DRI-315 for week of 9-22-13: What Has Happened to the Labor Market?

An Access Advertising EconBrief:

What Has Happened to the Labor Market?

The performance of the labor market should be gauged using multiple indices, but is commonly judged by only one. The unemployment rate currently stands at 7.3%, having fallen from a cyclical height of almost 10%. Although that may seem like sizable progress, 7.3% unemployment is unheard of almost four-and-a-half years into a cyclical recovery. Even more startling is the swan-dive done by labor-market participation, which has declined to its lowest point since 1978. These data coincide with repeated extensions in unemployment-benefit tenure and increased enrollments in the food-stamp (SNAP) program. SNAP now provides food to about one in seven American families.

Taken together, these facts suggest an ominous change in the U.S. labor market. The Wall Street Journal recently brought that change into sharper focus by interviewing a leading expert-participant in the labor market.

Bob Funk owns Express Employment Services, headquartered in Oklahoma City, OK. EES is the fifth-largest employment agency in the country, with annual sales of $2.5 billion and 60 franchises scattered across the land. Funk estimates that EES will place about a half-million applicants in jobs over the coming year. Clearly, he has a vested interest, but that cuts both ways – his financial stake in the market hones his perceptions all the more keenly. And he cuts to the bone in his analysis of what is wrong with the U.S. labor market.

The Great Shift

Like many an interviewee, Funk is promoting a product in which he has a personal interest. EES will soon release a study called “The Great Shift,” which sounds the alarm about the deterioration of the U.S. labor market. Few men are better qualified to pronounce on this topic than Funk, whose company places both blue- and white-collar workers ranging from the lowest level maintenance worker to hard-hat construction workers to high-level executives.

In the simplest terms, the U.S. labor market is morphing from a market that works well into one that fails or works poorly. Many forces are bleeding the life out of the U.S. labor market. In the interview, Funk and interviewer Steve Moore highlight the most pernicious of these.

Loss of work ethic. “In my 40-some years in this business,” Funk declares, “the biggest change I’ve witnessed is the erosion of the American work ethic. It just isn’t there today like it used to be.” If this sounds suspiciously familiar, perhaps that is because it echoes the lament of every older man – successful or not – pining for lost youth. That is probably why it has not fired the imagination of the public at large.

But business owners have no trouble connecting with Funk’s message. Funk’s list of the specific attributes necessary to success on the job – being on time, taking a conscientious approach to the job, treating every task seriously and being willing to do anything including work overtime – will light a fire of recognition in the eyes of every employer who reads it.

According to Journal interviewer Stephen Moore, Funk “thinks the notion of the ‘dead-end job’ is poisonous because it shuts down all sense of possibility and ambition…If low-level employees show a willingness to work hard,” Funk maintains that “most employers will gladly train them with the skills to fill higher-paying jobs.” Neither Funk nor Moore trouble to explain why employers would be so generous, but the point is worth developing. Contrary to the impression created by politicians and the news media, most job training occurs on the job rather than in academic and vocational institutions. Since the employer will have to train anybody who fills a higher-paying position anyway, it will generally be easier and cheaper to train an internal candidate rather than import one who must be wholly indoctrinated into company procedures. But any employer wants a trainee whose can-do attitude, enthusiasm and demonstrated productivity make the investment in training odds-on to succeed. That’s why holders of so-called “dead-end” jobs can actually have a leg up on outside applicants, and why so many of the rich and famous got started at the entry level.

Alas, as Moore puts it, Funk “fears that too many of the young millennials who come knocking on his door view a paycheck as a kind of entitlement, not something to be earned. He is also concerned that the trendy concept of ‘life-balancing’ is putting work second behind leisure.”

Some readers will find this jaundiced picture too one-sided. Surely there must be some people who see openings for hard work as an opportunity for economic advancement and personal improvement. Sure enough, Funk unhesitatingly identifies just such a class of go-getters. “I guess I’m a little prejudiced to the immigrants and especially Hispanics,” Funk admits. (Note the refreshing use of the word “prejudiced” in its correct, non-pejorative sense.) “They have an amazing work ethic. They don’t want handouts and are grateful to have a job. Our company has a great success rate with these workers.” Moore, who has decades of interaction with academic and government economists, observes grimly that “this focus on work effort is seldom, if ever, discussed by policy makers or labor economists when they ponder what to do about unemployment. To most liberals, the very topic is taboo and is disparaged as blaming the economy’s victims.” Moore tactfully refrains from pointing out that the benefits of immigration, too, are taboo among mainstream conservatives; they see only a camera-negative vision of immigrants as criminal, disease-ridden, welfare-sucking, invasive forces of destruction.

The relative attractions of subsidized leisure. When Moore pressed Funk “to explain what Washington can do to get Americans back on the job,” Funk replied that “the first step would be to start shrinking the ‘vast social welfare state programs that have become a substitute for work. There’s a prevalent attitude of this generation of workers that the government will always be there to take care of them.'” Funk mentions unemployment benefits, health care and food stamps as examples of welfare-state subsidies that kill the incentive to take entry-level jobs, but he reserves special condemnation for the Social Security disability program.

Funk considers disability, which now serves some 14 million recipients, the most-abused federal-government program. EES has discovered that over half of the disability claims filed by its workers are fraudulent, he claims. When the company challenges claims in court, “we win over 90% [of the time].”

Government regulation. Funk characterizes the Affordable Care Act (ObamaCare) as “an absolute boon for my business.” Why? The legislation requires businesses with 50 or more full-time employees to provide health care for their employees. ObamaCare defines “full-time” employment as 30 hours (!) or more per week. This has led to the already-notorious business categories known as “49ers” (businesses that cap their full-time employment at 49 workers) and “29ers” (businesses that cap their employee work week at 29 hours). “Firms are just very reluctant to hire full-time workers,” Funk says. “So they are taking on more temporary help, which is what we do.” While ObamaCare is statutory law, it will be implemented by an executive agency, the IRS. Its provisions have the substance of regulation and legislators were acting exactly as regulators do when they passed it. Indeed, the overwhelming public opposition to the bill gives it even more of the substance of regulatory fiat.

As Moore notes, “the hundreds of thousands of temporary workers [Funk] places in jobs are EEC employees. He pays their salary, benefits and payroll taxes and the firms that hire the workers reimburse EEC for those costs plus a commission. This feature of the temporary-worker industry allows companies trying to fill job openings to do so in a way that sidesteps ObamaCare’s mandates. After an on-the-job trial of several months, companies often offer the workers permanent positions.”

The function now performed by Funk’s temp agency was formerly performed routinely by business firms themselves without need for a middleman. Workers were hired under terms called “probation,” which stated that if the relationship did not prove mutually satisfactory they would be discharged. But the federal government overlaid the employer-worker relationship with so many “protections” ostensibly designed to promote worker security that businesses couldn’t discharge workers who didn’t work out without running the risk of a lawsuit. And a lawsuit was sure to result in either a settlement or a trial; either way the business would incur a significant cost. So businesses simply stopped hiring. Workers became more “secure,” all right – if they already had a job. But workers looking for a job became less secure, because businesses no longer had the choice of hiring on a hunch with the fallback option of discharging the worker if the hire didn’t work out. Apparently most people lost sight of the fact that the probationary period also gives a worker the same chance to try the job on for size. (The implicit stance behind government labor-market regulation seems to be that “fairness” demands gross asymmetry – employers must meet tremendous obligations while workers enjoy lots of “rights.” This implies that fairness and freedom are incompatible.) This is still another of the many ways in which government itself contributes to higher and longer unemployment through its own policies.

Fund adds “the problem isn’t just ObamaCare, though. It’s the entire assault on employers coming out of Washington – everything from the EEOC to the Dodd-Frank monstrosity. Employers are living in a state of fear.” One terrorized industry not mentioned by either Funk or Moore has been trucking, where the Department of Transportation has launched a veritable war on employment. DOT has revamped its regulatory modus operandi in favor of a statistical data base that has turned veteran drivers with previously spotless driving records into risky or even prohibitive employees. Frequent agency threats to require expensive health diagnostic checks for sleep apnea have cast a pall over the profession. DOT’s long delays in making up its mind on allowable hours of service for truckers left the industry hanging. And trucking firms have also felt the sting of the agency’s new regulatory scheme. Truck drivers already feel the breeze of a sword of Damocles swinging over their head, in the form of technological obsolescence impending due to eventual development of self-driving vehicles. The federal government acts as if duty-bound to beat technology to the punch by driving truckers out of the industry first.

The jobs mismatch. At one time, it was conventional thinking that an increase in job openings would lead to a decrease in unemployment and an increase in employment. The stunning exit of workers from the labor force has played hob with convention; the unemployment rate has fallen at the same time that the volume of employment has also declined sharply. When we probe for the reasons behind the out-migration of workers, the most striking datum is the mismatch between the types of workers sought and those now unemployed or no longer looking for work. When an unemployed worker’s job-search efforts are repeatedly met with rejection, surrender becomes easier to understand.

Funk claims that EES usually has around 20,000 jobs that it can’t fill owing to a lack of qualified applicants. Moore lists the most sought-after fields as “accounting (thanks to Dodd-Frank’s huge expansion of paperwork), information technology, manufacturing-robotics programming, welding and engineering. He’s mystified why EES has so much trouble filling thousands of information-technology jobs when so many young, working-age adults are computer literate.”

The idea of a mismatch between available job-seekers and available jobs has been around for at least a century. In economics textbooks, it is called “structural unemployment.” If the number of unfilled jobs is exactly equal to the number of unfulfilled job-seekers, this might mean that employer and employee just haven’t gotten together yet. But if this condition persists for a long while, this suggests that job and job-seeker are somehow incompatible. At first glance, this seems like the sort of problem that might arise in a modern economy due to the absence of central economic planning by government. After all, how do we know that the “right” number of engineers, accountants and welders will be trained and packed off to the labor market? Doesn’t this require rational planning by somebody – or bodies – who can see the whole “big picture” on a gigantic planning board?

It turns out that free markets are supremely qualified to handle this sort of problem because only free markets can transmit the information about the kind and quantity of jobs needed to the precise people who can help to solve the problem – namely, the would-be engineers, accountants, welders, et al. And the problems of matching are far too big to be solved by central planners – not merely too big, but too subtle and complex, as much a matter of subjective perceptions as objective information. That is why private for-profit agencies like EES, which exploit both the incentives and the information offered by the price system, outperform the state employment agencies.

The persistence of imbalances, whether structural or frictional, implies that prices are not being allowed to do their job. In the low-skilled segment of the market, the minimum wage is the longtime culprit. Recent increases in both the federal and state minimum wages would be bad enough under any circumstances, but in this climate they constitute criminal economic-policy malpractice. At the executive level, the recurring attempts to legislate CEO pay do nothing to improve the welfare of consumers but do hinder the workings of the market for executive talent.

It is the middle of the labor market that has suffered most conspicuously, and acutely, from meddlesome non-market forces. In order to get and hold a job as an accountant, engineer or IT specialist, fluency in mathematics is an absolute prerequisite. (Mere numeracy no longer suffices in accounting, since today’s accountant must command enough computer-related expertise to service his clientele.) The only thing American schools teach worse than mathematics is reading, which is another prerequisite for most high-end jobs. In contrast, foreign students tend to be well versed in mathematics, which explains the agitation to make visas available to high-skilled immigrants.  The educational deficit may not explain the entire skills deficit, but it is surely the beginning of wisdom on the issue.

The long-running failure of American public schools. Public-school reform in America now enters its second century. The breath of fresh competitive air blown in by charter schools and vouchers has brought the first genuine, effective reform to K-12 education. But the education establishment dies hard. With the death of the old telecommunications monopolies, teacher’s unions are the leading political force in many statehouses. The stubborn persistence of labor-market imbalances in math-, reading- and computer-skilled jobs has its corollary in the stubborn persistence of the political power of teachers’ unions.

How do teachers’ unions hurt educational performance? They are structured to favor incumbent teachers over newcomers, which means that they insist upon seniority as the basis for pay and advancement rather than actual teaching productivity. Even worse, it means that the tenure system reigns unchallenged. “Teacher is by far the most corrupt social institution in our time,” Funk flatly declares. “It doesn’t reward excellence or weed out bad teachers.”

Contrast tenure with the rule of free markets, in which business failure is penalized by financial failure. Success is rewarded with high(er) profits, which encourages entry of new firms and imitation by other businesses. All this is utter anathema to public schools, which abhor failure and exit by a public school – unless the school district itself decrees it for cost reasons, of course. There is no particular, automatic reward for successful teaching performance – in particular, no immediate and unequivocal financial reward for good teachers. (Indeed, in higher education it is axiomatic that good teachers usually fail to achieve tenure because they spend too much time concentrating on teaching and not enough worrying about the “research” that will lead to tenure.)

While it is true that change is finally coming, it proceeds at a glacial pace because it moves along the choked roadway marked “politics” rather than the speedy autobahn of free markets. Unions dictate the terms on which vouchers are allowed to exist (if at all) and operate; they dictate the funds allocated to charter schools. This is akin to running a poultry farm by appointing the fox foreman and letting him control access to the chicken house.

What Does This Pattern Remind You Of?

When we put the pieces of this labor-market pattern together, they form a familiar picture. For decades, Europe has produced the same picture: dreadful work ethic, open-handed government subsidies killing off the incentive to take entry-level jobs or work at all, smothering government regulation, declining academic performance, powerful unions blocking reform, increasing mismatch between available jobs and worker skills. Not only that, but the Continent’s long-running virus of sluggish growth and high unemployment has recently spread to the U.S.

Most ominous of all is the serial banking and financial crises experienced by countries within the Eurozone. They began with tiny, insignificant little Greece, whose troubles couldn’t possibly be big enough to harm anybody else. Besides, Greece was an outlier, an exception. Its people were exceptionally lazy, its banks horribly inept, its regulation unusually lax – or so the party line ran among the commentators and mainstream news media.

Soon, though, the financial woe spread to Portugal, Spain and Italy. France began to look shaky. Every few months a new crisis flared up. Each time, finance ministers and heads of state appeared to assure us that this new fix has achieved financial peace in our time – until the next crisis. And then came recession – again.

For years, the American labor movement has been holding up Europe as its model. Incredible as this may seem, labor leaders have pooh-poohed the high rates of unemployment and low rates of economic growth in Europe. They have maintained that people in Europe were happier than Americans. They were more secure. Wasn’t this worth putting up with a little more unemployment, a little less material wealth? Goods and services weren’t all that important, were they, when stacked up against the really important values in life?

Lately, though, we haven’t heard much of this rhetoric. Partly this was because riots and discord in Europe were blatantly at odds with the party line about the bovine placidity and content of the populace there. Partly it was because the American Left was now peddling a new party line about the rapine and plunder of the 99% by the 1%, and they needed to extend this paradigm internationally in order to demonize the phenomenon of globalization. And it’s pretty hard to harmonize the picture of happiness with one of rape and plunder.

The real importance of our growing resemblance to Europe, however, is that is raises the specter that we will follow in their financial footsteps. The mainstream news media has a history of disregarding the views of men like Bob Funk. But the carbon-copy example of Europe lends a chilling credence to his views. It happened there and is still happening there, which makes it that much tougher to pretend that it can’t happen here.

DRI-310 for week of 9-15-13: What is Wrong with President Obama’s Claim that the Government Rescued the American Economy?

An Access Advertising EconBrief:

What is Wrong with President Obama’s Claim that the Government Rescued the American Economy?

This week marked the unofficial five-year anniversary of the 2008 Financial Crisis, inaugurated by the bankruptcy of Lehman Brothers on September 15, 2008. In the world of politics and news media, disasters are celebrated as religiously as triumphs and advances. President Barack Obama delivered a solemn recapitulation of the Crisis and his administration’s actions over the ensuing five years. The President’s use of rhetoric has built a solid constituency that has swept him into the White House twice. A full understanding of economics allows us to understand why his actions (and his justifications for them) have been so popular, why his explanation of events is wrong and what the true nature of the Crisis was (and is).

The ICU Metaphor: Government as Emergency Physician, the Economy as Critically Ill Patient

President Obama described his primary duty as “making sure we recover from the worst economic crisis of our lifetimes.” By implying a crisis from which recovery is problematic, the President draws a clear analogy with emergency medicine. A patient faces a medical crisis; the doctor’s overriding goal is recovery; failure will result in death. Although the President mixes this metaphor several times, the basic structure of life-or-death emergency and problematic outcome is preserved.

In a medical emergency, a series of catastrophic events creates a crisis. This is the format in which President Obama recounted the economic history of the past five years. It was “five years ago this week that the financial crisis rocked Wall Street and sent an economy already in recession into a tailspin.” “…Some of the largest investment banks in the world failed; stocks markets plunged; banks stopped lending to families and small businesses.” And, hearkening explicitly to the medical metaphor, “the auto industry – the heart beat of American manufacturing – was flat-lining…By the time I took the oath of office, the economy was shrinking by an annual rate of more than 8 percent. Our businesses were shedding 800,000 jobs each month. It was a perfect storm that would rob millions of Americans of jobs and homes and savings that they had worked a lifetime to build. And it laid bare the long erosion of a middle class that, for more than a decade, has had to work harder and harder to keep up.”

In a hospital ER, a worst-case scenario will compel doctors to invoke the protocol known as “Code Blue,” a crash program to restore vital signs in the face of complete collapse. This was the Obama administration analogue: The federal government had to “…act…quickly through the Recovery Act” to “arrest the downward spiral” and “put a floor under the fall” by “put[ting] people to work…teachers in our classrooms, first responders on the streets.” The government “helped responsible homeowners modify their mortgages” and “jump-start[ed] the flow of credit.” Thanks to these and other measures, the President concluded triumphantly, “we saved the auto industry.”

Once the emergency has been met and the patient is out of immediate danger, doctors can then proceed with the process of rehabilitation. This may involve a hospital stay of short or long duration or possibly a trip to an outpatient facility and extended therapy. President Obama outlines his analogue of the American economy’s recovery after he saved it: The Obama administration “pushed back against the trends that have been battering the middle class… took on the broken health-care system…invested in new technologies… put in place new rules that we need to finalize before the end of the year, by the way, to make sure the job is done… and …locked in tax cuts for 98% of Americans.” All this was accomplished in exchange for “ask[ing] those at the top to pay a little more.”

How is the patient progressing, five years on? What is the economic prognosis? “So, if you add it all up, our businesses have added 7.5 million new jobs [over the last 3.5 years]” and “the unemployment rate has come down.” The housing market is “healing.” Financial markets are “safer.” Today, we “sell more goods made in America to the rest of the world than ever before… generate more renewable energy than ever before…produce more natural gas than anybody.” Why, “just two weeks from now, Americans [are] finally going to have a chance to buy quality, affordable health care on the private marketplace… we’ve cleared away the rubble from the financial crisis [and] begun to lay the foundation for economic growth and prosperity.”

In true doctorly fashion, the President issued some caveats. It seems that the “top 1% of Americans took home 20% of the nation’s income last year…most of the gains have gone to the top one-tenth of 1%.” Congress should be focused on issues such as “How do we grow the economy faster? How do we create better jobs? How do we increase wages and incomes; how do we increase opportunity… how do we create retirement security….” Government, of course, will have to make “the investments necessary” to achieve all these goals. Government will assume “the critical role in making sure we have an education system …for a global economy.” Congress will enable all this via the budget it passes – provided the quixotic Republicans don’t gum up the works with their monomaniacal insistence on “cuts” to trim the budget deficit. How can they say this when “the deficits are falling faster than at any time since before I was born”?

The Facts are Secondary

It would be easy to get hung up on the facts of President Obama’s “medical report.” Here and there he departs from metaphor to into boldfaced, bald-faced lie. Obama’s bland claim that “we saved the auto industry” doesn’t survive even a fast glance, unless the Ford Motor Company was exiled from the industry by a FISA court in the last five years. Ford didn’t receive any government subsidies, whereas General Motors and Chrysler each got a full-monte bailout makeover. It was telling that the former Big 3 all downsized to broadly similar degrees. In other words, they really underwent a reorganization process even though two of them were spared formal bankruptcy. Now, their lean, mean status has put them back on the front pages of business sections and spawned banner headlines reporting land-office sales of new models. The “salvation” of the auto industry can be ascribed to Ford’s refusal to be bailed out and the successful reorganization of the Big 2.

