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

An Access Advertising EconBrief:

Adding Entrepreneurship to Economics Makes ‘Disruptive’ Innovations Coordinative

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

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

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

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

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

A Brief Review 

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

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

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

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

Entrepreneurship – the Engine of Capitalism

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

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

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

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

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

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

The Consumer as Entrepreneur – A Case Study

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

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

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

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

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

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

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

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

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

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

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

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

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

Monopoly or Competition? 

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

Pattern Prediction

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

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

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

Can the Status Quo be “Disruptive?”

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

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

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

DRI-146 for week of 12-29-13: Catholic Doctrine and Economics: History and Evidence

An Access Advertising EconBrief:

Catholic Doctrine and Economics: History and Evidence

Pope Francis’s recent apostolic exhortation denouncing capitalism earned plaudits from mainstream media and the political Left. Last week’s EconBrief exposed the Pope’s rhetoric as emotive, superficial and devoid of intellectual content. Two questions follow: First, what impelled the Pope to comment at all? Second, what accounts for his assurance that the case for capitalism “has never been confirmed by the facts?”

Catholic Socio-economic Doctrine

Hostility to money, trade and finance by organized religion and the Catholic Church in particular dates back centuries. Religion developed in opposition to political absolutism. Prior to the rise of specialization and markets, economic stasis was the rule. Wealth was attained by military conquest and plunder rather than economic growth or, on a small scale, by banditry rather than business. Thus, wealth itself was suspect, as was its expression via money. Life expectancy was short and investment possibilities were scant, so the need for finance was correspondingly limited. Thus, financiers were viewed askance.

This view found expression within the Catholic Church in the prohibition of usury, defined as loaning money at interest. Since there was no economic theory to speak of, there was no recognition of principles such as time preference. Consequently, when medieval nobles purchased indulgences from the Catholic Church, the Vatican had no compunctions about insisting on paying less than the nominal value of a noble’s right to receive annual rents on his land. That is, the noble might own land on which he contractually received the equivalent of $30 per year in annual rent from the lessee, and the Church would pay less than $30 to gain title to that contractual payment. The Church was charging rent to the noble; i.e., was itself guilty of the usury it forbade its flock to commit.

This historic example tells us several things – that interest is an ineradicable, inevitable category of human action even outside of a monetary context; that the Church was slow to appreciate the economic logic governing human action; and that church doctrine tended to inhibit rather than accommodate change and progress.

By the 19th century, the Industrial Revolution had dramatically widened the scope of human possibility. Productivity was now increasing rapidly. Economic growth was a reality. War was more destructive and less beneficial to the victor. But all this was gained at a price – the time-honored ways of society were changing. Rather than embrace change, the Catholic Church lined up against it. After witnessing a century of political upheaval and the birth of socialism and communism, the Vatican issued its first formal statement on social policy in 1891 – the Rerum Novarum. Fourteen subsequent papal encyclicals followed, refining the doctrine and developing several fundamental principles.

Man is made in the image of God and thus inherits the quality of human dignity. This is expressed in various ways, one of which is through work. The principle of subsidiarity allows individuals to attain self-expression in their work and thus contribute to the communal welfare. While the principle of private property is recognized, however, it is subordinated to enjoyment of “the goods of the whole Creation,” which are “meant for everyone.” The principle of distributism governs the allocation of goods in a fashion consistent with “social justice.”

Which political system – capitalism, socialism or communism – is optimal for achievement of social justice? None of them, according to explicit Catholic doctrine. Communism not only violates private property but also renounces religion – so much for that. “Unfettered capitalism” is not acceptable either – here we can see the roots of Pope Francis’s call for subordination to government authority, which apparently acts as surrogate for the Church in enforcing social justice. As for socialism – well, the longtime affinity between Catholicism and the political Left suggests that this is the de facto preference of a sizable fraction of the flock.

If the above summary seems vague by the standards of political economy, there are good reasons for that. The Vatican had to somehow reconcile the rapidly evolving standards of science and technology and the brute facts of modern economic life with the basic teachings of the Church – without alienating the flock and causing an exodus of believers. Obviously, it took refuge in comforting generalities and uplifting rhetoric at the expense of logic. If there are no hard edges or bright lines drawn, then the faith can dodge its contradictions and practical shortcomings just well enough to survive.

It was this doctrinal tradition of emotive uplift and vague generalization that Pope Francis called upon in his latest apostolic exhortation. For over a century, the Church had relied upon government as its deus ex machina in social policy, and Pope Francis was certainly not about to deviate from that playbook now.

Economic History and the Church

Pope Francis’s quaint ideas about capitalism were not generated spontaneously within his brain. They were the outgrowth of a long history of antipathy expressed toward capitalism and free markets by historians and commentators, some of them affiliated with the Church. This attitude began at the time of the Industrial Revolution. We can simplify it by breaking it down into two key propositions: first, that the industrial factories worsened the lot of the working population and the poor by substituting an inferior lifestyle for a preferable one spent working on farms; and second, that factories were especially harmful to children, who were shamefully exploited and maimed by the factory system.

One of the leading historians of the Industrial Revolution and child labor, Clark Nardinelli, characterized the opponents of industrialization as the “Romantic movement.” During the “golden age” (e.g., prior to the Industrial Revolution), “England was populated with sturdy yeoman farmers who…produced enough for a comfortable subsistence for their families.” And shortfall in material goods was “more than compensated for [by] the serenity and beauty of rural life.” The Industrial Revolution “tore workers away from the land and forced children to enter the labor market” rather than enjoy a joyous, pastoral existence as carefree as it was healthful. Although the best-known Romantics today are writers such as Coleridge and Wordsworth, the Catholic Church provided a great deal of moral support and front-line activism to this movement. It also drew upon the Romantic literature for much of its later doctrinal expression.

The reality of industrial life and child labor, both pre- and post-Revolution, had little to do with Romanticism. It was driven by economics.

Prior to the Industrial Revolution, economies were predominantly agricultural. At the time of the American Revolution, for example, over 90% of U.S. output was produced on farms. Beginning in the mid-1700s, economic productivity began a long upward climb that is still underway today. It started with the birth of factories housing production processes for raw materials and finished goods. This affected agriculture at first by drawing away labor and other resources from farms to cities. Eventually the Revolution spread to agriculture itself; many machines and processes for producing and harvesting farm goods were invented. The increase in agricultural productivity led to huge increases in supply and lowered prices. Since increases in demand were less-than-commensurate with these supply increases, the result was a net exodus of resources away from agriculture and toward industry. This transformation occurred around the world and continues to accentuate the trend toward urbanization today.

British economist N.F.R. Crafts estimated that British per-capita income rose from $333 in 1700 to $399 in 1760 to $427 in 1800 to $498 in 1830 to $804 in 1860 (all figures expressed in 1970 U.S. dollars). As Nardinelli infers, this implies that economic growth occurred very slowly prior to 1760, slowly from 1760 to around 1820 and much faster between 1820 and 1860. According to detractors of free markets (to whom Nardinelli attaches the non-partisan label of Industrial Revolution “pessimists”), workers drawn into the factories were actually made worse off by the transformation.

Nardinelli estimates that the lowest 65% on the British income totem-pole received about 29% of all income in 1760. By 1860, this share had declined – but only to about 25%. (This relatively glacial pace of change is consistent with rates of change in the 20th century, too, despite loud protestations about the rapid pace of inequality.) On average, this would justify only a modest downward adjustment in the per-capita near-doubling of real income in Crafts’ figures, to about a 70% increase.

Within the historical profession, debate over the effects of the Industrial Revolution has raged for well over a century. “Optimists” like T.S. Ashton and R. M. Hartwell assembled data on real wages to overcome the anecdotal impression left by “pessimists” that life was a living hell for factory workers and children. Pessimists were left to argue that countervailing factors like urban crowding, unemployment and pollution overcame the material wealth created by capitalism to make workers worse off after all. But the best that pessimists have been able to manage is a case that the rate of growth was slow prior to 1840 and only began to accelerate thereafter.

