DRI-131 for week of 8-16-15: Hillary on CEO Short-Termism: Three Views

An Access Advertising EconBrief:

Hillary on CEO Short-Termism: Three Views

Among the mob of current candidates for President of the United States, the one most familiar to Americans is Hillary Clinton. As the First Lady to President Bill Clinton, she was a de facto Presidential advisor. She enjoyed official status as head of his proposed realignment of the nation’s health-care system. Her subsequent stints as U.S. Senator and Secretary of State kept her in the public eye.

Still, surprising as it seems, she faces the task of making her views known to voters during the current campaign. Mostly, this derives from her desire to downplay her past associations. Bill Clinton’s policies no longer resonate with her current constituency in the Democrat Party. Her health-care assignment was a disaster and she must find a way to dissociate herself from ObamaCare, so that subject is taboo. Thus, she finds herself in need of a political-personality makeover. Fortunately for her, personal reinvention is a Clinton family specialty.

Mrs. Clinton’s maiden voyage of reinvention was a recent speech in which she proposed to diagnose the ills of America business. She located the source in the CEO’s suite. The problem is that America’s CEOs are obsessively focused on short-term business results to the neglect of long-term performance. They are engaging in dividend payouts and stock buybacks rather than investing earnings to promote future growth. Having diagnosed the illness, she provides the cure; namely, higher capital-gains taxes with selective exemptions and reductions for “certain” businesses, communities and investments.

During an election cycle, any proposal advanced by any candidate receives predictable reactions. Opponents reject it scornfully and indignantly, impugning the candidate’s motives and qualifications. Supporters embrace it sincerely and naively, taking its expressed motivations at face value and its effects for granted.

Unless an observer has expert knowledge of the subject broached, it is hard to know which side to believe – assuming that one side or the other is believable. Mrs. Clinton’s inaugural policy position is as good an example as any to illustrate how to approach this sort of situation. To be sure, an economist has just the kind of expert knowledge needed to evaluate it. But the average person doesn’t. To complicate matters, that average person will be faced not only by the candidate, brandishing a bright, shiny policy statement, but by promoters and detractors of the candidate as well. What’s a mother to do in a spot like this?

Let’s use this early-season controversy as a test case. Having sketched Mrs. Clinton’s argument, we now amplify it by turning first to one of her supporters, then to a detractor.

The Case for Short-Termism: William Galston

In “Clinton Gets It Right on Short-Termism” (The Wall Street Journal, 07/28/2015), columnist William Galston declares that “Hillary Clinton has put her finger on a real problem: Too many CEOs are making decisions based on short-term considerations, regardless of their impact on the long-run performance of their firms.” As authority for his statement, Galston cites a public letter to the Fortune 500 CEOs by Laurence Fink, head of BlackRock, the world’s largest investment fund. Fink states that “…in the wake of the financial crisis, CEOs are “jeopardiz[ing] the ability of the[ir] compan[ies] to generate sustainable long-term returns” by eschewing investment spending for purposes of achieving future growth. Instead, they are choosing dividend distribution and stock buybacks.

Galston also cites historical data on earnings distributions for over 400 firms in the S&P 500 that were continuously present from 2004-2013. Stock buybacks comprised 51% of net income and dividend distributions were 35%, “leaving only 14% for all other purposes.” He compares this to 1981, when buybacks represented on 2% of earnings. In the interim, buybacks and dividends rose “inexorably,” to 25% from 1984-93, 37% during 1993-2003 and 47% in 2004-2013. “Some of America’s best-known corporations were returning more than 100% of their income to shareholders through buybacks and dividends” during the latter period.

Finally, Galston accuses CEOs of timing buybacks and company news releases so as to maximize their own income within company compensation formulas; for example, to take advantage of stock-option vesting.

The Case Against Short-Termism: Holman Jenkins

Holman Jenkins (“Hillary Vs. The Wisdom of Crowds,” The Wall Street Journal, 07/28/2015) characterizes Hillary Clinton’s remarks as “a speech to assure us that ultracompetent government can fix the failings of big business.” Those failings are not only those of CEOs, as cited by William Galston, but also those of shareholders and markets. Hillary is inveighing against “quarterly capitalism,” a philosophy she summarizes as “very real pressure from shareholders and the market to turn in good quarterly numbers.” Hillary claims, according to Jenkins, that it will take a “heroic policy effort to turn management’s attention back to ‘long-term growth, not short-term profits.'”

This policy effort consists of a complete revision of capital-gains tax policy. From a single capital-gains tax rate of 20%, Hillary would switch to 7 brackets ranging from zero (a special case applying to “certain” businesses, communities and investments) to 43.4% (on investments held for less than one year). Jenkins’ reaction to these provisions is to marvel at Hillary’s apparent belief that “America’s trouble is not enough rules, that the tax code is not complicated enough, that its distortions are not distorting enough.” This, he concludes, “seems insane.”

In promoting the doctrine of short-termism, Jenkins declares, Mrs. Clinton is spouting “an ancient jeremiad… a moldy-oldy from the 1980s,” for which there is “little academic evidence” or even “anecdotal evidence.” After all, he reminds us, the stock market shows great impatience with McDonald’s and endless patience with Amazon, both of whom have come up consistently short in the profits department in recent years. It seems that Hillary Clinton “would string syllables together in any order if she thought it would get her to the White House.”

CEOs and Capital Allocation: A Common-Sense View

So far, we have briefly outlined Hillary Clinton’s complaint against American CEOs and her policy proposal to improve corporate allocation of capital. We have viewed it from the perspectives of two commentators, a supporter and an opponent of Mrs. Clinton’s Presidential candidacy. Before providing the perspective of an economist, we should recall that millions of Americans do not have an economist on call. At present, there is no online economic advice hotline comparable to those offering medical and veterinary advice. How should the average American – who is unfamiliar with economic theory and logic – react when confronted with contradictory views on policy proposals such as Mrs. Clinton’s? After all, somebody without any expert knowledge simply sees and hears a candidate spouting off. Presumably, the candidate is motivated by his or her self-interest no matter how noble and public-spirited the candidate’s rhetoric may be. The commentators are nothing if not decided – this is what lawyers call a “swearing contest,” a “he-said, he-said” debate that is liable to give the average person a headache but not much in the way of enlightenment.

Saying that we should use our “common sense” is no good when common sense is not common or not commonly applied. The following is a process of reasoning that leads to the same conclusion as a priori economic theory.

If we are to accept Mrs. Clinton’s view, we must believe her story. It is roughly this: The CEOs of over 400 diverse corporations across America adopted the same policies toward capital budgeting – namely, reduction of investment spending in favor of dividend payout and stock buybacks – over a period of 30 years. Why? Mrs. Clinton says they did it to feather their own individual nests at the expense of their shareholders and, incidentally, the general public. Is this credible?

No. It is logical for the average person to assume that the CEOs must have been acting independently rather than collusively. (When we marshal the economic logic against short-termism, we will see why economists know this to be true.) Is it logical to think that a large group of people (mostly men, with a few women included) would abruptly begin to violate the canons of business responsibility and become steadily more irresponsible over time – simultaneously and while acting independently of each other? Tentatively, the answer is no, depending on whether any alternatively explanations for their behavior exist. What if they were responding to the same set of external circumstances, which caused them to react more or less identically because they all perceived those circumstances as requiring their change in behavior? Yes, that is surely a more likely explanation – the CEOs were responding to changes in the world around them which they all perceived as constituting a progressively less favorable investment climate. They were making the best of this unfavorable situation by distributing earnings to shareholders via dividends and share buybacks. They were not acting irresponsibly – although they could have been mistaken – they were guided by the force of circumstances as they perceived them.

Rather than simply rely in visceral instinct and emotion, observers should step back, take a deep breath and ask themselves if the candidate’s story makes sense. Mrs. Clinton’s story rings false in almost every way, the sole exception being her insistence that CEO’s time the execution of buybacks and release of corporate news to suit the vesting of their stock options or similar benefits. As paraphrased by William Galston, Mrs. Clinton’s allegations of CEO misbehavior are a variation on the age-old left-wing fallacy of the variability of human nature. Rather than being a constant, the political Left finds it convenient to assume that human self-interest varies dramatically up and down to suit their political needs. When something goes wrong with a government agency, policy or proposal, the Left can assign the blame to “greed” rearing its ugly head and prescribe a strong dose of big government as the cure. This is what Mrs. Clinton does here, with her call for seven different capital-gains tax brackets and her caveat that exemptions would apply to “certain” industries, communities and investments.

The average person knows from his or her own inner sense of human nature and personal experience of life that self-interest is a constant reality, not a virus that can suddenly flare up to epidemic proportions. Does that average person appreciate the multitude of circumstances that CEOs react to? No, probably not – but in this case the clue to evaluating Mrs. Clinton’s argument is right there in plain sight in William Galston’s article. He quotes Laurence Fink to the effect that the recent decline in investment spending and increase in dividend payouts and buybacks came “in the wake of the financial crisis” [emphasis added]. In other words, the CEOs didn’t just get greedy all of a sudden. They were reacting to events of 2008-2009 and looking to the future. And the average person can appreciate that, in retrospect, the CEOs’ anticipations for that future were pretty accurate.

Maybe the most important point to grasp is that this common-sense reasoning process has nothing to do, one way or the other, with what the average person thinks about any CEO’s personality. The CEO might be warm and compassionate, cold and heartless or anywhere in between – it doesn’t matter. The question is: What could reasonably motivate changes in CEO behavior, regardless of what kind of person the CEO is? The average person doesn’t know any CEOs and has no basis for assuming what any of them are like. It isn’t necessary or important to speculate on their personal qualities. The only thing the average person is entitled to assume is that the CEO has some minimal level of competence within his or her limited business sphere.

CEOs and Capital Allocation: An Economic View

Economists implicitly accept the common-sense view outlined above. They know that CEOs acted independently during the 30-year period referenced by William Galston. Collusion between many hundreds of CEOs is unthinkable. First, it would require acquiescence by company directors who have no obvious reason to go along with this dereliction of their fiduciary duty unless they were bribed. Second, every CEO would have an incentive to violate the collusive agreement if Galston’s scenario were correct. Third, there is no obvious means of making or enforcing such an agreement. These objections are decisive.

A few economists, such as Robert Higgs of the Independent Institute, have complained for years that investment spending has nosedived in recent years. Unlike Hillary Clinton, though, they do not identify a sudden upsurge in executive greed as the cause for this decline. Rather, the cause is the constellation of unfavorable external circumstances created by disastrous government policies.

Monetary expansion and artificially low interest rates. The average person has probably heard many times that the Federal Reserve lowers interest rates to encourage business borrowing, which stimulates production and income. If it were really this easy, we would never have recessions and unemployment, let alone Great Recessions or Depressions. There are various planted axioms underlying the simplistic Keynesian economics that gave rise to the myths behind easy money Fed policies. Most pertinent to our case are the assumptions that businesses would borrow because they anticipated producing additional output and selling all that they produce. If these assumptions don’t hold, then the low interest rates won’t have their anticipated effect.

In recent years, high unemployment has coexisted with high rates of job vacancy and low rates of labor-force participation. This has not encouraged business to believe that they can produce additional output if they borrow at the lower rates of interest. Shaky levels of consumer confidence have not encouraged business managers to think that they can sell additional output even if it is produced.

Perhaps most important of all has been the distinction between low interest rates as the natural outcome of a free market and low rates artificially contrived by the monetary authorities. The “Zero Interest Rate Policy (ZIRP)” maintained by the central bank in the U.S. and elsewhere does not allow the a priori savings desires of the public to equalize the investment demand of businesses at a free-market interest rate. Since there is no reason to think that actual interest rates reflect the true saving and investment desires of individuals, that means that businesses cannot draw any inferences about the future from existing interest rates. In a free market, interest rates are the informational link between the present and the future. When government severs that link, businesses cannot plan effectively. They cannot assume that the total supply of future goods produced will bear a reasonable relation to the volume of goods that people have been saving up to buy. This naturally makes business managers more cautious than they would otherwise be – no matter how low the nominal interest rate may be. If you can’t sell the output you’re producing with your brand new investment goods, it is little consolation that you got a great deal on the loan used to buy them.

Keynesian economists sometimes object that policies like Quantitative Easing affect only short-term interest rates, while investment spending typically involves a long term to maturity. But it is precisely this longer term that is most affected by the loss of interest rates as a planning tool. If we ever doubted it, our recent experience should have taught us once and for all that interest rates are comparatively trivial as a policy tool for government but they are invaluable as a planning tool for business.

Regulatory Costs and Uncertainty. The last 30 years have seen a steady procession of regulations and related costs. These costs have reduced investment by reducing the net earnings that finance it. In addition, the expectation of future regulation casts a pall over investment by increasing the probability of future cost increases.

When the Dodd-Frank bill was passed, it was advertised as a fail-safe measure designed to safety-wrap business against future failure in a crisis like the financial crisis of 2008-2009. Its costs and uncertainties of meaning and enforcement have proved so burdensome that they have pushed investment spending onto the back burner for the nation’s businesses. The regulatory present has pushed the business future into the deep shadows.

Bank regulation has made getting a loan so tough that the benefits of a lower interest rate have been more than counterbalanced. The derelictions of lenders during the real-estate bubble gave regulators such a black eye that they resolved to protect themselves in future by simply erring in the opposite direction of not approving loans, figuring that it will be much harder to blame them for this than for being too lax.

Mrs. Clinton’s assertions that she will, somehow, beneficially apply her seven-bracket capital-gains system to wring net benefits for us strains credulity. General reductions in capital-gains taxes have actually increased revenue in the past, but Mrs. Clinton’s plan calls forth memories of the wisecrack about the Clintons’ tenure in Arkansas. The Clintons believed in reducing taxes on business, so the joke went, “one business at a time, starting with their friends.” That is exactly the aroma wafting up from Hillary’s capital-gains brackets – the aroma of political favoritism.

Lack of Business Start-Ups and Entrepreneurship. The occasional technological success has somewhat obscured the generally dismal picture in business startups over the last decade. This is referred to explicitly by Holman Jenkins. This is another argument that strongly reinforces the common-sense conclusion reached above. If CEOs were able to able to work their will unhindered on shareholders and the general public, this would presumably have encouraged more people to start businesses. The fact that business startups have plummeted in the last 10 years suggests that external circumstances, not CEO misbehavior, are the root cause of the decline in business investment.

The Short Run and the Long Run. Mrs. Clinton takes it for granted that a focus on short-term profit is mutually exclusive with long-run performance. If by “performance,” she means “profit maximization” – and to an economist there is very little else that could be meant other than that – this is nonsense. By the terms of her own argument, Mrs. Clinton declares that long-run investment spending is necessary for growth and long-run “performance.” Precisely where could this long-run investment spending come from if not from short-run profits? After all, this is the debate – should short-run earnings be rebated back to shareholders via dividends or buybacks, or plowed back into the firm via investment?

Ironically, during the 1960s and 1970s, the political Left was excoriating CEOs and management for capital allocation, too. But in those days they were blaming management for shorting shareholders by reinvesting too much of the earnings and not returning enough in dividends! This was the outcome of a philosophy propounded in the 1930s by political scientist Adolf Berle and economist Gardiner Means in an extremely influential book warning that the modern corporation had created a “separation of ownership and control” that left management in the driver’s seat and the shareholders on the outside looking in. The board of directors was a rubber stamp for the CEO and the company was run for the benefit of management – and the proof was the overemphasis on investment and growth and the decline of dividend payouts!

Now, suddenly, the pendulum has shifted in the opposite direction. The only constant on the Left is that the corporation is bad and managers are the villains, although the reasoning now runs in the opposite direction.

In fact, there is no way that management can somehow ignore the long run and focus solely on the short run. The long run is a succession of short runs, so a constant focus on the short run cannot help but focus attention on the long run as well. The concept of discounted present value takes business revenue, cost and marginal revenue product of inputs and expresses their estimated future values in terms of a single present value by means of the practice of discounting. In this way, future values are telescoped back to the present day in value terms. The long run is united with the short run; the future is united with the present rather than being separated by the barrier of time. Markets automatically take account of the long run, whether we realize it or not – as long as interest rates and capital markets are allowed to work.

Viewing the situation as an economist, it is not hard to see why investment spending has slowed to a trickle. If we didn’t know better, we might easily suppose that the federal government had declared a “war on business investment spending.”

Short-Termism Weighed in the Balance

The economic case suggests that the arguments of Holman Jenkins are much closer to the mark than those of William Galston. It is true that one of Hillary’s shots from the hip found its mark; namely, her reference to CEO timing of events to maximize their own compensation. This certainly accords with the philosophy of self-interest, although the notion that shareholders are hurt by this practice is greatly overblown since it is not easy to show where the damage lies. But by the time we have finished shooting down the rest of Mrs. Clinton’s arguments, they are in shards.

