DRI-306 for week of 3-23-14: Property Rights

An Access Advertising EconBrief:

Property Rights

This space endlessly bemoans the depredations of the economics profession, often laments the teaching of economics and occasionally points out shortcomings of economics textbooks. The biggest error of omission made by economists in and out of the classroom concerns property rights. Nothing is more important to the successful function of society. Judging by the attacks launched against them by enemies of free markets, we might expect lively discussions of property rights inside every economics text. Yet they are virtually ignored by mainstream economics.

The great exponent of property rights was the late Armen Alchian, who may have been the greatest economist ever spurned by the Nobel Prize selection committee. Alchian wrote comparatively little, but his few papers are still among the most cited of any economist. They have been fixtures on the reading lists of graduate students for decades – except for his great work on the economics of property rights, which has been pointedly ignored by academia.

Property Rights and Human Rights

As Alchian observed, social critics have long maintained that the system of property rights maintained in capitalist societies conflicts with “human rights.” Ostensibly, this conflict hurts the poor by allowing those with property to exploit those without it. Only a society without private ownership of property can stop this exploitation.

Alchian insisted that property rights – indeed, all rights – must be human rights. The call for abolition of private property is really a call for government ownership or control of property. This has certain unavoidable implications for people of all income levels.

Alchian stated that the very concept of property is best understood as a system of rights governing the care and use of property. That system operates under the logic of economics.

The Three Elements of Property Rights

Alchian’s key writings on property rights are summarized in entries in the Fortune Encyclopedia of Economics and its successor, the Concise Library of Economics. Here Alchian identified the three key elements of a system of property rights.

First among these is control. A right to property entails control over its care and use. This applies particularly, but not exclusively, to physical or tangible property. We are accustomed to this proposition in its positive form; i.e., in the right of people to enjoy and preserve things they own. Its negative form is less familiar. Children enjoy fewer rights than adults because they lack the capability to properly exercise them. Property rights are a good example of this; since tangible property usually demands care and maintenance, children are less able to exercise a right to its ownership.

Second is the right of exclusion. A property right gives the owner the right to exclude others from the possession and enjoyment of the property. Perhaps the most common example of this is the price charged by sellers, which excludes non-payers from the enjoyment of goods for sale. One of the key requisites for a public good – one that must be produced by government because private producers cannot produce it – is “non-exclusivity,” the inability to exclude non-payers. National defense is a public good because once it is provided for one, it is available to all.

Finally comes the right of salability. A true property right gives the owner the right to sell, rent, assign or delegate all or part of the ownership interest in the property at discretion. This is a key distinction between so-called government ownership and private ownership. Although government ownership is frequently referred to as “public ownership,” this is a misnomer. The government, not “the public,” controls the use of the property. In principle, according to the Rule of Law, the government should not exclude the public, but it often does. The public lacks the right to sell, rent or bequeath all or part of its property interest. Thus, no individual owns the property when “the government” owns it.

Both history and theory are replete with examples that sharpen each of these distinctions. We offer a few of these below.

Case Study in Property Rights: The American Indian and European Settlement

North America was settled by Europeans – Spanish, French, English, Germans and Dutch – beginning in the 16th century. Prior to European settlement, the continent was inhabited by aboriginal peoples who came to be called by the mistaken appellation of “Indians.” Over a period of roughly 300 years, the Indians were displaced – that is, removed from their original habitations and resettled.

The continent was populated by a mixture of Europeans, dominated by the English but also including large numbers of French to the north and Spanish to the south. Beginning in the 17th century, the English established numerous colonies in the central section that later gained their independence and became the United States of America. The English and French coexisted more or less peacefully in the English colony of Canada, which later became part of the British Commonwealth. The Spanish colony of Mexico to the south eventually rebelled and gained its independence from Spain.

In Canada and the United States, the displacement of Indians was accomplished through treaty, land purchase and resettlement. This was historically significant, since conquered peoples were generally treated much more harshly. Indeed, for thousands of years, the principal method for mass acquisition of wealth was conquest and plunder – that is, redistribution rather than economic growth. In the U.S., the process was still violent, though, as treaties and resettlement were accompanied by Indian wars lasting from the early 17th centuries until the end of the 19th century.

Much academic and popular history has condemned the acquisition of land from Indians by Europeans and, later, Americans. “We stole the land from the Indians” is a common phrase used to describe the process. This seems an odd way to characterize a process of negotiation and purchase, the historical successor to conquest, eradication or subjugation. More important is the implication that the proper course events would have been for Indians to have retained title to “their property.” This premise deserves careful study.

The social organization of American Indians was tribal. For most, though not all, their lifestyle was nomadic. In what later became the eastern U.S., the land was heavily forested in both the north and south. Most tribes subsisted by hunting deer. Historian Stanley Lebergott quoted one tribal chief: “[W]e must have a great deal of ground to live upon. A deer will serve us but a couple days, and a single deer must have a great deal of ground to put him in good condition. If we kill two or three hundred a year, ’tis the same as to eat all the wood and grass of the land they live on, and this is a great deal.”

This explains why Indians claimed such large quantities of land as “theirs.” They hunted deer. Deer were voracious consumers of forest grassland. (Today, deer thrive in urban American settings; a recent Wall Street Journal letter writer complained that deer are “urban locusts.”) Indians, in turn, consumed large numbers of deer. Deer would ravage a section of land, then migrate in search of fresh forage. Rather than build fixed settlements, Indians would follow the deer.

