Guiding Seminar II

Iryna Khomyak

Financial Economics 2018

Bitcoin: Economics, Technology, and Governance
Rainer Böhme, Nicolas Christin, Benjamin Edelman, and Tyler Moore

The paper describes how Bitcoin works and risks connected with using it
Bitcoin
Bitcoin is an online communication protocol that facilitates the use of virtual currency,
including electronic payments
Since its inception in 2009, it has served approximately 62.5 billion transactions between 109
million accounts
§ Total number of bitcoins minted: $14 million vs. $16.8 million (as of February 2018)
§ US dollar equivalent at market price: $3.5 billion vs. $326.5 billion (as of December 2017)
§ Total daily transaction volume: $50 million vs. up to $5 billion (as of December 2017)

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How It Works
Bitcoin is built on a transaction log that is
distributed across a network of participating
computers
“Bitcoin core” software:
§ Creates a “wallet” file for the user to store
bitcoins
§ Creates an individual node in the “peer-to-
peer” Bitcoin network
§ Provides access to the “block chain”
data structure that publically verifies all
past transaction history
You hold bitcoins if you can prove that:
§ You received them in a transaction
§ You didn’t spend them in a transaction

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Technologies
Two fundamental cryptographic technologies:
§ Public-private key: allows to encrypt messages for a specified recipient or
confirm authenticity of a transaction (akin to a signature)
§ Cryptographic validation of transactions (“mining”): a block of transactions is
added to the block chain every 10 minutes by users solving a power-intensive
mathematical “puzzle” based on the pre-existing contents of the block (6
confirmations required); the difficulty of the puzzles is adjusted to keep the 10-
minute interval
Mining costs: $178 million per year only for electricity
Benefit: submitting “fake votes” in favor of a transaction is costly and difficult
Mining incentives: minted bitcoins awarded by the system (25 per puzzle in
2015; after $21 million bitcoins have been minted, it falls to zero and no further
bitcoins will be created) and “transaction fees” offered by users

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Decentralization in the Bitcoin Ecosystem
Significant economic forces push Bitcoin towards de facto centralization and
concentration among a small number of intermediaries at various levels of the
ecosystem
Intermediaries:
§ Currency exchanges: allow users to trade bitcoins for traditional currencies
or other virtual currencies (charge a commission of 0.2-2%)
Requirements: must register with the U.S. FinCEN as money services
businesses (high fees and capital requirements); need online infrastructure
capable of withstanding attacks, such as hacking and denial-of-service
Centralization: in 2012, the Japan-based Mt. Got exchange served over 80%
of all Bitcoin transactions (collapsed); in 2015, largest 7 exchanges served
more than 95% of the trades

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Decentralization in the Bitcoin Ecosystem
§ Digital wallet services: keep Bitcoin accounts, recorded transactions, and private
keys (not all) on a shared center with access via the web or phone-based apps
Software cons: difficult to install (downloading the entire block chain > 30 GB); a
crash or attack on a computer could cause the loss of bitcoins
§ Mixers: let users pool sets of transactions in unpredictable combinations,
preventing tracking across transactions (charge a fee of 1-3%)
Challenges: the finality of payments leaves payers with little recourse if a mixer
absconds with their funds; correlations in timing and amounts might still reveal
transaction counterparts (e.g. little-used mixers)
§ Mining pools: combine resources from numerous miners to solve mathematical
puzzles and verify transactions (bitcoin creation)
Centralization: in 2015, two largest pools account for around 1/3 of Bitcoin
mining activity (underpins trustworthiness)

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Uses and Risks Connected with Bitcoin
§ Early: Silk Road and other illicit activities (anonymity: online sale of narcotics,
gambling websites, international capital outflows in China)
§ Current: Consumer payments and buy-and-hold for appreciation benefits (low-
cost payments compared to credit card charges, but no rebates or bonuses;
currency exchange charges; block chain processing time and storage burdens)
§ Possible and future: General purpose payments, mainstream store of value, and
enabling technology (international remittances, transfers of digital property, and
other services besides payment)
Risks:
§ Market risk: fluctuations in the exchange rate between bitcoin and other currencies
§ The shallow market problem: a person seeking to trade a large amount of
bitcoins typically cannot do so quickly without affecting the market price