As was demonstrated here, one need not be an economist or even know basic economics to recognize the fallacy at the heart of Mrs. Clinton’s contrived case against CEO short-termism. All that is required is a determined application of straightforward logic.

DRI-173 for week of 8-2-15: The Donald Trumped

An Access Advertising EconBrief:

The Donald Trumped

The office of President of the United States has been held by some strange specimens since George Washington first gave in to public demand in 1792. The range of aspirants to the job has been even broader, running from children to comedians to ventriloquist’s dummies to just plain dummies. There may never have been a more outrageous candidate than Donald Trump who was (1) competing for the nomination of a major party; (2) taken seriously by all and sundry; and (3) who made a king-sized dent in the polls immediately upon announcing for the job.

Trump’s Presidential-campaign announcement speech created a sensation. The public is still talking about it and so are the other candidates. (There are so many Republican candidates that when they talk simultaneously it creates a deafening roar.) Trump’s extemporaneous remarks focused disproportionately on the subject of illegal immigration and international trade. That puts his remarks within the purview of this space.

In order to preserve the unique flavor of his speech, Trump will be quoted extensively. As will soon become clear, it is hardly necessary to wrench Trump’s words from their context in order to reveal him as one of the most economically illiterate men ever to seek the office of President.

Introductory passages are in plain type. Trump’s comments are in quotes. The valid economic analysis – envision Trump being interrupted in stop-motion – is in italics.

Trump on Trade

When lecturing on any topic, you can’t go wrong by starting with fundamentals. Trump began the announcement of his run for the Presidency by burnishing his credentials as an expert on the subject of international trade.

“When was the last time anybody saw us beating, let’s say, China in a trade deal? They kill us. I beat China all the time. All the time.”

Trump has introduced a novel understanding of the concept of a “trade deal.” It implies that one side tries to defeat the other, that a deal is a bargain struck between adversaries. In actuality, this does not apply to trade deals negotiated between countries just as it does not apply to trade between individuals. Commercial trade between individuals – whether intranational or international in scope – is voluntary, hence mutually beneficial. If it were not so, the voluntary character would preclude it. The same is true, at least in principle, for nations. The difference between a negotiated trade deal and voluntary individual trade comes when we consider whether the negotiators have truly represented their own national interests or, instead, sectoral “special” interests. But that doesn’t change the fact that negotiators to a trade deal are striving to achieve mutual benefit, it merely makes the content of “mutual benefit” subject to what economists call the “agency problem” – the nation’s consumers may not have anybody representing their interests at the negotiations.

Trump’s adversarial concept of negotiation does apply to certain types of negotiations, such as those between victor and vanquished at a war’s conclusion, or between those in power relationships rather than voluntary ones. A plea bargain is an example of a negotiation in which one party’s acknowledged inferior status severely limits their negotiating options. These are in no way analogous to international trade or commerce in general. This fact can be established by reference to the noted author and business expert Donald Trump in his bestselling book “The Art of the Deal.” In other words, Trump the Presidential candidate is vociferously contradicting Trump the billionaire businessman and celebrity author.

Trump’s claim that he, Trump, “beat[s] China all the time” is indecipherable in this context since he is not a trade negotiator nor is he in competition with the nation of China in any meaningful economic sense. The straightforward interpretation of this sentence is that Trump suffers delusions of grandeur, not unlikely given various quoted passages that follow.

“When did we beat Japan at anything? They send their cars over by the million and what did we do? When was the last time you saw a Chevrolet in Tokyo? It doesn’t exist, folks. They beat us all the time.”

Trump’s reference to “we” and “Japan” in the context of automobile production is a classic example of the “collective fallacy;” Japanese cars were (and are) produced by particular companies that happen to be domiciled in Japan. These companies are no more physically representative or metaphorically symbolic of Japan as a whole than (say) General Motors is of the United States of America. Moreover, the most successful Japanese automakers have established production facilities for their cars in the U.S., thereby defusing the fallacious claims that their activities were somehow “stealing our jobs.” The end-in-view behind all economic activity is consumption. None of the countless millions of Americans who drove automobiles produced by those Japanese companies would dispute the economic value of their activities. In no sense were those drivers – or any other American – “beaten” by the competition meted out by Japanese automakers to American car makers, just as Americans have always benefitted from intranational competition between American firms.

Trump’s characterization of the Japanese as the Mongol hordes of international trade seems bizarre when we look out our windows and see that Japanese economic growth has been flat on its back for over two decades. How does this square with Trump’s tale of conquest?

Intraindustry (two-way) trade is not unheard of in the international realm, but the absence of Chevrolets in Tokyo says nothing of consequence about American industry or politics.

Trump is continuing to employ the metaphor of war in discussions of business and trade. This is bad form in a layman, incredible in an experienced businessman and utterly inexcusable in a (Republican) Presidential candidate.

“When do we beat Mexico at the border? They’re laughing at us, at our stupidity. And now they’re beating us economically. They are not our friend, believe me. But they’re killing us economically.”

Once again, we are at war – this time with Mexico, who is “beating us economically.” Since trade is voluntary and mutually beneficial, this is an oxymoron – fittingly uttered by a moron. For decades, opponents of Mexican immigration into the U.S. derogated the Mexican government for its inept economic management, which ostensibly created such a poor economic climate that its poor had no alternative but to migrate here. Now Trump is excoriating Mexico for being too successful; its politicians are evil geniuses (“they are not our friend”) who are cleverly plotting our economic demise.

Meanwhile, we are now the stupid ones – everybody except Trump, that is. The situation has changed 180 degrees, except that Mexican politicians are still villains, Mexican immigrants (as we will see below) are still bad and Americans are still helpless victims. Except for Trump, that is.

“The U.S. has become a dumping ground for everybody else’s problems.”

Considering that what is being “dumped” here are goods and services and people to make goods and services, it would seem that the world is chock full of countries that would love to have these “problems” foisted on them.

Trump on Illegal Immigration

“…when Mexico sends her people, they’re not sending their best. They’re not sending you, they’re not sending you. They’re sending people that have lots of problems and they’re bringing those problems with us [sic]. They’re rapists. And some, I assume, are good people.”

This section includes probably the most quoted line from any presidential announcement speech. The phrasing is strikingly inapt. Immigrants are not “sent;” they voluntarily choose to leave their country of residence. This is a momentous decision. It entails learning a new language, adapting to an alien environment with different mores, absorbing a foreign culture and potentially accepting foreign citizenship. Emma Lazarus’s famous poem suggests that 19th-century immigrants to the U.S. were the “wretched refuse” of foreign shores and there was much truth in that. But it takes guts, initiative and courage to emigrate – and that goes double for illegal immigrants who are risking their lives just by crossing the border. The subject of immigration has attracted scads of research that overwhelmingly supports these common-sense conclusions. We may deduce that immigrants are not normally “the best” that foreign countries have to offer because that would vitiate the desire to leave. On the other hand, the worst generally lack the gumption to make the effort or to succeed if they do. 

What could Trump possible be thinking of? At the time he spoke, the only possible connection with reality seemed to be the notorious “Mariel boatlift,” in which Cuban dictator Fidel Castro reportedly deported a collection of criminals and undesirables to the U.S. in 1980. Since this was not voluntary immigration, though, it had nothing to do with Trump’s ostensible subject. Incredibly, Trump subsequently confirmed this connection by later categorically accusing the Mexican government of doing essentially what Castro had done – deporting criminal undesirables to the U.S. in order to cause mayhem here. Needless to say, he offered no evidence to back up this fantastic charge.

Meanwhile, Trump’s astounding decision to demonize immigrants as drug dealers, criminals and rapists made him an instant hero among the nativist lunatic fringe and an instant villain everywhere else. The respectable research on this issue has long been virtually unanimous. It is briefly summarized by Jason Riley in The Wall Street Journal (07/15/2015): “…while the illegal immigrant population in the U.S. more than tripled between 1990 and 2013…’FBI data indicate that the violent crime rate declined 48% – which included falling rates of aggravated assault, robbery, rape and murder.'” (Property crime fell by 41% as well.) Just in case anyone should suspect the presence of confounding factors, Riley makes it more explicit. “‘For every ethnic group without exception, incarceration rates for young men are lowest among immigrants…This holds true especially for the Mexicans, Salvadorans and Guatemalans who make up the bulk of the undocumented population.” If we single out states where large populations of illegal immigrants are known to live, that still holds true. “…Numerous studies going back more than a century have shown that immigrants – regardless of nationality or legal status – are less likely than the native population to commit violent crimes or to be incarcerated.” If anything, this differential has grown more pronounced in recent years. Since Trump cites no research, his audience must assume he relies entirely on episodic reports of violence committed by illegal immigrants.

To top it all off, the makeup of the immigrant population today (particularly the illegal segment) originates predominantly from Catholic countries and thus tends to be deeply religious. In The Wall Street Journal, Russell Moore and Samuel Rodriguez point out that Trump offended evangelical Christians throughout America with his repeated attempts to stigmatize immigrants.

“But I speak to border guards, and they tell us what we’re getting. And it’s only common sense. They’re sending us not the right people.”

After listening to Trump, it is hard to suppress the reflex to demand that he produce one border guard – just one – to support his claims. After all, illegal immigrants are – by definition – people not caught by border guards. It is difficult to consider border guards as the reigning authorities on those they don’t catch. If illegal immigrants are really, truly drug dealers, criminals and rapists, why does Immigration and Customs Enforcement (ICE) spend the bulk of its time staging raids on legal businesses like packing plants, construction firms and hotels? Isn’t it odd to find drug dealers and rapists spending the bulk of their day doing hard work?

And this is what Trump calls common sense?

“It’s coming from more than Mexico. It’s coming from all over South and Latin America, and it’s coming probably – probably – from the Middle East. Because we have no protection and we have no competence, we don’t know what’s happening. And it’s got to stop and it’s got to stop soon.”

As noted above, the bulk of illegal immigration apparently stems from Mexico, El Salvador and Guatemala – hardly “all over Latin America.” Trump cites no evidence of illegal immigration from the Middle East, although presumably he could have cited the legal immigration of several of the 9/11 bomber pilots if he chose. Trump’s stream-of-consciousness prose is so confusing that we don’t know if he is trying to warn us of a danger that only he can see or if he is concerned about our common ignorance. But his use of the pronoun “we” when bemoaning our lack of competence is well-chosen. His hints of a worsening situation that must be corrected for fear of dire consequences are ironic given (1) the existence of illegal immigration for decades; and (2) its slackening since 2009 as U.S. economic growth has slowed relative to Mexico’s.

“I would build a great wall, and nobody builds walls better than me, believe me, and I build them inexpensively. I will build a great, great wall on our southern border. And I will have Mexico pay for that wall.”

Reviewing the details of Trump’s speech and its later follow-up, it seems that (1) “Mexico is not our friend”; (2) Mexico’s political leadership is deliberately deporting criminals and undesirables to the U.S. in order to do us harm; (3) if elected President, Trump intends to build a massive wall stretching the length of the U.S. border with Mexico (one of the world’s longest); and (4) if elected President, Trump intends to force the Mexican government to pay the costs of construction for the wall. Currently, millions of legal border crossings between Mexico and the U.S. occur daily, but Trump apparently intends to replace this mutually beneficial status with a state of hostility, perhaps even war. Only war, or its threat, could be expected to achieve his aims.

 

Trump on What’s Wrong With the U.S.

“…a lot of people up there [sic] they can’t get jobs, they can’t get jobs, because there are no jobs; because China has our jobs and Mexico has our jobs. They all have jobs.”

Overlooking the obscurity of Trump’s prose, it is easy to spot the ancient “lump of labor” fallacy. There is no fixed quantity of jobs for the world to fight over; instead, the number of jobs varies with the kind and variety of goods and services demanded by consumers and produced by firms. Until Bill Gates and Steve Jobs came along, we didn’t realize that many of the jobs done today even existed. Many jobs performed throughout mankind’s history no longer exist and some done today will no longer exist tomorrow. 

No country holds a property right on jobs because economic efficiency dictates that production should occur at its most efficient locus. Since that varies with time and circumstance, jobs move from place to place within a country and between countries. As consumers, we shouldn’t want it any other way and we don’t – unless our name is Donald Trump and we need ammunition to fuel our Presidential ambitions.

Trump thinks so little of his audience that he expects us to overlook obvious inconsistencies in his argument. Mexico is one of Trump’s villains. (Mexico’s government or its citizens? Or both? Trump is willing to leave it to our imagination.) Mexico is villainous because its policies are so successful; it beats us and all its citizens have jobs while ours don’t. Uh…but if all its citizens have jobs and Mexico’s policies are so successful and they are beating us, why is Mexico flooding us with immigrants? Why is Mexico filled with criminals and undesirables that she must export to the U.S.? Why doesn’t all of Latin America simply emigrate to Mexico, where they can speak Spanish, instead of to the U.S.?

Trump has exquisitely timed his revelation that “China has our jobs.” As he spoke, pundits were alarmed at the prospect that China’s imminent economic collapse was the real danger to the world economy, not Greece’s.

“I’ll bring back our jobs from China, from Mexico, from Japan, from so many places. I’ll bring back our jobs and I’ll bring back our money.”

There are no reports from Japan on the reaction to Trump’s contention that they have our jobs – perhaps they were stunned into submission since the Japanese have suffered a historic lapse of economic growth for over two decades. Trump’s promise to “bring back our money” to a nation awash in liquidity must qualify as one of the great economic howlers of all time. Even the Japanese, the first to resort to quantitative easing as a full-bore policy tool, have reverted to this easy-money stance once again. If there is one thing the world doesn’t need, it is more money.

“…when was the last time you heard that China is killing us? They’re devaluing their currency to a level that you wouldn’t believe. It makes it impossible for our companies to compete, impossible. They’re killing us.”

If economics were like the Olympics, in which “our” companies competed with the rest of the world and all our citizens got satisfaction from their “gold medal” business success, Trump might have a point. But the analogy is way off base. We get satisfaction from the kind, quality and variety of goods and services produced, regardless of who produces them. Economically, there is no such thing as “our” companies, despite never-ending attempts by import-competing producers to seduce our allegiance on purely patriotic grounds.

In the 1930s, governments used competitive currency devaluation to win brownie points with their business constituents. But every commentator has cited this as a major contributor to the severity of the Great Depression. When one country devalues, others retaliate and the end result is that world trade shrivels to a cinder. Fortunately, that has yet to occur in our day. Trump’s repeated insinuation that the Chinese are evil geniuses at the Oriental practice of currency manipulation is yet another tactic of demonization.

“…you’re [Ford, who is proposing to build a $25 billion car- and truck-parts plant in Mexico rather than the U.S.] going to take your cars and sell them to the United States, zero tax, just flow them over the border? Where is that good? It’s not… Every car and every truck and every part that comes across the border, we’re going to charge you a 35% tax.”

Trump has taken the very concept of economics – the meaning of economic efficiency and consumption as the purpose of economic activity – and stood it on its head. In effect, he has said: “As President, I will penalize a firm for producing in the most efficient place if that place lies outside the borders of the U.S., and in the process penalize every citizen of the U.S. who is a potential consumer of that firm’s goods. In so doing, I will create a large aggregate amount of harm for a huge number of people while creating a small aggregate benefit (but large individual benefit) for a small number of people. In other words, I will create the reverse of economic growth.” This is the antithesis of free trade and mutually beneficial voluntary exchange. The Founding Fathers deliberately designed the Constitution to prevent this kind of thing from happening in interstate and intrastate commerce, but Trump is calling it a great thing in international trade.

“…I’m a free trader. But the problem with free trade is that you need really talented people to negotiate for you. If you don’t have talented people, if you don’t have great leadership, if you don’t have people that know business, not just a political hack that got the job because he made a contribution to a campaign, which is the way all jobs, just about, are gotten, free trade terrible” [sic].

Having spent his entire speech trashing everything that the concept of free trade stands for, Trump now asserts that he is a free trader. Taken at face value, this is a ghastly joke.  In fairness to Trump – the last person on earth who deserves a scrupulous effort in that direction – this attitude is common in the business world. Businessmen often say they would favor free trade if only the world didn’t put them at a disadvantage. But the purpose of free trade is to exploit whatever differing circumstances exist in different places – that is what gives rise to the differences in cost and price that make free trade profitable to consumers. If everything were equal everywhere and we had the “level playing field” that business demands, free trade would be superfluous and it wouldn’t occur.