Prior to the Industrial Revolution, America – like the world – was overwhelmingly rural and agrarian. The overwhelming preoccupation was producing enough food to sustain life. Lebergott estimated that, by the early 1800s, the eastern Indian lifestyle demanded roughly two thousand acres, or three square miles, to produce enough calories to feed one Indian. This is consistent with contemporary accounts like the quoted passage above. In contrast, the American settlers who cleared land and build farms needed only two acres per person. In other words, the descendants of the European invaders had become one thousand times more economically productive than the Indians. The incentive for settlers to displace Indians on the land was enormous.

Even more to the point, the Indians’ claim to property rights was very weak. They could not control the use of the land they claimed as theirs, nor could they exclude non-users. Their only resort was sporadic violence against encroachments, which was by no means synonymous with enforcement of property rights since was violent, punished the innocent along with the guilty and affected only a small minority of the “violators.” Given their inability to command the first two elements of property rights, they could hardly execute the third. Thus, the basis for denying most Indian tribes a property-right claim to most of the North American continent rested on the same logic as that by which we deny most property rights to children. In both cases, the claimant lacks the competence and capability of exercising the claim.

Rather than grant Indians a dubious de jure property right they were sure to lose de facto anyway to white settlers, American governments in the early 1800s – particularly the administration of President Andrew Jackson – paid Indian tribes off and resettled them on federally owned land outside the boundaries of the United States. (Jackson maintained that it was unconstitutional to execute treaties with Indian tribes as if they were foreign nations, then force state governments to accept resettlement within their borders. He insisted that sovereign states were not bound by the terms of a treaty between the federal government and a foreign nation.)

There was much to regret about the execution of this approach, but the property-rights logic that underlay it was sound. It is quite clear now that salvation for Indians lay in assimilation with modern civilization rather than adherence to tribalism and outmoded economic organization. By treating Indians as wards of the state and preserving the reservation system and a separatist way of life for Indians, the federal government was guilty of the same false paternalism that has condemned much of the American underclass to inferiority today.

What about the western Indians, who occupied the plains and deserts of the Midwest and west? Once again, the predominant lifestyle was nomadic. In this case, subsistence derived from the buffalo or (more properly) bison, who roamed the plains in profusion during the 17th and 18th centuries. Once again, Indians followed the bison, which followed a seasonal pattern of migration throughout the plains. They hunted buffalo with bow and arrow – Plains Indians were amazingly proficient at driving arrows through the hides and deep into the muscular bodies of bison – and by stampeding the animals over cliffs. Although legend says that Indians were thrifty in their use of each part of the bison carcass, the truth is that carcasses were often left to rot.

As with the eastern Indians, the Plains Indians were highly unproductive compared with American settlers. Cattle fed upon grass proved to be vastly more profitable than bison – they dressed out better, their meat was in better demand, cattle could be domesticated whereas bison could not.  Despite the fact that the subjugation of warring Indians predated the near-extermination of the bison by about a decade, no serious attempt was made to establish the bison as a domestic meat animal on the western prairie.

The property-rights claims of Plains Indians were just as weak as those of eastern Indians, for similar reasons. The Plains Indians could not control use of the vast prairies, nor could they exclude interlopers. For many decades, a staple plot of Hollywood movies was the eviction of Plains Indians by greedy, unscrupulous whites hoping to profit thereby. Usually the motivation is gold, newly discovered by treaty violators in some place such as the Dakota Black Hills. In reality, gold discoveries were few and far between. The real motive behind the displacement of Plains Indians was cattle, not gold. White ranchers were vastly more productive on the plains than were Indians.

To be sure, the forest Indians of the east and the Plains Indians of the west do not encompass all Indians. Some Indians, like the Pueblo and Navaho in the west, did establish viable settlements and agricultural lifestyles. They did have valid property claims. Thus, their property rights should have been respected for the same reasons that the questionable claims of most Indians were rejected.

Pure Theory of Excludability: Alchian and Allen Offer a Proof By Negation

The most legendary of all economics textbooks may be University Economics (later reissued as Exchange and Production), by Armen Alchian and William Allen (AA). Blissfully sparse in its use of mathematics but lively and witty, it offers perhaps the most complete exposition of economic logic in any general textbook. Among its many famous applications is the authors’ imaginative defense of property rights, which takes the form of a “proof by negation.”

AA ask us to envision the following world: Automobiles exist, but are not privately owned. Instead, they exist as a common resource. Each is equipped with an auto-start that vitiates the need for an ignition key. Individuals are invited to make use of any car they find on the street, use it as long as required – purchasing their own gasoline – then leave it for someone else to use.

What would such a world be like?

A little thought suggests that the most salient automotive characteristic of that world would be that we would be driving a fleet of clunkers and junkers. Why? Because nobody would have an incentive to invest in either maintenance or repairs, at least beyond the point it took to get them to their immediate destination. From any one individual’s viewpoint, what would be the point of investing any substantial amount of money in an automobile that you would probably never see again once you reached your destination and left the car to go inside a building? Remember that everybody is not only entitled but expected to appropriate any unoccupied car for his own use. If you bought a new radiator for a car you picked up on the street, you might as well kiss that investment goodbye after leaving the repair shop and reaching your house.

With nobody wanting to repair cars to any significant degree or invest in preventive maintenance, their condition would deteriorate rapidly. People would carry their own motor oil, since they would likely have to add it to any vehicle to prevent the engine from blowing a gasket. Long trips would be a risky venture.

