DRI-305 for week of 3-17-13: What is Behind the New ‘Sharing Economy?’

An Access Advertising EconBrief:

What is Behind the New ‘Sharing Economy?’

The once-distinguished British weekly The Economist highlights a new Web-based economic phenomenon in a recent (03/9-15/2013) issue. The name assigned by the magazine to this activity is the “sharing economy” – a dreadful misnomer that conjures up images of 60s counterculture and communes. But however misnamed, the transactions it denotes are a sign that cannot be ignored.

In his Wealth of Nations, Adam Smith explained the growth of markets by citing man’s innate “propensity to truck, barter and exchange.” Ever since, these words have received both veneration and ridicule. Smith’s admirers saw in them a beautifully realized portrait of human nature. Opponents of free markets have scoffed. They long since rejected whatever validity Smith’s “higgling and haggling of the marketplace” might have had in favor of Thorstein Veblen’s picture of “shadowy figures moving in the background;” they see corporate power, not voluntary exchange, as the dominant motif in the market. Since 2008, the Left has pooh-poohed the notion of rational choice by citing the financial collapse as proof of the irrationality of crowds and the infeasibility of deregulated markets.

But now comes The Economist to point out that even as world financial markets were imploding, unregulated private markets were springing up to enrich the daily lives of billions of the world’s citizens. Alas, the magazine itself misses the significance of its own reporting.

The “Peer-to-Peer” Rental Market

Every night some 40,000 people around the world rent rooms from a service that operates throughout the world – 192 countries, 250,000 rooms in 30,000 cities. The customers choose their rooms and pay online. But the provider is not a commercial business chain like Hilton, Marriott or even Motel 6. Instead, a San Francisco-based firm called Airbnb matches up customers with rooms in homes owned by private individuals. The company has operated since 2008, attracting roughly 4 million customers. Room renters choose and pay for their rooms online.

This is perhaps the largest business in the “peer to peer” rental market. Individual consumers rent assets like beds, boats, and cars directly from other individuals rather than from businesses. The rationale for these practices is quite straightforward. You may wish to cut your automotive transportation costs by earning income from giving rides to people whose destinations coincide with yours. Or, viewing the same situation from the other side of the market, you may wish to cut your costs by paying a peer to chauffeur you to a common destination rather than calling a taxi or riding the bus.

Boat ownership is commonly likened to owning a hole in the water into which you pour money. One way to offset this outflow is to rent the use of the boat to peers. The intermediary and clearinghouse for all this activity is the World Wide Web.

Observing and noting this market is easier than pinning a descriptive label on it. The Economist calls it “the sharing economy.” This is surely wrongheaded, if only because we do not associate “sharing” with commercial transactions. Carpooling arrangements, for example, involve a spatial arrangement for the pooling of transportation services. Participants “share” a common space inside a single vehicle for the purpose of reducing joint transportation expenses. But each vehicle’s owner is commonly responsible for fuel purchases. Pooling equalizes travel responsibilities and costs among participants; the net exposure should be zero. The benefits are symmetrical, both in quantity and kind. This is sharing in a true, meaningful sense; the benefits are objectively equal and depend on the shared use.

Charity is another conventional form of benefit sharing. The owner of income or assets shares it (them) with others with no reciprocation except, perhaps, a “thank you.” The mutuality derives from the satisfaction gained through helping.

But the peer-to-peer market is simple commerce, unlike the genuine sharing examples just cited. There is an exchange of money for goods-or-services. The buyer gains the usual consumer surplus – the excess of the maximum price he or she would have been willing to pay over the price actually paid. The seller gains better utilization of existing capacity, whether the capital good is a personal automobile, spare bedroom or pleasure boat. Sellers are no more “sharing” than are taxi drivers, motel owners or charter-boat skippers. Indeed, a better descriptor would be the “utilization” or “capital-utilization” economy. Of course, this clinical language lacks the warm and fuzzy feel of “sharing” but it compensates in accuracy.

The Economist also tosses out the term “collaborative consumption,” which is just as inapropo as “sharing.” Fairness and full disclosure require noting that the terms “sharing economy” and “collaborative consumption” date back several years. They are particularly associated with left-wing authors like Rachel Botsman, whose communitarian views are hostile to capitalism and private property. But The Economist, of all publications, should know that private ownership is essential to the preservation and maintenance of capital goods, without which the peer-to-peer market would vanish into thin air.

Come to think of it, why not follow current buzzword practice and adopt digital vernacular, using The Economist‘s own phrasing? Call it the P2P market.

The Key Role of the Internet

Where has this new economy been all our lives? Did it take over a century for people to wake up to the possibility of using their cars as taxis or rental cars? Was there an epiphany, a la Bell and Watson, when a restaurant habitué decided he could pay his bill by ferrying his fellow diners back and forth for a fee?

Actually, P2P has been operating in the background all along. It ran on word-of-mouth or classified advertising, using referrals as its primary security. This guaranteed that its importance would remain marginal. It took the Internet to turn it into a $26 billion annual, growing enterprise.

First, the Internet gave P2P the reach it lacked heretofore, allowing sellers to reach an unlimited audience at extremely low cost. Second, the Internet provided the security necessary to both sides of the market. For example, taxi drivers lead a notoriously precarious existence at the mercy of their passengers. But insecurity runs in both directions when the driver is not a business owner or employee, operating a highly visible vehicle. On the Web, though, the platform fulfills the role otherwise played by the business in vouching for its representatives. Follow-up reviews and ratings ensure that bad trips are not repeated.

The surest sign that P2P really works is that commercial businesses want a piece of the action. The Economist reports that Avis, GM and Daimler have all acquired their own piece of P2P; e.g., acquired P2P assets or entered the market de novo. The magazine speculates that the acquisition may enable the parent to list its excess capacity-assets on the P2P firm’s website. This looks like a clear case of evolutionary adaptation rather than creative destruction; P2P does not rate to destroy its competing industries but rather to modify their operations for the better.

Last April, The Wall Street Journal reported on the hottest extension of P2P in the financial realm – P2P lending. For roughly a decade, at least two P2P firms – Prosper Loans and Lenders Club – have offered individuals a chance to lend directly to their peers. The loans are extended versions of the payday/high risk loan that has long been a staple of the low-income and pawn-loan credit market. These P2P loans have terms of up to five years and principal amounts ranging up to $25-35,000. They are unsecured and assigned a risk rating based on the borrower’s creditworthiness.

The success of these P2P firms has now attracted the attention of Wall Street. Fund managers have started funds organized along similar lines, offering investors the chance to pool investment capital into funds offering the same types of high-risk, unsecured loans. Risk spreading and high returns make these funds an attractive alternative to current low-yield, fixed-income investments. The high risk means that their fraction of the total portfolio should be low. Naturally, the increase in lending activity will improve terms and outcomes for borrowers.

Lessons Learned

Even if we accept that P2P is an adaptive rather than a disruptive force, this should not obscure the powerful message it conveys. The rise of P2P overturns the conventional thinking that had prevailed since the financial crisis of 2008 and the ensuing global recession. That dominant view has been that market participants do not act rationally. They act emotionally, even hysterically. They are stampeded by mob psychology and incapable of gauging their own interests. Without the wise guiding hand of government regulation, free markets will inevitably devolve into chaos.

To be sure, this view is itself hysterical. It offers no clue as to why or how regulators themselves escape the emotional distractions that sway market participants. It doesn’t explain how regulators regulate markets without actually substituting their own decisions for those of markets. It also doesn’t tell us how regulators are able to perceive the interests of market participants who (supposedly) cannot discern their own interests. Nonetheless, this regulatory view won out (essentially by default) in 2008-2009.

Every major regulatory agency in Washington – OSHA, EPA, FDA, SEC, FTC, DOT, DOE, FMCSA, et al – has presided over a reign of terror for the last four years. If federal-government regulation were the key to safety, America would now be the safest nation on Earth by far. There is no logical or empirical case for this regulatory full-court press, other than the fact that the Democrats won the last two Presidential elections and the Republicans did not. Still, asking Democrats not to regulate is like asking a horse not to eat hay.

P2P offers the perfect test case for the new conventional thinking. Here we have both supply and demand sides essentially pioneering a new market all by themselves. According to today’s party line, this is a sure-fire recipe for disaster. After all, taxi regulators in New York
City have spent decades warning consumers to beware of “gypsy [unregulated] taxicabs.” Riders might be placing themselves in the hands of robbers, rapists or even worse. Unfortunately, New York City hasn’t approved the issue of a single new taxi license (they are issued in the form of medallions) since World War II, so its citizens have conditioned themselves to ignore these admonitions. They actually want to get somewhere without waiting for a bus or walking. Well, if an unregulated commercial vehicle is this unsafe, just imagine how risky P2P must be!

No, according to The Economist, “the remarkable thing is how well the system usually works.” Then again, P2P “is a little like online shopping,” where “15 years ago…people were worried about security. But having made a successful purchase from, say, Amazon, they felt safe buying elsewhere.” And there was eBay, which began essentially as P2P and morphed into a vehicle for professional sellers.

Well, gol-l-l-l-l-e-e, Sgt. Carter, could it be that old Adam Smith was right – not just about mankind’s inherent affinity for trade but also about the self-adjusting character of mutually beneficial voluntary exchange? So it would seem.

Yet The Economist‘s liberal knee cannot help jerking towards regulation. “The main worry,” they declare gravely, “is regulatory uncertainty.” Yes, politicians in America have cast lascivious glances at Internet trade for years, longing to tax it under a guise of benevolent regulation. Since The Economist sails under the banner of …er, economics – where a tax discourages the taxed activity, creates a welfare burden and reduces the well-being of the taxed – it should come out forthrightly against Internet taxation, right?

Wrong. “People who rent out rooms should pay tax, of course [of course!], but they should not be regulated like a Ritz-Carlton hotel. The lighter rules that typically govern bed-and-breakfasts are more than adequate.” Mere readers – being only consumers, humble recipients of The Economist‘s sunbursts of illumination – needn’t expect any illuminating insight on why tighter regulation of Ritz-Carltons is either necessary or beneficial, because none is forthcoming. The editorial’s anonymous author has the wit to notice that incumbent taxi firms are even now mobilizing the forces of regulation to protect their monopoly position. But the magazine’s leftist editorial stance is so ossified that it cannot permit that admission without an accompanying qualification that “some rules need to be updated to protect consumers from harm.” Taxicab regulation is probably the most notorious textbook example of regulatory harm to consumers in the history of economics, but The Economist is bowing its knee to it. (Elsewhere, the magazine laments the absence of even more Keynesian stimulus spending policies to create jobs.)

This is an old story. A precursor to P2P sprang up in black communities throughout the U.S. during the early and mid-20th century. Taxicab service was often sparse in these areas, not merely because of racial discrimination but also because high crime posed serious risks to drivers. Taxi regulation typically prevented black taxicab companies from entering the market or expanding to meet demand. It became common practice for private individuals to frequent grocery stores, barber shops and other high-traffic areas in order to provide “car service.” This service consisted of informal, unmetered charges (sometimes on a flat-rate basis) in return for carriage to and from shoppers’ homes. Carrying of bags and escort duties were usually included in the service.

Researchers have applied the term “jitneys” to the unregistered, unlicensed vehicles used to provide this service. Research is conclusive on two points: Consumers benefitted unambiguously from the service, and jitneys were legally hounded by taxi and bus companies in their jurisdictions. They were made illegal because taxi and bus owners feared and resented the competition and loss of income that this low-cost alternative form of transportation inflicted on them. Amazingly, jitneys still survive today in inner-city America; they are the “missing link” connecting modern P2P with its ancestral forebears.

When the worst that The Economist can cite is that “an Airbnb user had her apartment trashed in 2011,” you can rest assured that today’s P2P system is working extraordinarily well. It is a measure of our times that even a single complaint instantly triggers the demand for more regulation. When abuses occur despite the presence of tight, heavy regulation – as in financial markets – it should be clear that regulation is the problem rather than the solution. When complaints are rare, it hardly suggests a need for regulation.

The word “regulation” itself has become a rhetorical refuge of first resort precisely because its meaning is so vague. There is no clear-cut theory of regulation to explain why it is necessary, exactly what it does or how it does it. To a bureaucrat, this may constitute a highly desirable sort of flexibility. But it is not conducive to favorable outcomes.

All the News That’s Fit to Decode

Readers of The Economist should probably be grateful that the magazine deigned to notice P2P at all. The fact that we have to hack our way through the magazine’s ideological bias and occupational ineptitude to glean any value from the article is a journalistic scandal. Still, these days students of economics have to take our good news where we find it and our sources as we find them.

DRI-293 for week of 3-3-13: The Sequester: A Barack H. Obama Production

An Access Advertising EconBrief:

The Sequester: A Barack H. Obama Production

The appearance of First Lady Michelle Obama as presenter of the climactic Best Picture Academy Award at the recent Oscar ceremony is the latest sign of the symbiosis between American politics and Hollywood. The convergence between the political and entertainment industries is now so close that we can use the same economic model to analyze them.

Since both industries are popular and objects of public scrutiny, this model will have great practical value. Its first application will be to analyze the sequester, the current political-theater production now enjoying its first run on popular media throughout the nation.

The Model

The late Nobel-Prize-winning economist James Buchanan campaigned tirelessly against what he called the “romantic view” of government as the promoter of the “public interest.” Government is composed of particular individuals. In order to be operational, the concept of the “public interest” must be comprehensible to those people. If the activities of government were limited only to those whose net benefits were positive for everybody, it would be a miniscule fraction of its present size. Clearly, the actual purposes of government are redistributive. But what unique redistributive plan could possibly command unanimous support from the bureaucratic minions of government? The only conceivable answer is that bureaucrats serve their own interests, presumably having convinced themselves that their interest and the public interest coincide.

Government bureaucrats thus share a common goal with private business owners. But whereas private businesses produce goods and services in markets under the discipline of market competition, governments provide only executive, legislative and judicial services while contracting out for the production of and needed goods and services. Far from submitting to the discipline of competition, governments claim monopoly privileges for themselves and dispense them to others – often in exchange for political support.

From inception until the gradual disintegration of the studio system of moviemaking, Hollywood operated under the marketplace model of competition. When adverse antitrust decisions in the 1940s killed the long-term viability of the giant studios, movies changed their way of living. This drift away from competitive capitalism accelerated over the last two decades. Today, the approach of government and Hollywood to production is remarkably similar.

Private businesses produce goods and services in order to satisfy the demand of consumers. They satisfy consumer demand in order to earn profits and maximize the profit of their owners. Thus, both sides of the market strive to maximize their real income or utility through the consumption of goods and services. Consumers act directly when purchasing for their own consumption or saving for their future consumption. Producers act indirectly when producing for the consumption of others or directly when producing for themselves. Input suppliers act indirectly by supplying labor and raw materials to producers to facilitate production and consumption for others.

Governments cannot act as private businesses do because their bureaucrats are not spending their own money and taxpayers have no effective leverage over them. Bureaucrats serve their own interests – which are those of the politicians who control their fate. Politicians, in turn, most want to retain their hold on office. For the most part, this is accomplished by redistributing money in favor of those who vote for them. Since government has little or no power to increase the supply of goods and services but considerable power to reduce it, redistribution is accomplished predominantly by harming some people while purporting to help others.

We know that private production is beneficial because consumers voluntarily choose from among many competing products in a free marketplace in which producers can enter and leave at will. The existence of prices allows everybody to incrementally assess the value of every unit of input and output to insure its net benefit before purchase. Profit directs the flow of resources to areas of greatest value to consumers.

None of these safeguards applies to political production. In government, the principle of coercion replaces voluntary choice. No profits exist to tell bureaucrats whether they have succeeded or erred. No prices direct the incremental flow of resources and no competition is allowed to provide an alternative to government provision of goods and services. Sure, voting does take place. But the notion that a one-time choice between a restricted field of two candidates can somehow take the place of millions of everyday choices made under vastly better marketplace circumstances is quaint, if not utterly ridiculous.

How Hollywood Has Come to Resemble Politics

More and more, Hollywood production has come to resemble political production. This evolution has accelerated during the last two decades.

Under the old studio system, motion-picture production often left the confines of Hollywood in favor of distant locations. This was sometimes motivated by concern for production values, as when director John Ford sought the scenic vistas of Monument Valley, Utah for his revival of the Western genre in the 1939 film Stagecoach. Increasingly, however, economics lay behind the decision of producers to abandon Hollywood in favor of locations in the eastern U.S., Canada, Mexico, Spain or elsewhere in Europe. Hollywood production was hamstrung by inefficient work rules established by Hollywood craft unions under the sway of organized crime. It became far cheaper to incur heavy travel costs to foreign locations than to bear the costs of a Hollywood shoot.

That was back in the day when Hollywood still operated under the rules of economics that govern private markets. Today, every state of the Union has a state-level “department of economic development.” These Orwellian entities are distinguished by their lack of adherence to economic principles. In particular, they offer subsidies to private businesses for locating and operating within the state. In the case of motion pictures, this takes the form of subsidies to production companies that shoot movies in-state. The rationale for this activity is almost always a purported “multiplier benefit” to the location’s “economy.”

A subsidy is the opposite number of a tax. Both drive a wedge between the price paid by the buyer and that received by the seller; both are inefficient actions with adverse effects on production and consumption. Whereas a tax causes too little of the taxed good to be produced and consumed, a subsidy causes too much production and consumption of the good affected and too little production and consumption of other things. State agencies justify their actions by ignoring their bad results in favor of the supposed good effects.

The most highly touted benefit of movie-location subsidies is “job creation.” Even under the studio system, it was standard operating procedure for casting directors to scour the rolls of local actors to play subordinate parts, rather than pay travel expenses and higher salaries of Hollywood actors. The principal cast, whose work comprised the guts of the movie, was chosen on the basis of star power and acting ability. This was basic economics at work. Today, however, the pretense that subsidies are necessary to insure work for locals and keep local industry alive is another way in which Hollywood has abandoned economics for politics. Movie subsidies are directly analogous to protective tariffs (taxes) levied on foreign goods to make their prices higher than local prices, thus protecting the jobs of local workers.

There is no economic value in creating or protecting jobs because the end-in-view in all economic activity is consumption, not production. The idea is to provide the best combination of output quantity and quality. The implication behind job creation – rarely stated outright but unmistakable – is that our goal should be to maximize the quantity of human labor employed in producing output, rather than to produce the most and best output. This suggests that the profession of economics should hold up ancient Egypt as its model state. The production of pyramids using slave labor may be the best means ever devised for maximizing the number of human beings doing work and eliminating unemployment. (The slave-labor camps in the old Soviet Union’s Gulag Archipelago are a legitimate contender for the title, but lose out on the grounds that they produced comparatively little tangible output and services.)