Trump seems oblivious to the whole idea of voluntary trade between people; he refers only to negotiated trade deals between governments. Trump claims that we need “people that know business,” but he obviously doesn’t know it himself.

“…you know, China comes over and they dump all their stuff and I buy it. I buy it because, frankly, I have an obligation to buy it because they devalue their currency so brilliantly, they just did it recently, and nobody thought they could do it again…and it’s impossible for our people here to compete.”

One can only dissolve in helpless laughter when Trump, in the process of hard-selling himself as omnicompetent and omnipotent, suddenly blurts out that he is mesmerized by the brilliance of China’s monetary manipulation. The man who is going to force nations to do his bidding is hypnotized when China “dump[s] their stuff” and has to buy it because “they devalue their currency so brilliantly.

Trump Cleanup

In order to convey Trump’s sense of his own importance, this analysis includes a summary of Trump’s statement of intention regarding various non-economic (or marginally economic) matters. To wit, Trump will personally:

Destroy ISIS.

Save Social Security, Medicare and Medicaid without cutting benefits for recipients simply by eliminating waste, fraud and abuse in those programs.

Renegotiate all our foreign-trade deals.

Reduce our unsustainable federal-government debt – which he estimated variously during the speech at $16 trillion, $8 trillion and $18 trillion.

Rebuild our infrastructure at one-third the cost that our governments now pay.

Deal with the threat(s) posed by China.

End Common Core.

Repeal ObamaCare.

Rescind Obama’s executive immigration order.

Stop Iran from getting nuclear weapons.

Find the General Patton and General MacArthur in the U.S. military.

Trump made no mention of the fact that presidents lack the authority necessary to accomplish almost all the things he promised to do.

Trump in Summation

Readers who are convinced that Trump must have had something good and worthwhile to say in his Presidential announcement are encouraged to consult the text and try to find it. They will discover that this analytical synopsis has accurately portrayed a man so self-absorbed and heedlessly self-confident that he has not performed the routine self-criticism demanded of a public performer, let alone a public servant.

Americans benefit enormously from the practice of immigration. Key industries such as construction, agricultural labor, hospitality and restaurant service are staffed with immigrant labor to a predominant or important degree. We gain from this in the same way as we gain from domestic oil produced by processes such as fracking. In this sense, immigration is a “production process” that makes cheaper and/or more productive labor available, just as fracking is a production process that makes oil recovery more productive. Some 25 years ago, economists Stephen Moore and Julian Simon conducted a poll of economists in which they asked whether the benefits of immigration depended on whether immigration was legal or illegal. Over 90% of economists surveyed said it did not matter. The only surprising thing is that the vote wasn’t unanimous, since the benefits provided by immigration do not depend on how the immigrant arrived in this country. Trump’s speech displayed no cognizance of this economic reality.

No Republican in living memory has flaunted utter ignorance of economics so brazenly as Donald Trump. Trump’s strong showing in the polls after his announcement is proof that the Party is in danger of becoming incoherent to the public or worse. Trump is a modern-day Senator Bilbo; his way leads to extinction.

DRI-174 for week of 7-26-15: Oncologists’ Plea for Government Regulation of Cancer-Drug Prices is Dead Wrong

An Access Advertising EconBrief:

Oncologists’ Plea for Government Regulation of Cancer-Drug Prices is Dead Wrong

Economists learn to recognize a special-interest plea the way an ornithologist recognizes a bird call. The mellifluous sounds of special pleading were uttered last week by some 118 oncologists from leading cancer hospitals throughout the United States, who issued a statement calling for government regulations limiting prices of prescription drugs for the treatment of cancer. The statement was published in the form of an editorial in the medical journal of the prestigious Mayo Clinic in Rochester, MN. The signers hailed not only from Mayo’s but from such distinguished institutions as M.D. Anderson in Houston, TX, the Dana Farber Institute in Boston, MA and the University of Chicago.

The Attack on Drug Prices

As Jeanne Whalen of The Wall Street Journal told it (“Doctors Attack Drug Prices,” 7/23/15), “more than 100 oncologists from top cancer hospitals around the United States have issued a harsh rebuke over soaring cancer-drug prices and called for new regulations to control them.” These are the “latest in a growing roster of objectors to drug prices,” from “doctors to insurers to state Medicaid officials” to “have voiced alarm about prescription-drug prices.” Prices of prescription drugs rose an estimated 12% last year, the largest annual increase in the U.S. in over a decade.

And why does a price increase call for protest by the nation’s doctors? According to the editorial in the Mayo Clinic Proceedings, “out-of-pocket costs are bankrupting many just as they’re fighting a deadly illness. Patients have to make difficult choices between spending their incomes (and liquidating their assets) on potentially lifesaving therapies or foregoing treatment to provide family necessities.” According to the authors, some 10-20% of cancer patients do not take their prescribed treatments because they lack sufficient funds to do so.

Congress consists of people who live for the purpose of getting elected and re-elected. They are alert to every opportunity for gaining political advantage in the same way that entrepreneurs are alert to profitable market-price discrepancies. Hence we expect members of Congress to jump on the bandwagon of objections to drug prices. And sure enough, “members of Congress have demanded that pharmaceutical companies justify the pricing of hepatitis C medication, which costs tens of thousands of dollars per patient. Sen. Bernie Sanders has advised the Department of Veterans Affairs to break the patents on hepatitis C drugs so that generics companies can manufacture them more cheaply for ailing veterans.”

Trustees of the Medicare system predict that average annual increases in prescription-drug spending will rise by 9.7% through 2024, compared to the 6.5% annual increase over the previous eight years. Naturally, high prices for new medications are viewed as the culprit for these projected increases and the budgetary problems that will ensue.

The word “cancer” serves as a lightning rod to attract a disproportionate share and level of all this criticism. In the last fifteen years, prices for drugs to treat the disease have risen “five- to tenfold.” In 2012, the average cancer patient’s prescription medication cost over $100,000 per year.  Today, some new immune-system-boosting drugs cost over $150,000 per year or more. When used in “cocktail”-type combinations, they can run up a tab exceeding $300,000.

A spokesman for the oncologists, Ayalew Tefferi of Mayo Clinic, hit the keynote for true believers in government regulation of markets. “What we’re fighting is the greed. The greed and the additional maneuvering that is being exercised after you’ve already recouped what you’ve invested. There is no control, no regulation.”

To summarize the position of the objectors to high drug prices: High prescription drug prices – and increases in those prices – are ipso facto a bad thing. The motive force behind that bad thing is the greed of the price-setters; namely, the executives of pharmaceutical companies who produce the drugs in question.

The “Neutral” Press

There is another interested party in this story whose stance has not yet been made clear. In principle, the press does not participate in the news stories it reports. It is merely the messenger reporting the news. Alas, that principle is freely disregarded. Today the press is a partisan with its own agenda.

That agenda is on display here. The author, Ms. Whalen, dutifully devotes a short paragraph of summary rebuttal to the position of pharmaceutical-company executives. Its medicines “provide great value to patients and the health-care system… high prices are needed to fund future research and development.” A spokesman for a pharmaceutical trade association is quoted in a single sentence citing the falling cancer death-rates, rising survival rates and improvement in quality of life for patients.

Then she gets down to making her case against the pharmaceutical companies and in favor of government regulation. “Yet critics increasingly question whether the industry’s U.S. pricing truly reflects the value and R&D costs of medication, or simply what the largely unregulated market will bear. In most other countries, including Canada and European nations, single-payer health-payer systems bargain hard with pharmaceutical companies, sometimes refusing to pay for drugs they deem unreasonably expensive. As a result, prices are often far lower in these markets.”

“The U.S., by contrast, finds it hard to say no. ‘The U.S. has always taken a very hands-off attitude, that patients are going to have access to new medical treatments regardless of the cost,’ said David Howard [a professor of health policy]. For a big payer to refuse to cover a drug would be ‘a highly unprecedented situation,’ he said.”

The Economics of (Drug) Prices

Conspicuous by its absence in this article is any comment by or reference to an economist. As a result, there is no semblance of economic sense to any statement made by anybody, including particularly reporter Whalen. To see this, ponder the role played by prices in markets.

Prices coordinate the activities of buyers and sellers by determining the value of goods and services. The implicit assumption of the WSJ story is that prices perform the sole function of distributing – and redistributing – income between people. A high price is neither good nor bad in and of itself if the price accurately reflects the valuations expressed by individuals in the marketplace. High prices may mean that consumers are beating down the store doors trying to get their hands on the good in question. Or the high price may mean that the inputs necessary to produce the good are in short supply and have shot up in price, so that the good is now more costly to produce. Either way, the high price has sent a message to market participants. In the first case, the message to producers is “produce more of this good.” In the second case, the message to consumers is “buy less of this good because less is being produced and less is available for sale.” In neither case do we want to do anything to interfere with the transmission of the message. 

Both high prices and low prices send vital information from some people to other people. Those messages are how the economic system operates. Garble or interdict them and you make people worse off, not better off. The objectors to high prescription-drug prices are making the classic mistake of killing the messenger of bad news in the childish belief that by killing the news they can change the reality contained in the message.

A Special Case of Textbook Economic Regulation: Pure Monopoly

Inevitably, it will occur to somebody to wonder whether government regulation of price can ever be a good thing. And since even Democrats and opponents of free markets can read, one of them will pick up an economics textbook and leaf through it in hopes of picking up a few ideas. This is sound strategy because within the economics profession the political bias skews to the left; there are more left-wing economists than right-wing economists.

Most mainstream textbooks in intermediate price theory or microeconomics will include a discussion of the optimal regulatory strategy for setting the price of a pure monopolist; e.g., a single seller of a good for which there are no close substitutes. The pure monopolist will face the entire market demand for the good it sells. It will maximize its profit by producing the rate of output at which its marginal revenue is equal to its marginal cost. The price it will charge its customers for this rate of output will greatly exceed both marginal revenue and marginal cost. (Why? The market demand curve confronting the pure monopolist is always downward-sloping, which implies that the marginal or incremental revenue associated with additional sales always falls. That is, marginal revenue is always less than price at any rate of output.)

The textbooks remind their readers that, if the monopolized industry were instead comprised of a large number of sellers, each small in size relative to the whole market, no individual seller could influence the market price by varying its rate of output. In this “perfectly competitive” environment, each small seller views itself as a “price-taker.” This perception creates a mindset in which each seller views its marginal revenue and price as identical because it views market price as a given, not something the firm can influence through its own actions. Profit maximization still implies that the firm will produce the rate of output at which marginal revenue is equal to marginal cost, but since price is treated as equal to marginal revenue, it is also equal to marginal cost. Since price is equal to marginal cost for each individual competitive firm, this outcome applies to the whole industry as well. And that will result in a lower price and higher rate of output that those chosen by the pure monopolist, for whom price is greater than marginal revenue and marginal cost.

In the textbook application, the hypothetical regulator will choose to regulate a pure monopolist by locating the rate of output at which its marginal cost is equal to its price. The pure monopolist would not itself choose that rate of output at which to operate, for its marginal cost (being equal to price) is greater than its marginal revenue at that output. It could increase its profits by producing less and charging a higher price. But when confronted with the regulated price chosen by the regulator, the monopolist will produce that rate of output now because the regulator has changed the monopolist’s marginal revenue by fixing price at the competitive level. That fixity means that marginal revenue no longer falls as the monopolist increases output. Now marginal revenue, marginal cost and price are all equal at the competitive rate of output, so the monopolist is induced to operate under the same price and production conditions as would a competitive industry.

This undoubtedly strikes students as very ingenious. However, there is one tacit premise underlying this old standby textbook argument.

The argument presumes that the government regulator has the information necessary to choose the correct price.

When the student is reading this discussion in the textbook, this doesn’t appear to be a problem. The textbook’s author has made the whole problem look very easy. He (or she) has illustrated the logic behind the technique with a graph showing a market demand curve, marginal revenue curse and marginal and average cost curves. All the student has to do is follow the lines, observe the results and check the logic in his or her mind. It is seductively easy to assume that the pure monopolist must have exactly the same diagram at his disposal. And from that assumption, it is only a short way to the further assumption that a government regulator must have the same information at his or her elbow as well.

In reality, though, individual businesses do not have the kind of information that economics textbooks assume they have. Indeed, the only way businesses can acquire the sort of information shown in the diagram is by gradually piecing it together from markets, but since market data is constantly changing they don’t have the time to do it. This would be true many times over for a pure monopolist, who would have to have information about an entire market that might consist of many thousands, millions or billions of customers.

If businesses don’t have this information at their fingertips, we can bet that government regulators don’t. Businesses have the strongest possible incentives to acquire and use the information. Government incentives are much weaker and don’t run in the direction of efficiency, since the care and feeding of a government bureaucracy doesn’t depend on serving the needs of the public. Indeed, the opposite is true.

So the upshot is that the practical value of the famous textbook of government price-regulation is somewhere between slim and none. There are apparently no known cases of this technique being applied successfully. That is not surprising, since there is not much scope for its being used experimentally. Even if there were lots of pure monopolies to practice on – which there aren’t – that practice would end up getting pretty expensive to the public welfare.

The political incentive for a regulator charged with setting the price of a pure monopolist would be to set the price as low as possible. But this is very likely to produce a worse result than simply allowing the pure monopolist to maximize its profit, since it will probably equate price, marginal revenue and marginal cost at a much lower rate of output than the monopolist would choose. This is pretty obvious to anybody who studies the textbook diagram while keeping in mind that in real life, a regulator would be flying blind in deciding what price to set. Textbook writers are not anxious to undercut their carefully developed analysis and therefore do not usually point out this inconvenient fact.

Why is that bad? Well, put yourself in the position of a consumer of the monopoly good. In the case of a cancer drug, what its consumers want more than anything else is to be able to actually use the drug. To do that, it has to be produced. They can’t consume a cancer drug that isn’t produced. So any outcome that results in less output is bad from their standpoint.

What Kind of “Regulation” Are the Oncologists, Et Al, Talking About?

This brings us back to our motley band of objectors to high drug prices. According to the Mayo editorial, they want “regulation.” This is the all-purpose mantra of the day. But what can the word possibly mean?

“What we’re fighting is the greed.” The word “the” suggests we are supposed to know or intuit the meaning of “greed,” and certainly if repetition could confer meaning then further explanation would be superfluous. But Ms. Whalen’s “critics increasingly question…” implies that these people are embarked on a new crusade here. Pharmaceutical companies began in the 19th century; did they just catch the virus of greed in the last few years? Or did 118 oncologists just wake up, like so many Rip van Winkles, to the intransigent fact that investors are seeking the highest possible rate of return for a given level of risk? And while this point is up for discussion, why are the prices charged by oncologists and hospitals to their uninsured patients never tarred by this same brush?

The Mayo editorial dabbles (badly) in economics by broaching the subject of recoupment of investment, which is not the relevant economic criterion for gauging return on investment. The objectors are criticizing prices, which are the province of the managers and executives who run the pharmaceutical companies. But these people are not the greedheads. The beneficiaries of investment are the residual claimants of profits – the owners of the company, the shareholders. The shareholders are not the ones who set prices, so it’s a waste of time to link prices and greed even if it otherwise made sense to do it – which it doesn’t.

Some of the richest people in history – Bill Gates, Steve Jobs and their ilk – got that way by producing goods that were consumed by others. If we don’t begrudge them mind-blowing wealth, it stands to reason that the owners of companies producing cancer drugs are entitled to whatever wealth they get. What we really want is as many cancer drugs and as much effectiveness from those drugs as possible, not as little wealth accruing to pharmaceutical investors as possible.

Jeanne Whalen’s case for a single-payer system rests on the superior bargaining power of government vis-à-vis drug companies. In other words, the left wing that made its bones by painting “corporations” as monstrous behemoths crushing the little guy underfoot now wants us to trust our lives to a government whose efficacy depends on its relative size and coercive power against sellers unable to withstand the irresistible force of its buying power.

And will this massive power be used in a sensitive, compassionate way to tenderly protect the welfare of the consumers whose interests it places foremost? No, the government’s Food and Drug Administration has long been known for callously refusing efforts of the terminally ill to lawfully obtain promising experimental drugs. The FDA has long resisted efforts to reduce delay times to bring new drugs to market.

