’d start an ugly price war. In 1988 Miller and Coors lowered prices on their main beers. In response Anheuser-Busch slashed prices on their key beers. As August Busch III said, “We don’t want to start a blood bath, but whatever the competition wants to do, we’ll do.” Miller and Coors very quickly dropped their price cuts.

Winning everything through competition sounds great, but it is even better not to lose everything.

Academic research on tacit collusion in oligopolies shows that in highly concentrated markets, firms will often coordinate their behaviour simply by observing and reacting to their competitors’ moves. This often leads parallel price movements, and the results that you would associate with a traditional agreement to set prices, output levels, or other conditions of trade. In the US a wide variety of industries are now oligopolistic, which makes tacit collusion easy.

Suggested reading

The collapse of unions is corrupting capitalism

By Denise Hearn

In the corporate world, this is common knowledge. Hermann Simon is a recognised consultant and has worked for decades with companies on their pricing strategies. He wrote a book titled Confessions of the Pricing Man that explained how firms could increase their pricing and get around antitrust laws and competition policy. Simon recognised the easiest way to fix prices would be to speak to competitors but noted that is illegal. Instead, he suggested following a “price leader” and signalling to the market.

Companies in the US car market practiced exactly such price leadership for decades, with General Motors setting price increases. The largest company in most duopolies and oligopolies functions as the price leader, and other companies tend to follow price increases in lock step. These moves are almost never prosecuted.

Another frequent method that companies use is price signalling where CEOs will indicate to the market their desired price hikes to see what the reaction is from competitors. Before any planned hike, a company sends ‘signals’ to the marketplace. Then the company can listen to whether competitors, investors, or regulators send signals back. Simon helpfully explained that, “Signalling is not illegal per se. As long as companies keep their communication relevant to everyone in the marketplace, including customers and investors, and do not go overboard, they are usually on the safe side.”

Just in case these informal methods of price fixing encountered problems, Simon advised, “Please always discuss any application of these approaches with your legal department or advisors to make sure that your company’s policies comply with the law.”

Despite 15 price increase announcements and numerous supply reductions by paper companies over six and a half years, in August 2017 the courts decided in favour of six containerboard companies: Georgia-Pacific, Westrock, International Paper Company, Temple-Inland Inc, and Weyerhaeuser Company. The court ruled that it was not a violation of antitrust law for a firm to raise its price, hoping its competitors would do the same. The containerboard companies bet on a follow-the-leader strategy and that ‘gamble paid off’.

Proof that in business, tacit collusion is rarely punished.

This is the first of three extracts from “The Myth of Capitalism: Monopolies and the Death of Competiton” a new book co-authored by Jonathan Tepper and Denise Hearn