Since the general idea is to make people as happy as possible, though, we can rule out “job creation” as our lodestar. The reason it is such a popular political goal despite its economic drawbacks is that it concentrates benefits heavily on a group of easily identifiable people who can readily recognize and gauge their gains. The beneficiaries of a job-creation policy are a good bet to vote for their benefactor.

Another prime example of Hollywood’s shift from economic to political priorities is the re-ordering of the bottom line. The mainstream media still behaves as though the success or failure of a movie depends on its box-office receipts. This was certainly true throughout the 20th century, during the birth and development of the motion picture. But it is no longer true today.

Most movies today are conceived or at least approved by the “talent” – stars, writers, directors and their agents. Studios are coordinating and marketing vehicles. The astronomical fees commanded by the talent, together with high labor and insurance costs, make it prohibitively expensive to make most movies. The only way turn a profit is by marketing ancillary products to young customers. Most movies lose money at the box office and are subsidized by ancillary revenues and (as the studio level) the occasional box-office blockbuster.

The shift in priorities away from the box office has allowed the talent to cater to their own tastes in choosing the subject matter of movies. Under the studio system, the preferences of the audience were worshipped by movie-studio moguls like Louis B. Mayer, Irving Thalberg, Harry Cohn and Darryl Zanuck. Many of the moguls were immigrants and Jews who had strong opinions and might have loved to indulge their own tastes. Instead, they ruthlessly pruned the esoteric and controversial output of their directors, writers and stars because their instincts sensed that public tastes would not embrace it. Now Hollywood’s implicit motto is “the public taste be damned” – an attitude it would condemn unhesitatingly were it struck by a private industry producing hula hoops, automobiles or soap. This allows the talent to freely indulge their political preferences on screen.

Hollywood’s bias has long been to the Left. The Obama administration is now busily engaged in centralizing as much production as possible under the aegis of government – executive, legislative, judicial and regulatory. The case of Solyndra is a representative example of the results. Large subsidies were given for the production of an alternative energy facility. Market demand was unfavorably disposed toward the company’s output and it lost money hand over fist. But ancillary considerations – in this case, the ostensible necessity for the gestation of alternative energy production – outweighed the losses in the disposition of funds.

Losses, subsidies and the substitution of personal priorities for those of consumes has long characterized political production. But now it describes Hollywood, too.

How Politics Has Come to Resemble Hollywood

In the early 1950s, veteran actor and movie star Robert Montgomery was asked to tutor President Dwight D. Eisenhower on the fundamentals of spoken communication to improve Eisenhower’s performance in televised speeches and news conferences. Much was made of this intrusion of Hollywood into the pristine, public-spirited world of politics. The election of Ronald Reagan as Governor of California and U.S. President led to his subsequent anointing as the “Great Communicator” – a title that was given a pejorative cast by his critics on the Left. While these episodes may have painted the Oval Office with a show-business veneer, they hardly tell a story of Faustian corruption.

Today, however, candidates are chosen on the basis of qualities associated with movie stars rather than statesmen. Would a candidate as homely as Lyndon Johnson or with the profile of William Howard Taft even bother to register for the Presidential primaries? Journalists have expressed a public longing to sleep with Bill Clinton and Barack Obama, even though political scientists have never ranked amatory skill among the vital attributes of a Chief Executive. The candidacy of Mitt Romney was widely felt to be fatally handicapped by his biography, as if a Presidency were a movie that needed suitable first and second acts to set the stage for a dramatic finish.

Movies are an emotional medium rather than an intellectual one. Their narrative form is highly stylized, based on that of the theater. Movie scripts can be divided into first, second and third acts. There is a (preferably heroic) protagonist, who wages a conflict with one or more villains during the course of the movie. The protagonist undergoes a transformative experience and emerges better for it. There is a climactic resolution of the conflict.

Today, politicians structure campaigns and issues in this manner. They cast themselves as the hero. They demonize their political opponents as villains. And, most importantly, they appeal to the emotions of voters rather than to their intellect.

The timing of announcements, and sometimes even the substance of policies, is determined by “optics” – the snap judgments and emotive reactions of the public. The weight of issues is measured by their standing in opinion polls rather than by their impact on the real incomes of citizens. Like motion pictures, politics has become a purely emotional business in which objective truth is completely overshadowed by subjective perception.

The Sequester: A Barack H. Obama Production

Now we are engaged in a great civil debate on the issue government spending. It will ultimately determine whether our nation – or any nation so constituted – can long endure. The opening volley in that debate has been fired by President Obama himself. But it has not been launched in the rhetorical tradition of intellectual inquiry and contention. Instead, it has been presented as a production of political theater – a Barack H. Obama production. Its title is: “The Sequester.”

In 2011, the Obama administration and Congressional Republicans fought a symbolic struggle over the raising of the debt limit. In order to orchestrate a victory over Republicans, the President crafted the sequester. The word “sequester” means “to set apart, segregate, or hand over (as to a trustee).” That refers to funds in the budget that were removed from consideration for spending purposes. In return for agreement to raise the debt limit, the President met Republicans halfway by agreeing to spending reductions in the form of sequestration.

Now, in 2013, when the time to follow up on his promise has come, President Obama has rewritten the script. He has recast himself as the hero and Republicans as villains in a melodrama in which spending reductions threaten hardship and economic setback. The original terms of the sequester called for $1.2 trillion in spending reductions spread over 10 years, averaging out to around $120 billion per year in reductions.

The actual reduction for 2013 would be about $85 billion. But there is more to the story. First, the cuts come only from so-called discretionary spending; entitlement programs like Social Security and Medicaid are unaffected. Second, the $85 billion figure reflects a reduction in budgetary authority – the statutory authorization to spend. Actual reduction in government outlays is projected to be only half the $85 billion total, or about $42 billion. The difference is accounted for by “baseline budgeting,” the notorious government budgetary practice that automatically increases expenditures every year. When the budget is ruled by the implicit logic that government spending is always good and a growing country will always need more of it from year to year, it is easy to grasp why the federal government is swimming in a sea of debt.

The biggest chunk of sequestration (about half of the authorized total) is slated to come from military expenditures. The remainder is sprinkled more or less equally throughout the federal discretionary budget, with the proviso that it should be distributed to cause the most pain to the populace. Does that sound like a pejorative characterization? No, The Wall Street Journal cited a memo to precisely that effect. Perhaps the most telling index of the melodramatic nature of this Barack H. Obama production came from a White House memo announcing that free tours of the White House would be cancelled until further notice due to “staffing reductions” caused by the sequester. As various bloggers hastened to point out, the tours are conducted by volunteers.

The President’s exercise in political theater contained many other dramatic high points. A White House fact (!) sheet stated that federal programs like Meals On Wheels would serve 4 million fewer meals thanks to the sequester. The document also claimed that 70,000 youngsters “would be kicked off Head Start,” the subsidy program for pre-school education, thanks to the sequester – a claim backed up by Health and Human Service Secretary Kathleen Sebelius. White House Press Secretary Jay Carney expressed grave concern for federal-government janitors who would receive less overtime pay because of the sequester. Department of Education Secretary Arne Duncan made headlines by declaring that there are “literally now teachers who are getting pink slips,” a whopper so outrageous that he was forced to retract it within 24 hours. Not to be upstaged by his supporting cast, the President himself gravely warned that federal prosecutors “will have to let criminals go” if the sequester is allowed to proceed.

The public is accustomed to seeing movies tell lies in the service of dramatic effect. That is exactly what this Barack H. Obama production does. Like many popular movies, it has borrowed its storyline from other successes. For over three decades, state government legislatures have faced laws – such as Missouri’s Hancock Amendment – limiting state-government spending. The standard legislative tactic of opponents is to concoct a fantasy wish-list of worst-case spending reductions designed to terrify voters into repealing the laws. In fact, the laws say nothing about specific spending cuts. They allow the legislators themselves the flexibility to choose which spending to cut. The legislators are supposed to cut the most wasteful, redundant spending and retain only vital programs – assuming there are any. Yet in practice, the legislators do just the opposite – they pick the most painful cuts in order to blackmail voters into spending ad infinitum.

That tactic, straight from the playbook of radical activist Saul Alinsky, is the plotline of “The Sequester.” It makes no sense. When air-traffic controllers went on strike in 1981, President Ronald Reagan protected consumers, who were otherwise helpless against the threat posed by a government monopoly. He fired the striking controllers and hired replacements. Are we confronted by angry restaurant owners who threaten to close up unless we spend more money dining out? Of course not; the restaurant industry is competitive. Strikers would simply lose business to competitors who would step up to serve consumers. But government monopoly employees can successfully hold taxpayers hostage unless the Executive branch fulfills its duty to protect the public. Instead, the Obama administration is siding with the blackmailers.

The Administration’s economic rationale for its actions is transparently absurd. Unofficial Administration economic advisor Paul Krugman hints darkly of 700,000 lost jobs and the CBO forecasts a loss of one-half point’s worth of economic growth – all due to a net reduction in discretionary spending of $42 billion. Yet the Administration absolutely demanded that the Bush tax cuts end on schedule, producing a much larger effect on “aggregate demand” by Keynesian economic lights. Krugman has consistently maintained that the 2009 stimulus of nearly $800 billion was not nearly large enough to produce marked effects, so how can he now bemoan this piddling spending reduction?

Movie plots are not supposed to make sense. They are structured for emotional impact only. Producers, directors and screenwriters are granted dramatic license to lie in order to manipulate our emotions. Their actors and actresses are expected to speak lines from a script in order to enact the drama.

This is what politics has become. It is political theater, dedicated to the proposition that government of itself, by itself and for itself, shall not perish from the Earth.

DRI-281 for week of 2-24-13: Our Telecommunications Marketplace: The Rest of the Story

An Access Advertising EconBrief:

Our Telecommunications Marketplace: The Rest of the Story

Last week’s EconBrief told the tale of the man who, with reasoned premeditation, set out to release the telecommunications marketplace from the thrall of natural monopoly. This week we counter with what the late Paul Harvey might have called “the rest of the story” – the complement to the policy revolution wrought by Tom Whitehead in the White House Office of Telecommunications Policy.

This is a different story altogether. The actions of the Federal Communications Commission (FCC) and the Department of Justice (DOJ) were triggered by the chance decision of one man. That man was not an economist or a free-market ideologue. He was a lawyer and bureaucrat motivated by helplessness and disgust with his task of regulating the Bell system. He sought only to inflict a pinprick – but ended up helping to topple the world’s largest corporation from its monopoly throne.

The key elements of the story were told by economic historian Peter Temin in his short essay, “The Primrose Path,” in Second Thoughts: Myths and Morals of U.S. Economic History, edited by Donald N. McCloskey.

Enter Bernie Strassburg

Bernie Strassburg was a lawyer who headed the FCC’s Common Carrier Bureau. He was charged with regulating telephone and telegraph companies; e.g., he rode regulatory herd on AT&T and Western Union.

In the early 1960s, AT&T was the world’s largest corporation. Federal law gave them a virtual monopoly on American telephone service, both at the local level and for long-distance service. But the monopoly also extended to telephone equipment as well; it as illegal to use any equipment not manufactured by Bell. Thus, the Bell system was vertically integrated.

Regulating them was like wrestling an octopus. Each of the Bell regional companies was regulated by the public-utility commissions (PUCs) within its service area. PUCs conducted hearings to determine the allowable “fair rate of return” on the utility’s rate base. This formed the basis for the rates charged by the company.

The word “rates” applies literally. Instead of charging one universal rate to all users, the Bells charged differential rates to different classes of users. Residential users got preferential low rates, thanks to the doctrine of “universal service.” Telephone service was deemed a necessity to health and safety reasons and the low rates were ostensibly necessary to make it affordable to low-income residents. Business users got special rates – special high rates, that is. After all, businesses could apparently afford to provide all kinds of non-salary benefits for employees, such as health insurance, pensions, retirement accounts, etc. Why not make businesses pay high rates for telephone service and use the proceeds to subsidize residential service?

Of course, economists know why not. This is precisely analogous to a tax on business, and no business ever paid a tax. Instead, the tax – or, in this case, the high charges for telephone use – are borne in the short run by owners and employees of firms driven out of business by the higher costs, as well as by consumers of goods produced using telephone services as an input. In the long run, all costs are borne by suppliers of inputs and/or consumers. In this case, that means consumers of goods that use telephone services in their production and suppliers of inputs to those industries. Too few of those goods are produced and too many resources are devoted to providing telephone services to residential consumers. Although residential consumers pay a lower prices for telephone services – at least temporarily – their real incomes are almost surely lower thanks to the smaller quantity of other goods and services they consume.

A crowning irony of the politically sacrosanct doctrine of universal service is that the penetration of telephone service never reached the levels reached by television. Apparently telephone service wasn’t as necessary as television service, no matter what regulators claimed.

Instead of high nominal profits, public-utility owners earned the equivalent of lower nominal profits at virtually zero risk. Utility managers earned high salaries, worked in plush offices and oversaw huge staffs. Utility executives substituted easy living and a quiet life for the go-go, big-profit lifestyle of corporate America. Well-off elderly Americans held AT&T and Bell regional stocks in their portfolios for risk-free high returns. And this cushy deal was safeguarded by Bell’s political activities. State and local rate regulation attracted Bell lobbyists like locusts to the legislative harvest. Lobbying costs were paid by ratepayers.

The Bell system’s equipment monopoly was just as stifling as its monopoly on phone service. Bell’s monopoly on phone service was reinforced by a prohibition on the conjunction of Bell and non-Bell equipment. Thus, use of competing answering machines, modems and telephones was barred if it involved interaction with Bell facilities. In the mid-1950s, DOJ filed an antitrust lawsuit against AT&T challenging the integrated company’s refusal to allow “private communication” on its network.

Bell’s response was that it was willing to provide such items for its customers. Indeed it was – at a price. Bell’s AT&T Long Lines company also provided long-distance service – at high rates that subsidized the system’s artificially low residential customer rates. It provided data transmission service to business – at prices so high that some businesses even incurred the expense of setting up their own two-way private networks between key locations. The issue wasn’t so much provision of service as its terms.

The Paradox of Natural Monopoly Regulation

The idea behind natural monopoly is that one single firm is the most efficient supplier for the entire market. Even if competition is allowed, the process will inevitably culminate in the victory of a single firm, and that firm will then proceed to establish the price and output of a pure monopolist. Because that price is so much higher and the rate of output so much less than would be “chosen” (in the aggregate) by a competitive industry of firms, government regulation intervenes to seek a preferable compromise. The efficiency of single-firm production is enjoyed, while the price and output outcomes of pure monopoly are moderated – not to the degree attained under competitive conditions, but enough to reward the firm’s owners with only a “normal profit.” That rate of profit is only just sufficient to attract the capital needed by the firm.

This compromise seemed superficially attractive. It avoided the disadvantages of the other popular public-utility model, adopted in Europe and Canada. Equating the public-utility price to its marginal cost would approximate the price and output result under competition. But public utilities often exhibit decreasing average costs of production for technological reasons such as the famous 2/3 Rule. When an average magnitude is falling, that means its corresponding marginal value is less than the average; the marginal is pulling the average down. If price is set equal to marginal cost, it must be less than average cost under decreasing cost conditions of production. When price is less than average cost, the firm is losing money. The European/Canadian model is feasible only when accompanied by large public subsidies to the public-utility firm. Meanwhile, all the same difficulties and expense of conducting rate cases and calculating the utility’s costs are still present.

In actual practice, the case of the Bell system exposed the gaping flaws in the U.S. version of natural monopoly regulation – indeed, in the very concept of natural monopoly itself. If regulation had established a single price for all users, it might have remained viable. But this would have exposed the true costs of providing phone service to the American public. It would have allowed them to judge whether the benefits of having a single integrated firm provide service to everybody were worth the drawbacks of excluding competitors and innovation from the market.

Government was not willing to tell the public the truth when a politically irresistible lie was within their grasp. By setting residential-consumer rates artificially low, it could pose as the public’s benefactor, the savior who rescued them from the clutches of the evil monopoly. Of course, regulators would then have to make good on their promise to the public utility’s owners by making up the lost revenue somewhere else. They did this by allowing the company to charge draconian prices to business and long-distance users. This won the votes of dreamers who liked to fantasize that non-human entities called “businesses” could pay taxes and lift the burden of high prices from ordinary people.

It is true that the public avoided the obvious ill effects of unregulated pure monopoly – a single high price, reduced output and above-normal profits. But all these same effects were realized in hidden form – monopoly prices paid by businesses and long-distance users, reduced output of private communications and goods using telephone services and risk-free profits and lifestyles enjoyed by public-utility owners, managers and employees.

While an unregulated monopolist doesn’t have to worry about regulation, he does have to worry about entry of competing firms. Of course, the theory of natural monopoly claims that firms won’t want to enter once the natural monopoly is attained. But in that case, why did the federal government constantly fend off the advances of firms wanting to compete with AT&T? This highlights the worst aspect of natural monopoly regulation – the strangling of incipient competition in its crib.

And this is where Bernie Strassburg came in.

The Pinprick

The 1956 DOJ lawsuit sought to restructure the Bell system along European lines by forcing divestiture of the Bell Operating Companies (the regional Bells) and equipment divisions (Western Electric and Bell Labs). Bell insisted on maintaining its integrated system. The Eisenhower administration asked the FCC if it could regulate the integrated system.

Speaking in his capacity as head of the Common Carrier Division, Strassburg drafted a memo in which he maintained that the FCC had the authority to regulate the entire Bell system but lacked the resources and expertise to do the job. Strassburg was reflecting on the reality of natural monopoly regulation as we have described it. But his bosses at FCC, thinking only of their own welfare, deleted the second part of his reply and submitted this edited memo to the Administration. Consequently, the Bell system’s position was accepted on the presumption that the federal government’s regulatory authority would suffice to protect the public welfare.

Now Strassburg was in a fix. He had been told to herd an unruly rogue elephant without being given as much as a stick to help with the job. In desperation, he cast about for any means of prodding the beast towards lowering costs (hence, prices) and accepting competition. First, he used the imminence of computer technology as an excuse to force acceptance of private devices as adjuncts to Bell technology. He was aided by the FCC’s decision in the Carterfone case, which forbade Bell’s prohibition of outside equipment on private lines.

Next, Strassburg considered the application of a tiny company with only 100 employees. The company was named MCI. It wanted to lease its microwave-tower facilities stretching from St. Louis to Chicago to private businesses for use in voice and date transmission via radio waves. Companies that could not afford to build their own internal network could lease MCI’s facilities more cheaply than they could purchase Bell’s expensive package of business services.

