DRI-183 for week of 3-1-15: George Orwell, Call Your Office – The FCC Curtails Internet Freedom In Order to Save It

An Access Advertising EconBrief:

George Orwell, Call Your Office – The FCC Curtails Internet Freedom In Order to Save It

February 26, 2015 is a date that will live in regulatory infamy. That assertion is subject to revision by the courts, as is nearly everything undertaken these days by the Obama administration. As this is written, the Supreme Court hears yet another challenge to “ObamaCare,” the Affordable Care Act. President Obama’s initiative to achieve a single-payer system of national health care in the U.S. is rife with Orwellian irony, since it cannot help but make health care unaffordable for everybody by further removing the consumer of health care from every exposure to the price of health care. Similarly, the latest administration initiative is the February 26 approval by the Federal Communications Commission (FCC) of the so-called “Net Neutrality” doctrine in regulatory form. Commission Chairman Tom Wheeler’s summary of his regulatory proposal – consisting of 332 pages that were withheld from the public – has been widely characterized as a proposal to “regulate the Internet like a public utility.”

This episode is riven with a totalitarian irony that only George Orwell could fully savor. The FCC is ostensibly an independent regulatory body, free of political control. In fact, Chairman Wheeler long resisted the “net neutrality” doctrine (hereinafter, shortened to “NN” for convenience). The FCC’s decision was a response to pressure from President Obama, which made a mockery of the agency’s independence. The alleged necessity for NN arises from the “local monopoly” over “high-speed” broadband exerted by Internet service providers (again, hereinafter abbreviated as “ISPs”) – but a “public utility” was, and is, by definition a regulated monopoly. Since the alleged local monopoly held by ISPs is itself fictitious, the FCC is in fact proposing to replace competition with monopoly.

To be sure, the particulars of Chairman Wheeler’s proposal are still open to conjecture. And the enterprise is wildly illogical on its face. The idea of “regulating the Internet like a public utility” treats those two things as equivalent entities. A public utility is a business firm. But the Internet is not a single business firm; indeed, it is not a single entity at all in the concrete sense. In the business sense, “the Internet” is shorthand for an infinite number of existing and potential business firms serving the world’s consumers in countless ways. The clause “regulate the Internet like a public utility” is quite literally meaningless – laughably indefinite, overweening in its hubris, frightening in its totalitarian implications.

It falls to an economist, former FCC Chief Economist Thomas Hazlett of Clemson University, to sculpt this philosophy into its practical form. He defines NN as “a set of rules… regulating the business model of your local ISP.” In short, it is a political proposal that uses economic language to prettify and conceal its real intentions. NN websites are emblazoned with rhetoric about “protecting the Open Internet” – but the Internet has thrived on openness for over 20 years under the benign neglect of government regulators. This proposal would end that era.

There is no way on God’s green earth to equate a regulated Internet with an open Internet; the very word “regulated” is the antithesis of “open.” NN proponents paint scary scenarios about ISPs “blocking or interfering with traffic on the Internet,” but their language is always conditional and hypothetical. They are posing scenarios that might happen in the future, not ones that threaten us today. Why? Because competition and innovation protected consumers up to now and continue to do so. NN will make its proponents’ scary predictions more likely, not less, because it will restrict competition. That is what regulation does in general; that is what public-utility regulation specifically does. For over a century, public-utility regulation has installed a single firm as a regulated monopoly in a particular market and has forcefully suppressed all attempts to compete with that firm.

Of course, that is not what President Obama, Chairman Wheeler and NN proponents want us to envision when we hear the words “regulate the Internet like a public utility.” They want us to envision a lovely, healthy flock of sheep grazing peacefully in a beautiful meadow, supervised by a benevolent, powerful Shepherd with a herd of well-trained, affectionate shepherd dogs at his command. Soothing music is piped down from heaven and love and tranquility reign. At the far edges of the meadow, there is a forest. Hungry wolves dwell within, eyeing the sheep covetously. But they dare not approach, for they fear the power of the Shepherd and his dogs.

In other words, the Obama administration is trying to manipulate the emotions of the electorate by creating an imaginary vision of public-utility regulation. The reality of public-utility regulation was, and is, entirely different.

The Natural-Monopoly Theory of Public-Utility Regulation

The history of public-utility regulation is almost, but not quite, co-synchronous with that of government regulation of business in the United States. Regulation began at the state level with Munn vs. Illinois, which paved the way for state government of the grain business in the 1870s. The Interstate Commerce Commission’s inaugural voyage with railroad regulation followed in the late 1880s. With the commercial introduction of electric lighting and the telephone came business firms tailored to those ends. And in their wake came the theory of natural monopoly.

Both electric power and telephones came to be known as “natural monopoly” industries; that is, industries in which both economic efficiency and commercial viability chose one single firm to serve the entire market. This was the outgrowth of economies of scale in production, owing to decreasing long-run average cost of production. This decidedly unusual state of affairs is a technological anomaly. Engineers recognize it in conjunction with the “two-thirds rule.” There are certain cases in which cost increases as the two-thirds power of output, which implies that cost decreases steadily as output rises. (The thru-put of pipes and cables and the capacity of cargo holds are examples.) In turn, this implies that the firm that grows the fastest will undersell all others while still covering all its costs. The further implication is that consumers will receive the most output at the lowest price if one monopoly firm serves everybody – if, and only if, the firm’s price can be constrained equal to its long-run average cost at the rate of output necessary to meet market demand. An unconstrained monopoly would produce less than this optimal rate of output and charge a higher price, in order to maximize its profit. But the theoretical outcome under regulated monopoly equates price with long-run average cost, which provides the utility with a rate of return equal to what it could get in the best alternative use for its financial capital, given its business risk.

In the U.S. and Canada, this regulated outcome is sought by a public-utility commission via the medium of periodic hearings staged by the public-utility regulatory commission (PUC for short). The utility is privately owned by shareholders. In Europe, utilities are not privately owned. Instead, their prices are (in principle) set equal to long-run marginal cost, which is below the level of average cost and thus constitutes a loss in accounting terms. Taxpayers subsidize this loss – these subsidies are the alternative to the profits earned by regulated public-utility firms in the U.S. and Canada.

These regulatory schemes represent the epitome of what the Nobel laureate Ronald Coase called “blackboard economics” – economists micro-managing reality as if they possessed all the information and control over reality that they do when drawing diagrams on a classroom blackboard. In practice, things did not work out as neatly as the foregoing summary would lead us to believe. Not even remotely close, in fact.

The Myriad Slips Twixt Theoretical Cup and Regulatory Lip

What went wrong with this theoretical set-up, seemingly so pat when viewed in a textbook or on a classroom blackboard? Just about everything, to some degree or other. Today, we assume that the institution of regulated monopoly came in response to market monopolies achieved and abuses perpetrated by electric and telephone companies. What mostly happened, though, was different. There were multiple providers of electricity and telephone service in the early days. In exchange for submitting to rate-of-return regulation, though, one firm was extended a grant of monopoly and other firms were excluded. Only in very rare cases did competition exist for local electric service – and curiously, this rate competition actually produced lower electric rates than did public-utility regulation.

This result was not the anomaly it seemed, since the supposed economies of scale were present only in the distribution of electric power, not in power generation. So the cost superiority of a single firm producing for the whole market turned out to be not the slam-dunk that was advertised. That was just one of many cracks in the façade of public-utility regulation. Over the course of the 20th century, the evolution of public-utility regulation in telecommunications proved to be paradigmatic for the failures and inherent shortcomings of the form.

Throughout the country, the Bell system were handed a monopoly on the provision of local service. Its local service companies – the analogues to today’s ISPs – gradually acquired reputations as the heaviest political hitters in state-government politics. The high rates paid by consumers bought lobbyists and legislators by the gross, and they obediently safeguarded the monopoly franchise and kept the public-utility commissions (PUCs) staffed with tame members. That money also paid the bill for a steady diet of publicity designed to mislead the public about the essence of public-utility regulation.

We were assured by the press that the PUC was a vigilant watchdog whose noble motives kept the greedy utility executives from turning the rate screws on a helpless public. At each rate hearing, self-styled consumer advocacy groups paraded their compassion for consumers by demanding low rates for the poor and high rates on business – as if it were really possible for some non-human entity called “business” to pay rates in the true sense, any more than they could pay taxes. PUCs made a show of ostentatiously requiring the utility to enumerate its costs and pretending to laboriously calculate “just and reasonable” rates – as if a Commission possessed juridical powers denied to the world’s greatest philosophers and moralists.

Behind the scenes, after the press had filed their poker-faced stories on the latest hearings, increasingly jaded and cynical reporters, editors and industry consultants rolled their eyes and snorted at the absurdity of it all. Utilities quickly learned that they wouldn’t be allowed to earn big “profits,” because this would be cosmetically bad for the PUC, the consumer advocates, the politicians and just about everybody involved in this process. So executives, middle-level managers and employees figured out that they had to make their money differently than they would if working for an ordinary business in the private sector. Instead of working efficiently and productively and striving to maximize profit, they would strive to maximize cost instead. Why? Because they could make money from higher costs in the form of higher salaries, higher wages, larger staffs and bigger budgets. What about the shareholders, who would ordinarily be shafted by this sort of behavior? Shareholders couldn’t lose because the PUC was committed to giving them a rate of return sufficient to attract financial capital to the industry. (And the shareholders couldn’t gain from extra diligence and work effort put forward by the company because of the limitation on profits.) That is, the Commission would simply ratchet up rates commensurate with any increase in costs – accompanied by whatever throat-clearing, phony displays of concern for the poor and cost-shifting shell games were necessary to make the numbers work. In the final analysis, the name of the game was inefficiency and consumers always paid for it – because there was nobody else who could pay.

So much for the vaunted institution of public-utility regulation in the public interest. Over fifty years ago, a famous left-wing economist named Gardiner Means proposed subjecting every corporation in the U.S. to rate-of-return regulation by the federal government. This held the record for most preposterous policy program advanced by a mainstream commentator – until Thomas Wheeler announced that henceforth the Internet would be regulated as if it were a public utility. Now every American will get a taste of life as Ivan Denisovich, consigned to the Gulag Archipelago of regulatory bureaucracy.

Of particular significance to us in today’s climate is the effect of this regime on innovation. Outside of totalitarian economies such as the Soviet Union and Communist China, public-utility regulation is the most stultifying climate for innovation ever devised by man. The idea behind innovation is to find ways to produce more goods using the same amount of inputs or (equivalently) the same amount of goods using fewer inputs. Doing this lowers costs – which increases profits. But why do to the trouble if you can’t enjoy the increase in profits? Of course, utilities were willing to spend money on research, provided they could get it in the rate base and earn a rate of return on the investment. But they had no incentive to actually implement any cost-saving innovations. The Bell System was legendary for its unwillingness to lower its costs; the economic literature is replete with jaw-dropping examples of local Bell companies lagging years and even decades behind the private sector in technology adoption – even spurning advances developed in Bell’s own research labs!

Any reader who suspects this writer of exaggeration is invited to peruse the literature of industrial organization and regulation. One nagging question should be dealt with forthwith. If the demerits of public-utility regulation were well recognized by insiders, how were they so well concealed from the public? The answer is not mysterious. All of those insiders had a vested interest in not blowing the whistle on the process because they were making money from ongoing public-utility regulation. Commission employees, consultants, expert witnesses, public-interest lawyers and consumer advocates all testified at rate hearings or helped prepare testimony or research it. They either worked full-time or traveled the country as contractors earning lucrative hourly pay. If any one of them was crazy enough to launch an expose of the public-utility scam, he or she would be blackballed from the business while accomplishing nothing – the institutional inertia in favor of the system was so enormous that it would have taken mass revolt to effect change. So they just shrugged, took the money and grew more cynical by the year.

In retrospect, it seems miraculous that anything did change. In the 1960s, local Bell companies were undercharging for local service to consumers and compensating by soaking business and long-distance customers with high prices. The high long-distance rates eventually attracted the interest of would-be competitors. One government regulator grew so fed up with the inefficiency of the Bell system that he granted the competitive petition of a small company called MCI, which sought to compete only in the area of long-distance telecommunications. MCI was soon joined by other firms. The door to competition had been cracked slightly ajar.

In the 1980s, it was kicked wide open. A federal antitrust lawsuit against AT&T led to the breakup of the firm. At the time, the public was dubious about the idea that competition was possible in telecommunications. The 1990s soon showed that regulators were the only ones standing between the American public and a revolution unlike anything we had seen in a century. After vainly trying to protect the local Bells against competition, regulators finally succumbed to the inevitable – or rather, they were overrun by the competitive hordes. When the public got used to cell phones and the Internet, they ditched good old Ma Bell and land-line phones.

This, then, is public-utility regulation. The only reason we have smart phones and mobile Internet access today is that public-utility regulation in telecommunications was overrun by competition despite regulatory opposition in the 1990s. But public-utility regulation is the wonderful fate to which Barack Obama, Thomas Wheeler and the FCC propose to consign the Internet. What is the justification for their verdict?

