Breaking the ‘Medici Vicious Circle’ – monopolization trends in advanced economies

Competitive markets form the very foundation on which the edifice of the modern liberal economy rests. The neo-classical proposition, under which competition arbitrages away monopolistic advantages and costs, ensures in theory that (1) consumers receive improved value-added offers priced at zero economic profit; (2) entrepreneurs can avail themselves of feasible options to enter the markets with better offers; (3) resources used in production are priced to reflect their true value-added, and consistently with their efficient use; and (4) no firm can have a market power to engage in rent-seeking vis-à-vis the state in the long run.

Street sign with 'Perfect Competition' pointing left and 'Monopoly' pointing up.As such, this proposition provides for productivity-linked wages, and sustains the perpetuation of the long-cherished American Dream of social mobility based on merit, as opposed to an unfair advantage derived from proximity to and abuses of state power.

Put simply, the existence of competitive markets is one of the core checks and balances on both corporate and government-instigated abuses of power, and a corner stone of the liberal democracy, underpinning the basic doctrine of the post-World War II liberal order.

Alas, Theodon, the Greek god of reality, is a very distant relation to Metis, the Titaness of thought. While competitive in theory, our modern economy is becoming increasingly monopolistic and monopsonistic, with significant implications for the sustainability of our democracies. In this process, the U.S. is a proverbial canary in the mine, heralding the trend for other advanced economies.

Rent-seeking in the government ‘swamp’

A recent paper by Luigi Zingales of the University of Chicago deals with the growing evidence that the U.S. companies are engaging in aggressive and persistent rent-seeking behavior in an attempt to influence political processes to their advantage. As Zinglaes notes, neoclassical theory in economics assumes that firms have no power beyond the ordinary market contracting, and, thus, cannot “influence the rules of the game.” In reality, however, firms exert real power to define and shape policies that benefit their bottom line. In a way, companies not only ‘fish’ in the proverbial political swamp but cultivate it. “The more firms have market power, the more they have both the ability and the need to gain political power.” Accordingly, Zingales warns that market concentration can easily lead to a ‘Medici Vicious Circle’ where “money is used to get political power and political power is used to make money.”

A report by Global Justice Now from 2016 shows that 69 of the world’s largest 100 economic entities were corporations, not sovereign states. Ten companies appear in the ranks of the largest 30 entities in the world, all with annual revenues higher than the governments of Switzerland, Norway, and Russia. In many cases, these large corporations have private security forces that rival governments’ secret services, vast legal support that make the U.S. Justice Department jealous, and, as Zinglaes notes, “enough money to capture (through donations, lobbying, and even explicit bribes) a majority of the elected representatives.” The only powers these corporations lack are the power to wage legal wars, the power of judiciary and the power of taxation. However, in many cases, the aforementioned large corporations have recourse to state resources by proxy, as exemplified by the U.S. government’s active lobbying on behalf of larger American corporations, as well as by the Russian and Chinese corporates direct access to the security apparatus of their home states.

Product markets concentration

The trend over the last few decades clearly points to the rising power of the larger corporations across a wide range of metrics.

One example is the dramatic increase in the stock markets concentration in the U.S. over time. Since 1926, only 4 percent (or 1 in 25) of all publicly traded stocks accounted for all of the net wealth earned by investors, according to the research by Hendrik Bessembinder of the Arizona State University.

Four stylized facts well-established empirically describe today’s markets:

  1.  An increase in Tobin’s Q ratio to a level permanently above 1, so that the stock market value of the firm exceeds the productive value of the firm. Monopolistic powers and/or rent-seeking accounts for this disconnect between financial and economic valuations;
  2.  A relatively constant average rate of return on capital, even as the real rate of interest falls, suggesting that larger companies earn abnormal returns on investment;
  3.  An increase in the pure profit share, with a decrease in the capital and labor share, implying that firms transfer value added from technology, capital and labor to shareholders – a classical sign of monopoly power-linked profits; and
  4.  A decrease in investment-to-output ratio, even given historically low borrowing costs, which means that physical/technological investment and innovation are running low, even as the capital costs fall.