Another feature of this brave new world of socialized car ownership would be that everybody would drive off the bottom of their gas tank. Who would bother topping off the tank – unless undertaking a long trip – only to have somebody else drive off to enjoy most of the gas they purchased? For those who have not been subjected to this form of restraint, it can be a nerve-wracking experience calling for continual mental discipline.

AA suggest their example as an intellectual corrective for people who continue to regard property rights as a form of exploitation. Once absorbed, it can be applied to other forms of property to derive some idea what life without private property would be like. Alternatively, we can refer to the closest approximations provided by history. Visitors to socialist countries like Soviet Russia and Communist China often remarked upon the poor condition of the infrastructure and capital stock, usually without realizing that the lack of stock ownership and capital markets had killed off most of the incentive to maintain those capital goods.

Case Study in Salability: Property Rights and Species Preservation

The loss of species to extinction has been a chief selling point for the environmental movement ever since Rachel Carson published Silent Spring in 1962. Schoolchildren are taught the harrowing lesson of the passenger pigeon and the buffalo and told that only placing species on government’s “endangered species list” can save them. Typically, the grant of endangered status entails special protections and stern injunctions against harm.

A country whose wildlife has faced chronic preservation problems is Africa. Its exotic wildlife has always occupied a special place, if only because of its magnetic attraction for tourists. The elephant has been especially threatened because the unique properties of the ivory in its tusks have made it tremendously valuable. Poachers have reduced the elephant to the point of extinction in parts of its natural habitat.

The reflexive response throughout Africa has been twofold: ban elephant hunting and ban trade in elephant by-products like ivory. In Kenya, the government banned the hunting of elephants, but poachers decimated the elephant population from 140,000 to 16,000. In Tanzania, the government likewise banned hunting in 1970, but the elephant population was reduced from 250,000 to 61,000 in little more than a decade. In neighboring Uganda, the situation was even worse; its elephant population dropped from 20,000 to only 1,600.

To an economist well-versed in property rights, the reason for these failures was that the ban on hunting or harvesting elephants for commercial use was born of good intentions but was bound to produce bad results. In fact, it had the effect of killing thousands of elephants!

How could this possibly be true? How could people so sensitive to the welfare of these noble creatures do something so brutal, so insensitive, so utterly contrary to their intention? Alas, reason and emotion are completely different expressions of human thought. A surplus of the latter does nothing to promote the former; if anything, emotion tends to hinder the exercise of reason.

The laws against killing elephants had no effect on poachers because poachers are criminals by definition. They would have deterred ordinary people from killing elephants, but they actually encouraged poachers by killing off the legal market for elephants and elephant by-products, thereby making all things elephantine much more valuable in the black market. Being criminals, poachers were delighted to violate the law and sell their kill in the black market. In effect, the government was operating a price-support mechanism for the benefit of poachers.

One way to protect elephants as a species is by preventing the killing of existing elephants. The elephant-protection laws failed utterly in this respect. An even better means of species protection is by encouraging the breeding of more elephants. And the elephant-protection laws failed even more dreadfully here by destroying the legal incentive to breed elephants by destroying the legal market for them.

What a travesty of logic! Is it any wonder the results were so counterproductive? Well, it is one thing to sneer at failure, but another to actually succeed where good intentions alone have failed. Does ivory-tower economics have anything to show in the way of actual results?

In 1979, the African countries of Zimbabwe and Botswana created private property rights in elephants and allowed harvesting of elephants for commercial purposes. In a little less than 15 years, Zimbabwe’s elephant population rose from 30,000 to about 70,000. Botswana’s rose from 20,000 to 68,000.

The really amazing thing about this case study is that people are amazed by it. After all, we butcher many millions of cattle, chickens, hogs and sheep every year, but these species are not endangered because the legal market for them provides a continual incentive for their preservation and maintenance in good health and sufficient numbers to ensure viability. It seems as though people switch off their reasoning faculties when environmental subjects like species preservation arise.

Property Rights and Economic Development

In South America, economic development has been frustratingly elusive. A country such as Brazil possesses vast supplies of people and natural resources and seems on the verge of breaking through to developed-nation status. A country like Argentina was once among the world leaders in industrial production and economic growth, but now lags far behind. Venezuela has gone from being a continent leader in economic growth to Third-World status and near-chaos.

The insecurity of property rights throughout the continent has been identified as a leading culprit in this lack of enduring progress. It is difficult for investment to flourish in a climate where bribery is commonplace and cronyism runs rampant, where expropriation is a continual threat and financial-market transparency cannot be assumed.

Alchian’s Ghost

Today regulation looms larger in the lives of business and consumers than ever before. The ghost of Armen Alchian hovers over our shoulders. He does not haunt us. He is friendly, but admonitory and stern.

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

An Access Advertising EconBrief:

What Does ‘Social’ Mean Today?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

DRI-248 for week of 1-6-13: Rights vs. Power

An Access Advertising EconBrief: 

Rights vs. Power

Two recent examples of an endlessly recurring debate afford the opportunity to revive one of the most vital distinctions in political philosophy – between rights and power.

One example popped up at the Indiana University Health Goshen Hospital. Eight of its employees were fired for refusing to submit to flu vaccination via injection. Three of the eight were veteran nurses.

