Archives For Protectionism

The concept of European “digital sovereignty” has been promoted in recent years both by high officials of the European Union and by EU national governments. Indeed, France made strengthening sovereignty one of the goals of its recent presidency in the EU Council.

The approach taken thus far both by the EU and by national authorities has been not to exclude foreign businesses, but instead to focus on research and development funding for European projects. Unfortunately, there are worrying signs that this more measured approach is beginning to be replaced by ill-conceived moves toward economic protectionism, ostensibly justified by national-security and personal-privacy concerns.

In this context, it is worth reconsidering why Europeans’ best interests are best served not by economic isolationism, but by an understanding of sovereignty that capitalizes on alliances with other free democracies.

Protectionism Under the Guise of Cybersecurity

Among the primary worrying signs regarding the EU’s approach to digital sovereignty is the union’s planned official cybersecurity-certification scheme. The European Commission is reportedly pushing for “digital sovereignty” conditions in the scheme, which would include data and corporate-entity localization and ownership requirements. This can be categorized as “hard” data localization in the taxonomy laid out by Peter Swire and DeBrae Kennedy-Mayo of Georgia Institute of Technology, in that it would prohibit both data transfers to other countries and for foreign capital to be involved in processing even data that is not transferred.

The European Cybersecurity Certification Scheme for Cloud Services (EUCS) is being prepared by ENISA, the EU cybersecurity agency. The scheme is supposed to be voluntary at first, but it is expected that it will become mandatory in the future, at least for some situations (e.g., public procurement). It was not initially billed as an industrial-policy measure and was instead meant to focus on technical security issues. Moreover, ENISA reportedly did not see the need to include such “digital sovereignty” requirements in the certification scheme, perhaps because they saw them as insufficiently grounded in genuine cybersecurity needs.

Despite ENISA’s position, the European Commission asked the agency to include the digital–sovereignty requirements. This move has been supported by a coalition of European businesses that hope to benefit from the protectionist nature of the scheme. Somewhat ironically, their official statement called on the European Commission to “not give in to the pressure of the ones who tend to promote their own economic interests,”

The governments of Denmark, Estonia, Greece, Ireland, Netherlands, Poland, and Sweden expressed “strong concerns” about the Commission’s move. In contrast, Germany called for a political discussion of the certification scheme that would take into account “the economic policy perspective.” In other words, German officials want the EU to consider using the cybersecurity-certification scheme to achieve protectionist goals.

Cybersecurity certification is not the only avenue by which Brussels appears to be pursuing protectionist policies under the guise of cybersecurity concerns. As highlighted in a recent report from the Information Technology & Innovation Foundation, the European Commission and other EU bodies have also been downgrading or excluding U.S.-owned firms from technical standard-setting processes.

Do Security and Privacy Require Protectionism?

As others have discussed at length (in addition to Swire and Kennedy-Mayo, also Theodore Christakis) the evidence for cybersecurity and national-security arguments for hard data localization have been, at best, inconclusive. Press reports suggest that ENISA reached a similar conclusion. There may be security reasons to insist upon certain ways of distributing data storage (e.g., across different data centers), but those reasons are not directly related to the division of national borders.

In fact, as illustrated by the well-known architectural goal behind the design of the U.S. military computer network that was the precursor to the Internet, security is enhanced by redundant distribution of data and network connections in a geographically dispersed way. The perils of putting “all one’s data eggs” in one basket (one locale, one data center) were amply illustrated when a fire in a data center of a French cloud provider, OVH, famously brought down millions of websites that were only hosted there. (Notably, OVH is among the most vocal European proponents of hard data localization).

Moreover, security concerns are clearly not nearly as serious when data is processed by our allies as it when processed by entities associated with less friendly powers. Whatever concerns there may be about U.S. intelligence collection, it would be detached from reality to suggest that the United States poses a national-security risk to EU countries. This has become even clearer since the beginning of the Russian invasion of Ukraine. Indeed, the strength of the U.S.-EU security relationship has been repeatedly acknowledged by EU and national officials.

Another commonly used justification for data localization is that it is required to protect Europeans’ privacy. The radical version of this position, seemingly increasingly popular among EU data-protection authorities, amounts to a call to block data flows between the EU and the United States. (Most bizarrely, Russia seems to receive a more favorable treatment from some European bureaucrats). The legal argument behind this view is that the United States doesn’t have sufficient legal safeguards when its officials process the data of foreigners.

The soundness of that view is debated, but what is perhaps more interesting is that similar privacy concerns have also been identified by EU courts with respect to several EU countries. The reaction of those European countries was either to ignore the courts, or to be “ruthless in exploiting loopholes” in court rulings. It is thus difficult to treat seriously the claims that Europeans’ data is much better safeguarded in their home countries than if it flows in the networks of the EU’s democratic allies, like the United States.

Digital Sovereignty as Industrial Policy

Given the above, the privacy and security arguments are unlikely to be the real decisive factors behind the EU’s push for a more protectionist approach to digital sovereignty, as in the case of cybersecurity certification. In her 2020 State of the Union speech, EU Commission President Ursula von der Leyen stated that Europe “must now lead the way on digital—or it will have to follow the way of others, who are setting these standards for us.”

She continued: “On personalized data—business to consumer—Europe has been too slow and is now dependent on others. This cannot happen with industrial data.” This framing suggests an industrial-policy aim behind the digital-sovereignty agenda. But even in considering Europe’s best interests through the lens of industrial policy, there are reasons to question the manner in which “leading the way on digital” is being implemented.

Limitations on foreign investment in European tech businesses come with significant costs to the European tech ecosystem. Those costs are particularly high in the case of blocking or disincentivizing American investment.

Effect on startups

Early-stage investors such as venture capitalists bring more than just financial capital. They offer expertise and other vital tools to help the businesses in which they invest. It is thus not surprising that, among the best investors, those with significant experience in a given area are well-represented. Due to the successes of the U.S. tech industry, American investors are especially well-positioned to play this role.