The Case for Net Neutrality – Debunked

As we have seen, public-utility regulation was based on a premise that certain industries were “natural monopolies.” But nobody has suggested that the Internet is a natural monopoly – which makes sense, since it isn’t an industry. Nobody has suggested that all or even some of the industries that utilize the Internet are natural monopolies – which makes sense, since they aren’t. So why in God’s name should we subject them to public-utility regulation – especially since public-utility regulation didn’t even work well in the industries for which it was ideally suited? We shouldn’t.

The phrase “net neutrality” is designed to achieve an emotional effect through alliteration and a carefully calculated play on the word “neutral.” In this case, the word is intended to appeal to egalitarian sympathies among hearers. It’s only fair, we are urged to think, that ISPs, the “gatekeepers” of the Internet, are scrupulously fair or “neutral” in letting everybody in on the same terms. And, as with so many other issues in economics, the case for “fairness” becomes just so much sludge upon closer examination.

The use of the term “gatekeepers” suggests that God handed to Moses on Mount Olympus a stone tablet for the operation of the Internet, on which ISPs were assigned the role of “gatekeepers.” Even as hyperbolic metaphor, this bears no relation to reality. Today, cable companies are ISPs. But they began life as monopoly-killers. In the early 1960s, Americans chose between three monopoly VHF-TV networks, broadcast by ABC, NBC and CBS. Gradually, local UHF stations started to season the diet of content-starved viewers. When cable-TV came along, it was like manna from heaven to a public fed up with commercials and ravenous for sports and movies. But government regulators didn’t allow cable-TV to compete with VHF and UHF in the top 100 media markets of the U.S. for over two decades. As usual, regulators were zealously protecting government monopoly, restricting competition and harming consumers.

Eventually, cable companies succeeded in tunneling their way into most local markets. They did it by bribing local government literally and figuratively – the latter by splitting their profits via investment in pet political projects of local politicians as part of their contracts. In return, they were guaranteed various degrees of exclusivity. But this “monopoly” didn’t last because they eventually faced competition from telecommunication firms who wanted to get into their business and whose business the cable companies wanted to invade. And today, the old structural definitions of monopoly simply don’t apply to the interindustry forms of competition that prevail.

Take the Kansas City market. Originally, Time Warner had a monopoly franchise. But eventually a new cable company called Everest invaded the metro area across the state line in Johnson County, KS. Overland Park is contiguous with Kansas City, MO, and consumers were anxious to escape the toils of Time Warner. Eventually, Everest prevailed upon KC, MO to gain entry to the Missouri side. Now even the cable-TV market was competitive. Then Google selected Kansas City, KS as the venue for its new high-speed service. Soon KC, MO was included in that package, too – now there were three local ISPs! (Everest has morphed into two successive incarnations, one of which still serves the area.)

Although this is not typical, it does not exhaust the competitive alternatives. This is only the picture for fixed service. Americans are now turning to mobile forms of access to the Internet, such as smart phones. Smart watches are on the horizon. For mobile access, the ISP is a wireless company like AT&T, Verizon, Sprint or T-Mobile.

The NN websites stridently maintain that “most Americans have only a single ISP.” This is nonsense; a charitable interpretation would be that most of us have only a single cable-TV provider in our local market. But there is no necessary one-to-one correlation between “cable-TV provider” and “ISP.” Besides, the state of affairs today is ephemeral – different from what is was a few years ago and from what it will be a few years from now. It is only under public-utility regulation that technology gets stuck in one place because under public-utility regulation there is no incentive to innovate.

More specifically, the FCC’s own data suggest that 80% of Americans have two or more ISPs offering 10Mbps downstream speeds. 96% have two or more ISPs offering 6Mbps downstream and 1.5 upstream speeds. (Until quite recently, the FCC’s own criterion for “high-speed” Internet was 4Mbps or more.) This simply does not comport with any reasonable structural concept of monopoly.

The current flap over “blocking and interfering with traffic on the Internet” is the residue of disputes between Netflix and ISPs over charges for transmission of the former’s streaming services. In general, there is movement toward higher charges for data transmission than for voice transmission. But the huge volumes of traffic generated by Netflix cause congestion, and the free-market method for handling congestion is a higher price, or the functional equivalent. That is what economists have recommended for dealing with road congestion during rush hours and congested demand for air-conditioning and heating services at peak times of day and during peak seasons. Redirecting demand to the off-peak is not a monopoly response; it is an efficient market response. Competitive bar and restaurant owners do it with their pricing methods; competitive movie theater owners also do it (or used to).

Similar logic applies to other forms of hypothetically objectionable behavior by ISPs. The prioritization of traffic, creation of “fast” and “slow” lanes, blocking of content – these and other behaviors are neither inherently good nor bad. They are subject to the constraints of competition. If they are beneficial on net balance, they will be vindicated by the market. That is why we have markets. If a government had to vet every action by every business for moral worthiness in advance, it would paralyze life as we know it. The only sensible course is to allow free markets and competition to police the activities of competitors.

Just as there is nothing wrong or untoward with price differentials based on usage, there is nothing virtuous about government-enforced pricing equality. Forcing unequals to be treated equally is not meritorious. NN proponents insist that the public has to be “protected” from that kind of treatment. But this is exactly what PUCs did for decades when they subsidized residential consumers inefficiently by soaking business and long-distance users with higher rates. Back then, the regulatory mantra wasn’t “net neutrality,” it was “universal service.” Ironically, regulators never succeeded in achieving rates of household telephone subscription that exceeded the rate of household television service. Consumers actually needed – but didn’t get – protection from the public-utility monopoly imposed upon them. Today, consumers don’t need protection because there is no monopoly, nor is there any prospect of one absent regulatory intervention. The only remaining vestige of monopoly is that remaining from the grants of local cable-TV monopoly given by municipal governments. Compensating for past mistakes by local government is no excuse for making a bigger mistake by granting monopoly power to FCC regulators.

Forbearance? 

The late, great economist Frank Knight once remarked that he had heard do-gooders utter the equivalent words to “I want power to do good” so many times for so long that he automatically filtered out the last three words, leaving only “I want power.” Federal-government regulators want the maximum amount of power with the minimum number of restrictions, leaving them the maximum amount of flexibility in the exercise of their power. To get that, they have learned to write excuses into their mandates. In the case of NN and Internet regulation, the operative excuse is “forbearance.”

Forbearance is the writing on the hand with which they will wave away all the objections raised in this essay. The word appears in the original Title II regulations. It means that regulators aren’t required to enforce the regulations if they don’t want to; they can “forebear.” “Hey, don’t worry – be happy. We won’t do the bad stuff, just the good stuff – you know, the ‘neutrality’ stuff, the ‘equality’ stuff.” Chairman Wheeler is encouraging NN proponents to fill the empty vessel of Internet regulation with their own individual wish-fulfillment fantasies of what they dream a “public-utility” should be, not what the ugly historical reality tells us public-utility regulation actually was. For example, he has implied that forbearance will cut out things like rate-of-return regulation.

This just begs the questions raised by the issue of “regulating the Internet like a public utility.” The very elements that Wheeler proposes to forbear constitute part and parcel of public-utility regulation as we have known it. If these are forborne, we have no basis for knowing what to expect from the concept of Internet public-utility regulation at all. If they are not, after all, forborne – then we are back to square one, with the utterly dismal prospect of replaying 20th-century public-utility regulation in all its cynical inefficiency.

Forbearance is a good idea, all right – so good that we should apply it to the whole concept of Internet regulation by the federal government. We should forbear completely.

DRI-162 for week of 2-1-15: It Happens Every Season

An Access Advertising EconBrief:

It Happens Every Season

The Super Bowl has come and gone. And with it have come stories on the economic benefits accruing to the host city – or, in this case, cities. The refrain is always the same. The opportunity to host the Super Bowl is the municipal equivalent of winning the Powerball lottery. Thousands – no, hundreds of thousands of people – descend on the host city. They focus the world’s attention upon it. They “put in on the map.” They spend money, and that money rockets and ricochets and rebounds throughout the local economy with ballistic force, conferring benefits left, right and center. We cannot help but wonder – why don’t we replicate this benefit process by bringing people and businesses to town? Why wait in vain on a Super Bowl lottery when we can instead run our own economic benefit lottery by offering businesses incentives to relocate, thereby redistributing economic benefits in our favor?

It happens every winter. In fact, publicity about economic development incentives (EDIs) is always in season, for they operate year-round. Nowadays almost every state in the union has a government bureau with “economic development” on its nameplate and a toolkit bulging with subsidies and credits.

For years, the news media has mindlessly repeated this stylized picture of EDIs, as if they were all repeating the same talking points. Both the logic of economics and empirical reality vary starkly from this portrait.

EDIs In a Nutshell

The term “EDIs” is shorthand for a variety of devices intended to make it more attractive for particular businesses to relocate to and/or operate in a particular geographic area. The devices involve either taxes or subsidies. Sometimes a business will receive an outright grant of money to relocate, much as an individual gets a relocation bonus from his or her company. Sometimes a business will receive a tax credit as an inducement to relocate. The tax credit may be of specified duration or indefinite. Sometimes the business may receive tax abatement – property tax abatements are especially favored. Again, this may be time-limited or indefinite. Sometimes the tax or subsidy is implicit rather than explicit. Sometimes businesses will even receive production subsidies in excise form; that is, a per-unit subsidy on output produced.

Various forms of implicit or in-kind benefit are also offered. These include grants of land for production facilities and exemption from obligations such as payment for municipal services.

These do not exhaust the EDI possibilities but the list is representative and suggestive.

A Short, Sour History of EDIs

Proponents of EDIs indignantly reject the charge that their ideas are new. On the contrary, government favors to business trace back to the early years of the republic, they insist.

It is certainly true that the early decades of the 19th century saw a boom – today, we would call it a “bubble” – in the building of canals, primarily as transportation media. The Erie Canal was the most famous of these. Although the canals were privately owned, they were heavily subsidized and supported by government. Are we surprised, then, that the canal boom went bust, sinking most of its investors like sash weights? Railroads are traditionally given credit for spearheading U.S. economic development in the 19th century, and the various special favors they won from state and local governments are legendary. They include subsidies and extravagant rights of way on either side of their trackage. But economist Robert Fogel won a Nobel Prize for his downward revision of the importance of railroads to the economic growth of 19th-century America, so there is less there than meets the mainstream historical eye.

The modern emphasis on EDIs can be traced back to the state industrial finance boards of the 1950s. These became more active in the late 1960s and 70s when the national economy went stagnant with simultaneous inflation and recession. Like European national governments today, state and local governments were trying to steal businesses from each other. They lacked central banks and the power to print money, so they couldn’t devalue their currencies as European nations are now doing serially. Instead, they used selective economic benefits as their tools for redistributing businesses in their favor. And, like Europe today, they found that these methods only work as intended when employed by the few. When everybody does it simultaneously, they cancel each other out. One state steals Business A from another, but loses Business B. How do we know whether that state has gained or lost on net balance? We don’t, but in the aggregate nobody wins because businesses are simply being reallocated – and not for the better. Of course, we haven’t yet stopped to consider whether the state even gained from wooing Business A in the first place.

We can look back on many celebrated startups and relocations that were midwived by EDIs. In Tennessee, Nissan got EDI subsidies for relocating to the state in 1980. Later, GM built its famous Saturn plant there. In both cases, the big selling point was the large number of jobs ostensibly created by the project. We can get some idea of the escalation in the EDI bidding sweepstakes by comparing the price-tag per job over time. The Nissan subsidies cost roughly $11,000 per job created. At this price, it is hard to envision an economic bonanza for the host community, but compare that to the $168,000 per job created that went to Mercedes Benz for relocating to Alabama in 1993. In 1978, Volkswagen promised 20,000 jobs for the $70 million it got for moving to Pennsylvania, but ended up delivering only about 6,000 jobs before closing the plant within a decade.

There is every reason to believe that these results were the rule, not the exception. Economists have identified the phenomenon known as the “winner’s curse,” in which winning bidders often find that they had to bid such a high price to win that their benefits were eaten up. Economists have long objected to the government practice of setting quotas on imported goods because the quota harms domestic consumers more than it benefits domestic producers. Moreover, governments customarily give import licenses to politically favored businesses. Economists plead: Why not open up the licenses to competitive bid? That would force would-be beneficiaries of the artificial shortage created by the quota to eat up their monopoly profits in the price they pay for the import license. Then taxpayers would benefit from the revenue, making up for what they lose in consumption of the import good. This same principle prevents cities from benefitting when they “bid” against other cities to lure firms by offering them subsidies and tax credits – they have to offer the firm such lucrative benefits to win the competition against numerous other cities that any benefits provided by the relocating business are eaten up by the subsidy price the city pays.

The Economics of Business Location

The general public probably envisions an economic textbook with a chapter on “economic development” and tips on how to lure businesses and which types of business are the most beneficial, as well as tables of “multiplier” benefits for each one.