The hospital cited recommendations by the American Medical Association, the American Nurses’ Association and the Center for Disease Control that all Americans over 6 months of age undergo flu shots. One of the nurses, 61-year-old Ethel Hoover, insisted that “this is my body. I have a right to refuse the vaccine.” Website coverage of the incident by ABC News reporter Sydney Lupkin portrayed the dispute as a classic debate over “…which should come first: employee rights or patient safety.”

The other case occurred in Kansas City, MO, where Rockhurst High School, prestigious local Catholic high school, announced a policy of testing all students for the effects of drugs and binge drinking. A columnist for the Kansas City Star condemned the policy as “intrusive” and “unfair,” opining that experienced staff should be able to detect habitual users without the need for testing everybody.

The endless stream of back-and-forth debate over these cases suggests that the true governing principles have been long forgotten.

The Economic Implications of Political Rights

Few things arouse American ire as quickly as the subject of “rights.” The term is as old as the nation itself, appearing prominently in the Declaration of Independence and the Bill of Rights to the U.S. Constitution. And those references inform our understanding of the term.

Take the Declaration’s famous assertion that we possess the “right to life, liberty and the pursuit of happiness.” Why confer the right to pursue happiness – why not happiness itself? We sense the presence of a vital distinction. Our intuition tells us that government cannot very well grant a legal, constitutional right to happiness. Why not?

Of course, we realize that happiness is a subjective term and that it is impossible for one person to gauge whether another is happy or not. But we can make this point much more concrete by importing economic logic into the discussion. Economists gauge an individual’s happiness as a function of his or her real income or utility. This, in turn, depends on the consumption of life’s good things, both tangible and intangible.

Now we reach the nub of the problem. Goods are limited or finite in quantity while wants are infinite. Governments cannot promise happiness to everybody because governments cannot assure the supply of an unlimited volume of goods to satisfy wants. Again, this refers both to physical goods and services and to aesthetic wants such as beauty, truth and justice.

Although we may not realize it, we are all competing with each other for the limited supply of means with which to satisfy our unlimited wants. Naturally, we find it expedient to cooperate in order to serve our mutual interest in enlarging the volume of those means. Free markets and the price system are the evolutionary systems that have evolved for that purpose.

The Declaration of Independence enshrines the notion of the Rule of Law – or equality before the law – by granting to all alike the right to engage in the pursuit of happiness. But that does not imply that we all will achieve it. Indeed, stating the issue in this form makes it clear that we will not. Nonetheless, freedom allows everybody a shot at it and promotes cooperation not only in enlarging the size of the economic pie but in dividing it voluntarily through charity to help those who are least successful in fending for themselves.

The Economic Definition of Rights

A right is defined as something that can be enjoyed by one or more individuals without reducing the amount available for others to enjoy. This removes economic goods and services from the list of things to which a political right can be granted. Giving one person a guarantee of an economic good implies the necessity of denying a right to it (or, equivalently, to alternative goods) for others, since the good is not available in infinite quantities.

Guaranteeing a right to life means that others are not permitted to arbitrarily end your life unless you threaten theirs. Guaranteeing your liberty – and your right to pursue happiness – can be done without threatening the liberty of others. Indeed, the right to liberty must be guaranteed on equal terms for all law-abiding citizens in order to maintain the Rule of Law. That is why government exists in the first place.

The same reasoning applies to the other freedoms granted in the so-called Bill of Rights. It is vital to heed the Constitution’s explicit reminder that our rights are not limited to those explicitly listed in those first ten amendments. On the contrary, the Constitution limits the power of government by limiting it to its explicitly stated duties. (More than every, we are now coming to appreciate the wisdom of those who opposed ratification of the Constitution because they feared that the Bill of Rights would eventually come to be seen as limiting rather than reaffirming our rights.)

The Key Role Played by Competition

The case of nurses ordered by their employer to take flu shots is being treated by mainstream media as weighty and imponderable, a legal version of the clash between the irresistible force and the immovable object. But the principles outlined above – political and economic – provide the answer to this seeming quandary.

The nurses have committed no legal infraction and denied nobody their rights. Patients do not have an absolute right to good health any more than they have an absolute right to any other good or service. Ethel Hoover’s insistence that she owns her own body is impeccably correct. She has the right to refuse the flu vaccine. The government cannot force her to take it – not for the good of her patients or even for her own good.

But the government is not the entity requesting that she get a flu shot. Her employer is requesting that she do so as a condition of her employment. This request is perfectly valid and legitimate. The hospital chain serves customers. Those customers do not want to catch the flu while in hospital; they have just as much right to pursue happiness as nurses do. Hospitals compete with other hospitals. If some hospitals are forced to employ nurses who successfully resist flu shots, those hospitals may go out of business. Hospital owners have just as much right to pursue happiness as nurses do.

Are nurses being forced to take the flu shots by their private employer? No, because private employers cannot force employees to do anything. Employees can exercise the sovereign right of all employees – they can quit. Nurses are not guaranteed a particular job by law any more than they are guaranteed the right to a consumption good or service.

In this particular case, as it happens, the nurses in question apparently have lots of reasonable alternatives. They can pursue administrative jobs where their contact with patients is limited or nonexistent. They can pursue teaching opportunities within nursing. They can leave the profession and go elsewhere.

One other thing the nurses can do is pursue nursing employment elsewhere. Perhaps the fear of patient contamination is overblown, in which case competition between hospitals will provide an incentive for another hospital to exploit their veteran talents. Competition between hospitals works in their favor as well as working against them.

