Immediate problems for consumers

The root problem is the denial of consumer choice. I am writing on a laptop, which, being PC hardware, is extremely flexible. On it, I can install any version of Microsoft Windows I have install media for, any one of a number of Linux distributions (from fully fledged ones like Ubuntu, to Google’s cut-down Chromium/Chrome OS), Android, FreeBSD and its relatives, and a number of lesser known operating systems. I can also do the same with an Apple Mac (Macs are just PCs made by Apple). I cannot do this with tablets and smart phones.

The most immediate problem is the security problems this causes. Many Android devices cannot be upgraded, because users are dependent on the device vendor for updates, so security issues are not fixed. Any Android device quickly becomes highly vulnerable to viruses and hackers.

Apple is much better in this respect, but is deeply anti-consumer in its strategy of customer control and lock-in. Software must be bought through Apple’s App Store, and software that competes with Apple is banned. Apple takes a large  cut on the price books music and films bough through any app (or the app is banned). hardware works only with Apple devices (Android devices often work with PC hardware, from mice to mobile wireless dongles) to raise the price of switching to a competitor, media bought from Apple will only run on Apple devices (or, currently, on PCs with Apple software).

The long term threat to innovation

The leading tablet and phones operating systems are Android and Apple’s mobile version of MacOS. Android is based on Linux, and MacOS on a combination of FreeBSD and Mach. Linux, FreeBSD and Mach are open source operating systems that exist because PCs provided a cheap hardware platform that they could run on, giving them a much larger users base than would have been possible on specialist hardware and greatly bringing down the cost of development.

There also have been, and are, many experimental, research, and early stage operating systems that benefit from running on cheap hardware. These may come to obvious prominence by becoming widely adopted, or they may provide a a base to develop variants, or they may just pioneer ideas that later become more widely adopted.

Tablets could have made a great, cheap research platform. They could have provided scope for children to experiment with cheap devices and become the next generation of innovative software developers — as the Raspberry Pi allows but with a far more widely available mobile platform. Start-up companies could have modified and reprogrammed tablets to create completely new devices without needing the huge amounts of capital to create a custom device from scratch.  Learning, experimentation, and innovation are being pushed onto specialist hardware, and will therefore become less affordable.

The greatest danger is that PCs will become more like tablets. Microsoft has taken the first step towards this be requiring that all PCs that can run Window 8 supprt “secure boot” — i.e. they will only run operating systems that the manufacturer permits. At the moment, secure boot can be turned off — but for how long? If PCs become as closed as tablets, then what cheap platform will innovators have to work on? What platform will consumers have that disruptive innovation can run on?

The two key points are these:

1. Business friendly is not the same as market-friendly: in fact they are usually opposites. Given that Adam Smith pointed this out a long time ago, one would have thoughts governments might have noticed by now…
2. Rent seeking though lobbying, and the “business friendly” policy of governments around the world, has seriously undermined free markets.

Producers are intrinsically anti-market: or rather, everyone wants a free market, but not in their own industry (and people are endlessly ingenious in coming up with reasons why their own industry should be an exception).

Big businesses have the clout to influence regulators to do things their way. They are not unique in this respect: consider the EU region of origin rules which are designed to make it harder to compete with wine makers and farmers. However, it is the influence of big business that is most damaging and dangerous, because it reaches all parts of the economy.

I did rather wonder if I was being stupid, and missing something that all these journalists, and a scattering of academics out to get efficient markets, all knew. I was. I did not realise how stupid regulators were. It is less surprising that journalists have been conflating a number of related concepts: the efficient markets hypothesis, rationality, related bits of financial theory, and, most of all, market efficiency in the micro-economic sense (economic efficiency)

The main problem has been with the last of these: it is the justification for laissez-faire neo-liberal politics, which has become dominant. It is the basis on which

A related problem is that both the EHM and economic efficiency have been treated as absolutely true, not normative. They are a normal state of affairs to which correctly functioning markets tend, but the deviations from the normal state are what regulators and market participants should be focused on.

What the efficient markets hypothesis says is that securities prices reflect all available information. This also implies that you cannot predict futures movements in prices from past movements (i.e. technical analysis does not work). This is entirely different from economic efficiency that is the state in which markets in products and services function optimally.

Markets may function optimally without external intervention (as is the case for a market in perfect competition, with all consumers having full information and if no externalities or public goods (side effects on people other than a buyer and a seller) ) — then they do not need intervention. How well this reflects the market in financial services, especially given the existence of government guarantees against bank failure, you can decide for yourself.

The assumption that regulator made was the lassez-faire one, that the market in financial services (not the market in securities) would function correctly without much regulatory intervention. One reason this failed is that banks have both explicit and implicit state guarantees (they are “too big to fail” because of systemic risk)

The biggest single mistake made was to allow banks to use their own risk models for capital adequacy purposes. This was particularly stupid given that one reason for the reforms was that banks had been manipulating the previous system. Imagine you are running a bank and you are making a choice of different risk models. One says that you need to raise a lot more capital, and shut down some of your most profitable businesses (because they need so much capital raised that it would be uneconomic to do so). Another model says everything is fine. Which to you choose? If each model was devised by a different quant, who do you give a big bonus to?