Among many factors complicating the evaluation is the fact that the Romantics overlooked all the drawbacks of pre-Industrial life. While the factor system may have worsened air pollution, for example, the relative decline in air quality was not as great as it might seem. The widespread use of horses for transportation, for example, was a substantial source of air pollution. Agriculture caused water pollution and reduction in land quality, both of which were ameliorated by the outflow of resources from agriculture to cities. The fact that life expectancy in Great Britain rose 15% from 1781 to 1851 does not tell in the pessimists’ favor. The strong population growth between 1760 and 1830 is the only thing that kept per-capita growth in real income from being even larger, but this cuts both ways – it holds down per-capita income but suggests that dis-amenities of industrial life were not life-threatening in magnitude.

The Truth About Child Labor

History books throughout the 19th and early 20th centuries were replete with gruesome tales of children mangled and crushed by machinery or driven to early graves by the unhealthy hours and working conditions inside factory walls. Beginning in the 1940s, however, what the late Paul Harvey would have called “the rest of the story” started to emerge. Even before the Industrial Revolution, children normally worked on farms, either from age 12 onwards as outdoor farmhands or as younger hirelings of cottage industries. Outdoor farm labor was hardly less arduous and dangerous than factory labor. And it was certainly less remunerative. Today, child labor survives not in Western factories but rather in the subsistence agricultural economies of Africa and India.

There is no systematic evidence of child abuse and mistreatment of child labor by factor owners – which is what we would expect of factory owners who were dependent on child labor for substantial productivity. That productivity earned substantial wage income – this was what lured the children into work in the first place. Thus, the Industrial Revolution did not result in the exploitation of child labor, regardless of how the term “exploitation” is defined. Factories and other industrial employments were not a magnet for child labor; rather, large-scale child labor was a localized phenomenon confined mostly to portions of Great Britain and the American South where cotton mills were numerous. Children were ideally suited for textile production, which explains their sudden rise to prominence at the strategic moment in the Industrial Revolution. Employment of roughly 122,000 children in the textile mills of Lancashire, Yorkshire and Cheshire constituted the bulk of child labor – about 203,333 – in England and Wales. Since the total population of children was over 2,400,000, child labor accounted for only a little over 8% of the population of children. As the Revolution went on, the need for more technologically sophisticated labor militated against the use of child labor.

Free Markets and the Poor: Evidence from Around the Globe

Not surprisingly, the Pope’s proclamation and its ecstatic reception triggered indignant reaction from knowledgeable sources. One of America’s leading experts on economic policy, John Goodman of the NationalCenter for Policy Analysis, recalled his participation in an economic conference called by Pope John Paul II in 1996. Contrary to longstanding Church policy, then-Pope Karol Wotyla sought counsel from free-market economists before issuing his encyclical Centesimus Annus. This time, Pope Francis pointedly ignored economic logic and principles in adhering to traditional Church doctrine.

In an op-ed entitled “Papal Economics,” Goodman noted that for some 100,000 years, most of mankind subsisted on a real income equivalent to $1 per day, rarely reaching $3 per day. Then, about 200 years ago [actually, closer to 250], capitalism began to blossom throughout the world with the spread of free markets. Today, even the poor in the wealthiest countries are better off by thousands-fold.

Economists Benjamin Powell and Darren Hudson, writing on “Pope Francis’s Erroneous Economic Pontifications” for the Independent Institute, take on the Pope’s assertions directly. After excoriating “trickle-down” economics, the Pope further maintained that “when the glass [of economic growth] is full, nothing ever comes out for the poor.” Citing the specific case of China, the world’s most populous nation and formerly home to its largest quotient of poor residents, the authors remind the Pope that since 1980, 500 million people have been lifted out of poverty under the new, market-friendly economic policies pursued within China. This could hardly have been the work of the Catholic Church, since Christianity was condemned by the Communist regime of Mao Zedong and barely tolerated subsequently.

The Pope’s confident assertion that faith in free markets and economic growth as a tonic for the poor has “never been confirmed by the facts” was next to fall to the authors’ analytical scythe. They calculate that the average annual per-capita income of the poorest 10% of the population in the world’s freest countries exceeds $10,000 annually. In the world’s least-free countries, that same average annual per-capita income is less than $1,000.

But surely the Pope’s headline-grabbing point about capitalist inequality is ironclad? After all, today even defenders of capitalism and free markets fall over themselves apologizing for the widening gap between rich and poor. But Powell and Hudson utilize the most popular tool of left-wing student economists, the quintile tables, in comparing income distribution in most-free and least-free countries. The share of total income going to the poorest 10% of the population in the freest countries in the world is 2.76%. In the least-free countries, that same share of total income is less – 2.57%.

The quintile method (in this case, actually a decile method) is an analytically inferior method of parsing the mysteries of income distribution because it aggregates huge numbers of individuals inside each quintile (or decile) and hides the results of changes felt by them. Only the overall averages are visible. Just as bad is the fact that the individual components of the quintile do not stay the same over time. People are born and die. Even more pertinent to the analysis, their incomes change so much that they leave one quintile and move to another one. Historically, Americans have been quite mobile between quintiles; that is, they are likely to spend time at both the low end and the high end at different points in their lives.

Left-wing students of income distribution tend to act as though the makeup of the quintiles did not change – as if the poor remained in the poorest 20% (or 10%) all their lives. The evidence suggests that some do, but most don’t. This radically changes the implications of inequality between quintiles, since it is completely different to spend your whole life poor than (let’s say) to spend a few years poor, a few years well off, a few years very well off and a few years rich. It is no accident that the Left prefers the quintile method. Socialism began as a movement proposed by French philosopher Saint Simon, who longed to operate an entire national economy as if it were one big factory; in short, to pretend that a nation was a single collective entity.

Messrs. Powell and Hudson graciously agreed to play the comparative income-distribution game in the left-wing ballpark by employing the quintile method, a technique containing inherent bias against free-market outcomes. Yet the free-market side still won, which makes the victory all the more telling.

The immediate reaction to this analysis is to wonder what Pope Francis would respond when confronted with the refutation of his arguments. In fact, he has already responded. He told an interviewer that “I was not speaking from a technical point of view but according to the Church’s social doctrine.”

Exactly. Since 1891, the Catholic Church’s social policy has served the vital function of allowing Popes to speak out of both sides of their mouth on social policy. To the public, they can appear to address real-world problems and public-policy issues directly by using terms and phrases that seem to have real-world referents. To the cognoscenti, though, they can de-fang their comments by translating them into the vague mush of Catholic doctrine, chock-full of good intentions and nobility but unrelated to any logical or practical program. That is the way to understand Pope Francis’s latest apostolic exhortation, as just another in the long line of these duplicitous exercises.

The only exception in this deplorable line of double-talk was provided by John Paul II. John Goodman noted that, in Centesimus Annus, John Paul actually came out and said that capitalism was the most efficient instrument for utilizing resources and effectively responding to needs. It can hardly have been coincidental that John Paul was also the courageous Pope who joined with Ronald Reagan and Margaret Thatcher to topple Communism in the Soviet Union and Eastern Europe. He recognized the role played by capitalism in overcoming Communism and restoring religious freedom to his home country and a substantial chunk of his flock worldwide. He knew that capitalism created prosperity and that material security and leisure time enhance the quality of religious observance.

Summing Up

The Pope’s latest apostolic exhortation earned headlines and fawning press coverage for the Papacy but broke no new ground in theology or public policy. Pope Francis was simply plowing inside the same furrow cultivated by his predecessors for over a century. The Catholic Church’s exhortations can be traced back to the Church doctrine first codified in 1891. With only one exception, this policy has followed a consistently vague and unproductive line since its inception.

The Pope’s confident assertion that free-market economics has no provenance is the outgrowth of over a century’s worth of mistaken history. Accurate revisions in estimates of real wages and a more realistic comparison of life prior to the Industrial Revolution have put the effects on workers and children in proper perspective. Poor workers gained from the Industrial Revolution; children were not exploited but rather benefitted from relatively high wages and favorable working conditions within factories.