Not! The theory of economic development is silent on this subject. The only applicable economic logic is imported from the theory of international trade. The case of import quotas provided on example. The specter of European nations futilely trying to outdo each other in trashing the value of their own currencies is another; international economists use the acerbic term “beggar thy neighbor” to characterize the motivation behind this strategy. It applies equally to states and cities that poach on businesses in neighboring jurisdictions, trying to lure them across state or municipal boundaries where they can pay local taxes and provide prestigious photo opportunities for politicians.

What about the Keynesian theory of the “multiplier,” in which government spending has a multiple effect on income and employment? Even if it were true – and all major Keynesian criticisms of neoclassical theory have been overturned – it would apply only under conditions of widespread unemployment. It apply only to national governments that can control policies for the entire nation and have the power to control and alter the supply of money and credit and rates of interest. Thus, the principle would be completely inapplicable to state and local governments anyway.

Economists believe that there is an economically efficient location for a business. Typically, this will be the place where it can obtain its inputs at lowest cost. Alternatively, it might be where it can ship its output to consumers the cheapest. If EDIs cause a business to locate away from this best location by falsely offsetting the natural advantages of another location, they are harming the consumers of the goods and services produced by the businesses. Why? The business is incurring higher costs by operating in the wrong location, and these higher costs must be compensated by a higher price paid by consumers than would otherwise be true. That higher price combines with the subsidies paid by taxpayers in the host community to constitute the price paid for violating the dictates of economic efficiency.

Why do economists obsess over efficiency, anyway? The study of economics accepts as a fact that human beings strive for happiness. In order to attain our goals, we must make the best use of our limited resources. That requires optimal consumer choice and cost minimization by producers. When government – which is a shorthand term for the actions of politicians, bureaucrats and lower-level employees acting in their own interests – muck up the signaling function of market prices, this distorts the choices made by consumers and producers. Efficiency is reduced. And this effect is far from trivial. A previous EconBrief discussed an estimate that federal-government regulations since 1949 have reduced the rate of economic growth in the U.S. by a factor of three, implying that average incomes would be roughly $125,000 higher today in their absence.

EDIs are a separate issue from regulation. They are more recent in origin but growing in importance. In 1995, the Minneapolis Federal Reserve published a study by economists Melvin Burstein and Arthur Rolnick, entitled “Congress Should End the Economic War Between the States.” At about the same time, the United Nations published its own study dealing with a similar phenomenon at the international level.

Borrowing once again from the theory of international trade, these studies view production in light of the principle of comparative advantage. Countries (or states, or regions, or cities, or neighborhoods, or individual persons) specialize in producing goods or services that they produce at lower opportunity cost than competitors. Freely fluctuating market prices will reflect these opportunity costs, which represent the monetary value of alternative production foregone in the creation of the comparative-advantage good or service. Free trade between countries (or states, regions, cities, neighborhoods or persons) allows everybody to enjoy the consumption gains of this optimal pattern of production.

Burstein, Rolnick, the U.N., et al felt that politicians should not be allowed to muck up free markets for their own benefit and said so. That debate has continued ever since in policy circles.

The Umpires Strike Back: EDI Proponents Respond 

Responses of EDI proponents have taken two forms. The first is anecdotal. They cite cases of particular successful EDI regimes or projects. The cited case is usually a city like Indianapolis, IN, which enjoyed a run of success in luring businesses and a concurrent spurt of economic growth. A less typical case is Kansas City, KS, which languished for several decades in prolonged decay with a deserted, crumbling downtown area and crime-ridden government housing projects and saw its tax base steadily disintegrate. The city subsidized a NASCAR-operated racing facility on the western edge of its county, miles away from its downtown base. It also subsidized a gleaming shopping and entertainment district slightly inward of the racetrack. Both NASCAR and the shopping district have benefitted from these moves, and politicians have claimed credit for revitalizing the city by their efforts. A recent Wall Street Journal column described the policy has having revamped “the city and its reputation.”

The second argument consists of a few studies that claim to find a statistical link between the level of spending on EDIs and the rate of job growth in states. Specifically, these studies report “statistically significant” relationships between those two variables. This link is cited as justification for EDIs.

Both these arguments are extremely weak, not to say specious. It is widely recognized today that most investors are foolish to actively manage their own stock portfolios; e.g., to pick stocks in order to “beat the market” by earning a rate of return superior to the average rate available on (say) an index fund such as the S&P 500. Does that mean that it is impossible to beat the market? No; if millions of investors try, a few will succeed due to random chance or luck. Another few will succeed due to expertise denied to the masses.

Analogous reasoning applies to the anecdotal argument made by EDI proponents. A few cities are always enjoying economic growth for reasons having nothing to do with EDIs – demographic or geographic reasons, for example. With large numbers of cities “competing” via EDIs, a few will succeed due to random chance. But this does not make, or even bolster, the case for EDIs. Indeed, the use of the term “competition” in this context is really false, because cities do not compete with cities – only concrete entities such as businesses or individuals can compete with each other. It is really the politicians that are competing with each other. And this form of competition, quite unlike the beneficial form of competition in free markets, is inherently harmful.

This sophisticated rebuttal is overly generous to the anecdotal arguments for EDIs. Even if we assume that the EDIs produce a successful project – that is, if we assume that Saturn succeeds at its Tennessee plant or NASCAR thrives in Kansas City, KS – it by no means follows that one company’s gains translate into areawide gains in real income. A study by the late Richard Nadler found no gains at all in local Gross Domestic Product for Wyandotte County, in which Kansas City, Kansas resides, years after NASCAR had arrived. The logic behind this result, reviewed later, is straightforward.

The studies claiming to support EDIs lean heavily on the prestige of statistical significance. Alas, this concept is both misunderstood and misapplied even by policy experts. Its meaning is binary rather than quantitative. When a relationship is found “statistically significant,” that means that it is unlikely to be completely random or chance but it says nothing about the quantitative strength or importance of the relationship. This caveat is especially germane when discussing EDIs, because all the other evidence tells us that EDIs are trivial in their substantive effect on business location decisions.

For decades, intensive surveys have indicated that business executives select the optimal location for their business – then gladly take whatever EDIs are offered. In other words, the EDI is usually irrelevant to the actual location decision. But executives seal their lips when it comes to admitting this fact openly, because their interests lie in fanning the flames of the Economic War Between the States. That war keeps EDIs in place and subsidizes their moves and investments.

Thus, a statistical correlation between EDIs and job growth is not a surprise. But no case has been made that EDIs are the prime causal mover in differential job growth or economic growth among states, regions or cities.

Perhaps the best practical index of the demerits of EDIs would be the economic decline of big-spending blue states in America. These states have been high-tax, high-spending states that heavily utilized EDIs to reward politically favored businesses. This tactic may have improved the fortunes of those clients, but it has certainly not raised the living standards of the populations of those states.

If Not EDIs, What? 

It is reasonable to ask: If EDIs do not govern the wealth of states or cities, what does? Rather than offer selective inducements to businesses, governments would do better to offer across-the-board inducements via lower tax rates to businesses and consumers. Studies have consistently linked higher rates of economic growth with lower taxes on both businesses and individuals throughout the U.S.

Superficially, this strikes some people as counterintuitive. The word “selective” seems attractive; it suggests picking and choosing the best and weeding out the worst. Why isn’t this better than blindly lower taxes on everybody?

In fact, it is much worse. Government bureaucrats or consultants are not experts in choosing which businesses will succeed or fail. Actually, there are very few “experts” at doing that; the best ones attain multi-millionaire or billionaire status and would never waste their time working for government. Governments fail miserably at that job. Better to allow the experts at stock-picking to pick stocks and relegate government to doing the very, very few things that it can and should do.

States and municipalities typically operate with budget constraints. They cannot create money as national governments can and are very limited in their ability to borrow money. So when they selectively give money to a few businesses with subsidies or tax credits, the remaining businesses or individuals have to pay for that in higher taxes. If lower taxes for a few are good for that few, then it follows that higher taxes for the rest must be bad for the rest. And this means that even if the subsidies promote success for the favored business, they will reduce the success of the other businesses and reduce the real incomes of consumers. In other words, the “economic development” promoted by government’s “subsidy hand” will be taken away by government’s “tax hand.” What the government giveth, the government taketh away. Oops.

Lower taxes for everybody work entirely differently. They change the incentives faced at the margin, causing people to work, save and invest more. The increased work effort causes more goods and services to be produced. The increased saving makes more financial resources available for investment by businesses. The increasing investment increases the amount of capital available for labor to work with, which makes labor more productive. This increased productivity causes employers to bid up wages, increasing workers’ real incomes.

Lest this process sound like a free lunch, it must be noted that unless the increased incomes are self-financing – that is, unless the increased incomes provide equivalent tax revenue at the lower rates – government will have to reduce spending in order to fulfill the conditions for stability. Since modern government is wildly inflated – heavily bureaucratized, over-administered and over-staffed as well as obese in size – this should not present a theoretical problem. In practice, though, the willingness to achieve this tradeoff is what has defined success and failure in economic development at the state and local level.

Markets Succeed. Governments Fail

EDIs fail because they are an attempt by government to improve on the workings of free markets. Free markets have only advantages while governments have only disadvantages. Free markets operate according to voluntary choice; governments coerce and compel. Voluntary choice allows people to adjust and fine-tune arrangements to suit their own happiness; compulsion makes no allowance for personal preference and individual happiness. Since human happiness is the ultimate goal, it is no wonder that markets succeed and governments fail.

Free markets convey vast amounts of information in the most economical way possible, via the price system. Since people cannot make optimal choices without possessing relevant information, it is no wonder that markets work. Governments suppress, alter and distort prices, thereby corrupting the informational content of prices. Indeed, the inherent purpose of EDIs is exactly to distort the information and incentives faced by particular businesses relative to the rest. It is no wonder, then, that governments fail.

Prices coordinate the activities of people in neighborhoods, cities, regions, states and countries. In order for coordination to occur, people should face the same prices, differing only by the costs of transporting goods from place to place. Free markets produce this condition. Governments deliberately interfere with this condition; EDIs are a classic case of this interference. No wonder that governments, and EDIs, fail.

DRI-135 for week of 1-4-15: Flexible Wages and Prices: Economic Shock Absorbers

An Access Advertising EconBrief:

Flexible Wages and Prices: Economic Shock Absorbers

At the same times that free markets are becoming an endangered species in our daily lives, they enjoy a lively literary existence. The latest stimulating exercise in free-market thought is The Forgotten Depression: 1921 – The Crash That Cured Itself. The author is James Grant, well-known in financial circles as editor/publisher of “Grant’s Interest Rate Observer.” For over thirty years, Grant has cast a skeptical eye on the monetary manipulations of governments and central banks. Now he casts his gimlet gaze backward on economic history. The result is electrifying.

The Recession/Depression of 1920-1921

The U.S. recession of 1920-1921 is familiar to students of business cycles and few others. It was a legacy of World War I. Back then, governments tended to finance wars through money creation. Invariably this led to inflation. In the U.S., the last days of the war and its immediate aftermath were boom times. As usual – when the boom was the artifact of money creation – the boom went bust.

Grant recounts the bust in harrowing detail.  In 1921, industrial production fell by 31.6%, a staggering datum when we recall that the U.S. was becoming the world’s leading manufacturer. (The President’s Conference on Unemployment reported in 1929 that 1921 was the only year after 1899 in which industrial production had declined.) Gross national product (today we would cite gross domestic product; neither statistic was actually calculated at that time) fell about 24% in between 1920 and 1921 in nominal dollars, or 9% when account is taken of price changes. (Grant compares this to the figures for the “Great Recession” of 2007-2009, which were 2.4% and 4.3%, respectively.) Corporate profits nosedived commensurately. Stocks plummeted; the Dow Jones Industrial average fell by 46.6% between the cyclical peak of November, 1919 and trough of August, 1921. According to Grant, “the U.S. suffered the steepest plunge in wholesale prices in its history (not even eclipsed by the Great Depression),” over 36% within 12 months. Unemployment rose dramatically to a level of some 4,270,000 in 1921 – and included even the President of General Motors, Billy Durant. (As the price of GM’s shares fell, he augmented his already-sizable shareholdings by buying on margin – ending up flat broke and out of a job.) Although the Department of Labor did not calculate an “unemployment rate” at that time, Grant estimates the nonfarm labor force at 27,989,000, which would have made the simplest measure of the unemployment rate 15.3%. (That is, it would have undoubtedly included labor-force dropouts and part-time workers who preferred full-time employment.)

A telling indicator of the dark mood enveloping the nation was passage of the Quota Act, the first step on the road to systematic federal limitation of foreign immigration into the U.S. The quota was fixed at 3% of foreign nationals present in each of the 48 states as of 1910. That year evidently reflected nostalgia for pre-war conditions since the then-popular agricultural agitation for farm-price “parity” sought to peg prices to levels at that same time.

In the Great Recession and accompanying financial panic of 2008 and subsequently, we had global warming and tsunamis in Japan and Indonesia to distract us. In 1920-1921, Prohibition had already shut down the legal liquor business, shuttering bars and nightclubs. A worldwide flu pandemic had killed hundreds of thousands. The Black Sox had thrown the 1919 World Series at the behest of gamblers.