The pertinent distinction is between government action, which is coercive and allows no room for maneuver or escape, and marketplace action, which presents voluntary choices and alternative possibilities. When the government nails you, you either comply or go to jail. When an employer makes a request, you choose from a range of alternatives that normally offer much smaller decrements of loss.

By definition, competition means the presence of alternatives. By definition, government means their absence.

The All-Important Distinction: Rights vs. Power

Nurse Ethel Hoover wants to assert a “right” to refuse her employer’s request that she take a flu shot while at the same time retaining her job. In effect, she wants the right to hold her job in spite of her employer’s insistence that she is unsuitable to perform it.

This is not a right. The only way she can retain her job under these circumstances is by forcing the employer to give up his right to pursue happiness by producing health care profitably and safely and by forcing consumers to forego their rights to purchase good health. Nurse Hoover is demanding power – the power to force other people to forego their rights. Of course, she is cosmetically beautifying her claim by cloaking it in the faddish language of “rights.”

The debate over freedom vs. power goes back a long time. In the 20th century, it was wages between F.A. Hayek on the right wing and John Dewey on the left wing. Dewey defined freedom as the “power to do effective things” while Hayek defined it as “the absence of external constraint.” Hayek observed in his classic polemic The Road to Serfdom that Dewey confused freedom with power. Modern political philosophy has continued to observe the distinction with the dichotomy between “positive liberty” (Dewey’s version, which is really power, not liberty) and “negative liberty” (Hayek’s version).

The left wing has traditionally conflated power with freedom. It has tried to salvage its position by insisting that only government can solve cases like those of Nurse Hoover. Employers are unable and/or too venal to judge the safety of flu shots; consumers can’t choose safe health care for themselves. Thus, allowing markets to work will wrongly exile Nurse Hoover from her profession and stick us with inferior health care. Governments must objectively determine the safety of flu vaccines, once and for all and for everybody. Government must give Nurse Hoover her rights; otherwise, she won’t have any since markets always do the wrong thing.

The left’s position is untenable. It is logically absurd to contend that consumers not only make wrong choices about their own health but also continue to persist in those choices. It is absurd to maintain that bureaucrats somehow possess both the expertise and the wisdom to make life choices for people about whom they know nothing. It is absurd to suppose that bureaucrats – notoriously insulated from the consequences of their own mistakes – can judge safety better than doctors and managers whose livelihoods are on the line.

The Non-Sequitur of Childhood

The Rockhurst High School case is also being wrongly perceived. Here, the confounding factor is childhood, a factor that nowadays invariably puts the brain in neutral while shifting the emotions into forward gear.

Once again, the issue is being put as a conflict of “rights.” Does a high school have the “right” to “force” students to undergo drug tests? Do students have the “right” to refuse them? In this case, the presence of childhood in the equation turns some people into paternalists and others into public defenders.

The paternalists insist that kids cannot possibly perceive their own interests and that it is therefore up to us to step into the breach. Of course, this places overwhelming importance on the content of “us” – is that parents, teachers, administrators, judges, doctors or some artfully contrived mixture of the above? The public defender insist that children are helpless victims of the high school/teachers/administrators/judges/doctors (take your pick) and require the services of advocates provided by government or the press (to the extent that those two differ).

Economics has long realized that consumption decisions are made jointly within families and nominates “the household” as the family choice unit. As a practical matter, this means one or more parents with varying degrees of input from children. There is no reason to think that a system that makes choices on food, clothing, housing, entertainment, transportation and communications cannot also handle education and personal privacy.

Of course, households choose among competitive suppliers of food, clothing, housing, etc. And this particular situation actually deals with personal privacy rather than education, doesn’t it?

Yes and no. Large numbers of households are hamstrung by quasi-monopolies in secondary education; that is, they cannot afford to pay twice for the competitive alternative of private schools. In that sense, they are actually in the “government” case as outlined above. The law requires them to send their kids to school but doesn’t allow them the luxury of choosing alternative suppliers of public education if their school’s policy on personal privacy is obnoxious to them.

As it happens, Rockhurst High School is one of – perhaps the – most exclusive private high schools in the Kansas City metro area. There is little doubt that its families can afford to search out alternatives if necessary. Thus, Rockhurst should certainly have the alternative of offering drug testing to its students and parents. While the policy may well be unpopular with students, parents may just as well like it. Parents who don’t like it can enroll their children elsewhere.

If the policy proves unsuccessful, we all benefit from having learned this truth. Certainly it would have been better to have known it in the first place and avoided the hassle and unpleasantness of testing, but it isn’t always possible to know everything in advance. Sometimes we have to try things. That is one of the things that free markets are all about. If the policy proves successful, that will vindicate it in spite of initial objections – provided the objectors weren’t forced to undergo it.

But what about a policy of drug testing in the public schools? That’s a lab specimen of an entirely different color, to suit the metaphor to the occasion.

Time and again, this generic problem arises. Should public schools have a dress code? If so, which one? Should they teach evolution – or creation? And what does “teaching” either one of those mean, anyway? It turns out, then, that drug testing is not a unique issue at all. It is the same old issue in different guise.

There is no “solution” to questions like dress codes or religion in schools – no unique, one-size-fits-all solution, that is. The solution is competition. The solution is to allow different families to choose the alternatives they like best – and to change their minds when things don’t work out.

