DRI-173 for week of 1-25-15: Anti-Price-Gouging Laws: The Cure Is the Disease

An Access Advertising EconBrief:

Anti-Price-Gouging Laws: The Cure Is the Disease

This week, New York City Mayor Bill De Blasio announced an impending snowfall of two to three feet, accompanied by high winds. In anticipation of the upcoming blizzard, he slapped the city with a travel ban, effective at 11 PM on the following day. Only official snow-clearance and law-enforcement vehicles would be allowed on the streets. He seized the opportunity to remind New Yorkers that the travel emergency would trigger enforcement of New York State’s anti-price-gouging law, which forbids raising prices on goods and services beyond pre-emergency levels. Violations would be punished sternly, he assured his audience.

Oops. In the event, the blizzard forecast proved… er, optimistic in the quantitative sense or pessimistic in the qualitative sense. Snowfall fell short of one foot, causing no end of local grumbling by the ingrates who couldn’t simply be satisfied to avert disaster.

To economists, though, the real disaster isn’t the unavoidable inclement weather that strikes every year, nor is it the occasional failure of accurate weather forecasting. It is the self-infliction of wounds by laws passed to constrain a non-existent practice called “price-gouging.” The law purports to cure a non-existent ailment. The cure is far worse than anything the “disease” could inflict.

State Laws to Prevent and Punish “Price Gouging”

Nobody knows the origin of the term “price gouging.” It probably derives from the exercise of monopolies granted by monarchs under the old English common law, which is where we get the term “monopoly.” Since nobody could legally compete with them, they could figuratively gouge their price from the consumer’s hide without interference.

With the advent of big government in the 20th century, it was only a matter of time until this resentment of sellers was written into law. Legislatures needed a pretext for acting against sellers, though. Academia provided it in the 1930s with the “Imperfect Competition” revolution in economic theory. Led by Edward Chamberlain and Joan Robinson, this school pointed out that few, if any, actual markets corresponded to the textbook definition of a “perfect” market. Perfect competition required that no individual seller supply a sufficient quantity of output to materially influence market price through its pricing and output decisions. It also required that consumers view the output of each seller as homogeneous – otherwise, product quality might confer some degree of market (pricing) power on an individual seller. There should also be no barriers to entry into, or exit from, the market.

So all markets were “imperfect” and all sellers possessed “market power.” This homely truth gave the profession the small opening it needed to make a huge leap of logic: Most sellers were monopolists who must be restrained by the benevolent and enlightened force of government regulation from exercising their monopoly power. This conclusion provided a rationale for government intervention at the level of individual markets, or microeconomics. It was analogous to the role played in the 1930s by Keynesian economic theory in justifying government intervention at the macroeconomic level.

In World War II, the federal government’s Office of Price Administration (OPA) levied price controls, or maximum prices, on hundreds of industries. Although the public rationale for these controls was to prevent inflation, they served to accustom both the public and private business to the notion of government control of the price system. In practice, patriotism was at least as important in enforcing the price controls as inflation-control. Business owners who raised prices were open to charges of “war profiteering.” This was unpatriotic; it was “taking advantage of the crisis to make money” when they should have been “doing their part by sharing the sacrifice” borne by everybody else. In peacetime, the rationale of monopoly regulation could be slipped neatly into the vacuum left by inflation-fighting and patriotism.

In the late 1970s, the U.S. struggled in the throes of an “energy crisis.” The upward spike in oil prices initiated by the Organization of Petroleum Exporting Countries (OPEC) had hit Western industrialized nations hard. Threatened with across-the-board cost increases and associated widespread unemployment, their central banks chose the same remedy that is now being employed: rapid money creation. This created accelerating inflation but did not do much to resolve the unemployment problem. The melding of stagnation and unemployment gave rise to a hybrid term of disaffection, stagflation.

It was against this backdrop that home heating fuel prices in New York State rose dramatically in the fall of 1978. The evolving American tradition was to blame the seller for the underlying conditions of supply and demand giving rise to an existing price. That is just what the New York state legislature did when it passed the first state law proscribing price-gouging. It took four years for Hawaii to produce the second such law in 1983. Connecticut and Mississippi followed suit in 1986. Then came the deluge; eleven more states joined the party in the 1990s and sixteen more in the first decade of the new millennium. Today, 38 states have laws forbidding price-gouging in some form. Just what is it that these laws forbid, anyway?