Microwave technology had been around since World War II. The FCC had already decided in 1959 that the Bell system did not own airwave rights to microwave radio transmissions. The question was: Could MCI meet the government standard of “convenience and necessity” required to get permission to enter the market?

There were countless businesses tired of paying through the nose for AT&T’s business service, even on this one route, so lining up prospective customers to testify in their behalf was easy. But MCI had to show a “need” for their service by proving that they were more efficient than Bell. It wasn’t enough that they could offer their customers a lower price – the government didn’t recognize that as sufficiently valuable to justify allowing competition.

MCI claimed that their microwave technology was more efficient than AT&T’s landline technology. AT&T countered that MCI was simply “skimming the cream” of AT&T’s business customers, who were paying AT&T’s monopoly price, without having to assume the burden of providing residential service to AT&T’s local customers. In a sense, AT&T was right, because the technological differences did not represent large differences in cost. But in the substantive economic sense, MCI was lined up on the side of economic efficiency and consumer welfare. MCI was breaking up the AT&T pattern of cross-subsidy between business and residential consumers, which was creating concealed monopoly inefficiencies and harming consumers on net balance.

Strassburg has no illusions that MCI would be able to compete effectively with powerful AT&T. As Peter Temin noted, all Strassburg wanted was a pin to prick the rogue elephant with, something to wake it up to the changing technological realities of the unfolding new age. So he supported MCI’s petition to operate. AT&T’s appeal was denied.

MCI Unleashed

In 1969, MCI was allowed into the market for microwave voice and date transmission. Its new CEO, venture capitalist William McGowan, didn’t waste a second. He knew that there were dozens of routes whose profit opportunities mimicked those of the St. Louis-Chicago corridor. So he created over 2000 MCI-affiliate companies whose applications flooded the FCC.

Bernie Strassburg abandoned all pretense of considering each individual application. In 1971, the FCC issued a general rulemaking approving microwave facilities that met general criteria for service.

In order to serve hundreds of different customers, MCI couldn’t contemplate building separate connection facilities with each one. Instead, MCI applied to interconnect with Bell’s facilities. By this time, AT&T could see the handwriting on the wall and knew that MCI was a genuine competitive threat. It refused MCI’s interconnection requests. MCI filed an antitrust action against AT&T in 1974 alongside the DOJ’s celebrated suit.

Also in 1974, MCI offered its own package of switched long-distance service. This marked a competitive milestone. In five years, MCI had gone from a piddling 100-employee firm with no revenue and one private-service route to a full-fledged competitor of the mighty AT&T.

This was too much even for the FCC, which opposed MCI’s petition to offer long-distance service. But the genie was out of the bottle now. Bernie Strassburg has unleashed the forces of competition and nothing could pen them back up again. By 1981, AT&T had to give up ownership of the Bell Operating Companies in exchange for the right to retain vertical integrated status. The Bell System as such was gone. The monopoly was broken.

During its corporate career, MCI developed important innovations. The company applied for the first common-carrier satellite license when the White House OTP’s “Open Skies” policy went into effect. It was the first telecommunications firm to install single-mode fiber-optic cable, which is the industry standard today. In the early 1980s, MCI developed an early version of electronic mail. And in the mid-80s, MCI worked with several universities to establish high-speed telecommunications links between their computer systems – a forerunner of the Internet.

The Rest of the Story

Bernie Strassburg’s story complements that of Tom Whitehead. The birth of our modern telecommunications marketplace was a miracle. Tom Whitehead intended the substitution of competition for monopoly but it was miraculous that he ever ascended to a position of sufficient power to effect it. Bernie Strassburg intended no such outcome as the birth of competitive telecommunications; all he ever wanted was to get more regulatory leverage over the Bell System. He never questioned the bona fides of the natural monopoly argument nor did he hope that MCI would ever compete successfully with AT&T.

The fact we needed a miracle to give us the manifest blessings of cell phones, digital technology, I phones, smart phones, cable telephony and streaming Internet is profoundly disturbing. In a competitive environment, the fact that any particular firm succeeds as Microsoft or Apple has may be amazing but the fact that some firm does is no miracle at all; it is what we justifiably expect. But regulation gave us plodding, inefficient, complacent monopoly for decades; the fact that competition eventually triumphed over it was a miraculous accident.

Nor did it have to happen this way. The well-known industrial organization economist Harold Demsetz pointed out some four decades ago that regulated monopoly is not natural, necessary or inevitable. Even if there is no competition in the market, firms can still compete for the market. That is, we could have put up the right to operate as a monopolist in a public-utility market for competitive bids. In effect, firms could bid by committing to the price and quantity targets they would subsequently meet, with the best bid winning the contract. In this way, the bidding process itself would be the check on monopoly power. If there were enough bidders, we would expect the outcome to approximate that of a competitive process.

In his book Capitalism and Freedom, Milton Friedman pondered the possibilities under so-called “natural monopoly” conditions. He concluded that unregulated monopoly is preferable to regulated monopoly. The history of public-utility regulation vindicates Friedman’s position. The defects of hidden monopoly under regulation outweigh those of straightforward monopoly.

Today, the concept of natural monopoly is laughable when applied to the telecommunications marketplace because technological innovation proceeds so quickly that it offsets any temporary effects of monopoly power. Today’s “monopolist” is tomorrow’s has-been; a downward-sloping cost curve cannot compete with a downward-shifting cost curve.

Instead of relying on regulation to produce these miracles, it is long past time to reform it or eliminate it altogether.

DRI-293 for week of 2-17-13: The Man Who Created Today’s Telecommunications Marketplace

An Access Advertising EconBrief:

The Man Who Created Today’s Telecommunications Marketplace

Today we live in a world enveloped by telecommunications. I-phones and Smart-phones provide not only voice communications but data and Internet transmission as well. Cell phones are ubiquitous. Television stations number in the hundreds; their signals are received by consumers in direct broadcast, cable and satellite transmission form. Both radio and TV broadcasts can be streamed over the Internet. The Internet itself is accessible not only using a desktop computer but also via laptops, Wi-Fi and mobile devices.

For anyone below the age of forty, it strains the imagination to envision a world without this all-encompassing marketplace. Yet older inhabitants of the planet can recall a starkly primitive telecommunications habitat. In the United States – the most technologically advanced nation on Earth – there was one telephone company for almost all residents in 1970. There was one satellite transmission provider. In the wildly competitive corner of telecommunications – broadcast television – there were three fiercely competing networks.

How did we get from there to here in forty short years? And can we entertain an alternate scenario in which we might not have made the journey at all? The answers to these questions are chilling, for they open up the possibility that were it not for the efforts of one man, the great revolution in telecommunications might not have happened.

The man who created the telecommunications marketplace of today was Clay “Tom” Whitehead. The unfamiliarity of that name is an index of why we should study the unfolding of competition in the market for telecommunications. Before we introduce the leading character in that drama, we first set the scene by describing the terrain of the market in 1970 – and what shaped it.

The Economic Doctrine of Natural Monopoly

In 1970, American Telephone and Telegraph – the corporate descendant of the Bell Telephone Company founded by Alexander Graham Bell – was the monopoly telephone service provider for virtually all of America. The rationale for this arrangement was provided by the doctrine of natural monopoly.

A natural monopoly was said to exist when a single firm was the most efficient supplier for the entire market. This was caused by the unique cost structure of that market, in which the average cost of production decreased as output increased. It is vital to visualize this as a static condition, not a dynamic one; it is not dependent on a succession of technological innovations of the sort for which Bell’s scientists were renowned. If Bell Labs had never developed a single invention, in other words, the company’s status as a natural monopoly would not have changed.

If decreasing average cost was not due to innovation, what did cause it? The most plausible explanation came from engineering. The 2/3 Rule related the productivity of transmission through a pipe or transportation via a container to its cost. But since its cost increased as the square of surface area while its productivity or throughput increased as the cube of its volume, the average cost or ratio of total cost to total output continually fell as output increased because productivity (in the denominator) increased faster than cost (in the numerator).

Continually falling average cost meant that one firm could constantly lower its price while producing ever more output, while still covering all its costs. This would enable it to underprice and force out any and all competitors. Since monopoly was the eventual fate of the industry anyway, better to relax and enjoy it by declaring a monopolist while striving to mitigate the monopoly outcome.

In America, the mitigation was accomplished by profit regulation. The natural monopoly firm was allowed to earn a “normal” rate of return, sufficient to attract capital to the industry, but no higher. That normal rate of profit was identified by the public utility commission (PUC) based on hearings at which the company, regulators and various interest groups (notably regulators supposedly representing consumers) testified.

When outlined in textbooks and classrooms, this concept sounded surprisingly reasonable. When put into practice, though, it was a mess.

Perhaps the worst feature of PUC-regulation of so-called natural monopoly was the increasing chumminess between commissions and the monopoly firms they oversaw. This sounds like an accusation of collusion, but in reality is was the inevitable by-product of the system. Commissions lacked the technical expertise to regulate a high-tech business. While they possessed both the right and the ability to hire consultants to advise them, trouble and expense relegated this to rate-case hearings at which the profits and rates charged by the company were reviewed. On a day-to-day basis, the commission was forced to cooperate with and rely on the company’s employees to guarantee that the utility’s customers were served.

After all, the firm was a genuine, honest-to-goodness monopoly – not a phony, pseudo-monopoly like the oil companies, which faced scads of competition and any one of whose customers had lots of competitive alternatives to turn to. The oil companies were monopolies only for purposes of political theater, when politicians needed a scapegoat for their foolish energy policies. But if a public utility were threatened with insolvency or operational failure, then the lights might go out or the phones go dead for an entire city, metro area or region. So the PUC was regulating and utility and protecting it at the same time.

Regulation was probably an impossible task anyway, but this ambiguity made things hopeless. The result was that PUCs erred on the side of excessive rates of return and compliance with company wishes. Since high profits were out of the question anyway, public-utility executives took their “excess profits” in the form of perquisites and a quiet life, free from the stresses and strains of ordinary business. Public utilities became noted for lavish facilities, huge administrative budgets and large staffs – in the vernacular of the industry, this was called “gold-plating the rate base.” (The rate base was the agreed-upon list of expenses and investment the company was allowed to recover in rates charged to customers and upon which its rate of return was earned.)

Ordinary businesses feel constant pressure to hold down costs in order to maximize profit; cost-minimization is what helps insure that scarce economic resources are used efficiently to produce output. But public utilities were assured of their profit and coddled by regulators; thus, they faced no pressure to reduce costs or innovate. Indeed, the reverse was true – a cost innovation would theoretically call for new rate hearings to reduce the utility’s rates, since otherwise it would exceed its regulatory allowance of profit. Economists were so fed up with the sluggish pace of technological progress among public utilities in general, and the Bell system in particular, that most viewed the phenomenon of “regulatory lag” as a good thing. It was worth it, they reasoned, for the utility’s profits to exceed its limit in the short run as an inducement to effect cost reductions that would achieve long-run efficiency.

It would seem that PUCs would have faced public criticism for failure to hold down public-utility profits, since that was their primary raison d’être. Commissions sought to inoculate themselves from this criticism by a policy of offering artificially low prices to residential customers of public utilities. Since they had to raise enough total revenue to meet all utility costs plus an allowance for a fat profit, this subsidy to residential customers had to be recouped somewhere. In practice, it was regained by socking business users with onerous rates. The Bell phone companies, for example, charged notoriously high rates to business users of telephone service.

Commissions trotted out a legal rationale for this policy of price discrimination in favor of residential users and against business users. The policy furthered the goal of universal service, claimed commissioners proudly. Because public-utility products were goods like telephone service, electric power and gas service, commissions could plausibly depict them as necessary to public health and safety. Consequently, they justified subsidies to residential users by maintaining the necessity of assuring service to all, regardless of income, on the basis of need.

Of course, the economic logic behind the policy of universal service was non-existent. High rates levied on businesses were not paid by non-human entities called “businesses.” No business ever paid anything in the true economic sense because payment implies a sacrifice of alternative consumption and the utility or happiness delivered by it. Since a business cannot experience happiness – or lose it – a business cannot pay for anything. Those high business rates for phone service, for example, were paid in the long run by consumers of the business’s output in the form of higher prices and by suppliers of inputs to the business in the form of lower remuneration. But to the extent that the public were deceived by the rhetoric of the commission, they may have approved the wasteful doctrine of universal service. This is ironic, for the Bell system never succeeded in increasing the percentage of household subscriptions to phone service to the level of the percentage of households owning a television set. So much for the absolute necessity of telephone ownership!

Meanwhile, public utilities became public menaces when they spotted businesses threatening their turf. Cellular telephone technology was technically feasible as long ago as 1946 (!), but the Bell companies weren’t interested in developing it because they already had a highly profitable and completely secure fiefdom based on landline technology. And they weren’t about to stand idly by while other businesses moved in on their markets! Consequently, applicants for licenses to operate mobile phone businesses were either denied or hamstrung by red tape.

In 1956, the Justice Department was sufficiently fed up with Bell’s antics to launch an antitrust suit against the Bell system. In a sense, this was inherently contradictory since government had granted the monopolies under which the Bell companies operated. But Justice accurately realized that something had to be done to break up the cozy arrangement between Bell and the state and local politicians whose regulation was in fact serving as the barrier to competition in products ancillary to Bell’s landline phone service. It is one measure of the political influence wielded by the Bell empire that this lawsuit proved abortive and was dropped without result.

Another indicator of Bell’s power was the fact that the Bell companies annually issued more debt than did the federal government itself. When the federal antitrust action was revived in 1974, then-Secretary of State George Schultz (formerly a well-known labor economist at the free-market oriented University of Chicago) reminded prosecutors of this fact and advised that the antitrust suit be quashed for fear of “roiling the bond markets” prior to an upcoming bond issue by the U.S. Treasury. This advisory outraged a relatively obscure White House official at the Office of Technology Policy.

Tom Whitehead and the “Open Skies” Policy

In 1970, Clay T. “Tom” Whitehead was a young (32) graduate engineer whose life had taken a detour when he was introduced to economics. He followed up his Master’s in electrical engineering at MIT with a PhD in economics there, studying under noted scholar, theorist and consultant Paul MacEvoy. When the Nixon administration inaugurated the position of White House Office of Telecommunications Policy, Whitehead’s academic credentials and connection to MacEvoy earned him the post of Director. President Nixon viewed the subject of economics with ill-concealed disdain; his aides envisioned the job as a way of grabbing countervailing policymaking power away from the permanent regulatory bureaucracy that controlled the federal government and was dominated by Democrat appointees. Little did they know what kind of policymaker they were getting.

The moon landing in 1969 had achieved the objective of NASA’s space program, which was left with no immediate goal in sight. The Vietnam War had become a fiscal burden as well as a political one, and there was talk of enlisting the private sector to carry some of the financial freight by sponsoring a communications satellite. Up to that point, the satellite program (COMSAT) had been a de facto joint creature of the federal government and AT&T. NASA produced the satellites, the best-known being Telstar. AT&T owned a plurality of the stock shares and seats on the board of directors.

The chairman of the Federal Communications Commission (FCC), a Republican, drafted a proposal for a fully privatized company. It was to be a joint monopoly to be shared by NBC, ABC, CBS, RCA, GTE (a Bell company) and AT&T. The presumption was that satellite communications was a natural monopoly like all other forms of communications – television and radio networks, telephone and telegraph. There was no point in promoting a competitive process that was bound to culminate in a monopoly.

Tom Whitehead begged to differ. He put forward a radically different proposal called the “Open Skies” policy. There was plenty of room in space for many satellites owned by many different private companies, each serving their own interests and customers. There was plenty of bandwidth available for satellites utilize in receiving signals and transmitting them back to Earth. All that was necessary was to adjust orbits and frequencies to preclude collisions and confusion – something that all parties had an interest in doing.

Practically everybody thought Whitehead was crazy. The ones who didn’t doubt him feared him because he threatened their economic or political predominance. But he had the backing of the White House, not for ideological reasons but because he opposed the Establishment, which hated Richard Nixon. And he won his point.

One by one, private firms began sending up communications satellites into space. First came Western Union in 1974. Then came RCA in 1975, followed by Hughes and GTE. The first half-dozen were the pioneers. Eventually, the trickle became a deluge. And the modern age of telecommunications was born.

Privatization of satellite communications also stimulated competition in, and with, cable television. Cable TV had previously been strictly a local phenomenon, tied to AT&T by the need to lease coaxial cable facilities and rights of way. Whitehead approved FCC 1972 policy proposing to loosen federal regulations on cable. In 1974, he chaired a committee whose report advocated federal deregulation of cable. This freed the industry to lease and own satellites and take its product national. Satellite communications allowed competing cable providers uplink popular local and regional stations’ programming to satellite for national distribution. Later, satellite TV emerged as a leading competitor to cable TV, providing more channels, better reception and fewer problems.

More recently, satellite radio and TV have developed their own competitive niches. Satellites have become the transmission media of choice for telecommunications, establishing a transmission position of advantage from which signals could be sent throughout the planet. This revolution was the brainchild of Tom Whitehead.

Tom Whitehead and the Breakup of AT&T

Tom Whitehead did not initiate the antitrust suit against AT&T, nor was he directly involved in prosecuting it. But he was a powerful influence behind it nonetheless.

His staff at OTP had independently reached the conclusion that the political power and economic inertia of the Bell system formed an insuperable obstacle to competition in telecommunications. When he urged them to approach the Department of Justice about reactivating its 1956 suit against Bell, they learned that DOJ was moving in that direction already.

Had the White House opposed this initiative, it would have stalled out like its predecessor. The Department of Defense claimed that the lawsuit was a threat to national security because the Bell system was a vital cog in the national defense. (Among other things, AT&T worked closely with DOD, the Pentagon and the FBI on civil defense, counter-espionage and domestic military exercises.) As noted above, AT&T even wielded financial clout in government circles because its capital-intensive production methods made it even more heavily reliant on debt finance than the federal government itself.

But Whitehead was adamantly in favor of the action. The American public complained about the absurdity of fixing a phone system that wasn’t broke and compared the suit to a parallel action against IBM. In fact, the two had nothing in common, since IBM wasn’t a monopoly while AT&T was a monopoly in the old-time, classical sense – it was not only a single seller of a good with no close substitutes, but entry into its market was legally barred by the government itself.

The regional Bell companies resisted the breakup tenaciously and still to this day continue to fight harder against competition than they do commercially against their competitive rivals. After all, they were created as creatures of regulation, not competition, and don’t really know how to behave in a competitive market.