The foregoing seems to make a strong prima facie case that the recession of 1920 turned into the depression of 1921. That was the judgment of the general public and contemporary commentators. Herbert Hoover, Secretary of Commerce under Republican President Warren G. Harding, who followed wartime President Woodrow Wilson in 1920, compiled many of the statistics Grant cites while chairman of the President’s Conference on Unemployment. He concurred with that judgment. So did the founder of the study of business cycles, the famous institutional economist Wesley C. Mitchell, who influenced colleagues as various and eminent as Thorstein Veblen, Milton Friedman, F. A. Hayek and John Kenneth Galbraith. Mitchell referred to “…the boom of 1919, the crisis of 1920 and the depression of 1921 [that] followed the patterns of earlier cycles.”

By today’s lights, the stage was set for a gigantic wave of federal-government intervention, a gargantuan stimulus program. Failing that, economists would have us believe, the economy would sink like a stone into a pit of economic depression from which it would likely never emerge.

What actually happened in 1921, however, was entirely different.

The Depression That Didn’t Materialize

We may well wonder what might have happened if the Democrats had retained control of the White House and Congress. Woodrow Wilson and his advisors (notably his personal secretary, Joseph Tumulty) had greatly advanced the project of big government begun by Progressive Republicans Theodore Roosevelt and William Howard Taft. During World War I, the Wilson administration seized control of the railroads, the telephone companies and the telegraph companies. It levied wage and price controls. The spirit of the Wilson administration’s efforts is best characterized by the statement of the Chief Price Controller of the War Industries Board, Robert Brookings. “I would rather pay a dollar a pound for [gun]powder for the United States in a state of war if there was no profit in it than pay the DuPont Company 50 cents a pound if they had 10 cents profit in it.” Of course, Mr. Brookings was not actually himself buying the gunpowder; the government was only representing the taxpayers (of whom Mr. Brookings was presumably one). And their attitude toward taxpayers was displayed by the administration’s transformation of an income tax initiated at insignificant levels in 1913 and to a marginal rate of 77% (!!) on incomes exceeding $1 million.

But Wilson’s obsession with the League of Nations and his 14 points for international governance had not only ruined his health, it had ruined his party’s standing with the electorate. In 1920, Republican Warren G. Harding was elected President. (The Republicans had already gained substantial Congressional majorities in the off-year elections of 1918.) Except for Hoover, the Harding circle of advisors was comprised largely of policy skeptics – people who felt there was nothing to be done in the face of an economic downturn but wait it out. After all, the U.S. had endured exactly this same phenomenon of economic boom, financial panic and economic bust before in 1812, 1818, 1825, 1837, 1847, 1857, 1873, 1884, 1890, 1893, 1903, 1907, 1910 and 1913. The U.S. economy had not remained mired in depression; it had emerged from all these recessions – or, in the case of 1873, a depression. If the 19th-century system of free markets were to be faulted, it would not be for failure to lift itself out of recession or depression, but for repeatedly re-entering the cycle of boom and bust.

There was no Federal Reserve to flood the economy with liquidity or peg interest rates at artificially low levels or institute a “zero interest-rate policy.” Indeed, the rules of the gold-standard “game” called for the Federal Reserve to raise interest rates to stem the inflation that still raged in the aftermath of World War I. Had it not done so, a gold outflow might theoretically have drained the U.S. dry.  The Fed did just that, and interest rates hovered around 8% for the duration. Deliberate deficit spending as an economic corrective would have been viewed as madness. As Grant put it, “laissez faire had its last hurrah in 1921.”

What was the result?

In the various individual industries, prices and wages and output fell like a stone. Auto production fell by 23%. General Motors, as previously noted, was particularly hard hit. It went from selling 52,000 vehicles per month to selling 13,000 to 6,150 in the space of seven months. Some $85 million in inventory was eventually written off in losses.

Hourly manufacturing wages fell by 22%. Average disposable income in agriculture, which comprised just under 20% of the economy, fell by over 55%. Bankruptcies overall tripled to nearly 20,000 over the two years ending in 1921. In Kansas City, MO, a haberdashery shop run by Harry Truman and Eddie Jacobson held out through 1920 before finally folding in 1921. The resulting personal bankruptcy and debt plagued the partners for years. Truman evaded it by taking a job as judge of the Jackson County Court, where his salary was secure against liens. But his bank accounts were periodically raided by bill collectors for years until 1935, when he was able to buy up the remaining debt at a devalued price.

In late 1920, Ford Motor Co. cut the price of its Model T by 25%. GM at first resisted price cuts but eventually followed suit. Farmers, who as individuals had no control over the price of their products, had little choice but to cut costs and increase productivity – increasing output was an individual’s only way to increase income. When all or most farmers succeeded, this produced lower prices. How much lower? Grant: “In the second half of [1920], the average price of 10 leading crops fell by 57 percent.” But how much more food can humans eat; how many more clothes can they wear? Since the price- and income-elasticities of demand for agricultural goods were less than one, this meant that agricultural revenue and incomes fell.

As noted by Wesley Mitchell, the U.S. slump was not unique but rather part of a global depression that began as a series of commodity-price crashes in Japan, the U.K., France, Italy, Germany, India, Canada, Sweden, the Netherlands and Australia. It encompassed commodities including pig iron, beef, hemlock, Portland cement, bricks, coal, crude oil and cotton.

Banks that had speculative commodity positions were caught short. Among these was the largest bank in the U.S., National City Bank, which had loaned extensively to finance the sugar industry in Cuba. Sugar prices were brought down in the commodity crash and brought the bank down with them. That is, the bank would have failed had it not received sweetheart loans from the Federal Reserve.

Today, the crash of prices would be called “deflation.” So it was called then and with much more precision. Today, deflation can mean anything from the kind of nosediving general price level seen in 1920-1921 to relatively stable prices to mild inflation – in short, any general level of prices that does not rise fast enough to suit a commentator.

But there was apparently general acknowledgment that deflation was occurring in the depression of 1921. Yet few people apart from economists found that ominous. And for good reason. Because after some 18 months of panic, recession and depression – the U.S. economy recovered. Just as it had done 14 times previously.

 

It didn’t merely recover. It roared back to life. President Harding died suddenly in 1923, but under President Coolidge the U.S. economy experienced the “Roaring 20s.” This was an economic boom fueled by low tax rates and high productivity, the likes of which would not be seen again until the 1980s. It was characterized by innovation and investment. Unfortunately, in the latter stages, the Federal Reserve forgot the lessons of 1921 and increases the money supply to “keep the price level stable” and prevent deflation in the face of the wave of innovation and productivity increases. This helped to usher in the Great Depression, along with numerous policy errors by the Hoover and Roosevelt administrations.

Economists like Keynes, Irving Fisher and Gustav Cassel were dumbfounded. They had expected deflation to flatten the U.S. economy like a pancake, increasing the real value of debts owed by debtor classes and discouraging consumers from spending in the expectation that prices would fall in the future. Not.

There was no economic stimulus. No TARP, no ZIRP, no QE. No wartime controls. No meddlesome regulation a la Theodore Roosevelt, Taft and Wilson. The Harding administration and the Fed left the economy alone to readjust and – mirabile dictu – it readjusted. In spite of the massive deflation or, much more likely, because of it.

The (Forgotten) Classical Theory of Flexible Wages and Prices

James Grant wants us to believe that this outcome was no accident. The book jacket for the Forgotten Depression bills it as “a free-market rejoinder to Bush’s and Obama’s Keynesian stimulus applied to the 2007-9 recession,” which “proposes ‘less is more’ with respect to federal intervention.”

His argument is almost entirely empirical and very heavily oriented to the 1920-1921 depression. That is deliberate; he cites the 14 previous cyclical contractions but focuses on this one for obvious reasons. It was the last time that free markets were given the opportunity to cure a depression; both Herbert Hoover and Franklin Roosevelt supervised heavy, continual interference with markets from 1929 through 1941. We have much better data on the 1920-21 episode than, say, the 1873 depression.

Readers may wonder, though, whether there is underlying logical support for the result achieved by the deflation of 1921. Can the chorus of economists advocating stimulative policy today really be wrong?

Prior to 1936, the policy chorus was even louder. Amazing as it now seems, it advocated the stance taken by Harding et al. Classical economists propounded the theory of flexible wages and prices as an antidote to recession and depression. And, without stating it in rigorous fashion, that is the theory that Grant is following in his book.

Using the language of modern macroeconomics, the problems posed by cyclical downturns are unemployment due to a sudden decline in aggregate (effective) demand for goods and services. The decline in aggregate demand causes declines in demand for all or most goods; the decline in demand for goods causes declines in demand for all or most types of labor. As a first approximation, this produces surpluses of goods and labor. The surplus of labor is defined as unemployment.

The classical economists pointed out that, while the shock of a decline in aggregate demand could cause temporary dislocations such as unsold goods and unemployment, this was not a permanent condition. Flexible wages and prices could, like the shock absorbers on an automobile, absorb the shock of the decline in aggregate demand and return the economy to stability.

Any surplus creates an incentive for sellers to lower price and buyers to increase purchases. As long as the surplus persists, the downward pressure on price will remain. And as the price (or wage) falls toward the new market-clearing point, the amount produced and sold (or the amount of labor offered and purchases) will increase once more.

Flexibility of wages and prices is really a two-part process. Part one works to clear the surpluses created by the initial decline in aggregate demand. In labor markets, this serves to preserve the incomes of workers who remain willing to work at the now-lower market wage. If they were unemployed, they would have no wage, but working at a lower wage gives them a lower nominal income than before. That is only part of this initial process, though. Prices in product markets are decreasing alongside the declining wages. In principle, fully flexible prices and wages would mean that even though the nominal incomes of workers would decline, their real incomes would be restored by the decline of all prices in equal proportion. If your wage falls by (say) 20%, declines in all prices by 20% should leave you able to purchase the same quantities of goods and services as before.

The emphasis on real magnitudes rather than nominal magnitudes gives rise to the name given to the second part of this process. It is called the real-balance effect. It was named by the classical economist A. C. Pigou and refined by later macroeconomist Don Patinkin.

When John Maynard Keynes wrote his General Theory of Employment Interest and Income in 1936, he attacked classical economists by attacking the concepts of flexible wages and prices. First, he attacked their feasibility. Then, he attacked their desirability.

Flexible wages were not observed in reality because workers would not consent to downward revisions in wages, Keynes maintained. Did Keynes really believe that workers preferred to be unemployed and earn zero wages at a relatively high market wage rather than work and earn a lower market wage? Well, he said that workers oriented their thinking toward the nominal wage rather than the real wage and thus did not perceive that they had regained their former position with lower prices and a lower wage. (This became known as the fallacy of money illusion.) His followers spent decades trying to explain what he really meant or revising his words or simply ignoring his actual words. (It should be noted, however, that Keynes was English and trade unions exerted vastly greater influence on prevailing wage levels in England that they did in the U.S. for at least the first three-quarters of the 20th century. This may well have biased Keynes’ thinking.)

Keynes also decried the assumption of flexible prices for various reasons, some of which continue to sway economists today. The upshot is that macroeconomics has lost touch with the principles of price flexibility. Even though Keynes’ criticisms of the classical economists and the price system were discredited in strict theory, they were accepted de facto by macroeconomists because it was felt that flexible wages and prices would take too long to work, while macroeconomic policy could be formulated and deployed relatively quickly. Why make people undergo the misery of unemployment and insolvency when we can relieve their anxiety quickly and compassionately by passing laws drafted by macroeconomists on the President’s Council of Economic Advisors?

Let’s Compare

Thanks to James Grant, we now have an empirical basis for comparison between policy regimes. In 1920-1921, the old-fashioned classical medicine of deflation, flexible wages and prices and the real-balance effect took 18 months to turn a panic, recession and depression into a rip-roaring recovery that lasted 8 years.

Fast forward to December, 2007. The recession has begun. Unfortunately, it is not detected until September, 2008, when the financial panic begins. The stimulus package is not passed until January, 2009 – barely in time for the official end of the recession in June, 2009. Whoops – unemployment is still around 10% and remains stubbornly high until 2013. Moreover, it only declines because Americans have left the labor force in numbers not seen for over thirty years. The recovery, such as it is, is so anemic as to hardly merit the name – and it is now over 7 years since the onset of recession in December, 2007.

 

It is no good complaining that the stimulus package was not large enough because we are comparing it with a case in which the authorities did nothing – or rather, did nothing stimulative, since their interest-rate increase should properly be termed contractionary. That is exactly what macroeconomists call it when referring to Federal Reserve policy in the 1930s, during the Great Depression, when they blame Fed policy and high interest rates for prolonging the Depression. Shouldn’t they instead be blaming the continual series of government interventions by the Fed and the federal government under Herbert Hoover and Franklin Roosevelt? And we didn’t even count the stimulus package introduced by the Bush administration, which came and went without making a ripple in term of economic effect.