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Risks in Bitcoin
§ Counterparty risk: currency exchanges can cease operations (45%) without
reimbursing their customers (46%), while digital wallet services can be target
for cybercriminals
§ Transaction risk:
§ The system offers no built-in mechanism if bitcoins are sent due to error or
fraud (irreversible transactions)
§ Possibility to cancel the payment (miner collusion) or double-spend during
the 10-minute interval of block processing
§ Blacklisting stolen bitcoins transfers losses to those who accepted them
and gives abuse power to list managers
§ Operational risk: operator errors, security flaws, and malware (miner “51
percent attack”, denial-of-service attack - swamping a target firm with
messages and requests so that it becomes unusable or very slow)

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Risks and Issues Connected with Bitcoin
§ Privacy-related risk: transactions could be linked back to the people who made
them (real names are often revealed at currency exchanges or in purchase details)
§ Legal and regulatory risks: a law-abiding user could lose funds in an exchange
frozen or seized due to criminal activity
§ Problems:
§ Fighting crime: Bitcoin-specific crime (attacks on currency and infrastructure),
money laundering (through mixers), and Bitcoin-facilitated crime (payments for
unlawful services – no user or country verification)
§ Consumer protection (counterparty risk, lack of knowledge of customers,
irreversible transactions)
§ Regulatory options (where to impose constraints, since it is unfeasible to regulate
everyone): Silk Road, currency exchanges, tax on appreciation
§ Issue: users can always switch countries or systems to avoid regulation

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Thinking Ahead
§ Bitcoin and research: Bitcoin as a financial asset (diversification and
arbitrage studies), incentive-compatibility in Bitcoin protocols (miner reward
issues), privacy and anonymity, monetary policy design (“k-percent rule” –
fixing the annual growth rate of the money supply)
The future of Bitcoin:
§ Will it replace other forms of payments completely (low cost, privacy,
decentralization)?
§ Numerous competing virtual currencies that are waiting to achieve
confidence in their values and adoption (faster processing time, less
computational burden, concealed identifiers in transaction history, endless
money supply)

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Deciphering the Liquidity and Credit Crunch 2007-2008
Markus K. Brunnermeier

The paper attempts to explain the economic mechanisms that caused losses in the mortgage market to amplify into such large
dislocations and turmoil in the financial markets
General Outlook
The financial market turmoil:
§ Billions of dollars written down in bad debt as a result of the housing
bubble
§ Bank market capitalization declined twice
Key factors leading up to the housing bubble:
§ Low interest rate environment in the U.S.:
§ Large capital inflows from abroad, especially Asia (bought American
securities to both peg the exchange rate and hedge against currency
depreciation)
§ Lax interest rate policy by Federal Reserve (feared a deflationary
period after the internet bubble; “originate and distribute” banking model,
which also facilitated inflows from abroad)
§ Banking industry trends
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Banking Industry Trends
§ Short maturity instrument financing: maturity mismatch between investment
projects and financing (funding liquidity risk: unable to roll short-term debt over)
§ Investment vehicles (“asset backed” by CDOs) with “liquidity backstops” by
the sponsoring bank to keep the obligations off balance sheet
§ “Repos” (repurchase agreements, often overnight) used by IBs: the borrower
sells a collateral asset today with a margin or haircut and promises to
repurchase it later
§ “Originate and distribute” model (CDOs): loans are pooled, tranched (super senior
tranche with AAA rating; equity tranche, or toxic waste usually held by the bank), and
resold as collateralized debt obligations via securitization (off-loading risk allows
to widen the demand, e.g. pension funds, and lower mortgage and loan rates)
§ Credit default swaps (CDS): contracts insuring against the default of a
particular bond or tranche (in 2007, gross notional amount of $45-62 trillion;
indices of CDS)