Obviously, that is a gross oversimplification of how banks choose risk models: the process would involve many people, and there would be a lot of scrutiny: but everyone doing the scrutiny would have the same sort of bias.

This has absolutely nothing to do with the EMH. The only assumptions the risk models took from the EMH was that securities prices are unpredictable, and that is right. The financial theory, and the data, to do better risk models existed: fat tails, in particular, had been discussed extensively for decades before the financial crisis ()they were certainly a mainstream part of the syllabus when I did my MSc a decade ago).

Where regulators may have actually relied on EMH is in assuming that asset prices were always correct, so no unexpected nasty surprises would emerge. Even here they were really relying on rationality, not efficient markets: during a bubble prices reflect all available information, but the assessment of the information is systematically incorrect. Of course it means that the regulators did not believe bubbles happen: how did they come to that conclusion.

Now we have dealt with the stupidity of regulators, now back to the journalists. To be fair, the mis-reporting is not entirely their fault. A number of academics and other critics of the EMH have taken the chance of blame the EMH for everything that went wrong, and journalists have swallowed a line fed to them by experts.

Another reason for blaming the EMH, is to avoid admitting that the way markets have been allowed to function does not lead to economically efficient outcomes. It is a bizarre mixture of tight regulation and light touch, that largely favours big business. The problem here, is that this does not only apply to financial markets, but the whole economy, and there is little appetite among politicians, or journalists, or businesses, or anyone else that matters, for so fundamental a challenge.

Fruit juice is better for you. It is tastier unless you have developed a sweet tooth by getting used to heavily sweetened soda with a few favourings thrown in, but it is quite hard to get people to drink it instead.

The difference is that if a product is strongly branded, the owner of that brand had a strong incentive to push that brand. So Coca-cola spends a fortune on marketing their cola, Pepsi does the same with theirs, and so does everyone else in the game with their own.

The end result is that colas are heavily marketed. No one has the same budget to spend on fruit juice. Yes, there is marketing spend, but not anything close to comparable. The problem is that consumers know that one brand of orange juice is pretty much like another (with some variations in quality). No one owns brand that matters: “orange juice”, so no one pushes it. All the vendors would gain if someone did, but there is no incentive for any one to be the company that picks up the tab — the old problem of paying for a common good.

Windows is Coke, Apple is Pepsi, and Linux, with its multiple suppliers, is like fruit juice. Ironically, the existence of multiple competing suppliers is a key reason it is better for consumers, but there is no budget to tell them that.

Of course this means that the markets for both beverages and operating systems are failing to deliver optimal results. The usual fix for this is government intervention — that why governments build roads. I would suggest spending public money on promoting fruit juice, and ,pre than 100% tax breaks for open source vendors marketing expenditure (similar to those given in Britain for any company’s R & D, for example) would go a long way to fixing both problems.

The finding is that product specifications influence people in the regardless of the real evidence. This applies when the product with the worse specifications is observably better, or even when the specifications are acknowledged as being uninformative.

So much for the rationality of homo economicus.

He asks “if that’s your idea of “tyranny,” what would count as Utopia?”. My answer is simple: having every single piece of music ever recorded available for immediate download. Now that would be optimal. It is technically possible (even easy) and every consumer with internet access would love it. So, why have markets not delivered it?

If waiting 19 years is markets working, what would count as failure?

It appears that subjecting Wall Street investment research to legal pressure to be more independent has made things better. The effect has been that sell side analysts are now reasonably willing to make sell recommendations.

I am not certain that this has been entirely due to the legal pressure. Pressure on analysts have changed with the rise of hedge funds giving them an import group of clients who love sells, providing some balance to the traditional pressure from their own investment banking departments to be relentlessly positive about clients, potential clients (everyone who was not already a client).

However, given when the change occurred, I am pretty convinced that the change can be attributed to agreements forced on the major investment banks by the then New York attorney general Eliot Spitzer.

Economist Kash Mansori blogs that this is a case of market failure in financial markets, the show-piece of free market capitalism.

A less successful piece of legislation has been the US’s Sarbanes-Oxley legislation. No one doubts that it has been a very expensive way of protecting investors and the public from another Enron. It has also become apparent that it has been causing New York to lose business to London.

A recent piece of academic research has provided evidence for the loss of business to London. Even worse it has suggested that it has lead to American companies increasing hoarding of cash (rather then investing it or returning it to investors), and reducing both capex and R & D expenditure.

This is a very damaging set of unintended consequences, even by the standards of panic legislation. Will the next politician who thinks “we must do something”, just stop and think a little before acting? I know the answer, its “no”.