The result speaks for itself. Today, Americans have decisively rejected landline telephone service and embraced the new world of wireless and digitized telecommunications. They can obtain phone service via cell phones or more sophisticated mobile devices that perform multiple functions. They can combine phone service with data processing functions over the Internet. The last vestiges of the old monopoly remain standing alongside the dying Post Office in the form of mandatory service provided to remote and rural areas. Today, even the staunchest defenders of regulation and the old status quo cannot deny that Whitehead was the visionary and that they were the reactionaries.

Whitehead’s Subsequent Career

After leaving OTP in 1974, Tom Whitehead went first to a subdivision of Hughes Communications, where he started a private cable division. He thus became instrumental in what later became the development of satellite TV. Then he fomented his next revolution by moving to Luxembourg (!), where he started SES Astra, a satellite company that pioneering private television broadcasting in Europe. Before Whitehead, Europe had no private television broadcasters; they were all state-owned.

Luxembourg was chosen because its miniscule size allowed Whitehead and company to chainsaw their way through its government bureaucracy relatively quickly. The nature of their opposition can be gauged by the fact that they faced their first lawsuit within 20 minutes of receiving their incorporation papers. Today, the company Whitehead founded is the world’s second-largest satellite provider, riding herd on more than 50 satellites that serve over 120 million customers.

After retiring, Whitehead taught at GeorgeMasonUniversity where he hosted the world’s leading figures in telecommunications at his seminar. He died in 2008. This year, the Library of Congress received his papers. The American Enterprise Institute commemorated the occasion by organizing a symposium of his friends and co-workers to highlight his role in shaping the world we inhabit.

The Economic Significance of Tom Whitehead

Tom Whitehead’s life starkly defines the importance of individuals to history and human welfare. Only a tiny handful of other human beings on the planet might have occupied his position and achieved the outcomes he did. And without those outcomes, the world would be a vastly different – and far worse – place.

Tom Whitehead was fought tooth and claw by the forces of government regulation. (The historical chain of coincidence that lined up DOJ against AT&T will be the subject of a future EconBrief.) This illustrates the fact that government regulation of business is not a useful supplement to marketplace competition, but rather an inferior substitute for it. The purported aims of regulators are in fact precisely the outcomes toward which competitive markets gravitate. If regulators knew better than businesspeople and consumers how to produce, sell and select appropriate numbers and kinds of goods and services, they would work in the private sector rather than in government. Their position in government places them poorly to run companies or industries, or to impose their will on consumers. In this case, if regulators had their way, we would still occupy the telecommunications equivalent of the Stone Age.

Whitehead’s life illustrated the difference between technological progress and economic progress. Communications satellites became technically possible in the late 1950s; cell phones in the mid-1940s; cable TV in the 1930s. But these did not become economically feasible until the 1970s. And economic feasibility, not technical or engineering feasibility, determines value to humanity.

Economic feasibility requires demand – a use must be found that delivers value to consumers. It requires supply – the technically-feasible product or process must be produced and sold at a sacrifice of alternative output that consumers can accept. Last, but not to be overlooked, the technically feasible product or process must be politically tolerated. Incredible as it might seem, this last hurdle is often the highest.

Tom Whitehead played a direct role in meeting two of these requirements for telecommunications and indirectly allowed the third to be met. He created the telecommunications market we enjoy today as surely as did Edison, Tesla and the technological pioneers of the past.

His name should not languish in obscurity.

DRI-259 for week of 2-10-13: Coverage of President Obama’s SOTU Minimum-Wage Proposal

An Access Advertising EconBrief:

Coverage of President Obama’s SOTU Minimum-Wage Proposal

As advertised, President Barack Obama’s 2013 State of the Union (SOTU) address outlined the economic agenda for his second term in office. Among its planks was a proposal to raise the minimum wage to $9.00 an hour from its current $7.25. The reputation of economics as “the dismal science” is vindicated by the coverage of this proposal in the news media, which is indeed nothing short of dismal.

The Wall Street Journal‘s Coverage of Obama’s Minimum-Wage Proposal

The Wall Street Journal is the leading financial publication in America – indeed, in the world. On page four of its morning-after coverage of Obama’s SOTU message, the Journal provided a five-column box headlined “Bid on Minimum Wage Revives Issue That Has Divided Economists,” written by reporters Damian Palette and Jon Hilsenrath. The pair predicts that “President Obama’s proposal… is likely to rekindle debates over whether the measure helps or hurts low-income workers.” And the debates will be between “White House officials” who “say the move …is aimed at addressing poverty and helping low-income Americans” and “Republicans and business groups, which have traditionally said raising the minimum wage discourages companies from hiring low-skilled workers.”

The article rehearses the specifics of the President’s proposal, which raise the minimum wage in stages to $9.00 per hour by 2015, after which it would be indexed to the rate of inflation. It reminds readers that Mr. Obama originally proposed to raise the minimum to $9.50 by 2011. It reports confident projections by “Administration officials” that at least 15 million Americans would directly benefit from the increase by 2015, not counting those now earning above the minimum whose wages would be driven higher by the measure.

Three paragraphs in the middle of the piece gloss over the views of “economists and politicians [who] are divided over the issue.” These consist of two economists, one proponent and one opponent, and one central banker. David Neumark of the University of California Irvine unequivocally maintains that “the effects of the minimum wage are declines in employment for the very least skilled workers,” while “a lot of the benefits …leak out to families way above the poverty line.” Alan Krueger from PrincetonUniversity, currently Chairman of the President’s Council of Economic Advisors, “found positive effects” from the minimum wage on fast-food workers in New Jersey. The authors do not remark the apparent coincidence that Neumark and Krueger studied precisely the same group of workers in reaching their conclusions. Janet Yellen, Vice-Chairman of the Federal Reserve, was quoted as refusing to endorse the minimum-wage increase on grounds of its irrelevance to current conditions, while admitting its adverse effects would probably be small.

The authors close out by summarizing the political strategies of the White House and Republicans in proposing and opposing the measure. The authors toss in a few numbers of general economic significance – surging stock market, recent increase in hiring, persistently slow economic growth, nagging high unemployment, decline in median real income since 2000. They cite the most recent minimum-wage increase in 2009 and note that 19 states already have statewide minima in excess of the current federal minimum.

The reader will notice that the Journal‘s headline refers to a revival of a debate between economists. Yet the article only cites two economists and the debate consists of approximately five lines out of five columns of prose – just over 4% of the article’s 120 lines. A reader who isn’t already thoroughly familiar with the issue will learn virtually nothing at all about why the minimum wage is bad or – for that matter – why its proponents think it is good. The closest thing to analysis are cryptic references to “discourages companies from hiring,” “declines in employment” and – most mysterious of all – “benefits” that “leak out to families way above the poverty line.”

Between 90% and 95% of the article is devoted to politics. And that is utterly superficial. The world’s leading financial publication has devoted substantial space to a Presidential proposal of economic significance, yet its readers would never suspect that the subject is one of the most highly research, well-considered and settled in all of economics. The minimum wage has been a staple application in microeconomics textbooks for over a half-century. Along with policy measures like free international trade and rent control, the minimum wage has generated the most lopsided responses in opinion surveys taken of economists. In percentages ranging from 75% to 90%, economists have resoundingly affirmed their belief that minimum wages promote higher unemployment among low-skilled workers – among their many undesirable effects.

Yet today Wall Street Journal reporters imply that it’s a 50-50 proposition. Or rather, they imply that economists are evenly divided on the merits of the measure. The article mentions a revival of a debate without explaining the terms of the debate or its previous resolution. Indeed, even the arguments of the proponent economist – the Chairman of the CEA, no less! – go unmentioned.

Something more than mere journalistic incompetence is on display here. The WSJ reporters are showing contempt for the discipline of economics. The only significant thing about economists, they imply, is that they are “divided.” The economics itself is hardly worth our attention.

Economists have only themselves to blame for their low repute. But readers deserve a truthful and complete understanding of the minimum wage.

The Minimum Wage As Seen by Economics – and Economists

The minimum wage is a species of the economic genus known as the “minimum price.” Other species include agricultural price supports, imposed for the ostensible purpose of increasing the incomes of family farmers. The idea behind all minimum prices is to make the price of something higher than it would otherwise be. The alternative embodies in “otherwise” is to allow the price of human labor to find its own level in a free labor market. That level is the point at which the amount of labor workers wish to supply is equal to the amount that businesses want to hire. Economists call the wage that equalizes the quantity of labor supplied with the quantity demanded the equilibrium wage.

In practice, the minimum wage is always legislatively pegged at a higher level than the current equilibrium wage. Otherwise there would be no point to it. And in practice, the minimum wage applies only to low-skilled labor. This is because wages reflect the value of labor’s productivity and low-skilled labor is the least productive kind. What is the effect of a higher-than-equilibrium wage for low-skilled labor?

Holding the price of anything above its equilibrium level produces a surplus of that thing. A surplus of human labor is called “unemployment” in layman’s terms. Thus, a minimum wage produces unemployment where there would otherwise be no (persistent) unemployment.

If this sounds pretty categorical, cut-and-dried and matter-of-fact, that’s because it is. Supply and demand are economics. More precisely, they are what we today label “microeconomics.” Since there is no macroeconomic theory left standing that is worthy of the name, that leaves us with supply and demand and very little else.

The federal minimum wage was first introduced in the Fair Labor Standards Act of 1938. It first began attracting attention from academic economists after World War II when George Stigler wrote a celebrated article outlining its basic effects in 1946. The first edition of Stigler’s legendary textbook on microeconomic price theory appeared in 1949. This may have been the debut of the minimum wage as a textbook application – a way of illustrating what happens when the principles of supply and demand are flouted by government.

Stigler may have been the first future Nobel Laureate to oppose the minimum wage, but he headed up what became a long procession with few absentees. Since then, it has been rare to find an intermediate (junior-senior level) micro textbook that didn’t feature an analysis of the minimum wage and the effects of the labor surplus it causes. This practice has crossed political lines. Liberal economists write textbooks, too, but they were pitiless in their view of the minimum wage – at least until recently, anyway. Alan Blinder, former CEA member under President Bill Clinton, was embarrassed by the revelation that his political support for a minimum wage conflicted with his textbook’s unsparing criticism of it.

The Effects of a Minimum Wage

The effects of a minimum wage are those of a minimum price generally, translated into the specific context of the market for low-skilled labor. The overarching effect, whose implications far exceed the obvious, is the surplus of labor created. The resulting unemployment, in and of itself, confounds the expectations of minimum-wage proponents. Their stated purpose is to increase the monetary incomes, hence real incomes, hence well-being of low-income workers. But you can only benefit from a higher wage if you have a job from which to earn that wage. The low-skilled workers whose jobs are lost because of the minimum wage are harmed by it, not helped. Moreover, they have nowhere to go except the unemployment line. Ordinarily, people who lose their job look for another job. But low-skilled workers are already scraping the bottom of the barrel – when that residue is suddenly denied them, they’re out of luck.

But what about the people who don’t lose their job? They benefit, don’t they? True enough, at least as a first approximation. The minimum wage should be viewed as transferring income from some low-skilled workers to other low-skilled workers. It is tempting to say it transfers income from some poor workers to other poor workers, but this is not always true. Sometimes it transfer income from poor people to rich people or, more precisely, to the offspring of rich people. That outcome will be explained below.

Wait a minute – what about employers? To hear the left wing talk, the problems of the poor are mostly the fault of greedy bosses who refuse to pay the poor what they’re worth. (The ever-popular formulation is that employers owe their workers a “living wage.”) At least the minimum wage sticks it to those greedy bastards, doesn’t it?

The answer is: Yes and no, but mostly no. In the short run, owners of businesses share the cost of the minimum wage with workers who are driven out of work. Business owners share that cost because higher wages mean higher costs, and higher costs will reduce revenues and profits and drive marginal businesses out of business. The reduced supply of goods will drive prices to consumers higher.

In the long run, though, the higher price gradually attained by the market in response to the higher costs will restore the business rate of return (i.e., profit) to its “normal” level. So, the remaining businesses in the market do not suffer long-run harm from the minimum wage. In the long run, the burden of the minimum wage is borne by consumers of the products produced using low-skilled labor and by low-skilled workers who remain out of work or whose prospects for work and productivity are permanently reduced by their sojourn into unemployment.

In other words, the minimum wage does not exact class revenge against evil, greedy businessmen. It harms poor, low-skilled workers and consumers – who are mostly ordinary people. Is it any wonder, then, that even liberal economists have traditionally refused to endorse the minimum wage as a means of transferring income to the poor?

Wait – There’s More. A LOT More

If John Paul Jones were an economist, he might interject at this point that we have not yet begun our analytical fight against popular misconceptions about the minimum wage. The artificial surplus created by the minimum wage has even more insidious implications.

In a competitive market, the tendency toward equality between quantity supplied and quantity demanded of the good or service being provided exerts a restraining influence on the actions of buyers and sellers. If you show up to rent an apartment or house and the landlord doesn’t like the color of your skin, he might decide to not to rent to you. But when there are exactly as many buyers as there are apartments and houses on the market, this will cost him money. The economic history of the world – and the history of discrimination in the American South and South Africa, among other places – very strongly confirms that competition and economic incentives are the best means of overcoming racial discrimination.

But when the market is in surplus, the picture changes dramatically. Now the landlord can afford to discriminate among would-be buyers by turning down one he doesn’t particularly like, because he knows that others are out there waiting for his unit.

The logic applies to buyers as well. Under competitive conditions, employers cannot afford to discriminate against workers for any reasons not related to productivity. They know only too well how hard it is to find good help when the market is tight. But when unemployment is high, an employer with a “taste for discrimination” can afford to indulge it. (It is idle to talk about whether that behavior is against the law or not. In practice, the case for discrimination cannot be proved; legal cases are won by imposing heavy costs on defendants until they give up and settle by admitting guilt whether true or not. And the cases are prosecuted in the first place for political or economic reasons, not to achieve justice for defendants.)

One of life’s supreme ironies is that the very people who cry the loudest for an end to racial discrimination and lament the injustice of our racist society are the same people who lobby in favor of the minimum wage. By creating a surplus of low-skilled labor and reducing the effective cost of discrimination to zero, the minimum wage surely makes it easy for employers to exercise whatever racist urges they might feel.

…And More

The minimum wage is anti-black in its effects not only because it promotes discrimination, but also because it places blacks at an objective disadvantage. One thing employers look for is experience. On average, blacks are younger than other ethnic groups and have less experience. Thus, they are less able to cope with the labor surplus created by the minimum wage.

Both minimum and maximum prices bring the issue of product quality to bear on the decisions of businesses. When businesses can’t raise prices due to maximum prices, or price controls, they try to reduce product quality instead. Similarly, when businesses suddenly face an increase in the minimum wage, they look to offset its effects by retaining only their highest-quality low-skilled workers. That is, they retain the best-dressed, most punctual, technologically adept workers rather than the shabbier, less reliable, socially and technically awkward workers. All too often, the workers let go are the ones who need the job the most – namely, low-income blacks picking up the necessary skills to succeed in the working world. Their places are taken by the sons and daughters of the well-to-do, whose cultural and economic advantages gave them an occupational leg up when they entered the labor market. This is what David Neumark meant by benefits leaking out to the well-to-do.

Black (illicit) markets are an inevitable by-product of minimum and maximum prices. In this case, the existence of a labor surplus means that there are people willing to work at a lower wage than the prevailing wage. By offering sub-standard working conditions and employment “off the books,” some employers can induce workers into work that they wouldn’t accept in a competitive labor market. This is still another ill effect of the minimum wage and another way in which low-skilled workers bear its brunt.

The late Milton Friedman was outraged by popular efforts to depict the minimum wage as the salvation of the poor and underprivileged. He called it the most anti-black law on the books.

The Card-Krueger Study

In 1993, two economists made a bid to overturn the decades-old economic consensus against the minimum wage. David Card and Alan Krueger conducted a phone survey of fast-food establishments in New Jersey and Pennsylvania. They chose these two adjoining states because New Jersey had raised its minimum wage prior to the study period, during which Pennsylvania’s law remained unchanged. Their study found that New Jersey’s employment of low-skilled labor increased by 13% relative to Pennsylvania’s. They ascribed this to the fact that the higher wage had certain desirable effects on the labor force.

Both the general public and the economics profession went gaga over this single result. Despite decades of studies and negative results by dozens of distinguished economists, this one study was said to have revolutionized thinking on the minimum wage. In reality, its effects were more political than economic.

An attempt to replicate the study by the National Bureau of Economic Research used payroll records from the businesses surveyed by Card and Krueger rather than relying on the phone surveys. Apparent anomalies had been found in both the New Jersey and Pennsylvania date using the phone surveys, so the payroll records were substituted as a check on the results. Sure enough, recalculation of the results using the payroll records reversed the results of the study – New Jersey employment was now found to have declined by about 4% relative to Pennsylvania’s.

Alan Krueger parlayed the popularity of his study into the Chairmanship of the President’s Council of Economic Advisors. David Card has recently written a book about the subject of the minimum wage. But there is little reason to accept the results of their original study at its face value.

The Political Purpose of the Minimum Wage

Economists have long known that the true purposes of the minimum wage are political rather than economic. Low-skilled labor is a substitute for unionized labor and higher-skilled labor. By making low-skilled labor less attractive to employers, the minimum wage makes union labor more attractive. That is why unions have supported a minimum wage since long before it was actually adopted, both in the U.S. and in places like South Africa.

Unions are one of the strongest and most numerous constituent groups of the Obama administration. That is why the President has now opted to advance this proposal to increase the minimum wage. Yet The Wall Street Journal‘s piece – which purported to describe the economics and politics of the measure – did not breathe a word of this.

Note: The first draft of this post erred by saying that the minimum wage was introduced in the Wagner Act of 1935, rather than the Fair Labor Standards Act of 1938.

DRI-271 for week of 1-13-13: How (Not) to Help Orphans

An Access Advertising EconBrief:

How (Not) to Help Orphans

The current issue of Great Britain’s venerable weekly The Economist contains a revealing anecdote about Vice President Joe Biden – revealing not merely about Biden himself but about economics, politics and their interaction.

The anecdote is recounted by one of the magazine’s American correspondents, whose byline is “Lexington.” The column identifies Biden as chief mediator between the Obama administration and the Republican opposition. Lexington finds Biden suited to that task, citing his 40-year Congressional career mostly spent brokering deals and schmoozing colleagues. It is not Biden’s fault that “America’s problems are larger than the deals that a vice-president can cut.” It seems that, according to Lexington, “small-government conservatives – backed by the Tea Party and allies on the airwaves and online – have raised the political costs of dispensing political pork and favours.”