The world’s freest countries and economies not only enable their poorest citizens to have much higher real incomes than poor people in the least-free countries, those poorest people also enjoy larger shares of total income than the poorest people in the least-free countries. In short, Pope Francis was wrong about nearly everything he said.

DRI-180 for week of 12-22-13: Render Unto Caesar: A Response to Pope Francis’s Denunciation of Capitalism

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Render Unto Caesar: A Response to Pope Francis’s Denunciation of Capitalism

Papal exhortations to the faithful typically receive dutiful press coverage, but seldom create firestorms of controversy. Pope Francis’s recent apostolic exhortation is a historic exception. It is universally characterized as a “denunciation of capitalism.” Popes are not esteemed for the cogency of their economic commentary, but the Pope has become the darling of the political Left for the extravagance of his views – at least, those excerpted in print, broadcast and digital media.

Historically, Catholic doctrine is hostile to commerce and finance, so we should not be stupefied by papal adherence to tradition. Still, ascendancy of the Pope’s remarks to a position of dominance in public discourse suggests the extremity of the views expressed. They merit extensive examination – and reply. The paragraphs most often excerpted are numbers 53-60, from which the following have been taken:

“…We have to say ‘thou shalt not’ to an economy of exclusion and inequality. Such an economy kills. How can it be that it is not news when an elderly homeless person dies of exposure, but it is news when the stock market loses two points? This is a case of exclusion. Can we continue to stand by while food is thrown away while people are starving? This is a case of inequality. Today, everything comes under the laws of competition and the survival of the fittest where the powerful feed upon the powerless…”

“…People continue to defend trickle-down theories which assume that economic growth, encouraged by a free market, will inevitably succeed in bringing about greater justice and inclusiveness in the world. This opinion, which has never been confirmed by the facts, expresses a crude and naïve trust in the goodness of those wielding economic power and in the sacralized workings of the prevailing economic system. Meanwhile, the excluded are still waiting… A globalization of indifference has developed… we end up being incapable of feeling compassion at the outcry of the poor… as though all this were someone else’s responsibility and not our own. The culture of prosperity deadens us…”

“While the earnings of a minority are growing exponentially, so too is the gap separating the majority from the prosperity enjoyed by those happy few. This… is the result of ideologies which defend the absolute autonomy of the marketplace and financial speculation. ..they reject the right of states, charged with vigilance for the common good, to exercise any form of control. A new tyranny is thus born… Debt and the accumulation of interest also make it difficult for countries to realize the potential of their own economies and keep citizens from enjoying their real purchasing power. To all this we can add widespread corruption and self-serving tax evasion… a deified market …becomes the only rule.”

Was the Pope Mis- quoted/translated/interpreted?

In the conservative fortnightly National Review, longtime theologian and analyst Michael Novak tries to make the case that Pope Francis did not really mean what he apparently said. Novak finds the phrase “trickle-down” suspect, claiming that it does not appear in the original Spanish version of the apostolic exhortation. Thus, it must have been added by somebody in the translated version used as the basis for excerpts by the American news media.

Novak recalls Pope Francis’s background in Argentina, a land recently dominated by “crony capitalism;” e.g., government favoritism extended to business friends of those in power rather than truly free markets governed by the Rule of Law. Surely this must be the “capitalism” that the Pope is excoriating, Novak declares.

Novak’s case has a certain visceral appeal, particularly in its indictment of the appellation “trickle-down,” which is left-wing code language used to discredit tax cuts. Alas, the Pope’s own clarification of his comments, published in Time Magazine, offers no support to that interpretation. Not only does he fail to repudiate or qualify his use of the term “trickle-down,” Pope Francis expands on his earlier exposition with remarks couched in the same vein.

Pope Francis’s statements are neither factual nor analytical. They do not spring from any empirical foundation or develop a logical chain of reasoning. They are the kind of ad hoc, emotive outpouring long associated with the political Left. Thus, it is not surprising that Rush Limbaugh characterized them as “pure Marxism,” despite the absence of any Marxist trappings (surplus value, alienation, class conflict, etc.) or call for revolution.

The immediate reaction to these statements is shock at their utter, blatant falsity to fact and history. Even a non-economist recognizes instantly that the Pope – or his ghostwriter – is simply regurgitating prefabricated sludge with no intellectual or empirical content and no relationship to reality. Consider only those comments excerpted above, for example.

A Direct Rebuttal to Pope Francis

We can safely assume that Popes operate on a plane of existence utterly dissimilar to yours and mine. This presumably applies even to Francis, who is portrayed as humble and constantly in search of opportunities to interact with ordinary people. Yet if he were really in touch with day-to-day reality, he would surely know that it is indeed “news” when “an elderly homeless person dies of exposure.” In America, such events are the stuff of the nightly news, local and national, broadcast, telecast and online. So are stock-market fluctuations. This is not surprising; both events are the stuff of human drama. Roughly half of all Americans have a relatively direct financial interest in the stock market. That includes the “majority” that Pope Francis contrasts with the “happy few” in the “minority” whose earnings are “growing exponentially.” It is one thing to hear “outcry of the poor” – or claim to – but another thing entirely to heed it by contributing concretely to their welfare. Research shows that the predominant contributors are the very people that Pope Francis stigmatizes, the holders of financial assets who monitor their value and nurture it.

This represents the intellectual quality of the Pope’s statement well – a false dichotomy built upon an empirical falsehood, tending to create an impression that is the opposite of the truth, couched in rhetoric drenched with emotion.

If “such an economy kills,” how do we explain the soaring life expectancies during the 20th century? In particular, what do we make of the fact that the least free countries – Soviet Russia and its contemporary descendant, the African dictatorships – have made the smallest gains while the largest have accrued to the freest countries and markets? Does the Pope’s use of “inequality” refer to earned income? Wealth? These are all monetary measures of material wealth and the context strongly indicates that the Pope is referring to some such denominator of inequality. But he also lectures us sternly to abjure materialism and “the culture of prosperity,” which “deadens us.”

Strictly speaking, we should be striving for human happiness, towards which real income and wealth are only means and for which they are mere proxies, albeit plausible ones. Research shows that the incidence of happiness is nowhere nearly as unequal as that of income or wealth. Shouldn’t the Pope be celebrating this fact? By decrying the maldistribution of the very prosperity he wants us to repudiate, isn’t he vitiating his own case?

But even if we grant the Pope a dispensation from his own religious doctrine and allow him to become a materialist for purposes of this discussion, he can’t very well hold the free-market responsible for inequality if unfree markets produce even more inequality. And that is what records, at least up to the 21st century. Indeed, it was the Industrial Revolution and the growth of commercial society and free markets that created the middle class and made the study of income inequality relevant. Prior to that time, there were only nobility, merchants and the poor.

Incredible as it seems, Pope Francis labors under the misapprehension that famine and starvation result from food wastage by the rich. This flies in the face of centuries of starvation due to natural disaster and cyclical change, succeeded by political famines maneuvered by dictatorial governments superintending unfree markets. It was tremendous improvements in agricultural productivity, effected by technological changes implemented by competition and free markets, that brought us within sight of a starvation-free world.

It was resistance to competition and free markets in Africa, China and India that delayed this milestone. Only in the last twenty years have these barriers begun to crumble. Is the Pope blind to these miraculous improvements? Or does he allow use of the word “miracle” only in a supernatural context? Should he put Catholic Church investigators on the case, he will find the role of the free market much easier to verify than, say, that of Bernadette of Lourdes.

Economists throughout the world are struck dumb by the Pope’s revelation that today, “everything comes under the laws of competition.” Around the world, but most especially in the West and above all in financial markets, government sits tall in the saddle as never before. Government controls interest rates; government runs banks like public utilities; government tries to drive some industries out of business and lavishly subsidizes others. Government seizes control of our health care and arbitrarily makes and changes laws relating thereto. Government monitors our communications on the pretext of protecting us from external threats just as it monitors our personal behavior on the pretext of protecting us from ourselves. Today a Wall Street Journal op-ed laments the “demonization of free markets” that has taken place over the last five years. The author morosely pleads for mercy from the reign of terror unleashed by government on the competitive marketplace.