There is only one route to that solution. It lies through a free, privatized market in education. Mirabile dictu, this just happens to be the same economic solution to the decades-old problem of rising education spending and falling educational quality. Education reform dates back to the early 20th century, but results have been dismal. Economists know the source of the problem and they know that the answer is not more money spent on education. The bromide “you get what you pay for” is correct only when there is competition for the product being purchased.

Thus, a policy of drug testing in public schools should be rejected for the same reason that Nurse Hoover should be allowed to reject flu shots. Government has no right to force students to undergo drug testing against their will because public education is a quasi-monopoly provider. But the monopoly provision of public education should be ended, for this reason among a multitude of others.

Drug testing may be a good thing or a bad thing. Indeed, it may be a good thing for some people, in some environments or cultures, and bad for others. The only way to find out is to allow competition to prevail. And the only way to do that is to get government out of it.

The Politicization of Practically Everything

Today we face the Balkanization of American life, with interest groups facing off in the legislatures and courts. The executive branch of government (mayors, governors and the U.S. President) has come to view as a prerogative the ability to decide questions involving “rights.” In effect, this means deciding which people will have more goods and services and which people will have fewer. This is not the promotion of true rights. It is the exercise of power.

This abrogates the Rule of Law. It erodes respect for the law. It turns republican government into a form of totalitarianism called absolute democracy. Under that system, we vote to elect political representatives and they grant “rights,” or entitlements, to their supporters while depriving their opponents of true rights. This is what comes of elevating politics above all and ignoring economics.

The most recent manifestation of this aberrant democratic virus is the obsession to punish the rich. The party in power – the Democrats – has essentially unlimited power to write rules through legislation, regulation, executive order and judicial interpretation. That allows them the luxury of writing rules that reward their supporters and punish their opponents. Their supporters include plenty of rich people, but they are predominantly those who gain real income from foundations and carried interest. So Democrats write tax rules that favor those practices. Democrat rules define the “evil rich” as those who earn high annual incomes from entrepreneurship and salaries; i.e., Republicans. So Democrats raise taxes on “the rich” in the name of fairness by increasing marginal rates of taxation on high incomes. (Democrat entrepreneurs are granted waivers from Democrat rules and regulations such as ObamaCare legislation.)

Meanwhile, Republicans sit dazed and sullen. They await their return to power. At that point, they can implement their agenda by elevating the interests of their supporters and punishing the Republican analogues of the “evil rich,” such as immigrants and homosexuals.

George Orwell characterized a totalitarian society as one in which everything is politicized; everything is either mandatory or forbidden. The reflexive tendency to turn employment conditions and student privacy policies into political firefights is a symptom of neuropathy in the body politic. We have become insensitive to the freedoms of others.

The inherent purpose of government is to coerce, to promote conformity. Markets are not all-or-nothing propositions. They accommodate variety. They move incrementally. They promote diversity. By insisting that government do more and more, we are allowing markets to accomplish less and less. We are methodically chipping away at the zone of human freedom.

DRI-380 for week of 7-29-12: The OYPI Challenge Returns: Religious Belief, Overpaid CEOs and Payday Loans

Religious Belief, Overpaid CEOs and Payday Loans

Regular readers of this column may recall the OYPI Challenge. The acronym OYPI stands for “Oh Yeah? Prove It!” It questions the validity of popular lore by challenging believers to back their beliefs with action – and cash. Accepting the challenge demands only the courage of one’s convictions, since the challenged beliefs imply the opportunity for easy profits to be made. How much courage does it take to pick up a $1000 bill lying on the sidewalk?

The underlying thesis of the OYPI Challenge is that talk is cheap, and the world is full of people saying things they don’t believe for purposes of political or personal gain. It would be shocking if this thesis were wholly original, and there is evidence to the contrary. In his recent book The Big Questions (2009), well-known economic popularizer Steven Landsburg develops an example that incorporates this fundamental insight implicitly.

Steven Landsburg on the Shakiness of Religious Belief

In the chapter entitled “What Do Believers Believe?” Landsburg casts doubt on the strength of wholesale religious belief. Noting that “the beliefs I go around repeating are the ones I don’t really believe…but when I pass the threshold to actual belief, I stop reviewing the matter,” Landsburg cites the widespread need for religious observance as one indicator of the shakiness of real faith.

He goes further by drawing inferences analogous to those implied in the OYPI Challenge. In principle, believers should commit fewer crimes, since they face punishment in the hereafter, not merely in the here and now. He finds no statistical case to support this proposition. Believers should fear death less, since the possibility (or certainty) of life after death should reduce the loss suffered as a result of death. Once again, Landsburg rejects little or no evidence to support this notion. (Willingness to die for the faith, whether as a Christian martyr or an Islamic suicide bomber, seems decidedly scant.)

The anxiety to publicly engage in “interfaith dialogue” seems similarly suspicious, since it implies indifference to what are purportedly life’s guiding principles. Since religions proffer theories about the origin of the universe, the earth, life and its progression, one might expect that believers would specialize in the study of these matters. But they don’t.

It is true, Landsburg concedes, that some 90% of Americans profess belief in God. But this is suspect because there is so seldom anything of consequence riding on our beliefs or their expression. This explains why people so often give wrong or contradictory answers to pollsters.

From our perspective, the most intriguing thing about Landsburg’s analysis is its generic resemblance to our OYPI Challenge. Landsburg recognizes that public discourse is overrun with insincere and superficial professions of belief. He recognizes the reason why this is true; namely, that expression is costless; e.g., “talk is cheap.” Moreover, people are seldom motivated to probe or challenge their own professions of belief.