Ah, but perhaps those single-payer foreign governments extolled by Ms. Whalen are more solicitous of their citizens than is the U.S. government. No, if that were true, then U.S. citizens would be stampeding out of the country to receive treatment there. If anything, the reverse is true. Why, in spite of rising prices for prescription drugs and medical services of all kinds, is American health care still sought after by global consumers? Because foreign single-payer government health-care systems ration care among their citizens. They refuse to allow price to play its normal role in the marketplace, instead insisting on keeping official prices artificially low and forcing patients to suffer on waiting lists rather than allowing them to pay higher prices. (In the jargon of economics, this is called “rationing by queue.”) Oh, they bargain hard with doctors and drug companies, all right. They do so because all welfare states ultimately run out of other people’s money and go broke – and the health-care component is the first part of the system to break down, even before the pay-as-you-go old-age-and-survivor component that is following closely behind it. The single-payer systems bargain as follows: They hold a gun to the heads of patients, saying “Reduce prices or I’ll shoot.” This leaves doctors, hospitals and drug companies with the unenviable choice of cutting their own throats now or being forced to do it later after being publicly demonized as the villains by the government.

Even welfare states cannot afford to flatly deny medical care to their citizens. So those governments are forced to take over the medical sector completely. Pharmaceutical companies become wards of the state, consigned to the competitive limbo of companies that have been castrated but kept alive by government subsidies. Doctors become menial time-servers rather than true physicians. Hospitals become – well, take a look at our own state mental hospitals to get a general idea. Meanwhile, consumers are trapped in a downward spiral of deteriorating quantity and quality of medical care. Only those who can afford to travel abroad can escape. The rest can only hope to keep their health as long as possible; otherwise, they die on waiting lists cursing the system while the healthy young get free checkups and sing the praises of “free health care.” And nobody feels the sharp end of this system more keenly than cancer victims, whose care is the most expensive and who suffer the ultimate penalty from rationed care.

The irony is that Ms. Whalen began her article complaining that cancer victims have to make “difficult choices” and may well end up foregoing some care because prices are too high. She ends it criticizing the U.S. health care system because it “can’t say no!” Isn’t that exactly what the cancer victims she herself reports on are doing? The cancer victims she describes are making the tough choices and running their own lives, but she implies that they and the rest of us would be better off surrendering all our choices to a single-payer system. Ms. Whalen begins by subtly suggesting that in a single-payer system, cancer-drug prices will be lower and cancer victims magically will be able to buy all the drugs they want at those lower prices. Of course, that isn’t what actually happens. The truth is that a single-payer system achieves its artificial lower prices only at the cost of a lower supply of cancer drugs, which the government rations among the desperate consumers.  Apparently she expects us to believe that if cancer victims have no say in their own care, they won’t feel as bad as they do now when they have to forego treatment. Today, though, they have the hope of buying the drugs they need if they can get the money. Under the single-payer system, they have no hope unless they are among the lucky few who win the rationing lottery, because there aren’t enough drugs produced to accommodate the patients who need them. The laws of economics override any bureaucratic laws man can devise.

The Role of Monopoly

The recourse to regulation has become the knee-jerk reflex solution to every public-policy problem, despite its conspicuous lack of success in solving any of them. The concept of regulation is poorly defined and its actual workings are poorly understood. In the world of politics, this makes it the perfect solution – it is an empty vessel into which each citizen can pour his or her own personal dreams, ideals and vision.

The production-structure of pharmacology makes it a tempting target for this kind of hazy thinking. Patents are customarily granted on the formulas for complex new medicines. A patent is defined as a government grant of monopoly on the ownership rights to a product or process, which include the right to produce it and license its production and use. The general public is used to associating the notion of monopoly with regulation. It became accustomed to that from decades of exposure to public-utility regulation, in which privately owned utilities received a grant of monopoly in exchange for submission to rate-of-return regulation by state-government commissions.

The two situations have nothing in common. Public utilities are (or, more accurately, were) natural monopolies owing to the peculiar characteristics of their production functions. Pharmaceuticals have no natural-monopoly characteristics, so there is no inherent rationale to subject them to the same kind of regulation applied to electric, gas and phone companies – not that public-utility regulation compiled such a sterling record of success in any case. The purpose of the patent is to encourage innovation. The existence of drugs that patients want to take is evidence of success. This is not an argument for regulation – just the reverse, in fact.

The Role of the Private Sector

The prospect of death at the hands of a life-threatening, complex illness like cancer is by definition a catastrophic illness. We expect that catastrophic illnesses will impose severe and sudden financial burdens on patients even in a perfect, well-functioning health-care system. This is a classic case where insurance can and should function to protect both the patient and the public at large from the direct and indirect (spillover) effects of catastrophe.

Unfortunately, health-care insurance in America and elsewhere has gotten sidetracked from its proper function. Beginning in World War II, employers began offering more comprehensive health-care insurance as a means of evading wage and price controls and offering employees an effective increase in real income that, unlike wage increases, was not subject to taxation. The health-care insurance lost its focus on catastrophic illness and became more and more “first-dollar coverage” that paid for routine health-care procedures. In turn, this caused insurance companies to avoid paying the large claims that should and normally would have constituted their proper insurance province. Today, health insurance is upside down. Subsidization of most garden-variety health-care services has driven prices through the roof while the uninsured face sky-high prices.

The Mayo oncologists should be devoting themselves to the only problems worth solving. First, they should be reforming the system by returning it to its roots – fee-for-service medicine supplemented by catastrophic insurance policies with low premiums and inter-state competition between insurance companies. That is a reform program well worth the time of busy professionals like the Mayo 118.

Second, the oncologists should busy themselves in finding ways to get money to cancer patients who need it. This is the classic function of private charity. As it stands now, the oncologists support a program of reverse-reform that will succeed only in killing more of their patients.

Should any readers – or the oncologists themselves – indignantly insist that they know better than economists how the market works, let them prove it.

Since they claim that pharmaceutical companies are greedy and can subsist perfectly well by charging lower prices, let the oncologists start a pharmaceutical company or buy an existing company and make it thrive by putting their principles into practice. Rather than force existing companies to do it their way, they can prove their point the old-fashioned way by competing in the marketplace and winning out.

Judging by the popularity of politicians who demonize corporations and profit, they would have many people cheering them on.

What Could the Mayo Oncologists Have Been Thinking? 

Readers may be wondering what the Mayo oncologists could possibly have been thinking when they signed on to the editorial referred to above. The old adage “Never ascribe to venality that which can be explained by mere stupidity” may well apply here. On the other hand, it may also be true that the doctors hope to secure for themselves and their patients a favorable place in line in the future rationing regime of a single-payer health-care system that evolves as the natural heir to ObamaCare.

DRI-173 for week of 7-12-15: Beware Greeks Begging Gifts

An Access Advertising EconBrief:

Beware Greeks Begging Gifts

By now everybody is acclimated to the crisis atmosphere pervading economic life. It is the antithesis of life in the late 1980s, 1990s and early 2000s, when day-to-day rhythms had the hum of a well-oiled machine. Crises occasionally interrupted the era known as the Great Moderation, and they seemed all the more acute for their rarity. Events like the stock-market “crash” of 1987 or the technology bubble-burst of 1999 seem ridiculously tame and short-lived compared to the dragged-out, operatic and increasingly ominous spectacles of today. How fitting that the most meaningful one of all is a classic Greek tragedy unfolding in Greece itself.

Even Americans who shun economics and cover their ears to escape the business news know that the U.S. government is deeply in debt. Compared to its Greek counterpart, though, Uncle Sam is the Dave Ramsey of sovereign spenders. The Greek government defaulted on its debts for the first time in 2012 and recently became the first developed nation ever to default on a loan payment due the International Monetary Fund (IMF). Greece’s creditors consist mainly of five classes: its own citizens, institutional investors such as banks and private funds, international organizations to which it belongs such as the Eurozone, international agencies from which it has borrowed money like the European Commission, European lending facilities and the IMF, and fellow European nations such as Germany, France, Italy and Spain. The official members of those five classes – e.g., those in the last three categories – have ganged up to put heavy pressure on the Greek government to pay up. “Pay up” does not mean expunging its debt; it merely means getting current on the debt by making current interest payments and paying off principal as it comes due.

The most recently elected Greek government has refused to do this. The recent referendum showed that over 60% of Greek voters agree with their government. When an individual is hopelessly in debt and refuses to pay, that is bad news for him or her. When a recalcitrant government is likewise indebted, this is bad news – for somebody else.

How did this happen? How and why has it been allowed to persist? Who will suffer because of it? What are the implications of this for the rest of the world?

The Economics of International Debt

Margaret Thatcher once remarked that the trouble with socialism is eventually you run out of other people’s money. As the above classification of Greek-government debt suggests, Greece began by borrowing money from its own citizens for its government to spend. When its spending exhausted the willingness of its own citizens to lend, the government turned to other sources. One by one, Greece tapped them all until eventually they were tapped out. For a government, that point is reached when it loses the ability to pay interest on what it borrowed.

And when does that happen? Well, all of us have a pretty good instinctive grasp of how the process works at the household level. An individual or a family borrows until the size of its debt relative to its annual income gets too big. After all, the family has to eat, keep a roof over its head, get to and from work and clothe itself. It can’t devote all its income to paying interest, let alone paying down debt. The precise tipping point will differ between families, but it exists for everybody. What is the analogue of this for a country?

The standard tools of analysis are to treat the nation’s gross domestic product (GDP) as the national analogue of family income. The size of the national debt relative to GDP is the trouble light that signals which nations are on the verge of suffering a debt crisis. As with individual families, there is no absolute red-line point, but it does provide a good means of comparison between nations at a point in time, and also over time for a particular country.

As of 1970, Greece’s debt/GDP ratio was only 17%. By 1980, it had barely risen to 21%. But in 1985 it was over 60%; the country had started down the road to ruin. By the new millennium, the ratio had climbed over 100% – the country owed more than the value of its annual production. As with individuals, sovereign debt tends to increase exponentially because of the power of compound interest, which works inexorably in favor of savers but just as implacably against chronic debtors.

Once a country gets itself in a fix like this, can it get out? One of the celebrated analytical exercises in economics is the transfer problem. After World War I, the victorious Allied powers imposed stiff war reparations on the defeated Axis powers, which included Germany. In the formal sense, the obligation to pay off war debt is analytically indistinguishable from any other kind of debt, such as the more familiar kind of government debt that nations incur when their governments borrow from domestic or foreign citizens.

As economic textbooks relate, the only way Germany could pay off this war debt was by generating an annual surplus of exports over imports in the current account of its national balance of payments. But it couldn’t do that because (1) Germany, like most of Europe, had lost the cream of its manhood to the wholesale slaughter on the battlefields; and (2) the productive capacity of Germany had been badly mauled by the war. It needed all the consumption goods it was capable of producing just to keep its remaining population on their feet and all the investment goods it could produce to restore its industry to a semblance of its pre-war strength. That left it very little for export. Forcing it to pay reparations was tantamount to heaping further punishment on a country that had already been badly punished by defeat in a dubious cause.

Students sometimes have a hard time getting their minds around the concept of repaying international debt via an export surplus, but – as a first approximation – this mimics what goes on at the individual level. Any listener to the Dave Ramsey program knows that the formula for escaping debt is (1) don’t get in debt in the first place; or (2) lower your standard of living (e.g., your personal consumption) as low as possible as quickly as possible for as long as necessary to pay down the debt. Do NOT borrow more money and pay as little interest as possible. What the debtor is doing is “exporting;” consuming less than the value of what is produced (income) in order to send the net surplus “abroad” (to outsiders).

One key difference between the German situation between the World Wars and the Greek situation over the last three decades is that the German war debt was forced upon them by the unwise provisions of the Treaty of Versailles, while the Greeks dug their own money pit by electing and re-electing politicians who celebrated the virtues of deficit spending.

The Greek Welfare State

The term “welfare state” is credited to the British Labor Party theoretician, Lord William Beveridge, who coined it in the famous “Beveridge Report” of 1941 that laid the foundation for British post-war socialism. But it is Greece that has brought the art of the welfare state to its apogee – the asymptotic approach to a condition in which everybody is paid by the government not to work. Only in Greece can one find a sighted citizen receiving a subsidy dedicated to the blind. Only in Greece is it commonplace to retire with full benefits at age fifty.

The Greek Underground Economy

When the government becomes the source of all benefit, we would expect the government to become all powerful and relentless in its search for wealth to confiscate. The problem with an omnipresent government is that it tends to discourage active cooperation by the citizenry. This is particularly true when John Q. Public’s job one is to wangle a subsidy from the government. What is the point of being subsidized when the government deposits the benefit in your left pocket only to yank it out of your right pocket in taxes? Thus, job two in Greece is to evade taxation in order to make your subsidy effective on net balance.

According to a service that studies these things, Greece ranks as the most corrupt of the 19 countries in the Eurozone. The value of goods and services produced “off the books” in the Greek economy – thus, untouched by taxation – is estimated at 24.3% of total Greek GDP. By way of comparison, Italy – another nation so legendary for fiddling on its taxes that Italian movies have been built around this premise – ranks second among European countries at 21.9%. It is estimated that the Greek government collect only about half of all taxes due it.

The structure of the Greek economy undoubtedly lends itself to tax evasion. Of all the world’s economies, Greece may have the biggest comparative advantage in tourism owing to its breathtaking Aegean scenery and stock of venerable historic ruins and temples. An astounding 31.5% of Greek employees are self-employed, which greatly eases the task of avoiding taxes, particularly when the employee is providing a service to foreigners who have no interest and little opportunity to cooperate with the tax man. (Self-employment elsewhere in Europe is nowhere nearly as high as in Greece, averaging only 15%.)

 

Syriza and Fairness 

The populist party Syriza has built a controlling interest among the Greek electorate by harping on the issue of fairness. How dare foreign creditors insist on lowering the standard of living of the average Greek? Why should poor Greeks suffer to feed the appetites of the 1%? The word “austerity” has become a code word for privilege and wealth gained at the expense of the masses of the common people.

Economic theory itself, in the narrow sense, has nothing to say about fairness for the same reasons that the theory of consumer demand makes no effort to compare the utility or satisfaction gained by one person with that of another. There is nothing in economics that says it is “fair” or unfair that so many Greeks are subsidized by other Greeks (and non-Greeks). Economics merely says that somebody must pay – the money that funds the subsidies is not spontaneously generated and it is diverted away from productive alternative uses. Within Greece itself, the unsubsidized are paying for the subsidies given to their countrymen.

The irony is that the populist left has succeeded so well in turning the logic of fairness on its head. By resorting to international borrowing, the government ensures that the burden of repayment will be spread across the Greek population at large, which is forced to repay the debt in real terms via exports. When repayment takes the form of exports, the burden is reflected in the prices and quantities of all goods and services, not merely those that are internationally traded. So even the hard-working, industrious poor are “taxed” to pay subsidies to the loafers and dissemblers. Even the tax-dodgers pay, since this form of implicit tax can’t be evaded by cheating on taxes.

Syriza is complaining that the inhumane austerity policies transfer real income away from their supporters to the hated capitalists. But economics says that the capitalists only get a “normal” rate of return and nowadays they don’t even get that. It is the input suppliers who are the long-run gainers and losers from the subsidies. We know that some Greeks – subsidy recipients and government employees – are net gainers and non-government non-recipients must be losers. Syriza is in fact complaining about the unfairness of policies that prevent this gravy train from running indefinitely. As a matter of fact, the government and agency negotiators such as the IMF, the European Commission and the Eurozone bailout funds have in the past cheerfully sold out the only participants who could be called “capitalists;” namely, private lenders holding Greek paper. Private lenders have taken haircuts that were publicly announced at 50% in previous negotiations and were probably as high as 74%, according to sources like The Wall Street Journal.

In this case, “indefinitely” definitely does not mean “forever.” When one group of Greeks is subsidizing another one, this gives the non-recipients an incentive to climb on the recipient bandwagon. But when everybody wants to stop working at the same time, the volume of output necessary to pay the subsidies not only begins to decline, but does so at an increasing rate. And that spells trouble, with a capital T and that rhymes with p and that stands for politics.

The Reckoning

In the last two years, unemployment in Greece has risen above 25%. Syriza has tried to put the blame on the austerity policies favored by creditors, but if anything the feeble attempts at reform put forward by the Greek government produced slight improvement. To be sure, higher taxes are not a recipe for higher living standards, but that applies only to taxes that actually get collected. The only fiscal effect one can predict with any confidence in Greece is the bandwagon effect produced by the subsidy gold-rush. It is akin to what happens in hyperinflations when everybody is so busy trying to spend their money before its value declines even further that nobody has time to work and produce. Here, everybody is so busy trying to promote themselves a subsidy – that is, to reach the status where they are not working – that work and production become an afterthought.