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Banking Industry Trends (cont’)
§ Regulatory and rankings arbitrage: smaller capital requirements for contractual
and reputational credit lines (Basel I) and loans with higher ratings (Basel II)
§ “Pipeline risk”: risk of holding the loan for several months until the risks were
passed on through CDOs, which led to a decline in credit quality (little incentive
to care about approving and monitoring loans: NINJA loans – “no income, no
job or assets”)
Reasons for optimistic agency forecasts:
§ Models were based on historically low mortgage default and delinquency rates
§ Past downturns in housing prices were primarily regional phenomena
(diversification due to low cross-regional correlation)
§ Rating agencies collected higher fees for structured products
§ “Rating at the edge”: banks made sure that tranches were sliced in such a way that
they just crossed the dividing line to reach AAA
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Event Logbook
§ February 2007: an increase in the subprime mortgage defaults (graph)
§ June – July 2007: rating downgrades by Moody’s, Standard and Poor’s, and
Fitch, Bear Sterns hedge fund injections, house prices and sales drop
§ July 2007: asset-backed commercial paper market begins to dry up, IKB (a
small German bank) is rescued from default, interest rate rises and market
participants are unwilling to lend, continuous downgrades of investment vehicles
§ Summer 2007: the TED spread (LIBOR – risk-free U.S. Treasury bill rate) begins
to widen (crisis: more demand for risk-free, more risk in LIBOR)
§ August 2007: margin calls on hedge funds (required to deposit a minimum
maintenance margin in their account) and fire sales, European Central Bank
and U.S. Federal Reserve inject €95 billion and $24 million respectively into
the overnight interbank market, the Fed lifts borrowing requirements
(decreased discount rate, broadened collateral type, and lengthened lending
horizon)
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Event Logbook (cont’)
§ October 2007: series of write-downs of mortgage-related securities,
international banks have cleaned their books and injections seem to have
worked (silence before the storm)
§ November – December 2007: revision in the estimated mortgage losses, further
write-downs, Fed cuts interest rates and creates the Term Auction Facility (TAF),
through which commercial banks could bid anonymously for 28-day loans
against a broad set of collateral
§ January – February 2008: downgrades of “monoline insurers” insuring bonds
and structured products, which trigger a huge sell-off of previously AAA-rated
assets by money market funds, large drop in the U.S. equity market, first rate
“emergency cut” by the Fed since 1982
§ March 2008: the Federal Reserve announces $200 billion Term Securities
Lending Facility (secretly swapping agency and mortgage-related bonds for
Treasury ones) and the Primary Dealer Credit Facility (discount window to IBs),
investor pressure on Bear Sterns and its buy-out by JPMorgan Chase (too
interconnected to fail)

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Event Logbook (cont’)
§ September 2008: government-sponsored Fannie Mae and Freddie Mac
(“agency bonds” issuers) are put in federal conservatorship, IBs refuse to buy
out Lehman Brothers and the company announces bankruptcy (ripple effect),
Merrill Lynch is acquired by the Bank of America, AIG (a large international
insurance company highly active in CDS) discloses that it’s facing liquidity
shortage and is bailed out by the Fed
§ October 2008: Washington Mutual suffers a “silent” bank run and is sold to
JPMorgan Chase, Wachovia fell into the hands of Wells Fargo, the stock market
has lost $8 trillion in a year affecting the global economy, Citibank needs
additional support
§ December 2008: the Federal Reserve’s balance sheet has roughly doubled over
a year, the target interest rate is set between 0 and 0.25%
§ Economic events and political actions continued to unfold, but how was the
original loss of several hundred billion dollars sufficient to trigger such a series
of worldwide consequences?