Amazing as it seems, the answer is far from clear. But the common denominator between the laws is the notion that special circumstances or “emergency” justify a significant curtailment of pricing freedom. When we try to determine what the curtailment is, why it is justified and which circumstances qualify as emergencies, we find ourselves shrouded in ambiguity.

In a reasonable world, a judicial review of these statutes would undoubtedly find them void for vagueness. But that is hardly their worst drawback. Even if it were possible to objectively and precisely define an emergency and specify a quantitative curtailment of price tailored to it, we would not want to do anything so perverse and counterproductive even if we could.

The Economics of Emergency Behavior

How do people behave in emergencies? Why do governments and opponents of free markets object to that behavior? What kind of behavior is desirable in those circumstances?

Consider the example posed by the impending blizzard in New York City. In these situations, people routinely rush to acquire advance stocks of common everyday consumption goods. Included in this category are such goods are food (eggs, milk, water, ice, coffee, soft drinks, bacon, meat), fuel (gasoline, propane, heating oil) and household supplies (toilet paper, light bulbs, paper towels, batteries, radios, shovels, ice melt) and suitable clothing (heavy coats, gloves, hats, boots). The vast majority of this behavior is simply a reallocation of purchases in time, or an intertemporal reallocation of demand. There is nothing invidious or harmful about this. Indeed, it obeys the simply principle of preparedness that we all learned as children, whether in the Boy Scouts or in school.

Governments typically act as though this is the result of panic – as if, because everybody can’t immediately purchase everything they want from stocks immediately on hand, it must be a bad thing. But this is ridiculous. There is no reason to treat this increase in demand differently than any other increase in demand for any other reason. After all, those affected certainly have good reasons for wanting the extra stocks, with their government promising them that a blizzard of unprecedented proportions will certainly descend upon them! The only question is: What is the best way of getting the people the extra goods they need, allowing them to push their purchases forward in time to prepare for the emergency?

The Laws of Supply and Demand are the best means ever invented for solving that problem. They act automatically and immediately without the need for government action or intervention. The Law of Supply says that sellers will produce more output for sale at relatively higher prices. The Law of Demand says that buyers will wish to purchase less relatively high prices. When the blizzard announcement is made, people rush to stores and to their computers to make purchases. At the previously existing prices, people would be willing to purchase vastly increased quantities of goods. But they don’t get those vastly increased quantities – at least, not instantaneously. The Law of Supply says that sellers will be willing to supply larger quantities of output, all right – but only at higher prices. Well, at successively higher prices consumers are progressively less enthusiastic about buying more output – they still want more, mind you, just not as much as they would if price were held rock steady. Eventually, price will rise enough to equate the willingness of sellers to produce and sell more and the willingness of buyers to buy more. In this context, “eventually” means a matter of hours or a day or so.

Notice that the oft-expressed fears of government are shown to be groundless. There is no need for government to step in, regulate price or otherwise prevent an economic disaster caused by panic reactions to the weather disaster. Changes in price induce the necessary changes in behavior that do two things – cause sellers to produce and sell more goods and people to want less. The combination of those two things solves the problem.

There is a second kind of behavioral reaction common to some types of disaster emergencies, such as hurricanes and tornadoes. The disaster may cause large amounts of destruction. This may give rise to additional demand for goods for replacement purposes in addition to the intertemporal reallocation demand just analyzed. The replacement demand case is best considered as an addendum to the first case, by assuming that the price system has solved the reallocation demand adequately but now faces the problem of handling the replacement demand for goods that have been destroyed or damaged by the disaster. This will include many of the same goods mentioned above, but also capital goods and consumer durables such as homes, vehicles, buildings and infrastructure. The goods may be demanded in final form or may need to be reconstructed or repaired, in which case the inputs required will be In demand.

Replacement demand differs from reallocation demand in that the latter merely reallocates demand while the former increases it. Replacement demand actually increases the amount of goods demanded locally. There is obviously some scope for increasing the needed goods by drawing on local stocks and by drawing resources away from the production of other goods, as well as by pressing unused local resources into service. But the only way to fully satisfy replacement demand is by importing goods and resources into the local area from outside; that is, from other cities, states, regions and even countries.