Every country in the Eurozone is a welfare state, but not all are in the same stage of decay. For example, Great Britain under the long period of Margaret Thatcher’s leadership was able to divest itself of the state-ownership features of British Labor Party socialism, thereby reversing its label as carrier of the “British disease” to that of the “British miracle.” Thatcher’s economic program was not eviscerated by the subsequent Labor administration of Tony Blair and the current Conservative government has restored a modicum of it, which explain why British unemployment stands around 5.5%. At one end of the spectrum, we have the Eurozone basket cases: Spain (over 23%), Cyprus (over 16%), Portugal (over 13%) and Italy (over 12%). Germany (over 7%) ranks just above, or rather below, Great Britain at the other end. In the middle, are Ireland (just below 10% and on its way down after regaining fiscal discipline) and France (over 10% and rising as it bids to join the basket cases). We can use these unemployment rates as a rough proxy for the progression of this anti-productivity virus throughout the Eurozone. That is, the higher the unemployment rate, the closer is a particular country to eventual collapse when it faces the same day of reckoning that confronts Greece.

What About the Truly Needy?

The public face of Syriza’s constituents, those being subsidized by the Greek government – hence by multiple foreign governments and international agencies – is not a shifty-eyed tax dodger. It is not a blind beggar lifting up his eye patch to count the day’s takings. No, it is a homeless orphan starving on the street. It is a poor widow working two jobs to feed her children. It is an amputee propelling himself on a cart and subsisting on the charity of tourists. These are the deserving poor, the “truly needy.” They constitute the ultimate, conversation-stopping rejoinder to anyone having the temerity to tell the truth about Greece’s descent into subsidy hell.

In fact, the question should be turned back on the questioner. What, indeed, about the truly needy? For over a century, the political left has been allowed to get away with peddling the fantasy that they will disappear if only government gets big enough, intrusive enough and profligate enough. But the actual experience with the welfare state, as epitomized by Greece, is that the truly needy has gone from being cared for by their nearest and dearest relatives and/or friends to being cared for by charitable institutions to being cared for by local government to being cared for by state government to being cared for by a federal (national) government. In this final, terminal, phase, a nation’s truly needy are now at the mercy of foreign governments and international agencies. In other words, the progression puts the truly needy in the hands of ever more impersonal, less caring, more callous, less sensitive, less knowledgeable wards. The truly needy have become political pawns of big government and its fawning acolytes, neither of which gives a rap about them.

What in God’s name is so compassionate about this?

There is one and only one way to serve the truly needy well. It is by producing the largest possible flow of output from which charity can flow. Charity must originate from within the human heart, the geographic production point most efficiently located to serve those in need. Government inherently operates via coercion and compulsion, which is the enemy of the compassion and sensitivity required to serve the truly needy.

To be sure, charity is not an easy product to produce under the best of circumstances. But government is the worst producer, not the best one – and certainly not the only possible one. The appeal to human need is the most cynical and despicable Trojan horse being rolled out by those supporting a bailout of Greece.

Is There No Hope Without a Bailout?

Implicit in the story told by the mainstream media about Greece is the presumption that, absent a bailout, the country can only spiral to destruction. That is standard operating procedure for big government: “Without big government/ regulation/ programs/ planning, civilization as we know it will soon end and chaos will ensue.” Consigned to the memory hole is the last 35 years of Greek history, which began with Greece enjoying unprecedented prosperity under the commercial shelter of intra-European free trade.

Greece became a top-10 nation worldwide in tourism, astonishing considering that it is only in the top 50 in absolute size. Its shipping and fishing industries boomed. The country even developed a modestly successful manufacturing sector. It is only in the last 10 years that its political choices and subsidy mania overtook and tackled its productivity. This is only the most extreme case of a disease afflicting almost all of Europe. Although the Great Recession intensified its effects, it began years earlier.

This history proves conclusively that Greece can and should succeed economically. Like a convert to Dave Ramsey’s debt-elimination lifestyle, it needs to take the cure and swear fealty to free markets and free trade. Remember that Greece’s travails are nowhere near those suffered by Germany under the Weimar Republic. The Germans were decimated physically and demographically by war. The Greeks have merely suffered a recession, something every developed country suffers periodically.

So What If Greece Leaves the Eurozone?

Numerous commentators have shrugged their shoulders at the prospect of a Greek exit from the Eurozone due to debt default. Why should we care? And, apart from departments of revenue, why should people in the other 18 Eurozone countries care if Greece leaves? (This omits the seven non-Euro members and two “Euro opt-out” members of the European Union.) Germany will be relieved of the necessity of subsidizing Greece. Everybody will be relieved of the wearisome laments and regular bulletins of distress emanating from Athens.

To understand why so many people don’t care whether Greece stays in the Eurozone or not, we have to understand why some people do care. To understand that, we have to understand that the “Eurozone” is two things. In economic theory, it is a customs and (quasi-) monetary union, a group of nations united by a common commercial policy and (mostly) by a common currency. Since the customs union creates a free-trade zone, the mutual trade benefits provide a good reason for consumers in all countries to regret the exit of Greece. The general public gratefully exercises the prerogatives of international trade but somehow overlooks them when contemplating the subject in a public-policy context.

The Eurozone is also a gigantic bureaucracy headquartered in Brussels, Belgium. The bureaucracy ostensibly exists to run the Eurozone. It actually exists to benefit the people who comprise it and its political patrons, just as all giant bureaucracies do. They are desperate to keep Greece in the Eurozone for a perfectly logical reason: all bureaucracies resist getting smaller. If Eurozone countries somehow got it in their heads that they could come and go from the confederation as they pleased, then all those countries on the basket-case list above might decide to exit for roughly the same reasons as Greece. Then that giant bureaucracy would be up the Mediterranean without a paddle. And where do all the newspaper and online stories about the Greece debt crisis originate? From official sources; i.e., from Brussels or the IMF or some other agency with a vested interest in Greece’s Eurozone membership. Thus, while op-eds may display a carefree insouciance to Greece’s peregrinations, the front-page stories will reflect nothing but verbal hand-wringing and grave concern over the crisis.

The Rest of the World

To the world outside of Europe, Greece mostly represents a cautionary tale. Take the United States. We are a welfare state. In terms of unemployment, we are apparently with Great Britain – at the early stages of decay. But this is misleading, because Federal Reserve monetary policy and the Obama administration have combined to drive us far down F. A. Hayek’s “road to serfdom.” If we array countries on a debt/GDP scale ratio scale, for example, we compare less favorably. And our trend is directly opposite to that in Great Britain or Ireland.

Of all recurring headline stories that have preoccupied the public’s attention over the last five years, it is doubtful whether any other has embodied such a gulf between underlying truth and the picture provided to the public in news reports. The reports constantly speculate on the chances that a deal will be struck between Greek politicians and international creditors. This has nothing to do with the underlying economic reality staring Greece in the face – only with the chances of the Eurocracy cutting a deal to keep Greece in the Eurozone a while longer. Which of these two is of life-and-death interest to ordinary people the world over – the latest can-kicking exercise going in between Brussels and Athens or the preview of coming attractions now on view in Greece that will eventually face every welfare state in the world, including ours?

DRI-172 for week of 7-5-15: How and Why Did ObamaCare Become SCOTUSCare?

An Access Advertising EconBrief:

How and Why Did ObamaCare Become SCOTUSCare?

On June 25, 2015, the Supreme Court of the United States delivered its most consequential opinion in recent years in King v. Burwell. King was David King, one of various Plaintiffs opposing Sylvia Burwell, Secretary of Health, Education and Welfare. The case might more colloquially be called “ObamaCare II,” since it dealt with the second major attempt to overturn the Obama administration’s signature legislative achievement.

The Obama administration has been bragging about its success in attracting signups for the program. Not surprisingly, it fails to mention two facts that make this apparent victory Pyrrhic. First, most of the signups are people who lost their previous health insurance due to the law’s provisions, not people who lacked insurance to begin with. Second, a large chunk of enrollees are being subsidized by the federal government in the form of a tax credit for the amount of the insurance.

The point at issue in King v. Burwell is the legality of this subsidy. The original legislation provides for health-care exchanges established by state governments, and proponents have been quick to cite these provisions to pooh-pooh the contention that the Patient Protection and Affordable Care Act (PPACA) ushered in a federally-run, socialist system of health care. The specific language used by PPAACA in Section 1401 is that the IRS can provide tax credits for insurance purchased on “exchanges run by the State.” That phrase appears 14 times in Section 1401 and each time it clearly refers to state governments, not the federal government. But in actual practice, states have found it excruciatingly difficult to establish these exchanges and many states have refused to do so. Thus, people in those states have turned to the federal-government website for health insurance and have nevertheless received a tax credit under the IRS’s interpretation of statute 1401. That interpretation has come to light in various lawsuits heard by lower courts, some of which have ruled for plaintiffs and against attempts by the IRS and the Obama administration to award the tax credits.

Without the tax credits, many people on both sides of the political spectrum agree, PPACA will crash and burn. Not enough healthy people will sign up for the insurance to subsidize those with pre-existing medical conditions for whom PPACA is the only source of external funding for medical treatment.

To a figurative roll of drums, the Supreme Court of the United States (SCOTUS) released its opinion on June 25, 2015. It upheld the legality of the IRS interpretation in a 6-3 decision, finding for the government and the Obama administration for the second time. And for the second time, the opinion for the majority was written by Chief Justice John Roberts.

Roberts’ Rules of Constitutional Disorder

Given that Justice Roberts had previously written the opinion upholding the constitutionality of the law, his vote here cannot be considered a complete shock. As before, the shock was in the reasoning he used to reach his conclusion. In the first case (National Federation of Independent Businesses v. Sebelius, 2012), Roberts interpreted a key provision of the law in a way that its supporters had categorically and angrily rejected during the legislative debate prior to enactment and subsequently. He referred to the “individual mandate” that uninsured citizens must purchase health insurance as a tax. This rescued it from the otherwise untenable status of a coercive consumer directive – something not allowed under the Constitution.

Now Justice Roberts addressed the meaning of the phrase “established by the State.” He did not agree with one interpretation previously made by the government’s Solicitor General, that the term was an undefined term of art. He disdained to apply a precedent established by the Court in a previous case involving interpretation of law by administration agencies, the Chevron case. The precedent said that in cases where a phrase was ambiguous, a reasonable interpretation by the agency charged with administering the law would rule. In this case, though, Roberts claimed that since “the IRS…has no expertise in crafting health-insurance policy of this sort,” Congress could not possibly have intended to grant the agency this kind of discretion.

No, Roberts is prepared to believe that “established by the State” does not mean “established by the federal government,” all right. But he says that the Supreme Court cannot interpret the law this way because it will cause the law to fail to achieve its intended purpose. So, the Court must treat the wording as ambiguous and interpret it in such a way as to advance the goals intended by Congress and the administration. Hence, his decision for defendant and against plaintiffs.

In other words, he rejected the ability of the IRS to interpret the meaning of the phrase “established by the State” because of that agency’s lack of health-care-policy expertise, but is sufficiently confident of his own expertise in that area to interpret its meaning himself; it is his assessment of the market consequences that drives his decision to uphold the tax credits.

Roberts’ opinion prompted one of the most scathing, incredulous dissents in the history of the Court, by Justice Antonin Scalia. “This case requires us to decide whether someone who buys insurance on an exchange established by the Secretary gets tax credits,” begins Scalia. “You would think the answer would be obvious – so obvious that there would hardly be a need for the Supreme Court to hear a case about it… Under all the usual rules of interpretation… the government should lose this case. But normal rules of interpretation seem always to yield to the overriding principle of the present Court – the Affordable Care Act must be saved.”

The reader can sense Scalia’s mounting indignation and disbelief. “The Court interprets [Section 1401] to award tax credits on both federal and state exchanges. It accepts that the most natural sense of the phrase ‘an exchange established by the State’ is an exchange established by a state. (Understatement, thy name is an opinion on the Affordable Care Act!) Yet the opinion continues, with no semblance of shame, that ‘it is also possible that the phrase refers to all exchanges.’ (Impossible possibility, thy name is an opinion on the Affordable Care Act!)”

“Perhaps sensing the dismal failure of its efforts to show that ‘established by the State’ means ‘established by the State and the federal government,’ the Court tries to palm off the pertinent statutory phrase as ‘inartful drafting.’ The Court, however, has no free-floating power to rescue Congress from their drafting errors.” In other words, Justice Roberts has rewritten the law to suit himself.

To reinforce his conclusion, Scalia concludes with “…the Court forgets that ours is a government of laws and not of men. That means we are governed by the terms of our laws and not by the unenacted will of our lawmakers. If Congress enacted into law something different from what it intended, then it should amend to law to conform to its intent. In the meantime, Congress has no roving license …to disregard clear language on the view that … ‘Congress must have intended’ something broader.”

“Rather than rewriting the law under the pretense of interpreting it, the Court should have left it to Congress to decide what to do… [the] Court’s two cases on the law will be remembered through the years. And the cases will publish the discouraging truth that the Supreme Court favors some laws over others and is prepared to do whatever it takes to uphold and assist its favorites… We should start calling this law SCOTUSCare.”

Jonathan Adler of the much-respected and quoted law blog Volokh Conspiracy put it this way: “The umpire has decided that it’s okay to pinch-hit to ensure that the right team wins.”

And indeed, what most stands out about Roberts’ opinion is its contravention of ordinary constitutional thought. It is not the product of a mind that began at square one and worked its way methodically to a logical conclusion. The reader senses a reversal of procedure; the Chief Justice started out with a desired conclusion and worked backwards to figure out how to justify reaching it. Justice Scalia says as much in his dissent. But Scalia does not tell us why Roberts is behaving in this manner.

If we are honest with ourselves, we must admit that we do not know why Roberts is saying what he is saying. Beyond question, it is arbitrary and indefensible. Certainly it is inconsistent with his past decisions. There are various reasons why a man might do this.

One obvious motivation might be that Roberts is being blackmailed by political supporters of the PPACA, within or outside of the Obama administration. Since blackmail is not only a crime but also a distasteful allegation to make, nobody will advance it without concrete supporting evidence – not only evidence against the blackmailer but also an indication of his or her ammunition. The opposite side of the blackmail coin is bribery. Once again, nobody will allege this publicly without concrete evidence, such as letters, tapes, e-mails, bank account or bank-transfer information. These possibilities deserve mention because they lie at the head of a short list of motives for betrayal of deeply held principles.

Since nobody has come forward with evidence of malfeasance – or is likely to – suppose we disregard that category of possibility. What else could explain Roberts’ actions? (Note the plural; this is the second time he has sustained PPACA at the cost of his own integrity.)

Lord Acton Revisited

To explain John Roberts’ actions, we must develop a model of political economy. That requires a short side trip into the realm of political philosophy.

Lord Acton’s famous maxim is: “Power corrupts; absolute power corrupts absolutely.” We are used to thinking of it in the context of a dictatorship or of an individual or institution temporarily or unjustly wielding power. But it is highly applicable within the context of today’s welfare-state democracies.

All of the Western industrialized nations have evolved into what F. A. Hayek called “absolute democracies.” They are democratic because popular vote determines the composition of representative governments. But they are absolute in scope and degree because the administrative agencies staffing those governments are answerable to no voter. And increasingly the executive, legislative and judicial branches of the governments wield powers that are virtually unlimited. In practical effect, voters vote on which party will wield nominal executive control over the agencies and dominate the legislature. Instead of a single dictator, voters elect a government body with revolving and rotating dictatorial powers.

As the power of government has grown, the power at stake in elections has grown commensurately. This explains the burgeoning amounts of money spent on elections. It also explains the growing rancor between opposing parties, since ordinary citizens perceive the loss of electoral dominance to be subjugation akin to living under a dictatorship. But instead of viewing this phenomenon from the perspective of John Q. Public, view it from within the brain of a policymaker or decisionmaker.

For example, suppose you are a completely fictional Chairman of a completely hypothetical Federal Reserve Board. We will call you “Bernanke.” During a long period of absurdly low interest rates, a huge speculative boom has produced unprecedented levels of real-estate investment by banks and near-banks. After stoutly insisting for years on the benign nature of this activity, you suddenly perceive the likelihood that this speculative boom will go bust and some indeterminate number of these financial institutions will become insolvent. What do you do? 

Actually, the question is really more “What do you say?” The actions of the Federal Reserve in regulating banks, including those threatened with or undergoing insolvency, are theoretically set down on paper, not conjured up extemporaneously by the Fed Chairman every time a crisis looms. These days, though, the duties of a Fed Chairman involve verbal reassurance and massage as much as policy implementation. Placing those duties in their proper light requires that our side trip be interrupted with a historical flashback.

Let us cast our minds back to 1929 and the onset of the Great Depression in the United States. At that time, virtually nobody foresaw the coming of the Depression – nobody in authority, that is. For many decades afterwards, the conventional narrative was that President Herbert Hoover adopted a laissez faire economic policy, stubbornly waiting for the economy to recover rather than quickly ramping up government spending in response to the collapse of the private sector. Hoover’s name became synonymous with government passivity in the face of adversity. Makeshift shanties and villages of the homeless and dispossessed became known as “Hoovervilles.”

