DRI-358 for week of 10-7-12: More Expensive Free Lunches

An Access Advertising EconBrief:

 

More Expensive Free Lunches

 

Last week’s EconBrief developed the economic concept of the free lunch. “There’s no such thing as a free lunch” may be the most famous of all economic aphorisms. Often credited to Milton Friedman, it owes much to that late Nobel laureate’s astonishing talent for exposition. Friedman pointed out that the notion of a free lunch violated the principle of opportunity cost, which undergirds the very subject of economics. Since resources have alternative uses, anything produced using scarce resources must be costly. The highest-valued alternative output foregone constitutes the opportunity cost of production.

Neglect of opportunity cost is the hallmark of the free lunch. Another distinctive feature is the underpricing of a scarce good or resource on the pretext of improving welfare. The pretext obscures the true purpose of the free lunch, which is to grow government. Expansion of government regulation, agencies, bureaus and programs is another characteristic of the free lunch. Finally, the presence of unintended collateral damage – often the result of overindulgence in the underpriced “free” good – is an unmistakable sign of a free lunch.

 

Water Subsidies in the West

The lure of the free lunch acts as a sort of political Venus Fly Trap, tempting unwary citizens within range so as to swallow them up. Once gobbled up by the system, nobody emerges whole.

Farmers in the western United States were sucked in during the late 1800s and early 1900s. In this case, the lure was not a free lunch but a free drink – of water. The federal government built huge reservoirs and accompanying dams that it used to provide electric power. It made the water available to farmers in California’s Central Valley for purposes of irrigation.

As with free lunches to schoolchildren, the accompanying rhetoric was redolent with poetry and sentiment. The irrigation would “make the desert bloom.” And so it did. Eventually, farmers were able to grow crops on land that previously had little agricultural use. The federal government paid the farmers not to grow crops on the land, causing the farmers to set aside acreage and farm remaining land much more intensively, using larger amounts of water, fertilizer and pesticides. Then the federal government bought the crop surpluses produced by the farmers to artificially support crop prices, using taxpayer funds to pay for storage.

The tilled land was burned out by over-cultivation. Insects became resistant to the pesticides. Water shortages plagued the West. This was particularly irksome to farmers on better land located closer to the dams and reservoirs, who nevertheless needed some water for irrigation. Waterfowl and other wildlife species died by the tens of thousands as wetlands habitat dried up.

Acrimonious political divisions developed between Central Valley farmers and outsiders. Needless to say, farmers defended their subsidies, which had become a lucrative source of income.

Economists saw the problem as another free lunch gone wrong. The government undercharged Central Valley farmers for the water provided to them. Indeed, most communities through the U.S. and the world do not charge a true economic price for water. That is, a government-owned and operated water monopoly charges a flat rate for water usage instead of charging a price per unit of water consumed. This flat rate is economically equivalent to a price of zero.

Why? Because it is unchanged whenever the consumer increases or decreases water consumption. Thus, the marginal sacrifice (in terms of consumption foregone) for additional water consumed is zero. Under these circumstances, people are moved to treat water as a free good, to consume the maximum amount of it. Water is not a free good; additional quantities of it must be discovered, pumped, purified sufficiently for human consumption and made available to the consumer. Thus, by lying to the public, government encourages people to consume water well past the point where the personal value people place on additional water consumption is equal to the cost of producing and supplying that additional water. Because the cost exceeds the value, we are made poorer by the government policy.

Once more, practically everybody loses from the government “free lunch” policy on Western water. The possible exceptions are Central Valley farmers and government employees in the Department of Interior. Members of the Bureau of Reclamation and the Department of the Interior have made careers out of serving their constituents in the Central Valley. And, of course, proponents of big government can point to the irrigation projects and blooming desert and harvested crops. What can opponents point to? About all they can do is point to the environmental blight, the dead and dying wildlife. But farmers can deny that this has anything to do with them – they are just hardworking farmers, tillers of the soil – hardworking, God-fearing families who developed the desert in good faith.

Once again, the pattern is clear. A form of subsidy that benefits a few at the expense of the rest becomes entrenched and cannot be eradicated. No wonder, then, that economists wince when these programs start up. No wonder they take such an irritating, unyielding, hidebound stance against them. Once the programs are in place, dynamite cannot dislodge them.

Road Use

Americans are accustomed to climbing in their automobiles and taking off across the open road without let or hindrance. Public ownership of most roads has contributed to the fiction that road use is free, a fiction assiduously promoted by government policy. Sometimes a toll is charged for the use of a particular road, but traditionally the toll merely amortizes the debt incurred in construction. Expenses of road maintenance and repair are covered by revenues raised from the tax on gasoline purchases.