In simple terms, all four facts support the hypotheses that the U.S. economy is witnessing increased monopolization, and that this trend toward rising power is generating abnormally high returns consistent with rent-seeking.

On the product markets side, since 1997, more than 75 percent of the U.S. sectors experienced an increase in concentration levels as measured by the Herfindahl-Hirschman Index rising more than 50 percent on average across the U.S. economy. In line with the stock markets concentration evidence mentioned earlier, the size of the average publicly listed company in the U.S. as measured by market capitalization, went from $1.2 billion to $3.7 billion in constant dollars.

Three factors drive the above figures.

One: Entrepreneurship is on a decline. The rate of new company formations has fallen from 15 percent in 1975 to 14 percent in the 1980s, to 11 percent in 1995. In 2015, the rate was just above 8 percent. The quality of the new company formations, as measured by life expectancy of the firms and tangible returns on investment, have also deteriorated.

Two: Firms are getting larger not through organic growth in revenues, but through M&As. Over 1997-2017, average annual volumes of global M&A activities amounted to roughly one half of the entire nominal global GDP growth. At the end of May, global M&A deal flow was running double on the same period of 2017 to reach a total of $1.5 trillion of announced deals. U.S.-only deals account for about 37 percent of the global total in M&A transactions – a share that is more than 2.5 times greater than the relative share of the U.S. economy in global GDP on PPP-adjusted terms.

Three: The demise of the medium-sized firms. In the 1980s, only 20 percent of mid-cap companies had negative earnings per share. By 2015, that number stood at 50 percent.

As Zingales notes, “by separating the return to capital and profits, we can appreciate when profits come from non-replicable barriers to entry and competition, not from capital accumulation.”

A February 2018 study by Gauti Eggertsson, Jacob A. Robbins, Ella Getz Wold traced out the emergence of a non-zero-rent economy (or put differently, the monopolization of the supply side), along with persistent long-term decline in real interest rates. The study is flawed in some of its conclusions , but the empirical results on rising concentration of market power in the U.S. economy are indisputable.

In his interview with Pro-Market, Angus Deaton decries the rise of monopolization of the U.S. as being responsible for simultaneously diminished entrepreneurship, weakened innovation, dramatically lower labor force participation and structurally lower productivity growth. These are the same arguments that inform the twin secular stagnations hypothesis, the proposition that advanced economies are suffering from structural or permanent growth slowdown on both the supply and demand sides of the economy. A February 2018 note from the Federal Reserve Bank of San Francisco confirms this hypothesis for the U.S.

Monopsonies in the labor markets

As Deaton notes, “Both monopoly and monopsony contribute to lower real wages (including higher prices, fewer jobs, and slower productivity growth)… But there are things like contracting out, which are making it much harder at the bottom, or local licensing requirements—mechanisms for making rich people richer at the expense of stopping poor people starting businesses and stifling entrepreneurship. There are also more traditional mechanisms other than rent-seeking, like the tax system.”

Zingales and other researchers confirm this. For example, Simcha Barkai of the London Business School finds that the decrease in labor share of value added is not due to an increase in the capital share, but due to an increase in the profits, which jumped from 2 percent of GDP in 1984 to 16 percent in 2014. If company mark-ups (the difference between the cost of a good and its selling price) are fixed, as would be the case in a competitive environment, any change in relative prices or in technology that causes a decline in labor share of profits must cause an equal increase in the capital share.

This is not happening. Goldman Sachs’ Wage Tracker shows that the U.S. wages growth has been declining since the start of the Millennium, just as the capital share of profits has also shrunk. Consider some simple arithmetic: Prior to 2000-2001, longer-term wages growth was averaging above 3 percent per annum. Since then, excluding the depths of the Great Recession, we have an average of around 2.2 percent. Even assuming wages growth rises to 2.4 percent over the longer term implies that the life cycle earnings for workers who have entered the workforce post-2002 will be lower, cumulatively, by 6.4 percent, compared to the preceding generations.