Since it is not clear why this is a bad thing, it would seem that The Economist’s left-wing bias is showing. This is confirmed when Lexington cites “an old Senate belief cherished by Mr. Biden: that fellow politicians may be wrong but are rarely bad. Mr. Biden likes to recall his shock as an angry young senator on learning that a seemingly heartless Republican foe of disability rights, Jessie Helms, had adopted a disabled orphan.” Lexington’s point is that this experience chastened Biden and made him tolerant of Republicans, willing to oppose their policies but not to question their motives.

Lexington is wrong on both counts. Biden is bigoted, not tolerant. The episode reveals his intolerance of the right wing. But that is the least of its importance.

Helping the Disabled

Even as the current Economist was hitting the newsstands, the tolerant, conciliatory Mr. Biden was floating proposals for his boss to suspend the Second Amendment rights of Americans via executive order. In so doing, Biden was displaying the same callous insensitivity he displayed toward Jesse Helms in assuming that Helms’ opposition to federal disability “rights” legislation reflected a persona animus toward the disabled as a class.

Today, thanks to research by Arthur Brooks of the American Enterprise Institute, we know that right-wingers like Jesse Helms provide the bulk of charitable assistance in America. Left-wingers tend to consider their tax payments as their contribution to charity. We also know that federal-government welfare programs have become a monstrosity, mushrooming in number and size while failing to make a dent in the problems they were ostensibly intended to solve. The latter conclusion is now shared by many on the left as well as practically everybody else.

The notion that opposition to big-government is “heartless” implies that compassion is expressed impersonally, indirectly and ruthlessly by taking money from some people and giving it to others, rather than personally and directly by immediately benefitting those who need help. This not only prejudges the motives of the opponent, it takes for granted both the good will and the efficiency of the government. In other words, it was not only bigoted but dumb.

Biden’s opposition to Helms was simply the reflexive action of a man not given to reflective thought. His numerous verbal gaffes committed while Vice President reinforce this interpretation. Biden’s status as the Obama administration’s designated dealmaker does not bespeak any innate sense of empathy for his opposite numbers across the aisle, any more than a used-car dealer need feel kinship with his customers.

Jesse Helms vs. Joe Biden

Lexington’s anecdote has much more revealing economic implications. Contrast the two types of problem-solving approach illustrated. On the one hand, there is the “Jesse Helms” approach. Orphans are in trouble. They need help. Helms sees them. He responds immediately and directly – by helping orphans.

Now compare this with the “Joe Biden” approach. He sees orphans in trouble. He responds by – well, he “responds” by setting in motion a lengthy, ponderous, indirect process that just may, if all goes well, after many months or even several years elapse, succeed in helping some orphans, to some vague and indeterminate degree.

Is this comparison unduly pejorative? Does it prejudice the case against the Biden approach? No, this would seem to be a pretty dispassionate summation of the history of federal-government welfare programs over the last five decades, when balanced against the efforts of the private sector. The Congressional legislative process is indeed protracted, beginning with bill introduction, committee study and submission to the full chamber, followed by reconciliation and eventual passage by both houses. This alone often takes up the better part of one legislative session. Sometimes bills are held over into the next session; sometimes they linger on for years.

When the aid-to-orphans bill passes, does that mean the problem is solved? Certainly not. It means that government machinery is formally set up. It may take months or even years for the resulting program to become operational. After it does, the program may operate indirectly through pre-existing state and/or local programs. The federal program may generate related programs, exhibiting a form of political cellular mitosis.

The programs themselves are intended to help orphans, but they do not provide the form of direct help that Jesse Helms provided. That is, they do not take in orphans and provide them with those things the lack of which makes them orphans in the first place; namely, a loving, caring, compassionate home and family. They may provide institutional shelter in the form of a state-run home. They may provide real income, mostly in the form of in-kind assistance. This second-best form of care will be dispensed by bureaucrats and tied to all kinds of strings and rules. These rules are ostensibly designed to insure that the taxpayer funds bankrolling the program are wisely spent. But the result of this bureaucracy is invariably a system that works poorly and is disliked by the social workers who administer it, the recipients of its largesse and the taxpayers who fund it.

Ah, but surely private charity comes with its own constraints, its own delays, its own bureaucratic drawbacks and roadblocks? For example, Jesse Helms almost surely had to undergo a suitability test in order to adopt; running that gauntlet took time and effort. True enough, but the example of Father Flanagan and Boys’ Town in Omaha, Nebraska shines a glaring light of contrast on the difference between government welfare and private charity. Starting with nothing but a handful of homeless and impoverished boys and his own determination, Father Flanagan built Boys’ Town into a self-sufficient city of self-governing boys that has attracted orphans like a magnet for nearly a century.

It is true that the sunk costs of enabling legislation and setting up programs have already been expended; the welfare system is already in place. But instead of time take to pass new laws, we have to factor in time and expense of re-authorizing and financing programs already in place. Indeed, the crisis posed by public debt alone is reason enough to abandon the fiction of the “compassionate” Biden and the “heartless” Helms. It is not only that the Helms approach works and the Biden approach fails. The Biden approach is drowning representative government in a sea of debt throughout the world.

Roundabout Production

Even if we stipulate that the “Biden approach” has failed dismally in this particular case, can we say that this is a general result? That is, should we apply this lesson not merely to welfare programs but in all situations involving private vs. public assistance? And does it have even broader applicability?

“Helms vs. Biden” illustrates a lesson in the economic theory of production. To drive home the lesson in general terms, consider the example of fishing – a productive activity man has undertaken throughout recorded history. The most primitive production process is also the most direct: wading into the water and catching fish with bare hands. This requires skill and patience as well as access to shallow water holding fish.

A somewhat more productive process involves building a net, which improves the catch-per-unit-of-time. The first net builders had to take time off from fishing or hunting, which required them to build up a store of food to support themselves while net building. In turn, this required reducing their food intake for awhile prior to the investment period. This was an early historical example of the economic process of saving (dietary stricture and food stockpiling) and investment (net building).

More productive still is to construct rod and line to supplement the net. Yet more productive is to build a boat to enlarge the geographic range of fishing. These broaden the time frame of the production process considerably since they require much more time spent on investment and fishing itself. But the huge improvement in physical productivity in terms of potential catch makes the time spent worthwhile.

In the last half-century, fishing has become a production activity analogous to farming. Businesses have purchased infant fish and/or breeding stock and ponds, lakes or defined oceanic territory in which to raise colonies of fish for commercial harvesting. Obviously, this is the most protracted and costly of all fishing production processes, as well as potentially the most productive and lucrative.

The economic term of art that describes this continuum of production processes is “roundaboutness.” The most direct production processes are those that translate inputs into consumption output the quickest. Successively less direct processes take more and more time and involve more and more steps, but tend to gain more productivity with each increase in time and stages. The great Austrian economist of the late 19th and early 20th century, Eugen von Bohm Bawerk, described this by saying that roundabout production processes tend to be more productive.

Bohm Bawerk also found roundabout processes to be more characteristic of capitalism. Owners of capital (the machines and goods-in-process vital to the productivity of longer processes) can borrow to finance their own investment in these longer processes. They pay workers the discounted value of their marginal product for the work they do and use the premium above the discount to repay the borrowing. Thus, everybody can benefit from the enhanced productivity of roundabout production. Interest rates are reflected in the borrowing and in the discounting process that produces the premium.

Capitalism comes into the discussion because roundaboutness cannot be properly evaluated without the existence of prices and interest rates. It is tempting to view the productivity of roundabout production as an immutable physical law, but sometimes the good being produced is a service that has no physical yield. Now we have no alternative except to evaluate that yield in monetary terms using its price as a multiplicand. Even more compelling is the fact that a larger quantity of physical output in the future is not necessarily preferable to a smaller quantity today; it depends on the time preferences of individuals and their rate of preference for consumption today versus consumption in the future. A sufficiently high rate of preference for consumption today could override the possibility of more output in the future and tip the balance in favor of the simplest and most direct production process rather than a more roundabout one.

Another factor that might argue against roundabout processes is scarcity of inputs used in those processes. Thus, input prices have to figure in the evaluation, too. And interest rates reflect the intensity of consumer time preferences as well as the scarcity of funds made available by savers for investment purposes. Thus, interest rates are key to the calculation of costs and benefits for roundabout processes.

In a pure capitalist economy, roundabout processes are used only when they are profitable. That is the same as saying that they are used only when the value created by their higher productivity exceeds the value lost to their higher investment cost. Thus, under capitalism we are doubly blessed. As consumers, we benefit from the ofttimes greater productivity of roundabout production without having it jammed down our throats when it is not beneficial on net balance. The safety factor is the presence of the profit motive. When roundabout production is too costly, it will be unprofitable and firm owners and managers will veto it.

Government and Roundabout Production

Government is roundabout production to the max. The very existence of the legislative process itself gets government started in a roundabout direction. Stages of production increase every time a new level of bureaucracy is created. The difficulty of interacting with bureaucrats and repeating budget authorization procedures annually maintains and even increases the temporal distance between the consumer and the good or service being provided by government.

Unlike production in a pure capitalist economy, however, government production possesses no inherent internal check on roundabout processes. There is no profit motive; thus, there is no easy way to tell how much recipients like the service being provided. The absence of profit means that there is no check on costs incurred; indeed, the value of government services is traditionally gauged according to the value of the inputs used in providing them! In other words, the more we spend on government, the better off we are supposed to be. The polite way of describing this state of affairs is to say that the incentives are perverse.

Nobody has any reason to spend money carefully since bureaucrats are rewarded by overspending their budgets (with bigger budgets and larger departments) and for increasing the size of their departments (with promotions, larger salaries and more impressive titles). Government employees are the inputs into the roundabout production of government services; those production costs are income to them. Thus, the higher costs soar, the better they like it – no matter how economically inefficient this might be. True, government employees pay taxes, too, but they pay only a tiny fraction of the costs of their services while reaping all the wage, salary and fringe benefits.

To make matters worse, the demand side of the market is least amenable to roundabout production for goods and services provided by government. Welfare payments, disaster relief, military goods and services, “social insurance” and medical care for the aged and impecunious are things typically desired with the highest degree of immediate urgency. That is, they are areas where time preference is presumed to be very high and the wish for current consumption is at its greatest. Thus, even where productivity gains from roundabout production might be available, it is by no means likely that recipients of government aid would consider those gains to be “worth the wait” in the economic sense. Judging from the high level of dissatisfaction commonly expressed with government production, it is probable that neither consumers of government nor taxpayers are getting their money’s worth.

In summary, then, roundabout production has proven to be an economic triumph in free capitalist markets, where it has spurred tremendous improvements in productive techniques and living standards. And it has proven disastrous when used by government to produce goods and services. The difference between the two outcomes is the presence of the profit motive under free markets and its absence in government.

Why Has “Biden” Triumphed Over “Helms”?

Over time, various rationales have been advanced for the “Biden approach” and against the “Helms approach.” Originally, the “Helms approach” was seen as a “do-nothing” approach. The presumption – sometimes tacit, sometimes explicit – was that unless government adopted its roundabout approach, nothing would be done to help the poor, sick, orphaned, old, infirm, stricken, et al. We know now that this is not true and was never true. Even in past centuries, much voluntary effort was expended to help those in need. The reasons why this effort looks skimpy to modern eyes is twofold. First, real incomes in general were much lower and less was available for every purpose – charity included. Second, much activity was carried out informally within the boundaries of the family, neighborhoods and churches, without ever being recorded. Today, the omnipresence and scope of government has diminished the importance of the family and reduced the importance of the voluntary private sector.

The problem with the “do-nothing” presumption is that it contradicts the other premises of the welfare state. Much is made of the fact that we “voluntarily tax ourselves” to enable government to undertake its work. Of course, if this were really true, taxation would be superfluous and wasteful. The purpose of taxation is to coerce the unwilling; they are being taxed, not those who voluntarily surrender their income to the state. If people are unwilling, they presumably have a good reason. Either way, there is no reason to preserve a status quo that has broken down. Let the willing contribute to charities of their choice. This gesture will undoubtedly recruit many who are now unwilling to allow government to waste their money but would willingly give money if allowed to supervise, evaluate and find-tune their contributions.

Of course, somebody must be lobbying strongly in favor of the current system. It is the administrators, managers and employees of the 180 or so federal agencies that make up the welfare system. Welfare started out as an ostensible benefit for the poor but has now become a kind of dole for those who operate the system rather than its supposed beneficiaries. Most of these people earn higher salaries and larger employment benefits than they would otherwise earn in the private sector. Thus, they have a very strong motivation to preserve the status quo even though they are themselves taxpayers.

There is one more group – a small one – whose self-interest is identified strongly with the “Joe Biden approach.” That is the relatively small number of politicians who gain a large number of votes from their staunch of this system. And it is this group whose resistance to change has kept that system in place.

Meanwhile, what of the orphans themselves, disabled or otherwise? In a voluntary society, they could choose where to seek assistance just as the rest of us could choose whether and how to render it. The problem would be getting those who need help together with those willing and able to help. Today, the one thing available to all in profusion is information. It is impossible to believe that the voluntary efforts of a free people would accomplish less than the self-interested efforts of a badly motivated, poorly informed government.

That is the crowning irony of “Biden vs. Helms;” the Helms approach empowers the poor while the Biden approach renders them relatively powerless. The best way to help orphans is to keep government away from them.

DRI-233 for week of 12-9-12: Subsidy Nation

An Access Advertising EconBrief:

Subsidy Nation

Recently, several think tanks such as American Enterprise Institute have quantified the degree of Americans’ dependence on government. Federal-government transfer payments have increased from less than $100 billion dollars in 1960 to well over $2 trillion dollars today. Even in real terms, adjust for inflation, transfer payments per capita have increased sevenfold. In 1983, around 30% of U.S. households contained at least one member receiving a subsidy check from the federal government. Today, the number is close to 50%. The fraction of individuals between ages 18 and 64 who were receiving Social Security disability payments in 1960 was about 0.04%. By 2010, the percentage on disability had risen to about 4.6%. (This coincides with the time period in which government agencies charged with policing workplace safety were created.)

A book by AEI’s Nicholas Eberstadt summarizing our dependence on government summarizing our dependence on government is entitled A Nation of Takers. That conjures up the picture of a government-run gravy train on which an army of citizens queues up to hitch a ride, like hobos gathering just outside town at dusk. Transform that picture into a painting and its title would be: Subsidy Nation.

The Roots of Subsidy Nation

The roots of subsidy nation were planted in the 19th century with Henry Clay’s American System. Clay built a political coalition that offered American businesses protection from foreign competition in the form of tariffs – taxes levied on imported foreign goods. The owners and employees of import-competing domestic businesses gained from these tariffs. Everybody else lost, even allowing for the fact that the taxes were the primary basis for federal-government revenue prior to 1913. The American System died with Clay but the tariffs remain. Their height waxed with the Fordney-McCumber and Smoot-Hawley bills of 1922 and 1930, respectively, and waned with subsequent multilateral bureaucratic efforts to free up international trade through the General Agreement on Trade and Tariffs (GATT). But when the chips were down – e.g., when re-election was at stake – politicians could be relied upon to sacrifice the general interest of consumers and import-dependent producers to the special interests of import-competing producers.

American businessmen learned a valuable lesson from U.S. commercial policy. An ounce of protection purchased from government is worth a pound of competitive zeal. Subsidy Nation was born.

Over the course of American history, its farmers have made us the world’s breadbasket. Along the way, they have had to overcome the twin handicaps of price-inelastic and income-inelastic demand for most of their products. That is, when the prices of food and fiber decline and real incomes rise, people do not increase their purchases proportionally. After all, you can only eat so much or wear so many clothes. And falling prices were the norm throughout the 19th and 20th centuries, thanks to continuous improvements in technology and productivity and the resulting increases in agricultural supply.

But American farmers are tough. They know that when the going gets tough, the tough get going – to the government for handouts. Activist farmers carefully picked out a year when agricultural prices were high, then enshrined that year’s prices as their desideratum. They demanded “parity” – farm prices commensurate with those in the good old days. Eventually, after a few decades of hectoring by populist legislators, the New Deal acquiesced with agricultural subsidies.

Federal-government farm-subsidy programs have used techniques like price supports, which prop up prices artificially high using government purchases, creating huge surpluses and wasteful storage costs – not to mention the waste of resources in producing more agricultural goods that are desired in the first place. Target-price programs at least got rid of the surpluses by allowing market prices to fall until the surpluses were disposed of, while paying farmers a direct subsidy to make up the difference. But farmers were embarrassed at getting welfare checks instead of price-support checks, so taxpayers got stuck with the storage costs after all when target prices got shot down. Acreage allotments paid farmers not to farm part of their land. This produced a crop of undesirable consequences, ranging from overfarming and overfertilization of the smaller allotments to monopoly rents accruing to owners of the subsidized acreage.

The joke turned out to be on farmers in the end. Technology gradually turned agriculture into big business by requiring sizable capital investment for machinery and expertise (both scientific and financial). Large corporations are designed for the express purpose of raising large amounts of capital. Not surprising, agribusiness took over most of agriculture. Subsidy programs rewarded farmers according to output; therefore, most of the farm subsidies went to owners of the large corporations. The political left wing, who had called the loudest for government involvement to protect the small “family farmer,” now screamed bloody murder when the beneficiaries turned out to be Archer Daniels Midland instead of Okies from the Dust Bowl.

Subsidy Nation was up and running.

Social Insecurity

The concept of “social insurance” dates back at least to the 18th century, but it found concrete expression in late 19th century Germany. Chancellor Otto von Bismarck had his hands full coping with the socialist movement that had swept over Europe beginning in 1848. To consolidate his power by appeasing the opposition to his left, he agreed to a system of old-age, sickness and accident benefits, funded and administered by the state. By the 1930s, proponents of Social Security had convenient forgotten its origins and remembered only its intentions; namely, to end poverty and neglect suffered by the elderly.

The Roosevelt Administration sold its proposal to the American public by trading heavily on the word “insurance.” Social Security would take in “contributions” from citizens and “invest” them in “special trust funds” where they would be “pooled” for future need. In other words, it would operate much like private insurance, except it would have no need to earn profits and would consequently behave in a reasonable, compassionate manner toward its “beneficiaries.”