Ironically, Landsburg seems not to notice that he has conflated the problems of the existence of God and the origin and purpose of life with the nature and tenets of various organized religions. He seems equally unconscious of the fact that most of the best writing on religion and faith, both secular and theological, has addressed the issues he raises. Landsburg may have overlooked his debt to writers such as C. S. Lewis and Graham Greene, but we should not overlook ours to Landsburg for reinforcing the bedrock logic underlying the OYPI Challenge.

Our OYPI Challenge is objective in character. The result of the challenge is measured in dollars and cents. The believer is challenged to demonstrate financially both the truth of his belief and his confidence in it. Failure – or failure to respond – refutes the belief.

Overpaid CEOs

The current brouhaha over CEO pay owes much to the Occupy movement, which created the artificial distinctions of “1%” and “99%” as a way of dehumanizing and demonizing the possession of great wealth and high income. The greater the separation between “the rich” and the rest, the smaller the number of demons in comparison with the number of those possessed, the greater becomes the volume of outrage generated by the movement. CEOs are a highly visible minority, severely limited in number, whose activities are remote from the experience and sympathies of most people.

The popular theory of CEO overpayment goes something like this: CEOs are employed by corporations, which are inherently evil. Corporate boards of directors are rubber stamps of management, which somehow influences the board to pay the CEO in excess of his or her true worth. The gains to the CEO (and perhaps to the board, through bribery) come at the expense of rank-and-file workers – hence the dichotomy between the 1% and the 99%. This disproportion can be proved by two kinds of comparison: cross-section (U.S. CEOs compared to, say, Japanese CEOs) and time-series (the ratio of CEO-to-worker pay now compared to that in the past).

To those who (claim to) believe this thesis, this is the OYPI Challenge: Start a corporation in competition with one or more whose CEO is “overpaid” according to your criterion. Form a board of directors whose mission is to hire the lowest-paid CEO that can be found. Raise the wages of hourly workers in correspondence with the relative decline in salary paid to the CEO. According to the overpaid CEO hypothesis, one or both of two things should happen: the firm’s productivity and profits will increase because it will recruit higher-quality workers, or the firm will simply enjoy normal profits with a lower-earning CEO and higher-earning workers.

The reasons why nobody bothers to rise to this OYPI Challenge go beyond their skepticism of CEO pay. Part of the problem is the hypothesis being challenged. For example, consider the ambiguity of the phrase “in correspondence with.” If this is interpreted to mean “pay the CEO 15% less than average and pay the workers 15% above the market wage,” its unworkability sticks out like a nose bitten by a bumblebee. The firm would save 15% of a CEO salary but lose 15% of a much-larger wage bill; it would go broke in short order. Furthermore, the implication that all CEO’s are interchangeable but some workers are better than others seems contraindicated by the facts.

On the other hand, the phrase might be interpreted to mean “distribute any savings from CEO pay among workers in the form of hourly wage increases.” But this would mean distributing a few million dollars among thousands of workers over the course of a year’s wage earnings. The gains would be real enough, but negligible in size. Certainly they wouldn’t make a discernible dent in the overall distribution of income even if generalized across an entire economy. So much for the “CEO gains are workers’ losses” component of the overpaid CEO hypothesis.

Why are so many of us dubious about CEO pay but more than willing to endorse multimillion-dollar earnings for professional athletes and entertainers? They experience the value created by movie and rock stars viscerally and personally, while their grasp of CEO impact on the bottom line is shaky. They know the difference between a first-string and second-string quarterback, but the distance separating a first-string CEO from a second-stringer eludes them.

Yet there is a market for corporate managerial talent, just as for athletes and actors. The people who pay CEO salaries are not board members but shareholders. Theirs are the pockets CEO pay comes out of, not the corporation’s hourly workers. Labor is also purchased in a market. It the firm pays too little, it can’t buy the workers it needs. If it pays too much, it goes out of business. CEO pay is unrelated to the firm’s payment of its workers. So much for the “Management controls the board of directors which picks the CEO” component of the overpaid CEO hypothesis. So much for the “CEOs are paid more than their true worth” component of the hypothesis.

Time-series comparisons of CEO and worker pay are not meaningful because there is no technological or economic reason why those ratios should remain steady over time. Over the course of the 20th century, athletes and entertainers increased their earnings tremendously compared to those of their bosses. The reasons for this were both technological and economic. While this was happening, it also became possible for CEOs to add more shareholder value to the firms they managed. Consequently, their salaries and bonus earnings increased accordingly.

Cross-section comparisons between American and Japanese CEOs presumably reflect political and cultural differences that blur the relevant distinctions. But here, as elsewhere, the OYPI Challenge emerges to cut through the murk and clarify the issue: If Japanese firms pay their CEOS less and otherwise perform as well as U.S. firms, there should be more left over for shareholders, the residual claimants of the firm’s earnings. So, a corollary OYPI Challenge is that believers of the overpaid CEO hypothesis should invest in Japanese firms and brandish their above-normal rates of return as proof of their hypothesis. If they can produce them, that is.

The hardest part of dealing with the overpaid CEO hypothesis is not refuting it; it is stating it in a form that is halfway sensible in the first place. But the inescapable truth is that supporters of this hypothesis are implicitly alleging the existence of a free lunch, a $1000 bill just lying there on the sidewalk, waiting to be picked up but languishing all by its lonesome because nobody notices or cares that it’s there. In reality, the overpaid CEO hypothesis is one more myth laid low by the ultimate myth buster, the OYPI Challenge.