The President’s dire recollection of the imminent doom of investment banking is droll considering his unrelenting class-warfare assaults on Wall Street, the 1% and bankers generally. Ironically, the big banks who received bailouts were doing little investment banking at the time and are doing even less today. Moreover, neither Bear Stearns (whose failure was masked by its sale) nor Lehman Brothers qualify as among the biggest investment banks, so it is not clear which mega-bank failures the President is referring to.

These are mere quibbles, though, compared to the major point at issue, which is the fundamental basis of President Obama’s rhetoric. To what extent is his medical metaphor rooted in analytical reality?

The Utter Poverty of the ICU Analogy

It is likely that most of the President’s audience did not parse his metaphor as thoroughly as we are about to do. But they instinctively grasped that he was speaking figuratively. They probably experienced a déjà vu feeling of urgency, reminiscent of September, 2008 – a sense that something bad was happening and that something needed to be done quickly to stop it before the world fell apart. How apt was the President’s metaphor; how accurately did it depict the concrete economic reality? Was it true to reality or was it merely the language of political theater, intended to push the emotional buttons of his audience and achieve the desired effect?

The analogy between a modern economy – consisting of hundreds of millions of interacting individuals, and one single patient – suffering a critical illness and facing death – is very bad. There is little or no commonality between the two.

The patient is a single, holistic entity. The economy is an abstraction, made up of many millions of such entities. The patient’s existence is threatened. The economy’s existence is not threatened by a financial crisis, despite the apocalyptic language tossed about indiscriminately by the President. (To be sure, President Obama is only following the example set by Treasury Secretary O’Neill, who spoke darkly of “fac[ing] the abyss” and falsely warned Congress that unthinkable horrors would follow a failure to pass immediate bailout legislation.) The U.S. and every other advanced industrial nation have faced financial crises periodically since the 19th century. No nation has ceased to exist as a result of such a crisis. Indeed, as a first approximation, the individuals within the nation are not threatened with extinction by a financial crisis either, although many people may face a diminution in their standard of living.

A single patient is saved by doctors who utilize resources that originate outside the patient; e.g., outside his or her body. These include medicines, blood for transfusions, glucose and other basic forms of stabilizing fluids and numerous other forms of extraneous assistance ranging from diagnostic tools to organs for transplantation. A government instituting a “recovery program” – whether a Code Blue-type of emergency-bailout plan or intermediate assistance such as Fed Chairman Bernanke’s quantitative-assistance scheme or a longer term program for economic growth – can only use resources that originate inside the economy itself. The resources must come from somewhere and no government has the power to spontaneously generate resources out of thin air. Even money that is borrowed from foreign sources must be paid for by repaying principal and interest and in other ways as well. (A country that enjoys the privilege of “seigniorage” because its money is a “vehicle currency” held for transactions and investment purposes by foreigners may perhaps evade repayment longer than would normally be the case.) Really, “the economy” can be conceived in global terms, since the bailouts were a transnational operation on both sides.

Consider how hampered ER doctors would be if they had to rely on only the patient’s own resources and reserves of strength in fighting emergency illness or injury. Well, that is a fair analogy of the constraints governments face in “rescuing” their citizens from financial crises. Actually, that only begins to describe the limitations of government corrective action. Doctors can learn tremendous amounts about their patients via diagnostic tools like X-rays and cat scans and blood tests. But the information governments would have to know in order to “rescue” an economy is widely dispersed in fragmentary form among hundreds of millions of people. Not only that, much of that information is subjective and wouldn’t be useful to anybody except the particular individuals that possess it.

Doctors can rely on the patient’s help because the patient wants to live. The emergency efforts exerted by the hospital staff often succeed because they are a voluntary cooperative enterprise in which the patient fully cooperates. Governments operate on the basis of coercion and compulsion. This is necessary because governments can acquire resources to help some people only by taking resources away from other people. Coercion is a shaky basis for production and maintenance. If it were a superior form of economic endeavor, the totalitarian dictatorships of the 19th and 20th centuries would have been history’s great success stories. Instead, they were tragic, ghastly failures. The resistance to the bailouts of the big banks is only one of the pushbacks suffered by the federal government’s rescue program. The Fed’s Zero Interest-Rate Program (ZIRP) left millions of elderly Americans adrift without a suitable income-producing vehicle, given the artificially low interest rates imposed on fixed-income investments by the government policy. This population has become highly restive, not to say mutinous. Millions of Americans have left the labor force because the extension of unemployment benefits has made idleness more attractive than work – and because government regulation of the labor market has simply made job creation too costly and dangerous to businesses. These are all cases in which Americans oppose a program ostensibly designed to rescue them from economic emergency and privation.

This highlights the overarching dissonance in the Obama ICU analogy. Treating the economy as a single organic unity fulfills the old socialist dream originally enunciated by the French philosopher Saint-Simon, who declared that a nation should be run as though it were one single huge factory. The pretense that there really is a “nation as a whole” rather than a reality consisting of 312 million individuals allows governments to enact dreadful economic policies like the Economic Recovery Act. Pumping money into an amorphous entity called “the economy” ignores the individual interactions and logical connections that make up a functioning economy. We cannot even draw a useful analogy between the warring organisms within the human body and claim that government is helping the “good” organisms (e.g., people) against the “bad” ones for the good of the “whole body” (e.g., the nation). Doctors know how to separate good from bad organisms for the survival of a single patient; governments have no objective basis for transferring real income from some people to others for the good of the nation.

The Real Nature of Economic Crisis, Financial or Otherwise

Finance differs from non-monetary economic theory in dealing with the allocation of resources over time rather than at a single (hypothetical) point in time.  Thus, complicating topics such as saving, borrowing, interest rates and debt intrude on the analysis. A financial crisis occurs when a gross mismatch between the saving/investing and borrowing/lending desires of the public places financial institutions and mechanisms in jeopardy of failure. The only cure for the crisis is realignment between the value of goods people are willing to commit to future consumption and the value of goods producers commit to make available in the future. Proper alignment implies that the interest rates established in the markets for loanable funds equalize the amounts of borrowing people want to do for each future term to maturity with the amounts of money available for lending in the future. Sooner or later, there is no substitute for this curative process. When values are once again realigned, the resulting pattern of resources will require that businesses wrongly created and jobs formerly occupied due to the crisis will no longer exist. Once again, there is no substitute for this corrective process.

The U.S. has suffered recurrent financial crises throughout its history. Each financial crisis had one thing in common with all others. They all ended. The first financial crisis was in 1807. Another one – a big one – followed in 1837.The biggest one of all may have been in 1873. But none of them went on forever and none of them caused the death of the U.S. economy – whatever that might be interpreted to mean.

Keynesian economics was neither a necessary not a sufficient condition for recovery from a financial crisis. It was not necessary because Keynesian economics was not invented until 1936; numerous financial crises had come and gone by that time. It was not sufficient because the U.S. economy suffered financial crises after the invention of Keynesian economics that were unaffected, even worsened, by the implementation of Keynesian policies.

Bailouts of big banks were no more necessary than were the bailouts of GM and Chrysler. (Once again, blame should go primarily to the architects of these measures, Treasury Secretary O’Neill and Fed Chairman Bernanke – but the policies were wholeheartedly supported by President Obama.) These measures are often supported even by many so-called free-marketers, some of whom cite Nobel Laureate Milton Friedman’s claim that widespread bank failures triggered a massive decline in the money supply that caused the Great Depression. As an explanation of the Depression, Friedman’s view is misleading at best, but even if accepted it does not remotely justify bank bailouts. Friedman was famous for insisting that the Fed could, and should, have increased the money supply to counter the reverse-money-multiplier effects of the bank failures. His famous quip that the Fed could even drop money from helicopters if necessary illustrated his view that the Fed had countless ways to get money into the hands of the public. Bailing out banks – the realization of moral hazard under fractional-reserve banking regulation – has nothing to do with increasing the money supply. That is exactly what Ben Bernanke proceeded to prove with his program of quantitative easing. By creating money hand over fist after the banks had already been bailed out, Bernanke was closing the barn door after allowing the animals to escape!

Citations of Milton Friedman as authority for the bank bailouts by Ben Bernanke and other left-wing economists are an example of what the Soviet KGB used to call “disinformation” and what magicians refer to as “misdirection.” They are designed to confuse and mislead an opponent by presenting a false trail of reasoning and evidence.

The Real Threat to Life and Limb Posed by Economic Crisis

The only form of economic crisis that can, and has, threatened life and limb throughout human history is a monetary crisis. Only a monetary crisis can overturn the entire basis for trade or exchange, making it impossible or prohibitively difficult for people to exchange goods and services. This poses an immediate threat to life and limb because almost everybody specializes rather narrowly in their production. Specialization increases productivity and increases real incomes – provided people are able to exchange the fruits of their productive specialty for the consumption goods they love. But if and when they cannot do this, specialization turns into a nightmare. People cannot acquire the goods and services they know and love. At best, this is an incredible nuisance. At worst, it is a clear and present danger to life and limb.

Technically, it is true that an economy – or, more properly, a nation – will eventually recover from a monetary crisis, too. But prior to recovery, famine, pestilence and death may visit the nation beset by crisis. Ancient Rome was one nation felled by monetary crisis; the crisis not only caused havoc but weakened the Republic so much that it could no longer fight off its enemies. In Germany’s WeimarRepublic; the chaos caused by hyperinflation put the public’s sole focus on day-to-day survival. This completely delegitimized the democratic government and paved the way for Hitler. His authoritarian rule was seen as preferable to the ineffectual efforts of socialists who could no longer fulfill the promises of security that had won them election.

More recently, we have witnessed the devastating effects in such places as Zimbabwe, where hyperinflation was the last refuge of the scoundrel, Mugabe. The failure of investment projects financed by foreign loans, coupled with land-redistribution policies that dispossessed capable farming operations, had decimated the productive capacity of Zimbabwe’s economy. Unemployment reportedly approached 80%. To finance his administration’s regional wars and pay the government’s bills, President Mugabe permitted money creation on a scale not seen since the Weimar inflation. As we would expect, the result was the disintegration of trade and a retreat into dictatorship, subsistence, barter.

Thus, monetary collapse – not financial crisis – is the only real economic approximation to the emergency-threat-of-death metaphor rhetorically brandished by President Obama.

This is a sobering thought, since it suggests that America does, after all, face a potentially life-threatening menace in its not-too-distant future. It is the threat of hyperinflation and monetary collapse presented by the $4 trillion in excess reserves sitting on the accounts of American banks. This money is currently receiving interest, thanks to the change in policy allowing interest to be paid on excess reserve accounts. Should that status change, though, the money might be loaned out to businesses and promptly spent. This large volume of money chasing domestic goods would bid up prices with alacrity. The resulting hyperinflation would jeopardize the value of U.S. money. That is a disaster waiting to happen.

The threat is not in our past. It lies ahead of us, in our future. President Obama’s policies did not save us from it. Rather, they now threaten us with it.

Should we temper this conclusion with the reminder that the unprecedented money creation of the last few years is the work of the Federal Reserve and its Chairman, Ben Bernanke? Is the President exempt from criticism owing to the Fed’s independence from political influence and control?

President Obama has not moved to replace Bernanke. The President has not even expressed disapproval of the Fed Chairman’s policies. And the current favorite to succeed Bernanke early next year, Janet Yellen, is widely considered to favor even looser monetary policy than Bernanke, if such a thing can be imagined. Presumably, if President Obama disapproved, he could find another Fed Chairman. So far, there is no indication that he will do that.

Rhetoric Matters

The problem with President Obama’s recounting of events during and since the Financial Crisis of 2008 is not his errors of fact, glaring though they are. His rhetoric is built upon a superficially attractive but utterly wrongheaded metaphor – Obama Administration policies as ICU measures taken to rescue an economy that is likened to a critically ill patient. The metaphor leads directly to the wrong diagnosis of the Crisis and the wrong medicine for the patients, who are 315 million individuals rather than indistinguishable parts of one gigantic whole.

DRI-326 for week of 9-1-13: Quantity vs. Quality in Economists

An Access Advertising EconBrief:

Quantity vs. Quality in Economists

Students of economics have long complained that economics texts focus too much on quantity and not enough on quality when evaluating goods. The same issue arises when comparing economists themselves. The career of Nobel Laureate Ronald Coase, who died this week at age 102, is a polar case.

Economists advance by publishing articles in prestigious, peer-reviewed journals. The all-time leader in the number of articles published is the late Harry G. Johnson. Despite dying young at age 53, Johnson compiled the staggering total of 526 published articles during his lifetime.

The use of advanced mathematics and abstract modeling techniques has enabled economists to rack up impressive publications scores by introducing slight mathematical refinements that add little to the substantive meaning or practical value of their achievement. When asked to account for the comparative modesty of a list of publications only one-fourth the size of Johnson’s, Nobel Laureate George Stigler countered, “Yeah, but mine are all different.”

Coase stands at the other extreme. His complete list of articles numbers fewer than twenty, but two of those are among the most-frequently consulted by economists, lawyers and other specialists, not to mention by the general public. He published a long-awaited, widely noticed book in 2012 despite having passed his centenary the year before. His life is an advertisement for the value of quality over quantity in an economist.

Another notable aspect of Coase’s work is its accessibility. In an age when few professional contributions can be read and understood by non-specialists, much less by interested non-economists, Coase’s work is readily comprehensible by the educated layperson. Now is the time to rehearse the insights that made Coase’s name a byword within the economics profession. His death makes this review emotionally as well as intellectually fitting.

Why Do Businesses Exist?

At 26 years of age, Ronald Coase was a left-leaning economics student. He pondered the following contradictory set of facts: On the one hand, socialists ever since Saint-Simon had advocated running a nation’s economy “like one big factory.” On the other hand, orthodox economists declared this to be impossible. Yet some highly successful corporations reached enormous size.

Who was right? It seemed to Coase that the answer depended on the answer to a more fundamental question – why do businesses exist? Be it a one-person shop or a huge multinational corporation, a business arises voluntarily. What conditions give birth to a business?

Coase found the answer in the concept of cost. (In his 1937 article, “The Nature of the Firm,” Coase used the term “marketing costs,” but the economics profession refined the term to “transactions costs”.) A business arises whenever it is less costly for people to organize into a hierarchical, centralized structure to produce and distribute output than it is to produce the same output and exchange it individually. And the business itself performs some activities within the firm while outsourcing others outside the firm. Again, cost determines the locus of these activities; any activity more cheaply bought than performed inside the firm is outsourced, while activities more cheaply done inside the firm are kept internal.

Like most brilliant, revolutionary insights, this seems almost childishly simple when explained clearly. But it was the first lucid justification for the existence of business firms that relied on the same economic logic that business firms themselves (and consumers) used in daily life. Previously, economists had been in the ridiculous position of assuming that businesses used economic logic but arose through some non-economic process such as habit or tradition or government direction.

Today, we have a regulatory process that flies in the face of Coase’s model. It implicitly assumes that markets are incapable of correctly organizing, assigning and performing basic business functions, ranging from safety to hiring to providing employee benefits. To make matters worse, the underlying assumption is that government regulatory behavior is either costless or less costly than the correlative function performed by private markets. As Coase taught us over 75 years ago, this flies in the face of the inherent “nature of the firm.”

The “Coase Theorem”

In mid-career, while working amongst a group of free-market economists at the University of Virginia, Ronald Coase made his most famous discovery. It assured him immortality among economists. Just about the best way to make a name for yourself is to give your name to a theory, the way John Maynard Keynes or Karl Marx did. But in Coase’s case, the famous “Coase Theorem” was actually devised by somebody else, using Coase’s logic – and Coase himself repudiated the use to which his work was put!

To appreciate what Coase did – and didn’t do – we must grasp the prior state of economic theory on the subject of “externalities.” Tort case law contained examples of railroad trains whose operation created fires by throwing off sparks into combustible areas like farm land. The law treated these cases by either penalizing the railroad or ignoring the damage. A famous economist named A. C. Pigou declared this to be an example of an “externality” – a cost created by business production that is not borne by the business itself because the business’s owners and/or managers do not perceive the damage created by the sparks to be an actual cost of production.

Rather than simply penalizing the railroad, Pigou observed, the economically appropriate action is to levy a per-unit tax against the railroad equal to the cost incurred by the victims of the sparks. This would cause the railroad to reduce its output by exactly the same amount as if it had perceived its sparks to be a legitimate cost of production in the first place. In effect, the railroad “pays” the costs of its actions in the form of reduced output (and reduced use of the resources necessary to provide railroad transport services), rather than paying them in the form of a fine. Why is the former outcome better than the latter? Because the purpose is not to hurt the railroad as retaliation for its hurting the farmer, the way one child hurts another in revenge for being hurt. A railroad is a business – in effect, it is a piece of paper expressing certain contractual relationships. It cannot feel hurt the way a human being can, so the fine may make the farmer feel better (if he or she received the fine as proceeds of a tort suit) but does not compensate for the waste of resources caused by having the railroad produce too much output. (“Too much” because resources will have to be devoted to repairing the damage caused by the sparks, and consumers value the resources used to do this more than the farmer values the loss.) In contrast, when the costs are factored into the railroad’s production decision, everybody values the resulting output of railroad services and other things as exactly worth their cost.

Of course, the catch is that somebody has to (1) realize the existence of the externality; and (2) calculate exactly how much tax to levy on the railroad to neutralize (or internalize) the externality; and then (3) do it. In the manner of a philosopher king, Pigou declared that this task should be assigned to a government regulatory bureaucracy. And for the next half-century (Pigou was writing in the early 1900s), mainstream economists salivated at the prospect of regulatory agencies passing rules to internalize all the pesky externalities that liberals and bureaucrats could dream up.

In 1960, Ronald Coase came along and gave the world a completely new slant on this age-old problem. Consider the following type of situation: you are flying from New York to Los Angeles on a low-price airline. You have settled somewhat uncomfortably into your seat, survived the takeoff and are just beginning to contemplate the six-hour flight when the passenger in front of you presses a button at his side and reclines his seatback – thereby preempting what little leg room you previously had. Now what?

This is not actually the example Coase used – it was used by contemporary economist Peter Boettke to illustrate Coase’s ideas – but it is especially good for our purposes. Using the same logic Coase applied to his examples, we reason thusly: It would be completely arbitrary to assign either of us a property right to the space preempted by the seatback. Why? Because the problem is not to stop bad people from doing bad things. Instead, we are faced with a situation in which ordinary people want to do good things that are in some sense contradictory or offsetting in their effects. On the airplane, my wish to stretch out is no more or less morally compelling than his to recline. The problem is that  we can’t do both to the desired extent at the same time without getting in each other’s way; e.g., offsetting each other’s efforts.

Indeed, this is true of most so-called externalities, including the railroad/farmer case. Case law usually treated the railroad as a nefarious miscreant imposing its will on the innocent, helpless farmer. But the railroad’s wish to provide transport services is just as reasonable as the farmer’s to grow and harvest crops. It is not unthinkable to enjoin the railroad against creating sparks – but neither should we overlook the possibility of requiring the farmer to protect against sparks or perhaps even not locate a farm within the threatened area. Indeed, what we really want in all cases is to discover the least-cost solution to the externality. That might involve precautions taken by the railroad, or by the farmer, or emigration by the farmer, or payment by the railroad to the farmer as compensation for the spark damage, or payment by the farmer to the railroad as compensation for spark avoidance.

 

In general, it is crazy to expect an uninvolved third party – particularly a government regulator – to divine the least-cost solution and implement it. The logical people to do that are the involved parties themselves, who know the most about their own costs and preferences and are on the scene. These are also the people who have the incentive to find a mutually beneficial solution to the problem. In our airline example, I might offer the man in front of me a small payment for not reclining. Or he might pay me for the privilege of reclining. But either way, we will bargain our way to a solution that leaves us both better off, if there is one. One of us would object to any proposed solution that did not leave him better off.

Of course, it would be useful for bargaining purposes to have an assignment of property rights; that is, a specification that I have the right to my space or that the man in front of me has the right to recline. That way, the direction of compensatory payments would be clear – money would flow to the right-holder from the right-seeker.

What if bargaining does not produce an efficient outcome, one that both parties can agree on? That means that the right-holder values his right at more than the right-seeker is willing to pay. But in that case, no government tax would produce an efficient outcome either.