And Pope Francis declares us in thrall to “ideologies which defend the absolute autonomy of the marketplace?” In what universe does the Pope reside? Even more to the point, where do I go to sign up for the regime the Pope is warning us against?

Does the Pope recall the six million Jews murdered by the German government, elected by a plurality of voters in a democratic election? Is he aware of the dozens of millions murdered in Soviet Russia? The question is not rhetorical; Pope Francis grudgingly admitted in Time that “Communism is wrong” without citing its bloody past or its failure to provide economic freedom. What about the larger human toll taken by Communism in Red China, and the economic reversal behind its recent rise to prominence? All of these governments claimed to be exercising “vigilance for the common good,” just as the Pope prescribes. Indeed, the similarity of their rhetoric to the Pope’s is positively chilling. But the Pope is silent on the relative incentives and historical record of success of government in serving human wants, compared to the free market.

The only form of “corruption” cited by the Pope is tax evasion. But the historic form of abuse for centuries have been high taxes and inflation, which absolute monarchs and absolute democracies alike have used to appropriate the resources of the populace and “keep citizens from enjoying their purchasing power.” Is it perfectly proper for governments to oppress their citizens with taxes and inflation? The Pope regrets the constraints imposed upon “countries” by debt and debt service. But these are created by government spending, not by financial speculation. They are felt by the majority whom the Pope ostensibly cares for so deeply. Is debt only bad because it inconveniences government and not because it has to be repaid by taxpayers? And what about the crony capitalism cited above, which Pope Francis presumably witnessed up close and personal in Argentina? (South America was the birthplace of the practice and the term.) Is it only private citizens who possess the capability for corruption, not government?

The Pope defines the “survival of the fittest” as a condition in which “the powerful feed upon the powerless.” But this can hardly explain the inequality that is the centerpiece of his diatribe against capitalism. If the rich become rich by taking from the poor, eventually the poor run out of money altogether. There is very limited scope for this type of redistribution, but that is all. In our current context, in which a sizable number of fabulously rich coexist with a huge middle class and a relatively well-off class of poor people, the only possible explanation must involve production by the rich. Otherwise, where does the wealth come from? You can only take so much from poor people and keep doing so generation after generation. The volume of wealth created by free societies is produced by a class of tremendously productive rich people who stimulate productivity by middle-class and poor people; that is the only possible way the total volume of wealth can come into being. But this is way over the Pope’s head; he is wallowing in a trough of emotion, untroubled by logic or quantitative considerations.

Pope Francis is similarly silent about the Vatican and the Catholic Church, each of which have a centuries-old history of corruption, depravity and hypocrisy. Popes have enjoyed mistresses, waged war and accumulated vast wealth. The Vatican has tolerated and covered up the practice of pedophilia by its priests. Hypocrisy, La Rochefoucauld reminds us, is vice’s tribute to virtue, so we should not object to Pope Francis’s decorous avoidance of such matters. But the virtue of humility he affects in his daily ministrations would be equally well practiced in his apostolic pronouncements. Today the Church does not meddle in affairs of science by arguing about the age of the Earth, the date of Creation or the Great Flood. It should extend its circumspection to economics, about which Pope Francis clearly knows no more than the least among his flock. In the realm of intellectual inquiry, the Pope should render unto Caesar that which is Caesar’s.

Where is the Pope Coming From?

Pope Francis confidently asserts that the theory of free markets has “never been confirmed by the facts.” As shown above, it is confirmed both empirically and logically by people who spend their lives in that pursuit. It does not require us to hold “naïve trust in those wielding economic power.” Economic power is wielded by consumers, unlike government power which does demand trust and faith on our part but seldom rewards it.

What is Pope Francis thinking about? Even the Pope, who is used to people taking his word on faith, must have had something in mind when making such blanket assertions. In Part Two, the history of opposition to free markets – particularly that relevant to the Catholic Church – will be reviewed and analyzed. It will place the Pope’s statements in a clearer, if no less defensible, light.

DRI-277 for week of 11-3-13: Why Are There No Economists Among Leading Opinion-Molders Today?

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Why Are There No Economists Among Leading Opinion-Molders Today?

Today the discipline of economics occupies a strange position within the general public. The Financial Crisis of 2008 and ensuing Great Recession brought economics to the daily attention of Americans more forcefully than since the Great Depression of the 1930s. The Federal Reserve’s monetary policies, particularly its recent tactic of Quantitative Expansion (QE) of the stock of money, have made monetary policy the object of attention to a greater extent than at any time since the days of stagflation and supply-side economics during the Reagan administration in the early 1980s. One would expect to find economists occupying center stage almost every day.

Not so, surprisingly enough. Contrast the position of economics today with, say, that in the 1960s and 70s, just prior to Ronald Reagan’s election as President. At that point, three economists were familiar on sight and sound to a great many Americans: John Kenneth Galbraith, Paul Samuelson and Milton Friedman. Today, the venues, space and time available to economists far outnumber those existing forty years ago. Yet no economist today even approaches the influence and familiarity of the Big Three in their heyday. A brief recollection of each is in order for the benefit of younger readers.

The Big Three of Yesteryear: Galbraith, Samuelson and Friedman

The Big Three economists of yesteryear bestrode the 20th century like colossi and stood tall into the 21st. They were all born and died within a few years of each other: Galbraith (1908-2006) slightly outlasted Samuelson (1915-2009) and Friedman (1911-2006) in longevity although he died first, in April 2006. They were all self-made and experienced the Depression first hand. Each was a prolific writer but appealed to a different audience.

The best-selling writer of the three was John Kenneth Galbraith, whose literary zenith produced The Affluent Society (1958) and The New Industrial State (1967). Compactly put, Galbraith’s thesis was that Americans were satiated with consumer goods but starved for so-called “public goods;” i.e., the goods government was uniquely situated to provide. The economy thrived not on competition but on monopoly exercised by giant corporations, who artificially created the demand for their products via advertising rather than merely responding to the inchoate demands expressed by consumers. Since consumer wants depended on the same process that satisfied them, that process of want-satisfaction could not be justified or defended as simply “giving the people what they want.” Therefore, government was not merely allowed but morally required to tax and regulate business to restrain their behavior and acquire the resources necessary to redress the imbalance between public and private spending. Galbraith’s views resonated with the general public much more than with the economics profession itself, where only the New Left, radicals, institutionalist admirers of Thorstein Veblen and quasi-Marxists found them attractive. Needless to say, Galbraith’s ideas seem quaint today in light of the decline and fall of the supposedly invulnerable giant corporations he worshipped.

In addition to his economic works, which also included American Capitalism (1952) and A Theory of Price Control (1952), Galbraith wrote novels and memoirs of his travels and tenure as Ambassador to India. His iconoclastic views – he minted the phrase “the conventional wisdom” – and ironic style endeared him to the general public, whose distrust of authority he shared. This seems odd of a man whose World War II service as deputy head of the Office of Price Administration made him one of America’s chief bureaucrats, but Galbraith’s early life was spent on a farm in Canada. Another of his books was a novel satirizing America’s foreign-policy establishment (“Foggy Bottom”). Perhaps the chief object of his scorn over the years was the corporate hierarchy, whose morals and mores he never tired of mocking despite his exaggerated opinion of their power over markets.

Paul Samuelson was the leading theoretician among American economists and the first American awarded the economics version of the Nobel Prize in 1970. His scholarly articles numbered in the hundreds, but he is remembered today chiefly for two books: Foundations of Economic Analysis, based on his doctoral dissertation, which signaled a turning point in economics to mathematics as the formal mode of analysis; and Economics, his all-time best-selling college text that combined principles textbooks in microeconomics and macroeconomics in order to integrate the two analytically into the so-called “Neoclassical synthesis. Samuelson combined the elements of classical price theory as developed by Alfred Marshall and refined by subsequent generations with Keynesian macroeconomics as modified from Keynes by the neo-Keynesian generation that included Samuelson himself, Franco Modigliani and James Tobin, among others. This book (really, a double book) taught generations of economists through over twenty editions from the 1940s until the 21st century.