It took many years to dispel this myth. The first truthteller was economist Murray Rothbard in his 1962 book America’s Great Depression, who pointed out that Hoover had spent his entire term in a frenzy of activism. Far from remaining a pillar of fiscal rectitude, Hoover had presided over federal deficit spending so large that his successor, Democrat Franklin Delano Roosevelt, campaigned on a platform of balancing the federal-government budget. Hoover sternly warned corporate executives not to lower wages and officially adopted an official stance in favor of inflation.

Professional economists ignored Rothbard’s book in droves, as did reviewers throughout the mass media. Apparently the fact that Hoover’s policies failed to achieve their intended effects persuaded everybody that he couldn’t have actually followed the policies he did – since his actual policies were the very policies recommended by mainstream economists to counteract the effects of recession and Depression and were largely indistinguishable in kind, if not in degree, from those followed later by Roosevelt.

The anathematization of Herbert Hoover drover Hoover himself to distraction. The former President lived another thirty years, to age ninety, stoutly maintaining his innocence of the crime of insensitivity to the misery of the poor and unemployed. Prior to his presidency, Hoover had built reputation as one of the great humanitarians of the 20th century by deploying his engineering and organizational skills in the cause of disaster relief across the globe. The trashing of his reputation as President is one of history’s towering ironies. As it happened, his economic policies were disastrous, but not because he didn’t care about the people. His failure was ignorance of economics – the same sin committed by his critics.

Worse than the effects of his policies, though, was the effect his demonization has had on subsequent policymakers. We do not remember the name of the captain of the California, the ship that lay anchored within sight of the Titanic but failed to answer distress calls and go to the rescue. But the name of Hoover is still synonymous with inaction and defeat. In politics, the unforgivable sin became not to act in the face of any crisis, regardless of the consequences.

Today, unlike in Hoover’s day, the Chairman of the Federal Reserve Board is the quarterback of economic policy. This is so despite the Fed’s ambiguous status as a quasi-government body, owned by its member banks with a leader appointed by the President. Returning to our hypothetical, we ponder the dilemma faced by the Chairman, “Bernanke.”

Bernanke only directly controls monetary policy and bank regulation. But he receives information about every aspect of the U.S. economy in order to formulate Fed policy. The Fed also issues forecasts and recommendations for fiscal and regulatory policies. Even though the Federal Reserve is nominally independent of politics and from the Treasury department of the federal government, the Fed’s policies affect and are affected by government policies.

It might be tempting to assume that Fed Chairmen know what is going to happen in the economic future. But there is no reason to believe that is true. All we need do is examine their past statements to disabuse ourselves of that notion. Perhaps the popping of the speculative bubble that Bernanke now anticipates will produce an economic recession. Perhaps it will even topple the U.S. banking system like a row of dominoes and produce another Great Depression, a la 1929. But we cannot assume that either. The fact that we had one (1) Great Depression is no guarantee that we will have another one. After all, we have had 36 other recessions that did not turn into Great Depressions. There is nothing like a general consensus on what caused the Depression of the 1920s and 30s. (The reader is invited to peruse the many volumes written by historians, economic and non-, on the subject.) About the only point of agreement among commentators is that a large number of things went wrong more or less simultaneously and all of them contributed in varying degrees to the magnitude of the Depression.

Of course, a good case might be made that it doesn’t matter whether Fed Chairman can foresee a coming Great Depression or not. Until recently, one of the few things that united contemporary commentators was their conviction that another Great Depression was impossible. The safeguards put in place in response to the first one had foreclosed that possibility. First, “automatic stabilizers” would cause government spending to rise in response to any downturn in private-sector spending, thereby heading off any cumulative downward movement in investment and consumption in response to failures in the banking sector. Second, the Federal Reserve could and would act quickly in response to bank failures to prevent the resulting reverse-multiplier effect on the money supply, thereby heading off that threat at the pass. Third, bank regulations were modified and tightened to prevent failures from occurring or restrict them to isolated cases.

Yet despite everything written above, we can predict confidently that our fictional “Bernanke” would respond to a hypothetical crisis exactly as the real Ben Bernanke did respond to the crisis he faced and later described in the book he wrote about it. The actual and predicted responses are the same: Scare the daylights out of the public by predicting an imminent Depression of cataclysmic proportions and calling for massive government spending and regulation to counteract it. Of course, the real-life Bernanke claimed that he and Treasury Secretary Henry O’Neill correctly foresaw the economic future and were heroically calling for preventive measures before it was too late. But the logic we have carefully developed suggests otherwise.

Nobody – not Federal Reserve Chairmen or Treasury Secretaries or California psychics – can foresee Great Depressions. Predicting a recession is only possible if the cyclical process underlying it is correctly understood, and there is no generally accepted theory of the business cycle. No, Bernanke and O’Neill were not protecting America with their warning; they were protecting themselves. They didn’t know that a Great Depression was in the works – but they did know that they would be blamed for anything bad that did happen to the economy. Their only way of insuring against that outcome – of buying insurance against the loss of their jobs, their professional reputations and the possibility of historical “Hooverization” – was to scream for the biggest possible government action as soon as possible. 

Ben Bernanke had been blasé about the effects of ultra-low interest rates; he had pooh-poohed the possibility that the housing boom was a bubble that would burst like a sonic boom with reverberations that would flatten the economy. Suddenly he was confronted with a possibility that threatened to make him look like a fool. Was he icy cool, detached, above all personal considerations? Thinking only about banking regulations, national-income multipliers and the money supply? Or was he thinking the same thought that would occur to any normal human being in his place: “Oh, my God, my name will go down in history as the Herbert Hoover of Fed chairmen”?

Since the reasoning he claims as his inspiration is so obviously bogus, it is logical to classify his motives as personal rather than professional. He was protecting himself, not saving the country. And that brings us to the case of Chief Justice John Roberts.

Chief Justice John Roberts: Selfless, Self-Interested or Self-Preservationist?

For centuries, economists have identified self-interest as the driving force behind human behavior. This has exasperated and even angered outside observers, who have mistaken self-interest for greed or money-obsession. It is neither. Rather, it merely recognizes that the structure of the human mind gives each of us a comparative advantage in the promotion of our own welfare above that of others. Because I know more about me than you do, I can make myself happier than you can; because you know more about you than I do, you can make yourself happier than I can. And by cooperating to share our knowledge with each other, we can make each other happier through trade than we could be if we acted in isolation – but that cooperation must preserve the principle of self-interest in order to operate efficiently.

Strangely, economists long assumed that the same people who function well under the guidance of self-interest throw that principle to the winds when they take up the mantle of government. Government officials and representatives, according to traditional economics textbooks, become selfless instead of self-interested when they take office. Selflessness demands that they put the public welfare ahead of any personal considerations. And just what is the “public welfare,” exactly? Textbooks avoided grappling with this murky question by hiding behind notions like a “social welfare function” or a “community indifference curve.” These are examples of what the late F. A. Hayek called “the pretense of knowledge.”

Beginning in the 1950s, the “public choice” school of economics and political science was founded by James Buchanan and Gordon Tullock. This school of thought treated people in government just like people outside of government. It assumed that politicians, government bureaucrats and agency employees were trying to maximize their utility and operating under the principle of self-interest. Because the incentives they faced were radically different than those faced by those in the private sector, outcomes within government differed radically from those outside of government – usually for the worse.

If we apply this reasoning to members of the Supreme Court, we are confronted by a special kind of self-interest exercised by people in a unique position of power and authority. Members of the Court have climbed their career ladder to the top; in law, there are no higher rungs. This has special economic significance.

When economists speak of “competition” among input-suppliers, we normally speak of people competing with others doing the same job for promotion, raises and advancement. None of these are possible in this context. What about more elevated kinds of recognition? Well, there is certainly scope for that, but only for the best of the best. On the current court, positive recognition goes to those who write notable opinions. Only Judge Scalia has the special talent necessary to stand out as a legal scholar for the ages. In this sense, Judge Scalia is “competing” with other judges in a self-interested way when he writes his decisions, but he is not competing with his fellow judges. He is competing with the great judges of history – John Marshall, Oliver Wendell Holmes, Louis Brandeis, and Learned Hand – against whom his work is measured. Otherwise, a judge can stand out from the herd by providing the deciding or “swing” vote in close decisions. In other words, he can become politically popular or unpopular with groups that agree or disagree with his vote. Usually, that results in transitory notoriety.

But in historic cases, there is the possibility that it might lead to “Hooverization.”

The bigger government gets, the more power it wields. More government power leads to more disagreement about its role, which leads to more demand to arbitration by the Supreme Court. This puts the Court in the position of deciding the legality of enactments that claim to do great things for people while putting their freedoms and livelihoods in jeopardy. Any judge who casts a deciding vote against such a measure will go down in history as “the man who shot down” the Great Bailout/the Great Health Care/the Great Stimulus/the Great Reproductive Choice, ad infinitum.

Almost all Supreme Court justices have little to gain but a lot to lose from opposing a measure that promotes government power. They have little to gain because they cannot advance further or make more money and they do not compete with J. Marshall, Holmes, Brandeis or Hand. They have a lot to lose because they fear being anathematized by history, snubbed by colleagues, picketed or assassinated in the present day, and seeing their children brutalized by classmates or the news media. True, they might get satisfaction from adhering to the Constitution and their personal conception of justice – if they are sheltered under the umbrella of another justice’s opinion or they can fly under the radar of media scrutiny in a relatively low-profile case.

Let us attach a name to the status occupied by most Supreme Court justices and to the spirit that animates them. It is neither self-interest nor selflessness in their purest forms; we shall call it self-preservation. They want to preserve the exalted status they enjoy and they are not willing to risk it; they are willing to obey the Constitution, observe the law and speak the truth but only if and when they can preserve their position by doing so. When they are threatened, their principles and convictions suddenly go out the window and they will say and do whatever it takes to preserve what they perceive as their “self.” That “self” is the collection of real income, perks, immunities and prestige that go with the status of Supreme Court Justice.

Supreme Court Justice John Roberts is an example of the model of self-preservation. In both of the ObamaCare decisions, his opinions for the majority completely abdicated his previous conservative positions. They plumbed new depths of logical absurdity – legal absurdity in the first decision and semantic absurdity in the second one. Yet one day after the release of King v. Burwell, Justice Roberts dissented in the Obergefell case by chiding the majority for “converting personal preferences into constitutional law” and disregarding clear meaning of language in the laws being considered. In other words, he condemned precisely those sins he had himself committed the previous day in his majority opinion in King v. Burwell.

For decades, conservatives have watched in amazement, scratching their heads and wracking their brains as ostensibly conservative justices appointed by Republican presidents unexpectedly betrayed their principles when the chips were down, in high-profile cases. The economic model developed here lays out a systematic explanation for those previously inexplicable defections. David Souter, Anthony Kennedy, John Paul Stevens and Sandra Day O’Connor were the precursors to John Roberts. These were not random cases. They were the systematic workings of the self-preservationist principle in action.

DRI-192 for week of 6-7-15: Adding Entrepreneurship to Economics Makes ‘Disruptive’ Innovations Coordinative

An Access Advertising EconBrief:

Adding Entrepreneurship to Economics Makes ‘Disruptive’ Innovations Coordinative

Journalism pretends to be an objective profession. In reality, it is a subjective business. The subjective component derives from the normal limitations nature places on human perception; journalists may aspire to Olympian standards of accuracy and detachment, but they labor under the same biases as everybody else. The need to make a profit causes journalistic enterprises to cater to intellectual fads and fashions just as haute couture does when selling clothes.

The trendy business buzzword these days is “disruptive.” Ever since the Internet began revolutionizing life on the planet, technology has been occupying a bigger part of our lives. Somebody started saying “disruptive” to define new businesses that seemed to usher in noticeable changes in the status quo. When it comes to vocabulary, journalists imitate each other like parrots and chatter like magpies. Now slick magazines, websites and blogs are crawling with articles like “The 10 Most Disruptive Technologies/50 Most Disruptive Firms,” “How to Identify the Next Big Disruptive Technology” and “Which Sector Needs Disrupting the Most?”

It isn’t hard to identify disruptive firms; just picture the firms that have garnered the biggest and most recurring headlines – Apple, Amazon, Uber, Lyft, Airbnb, SpaceX and such. Our job here is to ascertain whether a systematic logic unites the success of these firms and whether the term “disruptive” is economically descriptive – or not. Business writers often associate disruptive technologies with economist Joseph Schumpeter, whose work we examined in last week’s EconBrief.

This association is understandable, but unfortunate. Schumpeter’s linking of entrepreneurial progress and capitalism with technological innovation is not the general case, but only a special case. That is, it is only a small part of the reason why capitalism has been so successful. Schumpeter’s view of the forest was obscured by a few redwoods, figuratively speaking. Even worse, the term “disruptive” – like Schumpeter’s famous phrase “creative destruction” – conveys an utterly misleading impression about the impact of entrepreneurial progress and technological innovation under capitalism.

Journalists and business analysts were right in looking to economics for an understanding of technological innovation. And, as we saw last week, they certainly didn’t get much help from traditional economic theory. But they picked the wrong maverick economist to consult.

A Brief Review 

Our previous EconBrief identified a serious lacuna in economic theory. No, make that multiple lacunae – certain simplifying assumptions that have alienated academic economics from reality. The pervasive use of high-level mathematics and statistical testing encouraged these assumptions because they kept economic theory tractable. Without them, economic models would not have been spare and abstract enough for mathematical and statistical purposes. In effect, the economics profession has chosen theoretical models useful for its own professional advancement but well-nigh useless for the practical benefit of the general public.

Evidence of this is supplied by the traditional indifference to entrepreneurship and innovation shown by mainstream theorists and textbooks. For contrast, we analyzed two striking exceptions to this pattern: the ideas of Joseph Schumpeter and F. A. Hayek. Schumpeter was contemptuous of the mainstream obsession with perfectly competitive equilibrium. He believed that economic development under capitalism was accomplished by a process of “creative destruction.” This did not involve small, incremental increases in output and decreases in price by perfectly competitive firms, each one of which had insignificant shares of its market. Instead, Schumpeter envisioned competition as a life-and-death struggle between large monopoly firms, each producing new products that replaced existing goods and improved consumer welfare by leaps and bounds. “Creative destruction” was a hugely disruptive process, a wholesale overturning of the status quo.

Hayek criticized mainstream theory just as strongly, but from a different angle. Hayek maintained that mainstream, textbook economic theory started out by assuming the things it should be explaining. Where did consumers and producers get the “perfect information” that traditional theory assumed was “given” to them? In effect, Hayek grumbled, it was “given” to them by the economists in their textbooks, not actually given in reality. He had the same complaint about product quality, an issue traditional theory assumed away by treating goods as homogeneous in nature. The trouble is that the vast quantity of information needed by consumers and producers isn’t available in one place; it is dispersed in fragmentary form inside billions of human brains. Only the price system, operating via a functioning free-market system, can collate and transmit this information to all market participants.

Hayek saw the true nature of equilibrium differently than did mainstream economists. The latter took their cue from mathematical economists such as 19th-century pioneer Leon Walras, who formulated equations for supply and demand curves and solved them algebraically to derive an equilibrium at which the quantity demanded and quantity supplied were equal. To Hayek, equilibrium meant that the plans human beings make in the course of living daily life turn out to be compatible, not chaotically inconsistent. That is the true Economic Problem – how to collect and transmit the dispersed information necessary to market functioning among billions of people in order to allow their plans to be mutually compatible.

Entrepreneurship – the Engine of Capitalism

Hayek’s work opened the door to an understanding of capitalism. We had long known that capitalism worked and socialism failed. But we could not supply a nuts-and-bolts, nitty-gritty explanation for why and how this was so. Theory is given little importance by the general public, but it is honored in the breach. The lack of a thoroughgoing theory of capitalist superiority has allowed a myth of socialist superiority to survive and even thrive despite the utter failure of socialism to prosper in practice. A disciple of Hayek and Hayek’s mentor, Ludwig von Mises, utilized the intellectual capital created by his teachers to complete their work.

Israel Kirzner was taught at New York University by Ludwig von Mises. His dissertation became an intermediate textbook on price theory, The Economic Point of View. In 1973, Kirzner synthesized the ideas of Mises and Hayek in a book called Competition and Entrepreneurship. For the first time, we had an explicit justification and explanation of the vital role played by the entrepreneur in economic life.