On the airline, suppose that I value the leg room preempted by the reclining seat at $10. Suppose, further, that airline policy gives him the right to recline. If I offer him $6 not to recline, he will accept my offer if he values reclining at any amount less than $6 – say, $5. Notice that we are now both better off than under the status quo ante bargain. I get leg room I valued at $10 – or course, I had to pay $6 for it, but that is better than not having it at all, just as having the airline’s cocktail is better than being thirsty even though I had to pay $5 for it. He loses his right to recline, but he gets $6 instead – and reclining was only worth $5 to him. He is better off, just as he would be if he accepted an airline’s offer of $500 to surrender his seat and take a later flight, as sometimes happens.

We cannot even begin to estimate how many times people solve everyday problems like this through individual bargains. The world would be vastly better off if we were trained from birth in the virtues of a voluntary society where bargaining is a way to solve everyday disputes and make everybody better off. That training would stress the virtues of money as the lubricant that facilitates this sort of bargain because it is readily exchangeable for other things and because it is the common denominator of value. Instead, most of us are burdened by an instinctive tribal suspicion that money is evil and bargaining is used only to seek personal advantage at the expense of others. Experienced businesspeople know otherwise, but throughout the world the Zeitgeist is working against Coase’s logic. More and more, government and statutory law are held up as the only fair mechanism for resolving disputes.

University of Chicago economist George Stigler used Coase’s logic to devise the so-called Coase theorem, which says that when the transactions costs of bargaining are zero, the ultimate price and output results will be the same regardless of the initial assignment of property rights. This is true because both parties will have the incentive to bargain their way to an efficient improvement, if one exists. The assignment of property rights will affect the wealth of the bargainers, because it will determine the direction of the money flow, but economists are concerned with welfare (determined by prices and quantities), not wealth. No government regulatory body can improve on the free-market solution.

Coase disagreed with the theorem named after him – not because he disputed its logic, but because he foresaw the results. Economists would use it to look for circumstances when transactions costs were low or non-existent. Instead, Coase wanted to investigate real-world institutions such as government to compare its transactions costs to those of the market. He knew that real-world transactions costs were seldom zero but that government solutions almost never worked out as neatly in practice as they did on the blackboard. In fact, he invented the phrase “blackboard economics” to refer to solutions that could never work in practice, only on a theoretical blackboard, because real-world governments never had either the information or the incentive necessary to apply the solution.

Why China Became Capitalist

Ronald Coase devoted his last years to learning how and why China evolved from the world’s last major Communist dictatorship to the world’s emerging economic superpower. In Why China Became Capitalist, he and his research partner Ning Wang delivered an account that contravened the popular explanation for China’s rise. China’s ruling central-government oligarchy has received credit for the country’s emergence as the growth leader among developing nations. Since the Communist Party retained political control throughout the growth spurt, it must have been responsible for it – so the usual explanation runs. Coase and Wang showed that government’s presence as the agency in charge of political life does not automatically entitle it to credit for economic growth.

The death of Mao Zedong in 1976 rescued China from decades of terror, famine and dictatorship. Mao’s designated successor, Hua Guofeng, was an economist who outlined a program of state-run investment in heavy industry called the “Leap Outward.” This resembled the various Five-Year Plans of Soviet ruler Joseph Stalin in general approach and in overall lack of results. Hua’s successors, Deng Xiaoping and Chen Yun, abandoned the Leap Outward in favor of an emphasis on agriculture and light industry. Although Deng was the political figurehead who garnered the lion’s share of the publicity, Chen was the guiding spirit behind this second centralized plan designed to spur Chinese economic growth. It placed less emphasis on production of capital goods and more on consumer goods. Chen allowed state-controlled agricultural prices to rise in an effort to stimulate production on China’s collective farms, which had failed disastrously under Mao, resulting in approximately 40 million deaths from famine. He also allowed state-run enterprises a measure of autonomy and private profit, heretofore unthinkable under Communism.

Although these central-government measures were the ostensible spur to China’s remarkable growth run, Coase and Wang assign actual responsibility to the resurgence of China’s private economy. Private farms had always existed as part of the nation’s 30,000 villages and towns, much as neighboring Russians continued to nurture their tiny private plots of land alongside the Soviet collective farms. And, just as was the case in Russia, the smaller private farms began to outdo the larger collectives in productivity and output. Mao fanatically insisted on agricultural collectivization, but his death freed private farmers to resume their former lives.  By late 1980, the Beijing government was forced to officially acknowledge the private farms. In 1982, China formally abandoned its costly experiment with collective agriculture and de-collectivized its farms. Official grain prices were allowed to rise and grain imports were permitted.

Agriculture wasn’t the only industry that flourished at the local level. Small businesses in rural China labored under official handicaps; their access to raw materials was not protected and they had no officially sanctioned distribution channels for their output. But they bought inputs on the black market at high prices and groomed their own sales representatives to scour the nation drumming up business for their goods. These local Davids outperformed the state-run Goliaths; they were the real vanguard of Chinese economic growth.

Growth was slower in China’s major cities. Mao had sent some 20 million youths to the countryside to escape unemployment in the cities. After his death, many of these youths returned to the cities – only to find themselves out of work again. They demonstrated and formed opposition political movements, sometimes paralyzing daily life with their protests. This forced Beijing to permit self-employment for the first time – another Communist sacred cow sacrificed to political expediency. This, in turn, created an urban class of Chinese entrepreneurs. This led to yet another government reaction in the form of Special Economic Zones, somewhat reminiscent of the U.S. “enterprise zones” of the 1980s. Economic freedom and lower taxes were allowed to exist in a controlled environment; Chinese officials hoped to encourage controlled doses of capitalist prosperity in order to save socialism.

Gradually, the limited reforms of the Special Economic Zones became more general. Increased freedom of market prices was introduced in 1992, taxes were lowered in 1994 and privatization of failing state-run enterprises began in the mid-1990s. For the first time, China began to replace local and regional markets with a single national market for many goods.

Coase and Wang identify perhaps the most important but least-known capitalist element to arise in China as the improved pursuit of knowledge. They accurately attribute the recognition of knowledge’s role in economics to Nobel Laureate F.A. Hayek and note the increasing popularity of books and articles by Hayek, his mentor Ludwig von Mises and classical forebears such as Adam Smith. The economics profession has pigeonholed the subject of knowledge under the heading of “technical coefficients of production,” but the authors know that this is only the beginning of the knowledge needed to make a free-market economy work. The knowledge of market institutions and the dispersed, specialized “knowledge of particular time and place” that can only be collated and shared by free markets are even more important than technical knowledge about how to produce goods and services.

The upshot of China’s private resurgence has been to make the country a “laboratory for capitalist experimentation,” according to Coase and Wang. That laboratory has brewed a recipe for unparalleled economic growth since the 1990s, leading to China’s admittance into the World Trade Organization in 2001. The final piece of the puzzle, the authors predict, is a true free market for ideas – the one thing that Western economies have that China lacks. When this falls into place, China will become the America of the 21st century.

Thus did Ronald Coase add a landmark study in economic history to his select resume of classic works.

Quality vs. Quantity

Never in the history of economics has one economist achieved so much productivity with so little scholarly output. Ronald Coase economized on the scarce resources of time and human effort (ours) by devoting the longest career of any great economist to specializing in quality, not quantity, of work.

DRI-309 for week of 8-25-13: What Does ‘Social’ Mean Today?

An Access Advertising EconBrief:

What Does ‘Social’ Mean Today?

For decades, European political parties have rallied around the banner of “social democracy.” Today, Catholic churches throughout the world solemnly urge their congregants to work for “social justice.” Businesses have long been advised to practice “social responsibility.” Certain investment funds are now organized around the principle of “social investing.” Celebrities advertise the possession of a finely honed “social conscience.”

The rhetorical weight carried by the word “social” has never been heavier. Judging by this, one would suppose that the adjective’s meaning is well-defined and universally understood. Assuming that to be so, it should be relatively easy to explain its meanings above, as well as many other similar ones.

That turns out to be far from true. A great economist and social theorist called “social” the great “weasel word” of our time. In the words of the old popular song, how long has this been going on?

Well over two hundred years, believe it or not. The great English philosopher Lord Action accurately observed that, “Few discoveries are more irritating than those which expose the pedigree of ideas.” Those people who invoke the word “social” as a holy sacrament will be outraged to learn its pedigree. For the rest of us, though, the knowledge should prove illuminating.

“What is Social?”
One man above all others made it his business to learn the history and meaning of the word “social.” F.A. Hayek was a leading European economist before World War II, and among his friends were the Freiburg School of German economists who styled themselves the “Soziate Marktwirtschaft” or “Social Market” economists. Why, Hayek wondered, didn’t they simply call themselves “free-market” economists? What magic did the word “social” weave to gain precedence over the idea of freedom?

Over the years, Hayek morphed from world-class economist to world-renowned social philosopher. His fascination with the rhetorical preeminence of “social” eventually produced the article “What Is ‘Social?’ What Does It Mean?” It was published in 1957, then reworked and republished in 1961. In it, Hayek performed feats of semantic archaeology in order to expose the pedigree of “social” in economics and political philosophy.

Hayek’s research produced a scathing assessment. He declared that “the word ‘social’ has become an adjective which robs of its clear meaning every phrase it qualifies and transforms it into a phrase of unlimited elasticity, the implications of which can always be distorted if they are unacceptable, and the use of which…serves merely to conceal the lack of any real agreement between men regarding a formula upon which… they are supposed to be agreed.” It is symptomatic of “an attempt to dress up slogans in a guise acceptable to all tastes.” The word “always confuses and never clarifies;” “pretends to give an answer where no answer exists,” and “is so often used as camouflage for aspirations that have nothing to do with the common interest… .” It has served as a “magical incantation” and used to justify end-runs around traditional morality.

Whew. Can one word that is thrown around so casually and so widely really justify this indictment? Let’s briefly take one example of its usage and try on a few of Hayek’s criticisms for size.

The Example of “Social Justice”
A popular reference source (Wikipedia) has this to say about the concept of “social justice.” “Social justice is justice exercised within a society, particularly as it is applied to and among the various social classes of a society. A socially just society is one based on the principles of equality and solidarity;” it “understands and values human rights as well as recognizing the dignity of every human being.”

The origin of the phrase is ascribed to a Jesuit priest in 1840. It was used to justify the concept of a “living wage” in the late 19th century. The Fascist priest Father Coughlin (curiously, his Fascism goes unremarked by Wikipedia) often employed the term. It became a mainspring of practical Catholic teaching and of the Protestant Social Gospel. Social theorist John Rawls developed a theory of equity intended to give substance to a secular version of social justice.

We can easily locate all of the characteristics identified by Hayek even in this short précis. The definition of “social justice” as “justice exercised within a society” is tautological; this expresses the communal syrup that the word pours over every subject it touches. The “principles of equality and solidarity” sound satisfactorily concrete, but the trouble is that there are no such principles – unless you’re willing to sign off on the notion that everybody is supposed to be equal in all respects. “Solidarity,” of course, is the complementary noun to “social;” each purportedly sanctifies without really saying anything substantial. As such, solidarity became the all-purpose buzzword of the international labor movement. It implies fidelity to an unimpeachable ideal without defining the ideal, just as “social” implies an ideal without defining it.

The reference to “human rights” may well seem obscure to those unfamiliar with the age-old left-wing dichotomy between “property rights” and “human rights” – a false distinction, since all rights are human rights by implication. There may some day be a society that recognizes the dignity of every human being, but the sun has not yet shone on it. Thus, social justice illustrates Hayek’s reference to an underlying lack of agreement masked by a façade of universal accord. The roll call of dubious subscribers to the concept, ranging from Fascists to socialists to left-wing extremists and simplistic activists, dovetails perfectly with a concept of “unlimited elasticity,” which masquerades “in the guise acceptable to all tastes” as a “magical incantation” used to justify dubious means to achieve allegedly noble ends.

The Basic Uses of “Social”
Devotees of the various “social” causes have used the word in certain basic recurring ways. Each of them displays Hayek’s characteristics. We can associate these generic uses with specific “social” causes and government actions.

First, there is the plea for inclusiveness. As originally developed, this had considerable justification. As Hayek admitted, “in the last [19th] century…political discussion and the taking of political decisions were confined to a small upper class.” The appending of “social” was a shorthand way of reminding the upper classes that “they were responsible for the fate of the most numerous and poorest sections of the community.” But the concept “seems somewhat of an anachronism in an age when it is the masses who wield political power.” This is probably the dawn of the well-worn injunction to develop a “social conscience.” We associate the mid-19th century with famous “social” legislation ranging from the end of debtor’s prisons and reform of poor laws to the repeal of the Corn Laws in England.

Second, “social” is a plea to view personal morality abstractly rather than concretely by assigning to it remote consequences as well as immediate ones. For example, traditional ethics implores the businessman to treat his employees and customers fairly by respecting their rights and not hurting them. But “social responsibility” demands that businessmen know, understand and affect the consequences of all their buying decisions as well. They should refuse to buy inputs produced using labor that is paid “too little,” even though this benefits their own customers and workers, because it ostensibly hurts the workers who produce those inputs.

This stands the economic logic of free markets on its head. Businessmen are experts on their own business and the wants of their customers. Free markets allow them to know as little as possible about the input goods they buy because this economizes on information – which is scarce – and on the use of businessmen’s time – which is likewise scarce. But the illogic of “social responsibility” demands that businessmen specialize in learning things it is difficult or impossible for them to know instead of things they normally learn in the course of doing business. This is so absurdly inefficient it is downright crazy; instead of doing what they do best, businessmen are supposed to divert their attention to things they know little about and disregard the value generated by the free market.

The crowning absurdity is that “socially responsibility” expects businessmen to accept on faith the assertions of activists that buying goods produced with low-wage labor hurts the workers who produce those goods. And this is dead wrong, since it does just the opposite – by increasing the demand for the goods labor produces, it increases the marginal product of labor and labor’s wage. The same illogic is sometimes extended even farther to consumers, who are even less well placed to gauge the remote consequences of their personal buying decisions and, thus, are even more at the mercy of the bad economics propounded by “social” theory activists.

Thirdly, “social” theory demands that government also reverse its traditional ethical role by treating individuals concretely rather than abstractly. The traditional Rule of Law requires government to judge individuals by abstract rules of justice – and that the same abstract rules apply to all individuals. But “social justice” requires government to judge individuals according to their respective merits, which requires treating different individuals by different rules; e.g., repealing the traditional Rule of Law. Contemporary examples of this repeal abound: affirmative action, bailouts for firms adjudged “too big to fail,” eminent domain for the benefit of private business, augmented rights granted to certain politically identifiable groups while basic rights are denied to others, and on and on, ad nauseum.

Finally, “social” theory clearly implies the upsetting of traditional morality by the substitution of “social” criteria for traditional moral criteria. Although it seems superficially that traditional moral criteria are without rational foundation, this is misleading. In fact, those criteria evolved over thousands of years because they were conducive to a successful order within humanity. As the Spanish philosopher Ortega y Gasset reminds us, “order is not a pressure imposed on society from without, but an equilibrium which is set up from within.” The word “equilibrium” implies the existence of change which culminates in a new, improved order. Social evolution is thus comparable to economic equilibrium, in which new goods and services are subject to a market test and accepted or rejected. Surviving moral criteria are abstract rules that may not benefit every single individual in every single case but that have demonstrated powerful survival value for humanity over thousands of years. And these rules are subject to a powerful evolutionary test over time.

In contrast, “social” theory substitutes the concrete, ad hoc rules adapted to each situation by self-appointed social theorists. These self-appointed experts reject free competition in both economics and political philosophy; thus, these social theories do not receive the same rigorous evolutionary tests that vetted traditional morality.

Both the impersonal workings of the free economic market and the abstract, impersonal workings of the “market” for morality and social philosophy seem to be harsh because there is no inherent spokesman or advocate to explain their operation to the public. Economists have failed to perform this task for free markets, while the influence of moral arbiters like clergymen and philosophers has waned in recent decades. The plans of “social” theorists appear to be kind because they are designed with appearance in mind rather than to actually attain the results they advertise.

Corollaries to the Uses of “Social”
Certain corollary effects of these uses are implied and have, in fact, emerged. When the appeal to the communal of “social” effects of our actions predominates over our personal actions, our personal responsibility for our own lives and welfare erodes. And sure enough, the widespread reluctance to take responsibility for individual actions is palpable. Why should we take responsibility for saving when the federal government takes our money by force for the ostensible purpose of saving and investing it for our individual retirement uses? Thus does saving decline, asymptotically approaching zero. Why should we accept responsibility for our own errors when we are forced to take responsibility for the errors of others by taxation, criminal justice, economic policy and a host of other coercive actions by government? Hence the growing tendency to claim universal “rights” to goods and services such as food, health care, housing and more.

The irony is that each of us is the world’s leading expert on our self. “Social” policy forces us to shoulder responsibility for people and things we aren’t, and can never be, expert on, while forswearing responsibility for the one person on whom our expertise is preeminent. In economic terms, this cannot possibly be an efficient way to order a society.

This leads to another important point of information theory. The demands of “social” theory imply that certain select individuals possess talents and information denied to the rabble. These are the people who decide which particular distribution of income or wealth is “socially just, which business actions are or aren’t “socially responsible, what linguistic forms are or aren’t “socially aware,” and so forth.

The elevation of some people above others is practiced predominantly by government. In order to reward people according to merit, government must in principle have knowledge about the particular circumstances of individuals that justify the rewards (or deny them, as the case may be). In practice, of course, government is so distant from most individuals that it cannot begin to possess that kind of knowledge. That is why the concept of group rights has emerged, since it is often possible to identify individual membership in a group. Race, gender, religion, political preference and other group affiliations are among the various identifiers used to justify preferential treatment by government.

The blatant shortcomings of this philosophy have now become manifest to all. One need not be a political philosopher steeped in the Rule of Law to appreciate that envy now plays a pivotal role in politics and government. Rather than concentrate on producing goods and services, people now focus on redistributing real income and wealth in their own favor. This is the inevitable by-product of a “social” theory focused on fairness rather than growth. The laws of economics offer a straightforward path toward growth, but there is no comparably unambiguous theory of fairness that will satisfy the competing claimants of “social” causes.

And once again, the shortcomings of “social” theory as magnified by a further irony. For decades, government welfare programs have been recognized as failures by researchers, the general public and welfare recipients themselves. Only “social theorists,” bureaucrats and politicians still support them. This is bad enough. But even worse, the rejection of free markets by “social” theorists has eliminated the only practical means by which individual merit might be used as the basis for compensatory social action. Although you are the world’s leading expert on you and I am the leading authority on me, you will sometimes gain authoritative information about me. By allowing you to keep your own real income and the freedom to utilize it as you see fit, I am also allowing to conduct your own personal policy of “social justice.” This concept of neighborhood or community charity is one form of tribalism that has persisted for thousands of years because it is clearly efficient and has survival value. Yet it is one of the first victims of government-imposed “social justice.” Bureaucrats resent the competition provided by private charity. Even more, they resent watching money used privately when it could have been siphoned off for their own use.

Socialism
What is the relation between the adjective “social” and the noun “socialism?” Socialism had roots traceable at least to the Middle Ages, but its formal beginnings go back to the French philosophers Saint-Simon and Comte in the 18th century. It was Saint-Simon who visualized “society” as one single organic unity and longed to organize a nation’s productive activity as if it were one single unified factory.

It is this pretense that defines the essence of socialism and the appeal of its adjectival handmaiden, “social.” Participation in the sanctifying “social” enterprise at once washes the participant clean of sin and cloaks pursuit of personal gain in the guise of altruism and nobility. It makes the participant automatically virtuous and popular and “one with the universe” – well, part of a subset of like-minded people, anyway.

Socialism sputtered to life in 19th-century revolutionary Europe and enjoyed various incarnations throughout the late 19th and 20th centuries. It has failed uniformly, not just in achieving “the principles of equality and solidarity” but in providing goods and services for citizens. Failure was most complete in those polities where the approach to classical socialism was closest. (In this regard, it should be remembered that the Scandinavian welfare states fell far short of Great Britain on the classic socialist criterion of industrial nationalization.) Yet socialism as an ideal still thrives while capitalism, whose historical preeminence is inarguable, languishes in bad odor.

Hayek’s criticisms of “social” explain this paradox. Socialism’s shortcomings are its virtues. Its language encourages instant belief and acceptance. It smoothes over differences, enveloping them in a fog of good feeling and obscurantism. It promises an easy road to salvation, demanding little of the disciple and offering much. Words are valued for their immediate effects, and the immediate effects of “social” are favorable to the user and the hearer. True, it is an obstacle to clear thinking – but when the immediate products of clear thinking are unpalatable, who wants clear thinking, anyway?