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Effect Catalysts
§ Funding liquidity risks: haircut funding risk (margins could change), rollover risk (costly or
impossible to roll over), and redemption risk (depositors withdraw money)
§ Market liquidity forms: the bid-ask spread, market depth (selling without moving the price),
and market resiliency (time it takes for prices to bounce back)
Four mechanisms amplifying the effect:
§ Borrowers’ balance sheet effects (loss and margin spirals – the value of assets erodes
faster than their gross worth because of leverage: asset prices drop eroding capital ->
lending standards and margins tighten (cannot borrow more) -> fire sales -> further pressure
on prices ->…)
§ Reasons for haircuts to increase: more risk, asymmetric information about collateral quality (“lemons”)
§ Lending channel (moral hazard when monitoring and precautionary hoarding due to fear)
§ Runs on financial institutions (those who withdraw money early get their full amount
back –Bear Stearns, AIG, Lehman Brothers, and Washington Mutual)
§ Network effects (counterparty risk: financial institutions are lenders and borrowers at the
same time, gridlock: holding additional funds due to counterparty risk, hedge fund vs.
Goldman vs. Bear example)

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Moore’s Law versus Murphy’s Law: Algorithmic Trading
and Its Discontents
Andrei A. Kirilenko and Andrew W. Lo

The paper reviews the major drivers of AT’s emergency and explores some of the challenges of unintended consequences
associated with it
Algorithmic Trading
§ Moore’s law in semiconductor industry: the number of transistors per square
inch on integrated circuits had doubled every year since their invention
§ Moore’s law in financial markets: from 1929 to 2009 the total market
capitalization of the U.S. stock market has been doubling every decade (better
and cheaper technology, population growth)
§ Murphy’s law: “whatever can go wrong will go wrong” (faster and bigger when
computers are involved)
§ Algorithmic trading (AT) – the use of mathematical models, computers, and
telecommunications networks to automate the buying and selling of financial
securities (benefits: cost savings, operational efficiency, and scalability)
AT facilitators:
§ More and more complex financial system (economic growth and globalization)
§ Breakthroughs in quantitative modeling of financial markets
§ Parallel breakthroughs in computer technology

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Five Developments Fueling Popularity
§ Quantitative models in finance
(portfolio theory, “two-fund separation theorem”, CAPM, Rosenberg’s linear
multifactor risk model, Barra timely estimates of covariance matrices
and portfolio weights, Black-Merton-Sholes formula, dynamic spanning –
frequent trading of a small number of long-lived stocks can create new
investment opportunities otherwise unavailable)
§ Emergence and proliferation of index funds
(“passive” investing: value-weighted portfolio need not be adjusted as it
automatically does so as MCaps change; Samsonite’s pension fund:
rebalancing weights to keep the $1 investment in each stock)
§ Arbitrage trading activities
(“statistical arbitrage”: large arbitrage portfolios are formed to maximize
expected returns while minimizing volatility and provide diversification from
the market)

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Five Developments Fueling Popularity
§ Push for lower costs of intermediation and automated execution
(“execution strategy”: executing a large “parent” order in a single
transaction is typically more costly than breaking it up into a sequence of
smaller “child” orders due to the short-run downward-sloping demand, or
“price-impact function”;
market making: continuously being ready to buy or sell at a quoted price;
“autoquoting”: indicative prices capturing real-time variables from other
systems – increased informativeness of quoted prices)
§ Proliferation of high-frequency trading
(40-60% of all trading activity, but the number of entities is quite low;
large persistent profits with little risk)

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Ghosts in the Machine
August 2007: Quant Meltdown, or Quant Quake:
§ The most successful market-neutral hedge funds suffered severe losses
§ Why? “Unwind hypothesis” – feedback loop: initial loss due to the forced liquidation of one
of the portfolios based on book-to-market anomalies (to raise cash or reduce leverage),
which was commonly used by algorithms, impacted the price and similar portfolios
May 6, 2010: Flash Crash:
§ In the course of 33 minutes, prices of the most actively traded companies crashed and
recovered (Accenture traded at a penny per share, while Apple traded at $100,000 per share)
§ Why? “Hot potato”: rapid automated sale of E-mini S&P 500 futures -> large order
imbalance ->:
§ HFT buying E-mini to gain on arbitrage -> traders reached inventory levels and began
unwinding long inventory (sparse liquidity = more downward pressure)
§ Cross-market arbitrage algorithms propagated E-mini price decline to ETFs,
stocks, and options -> purchased E-mini and sold individual equity index products
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Ghosts in the Machine (cont’)
March and May 2012:
§ Facebook IPO system glitch
Why? “In between the raindrops”: Interest in Facebook shares was to high ->
NASDAQ system was trying to calculate the price while new offers and
cancellations kept coming in -> a 30-minute delay in the Facebook’s IPO ->
errors persisted for hours -> heavy losses ($100 million)
§ The price of BATS plunged from $15.25 to a tenth of a penny
Why? BATS decided to list its IPO on its own stock exchange -> software
bug making symbols of stocks from A to BFZZZ inaccessible -> IPO was
cancelled
August 2012:
§ Knight Capital group sent out erroneous orders into the market because of a
technology issue with newly-installed software -> significant price swings in 150
stocks -> the company had to liquidate positions -> huge loss