Samuelson’s central conceit was that individual free markets worked beautifully, but markets in the aggregate were prone to unemployment or inflation. This aggregate shortcoming could only be corrected by government spending directed by… well, by men like Samuelson himself; although he always refused to take a policy post in the Democrat administrations he supported and advised.

As with Galbraith, it is difficult for non-economists today to credit the veneration Samuelson inspired in certain quarters. In the late 1950s, Samuelson began predicting that the Soviet Union would soon overtake the U.S. in per-capita GDP (then GNP). He retained this prediction in successive editions of his textbook – until the final overthrow of the Soviet Union in 1991. Galbraith and Samuelson made an odd couple of Keynesians – the former supporting massive government spending in spite of his distrust of the bureaucracy and the latter embracing deficit spending by government because he had faith in the ability of government to fine-tune aggregate economic activity. Samuelson shared a forum in Newsweek Magazine in an alternating column with the third member of our Big Three, Milton Friedman.

Friedman became well-known among fellow economists long before he attracted public notice. He won the John Bates Clark medal awarded to the leading economist under the age of 40 and published a notable collection entitled Essays in Positive Economics that contains some of the best expository writing ever done in his subject. 1957 saw what he considered his best piece of work, A Theory of the Consumption Function, which successfully reconciled cross-section data on aggregate consumption among different groups over the same time period with time-series data on consumption among all groups over time.

In the early 1960s, Friedman published two books within a year of each other that catapulted him to public attention and professional eminence. Capitalism and Freedom made both the political and economic case for free markets, an analytical position that had almost deteriorated through neglect. A Monetary History of the United States, which he co-authored with Anna Schwartz of the National Bureau of Economic Research, made an empirical case for the money stock as perhaps the chief economic variable of interest both historically and for policy purposes. Milton Friedman became the world’s chief exponent of the Quantity Theory of Money, which had been around ever since David Hume in the 18th century but had never before been put to such comprehensive use in economic theory. Ironically, Friedman’s single-minded focus on the money stock proved to be his Achilles heel. Although still greatly respected for his manifold contributions to economic theory and his prodigious talents as a defender of freedom and popularizer of economic thought, Friedman’s monetary theory is little regarded among professionals of all ideological stripes.

As the 60s and 1970s wore on, Friedman headed up the disloyal opposition to Keynesian economics within the economics profession. Keynes had been posthumously crowned king in the 1950s and early 60s as Western economies began to adopt the policy of spending their way to prosperity. But the advent of simultaneous high inflation and high unemployment, or “stagflation,” in the 1970s put paid to the Keynesian tenure atop the profession. Friedman and Edmund Phelps independently and more or less simultaneously developed the hypothesis of a “natural rate of unemployment” that defied Keynesian efforts to reduce it via deficit spending. Only through continually increasing injections of money into the economy – producing ever-increasing rates of inflation and resulting unrest – could unemployment be reduced and held below this “natural rate.” Friedman’s Nobel Prize, received in 1976, was by this time a foregone conclusion.

In 1980, Friedman reached his zenith of public popularity with the best-selling book and accompanying PBS television series Free to Choose. This was a popularized version of Capitalism and Freedom, updated for the 80s. For the first time, an economist had scaled the heights of public popularity, professional acclaim and policy prominence. Like Samuelson, Friedman preferred to exercise his influence outside of government. Unlike Samuelson, though, Friedman had actually worked for government in World War II. It was Milton Friedman, of all people, who devised the concept of government tax withholding to streamline the process of revenue collection.

Vacuum at the Top

Today, economics is omnipresent in our lives. Yet there is nobody in the public square whose position rivals that of the Big Three of yesteryear. The closest would be Paul Krugman, who has written several popular books, whose Nobel Prize is spelled exactly like the one received by Samuelson and who believes that the stock of money can play an important role in economic policy. In other words, he is a pale shadow of Galbraith, Samuelson and Friedman.

Noted economist Sam Peltzman probed this seeming paradox in an article published in the May, 2013 issue of Econ Journal Watch, 10(2) pp. 205-209, entitled “Why Is There No Milton Friedman Today?” Peltzman’s analytical qualifications are impeccable. He has carved out a distinguished career as a critic of government regulation. His crown jewel is a famous 1975 study on automobile safety that introduced the pioneering concept of “risk compensation” to the social sciences.

Risk compensation refers to the behavioral effects created by safety improvements and regulations. When people take more risk in response to safety improvements and/or regulation, this change in behavior has been christened the “Peltzman Effect.” Thus, Sam Peltzman has been given the greatest scientific honor of all – a scientific principle has been named for him.

Peltzman notes the absence of successors to the Big Three. He especially abhors the vacuum created by the loss of Milton Friedman. Peltzman’s explains it by citing Friedman’s unique talents. The first of these was his knack for communicating economic insights to the masses. The same expository skill Friedman brought to his professional work equipped him to educate the general public.

Peltzman illustrates Friedman’s style with a revealing anecdote from his own (Peltzman’s) academic career. Peltzman’s first graduate-school class was Friedman’s legendary class in Price Theory at the University of Chicago. The students “eagerly awaited our introduction to the technical mysteries of our chosen profession. Instead, we got an extended paraphrase of an article entitled ‘I, Pencil,’ in which a humble pencil tells us of the herculean coordination problem required to get itself produced and distributed and of the virtues of markets in solving that problem.” Peltzman correctly attributes the essay to Leonard Read, founder of the Foundation for Economic Education and its journal, The Freeman, in which the essay originally appeared. Peltzman’s points are that Friedman’s pedagogy was time-tested and simple and he employed it before professional audiences as well as public ones.

Friedman’s second unique virtue was his zest for combat. Libertarian economists were scarce in Friedman’s day and he knew his arguments would be received with scorn and incredulity. Nevertheless, his rejoinders were cheerful and clever; he relished the opportunity to buck the tide of collectivist conformism. And his devotion to his principles was unyielding. “All against one makes for a good show,” observes Peltzman, “and Friedman liked the odds.” This brings to mind the answer made by John Wayne’s character J.B. Books, the dying gunfighter in the movie The Shootist, when asked to account for his luck in surviving so many gunfights over the years: “I was willing.”

It is clear that even Galbraith and Samuelson couldn’t measure up to Milton Friedman by Peltzman’s criteria. Galbraith had the communication skills and debating talent but little worthwhile to communicate; his theory badly needed shoring up. Samuelson had the theory but communicated largely by writing letters to his fellow economists in the language of differential equations. His text worked well enough for a captive academic audience but nobody ever characterized his persona as “dynamic.” Both these men were, to some greater or lesser extent, arguing for the status quo, while one of Friedman’s books was titled The Tyranny of the Status Quo.

So far, so good. Peltzman makes a concise, compelling case for Milton Friedman as sui generis. Now, though, Peltzman tries to explain why today’s economists do not measure up to the standard set by Friedman. Although his observations of the economics profession seem descriptively accurate, his attitude toward their change in behavior is disturbingly complacent.

The Contemporary Economist as Engineer

In assessing the state of the profession today, Peltzman at first sounds optimistic. It’s true that there is no Milton Friedman leading the charge for freedom and free markets. But that isn’t due to a lack of free-market economists. “There are…numbers of them within our gates, perhaps more than in Friedman’s time…But they lack something that Friedman had in…his time.” Actually, they lack several somethings.

First, they lack the kind of dedicated, first-rate opponents Friedman had in abundance. “…The range of belief within economics has narrowed, partly because of Friedman’s efforts…the modal economist is less [interventionist]… than the modal economist of Friedman’s era…Market solutions…are given a respectable hearing or are part of the consensus today (think flexible exchange rates or unregulated railroad rates). There is less room today for a good fight among economists.” Apparently, Peltzman does not read Paul Krugman’s column in the New York Times.