“Social” keeps the ideal of socialism alive while burying its reality. As long as “social” prefaces anything except an “ism,” the listener has license to dissociate the adjective from the noun and luxuriate in the visceral associations of the former while ignoring the gruesome history of the latter.

Just One LIttle, Itsy-Bitsy, Teeny-Weenie Word
F.A. Hayek closed his essay on “social” by saying, “it seems to me that a great deal of what today professes to be social is, in the deeper and truer sense of the word, thoroughly and completely anti-social.” Hayek was right that “such a little word not only throws light upon the process of the evolution of ideas and the story of human error, but … also exercises an irrational power which becomes apparent only when… we lay bare its true meaning.”

Who would have dreamed that one word could say so much?

DRI-280 for week of 7-7-13: Unintended Consequences and Distortions of Government Action

An Access Advertising EconBrief:

Unintended Consequences and Distortions of Government Action

The most important cultural evolution of 20th-century America was the emergence of government as the problem-solver of first resort. One of the most oft-uttered phrases of broadcast news reports was “this market is not subject to government regulation” – as if this automatically bred misfortune. The identification of a problem called for a government program tailored to its solution. Our sensitivity, compassion and nobility were measured by the dollar expenditure allocated to these problems, rather than by their actual solution.

This trend has increasingly frustrated economists, who associate government action with unintended consequences and distortions of markets. Since voluntary exchange in markets is mutually beneficial, distortions of the market and consequences other than mutual benefit are bad things. Economists have had a hard time getting their arguments across to the public.

One reason for this failure is the public unwillingness to associate a cause with an effect other than that intended. We live our lives striving to achieve our ends. When we fail, we don’t just shrug and forget it – we demand to know why. Government seems like a tool made to order for our purposes; it wields the power and command over resources that we lack as individuals. Our education has taught us that democracy gives us the right and even the duty to order government around. So why can’t we get it to work the way we want it to?

The short answer to that is that we know what we want but we don’t know how government or markets work, so we don’t know how to get what we want. In order to appreciate this, we need to understand the nature of government’s failures and of the market’s successes. To that end, here are various examples of unintended consequences and distortions.

Excise Taxation

One of the simplest cases of unintended, distortive consequences is excise taxation. An excise tax is a tax on a good, either on its production or its consumption. Although few people realize it, the meaningful economic effects of the tax are the same regardless of whether the tax is collected from the buyer of the good or from the seller. In practice, excise taxes are usually collected from sellers.

Consider a real-world example with purely hypothetical numbers used for expository purposes. Automotive gasoline is subject to excise taxation levied at the pump; e.g., collected from sellers but explicitly incorporated into the price consumers pay. Assume that the price of gas net of tax is $2.00 per gallon and the combination of local, state and federal excuse taxes adds up to $1.00 per gallon. That means that the consumer pays $3.00 per gallon but the retail gasoline seller pockets only $2.00 per gallon.

Consider, for computational ease, a price decrease of $.30 per gallon. How likely is the gasoline seller to take this action? Well, he would be more likely to take it if his total revenue were larger after the price decrease than before. But with the excise tax in force, a big roadblock exists to price reductions by the seller. The $.30 price decrease subtracts 15% from the price (the net revenue per unit) the seller receives, but only 10% from the price per unit that the buyer pays. And it is the reduction in price per unit paid by the buyer that will induce purchase of more units, which is the only reason the seller would have to want to reduce price in the first place. The fact that net revenue per unit falls by a larger percentage than price per unit paid by consumers is a big disincentive to lowering price.

Consider the kind of case that is most favorable to price reductions, in which demand is price-elastic. That is, the percentage increase in consumer purchases exceeds the percentage decrease in price (net revenue). Assume that purchases were originally 10,000 gallons per week and increased to 11,200 (an increase of 12%, which exceeds the percentage decrease in price). The original total revenue was 10,000 x $2.00 = $20,000. Now total revenue is 11,200 x $1.70 = $19,040, nearly $1,000 less. Since the total costs of producing 1,200 more units of output are greater than before, the gasoline seller will not want to lower price if he correctly anticipates this result. Despite the fact that consumer demand responds favorably (in a price-elastic manner) to the price decrease, the seller won’t initiate it.

Without the excise taxation, consumers and seller would face the same price. If demand were price-elastic, the seller would expect to increase total revenue by lowering price and selling more units than before. If the increase in total revenue were more than enough to cover the additional costs of producing the added output, the seller would lower price.

Excise taxation can reduce the incentive for sellers to lower price when it is imposed in specific form – a fixed amount per unit of output. When the excise tax is levied ad valorem, as a percentage of value rather than a fixed amount per unit, that disincentive is no longer present. In fact, the specific tax is the more popular form of excise taxation.

The irony of this unintended consequence is felt most keenly in times of rising gasoline prices. Demagogues hold sway with talk about price conspiracies and monopoly power exerted by “big corporations” and oil companies. Talk-show callers expound at length on the disparity between price increases and price decreases and the relative reluctance of sellers to lower price. Yet the straightforward logic of excise taxation is never broached. The callers are right, but for entirely the wrong reason. The culprit is not monopoly or conspiracy. It is excise taxation.

This unintended consequence was apparently first noticed by Richard Caves of Harvard University in his 1964 text American Industry: Structure, Conduct, Performance.

ObamaCare: The 29’ers and 49’ers

The recent decision to delay implementation of the Affordable Care Act – more familiarly known as ObamaCare – has interrupted two of the most profound and remarkable unintended consequences in American legislative history. The centerpiece of ObamaCare is its health mandates: the requirement that individuals who lack health insurance acquire it or pay a sizable fine and the requirement that businesses of significant size provide health plans for their employees or, once again, pay fines.

It is the business mandate, scheduled for implementation in 2014, which was delayed in a recent online announcement by the Obama administration. The provisions of the law had already produced dramatic effects on employment in American business. It seems likely that these effects, along with the logistical difficulties in implementing the plan, were behind the decision to delay the law’s application to businesses.

The law requires businesses with 50 or more “full-time equivalent” employees to make a health-care plan available to employees. A “full-time-equivalent” employee is defined as any combination of employees whose employment adds up to the full-employment quotient of hours. Full-time employment is defined as 30 hours per week, in contradiction to the longtime definition of 40 hours. Presumably this change was made in order to broaden the scope of the law, but it is clearly having the opposite effect – a locus classicus of unintended consequences at work.

Because the “measurement period” during which each firm’s number of full-time equivalent number of employees is calculated began in January 2013, firms reacted to the provisions of ObamaCare at the start of this year, even though the business mandate itself was not scheduled to begin until 2014. No sooner did the New Year unfold than observers noticed changes in fast-food industry employment. The changes took two basic forms.

First, firms – that is, individual fast-food franchises – cut off their number of full-time employees at no more than 49. Thus, they became known as “49’ers.” This practice was obviously intended to stop the firm short of the 50-employee minimum threshold for application of the health-insurance requirement under ObamaCare. At first thought, this may seem trivial if highly arbitrary. Further thought alters that snap judgment. Even more than foods, fast-food firms sell service. This service is highly labor-intensive. An arbitrary limitation on full-time employment is a serious matter, since it means that any slack must be taken up by part-timers.

And that is part two of the one-two punch delivered to employment by ObamaCare. Those same fast-food firms – McDonald’s, Burger King, Wendy’s, et al – began limiting their part-time work force to 20 hours per week, thereby holding them below the 30-hour threshold as well. But, since many of those employees were previously working 30 hours or more, the firms began sharing employees – encouraging their employees to work 20-hour shifts for rival firms and logging shift workers from those firms on their own books. Of course, two 20-hour shifts still comprises (more than) a full-time-equivalent worker, but as long as the total worker hours does not exceed the 1500-hour weekly total of 50 workers at 30 hours, the firm will still escape the health-insurance requirement. Thus were born the “29’ers” – those firms who held part-time workers below the 30-hour threshold for full-time-equivalent employment.

Are the requirements of ObamaCare really that onerous? Politicians and left-wing commentators commonly act as if health-insurance were the least that any self-respecting employer could provide any employee, on a par with providing a roof to keep out the rain and heat to ward off freezing cold in winter. Fast-food entrepreneurs are striving to avoid penalties associated with hiring that 50th full-time-equivalent employee. The penalty for failing to provide health insurance is $2,000 per employee beginning with 30. That is, the hiring of the 50th employee means incurring a penalty on the previous 20 employees, a total penalty of $40,000. Hiring (say) 60 employees would raise the penalty to $60,000.

A 2011 study by the Hudson Institute found that the average fast-food franchise makes a profit of $50,000-100,000 per year. Thus, ObamaCare penalties could eat up most or all of a year’s profit. The study’s authors foresaw an annual cost to the industry of $6.4 billion from implementation of ObamaCare. 3.2 million jobs were estimated to be “at risk.” All this comes at a time when employment is painfully slow to recover from the Great Recession of 2007-2009 and the exodus of workers from the labor force continues apace. Indeed, it is just this exodus that keeps the official unemployment rate from reaching double-digit heights reminiscent of the Great Depression of the 1930s.

Our first distortion was an excise tax. The ObamaCare mandates can also be viewed as a tax. The business mandates are equivalent to a tax on employment, since their implementation and penalties are geared to the level of employment. The Hudson study calculated that, assuming a hypothetical wage of $12 per hour, employing the 50th person would cost the firm $52 per hour, of which only $12 was paid out in wages to the employee. The difference between what the firm must pay out and what the employee receives is called “the wedge” by economists, since it reduces the incentive to hire and to work. The wider the wedge, the greater the disincentive. Presumably, this is yet another unintended consequence at work.

ObamaCare is a law that was advertised as the solution to a burgeoning, decades-old problem that threatened to engulf the federal budget. Instead, the law itself now threatens to bring first the government, then the private economy to a standstill. In time, ObamaCare may come to lead the league in unintended consequences – a competition in government ineptitude that can truly be called a battle of the all-stars.

The Food Stamp Program: An Excise Subsidy

In contrast to the first two examples of distortion, the food-stamp program is not a tax but rather its opposite number – a subsidy. Because food stamps are a subsidy given in-kind instead of in cash – a subsidy on a good in contrast to a tax on a good – they are an excise subsidy.

Food stamps began in the 1940s as a supplement to agricultural price supports. Their primary purpose was to dispose of agricultural surpluses, which were already becoming a costly nuisance to the federal government. Their value to the poor was seen as a coincidental, though convenient, byproduct. Although farmers and the poor have long since exchanged places in the hierarchy of beneficiaries, vestiges of the program’s lineage remain in its residence in the Agriculture Department and the source of its annual appropriations in the farm bill. (Roughly 80% of this year’s farm bill was given over to monies for the food-stamp program, which now reaches some 47.3 million Americans, or 15% of the population.)

The fact that agricultural programs help people other than their supposed beneficiaries is not really an example of unintended consequences, since we have known from the outset that price supports, acreage quotas, target prices and other government measures harm the general public and help large-scale farmers much more than small family farmers. The unintended consequences of the food-stamp program are vast, but they are unrelated to its tenuous link to agriculture.

Taxes take real income away from taxpayers, but – at least in principle – they fund projects that ostensibly provide compensating benefits. The unambiguous harm caused by taxes results from the distortions they create, which cause deadweight losses, or pure waste of time, effort and resources. Subsidies, the opposite number of taxes, create similar distortions. The food stamp program illustrates these distortions vividly.

For many years, program recipients received stamp-like vouchers entitling them to acquire specified categories of foodstuffs from participating sellers (mostly groceries). The recipient exchanged the stamps for food at a rate of exchange governed by the stamps’ face value. Certain foods and beverages, notably beverage alcohol, could not be purchased using food stamps.

Any economist could have predicted the outcome of this arrangement. A thriving black market arose in which food stamps could be sold at a discount to face value in exchange for cash. The amount of the discount represented the market price paid by the recipient and received by the broker; it fluctuated with market conditions but often hovered in the vicinity of 50% (!). This transaction allowed recipients to directly purchase proscribed goods and/or non-food items using cash. The black-market broker exchanged the food stamps (quasi-) legally at face value in a grocery in exchange for food or illegally at a small discount with a grocery in exchange for cash. (In recent years, bureaucrats have sought to kill off the black market by substituting a debit card for the stamp/vouchers.)

The size of the discount represents the magnitude of the economic distortion created by giving poor people a subsidy in excise form rather than in cash. Remarkably, large numbers of poor people preferred cash subsidies to markedly that $.50 in cash was preferred to $1.00 worth of (government-approved) foodstuffs. This suggests that a program of cash subsidies could have made recipients better off while spending around half as much more money on subsidies and dispensing with most of the large administrative costs of the actual food-stamp program.

Inefficiency has been the focus of various studies of the overall welfare system. Their common conclusion has been that the U.S. could lift every man, woman and child above the arbitrary poverty line for a fraction of our actual expenditures on welfare programs simply by giving cash to recipients and forgoing all other forms of administrative endeavor.

Of course, the presumption behind all this analysis is that the purpose of welfare programs like food stamps is to improve the well-being of recipients. In reality, the history of the food-stamp program and everyday experience suggests otherwise – that the true purpose of welfare programs is to improve the well-being of donors (i.e., taxpayers) by alleviating guilt they would otherwise feel.

The legitimate objections to cash subsidy welfare programs focus on the harm done to work incentives and the danger of dependency. The welfare reform crafted by the Republican Congress in 1994 and reluctantly signed by President Clinton was guided by this attitude, hence its emphasis on work requirements. But the opposition to cash subsidies from the general public, all too familiar to working economists from the classroom and the speaking platform, arises from other sources. The most vocal opposition to cash subsidies is expressed by those who claim that recipients will use cash to buy drugs, alcohol and other “undesirable” consumption goods – undesirable as gauged by the speaker, not by the welfare recipient. The clear implication is that the food-stamp format is a necessary prophylactic against this undesirable consumption behavior by welfare recipients, the corollary implication being that taxpayers have the moral right to control the behavior of welfare recipients.

Taxpayers may or may not be morally justified in asserting the right to control the behavior of welfare recipients whose consumption is taxpayer-subsidized. But this insistence on control is surely quixotic if the purpose of the program is to improve the welfare of recipients. And, after all, isn’t that what a “welfare” program is – by definition? The word “welfare” cannot very well refer to the welfare of taxpayers, for then the program would be a totalitarian program of forced consumption run for the primary benefit of taxpayers and the secondary benefit of welfare recipients.

The clinching point against the excise subsidy format of the food-stamp program is that it does not prevent recipients from increasing their purchases of drugs, alcohol or other forbidden substances. A recipient of (say) $500 in monthly food stamps who spends $1,000 per month on (approved) foodstuffs can simply use the food stamps to displace $500 in cash spending on food, leaving them with $500 more in cash to spend on drugs or booze. In practice, a recipient of a subsidy will normally prefer to increase consumption of all normal goods (that is, goods whose consumption he or she increases when real income rises). Any excise subsidy, including food stamps, will therefore be inferior to a cash subsidy for this reason. In terms of economic logic, an excise subsidy starts out with three strikes against it as a means of improving a recipient’s welfare.

So why do multitudes of people insist on wasting vast sums of money in order to make people worse off, when they could save that money by making them better off? The paradox is magnified by the fact that most of these money-wasters are politically conservative people who abhor government waste. The only explanation that suggests itself readily is that by wasting money conspicuously, these people relieve themselves of guilt. They are no longer troubled by images of poor, hungry downtrodden souls. They need feel no responsibility for enabling misbehavior through their tax payments. They have lifted a heavy burden from their minds.

The Rule, Not the Exception

These common themes developed by these examples are distortion of otherwise-efficient markets by government action and unintended consequences resulting from the government-caused distortions. By its very nature, government acts through compulsion and coercion rather than mutually beneficial voluntary exchange. Consequently, distortions are the normal case rather than the exception. Examples such as those above are not exceptions. They are the normal case.

DRI-332 for week of 6-16-13: What Lies Ahead for Us?

An Access Advertising EconBrief:

What Lies Ahead for Us?

Last month, Federal Reserve Chairman Ben Bernanke announced that the Fed Open Market Committee is contemplating an end to the $85 billion program of bond purchases that has been dubbed “Quantitative Easing (QE).” The announcement was hedged over with assurances that the denouement would come only gradually, when the Fed was satisfied that general economic conditions had improved sufficiently to make QE unnecessary. Nonetheless, the announcement produced a flurry of speculation about the eventual date and timing of the Fed’s exit.

The Fed’s monetary policy since the financial crisis of 2008 and the stimulus package of 2009 is unique in U.S. economic history. Indeed, its repercussions have resounded throughout the world. Its motives and means are both poorly understood and hotly debated. Shedding light on these matters will help us face the future. A question-and-answer format seems appropriate to reflect the mood of uncertainty, anxiety and fear that pervades today’s climate.

What was the motivation for QE, anyway?

The stated motivation was to provide economic stimulus. The nature of the stimulus was ambiguously defined. Sometimes it was to increase the rate of inflation, which was supposedly too low. Sometimes it was to stimulate investment by holding interest rates low. The idea here was that, since the Fed was buying bonds issued by the Treasury, the Fed could take advantage of the inverse relationship between a bond’s price and its yield to maturity by bidding up T-bond prices, which automatically has the effect of bidding down their yields. Because $85 billion worth of Treasury bonds comprise such a large quarterly chunk of the overall bond market, this will depress bond yields for quite a while after the T-bond auction. Finally, the last stimulative feature of the policy was ostensibly to indirectly stimulate purchase of stocks by driving down the yields on fixed-income assets like bonds. With nowhere to go except stocks, investors would bid up stock prices, thus increasing the net worth of equity investors, who comprise some 40-50% of the population.

How was driving up stock prices supposed to stimulate the economy?

The ostensible idea was to make a large segment of Americans feel wealthier. This should cause them to spend more money. This sizable increase in overall expenditures should cause secondary increases in income and employment through the economic process known as the “multiplier effect.” This would end the recession by reducing unemployment and luring Americans back into the labor force.

How did the plan work out?

Inflation didn’t increase much, if at all. Neither did investment, particularly when viewed in net terms that exclude investments to replace deteriorated capital stock. Stock prices certainly rose, although the consumption increases that followed have remained modest.

So the plan was a failure?

That would be a reasonable assessment if, and only if, the stated goal(s) of QE was (were) the real goal(s). But that wasn’t true; the real goal QE was to reinforce and magnify the Fed’s overall “zero interest-rate policy,” called ZIRP for short. As long as it accomplished that goal, any economic stimulus produced was a bonus. And on that score, QE succeeded very well indeed. That is why it was extended and why the Fed is stretching it out as long as it can.

Wait a minute – I thought you just said that even though interest rates have remained low, investment has not increased. Why, then, is the Fed so hot to keep interest rates low? I always heard that the whole idea behind Fed policies to peg interest rates at low levels was to stimulate investment. Why is the Fed busting our chops to follow this policy when it isn’t working?

You heard right. That was, and still is, the simple Keynesian model taught to freshman and sophomore economics students in college. The problem is that it never did work particularly well and now works worse than ever. In fact, that policy is actually the proximate cause of the business cycle as we have traditionally known it.

But even though the Fed gives lip service to this outdated textbook concept, the real reason it wants to keep interest rates low is financial. If the Fed allowed interest rates to rise – as they would certainly do if allowed to find their own level in a free capital market – the rise in market interest rates would force the federal government to finance its gargantuan current and future budget deficits by selling bonds that paid much higher interest rates to bondholders. And that would drive the percentage of the federal government budget devoted to interest payments through the roof. Little would be left for the other spending that funds big government as we know it – the many cabinet departments and myriad regulatory and welfare agencies.

Even if you don’t find this argument compelling – and you can bet it compels anybody who gets a paycheck from the federal government – it should be obvious to everybody that the Fed isn’t really trying that hard to apply traditional stimulative monetary policy. After all, stimulative monetary policy works by putting money in public hands – allowing banks to make loans and consumer spending to magnify the multiplier effects of the loan expenditures. But Bernanke lobbied for a change in the law that allowed the Fed to pay interest to banks on their excess reserves.  When the Fed enforces ZIRP by buying bonds in the secondary market, it pays banks for them by crediting the banks’ reserve accounts at the Fed. The interest payments mean that the banks don’t have to risk making loans with that money; they can just hold it in excess reserves and earn easy profits. This is the reason why the Fed’s money creation has not caused runaway inflation, as government money creation always did in the past. You can’t have all or most prices rising at once unless the newly created money is actually chasing goods and services, which is not happening here.