In fact, road use is not a free lunch. Roads are a capital good that must be built, maintained and replaced. The resources required for this are scarce and have alternative uses. Not only that, my use of the road at any point in time precludes use by somebody else, which violates the economic definition of a free good.

Opportunity costs of road use arise in both production and consumption. The resources necessary to build, maintain, repair and replace roads have alternative uses. This argues in favor of a price to place a value on use of the road. Consumers could then compare their personal valuation to the value of the alternative output foregone by making the road available for individual use. Driving would occur as long as the personal value exceeded the value of the output foregone in producing a usable road. But what usually happens is that the “free-lunch good” is underpriced, causing overuse. That is particularly true of road use at certain places, times and locations.

The overuse causes congestion. This congestion causes all sorts of collateral damage, including time wasted sitting in traffic queues, delays, road damage, accidents, gasoline wastage and air pollution. The cumulative effect is hardly trivial, since the time lost to traffic delays is estimated to have quintupled in the last 30 years.

As always, the free lunch has served the ends of big government. The Department of Transportation owes its existence to it, as doe various sub-departments and bureaus like the Federal Highway Transportation Safety Administration. State highway departments dole out money for care, maintenance and policing of state highways.

The seminal problem with this free lunch is ownership. Public ownership of the roads implies that nobody has an incentive to earn profits from them, maintain them to conserve their profit-earning capability or price their services to serve the needs of consumers. The conventional thinking (as opposed to “wisdom”) has always been that profits are bad – and prices are bad because they lead to profits. Experience has taught us the folly of this line of thinking. Profits point to goods and services that consumers want more of. Prices allow consumers to compare their valuation of each additional unit to the value of the resources used to produce it (e.g., the value of output foregone due to production). Prices and profits are the rational tools markets use to govern economic life.

The best way to reform the public road system is to privatize it. The second-best way is to use free-market techniques within a government context. Lease public roads to private firms for conversion to toll roads. Institute time-of-day pricing, or congestion pricing, to charge higher prices for road use during rush hours. This will divert some traffic away from rush hours to off-peak hours, which is a cheaper and more efficient solution than building more roads with peak usage points that last only 2-4 hours per day.

These approaches are now being followed, albeit on a small scale. Various states have leased highways to private firms as toll roads. In the Manhattan borough of New York City, all fixed tolls have been converted to congestion tolls in an effort to divert some of the city’s fearsome rush-hour traffic to off-peak points.

Military Conscription – A Ghost of Free Lunches Past

The opportunity to discuss a failed government policy in the past tense is so rare that it should not be bypassed. Military conscription in the U.S. began with the Civil War and continued through two World Wars and various lesser conflicts. The practice became hotly controversial during the Vietnam War, when many young men of draft age left the country to avoid involuntary induction into the military. The unpopularity of the draft undoubtedly led to its discontinuance in 1973.

Today the all-volunteer military operates smoothly and accepts both men and women. Occasional calls for a return to conscription echo the arguments made for the practice during its heyday. Foremost among these is that conscription saves money by allowing government to force inductees to work for lower wages than they would accept voluntarily.

It is indubitably correct that conscription forces many recruits to work for less pay than they would otherwise demand in a voluntary setting. Whether this amounts to “saving money” is a semantic question. What it certainly does not do, though, is to reduce the economic cost of providing national defense. When it comes to acquiring enlisted personnel for the military, the cost of service is not simply the monetary payment received by those soldiers. It is the value of the output they could have produced in their highest-valued alternative occupation, or the value of their marginal product. In a competitive market, their wage will be bid up until it reaches this level.

If a conscript is forced to accept a draftee wage of (say) $20,000 per year instead of the $30,000 per year he could have earned in civilian life, this is not really a fiscal victory for the draft. The government has merely levied an implicit tax on his labor, with the incidence of the tax falling on the conscript and the rest of us. The conscript earns $10,000 less than he would have otherwise; we receive military services that are less valuable than the civilian goods or services he could have produced instead.

Conscription has traditionally been portrayed in purely emotional terms. Proponents cite submission to compulsory military service as a patriotic duty. Those unwilling to defend their country are unworthy to enjoy the rights and privileges of citizenship. Opponents perceive state compulsion of its citizens as immoral; why should people be forced to fight and die for a cause they reject?

Economists cut this philosophical Gordian knot. Patriots want to win wars. The best way to do that is to put the best and most willing fighters on the front line, the best strategists in the war room and the best suppliers in the factories. Conscription completely louses up efficient resource allocation by forcing the unwilling and training the less able to fight; by making sergeants out of factory superintendents and officers out of the politically connected. More technically, conscription makes unskilled labor artificially cheap, encouraging the military to use too much of it and not enough capital goods (skilled labor and sophisticated weaponry). Indeed, this argument applies just as forcefully in peacetime.