Economists Are Lousy Accident Investigators 

For nearly a century, the economics profession has accused free markets of possessing faulty shock absorbers; namely, inflexible wages and prices. When it comes to economic history, economists are obviously lousy accident investigators. They have never developed a theory of business cycles but have instead assumed a decline in aggregate demand without asking why it occurred. In figurative terms, they have assumed the cause of the “accident” (the recession or the depression). Then they have made a further assumption that the failure of the “vehicle’s” (the economy’s) automatic guidance system to prevent (or mitigate) the accident was due to “faulty shock absorbers” (inflexible wages and prices).

Would an accident investigator fail to visit the scene of the accident? The economics profession has largely failed to investigate the flexibility of wages and prices even in the Great Depression, let alone the thirty-odd other economic contractions chronicled by the National Bureau of Economic Research. The work of researchers like Murray Rothbard, Vedder and Galloway, Benjamin Anderson and Harris Warren overturns the mainstream presumption of free-market failure.

The biggest empirical failure of all is one ignored by Grant; namely, the failure to demonstrate policy success. If macroeconomic policy worked as advertised, then we would not have recessions in the first place and could reliably end them once they began. In fact, we still have cyclical downturns and cannot use policy to end them and macroeconomists can point to no policy successes to bolster their case.

Now we have this case study by James Grant that provides meticulous proof that deflation – full-blooded, deep-throated, hell-for-leather deflation in no uncertain terms – put a prompt, efficacious end to what must be called an economic depression.

Combine this with the 40-year-long research project conducted on Keynesian theory, culminating in its final discrediting by the early 1980s. Throw in the existence of the Austrian Business Cycle Theory, which combines the monetary theory of Ludwig von Mises and interest-rate theory of Knut Wicksell with the dynamic synthesis developed by F. A. Hayek. This theory cannot be called complete because it lacks a fully worked out capital theory to complete the integration of monetary and value theory. (We might think of this as the economic version of the Unified Field Theory in the natural sciences.) But an incomplete valid theory beats a discredited theory every time.

In other words, free-market economics has an explanation for why the accident repeatedly happens and why its effects can be mitigated by the economy’s automatic guidance mechanism without the need for policy action by government. It also explains why the policy actions are ineffective at both remedial and preventive action in the field of accidents.

James Grant’s book will take its place in the pantheon of economic history as the outstanding case study to date of a self-curing depression.

DRI-275 for week of 9-28-14: Touchdown-Celebration Prayer: Time for Separation of Church and Red Zone?

An Access Advertising EconBrief:

Touchdown-Celebration Prayer: Time for Separation of Church and Red Zone?

Fans of the National Football League (NFL) have become inured to the spectacle of celebrations conducted by players who score a touchdown. These actions have assumed a variety of forms, ranging from ordinary excesses of joy and enthusiasm like jumping up and down to esoteric rituals like spiking or dunking the football over the goalpost. Perhaps the most common form is some sort of gyration or celebratory dance. The practice originated among certain players whose fame depended at least as much on their self-promotional zeal as upon their athletic prowess – Deion Sanders, formerly of the Dallas Cowboys, comes particularly to mind.

Older readers will appreciate the striking contrast between this modern attitude and that exhibited by legendary stars of yesteryear like Jim Brown of the Cleveland Browns and Johnny Unitas of the Baltimore Colts. Brown, who may have been the greatest running back of all time, was slow to assume his stance prior to the center snap of the football and even slower to rise after being tackled when running the ball. His demeanor was impassive. He conserved his energy and saved his exertions for the time between the snap and the referee’s whistle signaling the end of a play. Did this account for the fact that his average-yards-gained per carry was the highest of any Hall of Fame runner?

Unitas was similarly deadpan on the field. As quarterback for the Colts, he terrified opponents and awed teammates with the knack for leading his team from behind in the closing seconds of a game. But fans could never have guessed by looking at him whether he had just been sacked for a loss or thrown the winning touchdown pass as time expired. If any of his teammates had ever done anything as gauche as celebrating a long run or spectacular catch, they would have been frozen solid by the icy stare known throughout the NFL as the “Unitas look.”

In the so-called “greatest football game ever played” – the 1958 NFL championship game between the Baltimore Colts and the New York Giants – Unitas provided the prelude to victory by completing a daring sideline pass to tight end Jim Mutcheller in the Giants’ one-yard line in sudden-death overtime. At the post-game press conference, a reporter ventured to question Unitas’s play-calling decision: “That was a pretty dangerous pass, wasn’t it? What if it had been intercepted?” The reporter was the first televised victim of “the look.” “When you know what you’re doing,” Unitas replied without needing to raise his voice, “they’re not intercepted.”

Nowadays many players feel obligated to supplement the audio and visual record of play supplied by television by advertising what has just happened. The newest wrinkle on this style of irrepressible self-expression is praying in the end zone after scoring a touchdown.

The Abdullah Case and Ensuing Fallout

In the fourth quarter of a game between the Kansas City Chief and New England Patriots at Arrowhead Stadium on September 29, 2014, New England quarterback Tom Brady completed a pass to Kansas City safety Husein Abdullah. Abdullah traversed the 39 yards to the New England end zone, where he dropped to his knees in prayer.

End-zone touchdown celebrations are now so commonplace that rules have been drafted to cover them. One of those rules forbids celebrating while “on the ground.” The referees invoked this rule, penalizing the Chiefs 15 yards on the ensuing kickoff for “unsportsmanlike conduct.”

That did not end the matter, though. Two days later, the NFL’s league office announced that the official decision had been in error. Why? It seems that “there are exceptions made for religious expressions,” according to NFL vice-president for football communications Michael Signora. But the referees may have been confused by Abdullah’s body language; he slid on his knees rather than simply kneeling down. Probably sensing an opportune moment, the well-known organization CAIR (Council on American-Islamic Relations) lodged an objection to the original ruling. According to an article in the Kansas City Star (“NFL Admitting Error on Abdullah Flag,” October 1, 2014, by Tod Palmer), “Abdullah is a devout Muslim.” The CAIR spokesman urged the league office to “clarify the policy” so as to “avoid the appearance of a double standard” for Muslims and non-Muslims.

The sensitivities of Americans have been abraded by over a half-century of controversy over the separation of church and state. Now the debate over public religious observance has invaded the football field or, more specifically, the end zone. Will theologians have to be on call for replay decisions by officials? Should the NFL nail a thesis on the separation of church and red zone to the main gate of its stadiums? Is all this really necessary?

The Economics of Player Celebration 

Does associating end-zone prayer with celebration seem odd? Abdullah himself referred to his action as “prostrat[ing] myself to God.” Still, the religious faithful at their devotions are often called “celebrants.” In any case, the attributes of prayer and those of celebration are virtually identical in this particular context, which allows us to apply economic principles to both types of action. Both interrupt the normal flow of play and divert attention away from the game and to the celebrant. A case exists that each kind of action might either please or annoy a football fan.

One interesting thing about this example is the diametric tacks taken by the economist and the non-economist. The non-economist feels compelled to ascertain whether prayer itself is “good” or “bad.” A particularly discriminating non-economist might put that to one side and focus on whether or not prayer is a good thing in this particular context; e.g., on a football field with hundreds of millions of spectators. The economist may or may not feel qualified to supply answers to those questions, but does not care about the answers because they needn’t be answered by any particular individual. Markets exist to answer questions that individuals cannot or should not answer. 

Professional football is an intangible product supplied by the National Football League and its member franchises (teams) to consumers (fans). That product consists primarily, but not solely, of competitive athletic performance. A rhetorical question posed previously in this space asked: If O. J. Simpson were still in full flower of his athletic skills, would he be working as a running back in the NFL, all other things equal? The obvious answer is no, because football fans do not want to watch murderers play professional football, no matter how talented they may be.

The advent of touchdown celebration allows us to add another qualifying example to our definition of the pro-football product. To the degree that some fans enjoy and even encourage end-zone celebrations, it is clear that they derive satisfaction (or utility, in economic jargon) from this practice. That means that the pro-football product is defined as “competitive athletic performance plus entertainment.”

This is not merely an ad hoc formulation cobbled together by an economist for a column. In the same edition of the same Sports section of the Kansas City Star as the story of the NFL’s recantation of the penalty on Abdullah, the adjacent story is a profile of Chiefs’ cornerback Sean Smith. Study Smith’s comments about his flamboyant style of play and the attitude of Chiefs’ coaches to the on-field exhibition of his personality.

“‘I think (the Miami game) gave the coaches a chance to see that when I’m able to go out there and just be myself and let my personality hang out there, not only do I play well, but people feed off my energy,’ Smith said.” [Quoting reporter Terez A. Paylor] “‘Smith, like his other more animated teammates, appreciates Coach Andy Reid’s philosophy. He encourages his players to play with passion and let their personalities shine through on the field, and Smith has embraced that approach this season.'”[Back to Smith again] “‘Coach emphasizes to let your personality show, go out there and cut loose, and be yourself and have fun…That’s something I definitely took personal. I’ve been a very enthusiastic guy. I like going out there and having fun and putting a smile on people’s faces.'”

This constitutes an implicit endorsement by a player and head coach, as cited by a beat reporter, of the economic model developed above.

Does this mean that end-zone celebrations are a good thing? Does it mean that players have a right to indulge them? Does it justify the NFL’s policy? Or condemn it? The answers to these questions are various forms of “no.” End-zone celebrations are one more input into the productive process, no better or worse a priori than any other. They may or may not be appropriate. Players have no “right” to indulge in them because players do not control the production process – the team does. The NFL is the franchisor; it has the right to control end-zone celebrations only if they affect its ability to provide the right competitive environment for the teams and not when only team profitability is at stake.

A last key question may be the one most frequently asked when this issue arises in public controversy. What about the player’s “right” of free religious observance?

Why Freedom of Religion Does Not Guarantee the Right to Celebrate in the End Zone 

Freedom is defined as the absence of external constraint. It does not guarantee the power to achieve one’s aims over opposition; in particular, it does not confer rights. A right can be enjoyed only when it does not abrogate the exercise of somebody else’s right. A contract is a voluntary agreement that imposes legal duties on both (all) parties to it.

These definitions lay the groundwork for our understanding of prayer in the end zone.

Husein Abdullah is an employee of the Kansas City Chiefs football team. He helps produce professional football entertainment but he does not control the mix of inputs into that product. The team decides who the other players will be, what style of football the team will play, what offensive plays the team will run, what defensive sets the team will employ, who the coaches, assistant coaches and trainers will be. If the team chooses all these inputs into the production of professional football entertainment, why should it not also control the nature of end-zone celebrations? Of course, the team may opt for spontaneity by giving free rein to players’ imaginations, just as conventional entertainers in show business may opt for improvisation over a scripted performance. Still, the team will almost certainly forbid players from celebrating by making obscene gestures to opposing players, revealing intimate body parts to fans and performing other acts virtually guaranteed to offend fans rather than entertaining them.

So we should hardly be astonished if the team should choose to regulate an action as potentially sensitive or embarrassing as an act of religious observance – should we? And, speaking as students of economic logic, we can make no objection to that – can we?

How about Husein Abdullah? Or, for that matter, any religious celebrant of any religious denomination? Is he being treated unfairly? Are his rights being violated?

No. As an employee of the team, Abdullah works at the direction of the team and for its benefit. The fact that Abdullah is engaging in a religious observance in this particular case is irrelevant. Abdullah certainly has freedom of religion. He has freedom of speech, too, but that doesn’t give him the right to say anything and everything under the sun in his capacity as an employee with no fear of repercussion.

Suppose Abdullah were an employee working in an office building. Does he have the “right” to pray at the top of his lungs while wandering around and between the desks of his fellow employees? No, he has no right to disrupt the workplace in this fashion even with the excuse that freedom of religion allows him the right of religious observance. Similarly, his “right” to pray in the end zone is circumscribed by team policy.

Does this mean that the Abdullahs of the world are inevitably booked for disappointment in their longing to prostrate themselves before God in the end zone? There is no reason to think so. We know, for instance, that celebrations were once frowned upon and suppressed yet are now practically de rigeur. There seems no way to predict what twists and turns this penchant for celebration will take because there is no way to predict how the tastes of the public will change.

Are we afraid that “discrimination” against unpopular minority groups (Muslims, for example) will proliferate? No, we are not, because in this context the term discrimination loses its familiar colloquial meaning. There is no arbitrary exercise of power against a group because no business has a duty to employ all inputs to an equal degree. Instead, businesses have a duty to their owners and consumers to employ inputs based on productivity precisely by discriminating in favor of the more productive and against the less productive. Whether the inputs are engaging in religious observance, speech or any other activity does not matter. If a player can produce a productive form of celebration, this will make money for his team and provide the player with a celebratory meal ticket. If not, the player will lose the privilege of celebrating in the end zone. Business is not about what the boss wants or what employees want – it is about what consumers want. Economists characterize this principle as consumer sovereignty.

If a player demands a right to pray in the end zone, what he is really demanding is not freedom, nor is an exercise of a valid right. Rather, it is the power to abrogate his duty to his employer at whim. As often emphasized in this space, this confusion of freedom and power suffered by the general public has been repeatedly exploited to political advantage by the left wing.