But the mere fact that hyperinflation hasn’t struck doesn’t mean that the all-clear has been sounded. And it doesn’t mean that we’re not being gored by the horns of a debt dilemma. We certainly are.

Being gored in the bowels of a storm cellar is a pretty uncomfortable metaphor. You make it sound as though we have reached a critical economic crisis point.

We have. Every well-known civilizational collapse and revolution, from ancient Rome to the present day, has experienced a financial crisis resembling ours. The formula is familiar. The government has overspent and resorted to money creation as a desperate expedient to finance itself. This has papered over the problem but ended up making things even worse. For example, the French support for the American colonies against Great Britain was the straw that broke the bank of their monarchy, fomenting the French Revolution. The Romanovs downfall occurred despite Russia’s increasing rate of economic growth in the late 1800s and because of financial profligacy and war – two causes that should be familiar to us.

It sounds as though government can no longer use the tools of fiscal and monetary policy to stimulate the economy.

It never could. After all, the advent of Keynesian economics after 1950 did not usher in unprecedented, uninterrupted world prosperity. We had recessions and depressions before Keynes wrote his General Theory in 1936 and have had them since then, too. And Keynes’s conclusions were anticipated by other economists, such as the American economists Foster and Catchings in the late 1920s. F.A. Hayek wrote a lengthy article refuting their arguments in 1927 and he later opposed Keynes throughout the 1930s and thereafter. The principles of his business-cycle theory were never better illustrated than by real-world events during the run-up to the recession and financial crisis in 2007-2008 and the later stimulus, ZIRP and QE.

It seems amazing, but Keynesian economists today justify government policies by claiming that the alternative would have been worse and by claiming responsibility for anything good that happens. Actually, the real force at work was described by the Chairman of Great Britain’s Bank of England, Mervyn King, in the central bank’s February Inflation Report:

“We must recognize [sic], however, that there are limits to what can be achieved via general monetary stimulus – in any form – on its own. Monetary policy works, at least in part, by providing incentives to households and businesses to bring forward spending from the future to the present. But that reduces spending plans tomorrow. And when tomorrow arrives, an even larger stimulus is required to bring forward yet more spending from the future. As time passes, larger and larger doses of stimulus are required.”

King’s characterization of transferring spending or borrowing from the future accurately describes the effects of textbook Keynesian economics and the new variant spawned by the Bernanke Fed. Keynesians themselves advertised the advantage of fiscal policy as the fact that government spending spends 100% of every available dollar, while private consumers allow part of the same dollar to leak into savings. This dovetails exactly with King’s account. The artificially low interest rates created by monetary policy have the same effect of turning saving into current consumption.

Today, we are experiencing a grotesque, nightmarish version of Keynesian economics. Ordinarily, artificially low interest rates would stimulate excessive investment – or rather, would drive investment capital into longer-maturing projects that later prove unprofitable, like the flood of money directed toward housing and real-estate investment in the first decade of this century. But our current interest rates are so absurdly low, so palpably phony, that businesses are not about to be suckered by them. After all, nobody can predict when rates might shoot up and squelch the profitability of their investment. So corporations have pulled up their financial drawbridges behind balance sheets heavy with cash. Consumers have pulled consumption forward from the future, since that is the only attractive alternative to the stock investments that only recently wrecked their net worth. This, too, validates King’s conclusions. Whether “successful” or not, Keynesian economics cannot last because the policy of borrowing from the future is self-limiting and self-defeating.

Didn’t I just read that our budget deficit is headed lower? Doesn’t this mean that we’ve turned the corner of both our budget crisis and our flagging recovery?

If you read carefully, you discovered that the improvement in the federal government’s fiscal posture is temporary, mostly an accounting artifact that occurs every April. Another contributing factor is the income corporations distributed at year-end 2012 to avoid taxation at this year’s higher rates, which is now being taxed at the individual level. Most of this constitutes a one-time increase in revenue that will not carry over into subsequent quarters. Even though the real economic benefits of this are illusory, it does serve to explain why Fed Chairman Bernanke has picked this moment to announce an impending “tapering off” of the QE program of Fed bond purchases.

How so?

The fact that federal deficits will be temporarily lower means that the federal government will be selling fewer bonds to finance its deficit. This, in turn, means that the Fed will perforce be buying fewer bonds whether it wants to or not. Even if there might technically be enough bonds sold for the Fed to continue buying at its current $85 billion level, it would be inadvisable for the federal government to buy all, or virtually all, of an entire issue while leaving nothing for private investors. After all, U.S. government bonds are still the world’s leading fixed-income financial instrument.

Since the Fed is going to be forced to reduce QE anyway, this gives Bernanke and company the chance to gauge public reaction to their announcement and to the actual reduction. Eventually, the Fed is going to have to end QE, and the more accurately they can predict the reaction to this, the better they can judge when to do that. So the Fed is simply making a virtue out of necessity.

You said something awhile back that I can’t forget. You referred to the Keynesian policy of artificially lowering interest rates to stimulate investment as the “proximate” cause of the business cycle. Why is that true and what is the qualifier doing there?

To illustrate the meaning, consider the Great Recession that began in 2007. There were many “causes,” if one defines a cause as an event or sequence of events that initiated, reinforced or accelerated the course of the recession. The housing bubble and ensuing collapse in housing prices was prominent among these. That bubble itself had various causes, including the adoption of restrictive land-use policies by many state and local jurisdictions across America, imprudent federal-government policies promoting home-ownership by relaxing credit standards, bank-regulation standards that positioned mortgage-related securities as essentially riskless and the creation and subsidy of government-sponsored agencies like Fannie Mae and Freddie Mac that implemented unwise policies and distorted longstanding principles of home purchase and finance. Another contributor to recession was the decline in the exchange-value of the U.S. dollar that led to a sharp upward spike in (dollar-denominated) crude oil prices.

But the reign of artificially low interest rates that allowed widespread access to housing-related capital and distorted investment incentives on both the demand and production side of the market were the proximate cause of both the housing bubble and the recession. The interest rates were the most closely linked causal agent to the bubble and the recession would not have happened without the bubble. Not only that, the artificially low interest rates would have triggered a recession even without the other independent influences – albeit a much milder one. Another way to characterize the link between interest rates and the recession would be to say that the artificially low interest rates were both necessary and sufficient to produce the recession. The question is: Why?

For several centuries, an artificial lowering of interest rates accompanied an increase in the supply of money and/or credit. Prior to the 20th century, this was usually owing to increases in stocks of mined gold and/or silver, coupled with the metallic monetary standards then in use. Modern central banks have created credit while severing its linkage with government holdings of stocks of precious metals, thus imposing a regime of fiat money operating under the principles of fractional-reserve banking.

In both these institutional settings, the immediate reaction to the monetary change was lower interest rates. The effect was the same as if consumers had decided to save more money in order to consume less today and more in the future. The lower interest rates had complex effects on the total volume of investment because they affect investment through three different channels. The lower rate of discount and increased value of future investment flows greatly increase the attractiveness of some investments – namely, those in long-lived production processes where cash flows are realized in the relatively distant future. Housing is a classic example of one such process. Thus, a boom is created in the sector(s) to which resources are drawn by the low interest rates, like the one the U.S. enjoyed in the early 2000s.

The increase in employment and income in those sectors causes an increase in the demand for current consumption goods. This bids up prices of labor and raw materials, provided either that full employment has been reached or that those resources are specialized to their particular sectors. This tends to reduce investment in shorter-term production processes, including those that produce goods and services for current consumption. Moreover, the original investments are starting to run into trouble for three reasons: first, because their costs are unexpectedly increasing; second, because the consumer demand that would ordinarily have accompanied an increase in saving is absent because it was monetary expansion, not saving, that produced the fall in interest rates; and third, because interest rates return to their (higher) natural level, making it difficult to complete or support the original investments.

Only an increase in the rate of monetary expansion will allow original investments to be refinanced or validated by an artificial shot of consumer demand. That is what often happened throughout the 20th century – central banks frantically doubled down on their original monetary policy when its results started to go sour. Of course, this merely repeated the whole process over again and increased the size and number of failed investments. The eventual outcome was widespread unemployment and recession. That is the story of the recent housing bubble. This mushrooming disaster couldn’t happen without central banking, which explains why 19th century business cycles were less severe than many modern ones.

I don’t recall reading this rather complicated explanation before or hearing it discussed on television or radio. Why not?

The preceding theory of business cycles was developed by F. A. Hayek in the late 1920s, based on monetary theory developed by his mentor, Ludwig von Mises, and the interest-rate theory of the Swedish economist, Knut Wicksell. Hayek used it to predict the onset of what became the Great Depression in 1929. (Von Mises was even more emphatic, foreseeing a “great crash” in a letter to his wife and refusing a prestigious appointment in his native Vienna to avoid being tarred by exposure to events.) Hayek’s theory earned him an appointment to the London School of Economics in 1931. It was cited by the Nobel committee that awarded him the prize for economic science in 1974.

But after 1931, Hayek engaged several theoretical controversies with his fellow economists. The most famous of these was his long-running debate with John Maynard Keynes. One long-term consequence of that debate was the economics profession’s exile of capital theory from macroeconomics. They refused to contemplate the distinction between long-term and short-term production processes and capital goods. They treated capital as a homogeneous lump or mass rather than a delicate fabric of heterogeneous goods valued by an intricate structure of interest rates.

That is why Keynesian macroeconomics textbooks pretend that government can increase investment by creating money that lowers “the” interest rate. If government could really do this, of course, our lives would all be radically different than they actually are. We would not experience recessions and depressions.

Public-service radio and television advertisements warn consumers to beware of investment scams that promise returns that are “too good to be true.” “If it sounds too good to be true,” the ad declares sententiously, “it probably is.” What we really need is a commercial warning us to apply this principle to the claims of government and government policymakers – and, for that matter, university professors who are dependent upon government for their livelihood.

It turns out to be surprisingly difficult to refute the claims of Keynesian economics without resorting to the annoyingly complicated precepts of capital theory. Ten years before Keynes published his theory, the American economists Foster and Catchings developed a theory of government intervention that embodied most of Keynes’ ideas. They published their ideas in two books and challenged the world to refute them, even offering a sizable cash prize to any successful challenger. Many prominent economists tried and failed to win the prize. What is more, as Hayek himself acknowledged, their failure was deserved, for their analysis did not reveal the fallacies inherent in the authors’ work.

Hayek wrote a lengthy refutation that was later published under the title of “The ‘Paradox’ of Saving.” Today, over 80 years later, it remains probably the most meticulous explanation of why government cannot artificially create and preserve prosperity merely by manipulating monetary variables like the quantity of money and interest rates.

There is nothing wrong with Hayek’s analysis. The main problem with his work is that it is not fashionable. The public has been lied to so long and so convincingly that it can hardly grasp the truth. The idea that government can and should create wealth out of thin air is so alluring and so reassuring – and the idea of its impossibility so painful and troubling – that fantasy seems preferable to reality. Besides, large numbers of people now make their living by pretending that government can do the impossible. Nothing short of social collapse will force them to believe otherwise.

The economics profession obsessively studied and research Keynesian economics for over 40 years, so it has less excuse for its behavior nowadays. Keynes’ main contentions were refuted. Keynesianism was rejected by macroeconomists throughout the world. Even the head of the British Labor Party, James Callaghan, bitter denounced it in a famous speech in 1976. The Labor Party had used Keynesian economics as its key economic-policy tool during its installation of post-World War II socialism and nationalization in Great Britain, so Callaghan’s words should have driven a stake through Keynes’ heart forevermore.

Yet economists still found excuses to keep his doctrines alive. Instead of embracing Hayek, they developed “New Keynesian Economics” – which has nothing to do with the policies of Bernanke and Obama today. The advent of the financial crisis and the Great Recession brought the “return of the Master” (e.g., Keynes). This was apparently a default response by the economics profession. The Recession was not caused by free markets nor was it solved by Keynesian economics. Keynesian economics hadn’t got any better or wiser since its demise. so there was no reason for it to reemerge like a zombie in a George Romero movie. Apparently, economists were reacting viscerally in “we can’t just sit here doing nothing” mode – even though that’s exactly what they should have done.

If QE and ZIRP are not the answer to our current economic malaise, what is?

In order to solve a problem, you first have to stop making it worse. That means ending the monetary madness embodied in QE and ZIRP. Don’t try to keep interest rates as low as possible; let them find their natural level. This means allowing interest rates to be determined by the savings supplied by the private sector and the investment demand generated by private businesses.

In turn, this means that housing prices will be determined by markets, not by the artificial actions of the Fed. This will undoubtedly reverse recent price increases recorded in some markets. As the example of Japan shows only too well, there is no substitute for free-market prices in housing. Keeping a massive economy in a state of suspended animation for two decades is no substitute for a functioning price system.

The course taken by U.S. economic history in the 20th century shows that there is no living with a central bank. Sooner or later, even a central bank that starts out small and innocuous turns into a raging tiger with taxpayers riding its back and looking for a way to get off. (The Wall Street Journal‘s recent editorial “Bernanke Rides the Bull” seems to have misdirected the metaphor, since we are the ones riding the bull.) Instead of a Fed, we need free-market banks incapable of wangling bailouts from the government and a free market for money in which there are no compulsory requirements to accept government money and no barriers to entry by private firms anxious to supply reliable forms of money. Bit Coin is a promising development in this area.

What does all the talk about the Fed “unwinding” its actions refer to?

It refers to undoing previous actions; more specifically, to sales that cancel out previous purchases of U.S. Treasury bonds. The Fed has been buying government bonds in both primary and secondary bond markets pursuant to their QE and ZIRP policies, respectively. It now has massive quantities of those bonds on its balance sheet. Technically, that makes the Fed the world’s largest creditor of the U.S. government. (Since the Fed is owned by its member banks, the banks are really the owner/creditors.) That means that the Federal Reserve has monetized vast quantities of U.S. government debt.

There are two courses open to the Fed. One of them is hyperinflation, which is what will happen when the Fed stops buying, interest rates rise to normal levels and banks have no alternative but to use their reserves for normal, profit-oriented purposes that put money into circulation for spending. This has never before happened in peacetime in the U.S. The other is for the Fed to sell the bonds to the public, which will consist mostly of commercial banks. This will withdraw the money from circulation and end the threat of hyperinflation (assuming the Fed sterilizes it). But it will also drive bond prices into the ground, which means that interest rates will shoot skyward. This will create the aforementioned government budget/debt crisis of industrial strength – and the high interest rates won’t do much for the general business climate for awhile, either.

Since it is considered a public-relations sin for government to do anything that makes the general public uncomfortable and which can be directly traced to it, it is easy to see why the Fed doesn’t want to take any action at all. But doing nothing is not an option, either. Eventually, one of the two aforementioned scenarios will unfold, anyway, in spite of efforts to forestall them.

Uhhhh… That doesn’t sound good.

No spit, Spurlock. Yet, paradoxical as it might seem at first, either of these two scenarios will probably make people more receptive to solutions like free banking and free-market money – solutions that most people consider much too radical right now. There are times in life when things have to get worse before they can get better. Regrettably, this looks like one of those times.

DRI-306 for week of 6-2-13: What Is (Or Was) ‘American Exceptionalism’?

An Access Advertising EconBrief:

What Is (Or Was) ‘American Exceptionalism’?

Ever since the 1970s, but increasingly since the financial crisis of 2008 and ensuing Great Recession, eulogies have been read for American cultural and economic preeminence. If accurate, this valedictory chorus would mark one of the shortest reigns of any world power, albeit also the fastest rise to supremacy. Even while pronouncing last rites on American dominance, however, commentators unanimously acknowledge our uniqueness. They dub this quality “American exceptionalism.”

This makes sense, since you can’t very well declare America’s superpower status figuratively dead without having some idea of what gave it life in the first place. And by using the principles of political economy, we can identify the animating features of national greatness. This allows us to perform our own check of national vital signs, to find out if American exceptionalism is really dead or only in the emergency room.

Several key features of the American experience stand out.

Free Immigration

Immigration (in-migration) fueled the extraordinary growth in U.S. population throughout its history. Immigration was mostly uncontrolled until the 1920s. (The exception was Chinese immigration, which was subject to controls in the late 19th century.) Federal legislation in the 1920s introduced the concept of immigration quotas determined by nation of origin. These were eventually loosened in the 1960s.

From the beginning of European settlement in the English colonies, inhabitants came not only from the mother country but also from Scotland, Ireland, Wales, the Netherlands, Spain, France, Germany and Africa. Scandinavia soon contributed to the influx. Some of the earliest settlers were indentured servants; slaves were introduced in the middle of the 17th century.

Today it is widely assumed that immigrants withdraw value from the U.S. rather than enhancing it, but this could hardly have been true during colonial times when there was little or no developed economy to exploit. Immigrants originally provided the only source of labor and have continued to augment the native labor supply down to the present day. For most of American history, workers were drawn to this country by wages that were probably the highest in the world. This was due not just to labor’s relative scarcity but also to its productivity. Immigrants not only increased the supply of labor (in and of itself, tending to push wages down) but also complemented native labor and made it more productive (tending to push wages up). The steady improvements in technology during the Industrial Revolution drove up productivity and the demand for labor faster than the supply of labor increased, thereby increasing real wages and continually drawing new immigrants.

Economists have traditionally underrated the importance of entrepreneurship in economic development, but historians have noted the unusual role played by Scottish entrepreneurs like Andrew Carnegie in U.S. economic history. At the turn of the 20th century, the business that became the motion-picture industry was founded almost entirely by immigrants. Most of them were Jews from Eastern Europe who stepped on dry land in the U.S. with no income or assets. They built the movie business into the country’s leading export industry by the end of the century. In recent years, Asians and Hispanics have taken up the entrepreneurial slack left by the native population.

An inexplicably ignored chapter in U.S. economic history is the culinary (and gastronomic) tradition linked to immigration. Early American menus were heavily weighted with traditional English dishes like roast beef, breads and puddings. Soon, however, immigrants brought their native cuisines with them. At first, each ethnic enclave fed its own appetites. Then immigrants opened up restaurants serving their own. Gradually, these establishments attracted native customers. Over decades, immigrant dishes and menus became assimilated into the native U.S. diet.

Germans were perhaps the first immigrants to make a powerful impression on American cuisine. Many Germans fought on the American side in the Revolution. After independence was won, a large percentage of opposing Hessian mercenaries stayed on to make America their home. Large German populations inhabited Pennsylvania, Illinois and Missouri. The so-called Pennsylvania Dutch, whose cooking won lasting fame, were German (“Deutsch”).

In the 19th century, hundreds of thousands of Chinese laborers came to the U.S., many to work on western railroad construction. They formed Chinese enclaves, the largest one located in San Francisco. Restaurants serving regional Chinese cuisines sprang up to serve these immigrants. When Americans displayed a taste for Chinese food, restaurateurs discovered that they had to tailor the cooking to American tastes, and these “Chinese restaurants” served Americanized Chinese food in the restaurant and authentic Chinese food in the kitchen for immigrants. Today, this evolutionary cycle is complete; American Chinese restaurants proudly advertise authentic dishes specialized along Mandarin, Szechuan and Cantonese lines.

Meanwhile, back in the 1800s, Italians were emigrating to America. Italian food was also geographically specialized and subsequently modified for American tastes. Today, Italian food is as American as apple pie and as geographically authentic as its Chinese counterpart. The Irish brought with them a simple but satisfying mix of recipes for starches and stews. Although long restricted to cosmopolitan coastal centers, French cooking eventually made its way into the American diet.

Mexicans began crossing the Rio Grande into the U.S. during the Great Depression. Their numbers increased in the 1950s, and this coincided with the advent of Mexican food as the next great ethnic specialty. Beginning in the late 1960s and coinciding with the rise of franchising as the dominant form of food retailing, Mexican food took the U.S. palate by storm. It followed the familiar pattern, beginning with Americanized “Tex-Mex” and culminating with niche Mexican restaurants catering to authentic regional Mexican cuisines.