In contrast, European investors may lack the needed knowledge and skills. For example, in its report on building “deep tech” companies in Europe, Boston Consulting Group noted that a “substantial majority of executives at deep-tech companies and more than three-quarters of the investors we surveyed believe that European investors do not have a good understanding of what deep tech is.”

More to the point, even where EU players do hold advantages, a cooperative economic and technological system will allow the comparative advantage of both U.S. and EU markets to redound to each others’ benefit. That is to say, of course not all U.S. investment expertise will apply in the EU, but certainly some will. Similarly, there will be EU firms that are positioned to share their expertise in the United States. But there is no ex ante way to know when and where these complementarities will exist, which essentially dooms efforts at centrally planning technological cooperation.

Given the close economic, cultural, and historical ties of the two regions, it makes sense to work together, particularly given the rising international-relations tensions outside of the western sphere. It also makes sense, insofar as the relatively open private-capital-investment environment in the United States is nearly impossible to match, let alone surpass, through government spending.

For example, national government and EU funding in Europe has thus far ranged from expensive failures (the “Google-killer”) to the all-too-predictable bureaucracy-heavy grantmaking, the beneficiaries of which describe as lacking flexibility, “slow,” “heavily process-oriented,” and expensive for businesses to navigate. As reported by the Financial Times’ Sifted website, the EU’s own startup-investment scheme (the European Innovation Council) backed only one business over more than a year, and it had “delays in payment” that “left many startups short of cash—and some on the brink of going out of business.”

Starting new business ventures is risky, especially for the founders. They risk devoting their time, resources, and reputation to an enterprise that may very well fail. Given this risk of failure, the potential upside needs to be sufficiently high to incentivize founders and early employees to take the gamble. This upside is normally provided by the possibility of selling one’s shares in a business. In BCG’s previously cited report on deep tech in Europe, respondents noted that the European ecosystem lacks “clear exit opportunities”:

Some investors fear being constrained by European sovereignty concerns through vetoes at the state or Europe level or by rules potentially requiring European ownership for deep-tech companies pursuing strategically important technologies. M&A in Europe does not serve as the active off-ramp it provides in the US. From a macroeconomic standpoint, in the current environment, investment and exit valuations may be impaired by inflation or geopolitical tensions.

More broadly, those exit opportunities also factor importantly into funders’ appetite to price the risk of failure in their ventures. Where the upside is sufficiently large, an investor might be willing to experiment in riskier ventures and be suitably motivated to structure investments to deal with such risks. But where the exit opportunities are diminished, it makes much more sense to spend time on safer bets that may provide lower returns, but are less likely to fail. Coupled with the fact that government funding must run through bureaucratic channels, which are inherently risk averse, the overall effect is a less dynamic funding system.

The Central and Eastern Europe (CEE) region is an especially good example of the positive influence of American investment in Europe’s tech ecosystem. According to the state-owned Polish Development Fund and Dealroom.co, in 2019, $0.9 billion of venture-capital investment in CEE came from the United States, $0.5 billion from Europe, and $0.1 billion from the rest of the world.

Direct investment

Technological investment is rarely, if ever, a zero-sum game. U.S. firms that invest in the EU (and vice versa) do not do so as foreign conquerors, but as partners whose own fortunes are intertwined with their host country. Consider, for example, Google’s recent PLN 2.7 billion investment in Poland. Far from extractive, that investment will build infrastructure in Poland, and will employ an additional 2,500 Poles in the company’s cloud-computing division. This sort of partnership plants the seeds that grow into a native tech ecosystem. The Poles that today work in Google’s cloud-computing division are the founders of tomorrow’s innovative startups rooted in Poland.

The funding that accompanies native operations of foreign firms also has a direct impact on local economies and tech ecosystems. More local investment in technology creates demand for education and support roles around that investment. This creates a virtuous circle that ultimately facilitates growth in the local ecosystem. And while this direct investment is important for large countries, in smaller countries, it can be a critical component in stimulating their own participation in the innovation economy. 

According to Crunchbase, out of 2,617 EU-headquartered startups founded since 2010 with total equity funding amount of at least $10 million, 927 (35%) had at least one founder who previously worked for an American company. For example, two of the three founders of Madrid-based Seedtag (total funding of more than $300 million) worked at Google immediately before starting Seedtag.

It is more difficult to quantify how many early employees of European startups built their experience in American-owned companies, but it is likely to be significant and to become even more so, especially in regions—like Central and Eastern Europe—with significant direct U.S. investment in local talent.

Conclusion

Explicit industrial policy for protectionist ends is—at least, for the time being—regarded as unwise public policy. But this is not to say that countries do not have valid national interests that can be met through more productive channels. While strong data-localization requirements is ultimately counterproductive, particularly among closely allied nations, countries have a legitimate interest in promoting the growth of the technology sector within their borders.

National investment in R&D can yield fruit, particularly when that investment works in tandem with the private sector (see, e.g., the Bayh-Dole Act in the United States). The bottom line, however, is that any intervention should take care to actually promote the ends it seeks. Strong data-localization policies in the EU will not lead to success of the local tech industry, but it will serve to wall the region off from the kind of investment that can make it thrive.

Chances are, if you have heard of the Jones Act, you probably think it needs to be repealed. That is, at least, the consensus in the economics profession. However, this consensus seems to be driven by an application of the sort of rules of thumb that one picks up from economics courses, rather than an application of economic theory.

For those who are unaware, the Jones Act requires that any shipping between two U.S. ports is carried by a U.S.-built ship with a crew of U.S. citizens that is U.S.-owned and flies the U.S. flag. When those who have memorized some of the rules of thumb in the field of economics hear that description, they immediately think “this is protectionism and protectionism is bad.” It therefore seems obvious that the Jones Act must be bad. After all, based on this description, it seems like it is designed to protect U.S. shipbuilders, U.S. crews, and U.S.-flagged ships from foreign competition.