The Absurd Position in Which the NFL Finds Itself

The framework for analysis outlined above is simple and logical. It is an outgrowth of the system by which we divide labor to produce and exchange goods and services. The pellucid clarity of this system stands out in brilliant contrast to the existing framework under which the NFL currently operates.

The NFL currently has rules governing player celebrations. These rules are part of the code that governs play on the field. Violations are punished with penalties such as the one Abdullah earned for the Chiefs. Consequently, the rules must be mastered, interpreted and applied by the referees. Inevitably, as with all sports decisions made by referees or umpires, subjective perceptions and interpretations cause mistakes and controversy. (The distinction between kneeling and sliding to his knees probably reminded Abdullah of the judging on Dancing With the Stars.) Meanwhile, the entities whose interests are most directly affected – team ownership and management – must sit back and await the chance to appeal any wrongful decision later.

And the fans – the people for whose benefit the system operates – don’t get any direct say in this administrative process. Whereas in a competitive market, input from fans directly determines the nature and extent of player celebrations, the regulated market gives immediate control to the administrative mechanism of the NFL. This allows the entertainment part of the product to contaminate the competitive part when penalties are levied for unsportsmanlike conduct, whereas under a competitive system the team handles problems of unsuitable celebration outside of the context of the competitive contest.

That’s not all to object to about top-down regulation of end zone celebration by the NFL. In fact, it may not even be the worst. The Abdullah case illustrates the political hazards of the top-down approach. The NFL began by wanting to suppress inappropriate celebration, which is surely not objectionable in and of itself. By doing the regulating itself instead of leaving it to the market, the NFL left itself open to the pressures of every special interest with an ax to grind. Because the NFL has no special interest in the profits of any one team, it has no incentive to favor popular celebration. Because the NFL is a bureaucratic organization, it is open to influence by every special interest with an ax to grind, CAIR being the most recent to step up to the grinder.

Suddenly, the NFL finds it can’t simply ban a form of celebration it doesn’t approve of (by “any player on the ground”) because that would run afoul of “religious observance.” Imagine – religious observance interfering with the conduct of a football game, when previously the only thing the two had in common was Sunday. And the minute the NFL starts making an exception for “religious observance,” it then has to confront the issue of different – and conflicting – religions. Wonderful – the two things attendees at a dinner party are never supposed to mention are politics and religion, and both are now elbowing their way into the end zone. What next? Will Stars of David start popping up on player helmets as an expression of their “right of free speech?” If only the fans had the power to throw a flag against the NFL for interference!

The General Principle at Work Here 

Americans have forgotten the value of allowing markets to decide basic questions. A recent Wall Street Journal op-ed commented offhandedly that we have lost confidence in free markets as a result of the Great Recession. If so, this is a monumental irony, since that event was caused by the interference with and subordination of the market process. It is not clear how much of the current attitude originates with a loss of faith and how much with simple ignorance. Regardless of the source, we must reverse this attitude to have any hope of survival, let alone prosperity. We know markets work because the world in general and the U.S. in particular would never have reached their present state of prosperity unless markets were as effective as free-market economists claim they are. The pretense that regulated, administrative markets are a vehicle for perfect “social justice” is not merely a sham – it is a recipe for tyranny. Administrators possess neither the comprehensive information nor the omniscient sense of fairness necessary to decide whose celebrations to allow, which ones to ban and what standard to apply to all.

The best thing about the example of touchdown celebrations is that they provide a side-by-side illustration of free markets and regulated administrative markets. The free market is player celebrations as they evolved in recent years, encouraged by fan response and governed by individual teams. The Kansas City Star excerpts show in so many words that this market exists and the evidence of our senses shows that this market works just as economic logic predicts that it will. And our ever-more-dismal experience with top-down, bureaucratic NFL regulation shows that rule by fiat and by ventriloquists in the chattering classes is an escalating failure.

What about the older fans who are appalled by player celebrations and long for the good old days of strong, silent, heroic players like Brown and Unitas? Why, we’ll just have to find a team that suits our tastes – or found one.

DRI-275 for week of 6-1-14: The Triumph of Economics in Sports: Economics Takes the Field to Build Winning Teams

An Access Advertising EconBrief:

The Triumph of Economics in Sports: Economics Takes the Field to Build Winning Teams

In the previous two EconBriefs, we spoke of a popular attitude towards sports. It looks nostalgically to a hazy past, when men played a boys’ game with joyous abandon. Today, alas, sports are “just a business,” which is “all about the money.” As elsewhere, “greed” – a mysterious force no more explicable than a plague of locusts – has overtaken the men and robbed them of their childlike innocence.

This emotional theory of human behavior owes nothing to reason. It is the view now commonly bruited by those who describe the financial crisis of 2008 and the Great Recession as the outcome of free markets run rampant. People are irrational, so the result of “unfettered capitalism” must naturally be chaotic disaster.

Economics is the rational theory of human choice. For a half-century, it has opposed the irrationalists from two directions. Its free-market adherents have been led by the Chicago School of Frank Knight, Milton Friedman and George Stigler. That school embraced a theory of perfect rationality: perfect knowledge held by all market participants (later modified somewhat by a theory of information only slightly less heroic in its assumptions), perfectly competitive markets and (where necessary) perfectly benevolent government regulators and/or economist advisors.

The neo-Keynesian opponents of Chicago accepted individual rationality but asserted that individually rational actions produced perverse results in the aggregate, leading to involuntary unemployment and stagnant economies. Only counteracting measures by far-seeing government policymakers and regulators – following the advice of economist philosopher-kings – could rescue us from the depredations of free markets.

The debate, then, has largely been defined by people who saw market participants moved either by utter irrationality or complete rationality. But our analysis has revealed instead an evolutionary climate in which participants in professional sports pursued their own ends rationally within the limits imposed by their own knowledge and capabilities. The great free-market economist F.A. Hayek observed that capitalism does not demand that its practitioners be rational. Instead, the practice of capitalism itself makes people more rational than otherwise by continually providing the incentive to learn, adapt and adopt the most efficient means toward any end. Professional sports has exemplified Hayek’s dictum.

Early on, in its first century, the pursuit of individual self-interest left baseball owners, players and fans at loggerheads. The first owner to address himself to the task of improving the product provided to sports fans was Bill Veeck, Jr., who introduced a host of business, financial and marketing innovations that not only enhanced his own personal wealth but also treated his fans as customers whose patronage was vital. The attitude of ownership toward fans prior to Veeck can be gleaned from the dismissal by New York Yankees’ general manager George Weiss of a proposed marketing plan to distribute Yankee caps to young fans. “Do you think I want every youngster in New York City walking around wearing a Yankees’ cap?” snorted Weiss. Veeck made owners and administrators realize that this was exactly what they should want.

Although few people seemed to realize it, economics had yet to play its trump card in the game of professional sports. Economics is the study of giving people what they want the most in the most efficient way. What sports fans want the most is a winning team – and that is exactly what economics had failed to give them. It failed because it had never been deployed toward that end. Even Bill Veeck, despite his success in improving the on-field performance of his teams, had not unlocked the secret to using economic principles per se to win pennants and World Series.

As sometimes happens in human endeavor, baseball had to traverse a Dark Age before this secret was finally revealed.

The Dark Age: Municipal Subsidies and the Growth of Revenue Potential

During Bill Veeck’s swan song as baseball owner in 1975-1981, baseball had entered the period of free agency. The reserve clause tying players to a single team had been drastically modified, allowing players to eventually migrate to teams offering them the best financial terms. As we indicated earlier, this development – viewed in isolation – tilted the division of sports revenue from ownership to players.

This created the pretext by which owners were able to extract subsidies from municipalities throughout the nation. Owners could truthfully claim that they were earning less money as a result of free agency. What they left out was that they were earning more money for a host of other reasons. The obscure nature of player depreciation hid the true financial gains of sports-team ownership from the public. Moreover, the early years of free agency coincided with the advent of massive new revenue sources for owners. Television had brought baseball to millions of people who otherwise saw few games or none; broadcast rights were becoming a valuable asset of team ownership. Radio-broadcast rights increased in value as the increased visibility of teams and players enhanced their popularity. These increases were just gaining speed when the vogue of sports-team subsidies became a national pastime of its own.

The movement of baseball teams had long been viewed as analogous to the movement of businesses. Even the loss of popular teams like the Brooklyn Dodgers and New York Giants to westward expansion of baseball in Los Angeles and San Francisco was grudgingly accepted, since baseball still remained in New York City and the Mets were added as an expansion franchise in 1962. But when the Athletics moved from Kansas City to Oakland in 1967, Missouri Senator Stuart Symington decided that the federal government could not countenance “unfettered capitalism” in the baseball business. He demanded that major-league baseball replace Kansas City’s lost franchise. This opened the floodgates to the intrusion of politics in baseball.

If it was fair for politicians to dictate where major-league baseball should operate, then franchises should be able to demand favors from local governments – or so reasoned baseball owners. And demand them they did.

Owners demanded that teams build new, larger, better-appointed stadiums for their sports teams. Cities should fund construction, own the stadiums, operate them, maintain them and lease them to the sports teams for peanuts – otherwise, owners would pack up and move to a city that would meet their demands.

What was in it for the host city? After all, not everybody is a sports fan. Owners sensed that they needed something to offer the city at large. Thus was born one of the great con games of the 20th century: the notion of sports as economic-development engine of growth. Owners seized on the same thinking that animated the dominant neo-Keynesian economic model. They sponsored “economic-impact studies” of the effect sports teams had on the local economy. In these studies, spending on sports took on a magical, mystical quality, as if jet-propelled by a multiplier ordained to send it rocketing through the local economy. And everybody “knew” that the more spending took place, the better off we all were.

It is hard to say what was worse, the economic logic of these studies or their statistical probity. It was not unusual to find that a study would add (say) the money spent on gasoline purchases at stations adjacent to the stadium to the “benefits” of sports team presence. Of course, this implies that locating the team as far as possible from the fans would increase the “benefits” dramatically; it is a case of cost/benefit analysis in which the costs are counted as benefits. This novel technique inevitably produces a finding of vast benefits.

As time went on, sale of team artifacts and memorabilia was added to the list of supplemental revenue. Larger stadiums, lucrative TV, radio and cable rights, team product sales – all these drove revenues to owners through the roof as the 20th century approached its close. With municipalities subsidizing the ownership, maintenance and improvement of stadiums, it is no wonder that the capital gains available to owners of sports teams were phenomenal. Ewing Kauffman bought the Kansas City Royals’ franchise for $1 million in 1968. At his death in 1993, the team’s value was estimated at well over $100 million.

One might have expected the usual left-wing suspects to recoil in horror from the income redistribution from ordinary taxpayers to rich owners and rich ballplayers – but no. Newspaper editorialists threw up their hands. The economists who supported free agency said that the major-market teams would get the best players, didn’t they? And hadn’t things worked out just that way, before free agency as well as after? If small-market taxpayers want to win – or even have a team at all – they’ll just have to ante up and face the fact that “this is how the game is played in today’s world.” Besides, doesn’t economic research show the economic-development benefits of sports teams?

Heretofore, economics had operated beneficially, albeit in a gradual, piecemeal way. Now the distortion of economics by the owners and their political allies meant that it was serving the ends of injustice.

Economics – and baseball fans – needed a hero. They got one – several, actually – from a pretty unlikely place.

Middle American Ingenuity to the Rescue

Bill James was born in tiny Holton, KS, in 1947. From childhood, he was a devoted sports fan. Like countless others before him, he was fascinated by the quantitative features of baseball and studied them obsessively. He was unique, though, in refusing to take on faith the value of conventional measures of baseball worth such as batting average, fielding average and runs batted in. James developed his own theories of baseball productivity and the statistical measures to back them up.

In 1977, he published the first edition of his Baseball Abstract, which subsequently became the Bible for his disciples and imitators. James was suspicious of batting average because it deliberately omitted credit for walks. (Ironically, walks were originally granted equivalent status with hits in computing batting average; “Tip” O’Neill’s famous top-ranking average of .485 in 1887 was accrued on this basis. The change to the modern treatment took place shortly thereafter.) While it may be technically true that a walk does not represent a “batting” accomplishment, it is certainly the functional equivalent of a single from the standpoint of run-producing productivity. (Veterans of youth baseball will recall their teammates urging them to wait out the opposing pitcher by chanting, “A walk’s as good as a hit, baby!”) Moreover, walks have many ancillary advantages. Putting the ball in play risks making an out. A walk forces the opposing pitcher to throw more pitches, thereby decreasing his effectiveness on net balance. Waiting longer in the count increases the chances that a hitter will get a more hittable pitch to hit, one that may be driven with power. For all these reasons, James made a convincing case that on-base percentage (OBP)is superior to batting average as a measure of a hitter’s run-producing productivity.

Rather than the familiar totals of home runs and runs batted in, James argued in favor of a more comprehensive measure of power production in hitting called slugging percentage (SP), defined as total bases divided by at bats. This includes all base hits, not just home runs. Instead of runs batted in, James created the category of runs created (RC), defined as hits plus walks times total bases, divided by plate appearances. James also sought a substitute for the concept of “fielding average,” which stresses the absence of errors committed on fielding chances actually handled but says nothing about the fielder’s ability or willingness to reach balls and execute difficult plays that other players may not even attempt. Moreover, fielding must be evaluated on the same level with offensive production since it must be just as valuable to prevent run production by the opposing team as to create runs for the home team.