Today, restaurant dining in America is an exercise in gastronomic globe-trotting. Medium-size American cities offer restaurants flying the ethnic banners of a dozen, fifteen or twenty nations – not just Italian, Chinese and Mexican food, but the dishes of Spain, Ethiopia, Thailand, Vietnam, Ireland, India, Greece, Denmark, the Philippines, Germany and more.

Immigration was absolutely necessary to all this development. As any experienced cook can attest, simple copying of recipes could not have reproduced the true flavor of these dishes, nor could non-natives have accomplished the delicate task of modifying them for the American palate while keeping the original versions alive until they eventually found favor with the U.S. market.

It is ironic that so much debate focuses on the alleged need for immigrants to assimilate U.S. culture. This single example shows how America has assimilated immigrant culture to a far greater degree. Indeed, American culture didn’t exist prior to immigration and has been created by this very assimilation process. Now, apart from learning English, it is not clear how much is left for immigrants to assimilate. For example, consumer products like Coca-Cola and McDonald’s hamburgers have become familiar to immigrants before they set foot here through U.S. exports.

Cultural Heterogeneity

Many of the great powers of the past were trading civilizations, like the Phoenicians and the Egyptians. By trading in the goods and languages of many nations, they developed a cosmopolitan culture.

In contrast, physical trade formed a fairly modest fraction of economic activity in the U.S. until well into the 20th century. The U.S. achieved its cultural heterogeneity less through trade in goods and services than via trade in people. The knowledge and experience shared by immigrants with natives produced a similar result.

Economists have long known that these two forms of trade substitute for each other in useful ways. For example, efficient use of a production input – whether labor, raw material or machine – requires that its price in different locations be equal. Where prices are not equal, equalization can be accomplished directly by movements of the input from its low-priced location to its high-priced location, which tends to raise the input’s price in the former location and lower it in the latter location. Or, it can be accomplished indirectly by trade in goods produced using the input; since the good will tend to be cheaper in the input’s low-priced location, exports to the high-priced location will tend to raise the good’s price, the demand for the input and the input’s price in that location.

Input-price equalization is a famous case of trade in goods obviating the necessity for trade in (movement of) people. Cultural heterogeneity is a much less well-known case of the reverse phenomenon – immigration substituting for trade in goods.

The importance of cultural heterogeneity has been almost completely overshadowed by the modern obsession with “diversity,” which might be concisely described as “difference for difference’s sake.” Unlike mindless diversity, cultural heterogeneity is rooted in economic logic. Migration is governed by the logic of productivity; people move from one place to another because they are more productive in their new location. Estimates indicate, for example, that some low-skilled Mexican workers are as much as five times more productive in the U.S. than in Mexico.

That is only the beginning of the benefits of migration. Because workers often complement the efforts of other workers, immigration also raises the productivity (and wages) of native workers as well. And there is another type of benefit that is seldom, if ever, noticed.

The late, great Nobel laureate F.A. Hayek defined the “economic problem” more broadly than merely the efficient deployment of known inputs for given purposes. He recognized that all individuals are limited in their power to store, collate and analyze information. Consumers do not recognize all choices available to them; producers do not know all available resources, production technologies or consumer wants. The sum of available knowledge is not a given; it is locked up in the minds of billions of individuals. The economic problem is how to unlock it in usable form. That is what free markets do.

Our previous extended example involving immigration and the evolution of American cuisine illustrates exactly this market information process at work. The free market made it efficient and attractive for immigrants to come to the U.S. U.S. consumers became acquainted with a vast new storehouse of potential consumption opportunities – eventually, U.S. entrepreneurs could also mine this trove of opportunity. Immigrant producers became aware of a new source of demand and new inputs with which to meet it. And the resulting knowledge became embedded in the mosaic of American culture, making our cuisine the most cosmopolitan in the world.

The upshot is that, without consciously realizing it, Americans have had access to vast amounts of knowledge, expertise and experience. This store of culture has acted as a kind of pre-cybernetic Internet, the difference being that culture operates outside our conscious perception. At best, we can observe its residue without directly measuring its input. One way of appreciating its impact is to compare the progress of open societies like the U.S. with civilizations that were long closed to outside influence, like Japan and China. Isolation fearfully retarded economic development.

Status Mobility

In his recent book, Unintended Consequences, financial economist Edward Conard stresses the necessity of risk-taking entrepreneurial behavior as a source of economic growth. The risks must be organically generated by markets rather than artificially created by politicians; the latter were the source of the recent financial crisis and ensuing Great Recession.

According to Conard, it is the striving for status that drives entrepreneurs run big risks in search of huge rewards that few will ultimately attain. Status may take various forms – social, occupational or economic. Its attraction derives from the human craving to distinguish oneself. It is this need for disproportionate reward – whether measured in esteem, dollars or professional recognition – that balances the high risk of failure associated with big-league entrepreneurship.

In the U.S., status striving has long been ridiculed by sociologists and psychologists. “Keeping up with the Joneses” has been stigmatized as a neurotic preoccupation. Yet the American version of status compares favorably with its ancient European ancestor.

England is famous for its class stratification. A half-century ago, its “angry young men” revolted against a stifling class system that defined status at birth and sharply limited upward mobility. Elsewhere in Europe, lingering remnants of the feudal system remained in place for centuries.

But the U.S. was comparatively classless. Economics defined its classes, and the economic categories embodied a high degree of mobility. Even those who started on the bottom rung usually climbed to the higher ones, where the rarefied climate proved difficult to endure for more than a generation or two.

The best feature of the status-striving U.S. class system has been the broad distribution of its benefits. The unimaginable fortunes acquired by titans of Industry like Carnegie, Rockefeller, Gates, Buffett, et al have made thousands of people rich while building a floor of real income under the nation. Our working lives and leisure have been defined by these men. The value created by a Bill Gates, say, is almost beyond enumeration.

Thus, it is not the striving for status per se that makes a national economy exceptional. It is the mobility that accompanies status. This will determine the form taken by the status striving process.

Before free markets rose to prominence, wealth was gained primarily through plunder. Seekers after status were warlords, kings or politicians. They gained their status at the expense of others. Today, plunder is the exception rather than the rule. Drug cartel bosses are the vestige of Prohibition; they profit purely from the illegalization of a good. Politicians are their counterpart in the straight world.

When status is accompanied by mobility, anybody can gain status. But they cannot have it without increasing the real incomes of large numbers of people. Ironically, the biggest complaint lodged against the American version of capitalism – that it promotes greed and income inequality – turns out to be both dead wrong and inaccurate. Mobility is achieved through competition and free markets, which absolutely demand that in order to get rich the status-striver must satisfy the wants of other people en masse. And income inequality is the inevitable concomitant of risk-taking entrepreneurship – somebody must bear the risks of ferreting out the dispersed information about wants, resources and technologies lodged in billions of human brains. If we don’t reward the person who succeeds in doing the job, the billions of people who gain from the process don’t get their real-income gains.

Free Markets

You might suppose that bureaucracy was invented by the New Deal. In fact, Elizabethan England knew it well. Price controls date back at least to the Roman emperor Diocletian. Prior to Adam Smith’s lesson on the virtues of trade and David Ricardo’s demonstration of the principle of comparative advantage, the philosophy of mercantilism held that government must tightly regulate economic activity lest it burst its bonds. Thus, free markets are a historical rarity.

England’s abolition of the Corn Laws in the mid-1800s provides a brief historical window on a world of free international trade, but the U.S. prior to 1913 probably best approximates the case of a world power living under free markets. Immigration was uncontrolled and tariffs were low; both goods and people flowed freely across political boundary lines.

Prices coordinate the flow of goods and services in the “present;” that is, over short time spans. Production and consumption over time are coordinated by markets developed to handle the future delivery of goods (futures and forward markets) and by prices that modify the structure of production and consumption in accord with our needs and wants for consumption and saving in the present and the future. For the most part, these prices are called interest rates.

Interest rates reflect consumers’ desires to save for future consumption and producers’ desires to invest to augment productive capabilities for the future. Just as a price tends to equalize the amount of a good producers want to produce and consumers want to purchase in a spot market, an interest rate tends to equalize the flow of saving by consumers with the investment in productive capital by producers. Without interest rates, how would we know that the amounts of goods wanted by consumers in the future would correspond to what producers will have waiting for them? As it happens, we are now experiencing first hand the answer to that question under the Federal Reserve’s “zero-interest-rate policy,” which substitutes artificial Federal Reserve-determined interest rates for interest rates determined by the interaction of consumers and producers.

Without knowing what policies were followed, we can scrutinize development outcomes in countries like China, India, Southeast Asia and Africa and draw appropriate inferences about departures from free-markets. High hopes and failure were associated with statism and market interference in China, India and Africa for over a half-century. Successful development has followed free markets like pigs follow truffles. But the obstacles to free markets are formidable, and no country has as yet found the recipe for keeping them in force over time.

What About Political Freedom?

Discussions of American exceptionalism invariably revolve around America’s unique political and constitutional history and its heritage of political freedom. Yet the preceding definition of exceptionalism has leaned heavily on economics. The world does not lack for political protestations and formal declarations of freedom and justice. Many of these are modeled on our own U.S. Constitution. History shows, though, that only a reasonably well-fed, prosperous population is willing to fight to preserve its political rights. Time and again, economic freedom has preceded political freedom.

When the level of economic development is not sufficient and free markets are not in place, the populace is not willing to sacrifice material real income to gain political freedom because it is too close to the subsistence level of existence already. And even in the exceptional case (usually in Africa or Latin America) in which a charismatic, status-striving leader heads a successful political movement, the leader will not surrender leadership status – even though the ostensible purpose of the independence movement was precisely to gain political freedom. Instead, he or she preserves that status by cementing political power for life. Why? Because there is no substitute status reward to fall back on; his or her economic and social status depends on wielding political power. This is the fault of the political Left, which has demanded that “mere” economic rights be subrogated to claims of equality, with the result that neither equality nor wealth has been realized.

Observation shows that when economic growth begins – but not before that – people begin to sacrifice consumption to control pollution and improve health. Similar considerations apply to political freedom. Expressing the relationship in the jargon of economics, we would say that political freedom is a normal good. This means that we “purchase” more of it as our real incomes increase. In this context, the word “purchase” does not imply acquisition with money as the medium of exchange; it means that we must sacrifice our time and effort to get political freedom, leaving less leisure time available for consumption purposes.

The U.S. was the exception because its economic freedom and real income was well advanced before the Revolution. Enough Americans were willing to oppose the British Crown to achieve independence because colonial America was living well above the subsistence level – at that, the ratio of rebels to Tories was close to even. George Washington was offered a crown rather than a Presidency, but he declined – and declined again when offered a third Presidential term. His Virginia plantation offered a substitute status reward; he did not need to hold office to maintain his economic status or social esteem. It is interesting to speculate about the content of the Constitution and the course of U.S. history had the U.S. lacked the firm economic foundation laid by its colonial history and favorable circumstances.

DRI-326 for week of 5-12-13: Paul Krugman Can’t Stand the Truth About Austerity

An Access Advertising EconBrief: 

Paul Krugman Can’t Stand the Truth About Austerity

The digital age has produced many unfortunate byproducts. One of these is the rise of shorthand communication. In journalism, this has produced an overreliance on buzzwords. The buzzword substitutes for definition, delineation, distinction and careful analysis. Its advantage is that it purports to say so much within the confines of one word – which is truly a magnificent economy of expression, as long as the word is telling the truth. Alas, all too often, the buzzword buzzsaws its way through its subject matter like a chain saw, leaving truth mutilated and amputated in its wake.

The leading government budgetary buzzword of the day is “austerity.” For several years, members of the European Union have either undergone austerity or been threatened with it – depending on whose version of events you accept. Now the word has crossed the Atlantic and awaits a visa for admission to this country. It has met a chilly reception.

In a recent (05/11/2013) column, economist Paul Krugman declares that “at this point, the economic case for austerity…has collapsed.” In order to appreciate the irony of the column, we must probe the history of the policy called “austerity.” Tracing that history back to the 1970s, we find that it was originated by Keynesian economists – ideological and theoretical soul mates of Paul Krugman. This revelation allows us to offer a theory about otherwise inexplicable comments by Krugman in his column.

The Origin of “Austerity”

The word “austerity” derives from the root word “austere,” which is used to denote something that is harsh, cold, severe, stern, somber or grave. When applied to a government policy, it must imply an intention to inflict pain and hardship. That is, the severity must be inherent in the policy chosen – it cannot be an invisible or unwitting byproduct of the policy. There may or may not be a compensating or overriding justification for the austerity, but it is the result of deliberation.

The word was first mated to policy during the debt crisis. No, this wasn’t our current federal government debt crisis or even the housing debt and foreclosure crisis that began in 2007. The original debt crisis was the 1970s struggle to deal with non-performing development loans made by Western banks to sovereign nations. At first, most of the debtor countries were low-income, less-developed countries in Africa and Latin America. Eventually, the contagion of bad loans and debt spread to middle-income countries like Mexico and Argentina. This episode was a rehearsal for the subprime-mortgage-loan defaults to follow decades later.

The original debt crisis was motivated by the same sort of “can’t miss” thinking that produced the housing mess. Sovereign nations were the perfect borrower, reasoned the big Wall Street banks of the 1970s, because a country can’t go broke the way a business can. After all, it has the power to tax its citizens, doesn’t it? Since it can’t go broke, it won’t default on its loan payments.

This line of reasoning – no, let’s call it “thinking” – found willing sets of ears on the heads of Keynesian economists, who had long been berating the West for its stinginess in funding development among less-developed countries. Agencies like the International Monetary Fund and the World Bank perked up their ears, too. The IMF was created at the end of World War II to administer a worldwide regime of fixed exchange rates. When this regime, named for the venue (Bretton Woods, New Hampshire) at which it was formally established, collapsed in 1971, the IMF was a great big international bureaucracy without a mandate. It was charmed to switch its attention to economic development. By brokering development loans to poor countries in Africa, Central and South America, it could collect administrative fees coming and going – coming, by carving off a chunk of the original loan in the form of an origination fee and going, by either rolling over the original loan or reformulating the development plan completely when the loan went bust.

The reformulation was where the austerity came in. Standard operating procedure called for the loan to be repaid either with revenues from the development project(s) funded by the loan(s) or by tax revenues reaped from taxing the profits of the project(s). Of course, the problem was that development loans made by big bureaucratic banks to big bureaucratic governments in Third World nations were usually subverted to benefit leaders in the target countries or their cronies. This meant that there were usually no business revenues or tax revenues left from which to repay the loans.

Ordinarily, that would leave the originating banks high and dry, along with the developers of the failed investment projects. “Ordinarily” means “in the context of a free market, where lenders and borrowers must suffer the consequences of their own actions.” But the last thing Wall Street banks wanted was to get their just desserts. They influenced their colleagues at the IMF and the World Bank to act as their collection agents. The agencies took off their “economic development loan broker” hats and put on one of their other hats; namely, their “international economics expert advisor” hat. They advised the debtor country how to extricate itself from the mess that the non-performing loan – the same one that they had collected fees for arranging in the first place – had got it into. Does this sound like a conflict of interest? Remember that these agencies were making money coming and going, so they had a powerful incentive to maintain the process by keeping the banks happy – or at least solvent.

Clearly, the Third World debtor country would have to scare up additional revenue with which to pay the loan. One possible way would be to divert revenue from other spending. But the agency economists were Keynesians to the marrow of their bones. They believed that government spending was stimulative to the economy and increased real income and employment via the fabled “multiplier effect,” in which unused resources were employed by the projects on which the government funds were spent. So, the last thing they were willing to advise was a diversion of spending away from the government and into repayment of debt. On the other hand, they were willing to advise Third World countries to acquire money to spend through taxation. If government were to raise $X in taxes and spend those $X, the net effect would not be a wash – it would be to increase real income by X. Why? Because taxation acquires money that private citizens would otherwise spend, but also money that they would otherwise save. When the entire amount of tax revenue is then spent by government, the net effect is to increase total spending – or so went the Keynesian thinking. One of Keynes’ most famous students, Nicholas Kaldor, later to become Lord Kaldor in Great Britain, complained in a famous 1950s’ article: “When will underdeveloped nations learn to tax?”

Thus, the development agencies kept a clear conscience when they advised their Third World clients to raise taxes in order to repay the debt incurred to Western banks. Not surprisingly, this policy advice was not popular with the populations of those countries. That policy acquired the descriptive title of “austerity.” Viewing it from a microeconomic or individual perspective, it is not hard to see why. By definition, a tax is an involuntary exaction that reduces the current or future consumption of the vict-…, er, the taxpayer. The taxpayer gains from it if, and only if, the proceeds are spent so as to more-than-compensate for the loss of that consumption and/or saving. Well, in this case, Third World taxpayers were being asked to repay loans for projects that failed to produce valuable output in the first place and did not produce the advertised gains in employment either. A double whammy – no wonder they called it “austerity!”

How austere were these development-agency recommendations? In Wealth and Poverty (1981), George Gilder offers one contemporary snapshot. “The once-solid economy of Turkey, for example, by 1980 was struggling under a 55 percent [tax] rate applying at incomes of $1,600 and a 68 percent rate incurred at just under $14,000, while the International Monetary Fund (IMF) urged new ‘austerity’ programs of devaluation and taxes as a condition for further loans.” Note Gilder’s wording; the word “austerity” was deliberately chosen by the development- agency economists themselves.

“This problem is also widespread in Latin America,” noted Gilder. Indeed, as the 1970s stretched into the 80s and 90s, the problem worsened. “[Economic] growth in Africa, Latin America, Eastern Europe, the Middle East and North Africa went into reverse in the 1980s and 1990s,” onetime IMF economist William Easterly recounted sadly in The Elusive Quest for Growth (2001). “The 1983 World Development Report of the World Bank projected a ‘central case’ annual percent per-capital growth in the developing countries from 1982 to 1995″ but “the actual per-capita growth would turn out to be close to zero.”

Perhaps the best explanation of the effect of taxes on economic growth was provided by journalist Jude Wanniski in The Way the World Works (1978). A lengthy chapter is devoted to the Third World debt crisis and the austerity policies pushed by the development agencies.

Two key principles emerge from this historical example. First, today’s knee-jerk presumption that government spending is always good, always wealth enhancing, always productive of higher levels of employment depends critically on the validity of the multiplier principle. Second, the original definition of austerity was painful increases in taxation, not decreases in government spending. And it was left-wing Keynesians themselves who were its practitioners, and who ruled out government spending decreases in favor of tax increases.

Fast Forward

Fast forward to the present day. Since the 1970s, the worldwide experience with taxes has been so unfavorable – and the devotion to lower taxes has become so ingrained – that virtually nobody outside of Scandinavia will swallow a regime of higher taxes nowadays.

Keynesian economics, thoroughly discredited not only by its disastrous economic development policy failures but also by the runaway inflation it started but could not stop in the 1970s, has emerged from under the earth like a protagonist in a George Romero movie. Its devotees still preach the gospel of stimulative government spending and high taxes. But they stress the former and downplay the latter. And, instead of embracing their former program of austerity as the means of overcoming debt, they now accuse their political opponents of practicing it. They have effected this turnabout by redefining the concept of austerity. They now define it as “slashing government spending.”

The full quotation from the Paul Krugman column quoted earlier was: “At this point, the economic case for austerity – for slashing government spending even in the face of a weak economy – has collapsed.” Notice that Krugman says nothing about taxes even though that was a defining characteristic of austerity as pioneered by development-agency Keynesians of his youth. (Krugman does not neglect devaluation, the other linchpin, since he advocates printing many more trillions of dollars than even Ben Bernanke has done so far.)

When Krugman’s Keynesian colleagues originated the policy of austerity, they did it with malice aforethought – using the term themselves while fully recognizing that the high-tax policies would inflict pain on recipients. Now Krugman projects this same attitude on his political opponents by claiming that not only does reduced government spending have harmful effects on real income and employment, but that Republicans will it so. The Republicans, then, are both evil and stupid. Republicans are evil because they “have long followed a strategy of ‘starving the beast,’ slashing taxes so as to deprive the government of the revenue it needs to pay for popular programs. They are stupid because their reluctance “to run deficits in times of economic crisis” is based on the premise that “politicians won’t do the right thing and pay down the debt in good times.” And, wouldn’t you know, the politicians who refuse to pay down the debt are the Republicans themselves. The Republicans are “a fiscal version of the classic definition of chutzpah…killing your parents, then demanding sympathy because you’re an orphan.”

