Around the world for the last twenty years, economists, governments and regulators have been singing the praises of “democratizing” markets — breaking open cartels and restrictive practices to produce the jungle of competition that is pure capitalism.

It is always assumed that the ultimate beneficiary of this activity, however painful, is the consumer — and the economy as a whole.

Why? Is it really more cost-efficient to do business in a jungle than in a gentlemen’s club?

Certainly I never found it so. As a banker, my most miserable period in business was those times I spent chained to a trading desk, trying to avoid my bank being ripped off by “barrow-boy” traders; my most profitable single deal was closed over a glass of Dow 1963 port after a frightfully good lunch at the Athenaeum Club in London.

One should not, however, generalize from one’s own experience, apart from noting that my background, like most people’s, is neither barrow nor clubland, but somewhere between the two. Instead, let’s look at the economic reality, and start with some definitions.

For those like myself, without Greek, oligarchy should be distinguished from oligopoly. An oligopolistic market is one with few competitors — think the U.S. cola market, or the world aircraft market. Oligopolistic markets are typically sclerotic in innovation, though they may be quite competitive owing to ancient and irremovable rivalries between the competitors. They may or may not be particularly profitable and may or may not have tight rules, written or unwritten. And an oligopolistic market may or may not be also an oligarchic market.

An oligarchic market, on the other hand, is a market dominated by an oligarchy. The oligarchy consists of a tightly defined (although possibly quite large) group of people, all of whom are bound by a rigid set of written and unwritten rules, breach of which causes a member to be thrown out of the “club.” A further characteristic of an oligarchic market is stability; being thrown out of the “club” must have serious consequences for the wrongdoer’s future existence, and hence the “club” must be around for long enough to maintain discipline over the course of a member’s full career of 30-40 years.

The oligarchic market may or may not be oligopolistic. In London merchant banking, a classic such market, there were 17 competitors that were members of the pre-1980 Accepting Houses Committee. The New York Stock Exchange, for most of the period before 1975 also a classic oligarchic market, had 1,300 members. The Petroleum Club of Calgary, Canada in the early 1980’s tried to operate as an oligarchy but failed to do so because it didn’t last long enough — by 1986 many of its senior members were out of business.

The most obvious benefit to consumers of an oligarchic market is that of low transaction costs. In a fully democratic market, it is impossible to trust the entity with which you are doing business, or to be sure that there isn’t some “catch” in whatever deal the salesman offers you. Accordingly, each transaction becomes like buying a used car in a new neighborhood because you don’t know what the problems will be with your purchase but you know there will be problems. To get around this difficulty, you can engage lawyers to draft a legally watertight document for you. The salesman with whom you are dealing will then also engage lawyers, and the cost of the transaction will quickly escalate beyond all reason.

In an oligarchic market, these difficulties don’t exist. You will pay more than the lowest possible price. Indeed, you will probably pay some “fixed” scale of fees. On the other hand, your negotiation will be simple and there will be no hidden rip-offs. Every well run oligarchy has a “club committee” to whom disputes can be referred (the Bank of England, in the case of the merchant banks) and your salesman will seek at all costs to avoid adverse references to that “club committee” since his livelihood depends on his remaining a member in good standing of the “club.”

Documentation, in an oligarchic market, will be very simple because a great portion of the matters of potential dispute will be governed by the “club” rules, against which there is no appeal, but which are most unlikely to be violated. Before the Financial Services Act of 1986, for example, both bond and share issues in the United Kingdom were carried out without a prospectus, and with issuer information contained on an “Extel Card” — a greatly simplified version of an annual 10-K filing.

Because of the greater simplicity all around, oligarchic markets tend to have much lower costs. The service providers don’t need teams of in-house lawyers, because documentation is simple, as indeed are transactions themselves. There is no regulatory bureaucracy, hence no “compliance officers” — a huge savings in overhead costs.

Further, in any case where there is a risk of outside regulation (including the United States after say the 1884 start of the Cleveland administration) the remuneration available to “club” members will be kept at a level that permits a comfortable, even, for senior members an opulent standard of living, but nothing beyond that. It must be remembered, for example, that even in inflation-adjusted terms, J.P. Morgan made considerably less money than Michael Milken.

Hence, as the costs of the “club” are relatively low, the staffing needs of the “club” are relatively low, and the remuneration per staff member is moderate, the total slice of the economic pie absorbed by the “club” is considerably lower than that absorbed by a “law of the jungle” democratic market.

In both London and New York, for example, staffing, remuneration levels and capital requirements for the investment banking/brokerage community have soared following the dissolution of the market “clubs” — in 1975 in New York and following 1980 in London. These greater costs have been absorbed by the economy as a whole, not generally through greater costs per transaction but by multiplying ad infinitum the number of transactions carried out.

The result has been an endless slew of overpriced stock issues and over-hyped derivative products, which have provided huge remuneration to the sellers and, in the long term, losses to the buyers. Investment banks have moved from acting as intermediaries to “position taking” — in practice, using their superior sources of information and powerful trading desks to move the market and thereby extract monopoly rents from the public.

Wall Street research has deteriorated from a largely objective attempt to assess stocks to a producer of slick sales material, while research analysts themselves have enjoyed increasingly fancy lifestyles.

A further result of the “democratization” of the market has been increased instability. The inordinate rise in share prices in 1995-2000 was fueled by the huge sales machine that Wall Street has become. Once share prices revert to their equilibrium levels it will become impossible to pay for the sales machine, hence Wall Street bankruptcies and further market disruption will follow.

Interestingly, Wall Street, but not London, underwent a partial market democratization in the 1920’s. The number of brokers greatly increased, and commercial banks, which had been passive “deal-takers” in the J.P. Morgan era, became active in their own right — Charles Mitchell at First National City Bank, Albert Wiggin at Chase and Waddill Catchings at the investment bank Goldman Sachs were all very active market participants from institutions that had not been part of the pre-1914 “club.”

The result is well known. This time, the trajectory may well be similar that of 1929-32, but on an immeasurably larger scale — one can only hope that financial correction will not be accompanied by macro-economic folly in the same way.

Oligarchic markets are not confined to the financial services industry, although because of the industry’s high remuneration and lack of “dirty hands” jobs, financial services markets are often oligarchic. Detroit in the 1950’s was an oligarchic market, with all automobile executives members of the same country clubs. As an oligarchy it made the best cars in the world, which cannot be said for its “democratized” successor. The French wine market was oligarchic until the advent of international competition in the 1980’s. From that period dates the astronomic price rises for top quality premiers crus. Japanese industry was oligarchic and successful until its opening to foreign participation in the late 1980’s; from that period dates its decline.

Democratization of industry has had its successes — think of personal computers and the Internet — but it also has had huge costs, that are not recognized by conventional economists.

In the short term, it is impossible to stuff the genie back into the bottle. An oligarchic market that has been broken open cannot be recreated, because the “club rules” cannot be re-imposed except over a lengthy period. Probably what is required in the case of financial services is a period of vindictive regulation by Congress, inspired by those who have lost their savings through the excesses of Wall Street, followed by at least a decade of market quiescence. After that, a small, unobtrusive oligarchy, with modest remuneration and limited capital may well again control financial markets.

In the next Kondratieff upswing, around 2050, let’s avoid market “democratization” and the costs and instability that result.

-0-

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.