Critics seize on this narrative. They point to the higher cost of Jones Act ships in comparison to those ships that fly foreign flags and argue that the current law has costs that are astronomical. Based on that type of criticism, the Jones Act seems so obviously costly that one might wonder how it is possible to defend the law in any way.

I reject this criticism. I do not reject this over some minor quibble with the numbers. In true Hendricksonian fashion, I reject this criticism because it gets the underlying economic theory wrong.

Let’s start by thinking about some critical issues in Coasean terms. During peacetime, the U.S. Navy does not need maintain the sort of capacity that it would have during a time of war. It would not be cost-effective to do so. However, the Navy would like to expand its capacity rapidly in the event of a war or other national emergency. To do so, the country needs shipbuilding capacity. Building ships and training crews to operate those ships, however, takes time. This might be time that the Navy does not have. At the very least, this could leave the United States at a significant disadvantage.

Of course, there are ships and crews available in the form of the U.S. Merchant Marine. Thus, there are gains from trade to be had. The government could pay the Merchant Marine to provide sealift during times of war and other national emergencies. However, this compensation scheme is complicated. For example, if the government waits until a war or a national emergency, this could create a holdup problem. Knowing that the government needs the Merchant Marine immediately, the holdup problem could result in the government paying well-above-market prices to obtain these services. On the other hand, the government could simply requisition the ships and draft the crews into service whenever there is a war or national emergency. Knowing that this is a possibility, the Merchant Marine would tend to underinvest in both physical and human capital.

Given these problems, the solution is to agree to terms ahead of time. The Merchant Marine agrees to provide their services to the government during times of war and other national emergencies in exchange for compensation. The way to structure that compensation in order to avoid holdup problems and underinvestment is to provide this compensation in the form of peacetime subsidies.

Thus, the government provides peacetime subsidies in exchange for the services of the Merchant Marine during wartime. This is a straightforward Coasean bargain.

Now, let’s think about the Jones Act. The Jones Act ships are implicitly subsidized because ships that do not meet the law’s criteria are not allowed to engage in port-to-port shipping in the United States. The requirement that these ships need to be U.S.-owned and fly the U.S. flag gives the government the legal authority to call these ships into service. The requirement that the ships are built in the United States is designed to ensure that the ships meet the needs of the U.S. military and to subsidize shipbuilding in the United States. The requirement to use U.S. crews is designed to provide an incentive for the accumulation of the necessary human capital. Since the law restricts ships with these characteristics for port-to-port shipping within the United States, it provides the firms rents to compensate them for their service during wartime and national emergencies.

Critics, of course, are likely to argue that I have a “just so” theory of the Jones Act. In other words, they might argue that I have simply structured an economic narrative around a set of existing facts. Those critics would be wrong for the following reasons.

First, the Jones Act is not some standalone law when it comes to maritime policy. There is a long history in the United States of trying to determine the optimal way to subsidize the maritime industry. Second, if this type of policy is just a protectionist giveaway, then it should be confined to the maritime industry. However, this isn’t true. The United States has a long history of subsidizing transportation that is crucial for use in the military. This includes subsidies for horse-breeding and the airline industry. Finally, critics would have to explain why wasteful maritime policies have been quickly overturned, while the Jones Act continues to survive.

The critics also dramatically overstate the costs of the Jones Act. This is partly because they do not understand the particularities of the law. For example, to estimate the costs, critics often compare the cost of the Jones Act ships to ships that fly a foreign flag and use foreign crews. The argument here is that the repeal of the Jones Act would result in these foreign-flagged ships with foreign crews taking over U.S. port-to-port shipping.

There are two problems with this argument. One, cabotage restrictions do not originate with the Jones Act. Rather, the law clarifies and closes loopholes in previous laws. Second, the use of foreign crews would be a violation of U.S. immigration law. Furthermore, this type of shipping would still be subject to other U.S. laws to which these foreign-flagged ships are not subject today. Given that the overwhelming majority of the cost differential is explained by differences in labor costs, it therefore seems hard to understand from where, exactly, the cost savings of repeal would actually come.

None of this is to say that the Jones Act is the first-best policy or that the law is sufficient to accomplish the military’s goals. In fact, the one thing that critics and advocates of the law seem to agree on is that the law is not sufficient to accomplish the intended goals. My own work implies a need for direct subsidies (or lower tax rates) on the capital used by the maritime industry. However, the critics need to be honest and admit that, even if the law were repealed, the cost savings are nowhere near what they claim. In addition, this wouldn’t be the end of maritime subsidies (in fact, other subsidies already exist). Instead, the Jones Act would likely be replaced by some other form of subsidy to the maritime industry.

Many defense-based arguments of subsidies are dubious. However, in the case of maritime policy, the Coasean bargain is clear.

In the wake of its departure from the European Union, the United Kingdom will have the opportunity to enter into new free trade agreements (FTAs) with its international trading partners that lower existing tariff and non-tariff barriers. Achieving major welfare-enhancing reductions in trade restrictions will not be easy. Trade negotiations pose significant political sensitivities, such as those arising from the high levels of protection historically granted certain industry sectors, particularly agriculture.

Nevertheless, the political economy of protectionism suggests that, given deepening globalization and the sudden change in U.K. trade relations wrought by Brexit, the outlook for substantial liberalization of U.K. trade has become much brighter. Below, I address some of the key challenges facing U.K. trade negotiators as they seek welfare-enhancing improvements in trade relations and offer a proposal to deal with novel trade distortions in the least protectionist manner.

Two New Challenges Affecting Trade Liberalization

In addition to traditional trade issues, such as tariff levels and industry sector-specific details, U.K, trade negotiators—indeed, trade negotiators from all nations—will have to confront two relatively new and major challenges that are creating several frictions.