But the real analytical point is that Krugman, and Democrats in general, are exhibiting the chutzpah. They have taken a policy term originated and openly embraced not merely by Democrats, but by Keynesian Democrats exactly like Krugman himself. They have imputed that policy to Republicans, who would never adopt this Democrat policy tool because its central tenet is excruciatingly high taxes. They have correctly accused Republicans of wanting to reduce government spending but wrongly associated that action with austerity in spite of the fact that their Keynesian Democrat forebears did not include it in the original austerity doctrine.

Why have they done this? For no better reason than that they oppose the Republicans politically. Psychology recognizes a behavior called “projection,” the imputing of a detested personal trait or characteristic to others. Having first developed the policy of austerity in the late 1970s and seen its disastrous consequences, Democrats now project its advocacy on their hated Republican opponents. In Krugman’s case, there are compelling reasons to suspect a psychological root cause for his behavior. His ancillary comments reveal an alarming propensity to ignore reality.

Paul Krugman’s Flight from Reality

In the quoted column alone, Krugman makes numerous factual claims that are so clearly and demonstrably untrue as to suggest a basis in abnormal psychology. Pending a full psychiatric review, we can only compare his statements with the factual record.

“In the United States, government spending programs designed to boost the economy are in fact rare – FDR’s New Deal and President Barack Obama’s much smaller recovery act are the only big examples.” Robert Samuelson’s recent book The Great Inflation and Its Aftermath (2008)covers in detail the growth and history of Keynesian economics in the U.S. During the Kennedy administration, Time Magazine featured Keynes on its cover to promote a story conjecturing that Keynesian economics had ended the business cycle. Samuelson followed Keynesian economics and such luminaries as Council of Economic Advisors Chairman Walter Heller, Nobel Laureates Paul Samuelson and James Tobin through the Kennedy, Johnson, Carter and Reagan administrations. One of his major theses was precisely that Keynesian economists produced the stagflation of the 1970s by refusing to stop deficit spending and excessive money creation – a view that helped to discredit Keynesianism in the 1980s. There can be no doubt that U.S. economic policy was dominated by Keynesian policies “designed to boost the economy” throughout the 1960s and 1970s.

Moreover, every macroeconomics textbook from the 1950s forward taught the concept of “automatic stabilizers” – government programs in which spending was designed to automatically increase when the level of economic activity declined. These certainly qualify as “big” in terms of their omnipresence, although since Krugman is an inflationist in every way he might deny their bigness in some quantitative sense. But they are certainly government spending programs, they are certainly designed to boost the economy and they are certainly continually operative – which makes Krugman’s statement still more bizarre.

“So the whole notion of perma-stimulus is a fantasy… Still, even if you don’t believe that stimulus is forever, Keynesian economics says not just that you should run deficits in bad times, but that you should pay down debt in good times.” The U.S. government has had one true budget surplus since 1961, bequeathed by the Johnson administration to President Nixon in 1969. (The accounting surpluses during the Clinton administration years of 1998-2001 are suspect due to borrowing from numerous off-budget government agencies like Social Security.) This amply supports the contention that politicians will not balance the budget cyclically, let alone annually. European economies are on the verge of collapse due to sovereign debt held by their banking systems and to the inexorable downward drift of productivity caused by their welfare-state spending. Krugman’s tone and tenor implies that “Keynesian economics” should be given the same weight as a doctor prescribing an antibiotic – a proven therapy backed by solid research and years of favorable results. Yet the history of Keynesian economics is that of a discredited theory whose repeated practical application has failed to live up to its billing. Now Krugman is in a positive snit because we don’t blindly take it on faith that the theory will work as advertised for the first time and that politicians will behave as advertised for the first time. If nothing else, one would expect a rational economist to display humility when arguing the Keynesian case – as Keynesians did when repenting their sins in favor of a greatly revised “New Keynesian Economics” during the mid-1980s.

“Unemployment benefits have fluctuated up and down with the business cycle and as a percentage of GDP they are barely half what they were at their recent peak.” Unemployment benefits have “fluctuated” up to 99 weeks during the Great Recession because Congress kept extending them. The rational Krugman knows that his fellow economists have debated whether these extensions have caused people to stop looking for work and instead rely on unemployment benefits. Robert Barro says they have, and finds that the extensions have added about two percentage points to the unemployment rate. Keynesian economists demur, claiming instead that the addition is more like 0.4%. In other words, the profession is not arguing about whether the extensions increase unemployment, only about how much. Meanwhile, Krugman is in his own world, pacing the pavement and mumbling “up and down, up and down – they’re only half what they were at their highest point when you measure them as a percentage of GDP!”

“Food stamp use is still rising thanks to a still-terrible labor market, but historical experience suggests that it too will fall sharply if and when the economy really recovers.” Food stamp (SNAP) use has steadily risen to nearly 48 million Americans. Even during the pre-recession years 2000-2008, food-stamp use rose by about 60%. Thus, the growth of the program has far outpaced growth in the rate of poverty. The Obama administration has bent over backward to liberalize criteria for qualification, allowing even high-wealth, low-income households into the program. This does not depict a temporary program whose enrollment fluctuates up and down with economic change, but rather a tightening vise of dependency.

Krugman’s picture of a “still-terrible labor market” cannot be reconciled with his claim that government spending is an effective counter-cyclical tool. If Krugman’s reaction to the anemic response to the Obama administration economic stimulus is a demand for much higher spending, he will presumably pull out that get-home-free card no matter what the effects of a spending program are. Why would much higher spending work when the actual amount failed? Krugman makes no theoretical case and cites no historical examples to support his claim – presumably because there are none. Governments need no urging to spend money – European governments are collapsing like dominos from doing exactly that. European unemployment has lingered in double digits for years despite heavy government spending, recent complaints about “austerity” to the contrary notwithstanding.

“The disastrous turn toward austerity has destroyed many jobs and ruined many lives. And its time for a U-turn.” Keep in mind that Krugman’s notion of “austerity” is reduced government spending but not higher taxes. This means that he is claiming that taxes have not gone up – when they have. And he is claiming that government spending has gone down, presumably by a lot since it has “destroyed many jobs and ruined many lives.” But government spending has not gone down; only a trivial reduction in the rate of growth of government spending has occurred during the first four and one-half months of 2013.

“Yet calls for a reversal of the destructive turn toward austerity are still having a hard time getting through.” Krugman’s rhetoric implies that Keynesian economics is a sound, sane voice that cannot be heard above the impenetrable din created by right-wing Republican voices. As a rational Krugman well knows, the mainstream news media has long been completely dominated by the Left wing. (It is the Right wing that should be complaining because the public is unfamiliar with the course of economic research over the last 40 years and the mainstream news media has done nothing to educate them on the subject.) Its day-to-day vocabulary is permeated with Keynesian jargon like “multiplier” and “automatic stabilizers.” The rhetorical advantage lies with Democrats and Keynesians. It is practical reality that has let them down. The economics profession conducted an unprecedented forty-five year research program on Keynesian economics. Its obsession with macroeconomics led to a serious neglect of microeconomics in university research throughout the 40s, 50s and 60s. By approximately 1980, the verdict was in. Keynesian economics was theoretically discredited, although its theoretical superstructure was retained in government and academia. Even textbooks were eventually revised to debunk the Keynesian debunking of Classical economics. Macroeconomic policy tools were retained not because free markets were inherently flawed but because policy was ostensibly a faster way to return to “full employment” than by relying on the slower adjustment processes of the market. The reaction to recent “stimulus” programs has demonstrated that even that modest macroeconomic aim is too ambitious.

Keynesian economics has had no trouble getting a hearing. It has had the longest, fairest hearing in the history of the social sciences. The verdict is in. And Krugman stands in the jury box, screaming that he has been framed by conservative Republicans as the bailiffs try to remove him from the courtroom.

Memory records no comparable flight from reality by a prominent economist.

DRI-326 for week of 3-31-13: The Kansas City Star Meets Flexible Baseball-Ticket Pricing

An Access Advertising EconBrief:

The Kansas City Star Meets Flexible Baseball-Ticket Pricing

Economics is the formal logic of human choice. Newspapers report human affairs. Reporting the news affords endless scope for economics as a tool of explanation and analysis. Yet newspapers are notorious for their ignorance and mishandling of economics. Why?

One possible answer is deliberate misrepresentation and concealment of facts by the papers for ideological reasons. Another is simple error. The latter hearkens to the old maxim, “Never ascribe to venality that which can be explained by mere stupidity.”

Whatever the cause, examples of this phenomenon abound. A recent front page of the Kansas City Star offers fresh evidence of it. The subject is the pricing of baseball tickets by the Kansas City Royals.

Major-League Baseball Meets “Dynamic Pricing”

“Get Set for Big Swings,” shouted the front-page headline of the Star on Sunday, March 31, 2013. An overhead explained: “Royals Ticket Prices: Like airfares and hotel rates, they will fluctuate.” The subhead continued with: “Dynamic pricing, a fixture in the travel industry and growing more common in the entertainment world, has come to Kauffman Stadium. Below are prices for the same outfield seat to see the Royals in their first week at home – as of now.” The graphic chart showed a $54 price for the sold-out home opener on April 8, followed by prices ranging from $23 to $31 to the identical seat for subsequent games that week.

The article underneath, written by veteran staffer Mike Hendricks, contrasts the age-old procedure of fixed seasonal pricing for Kansas City Royals’ baseball games with its successor. So-called “dynamic pricing” is familiar to contemporary shoppers for airline and hotel reservations. Prices can fluctuate from day to day instead of from one season to another. Moreover, these daily fluctuations are not uni-directional; they will move up and down. That is something new for baseball fans – for decades, the only changes in official ticket prices have been upward ratchets from one season to the next.

Economists will immediately recognize that the term “dynamic pricing” is a misnomer – probably owing to (bad) advertising psychology. The precise descriptive term is “flexible pricing.” It implies the actual state of affairs, in which prices are responsive to changes in consumer demand. Failure to recognize and report this misnomer is the first of many depredations committed by the author of this piece.

The headline – “Get Set for Big Swings” – embodies a longtime Kansas City Star tradition: promising revelations that the accompanying article does not deliver. This constitutes lying to the reader. It is reasonable to suppose that Star readers resent being lied to and that this has contributed to the precipitous declines in the paper’s circulation and consequent ad revenue. The only “big swing” in price cited in the article occurs between opening day and succeeding games. One of the safest predictions about any Royals season is that the opening-day game will sell out and that attendance will immediately plummet thereafter. Given flexible pricing, it is therefore axiomatic that opening day will command a high price and that the price will thereupon fall. Maybe there will be “big swings” later in the season, maybe not. But the author doesn’t say that and offers no evidence that it will happen.

By any reasonable standard of journalism, this article is off to a miserable start.

Flexible Pricing of Baseball Tickets

The author’s vagueness on future price fluctuations is not surprising because his grasp of the basis for pricing is demonstrably shaky. Although the phrase “supply and demand” appears once in the article, its underlying logic is left to the reader’s imagination.

The importance of consumer demand to pricing is never mentioned, let alone explained. In this case, the supply of tickets is fixed – limited by the seating capacity of Kauffman Stadium. Thus, the economic logic of baseball ticket pricing comes straight out of the textbook diagram marked “Very Short Run,” in which the supply curve is a vertical line and price is completely determined by its intersection with the downward-sloping demand curve. In the very short run, economists teach, price is “demand-determined.”

Thus, price changes are caused by changes in demand. These are given very short shrift indeed by the author. His marquee explanation for the Royals’ new pricing strategy is that “the hotel and airline industries have used variable pricing strategies for years as a way to encourage customers to make their reservations early.” It is true that hotels and airlines do have one thing in common with baseball teams; namely, a fixed capacity (seating or lodging) that offers the constant incentive to keep capacity utilization as high as possible.

Hotels and airlines, though, commonly suffer the peak-load problem. Their capacity is insufficient to handle demand at its very highest point(s), but too great to utilize efficiently much – perhaps most – of the time. Since the late 1980s, the Royals have suffered from inadequate capacity about one day each season – opening day. In recent years, they have had a hard time giving away tickets to late-season games – and that is not hyperbole. In any case, baseball teams simply do not suffer the kind of scheduling problems endemic to the airline and hotel industries. Business travelers or vacationers on strict timetables are key components of airline and hotel demand, but much less important to baseball teams. Even allowing for the Royals’ atypical status as a regional franchise, buying weeks or months in advance usually provides little value to fans and little convenience to the team.

Why Now? The Timing of the Shift to Flexible Pricing

Mel Brooks’ famous protagonist Maxwell Smart on the classic TV series Get Smart once responded to a villain’s derisive defense “You’re not going to try to convict me on that flimsy evidence, are you?” with the rejoinder “No, I’ve got some more flimsy evidence.” Similarly, the author buttresses his non-explanation of Royals’ ticket pricing with more flimsy evidence. “Of all professional sports, major-league baseball teams have the greatest challenge in selling tickets, given the number of seats [and] games played,” gravely declares a “market analyst” employed by a ticket reseller.

But when baseball was truly America’s national pastime, its long season and big edge in games played was not viewed as a disadvantage. On the contrary, it was cited as a+ leading factor in the economic advantage enjoyed by baseball. Pro football, basketball and hockey were second- and third-string sports, miles behind baseball in income and prestige. Owners envied baseball its long season, which provided a tremendous opportunity to generate revenue. Baseball’s only rival as a leisure-time activity was the movies, which were probably the true national pastime.

No, the long baseball season is only a drawback when the team is a poor attraction. 1985 marked the Royals’ last post-season playoff appearance – they won the World Series by overcoming 3-1 deficits in both post-season playoffs – and they have threatened to return only in 1989, 1994 and 2003. They are the deadbeats of major-league baseball. Their 27-year absence from the playoffs is by far the longest of any team in North American professional sports.

Of course, this begs the question of why the Royals have chosen to introduce flexible pricing now, at this particular point in their history. As it turns out, it is not pure happenstance. Flexible pricing is one of various types of pricing alternatives to single pricing. The common feature behind all these is motivation – the seller’s desire to increase total revenue and profit by charging multiple prices rather than just one.

That motivation stems from more than merely the desire to profit from multipart pricing. Conditions have to be right in order for the alternative scheme to work. The different prices must be designed to gain from differing characteristics of different buyers or different conditions existing among the same buyers at different times. Either way, the firm must have the ability not only to identify the differences but to act upon them. When it does that, it is engaging in price discrimination.

Baseball teams already strive to segment different groups of buyers and charge them different prices to watch the same baseball game. That is the purpose behind different seat categories such as general admission, reserve seats, box seats, field level, upper level, stadium boxes and luxury suites. Each seat category is geared to a different category of buyer and priced accordingly. The general admission tickets are geared toward low-income fans and students. Outfield general admission is the farthest away from the action and is also geared toward the low-income fans who might otherwise not attend games if not for the affordability of a low price. Luxury suites are reserved for corporate clients and millionaires who can afford to plunk down five figures to reserve a season ticket in relative luxury. Box and reserve seats are targeted toward upper-middle-class fans that want a good seat and can afford to pay a price slightly above general admission.

This system has long been in effect in baseball and other sports. It is familiar throughout the entertainment industry. The Star article cites the symphony – an art form whose legendary disdain for solvency seemingly places it above the vulgar domain of commerce and profit. Yet the time-honored seating divisions separating dress circle, orchestra, ground floor, loge or mezzanine and balcony represent the same price-discrimination segmentation of demand practiced by sporting events.

Flexible pricing takes the idea of differential demand in a different direction. Rather than focusing on demand differences among consumers at the same point in time, it considers fluctuations in demand that affect all categories of buyers – but at different points in time. For example, instead of targeting different groups of buyers, segmented by income, it targets different games that support a higher price. These are late-season games when pennant races and individual honors such as batting championships and pitching titles are at stake. These games should command premium prices, as long as the team can stand up under pressure. For over two decades, the Royals did not play such games because they were never in contention that late in the season. Consequently, there was little purpose in setting up flexible pricing because the team would not benefit that much from flexibility. There was little additional pricing strategy the Royals could use to enhance their revenue; all they could do was get what little they could from the standard price-discrimination techniques. The introduction of inter-league play did briefly inject some novelty into the schedule, particularly by adding an interstate rivalry with the St. Louis Cardinals, the Royals’ 1985 World Series opponent. This allowed the team to give flexible pricing a tryout last year in Cardinals’ games.

But prior to the 2013 season, the Royals beefed up their pitching staff. They acquired ace starter James Shields and starter/reliever Wade Davis from the Toronto Blue Jays and starter Ervin Santana in another trade. This transformed the league’s worst pitching staff into a potentially serviceable one while retaining their current offensive strength, spearheaded by all-star Billy Butler and Alex Gordon. Shields is currently pictured on Sports Illustrated’s cover, highlighting the magazine’s baseball pre-season issue. For the first time in years, the team seems able to contend for a playoff berth.

At lastthere is a prospect that late-season games may be competitively meaningful. Opening day may not be the only sellout game on the schedule this year. Thus, an effort to milk more box-office revenue from those games makes sense, since there is more potential revenue to seek.

In theory, flexible pricing benefits teams whenever there are substantial fluctuations in demand from game to game. Various factors other than competitive performance might influence the amplitude of demand over the course of a season. Weather is the most obvious; Kansas City is subject to cool Springs, hot Summers and brisk Falls. A spate of unseasonably bad weather might give the team a chance to head off bad attendance by offering offsetting discounts to fans. Games for which announced starting pitchers are marquee players will generate stronger demand.

But these subsidiary factors will become more important when core demand for tickets is strong. The improvement in the Royals’ competitive position was clearly the driving factor in the team’s change in pricing policy.

Baseball, Politics and the Star

One would suppose that an above-the-fold, front-page article would command the full attention and premium resources of a metropolitan newspaper. Yet none of the real considerations found their way into the Star‘s story on the Royals’ ticket-pricing change. Aside from simple incompetence, how can we explain this?

The Star is a left-wing newspaper. That encompasses more than merely a capsule summary of its editorial stance. Ideology infects every aspect of the newspaper’s operations, from coverage to reporting to editorials to op-eds to advertising. It permeates not only the editorial page but the front page as well. It infiltrates the sports pages, the entertainment section and even the comics. It also affects how the paper treats the Royals.

Sports teams have grown accustomed to public subsidies. These take various forms. Most commonly, they include stadia built and maintained at taxpayer expense – including periodic repairs, refurbishment and reconstruction. That does not mean there are not quid pro quo, though. It is tacitly understood that the team and its employees are to back the multifarious public projects launched by the local political establishment with endorsements and campaign cash.

The newspaper, as the establishment’s informal public-relations and promotion agency, treats the Royals with due deference. The team is viewed as a kind of quasi-public utility – an economic and psychological necessity that is not so much too big to fail as too important to fail. The newspaper sees the team’s economic interactions as gifted with remarkable generative powers – multiplier effects and such – that are really beyond the reach of any mortal business firm. But the Royals have a tacit left-wing seal of approval, which means that they are assumed to be above such vulgar considerations as profit. That is why the economic rationale for flexible and multipart pricing never reaches the tender ears of Star readers.

To the Star, the Royals are not so much a sports franchise as a political franchise and ideological asset. No information potentially damaging or embarrassing to that franchise – no matter how newsworthy – will pass unfiltered through the Star to the general public.

How has the new pricing regime been received by fans? “So far there hasn’t been much of an outcry here or anywhere else.” (21 of the 30 major-league baseball teams have now adopted some form of flexible pricing, the article discloses.) Why not? Again, the article’s author’s lips are sealed on this matter. But the answer is clear. The rise of ticket brokers and a legal secondary market for tickets, cultivated by firms like Stub Hub, has prepared the ground for flexible pricing. In other words, the free market is way ahead of Royals’ management. The author, a faithful Star minion, holds no brief for freedom or free markets and saw no reason to enlighten readers on this point.

The Economics of Flexible Ticket Pricing

The point of the Star‘s story is obscure. The headline promises “big swings” in ticket prices, but the article doesn’t provide any, nor does it suggest any real basis for them. It seems clear that something pretty new and different has come to baseball ticket pricing in particular and to professional sports in general, but the author either doesn’t know what it is or doesn’t want to reveal it. At this point, it is necessary for economic logic to take the tiller of the story in order to bring us to a coherent destination.

