The rules that bind us

Johan Fourie is associate professor in economics at Stellenbosch University.
Johan Fourie is associate professor in economics at Stellenbosch University.

I spent June in England, giving seminars at several universities (and following the Proteas on their unfortunate campaign at the Cricket World Cup).

One question that kept being asked by peers, was on the state of the South African economy. Why is President Cyril Ramaphosa moving so slowly in tackling the crisis at the heart of the economy: Eskom?

It’s a difficult question with a complicated answer, I would respond. Eskom is in a deep mess, with debt spiralling out of control.

It burns cash. Plans to transform it into three entities is being hampered by trade unions unwilling to see its members lose their jobs.

It requires immensely talented and brave leadership to find a negotiated solution that keeps the lights on.

Restructuring is essential, because the problems are ultimately structural. Eskom is a state-owned electricity monopoly; the Electricity Regulation Act 4 of 2006 makes Eskom the sole purchaser of electricity in SA.

Independent power producers are not allowed to sell to consumers – like municipalities – independent of Eskom. The only way that municipalities or large firms can escape Eskom’s reach is to produce their own electricity.

This arrangement made sense in the era before renewables. Large power plants were needed – because of huge economies of scale – to produce electricity that could then be distributed across the country and region.

But new technology has fundamentally shifted this production system. Production can be much closer to home. Solar panels and battery storage allow me to produce enough electricity to power my own home.

There are many other technologies – hydro, wind, wave – that could be far more efficient and compete effectively with the ‘old’ technologies. The International Energy Agency predicts that by 2023 renewable energies will account for almost a third of total world electricity generation.

It’s not the technology that prevents these new industries from emerging. Large investments in renewables, notably in China, have reduced the costs of solar panels significantly in the last decade.

The problem, instead, is government legislation. Laws like Act 4 prevent upstarts from competing with the incumbent, keeping the incumbent (and unproductive) firm safe.

SA has notoriously concentrated industries, from electricity to banking, construction and telecommunications. While economies of scale may have been the reason that these industries initially were concentrated, new technologies now make such requirements obsolete.

But while the technology may exist to improve efficiency, government legislation, drafted for an earlier era’s needs, is often slow to change with the times.

Incumbent firms benefit from past legislation, but also actively pursue new legislation to protect their privilege. This is not unique to SA.

A new NBER Working Paper by New York University economists Germán Gutiérrez and Thomas Philippon measures the entry and exit of firms across US industries over the past 40 years, showing that the entry of new firms (measured as the elasticity of new firms with respect to Tobin’s Q) has declined significantly around the year 2000.

The date is important, as this decline did not happen in a cyclical downswing. This means that there are other factors beyond the macroeconomy that explains this level decline. The authors posit two reasons.

First, perhaps better technology leads to higher returns to scale, allowing big firms to make bigger profits and preventing smaller firms from entering. Think of firms that rely on large networks, like Google, Apple or Facebook. But the authors, when using firm level data, fail to find any evidence of increases in returns to scale over the last 20 years.

The second possible reason is government regulation. The authors construct three tests to test this hypothesis. First, they compare large versus small firms. Larger firms are more likely to influence lawmakers.

“Consistent with this prediction,” the authors note, “we find that regulations hurt small firms and lead to declines in business dynamism (employment growth, establishment creation, establishment growth) in small relative to large firms.”

Second, they look at changes in the profitability of incumbents when there are large regulatory changes. “Large changes are most likely to motivate lobbying efforts. Until 2000. We find that large regulatory changes were not correlated with changes in incumbents’ profits.

After 2000, however, we find that large regulatory changes are systematically followed by significant increases in incumbents’ profits. Since regulatory complexity and lobbying expenditures increased after 2000, this suggests that large firms may be increasingly able to influence regulation to their benefit.”

The third test measures the impact of lobbying explicitly. “We know that lobbying is overwhelmingly done by large firms. Under the public choice theory, we would expect lobbying to hurt small firms relative to large ones, and indeed, this is what we find.”

Testing the combined effect of regulation and lobbying expenditures, they find that the confluence of lobbying and regulation are particularly harmful to small firms.

SA has high levels of concentration in almost all sectors, but especially those where government is an active participant (think electricity). It’s not a lack of new technological development that is holding back these sectors, but rather the laws and rules, imposed in an earlier era or by lobbyists hoping to protect their privileged position, that prevent new entrants from competing.

Much like the Proteas need to give a new generation of young, exciting cricketers a chance, giving young, dynamic upstarts an opening in these uncompetitive sectors is the first step to building a growing, thriving economy.

This article originally appeared in the 25 July edition of finweekBuy and download the magazine here or subscribe to our newsletter here.
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