First, behind-the-border anticompetitive market distortions (ACMDs) have largely replaced tariffs as the preferred means of protection in many areas. As I explained in a previous post on this site (citing an article by trade-law scholar Shanker Singham and me), existing trade and competition law have not been designed to address the ACMD problem:

[I]nternational trade agreements simply do not reach a variety of anticompetitive welfare-reducing government measures that create de facto trade barriers by favoring domestic interests over foreign competitors. Moreover, many of these restraints are not in place to discriminate against foreign entities, but rather exist to promote certain favored firms. We dub these restrictions “anticompetitive market distortions” or “ACMDs,” in that they involve government actions that empower certain private interests to obtain or retain artificial competitive advantages over their rivals, be they foreign or domestic. ACMDs are often a manifestation of cronyism, by which politically-connected enterprises successfully pressure government to shield them from effective competition, to the detriment of overall economic growth and welfare. …

As we emphasize in our article, existing international trade rules have been able to reach ACMDs, which include: (1) governmental restraints that distort markets and lessen competition; and (2) anticompetitive private arrangements that are backed by government actions, have substantial effects on trade outside the jurisdiction that imposes the restrictions, and are not readily susceptible to domestic competition law challenge. Among the most pernicious ACMDs are those that artificially alter the cost-base as between competing firms. Such cost changes will have large and immediate effects on market shares, and therefore on international trade flows.

Second, in recent years, the trade remit has expanded to include “nontraditional” issues such as labor, the environment, and now climate change. These concerns have generated support for novel tariffs that could help promote protectionism and harmful trade distortions. As explained in a recent article by the Special Trade Commission advisory group (former senior trade and antitrust officials who have provided independent policy advice to the U.K. government):

[The rise of nontraditional trade issues] has renewed calls for border tax adjustments or dual tariffs on an ex-ante basis. This is in sharp tension with the W[orld Trade Organization’s] long-standing principle of technological neutrality, and focus on outcomes as opposed to discriminating on the basis of the manner of production of the product. The problem is that it is too easy to hide protectionist impulses into concerns about the manner of production, and once a different tariff applies, it will be very difficult to remove. The result will be to significantly damage the liberalisation process itself leading to severe harm to the global economy at a critical time as we recover from Covid-19. The potentially damaging effects of ex ante tariffs will be visited most significantly in developing countries.

Dealing with New Trade Challenges in the Least Protectionist Manner

A broad approach to U.K. trade liberalization that also addresses the two new trade challenges is advanced in a March 2 report by the U.K. government’s Trade and Agricultural Commission (TAC, an independent advisory agency established in 2020). Although addressed primarily to agricultural trade, the TAC report enunciates principles applicable to U.K. trade policy in general, considering the impact of ACMDs and nontraditional issues. Key aspects of the TAC report are summarized in an article by Shanker Singham (the scholar who organized and convened the Special Trade Commission and who also served as a TAC commissioner):

The heart of the TAC report’s import policy contains an innovative proposal that attempts to simultaneously promote a trade liberalising agenda in agriculture, while at the same time protecting the UK’s high standards in food production and ensuring the UK fully complies with WTO rules on animal and plant health, as well as technical regulations that apply to food trade.

This proposal includes a mechanism to deal with some of the most difficult issues in agricultural trade which relate to animal welfare, environment and labour rules. The heart of this mechanism is the potential for the application of a tariff in cases where an aggrieved party can show that a trading partner is violating agreed standards in an FTA.

The result of the mechanism is a tariff based on the scale of the distortion which operates like a trade remedy. The mechanism can also be used offensively where a country is preventing market access by the UK as a result of the market distortion, or defensively where a distortion in a foreign market leads to excess exports from that market. …

[T]he tariff would be calibrated to the scale of the distortion and would apply only to the product category in which the distortion is occurring. The advantage of this over a more conventional trade remedy is that it is based on cost as opposed to price and is designed to remove the effects of the distorting activity. It would not be applied on a retaliatory basis in other unrelated sectors.

In exchange for this mechanism, the UK commits to trade liberalisation and, within a reasonable timeframe, zero tariffs and zero quotas. This in turn will make the UK’s advocacy of higher standards in international organisations much more credible, another core TAC proposal.

The TAC report also notes that behind the border barriers and anti-competitive market distortions (“ACMDs”) have the capacity to damage UK exports and therefore suggests a similar mechanism or set of disciplines could be used offensively. Certainly, where the ACMD is being used to protect a particular domestic industry, using the ACMD mechanism to apply a tariff for the exports of that industry would help, but this may not apply where the purpose is protective, and the industry does not export much.

I would argue that in this case, it would be important to ensure that UK FTAs include disciplines on these ACMDs which if breached could lead to dispute settlement and the potential for retaliatory tariffs for sectors in the UK’s FTA partner that do export. This is certainly normal WTO-sanctioned practice, and could be used here to encourage compliance. It is clear from the experience in dealing with countries that engage in ACMDs for trade or competition advantage that unless there are robust disciplines, mere hortatory language would accomplish little or nothing.

But this sort of mechanism with its concomitant commitment to freer trade has much wider potential application than just UK agricultural trade policy. It could also be used to solve a number of long standing trade disputes such as the US-China dispute, and indeed the most vexed questions in trade involving environment and climate change in ways that do not undermine the international trading system itself.

This is because the mechanism is based on an ex post tariff as opposed to an ex ante one which contains within it the potential for protectionism, and is prone to abuse. Because the tariff is actually calibrated to the cost advantage which is secured as a result of the violation of agreed international standards, it is much more likely that it will be simply limited to removing this cost advantage as opposed to becoming a punitive measure that curbs ordinary trade flows.

It is precisely this type of problem solving and innovative thinking that the international trading system needs as it faces a range of challenges that threaten liberalisation itself and the hard-won gains of the post war GATT/WTO system itself. The TAC report represents UK leadership that has been sought after since the decision to leave the EU. It has much to commend it.