The problem with the arguments of moralists is that they are neither necessary nor sufficient to deal with the problems posed by war and the necessity of raising and keeping a military force. In this pinched worldview, there is no stopping point between conscription on the one hand and unilateral disarmament and full-blown pacifism on the other hand. But voluntarism respects the arguments of the moralists while still allowing for optimal prosecution of war and national defense.

That conclusion is not merely theoretical. The record of the U.S. military in armed combat worldwide since the changeover to a voluntary force has been nonpareil. Recruits are now better educated – almost all are high-school graduates – and grade higher on aptitude tests at enlistment than under conscription. The military exhibits better morale, discipline and experience as a voluntary force. The logic developed above has been borne out in practice. If we were to revert to conscription, as is occasionally proposed, the resulting lower quality of recruits would raise the pecuniary costs of training to offset any monetary benefits accruing from lower wages.

In its heyday, conscription fit the free-lunch pattern like a glove. The opportunity cost of the conscript’s labor time – his or her civilian output – was ignored. The conscript’s work was underpriced, thereby distorting his or her use by government. Conscription contributed to the growth of big government in the form of the Veteran’s Administration, a massive bureaucracy devoted to processing, caring for and subsidizing citizen-soldiers rather than an army of professionals. And the collateral damage of the draft included not only the inefficiency of the armed services, but the contempt that it brought upon them and the lives it blighted.

Government Money Creation

Long before there were public schools to provide free lunches to, the foundations of the free-lunch concept were poured by the oligarchs of antiquity. They clipped coins, adulterated the metallic content of the money stock and generally debased the exchange value of the monetary media.

With the advent of paper money in the age of the printing press, monetary manipulation came into its own. Governments could pretend to create wealth by creating money – working the printing presses overtime creating currency for the public to spend. Prosperity is no farther away than the printer’s office. Happy days are here at last.

Unfortunately, money is not wealth. It merely allows the holder to acquire title to goods and services. Rapid money creation by government merely causes a mad scramble by holders of money to exchange it for the things they really want. Since the short interval between distribution of printed money and purchase does not allow for wholesale expansion of output, the result is more and more money holders waving currency and chasing a fixed supply of goods and services. The effect is to bid up prices.

The term “inflation” has come to be associated with the effect of money creation on prices when it might better be applied to the cause of the process; namely, the inflating of the money supply. The distinction is crucial, but we are only belatedly realizing that. It is sometimes true that the inflating of the money supply causes only some prices to rise. Even when all prices rise, they virtually never rise in perfect synchrony. And the world is now experiencing the most unusual case of all – a vast increase in government money creation with comparatively little effect on prices of goods and services (as of yet) but considerable effect on interest rates and the pattern of investment.

Governments today perceive virtually no monetary cost in money creation, since it is now effected by computer keystrokes to bank reserve accounts. The opportunity cost is that money that would otherwise be efficiently used in exchange and investment is now used inefficiently. Not only is its general purchasing power diluted – an effect that holds for all or most good, services and assets – but the distortion of relative values distorts specific markets such as housing, real estate, agriculture and many more. Once again, we see overuse of the free good whose value has been artificially cheapened by the free-lunch policy. As the supply of money rises, the urgency heightens to spend it before its value declines further.

And once again, we see the growth of government as beneficiary of the free lunch. The U.S. Federal Reserve was created in order to afford government control over the supply of money and credit. The Fed’s tentacles have spread until it now controls the banking and investment sectors, usurping not only private functions but even some functions of other government agencies.

Trying to sort out the direct from the collateral damage is somewhat arbitrary. For example, the entire financial crisis and ensuing Great Recession can be viewed as the collateral damage of the Fed’s money creation earlier in the decade, since the crisis would have been unthinkable in the absence of the monetary excess. But no matter how you allocate it, the overall damage has been enormous.

How Many Free Lunches Can We Afford?

As we have seen, the worst thing about economic free lunches is that they cost so much. That is the paradox of the free lunch – that it inherently promises what it logically cannot deliver. If this were all, perhaps we could write off the free lunch as a noble experiment. But the attempt to get something for nothing carries with it a big price tag. First there is inefficiency – neglect of opportunity cost means that resources are wasted and we become poorer. Then there is collateral damage – water shortages, water and air pollution, slaughter of wildlife, land devastation, road damage, highway gridlock, rush-hour tie-ups, inflation, malinvestment, unemployment add up to a gruesome butcher’s bill for just the four cases we discussed.

The Western world is currently undergoing a protracted financial crisis traceable to government overspending and debt. The crisis has its origins in the expensive free lunch.

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