Although Bruce does not take the argument beyond security products, the same problems help explain why people do not buy secure software in general. All computers handling really sensitive information or high value transactions should run something as good as Open BSD. We know from security breaches that many do not.

In the past I have been inclined to blame carelessness (choosing the easy solution rather than the secure one), part is organisational politics (choosing an insecure solution that allow someone else to be blamed for the breach, rather than a secure solution that would leave you with the blame if it does go wrong) for bad choices. Now, it appears to me that the inability evaluate the available choices is also a key factor.

Many of the best examples come from high tech sectors: IT, telecoms, and parts of the media. These important because they are growth industries, developments in them have extensive knock-on effects and as technology advances the methods used in them will become usable elsewhere.

Make your product incompatible with those of competitors

This strategy can be used to both eliminate direct competitors to your product that has a dominant market position, and to eliminate others’ complementary products to extend a monopoly to new markets.

The masters of this tactic are Microsoft. The earliest, and most blatant, incident I know of is deliberately making Windows 3.1 incompatible with DR-DOS. It was recently revealed that Bill Gates tried to make the power management system on PCs compatible only with Windows. The latter would have relied on leaning on PC manufacturers, as it was their product mattered. There are many other examples of this strategy (including variants), encompassing most of the company’s major products over many years.

A closely related issue is Microsoft’s current lobbying aimed at preventing government bodies (in particular) from adopting Open Document, which allows interoperability of software from multiple vendors, and provides a guarantee that software will be available to read archived documents even decades in the future.

Impose costs on someone other than your customer

A simple example of this are the termination charges on mobile phone calls. Mobile phone networks compete on charges for outgoing calls, because that is what their customers pay. Very few people will consider the cost of an incoming call to the person making the call. Therefore the latter cost can be raised without losing business. Regulators have been addressing the issue recently, but it took them long enough.

Another example comes from what is likely to happen if telecoms companies are successful in their attempt to move away from network neutrality. At the moment everyone who connects to the internet net pays their internet service provider, who then pays “upstream” providers. Some people have (usually more expensive) connections that allow them to distribute information (e.g., by running a web server) as well as download it.

What telecoms companies would like to do is to be able to charge who wants to be able to distribute information to their websites a fee, otherwise they would block of slow down access to those sites. They will then be able to sell cheap internet access, and make money on charging operators of web sites.

Block competitors’ access to sales channels

Again, the best examples are the actions of Microsoft. When Be Inc. attempted to promote it’s BeOS operating system by allowing PC manufacturers to install it along side Windows on dual boot PCs, it was blocked by Microsoft’s agreements with manufacturers. Be was doing this to work around Microsoft’s blocks on their access to distribution, described in this article by the CEO of Be.

Microsoft’s is currently using a similar tactic to the latter of the above, by using “co-marketing” funding to discourage PC manufacturers from marketing competitive products – especially Linux.

Bundle, bundle and bundle

This is a key tactic. I touched above on how Microsoft does this with Windows. However the beauty of this tactic is that it does not depend on network effects or technological compatibility issues, so it can be applied to any industry. 3M did it with sticky tape and Post-it notes.

Buy-out or or undermine competitors

Google has agreed to buy Double Click. Ironically, the deal is being opposed, on competition grounds, by Microsoft and AT & T.

Google has also announced that it intends to launch a social network service, similar to that run by Stumbleupon. This comes after Google failed to buy Stumbleupon, being beaten by Ebay. With a deep pocketed parent Stumbleupon has become a potential threat to Google, so Google has acted to reduce the threat.

Vapourware

This is a simple tactic, most popular in software. If a competitor has a product out ahead of yours then announce that your product will be launched soon. Even if it is going to take you years to develop, it will hold back the competitors sales in the meantime. You can also exaggerate its features. You can always drop them from the final product.

Do deals with suppliers of complementary products

The most obvious example is any product or service for media distribution (e.g. a new medium for recorded music, a video download service, etc.). You have to persuade the media to use your product or service. This means that you need to offer the service and features (e.g. DRM) that the media businesses want, not what consumers want.

The use of this tactic in IT markets is obvious from what I wrote above.

Patent everything

Patent everything you can. The more aspects of your operations are patented, the harder it is for a new entrant to work around them. Even better, the more patents, the more chance that a competitor will miss one, and you can then sue them. If you are lucky you may even be able to shut them down for a while, or force them to completely redesign their product or processes.

A larger patent portfolio is also useful for cross-licensing with other incumbents, making life even harder for new entrants.

As far as I can see, his position implies that he prefers private monopolies (which he admits arise) to public monopolies. I fail to see why they are better.

The argument for leaving things to the private sector is that competition forces firms to act in a way that delivers an optimal results. This is not true without competition, so what is so good about unfettered capitalism without competition. At least socialism in a democracy gives us some mechanisms to promote the public interest — and that is not even the best of the alternatives.

So, why leave everything the market?