Of course, if both labor and capital shares dropped, there must be a change in mark-ups – that is, the pricing power of the firms must have risen. As the U.S. economy becomes more monopolistic, the corporate engines of technological innovation switch to differentiation through less fundamental, and more incremental R&D. This means that new technology is enabling new investment in capital and skills at a slower rate, reducing the forces of creative destruction and lowering entrepreneurship and labor productivity growth.

Some of these trends relate to another aspect of the rising market power of the firms: monopsony in the labor markets, or the market power of the employer over the employees.

An NBER paper from December 2017, written by José Azar, Ioana Marinescu and Marshall I. Steinbaum, shows that labor market concentration in the average market is high, and is associated with significantly lower posted wages. These findings link up, among other things, to the aforementioned trends in M&As. Specifically, the authors argue that, “given high concentration, mergers have the potential to significantly increase labor market power … and can create anti-competitive effects in labor markets.”

Since the start of the age of computerization, we were taught to believe that technological innovation should be empowering workers to achieve greater competitiveness, and social, professional and personal mobility. In fact, when it comes to the promise of technologically-enabled workforce, competition, productivity and merit-based pay are the stuff of mythology.

Two recent NBER papers provide empirical evidence to support the thesis that monopsony powers are actually increasing thanks to the technologically enabled contingent employment platforms. In one of these studies, the authors find that in online workplaces employers are paying workers less than 20 percent of the value-added. This reflects a surprisingly high degree of market power even in large and diverse on-line spot labor markets. The other study shows that on average, U.S. labor markets are highly concentrated with Herfindahl-Hirschman Index at 3,157, which is above the 2,500 threshold for high concentration according to the Department of Justice/Federal Trade Commission horizontal merger guidelines.

In simple terms, the evidence on monopsony power in web-based contingent workforce platforms dovetails naturally into the evidence of monopolization of modern economies. Technological progress, that held the promise of freeing human capital from strict limits on its returns, while delivering greater scope for technology-aided entrepreneurship and innovation, is proving to be delivering the exact opposite.

Breaking the ‘Medici Vicious Circle’

Zinglaes offers a somber assessment as to what, historically, follows a systemic rise in the markets concentration by drawing an analogy to the “Medici Vicious Circle,” or the risk of corporate dominance over democratic institutions. In a recent study, myself and a co-author provide evidence to show that concentration of corporate power in the economy accounts, in part, for the structural decline in younger voters’ preferences for liberal democratic values.
Reducing the adverse effects of these activities, while sustaining a resilient, competition-based market economy requires a complex balancing act. Contrary to the knee-jerk reaction of the traditional state-centric view, promoting the power of the state over and above the private sector rights is not a panacea to restoring a more functional balance between the markets and the policymakers. Neither is higher taxation. Expanded state powers simply increase incentives toward more political rent-seeking by the monopolistic competitors.

Instead, the focus in regulation and policy reforms should shift toward improvements in corporate democracy, increased transparency in political and corporate activities, reducing the risk of capture of the media, and economic and policy analysts and academia by both the state and the corporate sector. The state institutions should be focused on creating a simpler, more transparent tax and regulatory systems, backed with robust enforcement, that are free from select exemptions. The U.S. and Europe must move away from providing direct subsidies to specific sectors and players – subsidies that can be gamed by the powerful corporates. The system of bankruptcy and insolvency at the corporate level must apply to all firms, irrespective of their size and systemic significance – the automakers, heavily connected to the traditional Democratic Party, the military-industrial complex, strongly linked to the Republican Party, and the banks, who have been able to capture both sides of the political spectrum.

Free markets, good regulation and efficient enforcement sustain our liberal democracies. Monopolistic and monopsonistic powers corrupt the very fabric of our society and render markets ineffective at rewarding the most efficient use of all scarce resources. We need to rebalance the power of the State and the powers of the larger corporations to free our entrepreneurs, smaller enterprises, and human capital to challenge the monopolization trends in advanced economies.

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