Assessment and Conclusion

Even when administered by committed free traders, real-world trade liberalization is an exercise in welfare optimization, subject to constraints imposed by the actions of organized interest groups expressed through the political process. The rise of new coalitions (such as organizations committed to specified environmental goals, including limiting global warming) and the proliferation of ADMCs further complicates the trade negotiation calculus.

Fortunately, recognizing the “reform moment” created by Brexit, free trade-oriented experts (in particular, the TAC, supported by the Special Trade Commission) have recommended that the United Kingdom pursue a bold move toward zero tariffs and quotas. Narrow exceptions to this policy would involve after-the-fact tariffications to offset (1) the distortive effects of ACMDs and (2) derogation from rules embodying nontraditional concerns, such as environmental commitments. Such tariffications would be limited and cost-based, and, as such, welfare-superior to ex ante tariffs calibrated to price.

While the details need to be worked out, the general outlines of this approach represent a thoughtful and commendable market-oriented effort to secure substantial U.K. trade liberalization, subject to unavoidable constraints. More generally, one would hope that other jurisdictions (including the United States) take favorable note of this development as they generate their own trade negotiation policies. Stay tuned.

This guest post is by Jonathan M. Barnett, Torrey H. Webb Professor of Law at the University of Southern California, Gould School of Law.

State bar associations, with the backing of state judiciaries and legislatures, are typically entrusted with a largely unqualified monopoly over licensing in legal services markets. This poses an unavoidable policy tradeoff. Designating the bar as gatekeeper might protect consumers by ensuring a minimum level of service quality. Yet the gatekeeper is inherently exposed to influence by interests with an economic stake in the existing market. Any licensing requirement that might shield uninformed consumers from unqualified or opportunistic lawyers also necessarily raises an entry barrier that protects existing lawyers against more competition. A proper concern for consumer welfare therefore requires that the gatekeeper impose licensing requirements only when they ensure that the efficiency gains attributable to a minimum quality threshold outweigh the efficiency losses attributable to constraints on entry.

There is increasing reason for concern that state bar associations are falling short of this standard. In particular, under the banner of “legal ethics,” some state bar associations and courts have blocked or impeded entry by innovative “legaltech” services without a compelling consumer protection rationale.

The LegalMatch Case: A misunderstood platform

This trend is illustrated by a recent California appellate court decision interpreting state regulations pertaining to legal referral services. In Jackson v. LegalMatch, decided in late 2019, the court held that LegalMatch, a national online platform that matches lawyers and potential clients, constitutes an illegal referral service, even though it is not a “referral service” under the American Bar Association’s definition of the term, and the California legislature had previously declined to include online services within the statutory definition.

The court’s reasoning: the “marketing” fee paid by subscribing attorneys to participate in the platform purportedly runs afoul of state regulations that proscribe attorneys from paying a fee to referral services that have not been certified by the bar. (The lower court had felt differently, finding that LegalMatch was not a referral service for this purpose, in part because it did not “exercise any judgment” on clients’ legal issues.)

The court’s formalist interpretation of applicable law overlooks compelling policy arguments that strongly favor facilitating, rather than obstructing, legal matching services. In particular, the LegalMatch decision illustrates the anticompetitive outcomes that can ensue when courts and regulators blindly rely on an unqualified view of platforms as an inherent source of competitive harm.

Contrary to this presumption, legal services referral platforms enhance competition by reducing transaction-cost barriers to efficient lawyer-client relationships. These matching services benefit consumers that otherwise lack access to the full range of potential lawyers and smaller or newer law firms that do not have the marketing resources or brand capital to attract the full range of potential clients. Consistent with the well-established economics of platform markets, these services operate under a two-sided model in which the unpriced delivery of attorney information to potential clients is financed by the positively priced delivery of interested clients to subscribing attorneys. Without this two-sided fee structure, the business model collapses and the transaction-cost barriers to matching the credentials of tens of thousands of lawyers with the preferences of millions of potential clients are inefficiently restored. Some legal matching platforms also offer fixed-fee service plans that can potentially reduce legal representation costs relative to the conventional billable hour model that can saddle clients with unexpectedly or inappropriately high legal fees given the difficulty in forecasting the required quantity of legal services ex ante and measuring the quality of legal services ex post.

Blocking entry by these new business models is likely to adversely impact competition and, as observed in a 2018 report by an Illinois bar committee, to injure lower-income consumers in particular. The result is inefficient, regressive, and apparently protectionist.

Indeed, subsequent developments in this litigation are regrettably consistent with the last possibility. After the California bar prevailed in its legal interpretation of “referral service” at the appellate court, and the Supreme Court of California declined to review the decision, LegalMatch then sought to register as a certified lawyer referral service with the bar. The bar responded by moving to secure a temporary restraining order against the continuing operation of the platform. In May 2020, a lower state court judge both denied the petition and expressed disappointment in the bar’s handling of the litigation.

Bar associations’ puzzling campaign against “LegalTech” innovation

This case of regulatory overdrive is hardly unique to the LegalMatch case. Bar associations have repeatedly acted to impede entry by innovators that deploy digital technologies to enhance legal services, which can drive down prices in a field that is known for meager innovation and rigid pricing. Puzzlingly from a consumer welfare perspective, the bar associations have taken actions that impede or preclude entry by online services that expand opportunities for lawyers, increase the information available to consumers, and, in certain cases, place a cap on maximum legal fees.

In 2017, New Jersey Supreme Court legal ethics committees, following an “inquiry” by the state bar association, prohibited lawyers from partnering with referral services and legal services plans offered by Avvo, LegalZoom, and RocketLawyer. In 2018, Avvo discontinued operations due in part to opposition from multiple state bar associations (often backed up by state courts).

In some cases, bar associations have issued advisory opinions that, given the risk of disciplinary action, can have an in terrorem effect equivalent to an outright prohibition. In 2018, the Indiana Supreme Court Disciplinary Commission issued a “nonbinding advisory” opinion stating that attorneys who pay “marketing fees” to online legal referral services or agree to fixed-fee arrangements with such services “risk violation of several Indiana [legal] ethics rules.”

