RIETI Report April 2009

Competition Policy amid Regulation

Despite the extensive amount of analytical resources RIETI has assigned to the immediate demands for research that have been created by the global economic crisis, RIETI researchers have not lost focus of longer-term issues and the intriguing question of what the global economy will look like post crisis. For one thing, it is a certainty that the post-crisis financial sector will be more regulated than the pre-crisis version, but how much more? Striking the right balance between regulation and competitive freedom is one of the key challenges facing policymakers tasked with fixing the overall financial sector and banking industry in particular.

In his article "Competition Policy in Times of Economic and Financial Crisis," RIETI Senior Fellow Hiroshi Ohashi examines both sides of this issue and makes some interesting observations about the optimal balance between regulation and competitive freedom for long-term, sustainable growth.

This month's featured article

Competition Policy amid Regulation

OHASHI HiroshiFaculty Fellow, RIETI

Competition Policy in Times of Economic and Financial Crisis

Along with the other economies across the world that are plunging into recession, Japan has been unable to find a way out of the ongoing economic crisis. Industrial output figures released on March 30 by the Ministry of Economy, Trade and Industry show that the nation's industrial activity declined in February for the fifth straight month. Combined with an alarming drop in exports, the data indicates that the Japanese economy continues to face a grim and unpredictable future. In the midst of this increasingly uncertain economic environment, high expectations have been placed on the government's intervening policy measures. At the same time, however, many people are questioning the legitimacy of government initiatives with respect to competition policy and regulatory reform. In what follows, I would like to examine competition policy by focusing on its role in times of economic and financial crisis.

Is market competition the culprit of the ongoing economic crisis?

In many countries, the banking sector is subject to the supervision of regulatory authorities, but it often falls outside of the jurisdiction of competition policy. As a matter of economic theory, it is known that certain banking sector functions, for example clearing and settlement services, and the supply of liquidity, may become less efficient if their fate is left to be decided by free market forces. Such peculiarities may have led to excessive protection in the banking sector today. At the same time, however, lack of competition may have permitted the situation where banks were capable of setting unnaturally uniform interest rates at the expense of consumers.

In the 1990s, the banking sector underwent extensive deregulation encompassing all areas with the exception of several that were susceptible to market failure (e.g., clearing and payment services), thus prompting banks to develop a sense of competition. As a result, the quality of financial services began to improve, as exemplified by an increase in the variety of financial products and the enhanced convenience of ATM services made available to consumers. Achieving an appropriate balance between regulation and competition policies enabled the sector to deliver the benefits of competition to consumers.

Improved services are not the only benefits of deregulation. There is a well-known general tendency of interdependence that often develops between regulators and the businesses they regulate. This phenomenon, referred to as "regulatory capture," poses the danger of regulations that should be implemented for the benefit of consumers being used instead as a disguise to protect a specific regulated industry. The introduction of competition as a byproduct of deregulation has prevented, to an extent, regulatory capture from functioning. This result, in itself, has effectively contributed to the increase in consumer benefits.

The ongoing global recession has prompted many in Japan to voice disappointment and regret over capitalism. However, most research findings from overseas point to deficiencies in the risk management regulatory framework as the cause of the U.S. financial crisis, with very few, if any, researchers blaming market competition. Just recently in separate articles contributed to the media, both Harvard University Professor Dani Rodrick (note 1) and former Federal Reserve Board Chairman Alan Greenspan (note 2) cautioned against hasty regulatory tightening, noting that such a move would undermine market competition. In order not to misread the medium- to long-term future of Japan, policymakers must make sober judgments when forming their opinions on what exactly did trigger the financial crisis.

Is competition useless when in need of public support?

Governments across the world, led by the United States and Europe, have been injecting massive amounts of public funds into the financial system with the aim of containing systemic risks. Japan is no exception. The Japanese government has implemented a series of supplementary measures that include providing capital assistance to banks, purchasing commercial paper and corporate bonds from corporate issuers, and expanding the government-backed loan guarantee scheme for small- and medium-sized enterprises (SMEs). Together, these public support measures appear capable of providing a quick cure for the crisis in front of us.

At the same time, however, we must not forget that these measures are not without risks. With one wrong step, these measures could distort otherwise desirable market functions and undermine consumer interests in the medium to long run. For example, the payout of big bonuses to executives of American International Group, Inc. (AIG) was a thought-provoking event that cast new light on the legitimacy of the current public support scheme the U.S. is using to address systemic risks. There is no ruling out the possibility of a relationship of interdependence developing between the regulatory authorities and the companies that are to be bailed out under the scheme.

In order to ensure sound and sustainable economic growth, it is important to maintain faith and utilize the efficient and self-correcting powers of market competition. Public support needs to be assessed and examined on an ex post basis, at minimum, to guarantee that such support will only be temporary so that any distortion to competition will be limited. Otherwise, it will be nearly impossible to realize the full effect of public support, which is absolutely necessary in consideration of its potential benefits to the general public.

Designing desirable post-crisis institutional systems

The economic crisis has revealed various problems in the risk management practices of financial institutions. The appropriate policy response to these problems cannot be achieved by criticizing market competition. We must not forget that much of Japan's postwar development and improvement in living standards was accomplished in an environment of free market competition. In dealing with the ongoing crisis, the market mechanism should be utilized in a supplementary manner to reduce the negative impact that new or enhanced regulations may have on public support. Japan should then move in a direction to enhance the coordination between sector regulators and competition authorities while maintaining a healthy tension between the two.

As the world population continues to grow, global environmental problems are posing a serious threat. Against this backdrop, Japan can contribute to the global cause by continuing to promote innovation through private-sector ingenuity by building social structures that facilitate such innovation. To that end, a rational determination of what exactly caused the ongoing recession, which is similar in many ways to the one of the 1930s, is necessary before we can design future institutional systems that will incorporate the most positive aspects of market competition and capitalism.

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