This always was, and remains, pure malarkey. Like all so-called “social insurance” systems of its day and until the last two decades, the U.S. Social Security system began and remains a “pay as you go” system in which current benefits are paid from taxes levied on contemporaneous workers and employers. (In the true economic sense, the full incidence of the tax falls on the worker even though half the tax is nominally paid by the employer; the worker pays the other half in lower wages.) The tax is a regressive tax levied on earnings up to a maximum. Thus, it transfers income not merely from young to old but from poor to rich(er). Total benefits have virtually no connection with amounts paid in. The first Social Security recipient began paying in 1937, receiving in 1939, lived to age 100 in 1974, paid in $24.75 and received $22,888.92. Today, most new recipients will not receive even what they pay in, let alone a reasonable rate of return on their “investment.”

For years, Social Security was pointed out as the crown jewel of the welfare state. The baby boom created huge numbers of payees relative to recipients, masking the inherent unsoundness of the system. Today, the reverse is true. Recent falling birth rates throughout the Western world have combined with increasing life expectancies at age 65 to produce an actuarial nightmare – the unfunded liabilities of social insurance systems are off the charts, dwarfing even those of sovereign debt. Politically powerful senior citizens’ groups like AARP agitate against reforms to the system and demand the return of “their” money, oblivious to the facts that it is long gone and that the trust funds are mere accounting fiction.

When private citizens save for their own retirement, their savings are invested in productive assets. Of course, not every investment is successful, but on net balance, American business is productive. After all, the increase in productivity from year to year is what enables more goods and services to be produced and consumed; that is what has constituted America’s rising standard of living. When government takes our Social Security contributions in lieu of allowing us to save, that money is spent to pay current benefit recipients and the productive investment that would otherwise occur is never made.

With the passage of Social Security, America had crossed an invisible divide. Subsidy Nation had hit the big time.

Welfare – But Whose?

In the mid-1940s, the federal government began subsidizing the lunches of public schoolchildren. The program was originally designed to do two things: help get rid of surplus foodstuffs piled up by federal farm subsidies and improve the nutrition of poor schoolchildren. Over the years, the program grew in size and scope. It expanded to include breakfasts as well as lunches – of course, this required children to arrive at school earlier. Recently, dinners have showed up on the menu. And what started out as a school-lunch program for the poor has now become an all-purpose program of nourishment for public schoolchildren.

As a means of improving welfare, it suffers all the defects of government programs. The program has expanded pari passu with an increase in childhood obesity and incipient diabetes. We now know that government-imposed dietary standards are responsible for some large measure of this; today’s new nutritional learning has stood yesterday’s virtually on its head. The subsidized prices students pay (or not) distort the choices made; encouraging food consumption via artificially low prices is not the way to deal with obesity. The distortion affects the supply side of the market, too, by reducing the incentive to craft desirable menus; yesterday’s wasted rotting food surpluses are today’s uneaten food shoveled down the drain or into trash bins.

Emboldened by its rip-roaring success with school children, the federal government broadened its food-subsidy programs to include poor people generally in the early 1960s. It began issuing stamps for use as vouchers in purchasing food, with each stamp good for a value of food purchases. Again, the program began with limited purposes – to insure a minimum amount of nutrition for citizens with incomes below the poverty line. Again, the program grew like Topsy. Today, some 47.7 million people – nearly 1 out of every 7 Americans – receive food stamps.

Was this stupendous growth owing to the brilliant success of the program? Hardly. The food-stamp program is such a notorious example of government subsidy gone wrong that it is featured in economics textbooks as a case study in what not to do when trying to help people. Over the years, food stamps have usually traded at a discount for cash in the black market – sometimes at rates of 50 cents per dollar of nominal value. The words “waste, fraud and abuse” should appear in dictionaries alongside the entry for “food stamps.”

Both school lunch and food-stamp programs run afoul of the general economic principle that subsidies in cash are generally preferred to subsidies in kind. People can use the cash in any way they prefer but are limited to particular uses for school lunch or food-stamp subsidies. This raises the highly pertinent question: Whose welfare are welfare programs supposed to increase – that of recipients or taxpayers? Given the tremendous waste inherent in both programs, that may seem a dumb question. Yet taxpayers display stubborn resistance to reform of these programs, typically based on the presumption that cash subsidies would be wrongly used by the poor and needy – who, unlike taxpayers, are presumably too stupid to be able to judge their own best interests.

At a moment in history when Western governments are staggering under the burden of overwhelming debt, it seems germane to point out that cash subsidies sufficient to life every man, woman and child in the U.S. above the poverty line would amount to much less money than is currently spent on “welfare” programs of all types. How much less? Over the decades, back-of-the-envelope estimates have ranged anywhere from two to ten times less.

In other words, these subsidies are staggeringly inefficient.

Medicare and Medicaid

In the 1960s, President Lyndon Johnson’s Great Society observed that there was evidently political capital in creating benefits for the elderly. Even more importantly, the fact that these benefits were financed by taxes and cost more than the value they created did not seem to be generally recognized. Nor did it affect their political popularity. Johnson’s advisors rubbed their hands and set to work creating a system of government medical care for the elderly and the indigent.

On the surface, Medicare may seem different than government-owned and operated systems like Great Britain’s National Health Service. The difference derives almost completely from the fact that Medicare is administered by large private contractees, such as Blue Cross and Blue Shield and hospitals. That does make at least one important difference on the supply side of the market – the presence of profit throughout the system means that there is an incentive to make and maintain capital investments in medical technology and pharmaceutical products. In Great Britain, by contrast, the lack of state-of-the-art equipment is a scandal.

But as the consumer experiences them, there is little to choose between the U.S. system and government systems. The overriding similarity is the rule of the third-party payment, in which the consumer chooses treatments but the government/insurance company pays the bills. Thus, the consumer has almost no incentive to economize or choose wisely and resources are wasted hand over fist. Walk into a U.S. emergency room – the context in which high prices would and should place the highest premium on careful choices by consumers – and chances are that hospital staff will refuse to quote a price for any particular service, at most providing a flat rate for provision of service. The consent to treatment form that the patient is obligated to sign is either a blank check written on the insurance company or (for the uninsured) a farewell note to his or her net worth.

Even worse is the effect on the demand for medical care. When somebody else is paying the bill, consumers react as if the price of medical services were zero. Demand zooms into the stratosphere. Proponents of government-run health care pretend that medical care is an absolute necessity, but only a tiny fraction of it pertains to immediate threats to life. The need for a working price system in health care is urgent.

All this is bad enough, but Medicare and Medicaid compound their basic felonies with Byzantine regulations that add complication in the name of saving money without reducing true economic costs. Economic cost is the value of alternatives in production and consumption, as reflected in market prices. Since Medicare and Medicaid suppress market prices, their supposed “cost savings” are bogus. Both bureaucrats and government contractees lack the information necessary to centrally plan the medical care of millions of individuals. Arbitrarily reducing the fees of doctors is not cost savings; it merely reduces the level of care and substitutes poor service for higher prices.

Subsidy Nation had achieved another milestone: entrapping the elderly in an inferior system of subsidized medical care with no escape route.

Environmentalism, Alternative Energy and Streetcars

The publication of Rachel Carson’s Silent Spring in 1962 marked the watershed when the movement for conservation of natural resources – a goal with some basis in logic – changed course into a secular religion called environmentalism. The latter term has no logical underpinnings since it offers no grounds for favoring one aspect of “the environment” over another. Clean air is a good thing, right enough – but how clean does it need to be? And whose idea of “clean” gets imposed on everybody else? Ditto for water, land and the rest of “the environment.” The very essence of free markets is to provide an efficient answer to questions like that, while in Subsidy Nation those questions not only go unanswered, but even unasked.

Insofar as environmentalism has anything one could call “principles,” it believes that there is some sort of absolute standard for damage to the holistic, personified entity called Mother Nature, and that the resources of nature cannot be exploited without violating that standard. This provides the implicit justification for subsidizing technologies like solar and wind and fuels like ethanol. Without subsidies, these would vanish from sight due to their unproductiveness. Indeed, the subsidies must be given on both sides of the market – business-firm subsidies to stimulate production and consumer subsidies to stimulate consumption. This is the sine qua non of Subsidy Nation: government at every level has to play Dr. Frankenstein by artificially animating the entire market.

Environmental hysteria reaches its apogee with the recent fad for streetcars. In an age when science has given us the power to ride in computer-guided, driverless cars, trucks and planes – thus vastly enhancing safety, increasing speed and boosting human productivity – we are going to ride around in streetcars? Voluntarily? These are so monumentally inefficient and ineffectual that they require massive subsidies funded by taxes enacted by stealth. This is Subsidy Nation run amok.

Uneconomic Development

Over the last quarter century, casual observers of state and local business blinked in amazement at the rise to prominence of “economic development.” Every state in the nation established a department, bureau or corporation of economic development. “Economic development incentives” became the order of the day. After a couple centuries of folding, spindling and mutilating economic principles and logic, at last local politicos were finally getting the message. Surely prosperity would follow closely in the wake of this phenomenon.

Not.

Seasoned observers knew better. They knew that the discipline of economics contained a field of specialization called “economic development,” pioneered by one of the most famous economists of all time, Joseph Schumpeter. They had remarked the curiosity that – like the dog that didn’t bark in the nighttime – state departments of economic development seldom employed actual economists and almost never spoke a word of genuine economic development theory.

The reality of economic development after World War II in the undeveloped Third World – Africa, most of Latin America and much of Asia – foundered on the lack of effective markets. A major roadblock was the stifling effect of crony capitalism – the preemption of investment by friends, relatives and associates of those in power. This is the kind of “economic development” being preached and practiced at the state and local level today. It may have been best described by the wags in Arkansas who remarked drily that, while Governor, Bill Clinton was bent on achieving economic development one business at a time – starting with his friends.

EDIs take various forms, but they all involve artificial encouragement of business and particularly of investment. The operative meaning of “artificial” is defined in two ways: by selectivity and by distortion. Selectivity implies the granting of favors and making of distinctions for one or a few, but not for any or all. The process known at “tax increment finance” is a classic example. It allows recipient businesses to get favored tax treatment on their business investment and it is awarded by a commission, not available to all on equal terms. Naturally, the commission is set up precisely to award TIF status to those who enjoy the favor of and/or play ball with the local political establishment. Also naturally, the pretense is made that TIF follows sound, established economic principles. Accordingly, awards and publicity are well larded with jargon terms and blue sky prospectuses. Distortion involves the waiving or modifying of normal outcomes and procedures, such as market prices, taxes and government rules and processes.

It takes a professional to see all the way through the economic development charade. For example, many well-meaning amateurs comment approvingly about the “competition between state and local governments for business” that gives rise to EDIs, and compare it with states that lower corporate and individual income tax rates to attract business and residential inhabitants. In the first place, tax reductions for everybody do not distort the relative merits of individual investments the way that EDIs do. Secondly, taxes discourage economic activity by distorting prospective returns and incentives – hence reducing taxes is eliminating a distortion when the reductions apply across the board. EDIs create distortions; by making one investment appear misleadingly attractive, they are making another one misleadingly less attractive.

But the professionals aren’t fooled. Organizations as diverse as the Minneapolis Federal Reserve and the United Nations have commented unfavorably upon EDIs. Economists across the political spectrum have condemned them. The problem here is that the only time public attention can be distracted by economists is when the debate focuses on unemployment, inflation, “creating jobs” or predicting interest rates. Since these are things economists don’t do well, the well is poisoned for discussion of genuine economics.

Going Down for the Third Time

Today, the U.S. is drowning in a sea of subsidies. Most Americans have grown up being subsidized by the federal government. They have watched their friends, neighbors and enemies being subsidized with their tax dollars. They have come to view the political process exclusively as a zero-sum game, a fight in which the majority gets to use its absolute power to take the minority’s money for its own use. “Rights” simply define the ways and means of effecting the seizure. Economic growth, if it is pondered at all, is viewed not in the aggregate but rather as their own, personal, cost-of-living increase, decreed from above by somebody in authority. Apparently, the source of all that bounty that comprises the American way of life is a mystery to them.

The truth is grim. Throughout the 20th century, real income rose in the U.S. But this aggregate outcome concealed an underlying struggle between two forces pulling real income in opposite directions. Technology was advancing, increasing productivity and driving real income up. Meanwhile, each new round of subsidies was reducing economic efficiency, driving real income down. The net result, fairly steady increases in real income, reflected the fact that science, technology and a brain-inflow from the rest of the world was enough to pay the subsidy bills with a little left over to grow on. But that long holiday is now over. The end of the baby boom and the death knell of Reaganomics sent economic growth on a downhill slide.

And we aren’t alone. A good part of the world preceded us, even outdid us, in the transition to Subsidy Nation. Their downfall is the preview of our coming detractions. They are already underwater. We are going down for the third time. Like them, we are going not with a bang, but with a whimper. Crying for political compromise. Moaning for our entitlements. Whining for our subsidies.

DRI-241 for week of 12-2-12: Look for the Fiscal Cliff in the Rear-View Mirror

An Access Advertising EconBrief:

Look for the Fiscal Cliff in the Rear-View Mirror

With the demise of responsible journalism has come the advent of the “hook,” an attention-grabbing theme or event that acts as a long-handled tool with which to snag the media consumer. These days, the hook du jour is the so-called “fiscal cliff,” an economic precipice off which our figurative fall is scheduled for January, 2013.

As popularly defined, the fiscal cliff is a media-bred and -fed red herring that serves to distract attention from our real impending calamities, which are much worse than those imagined by the press.

The “Fiscal Cliff” as Conventionally Viewed

The conventional explanation of the fiscal cliff goes as follows: Beginning in the New Year, various cuts in federal-government spending and increases in federal taxes are scheduled to occur. The cumulative impact of these actions will be sudden, large and adverse. Hence the metaphor of a cliff, whose “fiscal” dimension refers to the government-expenditure-and-taxation connotation of fiscal policy.

In order to swallow this conventional view, we must believe it to be correct. That involves more than its factual accuracy; it also refers to its inherent soundness.

The fiscal-cliff narrative implies that both decreases and government spending and increases in federal tax rates are “bad for the economy” in some clear-cut, obvious way. The usual presumption is that they are both contractionary, tending to induce recession. The problem is that there is no reason to believe this.

Why the Conventional Thinking About the Fiscal Cliff is Wrong

The planted axioms in fiscal-cliffery are deep-rooted in contemporary life. They are have been repeated so long by the news media that the citizenry accepts them as gospel. They are fundamental principles of Keynesian economics. In the simple Keynesian economic model, the multiplier principle assumes that autonomous expenditures by government create multiple increases in income and employment. (It should be, but seldom is, put it more carefully: Whenever the economy operates at less-than-full employment, this multiplier effect will hold true.) It is trundled out and paraded by local news outlets every time a convention hits town or a sport team wants a justification for public subsidies.

If this proposition were true, we need never fear the onset of recession. Simply crank up the government spending mechanism and restore prosperity and full employment. It should be plain to one and all that it is false. History refutes it. In line with Keynesian precepts, government spending steadily increased throughout the 20th century and into the 21st, both in absolute terms and relative to tax receipts and aggregate income. Contrary to received wisdom, recessions were not banished by this spending regimen.

There have been no recorded instances of recessions-in-progress halted and reversed by timely administrations of government deficit spending. There was a brief period in the early 1960s that was hailed as the dawn of a new Keynesian age, but it began years after the Eisenhower recession and was stopped in its tracks by a combination of recession and inflation in the late 1960s. The phenomenon of stagflation continued into the 1970s throughout the Western industrialized nations, confounding Keynesian theorists and leading politicians like Great Britain’s James Callaghan to publicly repudiate Keynesian orthodoxy.

Both the Thatcher administration in Great Britain and the Reagan administration in the U.S. accepted recession as the price for ending double-digit inflation. They were rewarded by the subsequent long climate of prosperity known as the Great Moderation, which lasted into the next millennium.

The empirical defeat of Keynesian economics was mirrored by its theoretical decline. This took place over a longer time frame but was equally decisive. It is doubtful if any theory in the physical or social sciences was ever subjected to scrutiny so long-lasting and thorough. Over some 45 years, the economics profession obsessively focused on little else. By the early 1980s, the verdict was in.

Keynes had made his case in favor of government deficit spending on three grounds. Non-professional students and a few economists had long nourished a grudge against free markets on account of their alleged underconsumption. Increases in productivity and investment, it was alleged, would lead people to spend too little of their income, causing unsold goods to pile up and recessionary layoffs to ensue. Although Keynes did not incorporate this notion into his theory, he expressed sympathy for it. A decade before Keynes published his General Theory in 1936, two American economists named Foster and Catchings anticipated him by calling for a program of government spending to take up the slack created by private oversaving and underconsumption. In his 1931 article, “The Paradox of Saving,” F.A. Hayek meticulously explained why Foster and Catchings were wrong.

Keynes identified various flaws in the operation of free markets that he hauled out to justify activist government policies. These flaws formed the basis for the neo-Keynesian theory developed by his disciples after Keynes’ death in 1946. One by one over a 45-year period of controversy and research, each one was refuted. Keynes developed a theory of consumption as a simple linear function of income, used to buttress his concept of the multiplier. This was overturned by research done by three later economists, two of them Keynesians. Keynes insisted that downward inflexibility of wages and prices would prevent restoration of full employment without government intervention. History and research have also overturned the empirical basis for this strand of Keynesian thought. Falling prices, or deflation, would cause real incomes to rise through the operation of the real-balances effect. In other words, there is no inherent tendency for a fall in aggregate demand to result in unemployment of indefinite duration.

In later sections of the General Theory, Keynes gave his anti-capitalist prejudices free rein and inveighed against what he called “the fetish of liquidity;” e.g., the desire to hold money as a hedge against uncertainty. Keynes claimed that central banks should increase the money supply sufficiently to drive interest rates to zero (!), so as to discourage the demand for liquidity and end the scarcity of capital. The Great Recession of the New Millennium has given policymakers the chance to put this notion into practice. The technique of quantitative expansion of the money supply has kept interest rates artificially low in Japan for most of two decades; in the U.S., for about three years.

Japan’s economy has become nearly dormant, while the U.S. has seen a torpid recovery gradually metamorphose into a double-dip recession. So much for “the fetish of liquidity”! Near-zero interest rates did not end the scarcity of capital – quite the contrary; they made it nearly impossible to judge the relative usefulness of different capital assets and ushered in a state of near-paralysis. These recent examples reinforce the earlier experience of the Soviet Union, where the absence of market interest rates made it impossible for Soviet planners to judge the relative efficiency of different investments.

Finally, those without a sense of history or a nose for theory can simply review the results of the huge stimulus bill passed in early 2009. Government action was supposed to be better than waiting interminably for private markets to restore full employment. Instead, we waited interminably for government to spend stimulus money and then…overall employment continued to fall. Most of the glacial reductions in the rate of unemployment were due to dramatic declines in the rate of labor-force participation. Nobody can credibly maintain that Keynesian economics lived up to its billing.