State bar associations similarly sought to block the entry of LegalZoom, an online provider of standardized legal forms that can be more cost-efficient for “cookie-cutter” legal situations than the traditional legal services model based on bespoke document preparation. These disputes are protracted and costly: it took LegalZoom seven years to reach a settlement with the North Carolina State Bar that allowed it to continue operating in the state. In a case pending before the Florida Supreme Court, the Florida bar is seeking to shut down a smartphone application that enables drivers to contest traffic tickets at a fixed fee, a niche in which the traditional legal services model is likely to be cost-inefficient given the relatively modest amounts that are typically involved.

State bar associations, with supporting action or inaction by state courts and legislatures, have ventured well beyond the consumer protection rationale that is the only potentially publicly-interested justification for the bar’s licensing monopoly. The results sometimes border on absurdity. In 2006, the New Jersey bar issued an opinion precluding attorneys from stating in advertisements that they had appeared in an annual “Super Lawyers” ranking maintained by an independent third-party publication. In 2008, based on a 304-page report prepared by a “special master,” the bar’s ethics committee vacated the opinion but merely recommended further consideration taking into account “legitimate commercial speech activities.” In 2012, the New York legislature even changed the “unlicensed practice of law” from a misdemeanor to a felony, an enhancement proposed by . . . the New York bar (see here and here). 

In defending their actions against online referral services, the bar associations argue that these steps are necessary to defend the public’s interest in receiving legal advice free from any possible conflict of interest. This is a presumptively weak argument. The associations’ licensing and other requirements are inherently tainted throughout by a “meta” conflict of interest. Hence it is the bar that rightfully bears the burden in demonstrating that any such requirement imposes no more than a reasonably necessary impediment to competition. This is especially so given that each bar association often operates its own referral service.

The unrealized potential of North Carolina State Board of Dental Examiners v. FTC

Bar associations might nonetheless take the legal position that they have statutory or regulatory discretion to take these actions and therefore any antitrust scrutiny is inapposite. If that argument ever held water, that is clearly no longer the case.

In an undeservedly underapplied decision, North Carolina State Board of Dental Examiners v. FTC, the Supreme Court held definitively in 2015 that any action by a “non-sovereign” licensing entity is subject to antitrust scrutiny unless that action is “actively supervised” by, and represents a “clearly articulated” policy of, the state. The Court emphasized that the degree of scrutiny is highest for licensing bodies administered by constituencies in the licensed market—precisely the circumstances that characterize state bar associations.

The North Carolina decision is hardly an outlier. It followed a string of earlier cases in which the Court had extended antitrust scrutiny to a variety of “hard” rules and “soft” guidance that bar associations had issued and defended on putatively publicly-interested grounds of consumer protection or legal ethics.

At the Court, the bar’s arguments did not meet with success. The Court rejected any special antitrust exemption for a state bar association’s “advisory” minimum fee schedule (Goldfarb v. Virginia State Bar (1975)) and, in subsequent cases, similarly held that limitations by professional associations on advertising by members—another requirement to “protect” consumers—do not enjoy any special antitrust exemption. The latter set of cases addressed specifically both advertising restrictions on price and quality by a California dental association (California Dental Association v. FTC (1999) ) and blanket restrictions on advertising by a bar association (Bates v. State Bar of Arizona (1977 )). As suggested by the bar associations’ recent actions toward online lawyer referral services, the Court’s consistent antitrust decisions in this area appear to have had relatively limited impact in disciplining potentially protectionist actions by professional associations and licensing bodies, at least in the legal services market. 

A neglected question: Is the regulation of legal services anticompetitive?

The current economic situation poses a unique historical opportunity for bar associations to act proactively by enlisting independent legal and economic experts to review each component of the current licensing infrastructure and assess whether it passes the policy tradeoff between protecting consumers and enhancing competition. If not, any such component should be modified or eliminated to elicit competition that can leverage digital technologies and managerial innovations—often by exploiting the efficiencies of multi-sided platform models—that have been deployed in other industries to reduce prices and transaction costs. These modifications would expand access to legal services consistent with the bar’s mission and, unlike existing interventions to achieve this objective through government subsidies, would do so with a cost to the taxpayer of exactly zero dollars.

This reexamination exercise is arguably demanded by the line of precedent anchored in the Goldfarb and Bates decisions in 1975 and 1977, respectively, and culminating in the North Carolina Dental decision in 2015. This line of case law is firmly grounded in antitrust law’s underlying commitment to promote consumer welfare by deterring collective action that unjustifiably constrains the free operation of competitive forces. In May 2020, the California bar took a constructive if tentative step in this direction by reviving consideration of a “regulatory sandbox” to facilitate experimental partnerships between lawyers and non-lawyers in pioneering new legal services models. This follows somewhat more decisive action by the Utah Supreme Court, which in 2019 approved commencing a staged process that may modify regulation of the legal services market, including lifting or relaxing restrictions on referral fees and partnerships between lawyers and non-lawyers.

Neither the legal profession generally nor the antitrust bar in particular has allocated substantial attention to potentially anticompetitive elements in the manner in which the practice of law has long been regulated. Restrictions on legal referral services are only one of several practices that deserve a closer look under the policy principles and legal framework set forth most recently in North Carolina Dental and previously in California Dental. A few examples can illustrate this proposition. 

Currently limitations on partnerships between lawyers and non-lawyers constrain the ability to achieve economies of scale and scope in the delivery of legal services and preclude firms from offering efficient bundles of complementary legal and non-legal services. Under a more surgical regulatory regime, legal services could be efficiently bundled with related accounting and consulting services, subject to appropriately targeted precautions against conflicts of interest. Additionally, as other commentators have observed and as “legaltech” innovations demonstrate, software could be more widely deployed to provide “direct-to-consumer” products that deliver legal services at a far lower cost than the traditional one-on-one lawyer-client model, subject to appropriately targeted precautions that reflect informational asymmetries in individual and small-business legal markets.