If this sounds dubious, just listen to Peltzman’s next assertion. “Consider…what has happened in the aftermath of the financial crisis of 2008. The chattering class pronounced with excited joy that Capitalism is now Dead, but the political center hardly moved, and in some countries even moved right – to fiscal rectitude, labor market reform, etc. Hardly any left party that moved away from socialism in Friedman’s heyday has moved back since. What is a committed free-market economist spoiling for a good fight to do when the other side is not so far away?”

This narrative hardly sounds like a description of the multi-trillion dollar stimulus, multiple bailouts of big banks and financial firms, government seizure and handover to autoworkers of two of the Big Three auto companies, impending nationalization of health care, regulatory reign of terror and Federal-Reserve money-creation and asset-purchase binges that have characterized the U.S. since 2008. Contrary to Peltzman, events since 2008 have conformed more to Newsweek‘s famous cover headline: “We Are All Socialists Now.” And what has today’s “modal economist” done in response to this overwhelming frontal assault on free markets?

If Peltzman’s judgment that the economics profession has gravitated toward freer markets were correct, we would expect to read protests from our modal economist. Instead, he has, according to Peltzman, turned into “a much cooler customer. This one tends to be less committed to any politico-economic system.” Wait a minute – what happened to all those “numbers of …free-market economists…within our gates” just a minute ago? We could sure use them, because it now turns out that among the cooler customers, “the animating spirit is more the engineer solving specific problems than the philosopher seeking a unified world view. The questions asked tend to be smaller than, say, the connection between capitalism and freedom.”

Strangely, Peltzman doesn’t seem perturbed about this loss of ideological fervor, because “the skill with which the question is answered tends to be greater than in times past.” What about their professional duty to educate the public in the great truths of economics? “At some point,” Peltzman declares airily, “today’s leading economists may want to communicate their results to a wider audience. But this is an afterthought, in the sense that what is valued within the profession – the skill in obtaining the result – is not what the outside audience is interested in.”

Peltzman is surely wrong about the outside audience, who is intensely interested in “the skill in obtaining the result” because (at least in principle) it should affect the veracity of the result. Presumably what Peltzman meant to say is that the audience doesn’t care what method economists use to get the answer as long as they get the right one. And in this connection, it is hard to see what economics profession Peltzman is referring to – surely not the one that actually exists. For over two decades, Deirdre McCloskey and Steven Ziliak have proclaimed that econometric practice within the social sciences – in economics and elsewhere – is scandalously incompetent. Most empirical articles in the leading professional journals over-rely upon and misuse the principle of “statistical significance.” Thus the foundation of empirical economics has rotted away – and with it has gone Peltzman’s claim of greater skill.

Peltzman is not merely blind to the failings of his profession today; he is complacent about its future prospects. “It is hard for me to see a reversal of the kind of trends I have described…in…fields where the engineer has replaced the philosopher. Perhaps an economic calamity will shake things up in economics. But we had one in 2008, and very little changed within the profession. There was a period of befuddlement [after which] economists went back to their tinkering and were largely irrelevant to the political response to the crisis.”

Peltzman’s complacency even extends back to Friedman’s work. He attributes the fact that “there is no serious socialist faction left within economics” to “Friedman’s success,” which “makes it harder for someone to follow in his footsteps.” Peltzman declares flatly that “there is no serious political/economic alternative to some form of capitalist organization in any major economy.” Peltzman cannot have forgotten – can he? – that this was exactly the point made by Ludwig von Mises and reinforced by Mises and his student F.A. Hayek in the Socialist Calculation debates of the 1930s. This was a central contention of Hayek in his great polemic The Road to Serfdom in 1944. It was Hayek, the guiding spirit behind the Mont Pelerin Society of worldwide free-market economists who sparked Friedman’s interest in political activism in the late 1950s. Friedman admitted all this in his Introduction to the 1994 edition of The Road to Serfdom and in interviews with Hayek’s biographer, Alan Ebenstein.

Peltzman’s most outrageous error is his claim that “the Fed chairman learned from Friedman not to permit a credit freeze to turn into a monetary implosion.” Milton Friedman would have slit both wrists and reclined in a warm bath before endorsing the policies followed by Ben Bernanke before, during or after the Financial Crisis of 2008. Friedman’s criticism of Federal Reserve policy during the Great Depression did not pertain to a “credit freeze” but rather to the wholesale failure of banks throughout the U.S. and resulting nosedive taken by the money stock when deposits were destroyed. A credit freeze – whatever else it might entail – implies no such rapid decline in the money supply and therefore does not demand a “helicopter drop” of money, a la Milton Friedman, in order to cure it. Peltzman’s jaw-dropping attempt to imply a posthumous endorsement of Bernanke by Friedman is as inexcusable as it is inexplicable.

Peltzman has chosen the wrong model for his model economist – Friedman rather than Hayek. He has also chosen the wrong model for his modal economist – the engineer rather than the philosopher. In The Counter-Revolution of Science (recently republished under its original planned title, Studies on the Abuse and Decline of Reason), Hayek outlines the disastrous effects of subjecting society to control by the “mind of the engineer.”

The engineer strives to bring all aspects of a problem under his conscious control in order to achieve a technical optimum. He chafes at external constraints such as prices, incomes and interest rates; they are not “objective attributes of things but reflections of a particular human situation at a given time and place.” He sees them as meaningless, irrational interferences with his optimization techniques. When an engineer confronts a machine, for instance, he typically strives to gain the maximum power or energy output from given inputs of resources. In fact, as Hayek points out, the engineer’s technical optimum is usually just the solution that would obtain if the supply of working capital or resources was unlimited or the interest rate was zero. In adopting the perspective of the engineer, the economist is losing his own unique perspective. A good real-world example of the engineering perspective gone wrong in economic practice would be the misguided activist economic policies of former-engineer Herbert Hoover in trying to combat the Great Depression.

Peltzman correctly recalls that Milton Friedman advanced the view that the profession should pursue “positive economics” by formulating hypotheses and testing them empirically. But Peltzman neglects to inform his readers that today this viewpoint is as dead as the dodo – deader, actually, since today we can clone dodos back to life but we are not about to resurrect the canard that econometrics can be used to test predictive hypotheses in the social sciences in the same way that laboratory experiments test natural scientific hypotheses. In academic economics today, nobody believes that anymore. The massive, sausage-producing enterprise of submitting articles to refereed professional journals for acceptance continues, but purely as a ritual for granting tenure. Nobody now pretends that this process has any value above the purely ceremonial. It is now axiomatic in economics that econometrics does not prove anything, test any hypotheses or rule out (or in) any part of economic theory.

The format mathematical models economists swear by give the appearance of scientific rigor, but this is spurious. In order to reduce actual human activity to systems of solvable equations and stable equilibria, economists have to remove so much realistic detail that their models are unrecognizable to the layman. They are virtually useless for making quantitative predictions. We know this because, as the former Donald McCloskey put it, economists cannot answer “the American question: If you’re so smart, why aren’t you rich?”

Today, economic policy is taking measured that economists have warned against for centuries. The attempt to create wealth and induce prosperity by massive money creation is traditionally a tactic of desperation, one that inevitably ends in crisis and chaos. Yet economists sit silent instead of rising in indignant protest. And Peltzman appears to approve both the desperation tactics and the compliance of his profession.

Actually, Peltzman does betray deep-seated doubts about the current path of economics profession in his last sentence. It reads: “But one wonders still: is this only the calm before the storm?” And one wonders if Peltzman will have cause to regret his failure to speak out.

Whither Economics?

Sam Peltzman has courageously taken on one of the great contemporary mysteries. It is a missing-persons case. Where did the economist go in our public discourse? Peltzman succeeds in finding his quarry, all right. But having found him, he is distressingly indifferent to the runout. His confidence in the methods and motives of today’s economists seems utterly misplaced. Without realizing it, Peltzman himself is providing part of the explanation for the absence of economists from public discourse. He is sanctioning the abandonment of what they do best – teaching the philosophy behind economics – in favor of what they do worst – pretending to employ the methods and techniques of engineering in the foreign realm of economics.