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Ghosts in the Machine (cont’)
§ Why? “Internalization”: broker-dealers like Knight were allowed to post
prices dominating the prevailing quotes by increments of a penny (later
buy cheaper from the market and pocket the difference) -> SEC allowed
exchanges to execute retail orders at sub-penny prices (“Retail Liquidity
Program”) -> broker-dealers had to develop software to compete
September 2012:
§ Hold Brothers On-Line Investment Services were involved in manipulative
actions possible due to HFT (839 milliseconds for a manipulation)
§ “Spoofing”: intentionally manipulating prices by placing an order to buy
or sell a security and then cancelling it shortly and starting a trade in
the opposite direction
§ “Layering”: placing a sequence of limit orders at successively
increasing or decreasing prices to artificially increase or decrease the
price (appearance of a change in demand) and cancelling the order
thereafter
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Regulation Proposals
Proposals (complexity and human behavior, costs vs. benefits):
§ Do nothing: will result in cost reductions for intermediaries, but will not address the
issue of fair and orderly markets
§ Ban algorithmic trading: will yield a more “fair” and orderly market, but also reduce
liquidity, efficiency, and capital formation
§ Change the definition and requirements of market makers to include HFT: will lead
to a more fair and orderly market, but will also increase the costs for intermediaries
(capital requirements, legal costs, etc.)
§ Fix time intervals between trades (market continuity): need more analysis to evaluate
the effects connected with demand for immediacy
§ Introduce a “Tobin tax” on transactions: will reduce trading activity, liquidity and
hedging activity (dynamic replication of options) and remove HFT
The regulatory framework that is supposed to oversee such innovation has become
antiquated and obsolete (slow amendments to outdated principles, lobbying)
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Financial Regulation 2.0
(a systemwide redesign and ongoing supervision and regulation)

§ Systems-engineered: should approach automated markets as complex

systems composed of multiple software applications, hardware devices and
human personnel
§ Safeguards-heavy: should have effective risk safeguards consistent with the
machine-readable communication protocol and human oversight
§ Transparency-rich: should aim to make the design of financial products
more transparent and accessible to regular automated audits
§ Platform-neutral: should be designed to encourage innovation in
technology and finance and should be neutral with respect to the specifics
of how core computing technologies work

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The Economic Consequences of Legal Origins
Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer

The paper discusses the findings of LLSV regarding legal origins and addresses the criticism received
Legal Origins
LLSV (La Porta, Lopez-de-Silanes, Shleifer, and Vishny):
§ Legal rules vary systematically among legal traditions and origins (common law,
originating in English law, vs. civil law, originating in Roman law)
§ Legal protection of outside investors limits the extent of expropriation of such investors by
corporate insiders and, thereby, promotes financial development
§ The influence of legal origins is not restricted to finance
§ IV regression: legal origins -> national commercial law -> financial development (cross-
country studies)
Background on legal origins (LO):
§ Legal traditions were mostly exogenous and introduced involuntary through conquest and
colonization (distinctive intuitions and ideologies) and then adapted to local circumstances
by cultural, political, and economic conditions
§ Two main secular legal traditions: common law and civil law (French, German socialist,
and Scandinavian)
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Common Law vs. Civil Law
Common law (vs. civil law) – seeking to sustain markets rather than replace them:
§ Stronger investor protection (improved financial development, better access to finance,
higher ownership dispersion)
§ Lighter hand of government ownership and regulation (less corruption, better functioning
labor markets, smaller unofficial economies)
§ Lower formalism of judicial procedures and greater judicial independence (secure
property rights, better contract enforcement)
Criticism: reverse causality (countries improve laws as financial markets develop: LO are still
exogenous and research about impact of regulatory changes on the market), omitted variable
bias (difficulties with identifying legal rules as the channel of influence: controlling for contract
enforcement and research on flexibility of the judicial decision making under common law)
LO affect resource allocation in an economy through their effect on finance, labor markets,
and competition
Can we connect LO and economic growth?
Problem: alternative measures of human capital, such as higher years of schooling (vs. more
flexible in common law)