In another example, the blanket requirement of seven years of undergraduate and legal education raises entry costs that are not clearly justified for all areas of legal practice, some of which could potentially be competently handled by practitioners with intermediate categories of legal training. These are just two out of many possibilities that could be constructively explored under a more antitrust-sensitive approach that takes seriously the lessons of North Carolina Dental and the competitive risks inherent to lawyer self-regulation of legal services markets. (An alternative and complementary policy approach would be to move certain areas of legal services regulation out of the hands of the legal profession entirely.)

Conclusion

The LegalMatch case is indicative of a largely unexploited frontier in the application of antitrust law and principles to the practice of law itself. While commentators have called attention to the antitrust concerns raised by the current regulatory regime in legal services markets, and the evolution of federal case law has increasingly reflected these concerns, there has been little practical action by state bar associations, the state judiciary or state legislatures. This might explain why the delivery of legal services has changed relatively little during the same period in which other industries have been transformed by digital technologies, often with favorable effects for consumers in the form of increased convenience and lower costs. There is strong reason to believe a rigorous and objective examination of current licensing and related limitations imposed by bar associations in legal services markets is likely to find that many purportedly “ethical” requirements, at least when applied broadly and without qualification, do much to inhibit competition and little to protect consumers. 

[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.

This post is authored by Eline Chivot, (Senior Policy Analyst, Center for Data Innovation, Information Technology and Innovation Foundation.).]

As the COVID-19 outbreak led to the shutdown of many stores, e-commerce and brick-and-mortar shops have been stepping up efforts to facilitate online deliveries while ensuring their workers’ safety. Without online retail, lockdown conditions would have been less tolerable, and confinement measures less sustainable. Yet a recent French court’s ruling on Amazon seems to be a justification for making life more difficult for some of these businesses and more inconvenient for people by limiting consumer choice. But in a context that calls for as much support to economic activity and consumer welfare as possible, that makes little sense. In fact, the court’s decision is symptomatic of how countries use industrial policy to treat certain companies with double standards.

On April 24, Amazon lost its appeal of a French court order requiring the platform to stop delivering “non-essential items” until it evaluates workers’ risk of coronavirus exposure in its six French warehouses. The online retailer is now facing penalties of about 100,000 euros (about $110,000) per delivery, and was given 48 hours to reduce its warehouse activities and operations. 

But the complexity of logistics would make it difficult to adjust and limit deliveries to just “essential items.” Given the novelty of the situation, there were no official, precise, and pre-determined lists in place, nor was there clarity about who gets to decide, nor was there a common understanding of what customers would consider essential services or goods. As a result, Amazon temporarily closed its six French distribution centers, and is now shipping to its French customers from its warehouses in other European countries. If France wants to apply such measure for worker safety in this time of crisis, that’s clearly its right. But the requirement should apply to all online retailers equally, not just to the American company Amazon.

The court’s decision was made on the grounds that Amazon had not implemented sufficient safety measures for its workers. The turnaround last week of trade unions (who had initiated the complaints against Amazon and called for the shutdown of its facilities) and their proposition to “gradually” resume operations speak volume. Like many other companies, Amazon had  invested in additional safety measures for its employees during the crisis, distributed masks and gloves to its workers, had taken their temperatures before their shifts, had built testing capacity, and proactively decided to prioritize the delivery of essential goods. Like many other companies, Amazon had to rapidly cope with unprecedented circumstances it wasn’t prepared to handle, while having to juggle a surge in online orders during lockdowns and make do with some governments’ unclear guidance regarding safety measures.

But France has long prioritized worker welfare over broad economic welfare—which includes worker welfare, but also consumer welfare and economic growth. Yet, in this case, that prioritization seems to only apply to Amazon. French retailers like Fnac, Cdiscount, Spartoo, and La Redoute did not face the same degree of judicial scrutiny despite similar complaints about distribution centers. Nor did they have to restrict their deliveries to “essential goods.” But in France, it seems, what is good for French geese isn’t good for U.S. ganders. In fact, the real issue appears to be the French application of industrial policy.  According to a union representative of Fnac, this is about “preventing Amazon from gaining market share over French retailers during lockdown,” so that the latter can reap the benefits. Using the crisis as an excuse to restructure the French retail sector is certainly one creative application of industrial policy.

Moreover, by applying these restrictions (either just to Amazon or across all retailers who engage in e-commerce), the French government is deepening the economic crisis. The restrictions it has imposed on Amazon are likely to accentuate the losses many French small- and medium-sized companies are already facing because of the COVID-19 crisis, while also having longer-term negative consequences for its logistics network in France. Many such firms rely on Amazon’s platform to sell, ship, and develop their business, and now have to turn to more expensive delivery services. In addition, the reduction in activity by its distribution centers could force Amazon to furlough many of its 9,300 French workers.

According to the unions, Amazon’s activity is judged “nonessential to the life of the country.” Never mind that Amazon partners with French retailers like Casino and is rescuing brands like Deliveroo during the crisis. In addition, online companies like Amazon, HelloFresh and Instacart hired more workers to manage growing demands during the crisis, while others had to furlough or layoff their staff. Beyond, French brands will need economically robust allies like Amazon to compete with Chinese state-backed giants like Alibaba that are expanding their footprint in European markets, and that have come under fire for dubious workplace practices.  

Finally, the French court’s decision is an inconvenience to the 22.2 million people in France who order via Amazon, depend on efficient home deliveries to cope with strict confinement measures, and are now being told what is essential or not. With Amazon relying on other European warehouses for deliveries and being forced to limit them to items such as IT products, health and nutrition items, food, and pet food, consumers will be faced with delayed deliveries and reduced access to product variety. The court’s decision also hurts many French merchants who use Amazon for warehousing and fulfillment, as they are effectively locked out of accessing their stock. 