DRI-312 for week of 8-18-13: Understanding Risk, Benefit and Safety

An Access Advertising EconBrief:

Understanding Risk, Benefit and Safety

The mainstream press has propagated an informal historical narrative of safety in America. Prior to the Progressive era and the advent of muckraking journalism, the public lay at the mercy of rapacious businessmen who knowingly produced unsafe products and unwholesome foods in order to maximize their personal wealth. Thanks to the unselfish labors of investigating journalists and the subsequent creation of government regulatory agencies, products and foods became safe for the first time.

Now regulators and the press fight a never-ending battle for safety against the forces of greedy capitalism. Alas, there are so many industries and goods to regulate and so little time and money in the federal budget with which to do it.

In order to appreciate the full falsity of this doctrine, we must grasp the economic meaning of concepts like risk, benefit and safety. A good route to this goal lies through our own inner sense of the logic of human behavior.

A Reductio Ad Absurdum

To highlight the concepts of risk, benefit and safety, consider the following example. It is a reductio ad absurdum – an example “reduced to absurdity” in order to eliminate extraneous considerations and shine a spotlight on a few insights.

Assume you have only one day left to live – exactly twenty-four hours. You are aware of this. You are also aware that your death will be instantaneous and painless and your vitality, faculties and awareness will remain unimpaired up to your last second of consciousness. How will this affect your behavior?

A little thought should convince you that the effect will be profound. You have only one day left to wring whatever excitement, enjoyment and satisfaction you can from life. Will that day be business as usual, awakening at the normal time and departing to work at your job? Unless you work at one of the world’s most stimulating and fulfilling jobs, the last thing you will want is to spend your final day on Earth at work.

Instead, you will devote your time to the most intense and meaningful pleasures. These may be physical or mental, aesthetic or gastronomic, boisterous or sedate. The word “pleasure” inevitably evokes the notion of hedonism in some people, but this need not apply here. The pleasures you seek during your last day may be sensual but they may just as easily be as cerebral as reading a book or as contemplative as observing a sunset. Your personal selections from the vast menu of choice will be highly subjective, in the sense that my choices might very well differ drastically from yours. In spite of this, though, the example affords highly useful insights about economics – particularly the concepts of risk, benefit and safety.

Economic Benefit

The first conclusion to emerge from our artificial but enlightening example relates to the nature of economic benefit. In recent decades, a Martian studying Earth by scanning its news media transmissions and publications might well conclude that the benefit of human existence derives from work. After all, politicians and commentators yammer endlessly about the glories of, and necessity for, “jobs, jobs, jobs.” Taking this preoccupation at face value implies that work, in and of itself, is what makes life worthwhile. The obiter dicta of the rich and famous, who recklessly profess such heartfelt love for their profession that they would practice it for nothing, reinforce this impression.

Our example, though, shatters this shibboleth. Economic value inheres not in work but rather in the things that work produces, which produce pleasure and satisfaction when consumed. It is certainly possible to love one’s work, but it is not coincidence that the people who love it the most are the ones most highly compensated for it; their earnings can purchase the most satisfaction and pleasure. It is a famous truism that nobody’s deathbed reflections are mostly regrets at not spending more time at the office.

Risk

Ever since the pathbreaking work of economist Frank Knight some ninety years ago, economists have defined risk as mathematically expressed variance of possible future outcomes. Uncertainty, the first cousin of risk, applies when the future outcomes vary in ways not susceptible to mathematical expression. For our purposes, however, we will view risk colloquially, as the possibility of unfavorable future outcomes.

Again, it should be obvious that the prospect of death in twenty-four hours’ time will radically affect your attitude toward risk and benefit. You are out to grab all the gusto you can get in the day you have left. From experience, we realize that the pursuit of pleasure can involve some element of risk. For example, the most hair-raising rollercoaster ride may well provoke the most pleasurable response. But it may also produce nausea, vertigo and unsteadiness. There is even the risk of injury or death if the mechanism malfunctions or you somehow are thrown from the ride.

If you are the kind of person who enjoys rollercoasters, you will be undeterred by their risk in our special case. You are certainly not going to pass up this big thrill for fear of a one-in-a-hundred-million chance of death – you’re going to be dead tomorrow anyway! On the other hand, you might well refuse to ride the coaster with your safety belt unbuckled for the first twenty-three hours of your last day. You don’t want to take foolish risks and waste most of your last day. But you might well reverse that decision during your final hour, especially if you always wondered what it would be like to take that ride unbuckled. You certainly aren’t risking much for that thrill, are you, with only minutes left to live?

Safety

Safety is best understood as reduction in risk or uncertainty. In colloquial terms, it is time and trouble taken to reduce the likelihood of unfavorable outcomes. Put in those terms, the equivocal nature of safety is clear. It demands the sacrifice of time – and time is just what you have so little left of. Why should you take much trouble reducing the likelihood of an unfavorable outcome when you will experience the most unfavorable outcome of all within twenty-four hours? Every second of time you spend on safety reduces the time you could be spending experiencing pleasure; every bit of trouble you take avoiding risk lowers your potential for happiness during the dwindling time you have left.

Now is the time for you to go hang gliding, even launching off a mountain top if the idea takes your fancy. Bungee jumping is another good candidate. In neither case will you spend an hour or two inspecting your equipment for defects or weakness.

Of course, we know that safety is a significant concern for all of us in our daily lives. That is one of the changes introduced by the reversion to reality in our model. Comparing reality to the polar extreme of our reductio ad absurdum outlines the continuum of risk, benefit and safety.

The Reality of Risk, Benefit and Safety

Reality differs from our artificial example in key respects. Although a relative few of us actually do have only twenty-four hours to live, only a tiny few of that few know (or suspect) the truth. And of those, virtually none have the freedom and vitality accorded our example individual. That clearly affects the central conclusions reached by our model – that the individual would seek out pleasure, eschew work, embrace risk if doing so heightened pleasure significantly and “purchase” little safety at the cost of foregoing pleasure.

We observe, and instinctively realize, that most people must work in order to earn income with which to buy pleasurable consumption goods. They tend to be “risk-averse” within relevant ranges of income and wealth; that is, they will buy a lottery ticket but not play roulette with the rent money. They value safety, but nowhere nearly to the extent implied by the mainstream news media and politicians. In a world of work and production, safety is produced using time and physical resources, which reduces the value of pleasurable goods produced because that time and those resources cannot then be used to produce pleasure. Thus, safety production adds to the money cost and price of consumption goods, which creates a tradeoff between safety and purchasing power. Nobel Laureate George Stigler once colorfully averred that he would rather crash once every 500,000 takeoffs than pay a fortune to fly between major U.S. cities.

In other words, the insights gained from our reductio ad absurdum turn out to be surprisingly useful. We merely have to adjust for the length, variability and unpredictability of actual life spans in order to predict the general character of human behavior in the face of risk. And when we apply these adjustments retroactively, we appreciate how badly astray the mainstream historical view of safety has led us.

Rewriting (Pseudo) History

The mainstream view contains at least a grain of truth in its suggestion that the emphasis on safety is a modern development. But the blame attached to profit-hungry capitalists is wrongheaded. This is not because capitalists aren’t profit-hungry; they most certainly are. But the hunger for profits has always been strong even as the production and consumption of safety have varied. Profit-hunger did not suppress safety for centuries, could not prevent the demand for safety from arising and cannot put it back into the bottle now that it has emerged.

The industrial revolution and the rise of free markets created a tremendous increase in human productivity, thereby increasing real incomes throughout the world. The increases were not uniform; certain countries benefitted much more, and faster, than others. The higher incomes increased the demand for safety and for medical research, which in turn led to tremendous gains in life expectancy.