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LO History
§ Common law: developed because the side of lawyers and property owners
wanted to limit the crown’s ability to interfere in the markets
(“dispute resolving”, social control supporting market outcomes, courts spell out the rules
before they’re applied, more adaptable – law responds to a changing environment)
§ Civil law: rediscovered in the Middle Ages in Italy and adopted by Catholic
Church (“policy implementing”, state-desired allocations)
§ French civil law: written during the 19th century French Revolution in
Napoleon’s codes to deprive judges, who were on the losing side with
royalty, of law-making power, but the notion that legislation can foresee all
future circumstances proved unworkable
§ German civil law: written in 1897 after Bismarck’s unification of Germany
(greater judicial law making)
§ Scandinavian civil law: developed as a mix of civil law and Scandinavian
customary law (less derivative of Roman)

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Legal Origins Theory
§ By the 18th-19th centuries England and Continental Europe have
developed very different styles of social control of business and
institutions (balance between disorder and dictatorship)
§ These styles were transplanted by the origin countries to most of the
world rather than written from scratch
§ Although a great deal of regulatory change as occurred, these styles
have proven persistent in addressing social problems (why?)
§ Neither of the systems is perfect, which is why most countries are
mixing two approaches (e.g. civil law’s regulation and state control may
be efficient responses to disorder, where common-law solution fails to
sustain the market) – globalization and convergence

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LO as Merely a Proxy
Criticism: LO are merely proxy for other factors influencing legal rules and outcomes,
such as culture, history, or politics
§ Culture: religion, nation’s masculinity (*), belief in the independence of children (little
effect)
§ Politics: political alliances between families that controlled firms writing legal rules to
benefit themselves (20th century in Continental Europe) – why would organized labor
accept rules that facilitate tunneling of corporate wealth? (only occasional effect of
leftist politics, while a significant effect from LO even in autocracies)
§ History: the Great Reversal in the 20th century by Rajan and Zingales:
§ Divergence, not reversal: wrong market capitalization calculations – including debt
and companies listed abroad
§ Shareholder protection: British shareholders were quite protected (mandated
disclosure, best commercial courts)
§ WWII effects: The war destruction does not manage to explain the divergence
phenomenon (different samples and proxies)

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LO as Merely a Proxy
§ History: the Great Reversal in the 20th century by Rajan and Zingales:
§ Divergence, not reversal: wrong market capitalization calculations – including debt
and companies listed abroad
§ Shareholder protection: British shareholders were quite protected (mandated
disclosure, best commercial courts)
§ WWII effects: The war destruction does not manage to explain the divergence
phenomenon (different samples and proxies)

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Some Considerations
Two findings (support LO theory):
§ Common law countries appear to have moved sharply ahead of the civil law
ones in financial development over the course of the 20th century
§ Investor protection improved sharply in the common law countries over the
same period
Blueprint for policy reforms:
§ Legal or regulatory styles shaped by legal tradition might be applied in areas
where they are inappropriate (objective data on consequences required)
§ Legal and regulatory rules introduced in a situation of extreme disorder may
fail when the situation returns to normal
§ Transplantation of legal and regulatory rules might itself become a source of
inefficiency (developed vs. developing countries)