Heretofore, the entrepreneur had been the mystery figure of economic theory, akin to the Abominable Snowman or Bigfoot. To some, he was simply the organizer of production. To others, he was a salesman or promoter. To Schumpeter, he was an innovator who created new products using the lever of technology. Israel Kirzner took a completely different tack.

The keynote in Kirzner’s view of the entrepreneur is alertness to opportunity within a market framework. As a first approximation, the entrepreneur’s attention is fixed upon the price system. He or she is constantly searching for “value discrepancies;” that is, differences between the price(s) of input(s) and output. For example, he may observe that a, b and c can combine in production to produce D. The price of amounts of a, b and c sufficient to produce one unit of D is $5, while the entrepreneur sees (or envisions) that D will sell for $10. This act of intellectual visualization itself is what constitutes entrepreneurship in Israel Kirzner’s theory. Acting upon entrepreneurial observation requires productive activity.

There is a family resemblance between Kirzner’s concept of entrepreneurship and what is often termed “arbitrage.” But the two are far from identical. Arbitrage is loosely defined as buying and selling in different markets to profit from price differentials. Often, the same good is purchased and sold – simultaneously if possible – to reduce or even eliminate any risk of financial loss. Kirznerian entrepreneurship is far more comprehensive. Different goods may be involved, purchases need not be simultaneous or even close to it; indeed, markets for some of the goods or inputs involved may not even exist at the point of visualization! The entrepreneur may be contemplating the introduction of an entirely new good, a la Schumpeter. At the other extreme, the entrepreneur may be hoping to profit from the smallest price discrepancy in the most homogeneous good, as banks or traders do when they arbitrage away tiny price differences in stocks, bonds or foreign currencies in different exchanges.

In fact, the entrepreneur need not even be a producer or a seller at all. Consumers can and do engage in entrepreneurial activity all the time. Consumers clip and redeem coupons. They scan newspapers and online ads for sales and comparative prices. This activity is analytically indistinguishable from the activity of producers, Kirzner claims, because in both cases there is a net increase in value derived by consumers – and consumption is the end-in-view behind all economic activity.

The Consumer as Entrepreneur – A Case Study

In 1965, Samuel Rubin and a few friends were dismayed by the vanishing interest in, and availability of, silent movies. They held a small film festival for silent-movie enthusiasts and created the Society for Cinephiles. This gathering became the first classic-movie film festival. Fifty years later, Cinecon remains the oldest and most respected of this now-worldwide genre. Three years later, Steven Haynes, John Baker and John Stingley hosted a small gathering for classic-movie lovers in Columbus, Ohio. This year, Mr. Haynes died after planning the 47th meeting of the Cinevent festival, which annually attracts a few hundred dedicated lovers of silent and studio-system-era movies. In 1980, classic-movie fanatic Phil Serling began the Cinefest gathering in Syracuse, New York with a few close friends. 2015 marked the final meeting of this festival, which attracted attendees from around the world. Today the San Francisco Silent Film Festival is a headline-making event featuring the latest newly found and restored rarities.

This genre of classic-movie worship was begun by consumers, not by profit-motivated producers. But these consumers nevertheless were alert to opportunity – the discrepancy in value between the movies currently available for viewing and those of the past. Prior to the digital age, older movies (particularly silent movies) were seldom screened and hard to view. Moreover, they were disintegrating rapidly and dangerous to maintain because of the fire-danger posed by nitrate film stock. Yet thanks to the efforts of these pioneering consumers, today we have multiple television channels exclusively, primarily or secondarily devoted to showing classic films, including silent movies. Turner Classic Movies (TCM) leads the way, while the Fox Channel is close behind. Over twenty thousand people attend the Turner Classic Movies Festival in Hollywood every year and TCM’s annual cruise and other promotions attract thousands more. Film preservation is a major endeavor, with new discoveries of heretofore “lost” movies occurring every year. Classic movies is big business, thanks to the dispersed entrepreneurship efforts of the scattered but determined few decades ago. The small net gains in value experienced by the silent-movie lovers in 1965 multiplied millions-fold into the consumption gains of millions worldwide today on television and in person.

Schumpeter Vs. Hayek/Kirzner: Away from Equilibrium or Towards It?

Contemporary business analysts take an ambivalent attitude toward innovation and entrepreneurship. They give lip service toward its benefits – new products and services, the benefits reaped by consumers. But they imply in no uncertain terms that these benefits carry a terrible price. Terms like “creative destruction,” with heavy emphasis placed on the second word, directly state that there is a tradeoff between consumer gains and destructive loss suffered by workers, owners of businesses driven into insolvency and even members of the general public who lose non-human resources that are somehow vaporized by the awesome power of technology. Instead of stressing the labor-saving properties of technology, commentators are more apt to refer to labor-killing innovations. No wonder, then, that journalists have turned to Schumpeter, whose apocalyptic view of capitalism was that its superior productivity would ultimately prove its undoing. With friends like Schumpeter, capitalism has grown ever more defenseless against its enemies.

Schumpeter believed that entrepreneurial innovation was both creative and destructive – creative because its products were new, destructive because they completely supplanted the replaced competing products, driving their competition from the field. In the technical sense, then, Schumpeter saw entrepreneurs as a dysequilibrating force, spearheading a movement away from one stable equilibrium position to a different one. Schumpeter himself recognized that, in practice and unlike the blackboard transitions that academic economists effect in the blink of an eye, these movements would often be wrenching. But the analysis of Kirzner, using the framework built by Hayek and Mises, leads to different conclusions.

Kirzner acknowledged the validity of Schumpeter’s form of entrepreneurship. But he recognized that it was only the exceptional case. The garden variety, everyday forms of entrepreneurship – practiced by consumers as well as producers – produce movements toward equilibrium, not away from it. This is true for two reasons. First, entrepreneurship does not lead away from equilibrium because the traditional concept of equilibrium is a myth; reality changes far too quickly for actual equilibrium ever to be reached, let alone be maintained. Second, entrepreneurship leads toward equilibrium because it enables human beings to better coordinate their plans by allowing a more efficient exchange of information. Hayek objected to the traditional economic assumption of “perfect information” because he claimed that this assumed the existence of equilibrium at the outset. Kirzner’s theory of entrepreneurship tells us that the so-called “disruptive” businesses of today are pushing us closer and closer to that condition of perfect information – which means we are getting closer and closer to perfectly coordinated equilibrium. Of course, we never reach this blissful state, but capitalism keeps us steadily on the move in the right direction.

What is Google, with its search-engine technology, if not the search for the economist’s informational Shangri-La of perfect information? Wikipedia, a user-created encyclopedia, is the archetype of Hayek’s model of a world in which information exists in dispersed, fragmentary form that is unified by a voluntary, beneficial market. Facebook has become a colossus by making it easy for people to provide information about themselves to others – and in the process become a kind of worldwide clearinghouse for information of all kinds. Pinterest has narrowed this same type of focus to photos, but the key is still information. Newer technology businesses like Crowd Strike, specializing in cyber intelligence and security, and the Chinese company Tencent, with its emphasis on mobile advertising, are also informational in character.

In each of these cases, entrepreneurs were alert to the market opportunities opened by technology and signaled by the low prices ushered in by the digital age. The entrepreneurial character of some of these businesses has baffled the business establishment because it has not emulated the conventional, profit-seeking model. That is usually because the initial entrepreneurs have been consumers striving to create value for their own direct use. Only later have they realized the potential for exporting the value surplus created to the rest of the world. This looks outré to most observers but it is fully consistent with Israel Kirzner’s theory of entrepreneurship.

Another of the unrealistic simplifying assumptions deplored by Hayek was “costless” transactions, particularly entry, exit and determination of product quality. This was another case of economists assuming what they should be proving, or at least investigating; it started out by assuming equilibrium and skipped the market process necessary to produce – or, more realistically, approach – an eventual equilibrium. The technological innovations of the last two decades that weren’t information in character were mostly directed at reducing various costs, either natural or man-made costs.

The Internet itself is a mammoth exercise in reducing the costs of transport and communication. Instead of calling in the telephone, we can now send an e-mail. By inventing smartphones, Apple has one-upped the Internet and desktop computers by making this communication mobile. In between these two inventions, of course, came cell phones – invented decades earlier but made practical when Moore’s Law eventually shrank them to pocket size. The shocking thing is how little economics had to say about any of these revolutionary human innovations – because traditional economic theory had long assumed zero transport and transactions costs. Why concern yourself with an innovation when your theory says there is no need for it in the first place?

The development of cell phones was held back for years by government regulation of telecommunications, which fought tooth and claw to prevent competition between phone companies and innovation by monopoly providers. In formal logic, the effect of government regulation is best envisioned as equivalent to the effect of a mountain range or an ocean on transportation. Alternatively, think of costs as being like taxes. Transport costs are “levied” by nature, while taxes are levied by governments. Transactions costs may be either natural or man-made. And a review of recent “disruptive” businesses shows many designed specifically to overcome either natural or man-made costs.

The entrepreneurs of Uber and Lyft observed the artificially high taxi fares created by local-government regulation in the U.S. and elsewhere in the world. They envisioned lower prices and faster response-times resulting from assembling a voluntary workforce of casual drivers and independent professionals, operating free from the stranglehold of regulation. Airbnb looked at the rental market for habitation and saw the potential for achieving the same kind of economies by enlisting owners as vendors. Jeff Bezos of Amazon envisioned consumers freed from the shackles of traveling to retail stores and a supplier with transport costs lowered by economies of scale. The result has shaken the world of retail sales to its foundations. (We should note that this combines the lowering of natural transport costs and the lowering of artificial man-made sales taxes.) Driverless cars threaten an even bigger revolution in the world of transportation by overcoming the costs of human error and accidents – if they can overcome the “tax” of government regulation to achieve liftoff. Body sensors are a revolutionary innovation triggered by the consumer desire to overcome high medical costs of maintaining good health, which are an artifact of regulation. The new website Open Bazaar dubs itself “a decentralized peer-to-peer marketplace” whose goal “is to give everyone in the world the ability to directly engage in trade with each other.” In other words, it is dedicated to reducing transactions costs to the irreducible minimum.

Once again, these cost-based innovations are entrepreneur-driven. Again, some of them were pioneered by consumers rather than by the corporate or venture-capital establishment. This is exactly what we would expect, given the theory developed by Israel Kirzner.

Monopoly or Competition? 

Schumpeter believed that true progress came from monopoly, not competition. He meant monopoly in the effective, substantial sense, not merely the formalistic sense of a transitory market hegemony enjoyed by the innovator. Events have clearly proven Schumpeter wrong. It is hard to find a case today that would correspond to Schumpeter’s archetype; instead, the initial innovator has been superseded by somebody else. Market leadership has been the result of performance, not entry barriers or patents or government pull. And the innovators themselves have often been “nobodies” rather than monopolists boasting war chests heavy with monopoly profits.

Pattern Prediction

In 1929, Ludwig von Mises predicted a “great crash” and refused to take a position in the Austrian government for fear of association with the economic downturn he anticipated. F.A. Hayek predicted a sharp recession, pursuant to the business-cycle theory he had recently developed. Later, Hayek predicted the failure of Keynesian counter-cyclical fiscal and monetary policies and the high worldwide inflation of the 1970s, coupled with the recession that followed measured taken to break the inflation.

In general, Hayek did not believe that accurate quantitative prediction of economic events was possible. At most, he felt, economic theory could offer “pattern predictions” of a more general nature. His own statements, both in economics and political philosophy, tended to support this approach.

Israel Kirzner did not “predict” the advent of the Internet or the invention of the smartphone. But the technological revolution and the businesses spearheading it conformed to the general pattern of entrepreneurship outlined in Israel Kirzner’s theory. In this sense, while this revolution came as a complete surprise to the mainstream economics profession, it can hardly have surprised Kirzner. The revolution was led by people behaving just as Kirzner hypothesized that entrepreneurs do behave.

Can the Status Quo be “Disruptive?”

Based on our analysis and Israel Kirzner’s theory of entrepreneurship, the business buzzword “disruptive” is misleading when applied to the cutting-edge firms and technologies of today. It is indeed true that these technologies overturn the status quo. But the status quo is hindering human progress and preventing attainment of true economic equilibrium; it is hurting people rather than helping them. If transport costs or transaction costs or taxes or regulation are hurting people – and helping at most only a minority vested interest in the process – then changing the status quo is the indicated action. “Stability” is not always good. After all, Stalin’s Soviet Union was stable. Fortunately, the Soviet Union later collapsed when that stability disintegrated.

As Israel Kirzner himself has always maintained, economics is all about making people better off. When this criterion is placed foremost, discarding the pure formalism of mainstream theory, is becomes clear that Mises, Hayek and Kirzner were right and Schumpeter was wrong. Entrepreneurship is equilibrating because it tends to better coordinate the plans made by individual human beings.

The process by which Nobel Prizes are awarded is highly secretive. The Nobel committee keeps their candidate “cards” close to their vests. Rumors have circulated, however, placing Israel Kirzner’s name on the short list of potential awardees. No man alive has done more than he to redeem the tarnished prestige of economics as a subject worth studying for its practical value to humanity.

DRI-184 for week of 5-31-15: Why is Economic Theory MIA Amidst Humanity’s Biggest Innovation Boom?

An Access Advertising EconBrief: 

Why is Economic Theory MIA Amidst Humanity’s Biggest Innovation Boom?

It is obvious even to casual observers that humanity has experienced an unprecedented boom in technological improvements in recent decades. Apparently even greater advances lie in store, although some contrarians insist that the best is behind us. We might expect to find economists in the thick of all this – spotting trends, lauding entrepreneurs and listing the factors responsible for their success, toting up the gains in real income, output and wealth, applauding the effects on rich and poor alike and approving the nosediving rate of world poverty.

Those expectations would be disappointed, at least by a perusal of mainstream sources. True, there are periodic ex cathedra pronouncements by stray economists on these matters. Scattered foundations, think tanks and institutes devoted to entrepreneurship pop up. The continuing popularity of the late maverick economist Joseph Schumpeter ensures that the subject of innovative entrepreneurship does not fade entirely from the public consciousness or the minds of economists. But the leading professional journals in economics, such as The American Economic Review and the Journal of Political Economy, remain preoccupied with the perennial concerns of the profession. And those do not include the topics of innovation and entrepreneurship.

Why not? What have critics of mainstream theory suggested to improve matters? Those are the subjects of this EconBrief. Next week we will see how non-traditional economic theory can improve our understanding of revolutionary technological innovation.

The Wrong Turns in Economic Theory

In the 1870s, economic theory underwent a revolution. Prior to that time, a vital element was missing from economics. Its theory of value was defective. The Classical Economists believed that the value of economic goods depended on the objective cost of the inputs that went into their production. They lacked a solid, systematic theory of consumer demand. Beginning in 1871, three different economists – working independently in England, Switzerland and Austria – developed the concept of marginal utility, thereby laying the foundation for the modern theory of consumer demand. This Marginal Revolution presaged the Laws of Supply and Demand and the famous diagram depicting equilibrium price formation via the junction of the supply and demand curves. (The diagram was dubbed the “Marshallian Cross,” after the great English economist who popularized it, Alfred Marshall.)

One of the original three founders of marginal utility, Leon Walras, was also the modern developer of mathematical economics. Walras believed that the most concise and precise means of depicting economic relationships was by expressing them in mathematical form. He envisioned an economy as a mathematical model consisting of supply-curve equations for all goods and demand-curve equations for all consumers. He stated that such a system of equations could be solved simultaneously – that is, algebraically – to yield an equilibrium solution. That equilibrium would be one in which the quantity of each good chosen by all consumers and the quantity supplied by all producers would be identical. Eighty years later, two economists proved Walras’s conjecture correct and later received a Nobel Price for their efforts.

Walras believed that his procedure was more scientific than that followed heretofore by economists because it imitated the procedures of the physical sciences like biology, chemistry and astronomy. Despite his scientific pretensions, he also believed that economists could never hope to actually formulate a full set of general equilibrium equations in which actual coefficients were calculated for the variables. As the years went on, Walras’s mathematical approach gained steadily in popularity, but economists inherited none of his realism. Meanwhile, the canons of statistical inference developed by the English mathematical statistician Ronald Fisher also gained favor and were applied to the social science of economics as well as to the natural sciences. After World War II, economists increasingly practiced their craft by developing a mathematical model to express a theoretical hypothesis and using statistical methods to “test” its validity and quantitative boundaries.