Payday Loans

For sheer heart-tearing poignancy, no concert for strings can match a publicity campaign against “payday loan” or high-interest loan companies. High-interest loans are those whose interest rate exceeds that normally carried by bank, finance-company or even pawn loans. The loans are unsecured, which gives them the highest risk.

The term “payday loan” derives from the popular practice of arranging the term of the loan to expire on a future payday, thus insuring that sufficient funds for repayment will be delivered in the borrower’s paycheck. Standard operating procedure is to provide bank account information – account number, routing number, etc. – to the loan company, which then automatically debits the borrower’s bank account for the loan service fee or repayment, whichever is the case.

The “first law of finance” is the inverse relationship between risk and rate of return. The extreme high risk of payday loans comes from the fact that they are unsecured loans made to those who cannot qualify for any lower-cost alternative. Thus, payday loan borrowers typically cannot qualify for (or have maxed out on) a credit card or a consumer finance loan or mortgage, and have exhausted all other borrowing alternatives. The first law of finance postulates the inverse relationship between the rate of return of any asset and its risk. In the case of payday loans, this can mean that borrowers may pay an effective annual interest rate to maturity exceeding 400%. Only true loan sharks – that is, members of organized crime who use physical violence to collect on their loans – charge higher loan rates of interest.

A jeremiad against payday loan firms goes something like this: Evil, greedy lenders prey on poor, unsuspecting borrowers by lending them money at stratospheric, usurious rates of interest. Once sucked in by the irresistible lure of immediate cash, the borrowers are caught in a fatal downward spiral of debt repayment at 400%+ annual rates of interest. The only way to prevent these financial merchants of death from sucking the wealth of the poor into their own pockets is by driving the payday lenders from the market or, at a minimum, capping the interest rates they charge.

The countervailing OYPI Challenge is this: Apparently, payday-lender-enders believe that payday-loan firms have discovered the financial equivalent of the perpetual motion machine – a way to turn the poverty of the poor into their own wealth. OK, prove it – start your own payday loan firm and charge (say) a mere 200% or so effective annual interest rate. You’re lifting a heavy burden on the poor by cutting their costs in half while proving your contention that those dreadfully high payday loan interest rates are indeed abusive, excessive and unnecessary for the operation of a viable high-risk loan firm.

Of course, that is the $64,000 question – do the crusaders really believe their own inflammatory rhetoric? A local talk-radio host in Kansas City, MO recently offered a counterproposal to draconian legislation against payday loan firms; namely, that religious charities should loan money to the poor at a rate of 4%. At this point, one is moved to inquire: Why not 3%? Or 2% Or 1%? Why charge any interest at all?

The charging of interest reflects the phenomenon that economists call “time preference.” People prefer consumption in the present to consumption in the future, and the interest rate is an index of the discount placed on future goods – the farther out, the greater the discount. (If this were not true, the productivity of investment would induce an infinite amount of saving, since it would always be possible to increase the amount of real income available for consumption purposes by saving.) The interest rate charged by a lender must be at least sufficient to assure him or her of consumption opportunities greater in the future than those available today.



Super-high interest rates reflect the fact that unsecured loans made to low-income, bad-credit borrowers result in extremely high default rates. Thus, interest payments made by current borrowers must be sufficient to compensate for these defaults, which are simply written off by the payday-lending firms. (Mafia loan sharks, by contrast, never write anything off the books and collect in pain, suffering and death what they cannot collect in cash.) Anybody who doubts that 400% interest rates are necessary to insure a profit plus a rate of return commensurate to the risk has simply never been in the business.

In reality, the payday loan business is a highly competitive business just like any other competitive business. The dozens of recent entrants in national and local markets, like Cash America, have succeeded in lowering the effective interest rates somewhat from the norm of $30 per month per $100 borrowed (an annual repayment total including principal of $460). The fact that those rates remain very high is proof that the OYPI Challenge will not be successfully met.

Incredibly, a question often posed by payday-lender-enders is: Why would anybody borrow money at 400%+? Isn’t this presumptive evidence of economic stupidity, justifying community action to save borrowers from themselves? Put this way, the question virtually answers itself. Payday-loan (or high-interest loan) customers are those who need money quickly and lack alternative access to money or credit. Legitimate needs are legion, ranging from home and automotive repairs to pet medical emergencies to avoidance of fees for overcharges and defaults. Really, virtually any sudden need might give rise to a payday loan, and people from every strata of society have sought them.

The truly penetrating questions are never asked. What gives payday-loan critics the right or the hubris to run the lives of borrowers by denying them access to the only form of credit open to them? What gives them the right to virtually run law-abiding businesses out of business? How would they feel if somebody came along and began running their lives based on confused and inaccurate analysis?

The OYPI Challenge Strikes Again

Public discourse is traditionally like the weather; everybody talks about it but nobody does anything about it. Everybody goes on believing what they began believing on the basis of their instincts and emotions. Nobody subjects their beliefs to scrutiny or test.

The OYPI Challenge is truth’s counterattack against the encroachments of habit, superstition and fable. It poses what the great economic historian Deirdre (formerly Donald) McCloskey called “the American Question: If you’re so smart, why ain’t you rich?” In McCloskey’s vein, we might call it “the American comeback: Put up or shut up.” After all, the one distinctive American school of philosophy is pragmatism.