These measures and maxims formed the core of Bill James’ theory of baseball productivity. His Baseball Abstract computed his measures for the major-league rosters each year and analyzed the play and management of the teams each year. Gradually, James became a cult hero. Others adopted his methods and measures. The Society for American Baseball Research (SABR) sprang up. The intensive study of quantitative baseball – eventually, sports in general – came to be known as “sabermetrics.” Even with all this attention, it still took decades for Bill James himself to be embraced by organized baseball itself. That, too, happened eventually, but not before sabermetrics left the realm of theory and invaded the pressbox, the front office and the very baseball diamond itself.

Moneyball Takes the Field

Billy Beane was a high-school “phenom” (short for phenomenal), a term denoting a player whose all-round potential is so patent that he “can’t miss” succeeding at the major-league level. Like a disconcerting number of others, though, Beane did miss. He played only minimally at the major-league level for a few years before quitting to become a scout. He rose to the front office and was named general manager of the Oakland Athletics in 1997. Beane’s mentor, general-manager Sandy Alderson, taught him the fundamentals of Bill James’ theories of baseball productivity. To them, Beane added his own observations about player development – notably, that baseball scouts cannot accurately evaluate the future prospects of players at the high-school level because their physical, emotional and mental development is still too limited to permit it. Thus, major-league teams should concentrate on drafting prospects out of college in order to improve their draft-success quotient.

Beane hired a young college graduate from HarvardUniversity – not as a player but as an administrative assistant. Paul DiPodesta was an economics major who was familiar with the logic of marginal productivity theory. The theory of the firm declares that managers should equalize the marginal productivity per dollar (that is, the ratio of output each unit of input produces at the margin to the input’s price) between inputs by continually adding more of any input with a higher ratio until the optimal output is reached. Of course, the problem in applying this or any other economic principle to baseball had always been that the principles were non-operational unless a meaningful measure of “output” could be found and the inputs contributing to that output could be identified. That was where Bill James and sabermetrics came in.

In 2001, the Oakland team had won the Western Division of the American League. But their star player, Jason Giambi, has been wooed away by a seven-year, $120-million dollar contract offered by the New York Yankees. It was the age-old story, the “Curse of the Bambino” all over again in microcosm. Oakland’s success had ramped up the value of its players on the open market; replacing those players with comparable talent at market rates would bust the payroll budget. Various other Oakland players were lost to injury or disaffection or free agency. Throughout baseball, opinion was unanimous that the Athletics were in for hard times until the team’s talent base could be rebuilt through player development.

Beane and DiPodesta used the most basic sabermetric concepts, such as ONB, SP and RC, as their measures of productivity. Using publicly available information about player salaries, they calculated player productivities per dollar and discovered the startling number of players whose true productivity was undervalued by their current salaries. Methodically, they set out to rebuild the Oakland Athletics “on the cheap” by acquiring the best players their budget could afford through trade or purchase of contracts. They substantially remade the team using this approach. Despite a slow start, their rebuilt club eventually tied the all-time major-league baseball record by winning 21 straight games and successfully defended the Western Division championship in 2002 and 2003. Author Michael Lewis outlined their story and the rise of sabermetrics in baseball in his 2003 best-selling book Moneyball, which later became a 2011 movie starring Brad Pitt that received six Academy Award nominations.

For the first time, baseball management had explicitly used an economic production function – marginal productivity theory with an operational definition of product or output – to maximize a meaningful object function – namely, “wins” by the team. And they succeeded brilliantly.

Money See, Money Do

In 2003, new Boston Red Sox owner John Henry hired Bill James as a consultant to management, to put the theories of sabermetrics into practice in Boston. During 2001 and 2002, the team had lugged the second-highest payroll in major-league baseball to disappointing results. But in 2003, with a lower- (6th-) ranked payroll, the Boston Red Sox laid the ghost of Babe Ruth by winning their first World Series since 1918. Over the succeeding decade, the Red Sox became the success story of baseball, winning the World Series three more times.

Was this a case of what Rocky’s manager Mickey would call “freak luck?” Not hardly. Thanks to the success of Oakland and Boston and Michael Lewis’s book, the tale of Bill James and sabermetrics traveled. Throughout baseball, sabermetrics ran wild and economics reigned triumphant. In 2003, the Detroit Tigers lost an American-League-record 119 games. In 2006, with only the 14th-highest payroll out of 30 major-league teams, the Tigers won the American League championship. In 2008 and 2009, the Washington Nationals were the worst team in baseball. In 2012, with baseball’s 20th-highest payroll, they had baseball’s best record. In 2010, the Pittsburgh Pirates lost 105 games. In 2013, with baseball’s 20th-highest payroll, they made the post-season playoffs. The Cleveland Indians rebounded from sub-.500 seasons to playoff finishes twice between 2006 and 2014, despite never ranking higher than 15th in the size of their payroll; usually, they ranked between 20th and 26th.

The crowning achievement was that of the perennial cellar-dwelling Tampa Bay Devil Rays. Cellar-dwelling, that is, in the size of their payroll, but not necessarily in the season standings. After years of dismal finishes, the 2008 TampaBay team became American League champs despite ranking 29th (next to last!) in the size of their payroll. They have made the playoffs in four of the six subsequent years, but their payroll continues to languish at the bottom of the major-league rankings.

The New Frontier

Does this mean that the generalization about large-market teams getting the better players and enjoying the better results was and is a lie? No, it was and still is true. But like all economic propositions it is subject to qualification and careful statement.

First, it is a ceteris paribus proposition. It is true that “you can’t beat the stock market (averages)” but every year some people (particularly professional investors) do it. You can’t do it systematically by trading on the basis of publicly available information. The few people who succeed do it on the basis of (unsystematic) luck or by uncovering new information (legally) before it becomes generally known. The market for professional sports is not nearly this efficient; techniques of sports productivity evaluation are not nearly as refined and efficient as those of stock evaluation and trading, which leaves much more room for systematic exploitation by techniques like those of sabermetrics.

Second, the term “large market” is no longer limited by geography as it has been during the first century and a half of U.S. professional sports. Ted Turner’s promotion of the Atlanta Braves using his cable-TV stations blazed the trail for turning a local team into a national one, thereby increasing the value of the team’s broadcasting and product rights. Today, there is no inherent geographic limitation of the size of the market for any team – no reason, for example, why the Kansas City Royals or Chiefs could not become “the world’s team” and sit atop the largest market of all.

The Evolutionary Approach to Free Markets

The correct approach to economics is not the irrationalist view that has clouded our understanding of professional sports. Neither is it the perfectionist view of the ChicagoSchool, which has oversold the virtues of free markets and damaged their credibility. It is certainly not the remedial view of the neo-Keynesian school, which has failed whenever and wherever tried and is now undergoing its latest serial failure.

The evolutionary approach of the true free-market school, so nobly outlined by Hayek and his disciples, fits the history of baseball like a batting glove. It is now in full flower. Taxpayers need no longer be violated by owners who promote false economic benefits of sports and hide the real ones. Fans no longer need languish in a limbo of psychological unfulfillment. Economics – not politicians, regulators or academic scribblers – has come to the rescue at last.

DRI-290 for week of 5-18-14: The Role of Economics in Sports

An Access Advertising EconBrief:

The Role of Economics in Sports

It is a commonplace that sports today is “just a business.” Once upon a time, so the thinking goes, sports was a magical realm, a “kid’s game” in which everybody played for fun and decisions were motivated by “the love of the game.” Now, though, it’s “all about the money.” From this, we might draw the inference that sports were once an economics-free zone.

The cliché applies: Nothing could be further from the truth. Indeed, sports today are ruled less by economic considerations than formerly. That isn’t quite the same thing as saying that money plays a smaller role. It doesn’t; the role of money has been distorted by the introduction of non-economic factors.

By applying the logic of economics to baseball, the national pastime, we can appreciate the historical role played by economics and understand how this role has been misshapen in recent decades.

Profit in Baseball

Baseball began as a game played for fun. Its origins are shrouded in mystery but date to before the Civil War. (Thus, the celebration of Abner Doubleday, Civil War general in the Union army, as baseball’s inventor is undoubtedly misplaced.) Professional baseball began in 1869 with the first professional team, the Cincinnati Red Stockings. Since then, profit has been inseparable from the game of baseball as a commercial enterprise.

Until recent decades, owners of baseball teams earned revenue from one primary source – the admission of baseball fans to watch games in person. The calculation of profit was quite straightforward: an admission price was charged to games and collected – either from advance ticket sales or at the gate prior to game time – and the revenue from the sum of all such sales was weighed against the costs of owning the team. The costs varied with circumstances, but less in true economic terms than might be supposed. For example, a team that owned its stadium would not pay rent according to a lease, but an economist would still reckon that rent as an implicit cost, since the team is foregoing the rent it could earn by leasing the stadium out to somebody else. Salaries paid to players and administrative staff, wages paid to low-level employees, travel costs, marketing costs – these comprise the standard costs of operating a baseball team and are subtracted from revenue in reckoning profit.

Like so many things in life, though, even this simple calculation has its complications. Revenue always has been, and remains today, a function of market size. The larger the potential number of fans, the greater is a team’s revenue potential. But for most of its history, revenue was also a function of stadium size. The Philadelphia Phillies have been a National League mainstay for over a century. For the first third of the 20th century, they played their games in the Baker Bowl, a tiny stadium whose capacity never exceeded 20,000 people and was typically less. The New York Yankees, on the other hand, played in a stadium befitting the nation’s largest city, as New York City was for nearly the first century of professional baseball’s existence. Yankee Stadium, built expressly to house the Yankees in the early 1920s, could hold around 70,000 people. Even the Polo Grounds, home of crosstown National League New York Giants, held over 60,000. Cleveland’s Municipal Stadium held over 80,000. If that seems incongruous, given the city’s comparatively modest size, our later discussion will rectify that impression.

Economists have developed a theory of the firm. They teach it to students in microeconomics courses. It is designed to apply broadly to business firms of all kinds, shapes and sizes. Given the tenuous connection traditionally made between sports and business, that attitude might seem arrogant. It turns out to be well-justified confidence.

The traditional formula for profit maximization in the economic theory of the firm requires equality between marginal revenue and marginal cost. But in order to apply the theory, we must have a measure of output. Businesses exist in order to produce goods and services. What do baseball teams exist to produce, anyway? In the ultimate sense, they produce satisfaction by entertaining fans. But this feeling of satisfaction is subjective; it is a non-operational definition of output. Is there something hard-edged and quantitative that we can measure as a source of this satisfaction?

Yes. It is winning games. If this doesn’t make baseball fans happy, it is hard to think of something else that does. Now all we have to do is identify the process by which the wins are produced – what economists call the production function. Inconceivable as it seems, it is only in the last 15 years that any real headway has been made in quantifying this formula. For over a century, professionals and amateurs alike were content to apply more or less subjective criteria to this concept.

Everybody always knew that good players and athletic talent were the raw material from which the production function sprang. But exactly how did they interact to produce winning baseball? Everybody had their own pet theories. Owners and their administrative staffs applied the theories to the selection and grooming of talent. Really, all that was done was to throw money at the problem. The amount of money and the direction of the throw varied widely from team to team and owner to owner. And baseball fans throughout America developed a time-honored set of prejudices, educated guesses and conventional thinking about the subject.

Bigger Market = More Revenue = Larger Expenditure on Player Salaries = Better Team

Even without a clear theoretical idea of the production function, though, we can still say a lot about how economic logic influenced the conduct of baseball operations and the course of baseball history. Regardless of how you go about calculating the marginal revenue associated with an additional win, it will be larger for a (say) New York City than (say) a Kansas City. (That is true even though New York City has two baseball teams to Kansas City’s one.) That an owner in New York City will find it profitable to expend a larger amount on player salaries than will an owner in Kansas City. All other things equal, this should produce better teams in New York City. In the broader context, that means that larger-market teams should tend to be better teams.

“All other things equal” (or “ceteris paribus,” as economists prefer to disguise it) is the great weasel phrase joining theory to reality. As we will see in the second installment of this discussion, those things became unequal indeed when a few wise guys cracked the code for the production function in baseball. But this generalization certainly worked well for over a century of baseball history.

No baseball team has come within a country mile of the Yankees’ 27 world championships. The St. Louis Cardinals hold second place, and for most of baseball history St. Louis was among the most populous cities and metropolitan areas in the nation. The New York Giants and Brooklyn Dodgers also rank among the most successful teams in history despite vacating New York in the 1950s. The Los Angeles Dodgers picked up the mantle doffed by their Brooklyn predecessor.

Chicago might seem a conspicuous exception to this rule of thumb, but even there it held good in the early days of the modern era. The Chicago White Sox and Chicago Cubs were two of the most successful teams in the first two decades of the modern era beginning in 1901. The Cubs set the all-time record for wins in a season in 1906 and appeared often in the World Series until 1918. The White Sox vied with the Philadelphia Athletics and Detroit Tigers for American League supremacy during that era and upset the Cubs in the 1906 Series. The Cubs enjoyed periodic success until after World War II, their final World Series appearance to date being 1945.