Non-discrimination is, or least should be, a core principle of rule-of-law nations. It appears that, at least in this case, France does not think it should apply to non-French firms.

On March 31, a federal judge gave the city of Boston six months to rectify the disparities between the way it treats Transportation Network Companies (“TNC”) (such as Uber and Lyft) and taxicab companies. This comes pursuant to an order by US District Court Judge Nathaniel M. Gorton in a suit filed by members of the Boston taxi industry against the city and various officials. The suit is an interesting one because it reveals unusual fault lines in the ongoing struggle between taxi companies, local regulators, and the way that federal law recognizes and respects property and economic rights.

The three chief claims by the Boston taxi medallion holders are that the city had wronged them by by devaluing their medallions in violation of the Fifth Amendment’s prohibition on regulatory takings, by discriminating against them in favor of TNCs under the equal protection clause (“EPC”) of the Fourteenth Amendment, and by violating Massachusetts law under a theory of promissory estoppel.

On the federal claims, the court seems to get it half right, and half wrong.  In sum, Judge Gorton seems to get the takings argument more or less correct. He notes:

The exclusivity of medallion owners’ access to the market prior to the arrival of TNCs existed by virtue of the City’s regulatory structure rather than the medallion owners’ property rights.  Medallion owners have no property interest in the enforcement of Rule 403 against others  … If a person who wishes to operate a taxicab without a medallion is prevented from doing so, it is because he or she would violate municipal regulations, not because he or she would violate medallion owners’ property rights.

Indeed. The plaintiff’s takings argument essentially amounts to a claim that the government, by virtue of creating the medallion system, is thereby disabled from ever regulating in a way that disrupts medallion owners from making a profit. Efficiency concerns, consumer safety concerns, and the like be damned! takings can be a fairly complicated body of law, but it seems highly unlikely that the plaintiff’s view is right—for one thing, a medallion is much more like a business license subject to health and safety considerations than it is like a property right— and Judge Gorton handily disposes of the plaintiff’s claims.

However, on the EPC analysis Judge Morton’s analysis goes off the rails. He first properly notes that, as an economic rights claim, the EPC analysis is controlled by rational basis review. As the legally trained reader will already know,  “[r]ational basis review simply requires that there be “any reasonably conceivable set of facts justifying the disparate treatment.”

According to the Supreme Court:

[B]ecause we never require a legislature to articulate its reasons for enacting a statute, it is entirely irrelevant for constitutional purposes whether the conceived reason for the challenged distinction actually motivated the legislature.

And as Clark Neily, a constitutional litigator from the Institute for Justice, has noted: “Not only is the government invited to dream up entirely post hoc rationalizations for challenged legislation, it has “no obligation to produce evidence” in support of those rationalizations either.” (citing Heller v. Doe).

In short, rational basis review is an exceedingly easy burden for the government to meet when one of its regulations is challenged.

In this case, Boston offered a number of reasons that it decided to regulate TNCs and taxi companies differently, including a very strong one that doing so “enhances the city’s interest in increasing the availability and accessibility of cost-effective transportation[.]” Nonetheless, Judge Morton disagreed, holding that

[T]he Court finds persuasive plaintiffs’ argument that many of the obvious differences between taxis from TNCs, such as the kind of vehicle used and the fact that taxicabs must be clearly labeled, are caused by the City’s application of the requirements of Rule 403 to taxi operators but not to TNCs.  The City may not treat the two groups unequally and then argue that the results of that unequal treatment render the two groups dissimilarly situated and, consequently, not subject to equal protection analysis.  Such circular logic is unavailing.

The judge pegged his opinion to the fact that Rule 403 — which regulates “hackney carriages” — defines the subject of its regulations as “used or designed to be used for the conveyance of persons for hire from place to place within the city of Boston.” Both TNCs and taxi cabs arguably fit into this definition, thus for Judge Morton, despite the fact that the city offered at least two policy goals for its differential regulations, “[n]either objective is … rationally related to any distinction between taxi operators and TNCs.”

This just has to be wrong under current federal law. As I noted above, rational basis review requires “any reasonably conceivable set of facts”  and, even though the city created the distinctions itself through its regulations, the reasons it states for doing so — including increasing availability of transportation for its citizens — are definitely rationally related to its distinction between the two types of consumer carriers. Sure, Rule 403 provides a scope of regulatory power for the city that sweeps in both TNCs and taxicabs, but within that regulatory scope the City then has the power to “rationally” assign rules as it sees fit (unless someone comes up with a fundamental right here that is more important than economic interests, of course).

I get it, rational basis review of economic regulations is frustrating and often just provides a free pass to protectionist regulators. Nevertheless, it is the law, and I think that Judge Morton got the equal protection claim wrong.

The real lesson here? Don’t get into bed with government and expect a virtual monopoly to protect you indefinitely. It’s no secret that federal law provides scant little protection for economic liberty, so when the government decides it wants to do something that harms the industry that it was previously cozy with it’s just too bad. Maybe there is a future world in which courts will recognize the right to earn a living is as deeply important as the right to speak or practice your religion or vote — but that is not the world we live in today.

Moreover, when an industry depends upon the government to explicitly protect it from competitors it is the worst kind of cronyism, and, at least in this case, represents an economic mindset that is badly aging. As upstart competitors like Uber and Lyft discover new ways to deploy cost-effective (and generally just more effective) technology to manage different industries, the fig leaf of legitimate government intervention is stripped away and revealed for what it often is: protectionism.

So to some extent, I sympathize with  Judge Gorton’s instinct in the equal protection claim: it should be the case that the government is not allowed to pick winners and losers in the economy based on its own taking of the political temperature. But the larger lesson is the opposite of the plaintiff’s intention, in my opinion. The government should roll back the regulations that created the medallion industry in the first place, and find a way to strike a politically feasible deal that eases the taxi companies out of their well-painted corner. We need more competition and more service in pursuit of consumer choice, and we need much less industry control guided in a top-down manner by state fiat.