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Towards a Political Theory of the Firm
Luigi Zingales

The paper discusses the relationship between economic and political power, its risks and reasons
General Facts
§ The revenues of large companies often rival those of national
governments (10 companies among 30 largest entities in the world)
§ Companies have large security forces, public relations offices and
resources (political influence), lacking only the direct power to wage
war and the legal power of detaining people
§ Contemporary economics ignores all these elements of politics and
power in the prevailing view of the firm
§ Firm is a simple “nexus of contracts” with no objectives or life separate
from those of its contracting parties (a veil to achieve personal goals)
§ In reality: lots of power, no accountability (hostile takeovers
disappeared, activist investors under political pressure)

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Historical Development
Adam Smith: East India Company vs. British Parliament (acquiring the
competitor when monopoly expires and bribing Treasury) – 15-year monopoly
right lasted 223 years, which resulted not only in lower quantities and higher
prices, but also starvations and deaths
The gilded age (19th century):
§ Incorporation as the right of citizens and rise in economies of scale
§ Lobbying and corruption of entrepreneurs (seizing first-mover competitive
advantage and preserving power over time) – Tillman and Clayton Acts in the
20th century, aggressive antitrust enforcement in the U.S.
20th century:
§ Competitive selection process in the markets and risk of takeovers (corporate
control market)
§ Limits to the firms’ power

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Neoclassical Economics
§ Moving attention away from the “power” aspect to the more technological one
§ “Standardized” transactions, even though most contracts are incomplete (do not
fully specify the division of surplus in every possible contingency) and are decided by the
bargaining power based on different factors
Incomplete Contract Paradigm:
§ Firms’ power stems from their market power (past investments, economies of scale,
network externalities, and government-granted licenses)
§ This creates scope for lobbying, rent seeking and power grabbing to get the larger
share of economic rents
(low share of revenues spent either because the opposition of general public is
disorganized, or because companies can make good offers; Citigroup’s acquisition of
Travelers against the Glass-Steagall Act; charges against Google’s monopoly dropped
in the U.S.; Business Roundtable suit against SEC on corporate board composition;
DuPont hiding information behind trade secret law)

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Neoclassical Economics
The ability to influence the political power increases with economic power, so
does the need to do so (fear of expropriation by politics)
“Medici vicious circle” risk: money is used to gain political power and
political power is then used to make money (Italian governments run by rich
families with commercial interests as a main objective)
The increasing market power of US firms (less new firms, more mergers):
§ More than 75% of U.S. industries experienced an increase in concentration
levels in the last two decades (Herfindahl index increased by 50%) ->
increase in profits not caused by capital accumulation
§ The size of the average publicly listed company tripled in market
capitalization

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Explanations for the Trends
§ Network externalities (an increase in usage leads to a direct increase in the value
for other users)
§ Proliferation and information-intensive goods (high fixed and low marginal costs
with increasing returns to scale)
§ Reduced antitrust enforcement
Why is the power of U.S. corporations becoming stronger?
§ The size and market share of companies has increased reducing the competition
(more powerful vis-à-vis consumers)
§ The size and complexity of regulation has increased (easier to tilt the playing field)
§ Demise of the antibusiness ideology that prevailed among Democrats took place
§ The ideal state of affairs is the “goldilocks” balance between the power of the
state and power of the firms (otherwise, one entity will exploit the other)

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Towards a Political Theory of the Firm
§ Closest to ideal are Scandinavian countries and the U.S. (country size and
government quality)
Institutional characteristics behind the trends:
§ The main source of political power
(monopoly over legal use of force vs. broad social consensus, electoral law and
political consensus, taxonomy and political regimes – communist dictatorship,
plutocratic regimes, political patronages, and vertical politically integrated regimes)
§ The conditions of the media market (influenced by the political power through
government censorship and by the economic power through advertising, corporate
censorship)
§ The independence of the prosecutorial and judiciary power (degree of
independence from the political and economic powers)
§ The campaign financing laws (government vs. private donations)
§ The dominant ideology

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