“Free Agency Will Be the Death of Baseball”

Much has been made over the years of the fact that major-league baseball enjoys exemption from the anti-trust laws, thanks to a federal-court decision in 1922 (Federal Baseball Club of Baltimore v. National League et al). While it is technically true that “major-league baseball” constitutes a combination of businesses that restricts its membership via the issuance of franchises, this exemption means very little in practice.

Over the course of baseball history, various competitive leagues have arisen. The American League itself was once one of those, just as the American Football League once competed with the National Football League. And major-league baseball has often reacted to its competition by absorbing it, as the NFL did the AFL. At other times, the Federal League (in 1915) and the Mexican League (in the late 1940s) briefly constituted significant threats to the major leagues.

Even more significant, though, has been the very substantial inter-industry competition provided by competing forms of sports and entertainment generally. Today, pro football and pro basketball have supplanted major-league baseball in the attraction of athletic talent. Insofar as the antitrust exemption applies to the product market in which major-league baseball operates, it has become a dead letter.

By far the most important antitrust issue faced by baseball concerned its input market. Economists have traditionally contended that baseball teams should compete with each other for players in the labor market. Until 1975, labor-market competition for players was severely restricted by the reserve clause. That clause granted exclusive bargaining rights to a player to the team first to sign that player. In recent years, a draft has assigned initial bargaining rights in baseball, as in football and basketball. It is still true that the right of players to initiate transfers to different teams is restricted in various ways.

The first economist to publicly question this arrangement was Gerald Scully in 1974 in a pathbreaking article in the American Economic Review. Scully maintained that competitive bidding normally drives a worker’s wage at or close to marginal revenue product – the value of additional output created at the margin by the input. In the case of uniquely talented inputs such as athletes – the antithesis of homogeneous unskilled labor – a player should earn his incremental contribution to revenue. By allowing freedom of player movement, players would naturally move where they would earn the most money.

Owners and baseball administrators spoke with one voice in response to this theory. They hated it. They loathed it. They reviled it. Almost unanimously, they proclaimed that to allow players the freedom of movement, or “free agency,” would be the death of organized baseball. Owners would be unable to recoup their “investment” in players. They would be unable to make enough profit to stay in business – the result would be carpetbagging teams moving from city to city in an effort to skim the cream of popularity off the top before moving on to the next city. Most of all, fans would lose their sense of identification with players who rented their services to the highest bidder rather than establishing loyalty to a city and its fan base.

An often-repeated fallacy is that the higher salaries associated with free agency would cause ticket prices to skyrocket upwards. Economists often use this as a case study in their microeconomics classes. Assuming owners want to maximize the revenue earned from ticket sales, they will choose the ticket price (or range of prices) that accomplishes that objective – with no regard whatsoever for what players are paid. The profit maximizing price depends on fan tastes, incomes and the substitute forms of entertainment available, which are the parameters of what economists call the demand curve. It is unrelated to supply-curve considerations such as player salaries.

But don’t fans pay player salaries ultimately, through ticket payments and various other means? Indeed they do. In fact, it is useful to employ the framework of the late, great Nobel laureate Ronald Coase from his classic article “The Theory of the Firm.” A business firm is a middleman between the players and fans. It is too costly for fans to contract directly with players for entertainment, so the team acts as a business intermediary. Free agency settles the question of how the fans’ payments are divided between players and team, not how much the total payment will be. The reserve clause allocated more to the team (e.g., the owner) than was economically efficient; free agency changes the division to favor the players more.

Of all these predictions, the least likely was the one that was most widely subscribed. Most people believed that free agency would cause players to move between teams much more freely and often than before. But economists like Scully contended that this would not happen. And years after the case of outfielder Curt Flood set in motion the eventual destruction of the reserve clause, they produced studies showing that player movement was no more rapid or frequent after the reserve clause was gone than in its heyday.

Although Scully and his colleagues thought they needed econometrics to persuade the public, simple logic should have sufficed. On second thought, a glance backward at baseball history should have been enough. This is how Scully put it in his contribution to the Fortune Encyclopedia of Economics: “When players are not free to move, does a small city that acquired a star player… keep him? …A small-city franchise…holding the contract of the player expects him to contribute, say, $1 million in incremental revenue to the club. In a large city that same player’s talents might contribute $3 million. Since the player is worth more to the big-city team…the big-city team will pay more for him [so] the small-city franchise has an incentive to sell the player’s contract to the big-city team and thereby make more money than it could by keeping him. Thus, players should wind up allocated by highest incremental revenue, with or without restrictions on player-initiated movement.”

There are countless examples of this principle in operation. The most famous example involved baseball’s greatest player.

“The Curse of the Bambino?” No, Just Economics at Work

In 1920, Boston Red Sox owner Harry Frazee was in trouble. His trouble wasn’t baseball-related. The Red Sox had won the World Series in 1912, 1915, 1916 and 1918. They had baseball’s greatest player, Babe Ruth. He was the American League’s best left-handed pitcher who had lately taken to playing the outfield in his spare time – and had led the league in home runs in 1919 and 1920.

No, Frazee’s troubles were related to his main business, which was bankrolling Broadway shows. Financing shows was and still is a high-risk business. Now Frazee was in debt up to his ears. He was contemplating selling baseball’s best and most popular player, Babe Ruth, to the New York Yankees, in spite of the pleading of his general manager, Ed Barrow.

Eventually, Frazee did just that. He got $100,000 (the tax-free equivalent of several million today) plus a $300,000 loan. And Babe Ruth went on to set a flock of records in a Yankee uniform and earn more in a single year than the President of the United States. Frazee went on to sell numerous other players to the Yankees in the next few years for another $305,000 in sale proceeds. And he produced successful shows such as “No, No, Nanette.”

According to baseball history, Frazee was an idiot who sacrificed his fans to his personal bank balance. But economics tells us that the Red Sox could never have paid Ruth anywhere close to his maximum potential salary. Only the Yankees, with their tremendous geographic and demographic reach, could have paid Ruth the salary he later commanded. It is no coincidence that Barrow, who criticized Frazee so sternly at the time, later went to work for the Yankees himself, became baseball’s most famous general manager and entered the Hall of Fame in his own right. Barrow also became rich by working for the Yankees.

Is it a coincidence that all the great power hitters, the players who commanded the biggest salaries and drew the most fans to the park, played for large-market teams? Lou Gehrig played alongside Ruth on the Yankees. Joe Dimaggio joined Gehrig in the 1930s and flanked Mickey Mantle in Mantle’s formative years. Roger Maris dueled teammate Mantle on his way to hitting 61 home runs in 1961. Yogi Berra was their teammate. Willie Mays played for the New York Giants, then moved with them to San Francisco, finishing up his career back in New York with the Mets. Duke Snider’s glory years were spent in Brooklyn before he, too, ended up with the New York Mets. Jimmie Foxx’s two primary teams were the Philadelphia Athletic and Boston Red Sox. The exceptions, Harmon Killebrew (Minnesota) and Ralph Kiner (Pittsburgh), were one-dimensional players who were slow runners and mediocre defensive players; thus, their value was limited by their liabilities.

Misers? Or Profit-Maximizers?

Connie Mack was one of baseball’s most beloved figures. Prior to that, he was a well-known and skillful major-league catcher. He owned and managed the Philadelphia Athletics for 50 years, from 1901 to 1950. He managed his teams to 8 World Series appearances and 4 championships. He retired as manager at age 87 and died at 95. Late in life, he was universally revered as the “grand old man” of the game.

Yet on three separate occasions he created furious controversy by selling his star players wholesale or (less often) trading them. He didn’t merely trade away one popular, talented player. He either sold or traded all his stars and started all over again with young players. At the time, he was not much more popular in Philadelphia than Frazee had been in Boston. He was even accused of being “no better than a miser, selling the contracts of players to line his own pockets.”

In order to have meaning, the word “miser” must denote inordinate stinginess. It must imply actions of thrift and economy that exceed in intensity those of ordinary men. But when we examine Connie Mack’s actions by the standards set by Scully and the principles of economics, they resemble instead the same kinds of profit-maximizing actions that any businessman would take.

In 1907, pitcher Rube Waddell was arguably the best pitcher in the American League, certainly the best left-handed pitcher. He had just set a season record for strikeouts (349) that was to last for over half a century. His off-the-field behavior was just as fast and even less controllable than his blazing fastball and wicked curveball. His drinking and carousing gave Mack the excuse for selling his contract to the St. Louis Browns, where he set a single-game league record for strikeouts (16) in 1908. Mack also disposed of Waddell’s batterymate, catcher Ozzie Schreckengost. The sale of the popular duo was highly unpopular with the public, although team members were more willing to bid goodbye to Waddell’s eccentric antics. The players had been instrumental in the two American League pennants won by the Athletics in 1902 and 1905.

Mack set about rebuilding his team. He produced a group of players – Frank “Home Run” Baker, Jack Barry, Eddie Collins and Stuffy McInnis – who became known as the “$100,000 Infield” because of their defensive positions and their aggregate salaries. They spearheaded pennant-winning seasons in 1910, 1911, 1913 and 1914. The first two of those were also World Series championship years.

Yet following the Athletics’ stunning upset loss to the Boston Braves in the 1914 World Series, Mack broke up this winning team through sales and trades over the course of the next three years. At the time, this action was explained by Mack’s financial troubles caused by competition from the new Federal League, which raided major-league teams for players and reportedly drove up player salaries with their competitive forays. But Mack’s actions caused a furor throughout professional baseball and were front-page news in Philadelphia, where he was bitterly criticized in the press.

Once more, Mack slowly and painfully rebuilt his team. Despite having to play in the American League against the powerful New York Yankees of Babe Ruth, Lou Gehrig, Bob Meusel, Herb Pennock and Waite Hoyt, Mack eventually assembled a powerhouse squad that included future Hall of Famers Jimmie Foxx, Lefty Grove, Al Simmons and Mickey Cochrane. They won consecutive American League pennants in 1929, 1930 and 1931 against the “Murderer’s Row” lineup from New York and took two World Series titles in 1929 and 1930.

And once again, Mack pleaded financial exigency – this time citing the Great Depression – as his justification for selling or trading away all of those great players and others. This succession of transactions was nearly as unpopular as the previous one, and this time there was no comeback. Mack’s Philadelphia Athletics won no more American League pennants and mostly occupied the lower rungs of the league rankings until Mack’s retirement as manager at age 87 in 1950.

In retrospect, the citation of financial necessity was flimsy and unnecessary. Mack’s philosophy of player management and development was well-known and documented. He believed in using young players in preference to older ones. He was convinced that maximum value could be extracted from a player by trading or (preferably) selling him before his abilities declined markedly. Sure enough, players such as Waddell, Baker, Collins, Grove, Foxx and Cochrane produced productive years with their new teams. Collins and Grove went on to have unexpectedly long careers; the rest declined in ability and retired or became benchwarmers within a few years after leaving the Athletics.

Mack was obviously following the philosophy of profit-maximization to the best of his knowledge and ability. He used his formidable contacts throughout the baseball industry to scout and develop young talent. He could hardly be accused of stinginess when he paid the impressive talent he developed the high salaries that eventually made the team payroll a financial burden to him.

Economist James Quirk did voluminous research into the financial history of major-league baseball and found that only in the major-market cities like New York City did owners typically earn large profits from their teams. It is also important to note that the large-market owners, like Jacob Ruppert of the Yankees, were already independently rich before entering the baseball business. This enabled them to undertake any investments necessary to capitalize on the opportunities presented by their market size. The norm was represented by hardscrabble owners like Connie Mack, who worked with small- to medium-size stadiums circumscribed by downtown urban environments. Mack played the game better than most of these lower-class owners, which explains his amazing longevity.

Connie Mack borrowed the money he used to buy part-ownership in the Philadelphia Athletics in 1901. He remained part-owner until 1937, when he was 75 years old. Yet he was able to hand on through difficult business and economic circumstances for a half-century as both owner and manager of a leading major-league team. He was a classic example of economics at work in major-league baseball during its first century.

The Changeover

The great manager Casey Stengel is famous for remarking, upon viewing the lack of talent assembled by the expansion-team New York Mets, “Can’t anybody here play this game?” There is no doubt that for baseball’s first century it was a business, not just a game. The problem was that most of its practitioners lacked the acquired skills and natural talent to play the game of baseball from a purely business standpoint. A baseball genius like Connie Mack was able to exist and earn a comfortable living for over fifty years without stacking up the fortunes earned by today’s moguls.

The watershed came when baseball owners started treating the game less like a hobby – as it was viewed by rich, large-market owners – or just a way of earning a decent living – as the lower-level owners experienced it. A man came along with the marketing skills, business acumen and love of the game to take the business of baseball to a new level. That paved the way for the ascension of baseball – and professional sports generally – to the economic level it now occupies. The man’s name was Bill Veeck. His story will be told in our next EconBrief.