This modus operandi seduced the economics profession en masse. In view of its disastrous effects, we might well ponder why this research agenda proved so irresistible. First, it provided a made-to-order research agenda to justify diverting attention away from instruction. Second, it provided an apparently objective standard by which to evaluate faculty for tenure and later promotion. This, in turn, allowed administrators to press graduate students and non-tenured adjunct faculty into service as cut-price teachers of the undergraduate curriculum while the faculty did research and earned money from consulting contracts. It turned economics departments of public universities into sausage factories for producing research studies for academic journals. This made politicians and bureaucrats happy because it gave them several excellent excuses for spending more money – “investing” in research, democratizing higher education by loaning money to students in an effort to create “universal” higher education. (“Universal service” and “affordability” are the two leading political excuses for redistributive spending.) The face that this “research” was completely worthless to everybody except economists meant that the public wouldn’t poke its nose too deeply into the process – which suited everybody involved.

Indeed, the output of this research agenda turned out to be of little value even within the economics profession. The fact that a mathematical model is “precise” and “rigorous” means nothing in itself. The question is: Can the mathematical models of economists capture human action sufficiently well to be of practical use? In the mid-1990s, the noted economists Deirdre McCloskey and Steven Ziliak discovered that economists (and many other scientists) had been misusing the statistical tools of Fisher, et al for years, thereby vitiating the empirical as well as the theoretical basis of most economic research.

Mathematics and statistics work well in the natural sciences because the phenomena are under study in controlled circumstances, which enables the staging of meaningful experiments. This permits the finding of empirical regularities or laws in the natural sciences. But human action, unlike that of inanimate objects and simple life forms, is both purposeful and full of complexity and ambiguity. Moreover, economic life is ordinarily not subject to controlled experimentation. Consequently, the practical results of the economic research model using mathematical models and statistical testing have been hugely disappointing.

The model still lingers on because it is so convenient for the people whose preferences matter most in universities; namely, government, administrators and faculty. The people badly served – undergraduate and graduate students – are the lowest forms of animal life in the university setting.

It is highly interesting to observe that this outcome is directly counter to the very logic taught by economics. Consumption is the end-in-view behind all economic activity. This includes university study and research. Thus, economic logic counsels removing universities from the aegis of government and subjecting them to market competition by abolishing tenure, privatizing research funding and separating the functions of teaching and research. Unfortunately, the two vested interests who have the most to lose from this change in approach, faculty and administrators, are the ones most powerfully in control of the present system.

If You’re So Smart, Why Ain’t You Rich? 

Inevitably, some readers will disagree with the foregoing, perhaps even find it outrageous. The dissenters should ask themselves what the distinguished economic historian and statistician Donald (now Deirdre) McCloskey called “the American question:” If you’re so smart, why ain’t you rich?” Here, the “you” are economists who devise theoretical models for stock and options prices, bond prices, GDP and interest rates. If those models really work – if they are statistically “robust” – why haven’t economists become rich as Croesus from using them to predict the future course of financial markets? For that matter, why were economists generously willing to publish their results for the world to see rather than jealously hoarding them as a source of income?

Most people couldn’t care less whether economist themselves make money from their work, but they are passionately convinced that government should somehow “regulate” the economy to make good things happen for them and prevent bad things from happening. Where did governments, which have existed for thousands of years of human history in myriad forms, suddenly acquire this mystical power to control human behavior and steer the course of future events?

Well, if the alleged control relates to the so-called “macro economy,” it clearly dates back to 1936 and the publication of John Maynard Keynes’ famous treatise on employment, interest and money. Here, the version of the American question relates to policy: Why hasn’t Keynesian economics worked as advertised? After forty years of the most intensive research ever expended on a scientific topic and forty more years of attempts to modify Keynesian theory and put it into practice, the world finds itself perched on a financial precipice.

Then then there are those who apply the term “regulation” in an administrative sense to individual industry sectors, or even to individual firms. In this case, the “American question” should be modified to “if you’re so smart, why ain’t you running the business?” Agency regulation is such a nebulous concept that any attempt to criticize it allows proponents to slide out from under by changing the terms of the argument. But proponents cannot be permitted this luxury; regulation must have some definite purpose. And in practice, government regulation of business fails every test known to mortal man. The things that most people claim they want from regulation are precisely the things that can only be supplied by market completion rather than by regulation. Regulation is not a supplement or corrective to competition; it is an inferior substitute for it.

This failure of economic theory is particularly important because it drags the research model down to failure along with it. The majority of academic economists are left-wing in political orientation. (After all, they work for government.) In practice, their theoretical model and statistical tests have been designed to demonstrate the failure of free markets and the need for government intervention to produce an optimal result. The optimal result is the one that would obtain if private markets worked perfectly. Since they don’t, so runs the academic party line, we need government intervention and regulation to correct the market failures.

But real life has overtaken the academic research model. It is free markets, not government- controlled ones, that deliver the goods. This is still another argument for junking the current research model. It’s hard to do good research starting with a bad economic theory.

The Nitty-Gritty: Where Does Mainstream Economic Theory Go Wrong?

We have said that the mathematical model seduces economists into wrongly specifying their theoretical models. Exactly what does this mean?

Go back to Walras’s model of supply and demand. He, or rather his successors, assumed that we could model consumer demand as a function of consumers’ incomes, tastes and the prices of substitutes and complements for the good under study. But this implicitly assumes that consumers know all this information. As we all realize, they don’t. Nevertheless, it was long traditional for economists to begin by assuming the existence of “perfect information.” Since people consume not only in the present moment but also save for future consumption, this perfection of knowledge applied to the future as well as the present.

How’s that for an abstract model with no relationship to reality?

The same consideration applies on the supply side of the market, where producers are assumed to know not only every price relevant to the production of their own product – all input prices, the prices of all competing goods and so on – but also all technological facts relevant to production of their product and related products. And that’s not all, folks.

When devising models of general equilibrium, economists long assumed that all firms were “price-takers.” That simply meant that each firm supplied such a miniscule fraction of total market output that its contribution to that output had virtually no effect on the market price. That is, regardless of whether it operated at maximum production or went out of business, the market supply curve didn’t budge enough to change the equilibrium price materially. Therefore each firm took the market price as a parameter and treated the quantity it supplied as its only decision variable.

What about the quality of the good it produced? That led to still another simplifying assumption. Since “quality” was a variable that seemed to defy quantification, economists at first sought to treat the output of all firms as homogeneous – thereby removing product quality from discussion.

At this point, readers are probably experiencing the same mixture of disillusion and disbelief that hits college freshmen and sophomores when they are exposed to the economic concept of “perfect competition” for the first time. “What planet do economists live on” is a representative specimen of the thoughts running through student heads at this moment.

As a temporary venture in devil’s advocacy, it is worth noting that an individual farmer operating in certain industries may meet some of these criteria. It is not too big a stretch to treat a particular variety of (say) wheat as a homogeneous good and it is definitely no stretch to treat the output of (say) one family farmer as an insignificant fraction of industry output. But even this kind of partial correspondence between model and reality is the exception, not the rule.

Over the decades, economists have modified the stringent assumptions listed above in various ways. But these modifications have been minor in their practical consequences. Instead of assuming perfect knowledge, for example, economists assumed that market participants possessed probability distributions about the outcome of future events or the existence of certain kinds of information. This minor concession didn’t add much value to their models. If I can play blackjack using the “card-counting” technique, this shifts the odds slightly in my favor. I will always win in the long run, assuming that my initial stake is big enough to withstand any runs of bad luck and I can play “forever.” Unfortunately, most economic decisions do not offer even this probabilistic level of certainty, let alone the perfect information available in the less sophisticated version of economic theory. (And in real life, blackjack doesn’t either; the casinos will ban me if they catch me card-counting.)

Economists introduced even more modifications on the supply side of markets. Beginning in the 1930s, they began to contemplate alternatives in between the polar opposites of perfectly competitive markets and pure monopoly. But these alternatives, such as product differentiation and strategic interaction among a small number of large firms, were so slow to catch on that economists became habituated to focusing only on the equilibrium outcomes of markets and not on market processes. This meant that even when more sophisticated models began utilizing game theory and other non-traditional approaches, their focus was still directed away from entrepreneurship and innovation.

The Effects on the Study of Innovation and Entrepreneurship

The esoteric assumptions behind mainstream, traditional economic theory have backed that theory into a corner. Economists came to depend on the research model behind the theory for their livelihood. This gave them an underlying, unconscious identification with its biases and conclusions.

When Alfred Marshall first promoted his supply-demand Marshallian Cross, he viewed it as a valuable teaching tool for educating the masses. But economists became so obsessed with the concept of equilibrium that it became the primary focus of every theoretical model. The conditions necessary for equilibrium and the conditions prevailing at the state of equilibrium became the centerpiece of nearly every journal article. Little or nothing was said about the time-path to equilibrium and what might affect it.

The noted economist Joseph Schumpeter (1883-1950) prided himself on his personal and professional eccentricity. (He is said to have espoused the goals of being the best horseman in Vienna, the best lover in Europe and the best economist in the world.) In his theory of economic development, he derided the mainstream obsession with equilibrium, perfect competition, perfect information and – most of all – product homogeneity. Schumpeter believed that economic progress was made primarily by firms that created entirely new products. This could come about only as a result of innovation.

But Schumpeter knew that the mainstream world inhabited by his colleagues was hostile to the notion of innovation. In traditional economic theory, perfectly competitive firms were each earning a “normal” profit in long-run equilibrium. That is another way of saying that each firm’s books recorded exactly enough money under the heading “profit” to prevent shareholders from withdrawing their money and investing elsewhere, but not enough to attract the entry of new competitors into the industry. (Another way of putting it would be to say that the firm’s investment earned an amount equal to the best alternative investment of equal risk; e.g., its “opportunity cost” of investment was exactly covered.) In such an environment, an innovator would find that any temporary profits from creating a new product would soon – in principle, instantaneously – be competed away by a horde of imitative firms entering the market. After all, with “perfect information” all relevant information necessary for production would be publicly known.

According to Schumpeter, innovative firms strive not only to erect but to maintain durable monopoly positions in the products they create. The resulting monopoly profits not only reward owners for the risks they take but also bankroll the research necessary to improve their product and create new innovative products. The actual world of imperfect information makes it harder on producers but it also makes it easier to maintain monopoly status once it is attained.

Mainstream economists couldn’t stomach this analysis because they had been preaching (and practicing) a doctrine of enforced competition and government intervention to eradicate monopoly. How could they now praise the monopoly structure that they had made their bones by condemning? (Of course, economists were all-too-willing to relax their standards and overlook monopoly when it was organized and enforced by government itself because they viewed government as the sole economic actor not actuated by self-interest. In effect, economists of Schumpeter’s day were, and remain today, employees of Government R’Us.)

Schumpeter replied to his mainstream colleagues by pointing out that innovating monopolists did face competition even if they were able to exclude direct competitors from their market by (for example) obtaining patent protection for their new products. That competition came from other creative would-be monopolists. After all, the demand for the original monopolist’s product had to come from people shifting purchases from goods being produced by competitive firms. Why wasn’t the monopolist also vulnerable to the same line of attack from other innovators?

For Schumpeter, “competition” was not merely a dull, incremental process of bland, homogeneous products duking it out for tiny shares of a market and a normal profit. He called his model of competition between monopolists “creative destruction,” implying that innovation can occur only by destroying or disrupting the existing order in favor of a new creative equilibrium – which will eventually be toppled by a new innovator. Thus, said Schumpeter, “…competition from the new commodity, the new technology, the new source of supply, the new type of organization… which… strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives,” is the true explanation behind the superiority of free-market capitalism to other systems. In Capitalism, Socialism and Democracy, Schumpeter cited the example of ALCOA, a “monopoly” so notorious that it would soon be convicted under U.S. antitrust laws. Yet between 1890 and 1929, the price it charged for aluminum had fallen by 91% and its output had risen by a factor of 30,000! Schumpeter believed that the company had, in effect, been competing against the threat posed by potential competition.

Schumpeter was the most popular of the economic heretics because his model corresponds much more closely with certain aspects of reality. New products and product heterogeneity are a fact of life. Market uncertainty faces every participant, none more so than the would-be innovator. If injected with truth serum, every economist would be forced to admit that the concept of equilibrium is best conceived as a constantly changing point toward which competitive markets tend, rather than a point of rest actually attained by real-world markets.

The more telling critique of traditional economic theory, though, was made by Schumpeter’s fellow Austrian, F.A. Hayek (1899-1992), from a different theoretical perspective. Hayek pointed out that the term “perfect competition” violates every commonsense precept of the word competition. Under perfect competition, each firm has no sense of any other firm as a rival, hence does not perceive itself as “competing” with anybody. It has no incentive to lower its price for competitive reasons since it can already sell all it produces at the prevailing market price. If it attempted to raise its price arbitrarily, its sales would fall to zero. Every firm produces exactly the same product, so there is no competition on the basis on product quality.

Another simplifying assumption of traditional theory has been that no barriers to entry or exit exist in a “competitive” industry. This absence of barriers was formalized mathematically as costless entry and exit, meaning that the emergence of profits above those available in comparable investments elsewhere would instantly attract new entrants. The additional supply provided by that new entry would lower market price until the supra-normal profits were fully eroded.

What is there left to compete about? Nothing. Each firm selects the rate of output optimal to its situation; that is all. “Price-taking behavior” is the antithesis of “competition” as it is commonly understood. In “The Meaning of Competition” (1946), Hayek observes that the array of simplifying assumptions made by traditional theory assume competitive equilibrium to exist – the process that brings it about it not explained by the theory but merely assumed at the outset. Nowhere does the theory explain how or why information should be so perfect, entry should be so easy, goods should be homogeneous and so many firms should exist.

Hayek found the assumption of “perfect information” especially paradoxical. Assuming that everybody knows everything is really just a way of evading the issue that economists should be making the central issue of their studies; namely, how is information transmitted and acquired in a market economy? We know that people know some of the things that economists assume they know – the question is how they came to know them.

When Hayek broached this issue in a seminal article – “The Use of Knowledge in Society” in 1945 – the fashion among economists was to treat information about prices and goods as “given data.” He wondered to whom the data were “given?” The phrase must have meant “given to the observing economist” rather than actually given to the people who were supposed to possess it, since there was no agency that literally gave people such information. “The data from which the economic calculus starts are never for the whole society ‘given’ to a single mind… and can never be so given.” In fact, no one person or institution possessed it in its totality. It existed only in dispersed, fragmentary form in the minds of many millions (today, read “billions”) of people.

There is only one way for people to acquire the invaluable information they need to participate effectively in a market economy. They get from markets themselves. That is why free markets are a necessary prerequisite for economic prosperity.

In another article (1937’s “Economics and Knowledge”), Hayek illumined the concept of equilibrium even more brightly than did Schumpeter. Rather than treating equilibrium merely by defining it as the correspondence of quantity demanded with quantity supplied in a market or markets, Hayek looked at the human implications of this fact. People order their lives by making plans that guide their behavior. When their individual plan is optimal when juxtaposed with the galaxy of facts at their disposal, the individual is said to be “in equilibrium.” But each individual’s plan is typically made independently of others; all plans need not automatically or necessarily be compatible with each other a priori. A market is said to be in equilibrium when all plans do mesh and are compatible. Thus, the impersonal workings of a free market serve to coordinate the plans of individuals by collating the dispersed information existing in the minds of its participants and using it to reconcile the wants and needs of all.

Writers of economics textbooks have traditionally begun by outlining what they call the Economic Problem. Since the resources necessary to produce economic goods are scarce and have alternative uses, we must allocate them logically in order to best satisfy the infinite wants of consumers. Optimal allocative logic is what textbook writers envision as economic theory.

Hayek redefined the Economic Problem. Because economists themselves do not possess the knowledge that mainstream theory has assumed market participants possess, they cannot “allocate” resources. Neither can government, for the same reason. The knowledge exists only in dispersed form, and the only way to unlock and make use of it is by utilizing markets to collate it and distribute it. That same market process then coordinates the plans of market participants to make them (more) compatible. The true Economic Problem is how to coordinate the plans of individuals by distributing the dispersed information not possessed by any one individual or institution.

We know that free markets perform this function better than government central planning and regulation. For over seventy years, central planning reigned in the Soviet Union. The result was the antithesis of coordination, in which an ordinary citizen might spend as much as six hours per day standing in line or hiring substitutes to do it for him. And the reward was a level of income and wealth equal to a small fraction of that obtainable in free societies without having to stand in line.

The Revised Economic Theory: Innovation and Entrepreneurship

Hayek’s work paved the way for an explicit economic theory of entrepreneurship and innovation, one that not only corrected the errors of mainstream theory but also put the work of Schumpeter in its proper perspective. In this space next week, we will explain how one man – now apparently on the short list for the Nobel Prize in economics – extended and refined Hayek’s analysis.