Fiscal Cliff – or Fiscal Standoff?

We should not recoil in horror from reductions in government spending. When the federal government declines to spend our money, this does not constitute a lost opportunity to conjure goods and services out of thin air. It simply means that resources that would otherwise have been used to produce goods at the direction of government are now free for alternative use. This is no tragedy. Since the private sector follows the guideposts of profit, consumer sovereignty and utility maximization, the resources will probably be put to better use there than in the public sector anyway.

Nothing has been said here about where the spending reductions would take place. In principle, that should matter. After all, there are a few valid examples of public goods – goods that cannot be privately produced because private producers could not exclude non-payers from consumption and which cannot be consumed by one without being available to all. But the fiscal-cliff melodrama now playing full-time in media outlets makes no distinctions of this kind. It treats all government spending reductions equally, implicitly following the dictum of the late Keynesian economist James Tobin, who proclaimed, “Spending is spending; it doesn’t matter what you spend the money on.”

If government spending cuts are a bogeyman, who is it lurking underneath the white sheet blurting, “Boo!” Perhaps the defense of simple ignorance can absolve the news media for misinforming its audience – or perhaps not – but why don’t the President, Congress and professional economists blow the whistle on this farce? Each benefits from lying to the public about government spending, both in general and in this particular instance.

President Obama gains because his entire professional existence is focused on maximizing the power, influence and activity of the federal government The Republicans made the strategic mistake of assuming that the ineffectiveness of President’s policies would doom his candidacy. As this space accurately predicted three years ago, the President’s policies were not intended to be effective in the traditional sense, although that outcome would have been a welcome byproduct had it occurred. The policies were intended to make as many people as possible either employed by, subsidized by or beholden to the federal government. Thus, policies that increased unemployment rather than reducing it were still successful if they increased participation in unemployment benefits, food stamps, administration of benefits or any other government-related activity.

Democrats gain in Congress because their strategy is focused on demonizing Republicans. Their constituency consists overwhelmingly of net beneficiaries from redistributing government spending – or people who consider themselves net beneficiaries. By painting government spending as ipso facto beneficial, Democrats can achieve what gamblers call a “middle” – they can win either way. If Republicans cave in and restore threatened spending, Democrat constituents and their patrons in Congress gain. If Republicans hold firm against negating the cuts, Democrats can paint Republicans as villains. What’s more, if the overall economy deteriorates markedly as seems increasingly likely, Republicans will bear the blame for forcing us off the fiscal cliff.

Difficult as it may be to believe, Republicans also perceive gains from perpetuating the myth of the fiscal cliff. For one thing, Republicans have their own roster of constituent beneficiaries from federal-government subsidies, so they are secretly content to see spending continue – at least spending that they approve of. For another, Republicans also harbor hopes of blaming Democrats for anything that goes wrong next year. Most tellingly, Republicans by now have acquired a pathological fear of being publicly blamed and stigmatized by Democrats for anything and everything. They visualize an outcome similar to past misadventures with the debt ceiling and other attempts at spending discipline. Like whipped dogs, they cower in fear of another beating and will crawl in submission rather than face one. Thus, they are afraid not to cut a deal avoiding the mythical fiscal cliff.

One other factor influences Republican fear; namely, the other face of the fiscal cliff – tax increases.

Tax Increases – Good or Bad?

Republicans, goaded by longtime anti-tax activist Grover Norquist, have built a solid reputation as the party of opposition to tax increases. It is just about their one remaining principle of any substance. It dates back to the days of supply-side economics and the presidency of Ronald Reagan, whom Republicans venerate as the Democrats traditionally do Franklin Roosevelt. Is this principle well-founded?

The answer is complicated. Economic activity is conducted at the margin, so increases in marginal tax rates are well worth opposing because they deter the activities being taxed. Since most taxes are on earned income or production of goods and services, this means that taxation has an adverse effect on economic activity. This idea is conveyed by economic specialists in public finance through the concept of the “excess burden” imposed by the tax. On the other hand, surtaxes and lump-sum taxes have comparatively little effect on economic activity one way or the other – not enough to drive an economy off a cliff.

Many Republicans would really prefer to separate the issues of spending reductions and tax increases by embracing the first and opposing the second. But their track record on making fine distinctions in public debate is so dismal that they are inclined to give up that project as a bad job. After all, they had a whole year to work with but couldn’t even convince a majority of the electorate that Barack Obama was a bad President. Teaching the public basic economics in less than one month seems like a lost cause.

If the distinction between spending decreases and tax increases seems arcane, the bottom line about tax increases will sound positively esoteric. The Keynesian view of taxes is the same as that of spending – taxes are taxes. They affect the economy only as the receipt or loss of income rather than through their effect on incentives and behavior. Thus, their impact is cyclical; tax changes increase or decrease the likelihood of recession or expansion. But in reality, the Keynesian view is wrong here, as elsewhere. Changes in marginal tax rates affect long-run growth. (Whether the effects are temporary or permanent is another complex question.) They have little or no effect on business cycles because the causes (and cures) for business cycles lie elsewhere than with changes in aggregate demand. This is still one more reason why the current debate over the fiscal cliff is phony.

There is true irony in the fact that we are confronted with this faux fiscal cliff that nobody is willing to expose. We are facing a very real fiscal cliff. Or rather, we faced it over a period of decades. But we drove off the cliff like Thelma and Louise. Now the cliff is fading into the distance above us, getting small in our rear-view mirror. And we are about to crash into the ground below.

The Real Fiscal Cliff

The real fiscal cliff is the debt and spending behavior of U.S. governments at every level. The federal government’s debt (public and inter-governmental) is now approximately the size (100%) of annual GDP, or roughly $16 trillion. But this does not begin to capture the true size of federal government obligations. Taking future Social Security and Medicare committments into account (on a discounted present value basis) would make that number over 4 times greater. The Federal Reserve is monetizing debt; e.g., indirectly paying for government expenditures by creating money used by banks to purchase government bonds. This is a traditional sign of a government in the throes of a debt crisis, about to succumb to hyperinflation.

The Fed has created vast sums of money, but so far this has contributed only modestly to measured inflation because most of it has sat idle in excess bank reserves. By changing the rules allowing it to pay interest on those reserves – and by tightening regulations on conventional business loans to draconian degree – the Fed has persuaded banks to forego traditional lending and fatten their income statements passively. Meanwhile, the Fed has desperately tried to pump up real-estate prices and mortgages by buying mortgage-backed securities, the toxic asset most prevalent on bank balance sheets. In other words, the Fed has put the real economy in a therapeutic coma – therapeutic for banks but not for everybody else.

The Fed is working against time because default dominoes are wobbling in Europe. Greece has already defaulted; Spain, Italy and Portugal are on the brink and France is starting to look shaky. Outside Europe, Japan’s debt makes the U.S. look conservative by comparison and its coma is now Rip Van Winkle-length. This worries the Fed because U.S. banks are owed money and/or financial assets by banks in these countries, where the banking systems are mostly in even worse shape than ours.

Just about the only virtue displayed by leaders of the European Union is that they see the handwriting on the wall, even if they show varying degrees of willingness to act on their knowledge. But as an editorialist at London’s Financial Times recently observed, the belated willingness of Europe’s leaders to address the crackup of socialism and the welfare state comes just as the general public in the U.S. is embracing socialism at the polls.

In the past, economists have allayed fears about federal-government budget deficits by contending that what matters is the unified budget of state, local and federal governments. For many years, state government budgets were constrained by statute and tradition to remain in balance or even in surplus, thus offsetting federal extravagance somewhat. But today, at least a dozen state governments are nearly as bad off as the federal government. These include some of our most populous states, such as California, Illinois, New York and New Jersey.

The rot extends down to the level of city government. Detroit, Michigan was once an American powerhouse, home to the Big Three automakers. Today it lays in ruins, a dysfunctional ghost town whose City Council is reduced to begging for bailouts from a federal government that cannot bail itself out. Stockton, California has declared bankruptcy; a few other cities are teetering on the edge. Some major cities, like New York City and Chicago, are out of control and in decline.

If the American public and policymakers were united in perception and purpose, heading off default would be difficult. It would require a reversal of economic policy to promote economic growth. First, though, markets would have to reset and housing prices in numerous markets throughout the country would have to be turned loose to find their own level. This would entail a recession of indeterminate length, unfortunate but just as unavoidable as was the short, sharp recession back in 1981-82. Then government spending would have to be massively reduced – not trimmed, but chopped with a meat ax. Whole Cabinet-level departments would have to be eliminated and their work forces terminated.

Instead, we are traveling in exactly the opposite direction. Vice-Presidential Ryan’s modest proposal for entitlement reform went down to defeat along with Presidential candidate Romney. The two parties are squabbling about trivial differences in a plan for avoiding a fiscal cliff that doesn’t exist.

Après Moi, Le Deluge

Legend has it that his ministers confronted France’s Louis XV about the profligacy of his spending – palaces at Vincennes and Tuileries, wars against European rivals, a stable of mistresses including Madame de Pompadour. What legacy would he leave his successor and the nation? The king shrugged. “Après moi, le deluge,” he replied. (“After me, the deluge.”) That is apparently the position taken by politicians in Washington, D.C. in the face of the greatest crisis the United States of America have ever faced.

DRI-285 for week of 11-18-12: Twinkie Recipe: Separate Politics from Economics, Bake Cheaply and Deliver Efficiently


An Access Advertising EconBrief:

Twinkie Recipe: Separate Politics from Economics,

Bake Cheaply and Deliver Efficiently

Contemporary economic theory is now so heavily formalized by high-level mathematics and statistics as to be inaccessible to non-specialists. This has many drawbacks. Among them is the difficulty of integrating the effect of politics on markets. This is one of the few points of agreement between left- and right-wing commentators, who insist that we have a system of political economy rather than a system of markets as such.

Both sides are correct. Unfortunately, this realization causes them to neglect economics rather too much and concentrate on politics too heavily. Faced with a controversy, they tend to choose sides as if engaged in a war – by looking at the political uniform worn by the participants. Their most recent skirmish has attracted national attention. The baker, snack-food and confectioner Hostess, Inc. has filed for bankruptcy after a protracted dispute with its unions. One union in particular, the bakers’ union, has drawn the focus of attention.

The Decline and Fall of Hostess

Hostess was formerly Interstate Brands Corp., of Kansas City, MO, producer of over 30 brands of breads, cakes and snacks. These include legendary names like the Twinkie, Wonder Bread and Hostess Ding Dongs. The current dispute between Hostess and its unions is only the terminal event in a decades-long history of gradual decline. Hostess’s bankruptcy is its second; the first resulted in reorganization and the name change from IBC to Hostess. How could a company with such a distinguished roster of popular brands have fallen so low?

Some of the decline is due to a change in consumer tastes. High-calorie, high-fat, high-sugar snacks have lost favor. The realization that carbohydrate consumption carries just as much danger as fat consumption, if not more, has dampened the American enthusiasm for bread and cake. This is only part of the explanation for Hostess’s problems, though.

The longtime popularity of brands like Twinkies and Ding Dongs allowed the company to endure some highly uneconomical labor practices. The Teamsters Union – one of 12 unions operating under more than 300 collective-bargaining agreements with Hostess – forbade drivers from helping to load and unload their trucks. A stocker had to be employed to drive to the store and stock retail shelves with products transferred from storage. Some brands, such as Wonder Bread, could not share space on trucks with others.

When the falloff in brand popularity hit, Hostess could no longer subsidize this sort of inefficiency. The company has operated in bankruptcy reorganization for most of the preceding decade. The final crisis occurred within the last week, when Hostess announced that it had asked for contract concessions from the baker’s union, having already received concessions from the other 11 unions. It could not operate under the current contract and the law forbade operation without a contract. Thus, it announced that unless the bakers agreed to a deal, Hostess would once more file for bankruptcy and this time would proceed to liquidate the company’s assets.

The bakers refused. The company filed for bankruptcy. A federal judge intervened with by demanding that the parties undergo mediation. That process failed, and the bankruptcy and liquidation will now proceed.

The Left-Wing Reaction

The response on the hard left-wing, particularly among union proletarians, is that once more a company was undone by “vulture capitalism.” Private-equity firms took over the firm and ran roughshod over the rights of honest workers, raping and pillaging the firm’s assets. These commentators are doubtless fortified by the election returns, which suggest that the campaign of career-character assassination against former Bain Capital CEO Mitt Romney worked well enough to secure re-election of a fairly unpopular President.

The commentators looked at the day-to-day uniforms worn by the managers of Hostess and saw “venture capital” emblazoned thereon. Had they looked behind the scenes, however, they would have noticed that many of the particular venture capitalists involved with Hostess were closely associated with the Democrat Party. That’s right – the party of compassion, of equality and fairness, of comparable worth and social justice and the 99% and share-the-wealth and soak-the-rich. How could this be?

Actually, the real question is: How could it be any other way? Take-over artists and private-equity managers are primarily engaged in turning around businesses, not liquidating them. A liquidation is a fire sale, in which assets are generally sold at rock-bottom prices. That is why potential buyers tend to wait out dramas like the Hostess episode rather than riding to the rescue like the Lone Ranger. The rate of return on an asset depends crucially on the price paid for it. Who wouldn’t rather pay a low price rather than a higher one? Private-equity managers are business experts, right enough, but there’s no such thing as an expert in getting a high price at a close-out sale. Ask any business owner who ever went bust or any grieving son or daughter who ever liquidated their parent’s possessions at an auction. It’s pretty tough to profit from this process and it’s just as tough to earn fees from producing outcomes like this, since nobody has an incentive to pay the fees.

No, the people who bought Hostess bought it in order to run it, not break it up. Their record shows they usually succeed in doing that. They’re liquidating Hostess now because they failed this time and there’s no point in throwing good money after bad by failing to play their hole card. That card is the fact that Hostess’s 30+ brands still have considerable market value. In fact, their individual market value – outside the company and freed from the dead weight of union presence – probably exceeds its collective value inside Hostess.

The link between private-equity and the Democrat Party is eminently logical. It is economic, not political; that is, it has no necessary connection with the political sympathies of the vulture capitalists involved. Takeover targets are failing companies that have the potential to succeed. Why does a potentially successful company fail? Answer: it is being dragged down by unions, just as Hostess was. How to overcome this roadblock? Answer: persuade the unions to cease and desist from their uneconomic practices for their own good as well as the good of the shareholders. The best people to do this are not card-carrying Republican Party members or Ayn Rand sympathizers. They are fellow Democrats, who can at least gain the ear of the union bosses and perhaps retain a shred of credibility with the rank and file. And look what happened here – Hostess’s managers succeeded in keeping the company going for over a decade and persuaded 11 of the 12 unions to sign off on their latest resuscitation plan.

So much for the standard left-wing boilerplate view of the Hostess affair. Alas, the view from the right wing is not much more cogent.

The Right-Wing Reaction

Somewhat surprisingly, the right-wing view has gained considerable momentum even in mainstream media. The baker’s union suffers from false consciousness, say the mavens of talk radio. They stubbornly cling to their high union wages and benefits at the cost of their own jobs – and the 18,500 other jobs at Hostess in the bargain! How selfish can you get? Just one more case of what “union bloody-mindedness…at work.”

Wall Street Journal columnist Holman Jenkins (11/21/2012) provides a refreshing antidote to the stereotypical thinking of both right and left. He reveals that the Hostess story is a tale of two unions, not just one. It is the Teamsters who are the stereotypical hard-liners, insisting on featherbedding work rules that have driven Hostess’s product distribution costs into the stratosphere. The bakers (the Bakery, Confectionery, Tobacco Workers and Grain Millers International Union) have made repeated concessions, to the point where production costs hardly exceed industry norms.

From the bakers’ standpoint, they are being asked to make even more concessions now in order to protect the current status of the Teamsters, whose work rules are still hamstringing the company. No matter what you may have heard, solidarity is not “forever” – that is merely a song lyric.

As organized under laws mostly passed in the 1920s and 1930s and reinforced by labor regulations handed down for decades by the federal government, a labor union is a cartel. It is analogous to cartels set up by businessmen who sell products and services. Cartels strive to emulate the outcome of a monopoly, which is to thwart the competitive process and attain the same collective profit-maximizing outcome theoretically open to a pure monopoly seller.

In practice, a pure monopolist cannot even approach that theoretical outcome without the aid of government in restricting competition. That is even truer of cartels and much truer of labor unions. That is why the federal government has conferred their coercive powers upon unions. Unions operate to raise wages above the level that would otherwise prevail in a free labor market. The only ways to do that are to artificially hold wages high or to artificially restrict the supply of labor to the market. Unions do one or the other, depending on circumstances.

Both of these practices reduce employment in the unionized sector. This drives workers into unemployment and/or into non-unionized sectors, thereby driving down wages there. Union workers have no particular incentive to sacrifice on behalf of other union workers, who are after all merely workers like the ones whose interests have already been harmed by the union cause.

Jenkins points out that the bakers had a strong case for not agreeing to Hostess’s offer. Why not “hold back further concessions, let the company liquidate, and try their luck with a new owner or owners who might materialize for its bakery operations. These new owners presumably would be in a position to invest cash in marketing and promotion… They would benefit from the deluge in free media that has befallen the Twinkies brand this week. All the more so given that Hostess plans to close or sell some of the bakery plants anyway, that unemployment benefits are generous, that bakery jobs have become crummy-paying thanks to previous givebacks, that the government-run Pension Benefit Guaranty Corp. will be assuming the Hostess pensions in any case.”

So it seems that the bakers are not dumbbells after all. They are pursuing their own interests rationally given the cards they were dealt under a system they didn’t design. The right wing is repeating a frequent mistake of blaming victims of progressive socialism for acting in their own behalf. The right should instead expend all its energies working to change the system.

Jenkins observes that “one could always ask about the wisdom of a labor-law structure that causes companies like Hostess to drag on for decades without adapting to their marketplaces.” Indeed. This is a structural consequence of the substitution of politics for economics.

The Vocabulary of Political Theater

The medium of political theater employs a vocabulary of perception rather than one of real meaning. Words are assigned a political meaning unrelated to their substantive economic impact. One such word is “corporation.”

A corporation is a set of meanings that assign claims to various assets. But the political meaning of the word “corporation” describes a personified entity that is “large,” “wealthy,” “powerful,” “insensitive,” and “evil” when remotely viewed, or “paternalistic,” “secure” and (still) “wealthy” when viewed up close – say, from the perspective of an employee. All these traits are those of individual human beings; the political view of a corporation equates it to a person.