Longer life spans increased the demand for safety even more. This is our reductio ad absurdum played out in reverse. The longer we expect to live, the more future value we are safeguarding by sacrificing present pleasure with our “purchases” of safety. Prior to the 20th century, with life expectancies at birth not much over 50 years even in the developed industrial nations, it didn’t pay to make great sacrifices in current consumption to safeguard the safety of many people whose longevity was limited anyway. But as life expectancy steadily lengthened – particularly for those in the later stages of life – the terms of the tradeoff changed dramatically.

Risk Compensation

Another factor that greatly affects the balance between risk and safety also emerged in our artificial example. We noted that many of the pleasure-producing human activities carry risk along with their beneficial properties; indeed, therisk itself may even be the source of pleasure. This is true of a wide range of human pursuits, ranging from the rollercoaster rise in our model to auto racing, casino gambling and bungee jumping. Some pastimes such as mountain climbing and hang gliding may produce secondary benefits like physical fitness to supplement their primary purpose of slaking a thirst for risk.

Mainstream society has traditionally viewed risky activities ambivalently. It has tolerated some (mountain-climbing) and frowned on others (gambling, illicit drug-taking) without acknowledging the bedrock similarity common to all. That failure has not only caused much needless death and suffering but has also endangered our freedoms.

Strongly influenced by mid-century muckraker Ralph Nader’s research on the Chevrolet Corvair (later discredited), the U.S. Congress passed legislation beginning in the 1960s requiring American automakers to include safety equipment on all vehicles as standard equipment rather than optional extras. Those safety features included safety belts and, eventually, crash bags. Starting in 1975, University of Chicago economist Sam Peltzman published studies of the results of this legislation. His work showed that any lives that might have been saved among occupants of vehicles tended to be offset by lives lost among pedestrians, cyclists and other non-occupants. That was not to deny the existence of a trend toward fewer highway vehicle deaths. Indeed, that trend had been underway well before the safety legislation was passed owing to factors such as improvements in vehicle design, production and maintenance. Sorting out the effects of this trend from those of the legislation required considerable statistical effort, not to say guesswork.

But the existence of a countervailing force was clear. Peltzman suggested that the safety devices made people feel safer, causing them to drive less carefully. This might be due to increased carelessness or a willingness to embrace a certain level of risk when driving, which caused them to compensate for their increasedlevel of personal protection by taking additional driving risks.

Politicians, regulators and do-gooders of all sorts went ballistic when confronted with Peltzman’s conclusions. How dare he suggest that federal-government safety legislation was anything less than a shining example of nobility and good intentions at work? Rather than ponder the implications of his analysis, they hardened their position. Not only did they force businesses to produce safety, they began forcing consumers to consume safety as well. This campaign began with mandatory seat-belt legislation requiring first drivers, then passengers and eventually children to wear seat belts while vehicles were in operation.

Essentially, the implications of the regulatory position were that markets are dysfunctional. In a competitive market, producers not only produce automobiles that provide transportation services, they also provide various complementary features for those autos. One of those features is safety. (In fact, virtually every safety feature was offered by private auto companies before it was required by the government.) Consumers can patronize auto companies and models that provide the most and best safety features, such as seat belts, air bags, anti-lock brakes and more. They can also reject those that omit safety features. Or consumers can choose to reject safety features by buying autos that lack them. Why would they do that? The obvious reason is that safety features require physical resources and engineering talent to provide, making them costly. Consumers may not wish to pay the cost.

By overriding producer decisions and consumer preferences, regulators in effect assert that markets do not work and government commands should replace the voluntary choices made in the marketplace. One obvious problem with this approach is that it creates momentum in the direction of a centrally planned, totalitarian economy and away from a voluntary, free-market one. But for those who believe that the end justifies the means, the loss of freedom may be justified by the greater safety resulting from the regulatory command-and-control approach.

As time went on, however, it became clear that the regulatory approach was not achieving the results claimed for it. Not only were markets being circumvented, but the regulatory nirvana of a risk-free world was no closer to reality. How could this be? What was going wrong?

As far back as 1908, the British equivalent of America’s Auto club urged landowners to cut back their hedges to improve visibility for drivers of the newly invented automobile. A retired Army colonel responded to this appeal by noting that this hedge-trimming had caused unintended consequences: his lawn had been filled with dust caused by zooming motorists who exceeded speed limits and skidded into his yard. When detained by police, the offenders maintained that “it was perfectly safe” to drive so fast because visibility was clear for a long distance. So the colonel changed his mind and let his shrubs grow in order to deter the speeders.

Following Sam Peltzman’s lead, researchers in succeeding decades discovered a myriad of analogous phenomena. The proliferation of wilderness- and mountain-rescue teams induced hikers and climbers to take more and bigger risks, thus assuring that deaths and injuries from hiking and climbing would not decline despite the increase in resources devoted to rescue. Parachute manufacturers built superior rip cords, but chutists pulled the rip cord later because they were more confident of the cord’s resilience. The result was stability of death rates for sky divers. Stronger levees did not reduce the incidence of death, injury and damage from floods because people were induced to remain in floodplain areas rather than move out. Indeed, the desirability of these locations meant that more people moved in when they became more safe, leading to even more deaths, injuries and damage when a flood did occur. Workers who began wearing back supports still suffered injuries from lifting because the safety supports encouraged them to life heavier loads – which overcame the effect of the supports. Research on children who began wearing more protective sports equipment consistently showed that the kids responded by playing more roughly, overriding the benefits of the equipment and continuing the trend toward injuries. Better contraceptives and more effective medical treatments for HIV infection encouraged people to engage in riskier sexual practices, thereby preventing infection rates from declining as much as expected.

The technical term for all these cases is risk compensation. The general public and those with vested interests in government regulation tend to scoff at the concept, but its presence has been confirmed so repeatedly that it is now conventional wisdom. According to the popular purveyor of mainstream science, Smithsonian Magazine, “This counterintuitive idea was introduced in academic circles several years ago and is broadly accepted today…today the issue is not [about] whether it exists but about the degree to which it does.”  We see it “in the workplace, on the playing field, at home, in the air (“Buckle Up Your Seat Belt and Behave,” April 2009, by William Ecenberger).”

The implications of this research for even so widely venerated a government policy as mandatory seat-belt use are startlingly negative. People inclined to use seat belts are unaffected by the laws, but unwilling wearers who are forced to buckle up are presumably risk-loving types. When their seat belts are firmly in place, they will take more driving risks – after all, they must have had a reason for refusing the belt in the first place and risk-preference is the logical explanation. It follows, then, that they must feel safer when buckled in, which implies that they will try to return to their preferred status of risk tolerance. And studies of seat-belt mandates by economists do tend to show this result.

Risk compensation is so widely accepted among scientists outside of government that a Canadian psychologist has carried it to a logical extreme. Gerald J. S. Wilde propounds the philosophy of risk homeostasis, which posits that human beings automatically adjust their behavior to keep their exposure to risk at a constant level, just as the human body regulates its internal temperature at 98.6 degree Fahrenheit despite variations in external conditions.

The Economic View of Risk

We need not carry belief in adjustment to risk this far in order to recognize the futility of government attempts to fit society into a one-size-fits-all risk-free straitjacket. Not only is it a blatant violation of freedom and free markets, it doesn’t even achieve its intended objectives. It is wrong in theory and wrong in practice.

Risk is not an unambiguous bad thing. It is an unavoidable fact of life toward which different people take widely varying attitudes. For some people, risk is a benefit in and of itself. For practically everybody, risk is a by-product of other beneficial products and activities. Free markets give the most scope for the satisfaction of those different attitudes by allowing the risk-averse to avoid risk and the risk-loving to embrace it – and enabling both groups to do so efficiently via the price system.

Those who claim to see a role for government in allowing the risk-averse to avoid risk are practitioners of what Nobel Laureate Ronald Coase calls “blackboard economics.” This is favored by policymakers standing at a figurative blackboard and divorced from the real-world costs and complications of actually putting their government intervention into operation. In practice, risk and safety policies are delegated to regulators who issue orders and run roughshod over markets. The end result benefits regulators by increasing the size and power of government. The rest of us are stuck with obeying the regulations and picking up the tab.