Will flexible pricing produce higher or lower prices than the old seasonally fixed pricing method? The short answer is: Both. But that’s not a satisfactory answer. The precise answer is that price will be closely attuned to demand on a game-by-game basis, rather than a yearly basis. (We should bear in mind that there are as many separate “demands” as there are ticket categories – that was true under the old system and remains so under flexible pricing.) From a fundamental economic perspective, that is a good thing.

The article is woefully ambiguous on this point. It first informs us (correctly) that “the prices…will fluctuate day to day, and across all sections based on supply and demand.” (This is the article’s only reference to supply and demand.) It then continues by revealing that “fewer than half the seats in your average ballpark are occupied by fans who have bought season tickets,” thereby setting a “challenge for baseball clubs…to attract casual fans who want to see a game or two during the year.” And “free bobbleheads and ‘buck nights’ only go so far in building attendance numbers.” So far, so good – flexible pricing’s raison d’être is improving ballpark-capacity utilization.

Sure enough, a company called Qcue, headed by entrepreneur Barry Kahn, sold the San Francisco Giants on the concept of flexible pricing on a trial basis in 2009. It yielded a 20% increase in sales of the seats in sections picked for the trial. Today, the company works with two-thirds of major-league clubs and has achieved revenue increases of between 5% and 30%. “That’s ticket-revenue dollars, not an increase in the number of tickets sold. However, that tends to go up, too. Dynamic pricing doesn’t necessarily make it more affordable to attend a ball game than before, but it can.”

This burbling incoherence is typical Star analysis. If attendance is increasing across the board and the only thing that’s changed is prices charged, then the prices must be falling on net balance. That’s the Law of Demand at work. The questions are: What makes them fall? When do they fall? Do they ever rise? When is the best time to buy? And – the $64,000 question – is flexible pricing a good thing overall for baseball fans and for the rest of us?

The article implies that midweek games will carry a lower price tag. It is certainly true that, all other things equal, the demand is greater on weekends when kids and working parents are less encumbered by obligation. But that is a comparatively minor factor in segmenting demand.

High-demand games are special occasions – opening day, marquee players or teams appearing – and pennant-race games. A computer algorithm will alert team officials to opportunities for price increases, which will be implemented electively. It is these games in which Royals’ sales director Steve Shiffman’s advice to “buy early, save money” makes sense. Not only will buying early get the best price, it will also avert the possibility of a shutout; e.g., failure to “score” a ticket at all due to unavailability.

The rest of the time, buying early benefits the team, not the fan. A baseball ticket, like a stock option airline seat or radio advertising time, is a wasting asset whose value expires when the game’s first pitch is thrown. (More precisely, it plummets dramatically, expiring completely at about the fourth or fifth inning.) As game time nears, the holder will likely accept successively lower prices rather than see it expire unused. This is particularly true of sports teams, who have a vested interested in filling seats to increase the incomes of concessionaires. The rise of ticket brokers has complicated pricing for team management, who are extremely reluctant to stimulate price wars lowering seat prices too much. Thus, the Royals advertise the season-ticket-holder’s discounted single-game price as their rock-bottom price. But from the fan’s standpoint, there is no point in transacting before this price is offered and no reason to rush once it is in place – for garden-variety, low-demand games.

Thus, the brave new world of flexible baseball-ticket pricing does demand that fans distinguish between high-demand and low-demand games, in order to get the best price. But this should not tax the capabilities of any experienced fan or intelligent non-fan. As a practical matter, it will not severely disadvantage even the most incapable consumer until and unless the Royals become contenders.

Is flexible pricing economically efficient? Flexible pricing brings the number of tickets fans wish to purchase in each seat category closet to equality with the number available, using price as the coordinating mechanism. This is another way of saying that the amount of alternative consumption fans are willing to sacrifice to get a ticket (their demand for it) is closer to the amount they have to sacrifice (determined by the ticket price). Equality between those two things constitutes the famous economic condition called “equality at the margin.” It is one good way of defining economic efficiency. Thus, the verdict on flexible pricing and economic efficiency is favorable.

This is good for everybody because we all have a stake in using what we have to make each other as well off as possible. It’s good for taxpayers because baseball is publicly subsidized, but the presence of subsidies doesn’t make the case stronger. In fact, the subsidies themselves are inefficient and should be ended – that would make things even better. (Sports meet none of the textbook criteria for subsidy and none of the claims to economic exceptionalism advanced in their behalf.)

If prices sometimes go down but sometimes go up, how can we claim that fans, per se, are better off? Prices go up when people value a ticket than they value the alternative consumption that the ticket’s price embodies. Flexible pricing enables us to sort out the cases when this is true from the cases when it isn’t true. In the old days, we needed illegal ticket scalpers to do that. Now ticket brokers can do it, but not as well as when the team gets involved in the process, too.

If the Royals benefit from flexible pricing, doesn’t this mean that fans must lose? Both entities can’t benefit at the same time, can they? The left-wing, socialist concept of exchange as a power relation implies that trade is a zero-sum game in which the gains of one party are the losses of the other. Mutually beneficial voluntary exchange benefits both parties to the exchange, and when the gains from trade are increased the gain can be divided to benefit both traders. This needn’t be true in every transition from inefficient to efficient conditions, but there is no reason to doubt its occurrence here.

Perhaps the most concrete way to drive home the importance of this principle is by stressing the fact that the benefits of sports teams are heavily location-dependent. If the Royals move away from Kansas City and operate elsewhere, most of the benefits created by the team will flow to sports fans in that new location. Allowing the Royals to maximize the benefits they earn from the value the team itself actually creates will maximize the chances that the Royals continue to operate in Kansas City. The current system strives to keep the team in town by giving them subsidies extracted from non-fans based on phony economic value not really created. Baseball fans deserve to get the value they want and are willing to pay for – not value extorted from unwilling third parties who gain nothing from the team’s presence.

DRI-313 for week of 3-24-13: The Power to Tax

An Access Advertising EconBrief:

The Power to Tax

The long-running economics news story of 2013 has been the budgetary battle between the Obama Administration and Congressional Republicans. The most recent skirmish featured a clash between Senate- and House-approved budgets – that is, between Democrat and Republican pretenses to reform.

Both sides are pretending because neither side really wants to abandon big government and out-of-control spending. The Republicans are harder pressed because they have long given lip service to concepts of limited government and budgetary control. But both sides want to make a political show of deficit reduction. The Democrats are wedded to their political constituencies unto death and must fund the spending that supports them.

The Republican approach is to cut spending in order to lower government expenditures closer to revenue. The Democrat philosophy is to raise taxes to raise revenue to meet expenditures. The failure of either side to change their position significantly is presumably what the public means when it charges individual legislators with deliberately promoting gridlock and refusing to compromise.

Republicans are adamant in their unwillingness to raise taxes. This attitude has won them a public reputation for being unwilling to compromise. In recent years, the Republican reaction to public disapproval has been to retreat in confusion and dismay. This time, though, they remain intractable. Why are they so unwilling to raise taxes? What is the overarching purpose of a tax, anyway? How do taxes affect economic welfare and growth?

Taxation

Taxation is as old as civilization. Before democratic government, monarchs used it to extract wealth and income from their subjects. It has taken numerous forms, but the underlying principle invariably requires an involuntary levy or exaction paid to government by the governed.

One traditional form is a tax on either the production or consumption of a good or service. This is called an excise tax. This tax may consist of a fixed amount per-unit (a specific tax) or an amount expressed as a percentage of the selling price (an ad valorem tax, where the Latin phrase means “to the value”). It is a good place to start looking at taxes because its simplicity gives us a good look at the general principles of taxation.

The basic economic effect of a tax is to drive a wedge between the price paid by the buyer of the good and the price received by the seller. The result applies regardless of whether the tax is levied on the buyer or the seller. In fact, the resulting market price and quantity are the same regardless of who bears the nominal impact of the tax. This is referred to as the equivalence theorem; it is a fundamental principle of Public Finance, the economic sub-discipline under which taxation is studied.

The words “nominal impact” imply that the people who pay the tax may not necessarily be the ones who bear its real economic burden. This is correct. The ultimate end-in-view behind all economic activity is consumption, now or in the future. Only human beings can consume in this meaningful economic sense. Only human beings can suffer a loss of current or future consumption (e.g., savings). While a non-human entity like a corporation – recognized by law as a “fictitious person” – may pay a tax in the legal sense, it cannot bear the true economic burden or incidence of the tax.

Because both short- and medium-term market demand and market supply are each a function of price, an excise tax affects both the quantity buyers wish to purchase and the quantity producers wish to produce and sell. This means that the incidence of the tax is shared by consumers and business owners.

Consider first the case in which buyers pay the tax. If the tax is (say) $2 per unit of the good, the market price (net of tax) that buyers are willing to pay for every quantity of the good is now $2 less, since their total outgo will include the market price plus the tax. That is, their demand for the good will fall. This will lower the market price, forcing producers to produce and sell a lesser quantity. Alternatively, suppose that producers are liable for the tax. Now their costs will rise by $2 per unit, decreasing supply and increasing price. Consumers will pay a higher price for the decreased quantity.

In either case, consumers will pay more than before the tax – in the first case, a lower market price plus the tax; in the second case, a higher market price inclusive of the tax as reflected in producers’ costs. In either case, producers will receive less than before the tax- in the first case, a lower market price; in the second case, a higher market price whose value is reduced by their higher costs due to the tax they owe. The equivalence theorem states that the buyer and seller pay and receive, respectively, exactly the same in the two cases no matter who “pays” the tax.

In the long run, there is sufficient time for business firms to enter and (in this case) leave the market. Exit of firms tends to increase price by the full amount of the tax and drive profit toward the so-called “normal” level, at which owners receive a return just equal to what they could earn in the best alternative investment of equal risk. Thus, the long-run incidence of the tax may be shared by consumers and suppliers of inputs to the industry, or it may be borne by consumers alone.

Our excise-tax example illustrates general principles applicable to all taxes. Taxes discourage economic activity. They harm people on both sides of the market. Over and above this harm, they distort the prices faced by buyers and sellers, creating what public-finance economists call the “excess burden” of a tax.

Because taxes have these adverse effects, economic textbooks deem them a tool of limited resort. Some goods and services, such as national defense, cannot be produced and sold in private markets. These “public goods” must be produced and administered by government. To finance this activity, taxes are considered expedient.

In practice, however, public goods are very few in number, while government is pervasive. Taxes are numerous and lucrative sources of government revenue. Instead of a necessary evil, taxes have become a threat to our well-being. America today has become a locus classicus of the aphorism “the power to tax is the power to destroy.”

In the United States, the most familiar excise taxes have long been specific taxes on gasoline, cigarettes and alcohol. At the federal level, gas tax proceeds are devoted to maintenance of federal highways. Or rather, that was the original intention; today, about 40% of proceeds are diverted to general revenue for earmarked programs. Meanwhile, our roads and (especially) bridges have deteriorated markedly.

Maintaining vital infrastructure with a funding mechanism that is both ineffective and harmful to growth and prosperity seems quixotic. Recently, some state legislatures have begun to make long-term lease contracts with private firms who operate and maintain roads in exchange for the right to charge tolls and book the revenue. The companies have the strongest possible incentive to keep the roads in good condition and maximize their use. Other countries have already seized this chance to improve their transportation network by relieving government of a responsibility it handles badly.

We now shift from general principles of taxation to evaluation of particular types of tax.

Excise vs. Ad-valorem Taxation

A longstanding source of periodic irritation to Americans is the retail price of gasoline. The usual focus of anger is “the oil companies,” who are popularly supposed to possess monopoly power with which they earn “obscene profits” – modified to read “windfall profits” whenever an increase in gasoline prices accompanies an oil-related event on the national or international scene or “record profits” whenever a quarterly release of income statement date from Exxon Mobil reveals that the company’s total net income has exceeded its previous high.

The complete lack of cogency in these complaints has been demonstrated time and again. Another recurring gripe, however, bears on the issue of taxation. Talk-show callers often gripe that gasoline sellers are quick to raise prices but slow to lower them – even when this appears justified by events. If price increases are merely supply and demand at work, they inquire heatedly, why does the process only work in one direction? Shouldn’t prices be just as quick to fall when supply increases, when costs decrease, when Middle-East tensions dissolve, when demand goes slack?

Nearly fifty years ago, the distinguished specialist in international trade and industrial organization, Richard Caves, pointed out the role played by specific excise taxation in pricing. To modify his example using fictitious numbers for convenience, suppose that the retail price of gasoline is $2 per gallon and the excise tax is $1. Now ponder the effects of a 10 cent price reduction by a seller. In actual fact, sellers pay the tax, so the seller’s gross receipts fall by 10% (10 cents as a percentage of $1). But the price faced by buyers falls by only 5% (10 cents as a percentage of $2). Thus, the purchasing response to a price reduction will be depressed by a price reduction, compared to the case where taxation is absent.

Now consider the opposite case, where price is increased. A 10-cent price increase will increase gross margin by 10% while increasing the price faced by buyers by only 5%. It is the opposite situation to the price-decrease case. Specific excise taxation increases the incentive to raise the price of the good while reducing the incentive to lower price. In other words, it tends to create just the short of world complained of by gasoline consumers – one in which sellers are relatively quick to raise price but slow to lower it!

As Caves mentioned, this flaw could be remedied by changing the specific excise tax to an ad-valorem tax, in which the tax is comprised of a fixed percentage of the good’s selling price. But this hasn’t happened in the 49 years since Caves wrote.

The excise taxes on cigarettes and alcohol have created additional problems by encouraging smuggling and illegal production to avoid payment of the taxes. Unlike the fuel tax, those taxes do not have a clear-cut rationale other than the raising of revenue. Lip service is given to the goals of discouraging smoking, but a prohibitive tax would be high enough to persuade all smokers to quit. Since the tax is set well below this point, its purpose is presumably to raise revenue instead. Another oft-stated goal is to use tax proceeds to defray medical expenses attributable to use of the products, such as medical bills of lung cancer sufferers. Again, this ambition has not been fulfilled. The only reasonable explanation for the persistence of these taxes is to support government – not for any productive or valuable purpose, but merely to provide income for officials and employees.

Income Taxation

This year, the federal income tax celebrates its centenary. From its miniscule beginnings, the federal income tax code has grown into a monstrosity fed and cared for by a huge federal bureaucracy, the Internal Revenue Service. The top marginal tax rate began at 7%, has grown as high as 92% and currently resides at 39.6%.

But the most destructive thing about income taxes is not their height but the indirect costs they impose on all of us. These include the impossibility of definition, verification and collection. The continual additions and modifications to the tax code have made it a byzantine nightmare for preparers; it is proverbial that even pre-eminent experts cannot warranty their interpretations of its provisions. Each year, Americans spend a chunk of Gross Domestic Product on federal tax preparation. This calculation includes the time and effort devoted to tax avoidance.

The biggest irony associated with the income tax is that its central logic was developed by a free-market libertarian economist, Henry Simons of the University of Chicago, while working for the federal government during World War II. In particular, it was Simons who developed the definition of “income” that had made the tax code so baffling and infuriating to subsequent generations. In fact, Simons sought to make the income tax consistent with the concept of real income or utility as defined by economic theory. Alas, his efforts demonstrated that the precise theoretical categories beloved of economists all too often lack real-world referents.

The clearest demonstration of the damage done by income taxation may be migration by high individual earners and businesses away from high income-tax rate habitations. Over the years, some of the world’s wealthiest authors, movie stars, athletes and moguls have become tax exiles. Among the historical sufferers of this brain drain have been Great Britain (movie stars Anthony Hopkins and Michael Caine), Italy (movie mogul Carlo Ponti and star Sophia Loren) , France (movie star Gerard Depardieu) and Sweden (tennis great Bjorn Borg).

Apart from revenue, the other claim made in behalf of income taxes is fairness. For over a century, the Left has maintained that progressive income-tax rates are necessary to insure an equitable distribution of income. The most recent rhetorical recurrence accompanied the Occupy Wall Street movement. The counterarguments, marshaled concisely by authors Blum and Kalven in The Uneasy Case for Progressive Taxation, are convincing on a theoretical level. Empirically, the utter failure of regimes such as Soviet Russia and Communist China to achieve distributional equality suggests that government power is either inappropriate or insufficient for the task – even assuming it is worth doing.

Property Taxation

Property taxes have long been the primary source of income for local governments and schools in the United States. That constitutes a recommendation only to those employed by governments and schools. The assessments used to determine the property values to which the property-tax rates apply are notoriously inaccurate when compared to actual market values. For years, local politicians used rising property values and the prestige associated with education as levers to ratchet up property taxes and continually increase education funding.

In the late 1970s and early 80s, this gravy train came to a screeching halt. It became clear that continually rising taxes were funding an education system that was failing its customers. Despite fivefold spending increase in real terms over the previous three decades, average test scores were flat or falling. California taxpayers felt so thoroughly victimized that they approved the landmark tax-limitation measure Proposition 13. Other state-level tax limitation measures, such as Missouri’s Hancock Amendment, accomplished the same goals through less direct means.

The concept of property taxation bears at least a family resemblance to the form of taxation most admired by economic students of the subject. Henry George’s “single tax” on land was based on the premise that land is the only resource in completely inelastic supply. Given this, a tax on land cannot discourage its supply. George became the most popular economist of the 19th century by promoting this program of public finance.

Unfortunately, his view was simplistic. While the physical supply of land is indeed in fixed supply, the economically valuable and available supply of land is not. To achieve its goals, the single tax would have to apply only on the undeveloped component of developed land. It is not commonly feasible to sort out this datum and property taxes in reality do not even make the attempt.

Sales Taxes

Just as water seeks its own level, taxation tends to follow the path of least resistance. In recent years, this has been traced out by the sales tax. A tax on retail commercial transactions is easy to implement, verify and collect. This gives it a big advantage over other forms of tax that can be avoided legally, evaded illegally and put off indefinitely.

Ironically, the sales tax has also become popular with the organized anti-tax movement, many of whom have proffered it as a composite replacement for virtually all other forms of taxation. A flat sales tax of X%, where X might be some number between 10 and 25, could substitute for all other taxes by providing government with roughly the same amount of total revenue it currently collects, but without the tremendous costs of collection, verification and monitoring it now incurs. Similarly, citizens would be spared the tremendous burden of preparing, calculating and worrying over the taxes they now pay. And they could fight one single battle against future tax increases rather than having to fight on multiple fronts simultaneously.

One counterargument, perhaps the most telling, is that government cannot be trusted to first pass an omnibus sales tax, then repeal other taxes. We might well be stuck with a vastly higher sales tax on top of our current tax burden. From the Left comes the objection that sales taxes are highly regressive, falling much more heavily on low-income taxpayers whose annual retail transactions form a large part of their incomes and wealth.

Taxes and Economic Growth

In the late 1970s and early 80s, the economic philosophy of “supply-side economics” drew attention to the effect of taxes on economic incentives and growth. Federal tax-rate reductions in the U.S. and Great Britain, followed by the revival of growth and retreat of inflation in both countries, preceded tax-rate reductions in dozens of other countries around the world. To this day, economists argue about the effects of this revolution. The argument centers mainly on the sensitivity of households and business to tax-rate changes, with left-wing economists seeing little reaction and right-wingers finding great responsiveness.

One way to break this logjam would be to examine state-level U.S. data. Policy studies by think tanks like the Heartland Institute, American Legislative Exchange Council, Cato Institute and Heritage Foundation have all found in-migration toward, and higher rates of economic growth in, states with lower tax rates and downward tax-rate trends. These states have also tended to be the so-called “red states,” which have voted Republican in national elections.

The Power to Tax

There is simply no doubt that the incentives created by taxation are perverse; that is, they tend to discourage economic value, welfare and growth. The arguments for taxation are twofold – first, that its undesirable effects are quantitatively small; second, that it is necessary to support activities that would otherwise go begging and needs that would otherwise go unmet.

Both these arguments are remarkably weak. Given the omnipresence of taxes, their aggregate impact can hardly be weak. The case for a tepid reaction by individuals to changes in tax rates does not accord with everyday life or historical experience. And the Left has done nothing at all to convince the public that government programs are necessary, successful and responsive to consumer wants.

It is no wonder that Republicans in Congress are drawing a line in the sand on taxation. The wonder is that they have waited so long. Doubtless their reluctance reflects their unwillingness to face the implications of this decision. The welfare state has come to a dead end. It survives in an artificial atmosphere oxygenated by spending pumped in by government. We can no longer borrow or print the money to spend. Opposition to taxes implies opposition to spending. And that requires a political will that Republicans have not had to summon for many decades.