When a corporation goes out of business, it closes – often declaring bankruptcy – and its assets are liquidated. When a person goes out of business, he or she dies. A person cannot undergo “asset liquidation” even though a person’s assets can be liquidated. Thus, a person is not a corporation. But because politics views a corporation as a person, bankruptcy is viewed as akin to human death, even though it is not.

Bankruptcy is a process of evaluating the business to determine whether, and in what form, the business should go forward. That evaluation will gauge whether the business’s assets are worth more in combination or singly. This determination is a vital social process because your welfare and mine suffers if business assets are misused. True, we may not be owners of the business, but the real beneficiaries of a business are consumers, who benefit from what the business produces. That, after all, is the whole purpose of businesses – to produce goods and services for consumption.

When companies like Hostess die lingering deaths of a thousand union and bureaucratic cuts, all of us experience imperceptible losses. We pay more for government regulatory and bureaucratic functions. We pay more for the goods and services those businesses produce and we get less. Perhaps we are able to buy less in the coin of a depreciated currency.

Bankruptcy is in no sense analogous to human death. If an analogy is absolutely necessary, the “burnoff” of dead, accumulated brush that occurs in nature would be a good one. This pruning away of dead, useless stuff enables the remaining ecosystem to thrive.

One of the most destructive of all political terms is “economics,” which means “macroeconomics.” Currently, there really is no such coherent economic theory. Even less is there a set of valid, generally recognized policy prescriptions that could be grouped under that heading. The only valid meaning for the term “economics” would be described by the sub-head “microeconomics,” with the proviso that this would include the specialty of monetary theory and the study of business-cycle dynamics. One of the two sub-disciplines of microeconomics is the theory of the firm. That logic is of more help in understanding Hostess than anything provided by the Council of Economic Advisors.

A politico-economic term that has no meaningful economic referent is “job creation.” The purpose of economics is not to create jobs but to create value. Human labor is the key means of doing that, but it is the value, not the labor itself, that is the desired end product. Totalitarian regimes are wonderful job creators; there was no unemployment in ancient Egypt or in Soviet Russia or Communist China under Mao. The trick is not putting people to work; it is getting the most out of the work they do. That is what the “labor-law structure” referred to by Holman Jenkins completely overlooks.

Whither Twinkies, et al?

A few observers are sheepishly acknowledging that maybe we haven’t seen the last of Twinkies after all. The current owners of Hostess intend to sell the rights to produce all those branded products, which portends a bright future for any brand not encumbered by the same union rules that felled Hostess. And it may well mean a brighter future for many of those in the baker’s union as well.

DRI-280 for week of 11-11-12: Restaurant-Dish Takeaway and Comparative Economic Systems


An Access Advertising EconBrief:

 Restaurant-Dish Takeaway and Comparative Economic Systems

You are eating dinner in a casual restaurant with a spouse. No sooner does the last forkful of food ascend toward your mouth than your waiter whisks away the plate. His request for permission – “Done with that?” – is purely a formality since the plate is gone before you can object.

You have observed a tendency in recent years for restaurant servers to remove dishes with increasing alacrity. You remark this to your dinner companion who, unlike you, is a non-economist. Her all-purpose explanation of human behavior is binary: Is the object of study a nice guy or not? Nice guys remove dishes quickly so diners have more elbow room to relax.

You are an economist. You believe people act purposefully to achieve their ends. Moreover, you are thoroughly acquainted with tradeoffs. You have often had waiters take your plate before you were through with it. Some people bristle when they perceive others constantly hovering over them. There are even those – not you, of course, but boors and gluttons – who eat the food of others after finishing their own. One of these types might just react by snatching back his plate and declaring, a la John Paul Jones, “I have not yet begun to eat!”

The “nice-guy” explanation won’t suffice, since the quick-takeaway approach will suit many people well but others poorly. Restaurants that follow a consistent policy of quick takeaway risk offending some customers. Offending customers is not something restaurants do lightly. In order to make this risk worthwhile, there should be some strong motivation in the form of a compensating prospect of gain. What might that be?

One way to define an economist is by saying that they are the kind of people who ask themselves questions like this. And the mark of a good economist is that he can supply not only answers but also further implications and ramifications for social life and government policy.

The Economics of Restaurant Service

Americans have eaten in restaurants ever since America became the United States and before that. While the basic concepts underlying the restaurant sector have remained intact, structural changes have remade the industry in recent decades. The most important contributor has been the institution of franchising.

Fast-service franchising began was begun in the 1920s by A&W root-beer stands and Howard Johnson motel-restaurants. Baskin Robbins, Dairy Queen and Tastee Freeze hopped on the bandwagon in the 1930s and 40s. McDonald’s and Subway became big business in the 1950s. The decade of the 1960s saw restaurant franchises zoom to over 100,000 in number. After overcoming legal challenges posed by antitrust and the economic threat of OPEC in the 70s, franchising became the dominant form of restaurant business organization in the 1980s.

Franchising enlarged markets and made competitive entry easier. By standardizing both product and service, it made restaurant operation easier. It raised the stakes involved in success and failure. All these increased the intensity of competition. In turn, this shone the spotlight on even the minutest aspects of restaurant operation. Franchises and food groups ran schools in which they taught their franchisees and managers the fundamentals of restaurant success. Managers went out on their own to put those principles into practice. The level of professional operation ratcheted upward throughout the industry.

The word “professional” means numerous things, but in context it refers to the rigorous, even relentless application of restaurant practices single-mindedly aimed at achieving profitable operation. This entails developing a repeat-customer base and making the largest profit possible from serving that base.

Whether the quality of all types of restaurant food improved is open to debate, but it cannot be doubted that average quality rose. Today, the “greasy spoons” of yesteryear are nearly as scarce as passenger pigeons.

It was during this period of franchise domination that the practice of quick takeaway gained widespread currency. Maximizing the daily turnover of the given restaurant capacity is a commandment in the operations bible for profit-maximization. Minimizing the time between the departure of one set of guests and the arrival of their successors at each table is one way to maximize turnover. One way to reduce the time taken by clearing tables at meal’s completion is to begin the process before departure rather than waiting until the guests get up to leave; that way, fewer dishes remain to remove upon actual departure.

Fast removal of dishes not only maximizes turnover, it also maximizes the revenue take from each separate turnover. From the restaurant owner’s perspective, maximizing the size of each table’s check is another step toward maximizing total profit. After-dinner items like coffee and dessert are the obvious route to that goal. (Alcoholic drinks are the before-dinner complement of this strategy, which is why attainment of a liquor license is a coveted goal for most restaurants.) Quick takeaway aids this strategy in two ways. First, it speeds the transition from dinner to dessert. Second, it aids the server, who is in no position to handle dish removal when arriving at the table laden with desserts.

“Quick takeaway” has been standard practice throughout most of the industry for quite awhile, though. This doesn’t account for a recent speedup. For that, look deeper into the details of restaurant operation.

Table Size, Takeaway and… Demographic Trends?

Concomitant with the trend toward faster takeaway, the economist has also observed a trend toward smaller tables and booths in casual restaurants. Tables, chairs and booths come in standard sizes (there are five different booth sizes, for example), but the observed trend has been toward more booths designed to accommodate two people. Greater usage has been made of bar areas to provide food service, wherein diners can often obtain quicker service at the cost of table space and chairs limited to two people.

To understand the rationale for this changeover, pretend for a moment that all of the restaurant’s patronage consists of parties of two. Larger tables and booths would waste space and unnecessarily limit revenue per turnover, whereas designing for two would maximize the number of people served (and revenue collected) from an individual full-house turnover.

The link between table size and quick takeaway is obvious. Smaller table and booth sizes leave less room to accommodate elbows, books, newspapers, miscellaneous articles – not to mention additional dishes like dessert. (Technically, a smaller table doesn’t mean less room per person, but the whole idea behind the move to smaller tables is to achieve better utilization of capacity – the result leaves much less unused space available than did the larger tables and booths.) Now servers have even more reason to get those vacated dishes moving back to the kitchen, since there was barely room for them on the table to begin with. This reinforces the preexisting motivation for fast table-clearing and enlists the diners’ sympathy on the side of management, since table-crowding has become all too obvious.

There is still one major link left out of the chain of reasoning. In practice, restaurant parties do not consist entirely of twosomes. Casual restaurants usually include a few larger tables and/or booths, but what is to prevent larger parties from dominating smaller ones in the great scheme of things?

The last four decades have seen an increasing demographic trend toward smaller U.S. household size. In 1970, there an average of 3.1 people comprising the average U.S. household. By 2000, this had fallen to 2.62; by 2007, to 2.6 and by 2010, to 2.59.

Several forces drove this trend. First has been a shrinking birthrate. Here the U.S. is merely following the lead of other Western industrialized nations, which have seen shrinking birthrates throughout the 20th century. In the U.S., the shrinkage has waxed and waned since the 1930s. The 1990s saw a modest resurgence and U.S. births barely struggled above 2.0 per 1,000 early in the millennium. That is the replacement point – the level at which births and deaths counterbalance. As noted by leading demographer Ben Wattenberg and others, the large influx of Hispanic immigrants in recent decades undoubtedly spearheaded this comeback. Hispanics tend to be Catholic, fecund and pro-life. But since 2007, the rate has backslid down to 1.9; even the Hispanics seem to have assimilated the American cultural indifference to reproduction.

Other cultural forces have reinforced demography. Birth control has become omnipresent and routine. Divorce and illegitimacy have lost their stigma, thereby conducing to households containing only one parent. Whereas formerly it was commonplace for two men or two women to room together and share expenses, the legal status granted to homosexual partnerships has now placed a question mark around those arrangements. (This applies particularly to males; apparently the politically correct status conferred upon homosexuals does not much reassure two heterosexual men who contemplate cohabitation.) Indeed, it is today less socially questionable for unmarried male/female couples to live together than for same-sex couples – but this is practical only as a substitute for marriage, so its effect on household size is negligible.

The aggregate effect of this cultural attrition has been nearly as potent at the declining birthrate. In 1970, the fraction of households containing one person living alone was 17%. By 2007, this had risen to 27%.

Given this trend toward declining household size, we would expect to see a corresponding decline in the average size of parties at casual restaurants. After all, households (particularly adults) typically dine together rather than separately. Certainly, large groups do assemble on special occasions and regular get-togethers. But the overall trend should follow this declining pattern.

And there you have it. Smaller average household size produces smaller restaurant table and booth size, which in turn produces quick – or rather, quicker – takeaway of dishes at or before meal completion.

Many people instinctively reject this kind of analysis because they can’t picture most restaurant owner and employees thinking this deeply about such minute details or putting their plans into practice. But the foregoing analysis doesn’t necessarily assume that all restaurant owners and managers are this single-minded and obsessive. In a hotly competitive environment, the restaurants that survive and thrive will be those that do take this attitude. They will attract more business – thus, the odds of encountering smaller tables and quick takeaway will be greater even though those practices may not be uniform across the industry. Indeed, this reasoning supports the very notion of profit maximization itself. This survivorship principle was pioneered by the great economist Armen Alchian.

The Larger Meaning of Little Details

Economics is capable of supplying answers to life’s quaint little questions. (Some people would rearrange the wording of that sentence to “quaint little answers to life’s questions.”) But economics was developed to tackles bigger issues. It turns out that the little questions bear on the big ones.

One of the big questions economists ask about the behavior of business firms is: Is it socially beneficial? Business firms exist because, and to the extent that, they produce goods and services cheaper and better than individual households can. The gauge of success is the welfare of consumers.

Smaller tables and quick takeaway enable restaurants to achieve better capacity utilization. This enables them to cut costs and serve more customers. These are beneficial to consumers. The more intense competition serves to lower prices of restaurant food. This also benefits consumers.

What about the quality of food served? Table size and dish removal do not bear directly on this question, but the industry shift towards corporate control and franchised ownership has sometimes been blamed for a supposed decline in overall food quality. This hypothesis overlooks the analytical nose on its face – the fact that consumers themselves are the only possible judges of quality. Even if we assume that average quality has fallen, we have no basis for second-guessing the willingness of consumers to trade off lower quality for lower price and greater quantity. This is the same sort of tradeoff we make in every other sphere of consumption – housing, clothing, entertainment, medical care, ad infinitum.

The Left wing has recently developed a variation on its theme of corporate malignity in production and distribution of food. Corporations are destroying the health of their customers by purveying food containing too much sugar, salt, fat and taste. Only stringent government regulation of restaurant operations can hope to counteract the otherwise-irresistible lure of corporate advertising and junk food.

This hypothesis is not merely wrongheaded but wrong on the facts. Consumers have every right to trade off lower longevity for heightened enjoyment of life. This is something people often do in non-nutritive contexts such as athletics, extreme leisure pursuits like hang-gliding or public-service activities like missionary work. History indicates that, far from promoting public health, government has aided and abetted the increased incidence of type-II diabetes through wrong-headed dietary insistence on carbohydrate consumption as the foundational building block of nutrition.

Any objective appraisal must recognize that nowhere on earth can consumers find such abundance and diversity of cuisine as in the United States of America. World cuisine is amply represented even in mid-size metropolitan markets like Kansas City, Missouri and Sioux City, Iowa. There is no taste left unfulfilled – even the esoteric insistence on vegetarian meals, organic cultivation and free-range animal raising.

Restaurant Regulation

In order to appreciate the operation of a free market for restaurant meals, we need to dial down our level of abstraction and conduct a comparative-systems comparison. Heretofore we have conducted an imaginative exercise: we have explained a piece of restaurant operations under free-market competition. Now we need to envision how that piece would work under an alternative system like socialism.

In a socialist system, public ownership of the means of production dictates thoroughgoing, top-down regulation of business practice. For example, a regulator will pose the questions: How many booths and tables should the restaurant have? How big should they be? How far apart should they be spaced? How many people should we allow the restaurant to serve and how many should be allowed to sit at each table and booth?

In a socialist system, a regulator or group of them will ask this question in a centralized fashion. That is, he will ask it for a large grouping of restaurants – perhaps all restaurants, perhaps all fast-service restaurants, all bar-restaurants, all casual sit-down restaurants and all fine-dining restaurants. Or perhaps regulators will choose to group the restaurant industry differently. But group it they will and regulate each group on a one-size-rule-fits-all basis.

How will the regulator decide what regulations to impose? He will have government statistics at his disposal, such as the information cited above on average household size. It will be up to him to decide which information is relevant and how to apply the aggregate or collective information that governments collect to each individual restaurant being regulated. Even in the wildly unlikely instance that a regulator could actually visit each regulated restaurant, that could hardly happen more than once per year.

As we have just seen, free markets don’t work that way. One of the most misleading of popular perceptions is that free markets are “unregulated.” In reality, they are subject to the most stringent regulation of all – that of competition. But because the regulation part of competition works invisibly, people seem to miss its importance completely.

Instead of waiting for a central authority to certify its product as tasty and wholesome, markets supply their own verdict. Consumers try it for themselves. They ask their friends or take note when opinions are volunteered. They seek out reviews in newspapers, online and on television. When the verdict is unfavorable, bad news travels fast. This applies even more strongly to the aspect of health, by the way. Nothing empties a restaurant quicker than food-borne illness or even the rumor of it – as entrepreneurs know only too well.

In contrast, government health regulation doesn’t move nearly this fast. The cumbersome process of visits by the health inspector, trial-by-checklist followed by re-inspection – a pattern broken only rarely by a shutdown – is a classic example of bureaucracy at work. Political favoritism can affect the choice of inspections and the result. The de facto health inspector is the free market, not the government employee who holds that title.

Competitive regulation is decentralized. In our restaurant example, decisions about table size and restaurant takeaway are not made by a far-off government authority and applied uniformly. They are made on the spot, at each restaurant on a day-by-day basis. Restaurant owners and managers may possibly have the same government-collected information available to regulators, although it seems likely that they will be too busy to spend much time evaluating it. More to the point, though, they will have what the late Nobel laureate F. A. Hayek called “the information of particular time and place.” That is the time- and place-specific information about each particular restaurant that only its owner and managers can mobilize.

Merely because average household size has fallen over the U.S. does not mean that households in each and every individual neighborhood are smaller. It may be the case, for example, that in Hispanic neighborhoods – not gripped by declining birthrates or an epidemic of divorce – average household size has not fallen as it mostly has elsewhere. Those restaurants would not feel the urge to decrease table size and speed up dish collections in line with most restaurants. And well they shouldn’t, since they would serve their particular customers better by not blindly playing follow-the-leader with national trends.

Would centralized regulators pick up on this distinction? No, they would have to be clairvoyant in order to sort out the kind of exceptions that markets automatically catch.

After all, their aggregate statistics simply do not sift the data finely enough to make individual distinctions and differences visible.

But decentralized markets make those individual differences keenly felt by the people most affected. For restaurants, variations in consumer preference are felt by the very people who serve the consumer groups. Changes in demographic trends are witnessed by those whose very livelihoods are at stake. Competitive regulation works because it is on the spot, informed by the exact information needed and directed by the very people – on both sides of the market – with the motivation and expertise needed to make it effective.

Free markets allow participants to collect, disperse and heed information from any source but do not force people to respond to it. They do, however, provide incentives to respond proportionately to the magnitude of the information provided. A huge disruption of the supply of something will produce a big increase in price, suggesting to people that they reduce their consumption of this good a lot. A small decrease in a good’s price will offer a gentle inducement to increase consumption of something but not to go hog wild over it.

Again and again, we find ourselves saying that free markets nudge people in the right direction, towards doing the thing that we would want done if we could somehow magically observe all economic activity and direct by waving a magic wand. Economists laconically define this quality as being “efficient.”

Restaurant Economics and Rational Behavior

This object lesson in restaurant economics reminds us of a perceptive argument for free markets put forward by Hayek. He was responding to longtime arguments put forth by critics on the Left. The same arguments have recently reechoed following the housing bubble, financial crisis and ensuing Great Recession. Free markets may be logical, the critics concede, but only if people are rational. Since people behave irrationally, free markets must fail in practice, however well grounded their principles might be.

Hayek observed that the critics had it backwards. Markets do not require rational behavior by participants in order to function. Instead, markets encourage rational behavior by rewarding those who act rationally and penalizing those who do not. The history of mankind reveals a gradual movement towards more rational behavior; the widely noted reduction in the incidence of warfare is one noteworthy example of this.

The Audience Responds With a Burst of Applause

Can you imagine a nobler progression from the trivially mundane to the globally significant? That is what economists do.

And, by way of gratitude for this insight, your dinner companion rewards you by inquiring: “OK, now explain why restaurants are so stingy with the butter these days.”