Once again, the price system solves this problem. Higher local prices will increase profits locally; the higher local profits will attract resources from other cities, states and regions. The increase in resources will comprise an increase in supply that will reduce the shortfall in replacement goods. As long as a shortfall exists, local demand will keep prices high. Those high prices will keep profits high enough to attract outside resources. If the affected area is large enough and the time frame long enough, international investment may even be attracted to the area. Only when the shortfall in replacement demand is eliminated will prices no longer signal the need for an inflow of goods and resources from outside.

The cases of reallocation and replacement demand do not exhaust all the possibilities created by emergencies and disasters, but they do handle those targeted by state price-gouging laws. We can see that those laws are a clear case of reinventing the wheel. So far, so bad. Now – how does the reinvention work?

Anti-Price-Gouging Laws: Reinventing the Wheel Square 

So the price system solves the problem posed by the need for emergency disaster planning. Is it possible that anti-price-gouging laws might solve it better? Or fairer?

Anti-price-gouging laws are intended to stop price from rising or, more precisely, to stop price from rising beyond a certain point. In the analysis presented above, the price system solved the problem of emergency disaster planning precisely through the medium of an increasing price. Thus, the laws are an economic contradiction in terms. They seek to solve a problem by denying the solution to the problem. So the only way anti-price-gouging laws could improve on the price system would be by substituting another solution for price increases as a means of getting more goods and resources and persuading people to want fewer goods and resources.

They do not substitute any alternative solution. There is no alternative solution. Instead, they assert that an alternative state of affairs – a lower price and fewer goods and resources – ought to be preferred to the one that the price system would bring about. The laws do not explain or justify the superiority of the alternative they exalt. They just assert it.

The laws are justified by rhetoric. The rhetoric claims to be protecting consumers against rapacious sellers who are taking advantage of them by raising prices in an emergency. This contravenes the basic logic of economic exchange, which says that exchange occurs between a willing buyer and a willing seller. So how can either one be “taken advantage of?” The laws assert that it is “unfair” to charge higher prices in an emergency than under non-emergency conditions. This also contravenes established legal precedent, which defines a “fair price” as one agreed upon by a willing buyer and a willing seller. So how can such a price be “unfair?” It also contravenes centuries of human behavior, during which higher prices have been charged for emergency medicine than non-emergency medicine, for emergency hotel rooms than non-emergency hotel rooms and so on.

Since particular anti-price-gouging laws specify exact limits on price increases during emergencies compared to pre-emergency prices, it behooves us to deal with this specific issue. Take the example of a 10% limit on price increases – which, as it happens, is the limit imposed in more than one state. The emphasis placed on this number by proponents is the “fairness” of a 10% gross margin. But this is a non-sequitur. In the first place, there is not and never has been any objective standard of fairness by which 10% (or any other number) could be adjudged fair.

Now go beyond the issue of fairness to consider the internal logic of the process itself. We previously discussed the dynamic reactions of sellers and buyers, in which each group react to the rising price by, respectively, increasing output and reducing desired purchases while continuing to want more than is available. As price goes up by 1%, 2%, 5%, 9%…the law and its proponents approve the outcomes. But suddenly when the price hits 10% – bang! This adjustment process must stop even when some sellers and buyers want it to continue. This is self-contradictory nonsense; law proponents cannot justify this arbitrary limit without explaining why production and sale above the 10% limit is wrong while it is right below the limit.

Proponents argue that complaints by the citizenry justify restriction of high-priced production and sales. But complaints about speech don’t justify arbitrary restrictions on the First Amendment. The law has not traditionally allowed third parties to prohibit economic transactions among consenting transactors except on moral grounds – and anti-price-gouging laws make no valid moral case.

Another way of looking at this same example is to ask: Why do the laws allow any price increases at all? It would seem that proponents are guiltily aware that people want and need more goods and resources and that price increases are necessary for provision of them. As in the age-old joke (“we’ve already established what you are; now we’re just arguing about the price”), anti-price-gouging proponents have implicitly given up and recognized the truth about economic logic, but are determined to argue about the price of those additional goods and how it is determined.

To sum up briefly, anti-price-gouging laws do not solve the problem they purport to address because they do nothing whatever to provide more goods and resources to local areas affected by disaster emergencies. The rhetoric they assert in support of their claims of fairness – which attempt to persuade constituents that they should be happier with lower prices and fewer goods and resources – is illogical and contradicts common practice and long historical experience.

Anti-price-gouging laws not only reinvent the wheel – they reinvent it square.

Black Markets and Other Costs of Shortages

In wartime, which we can view as the ultimate emergency, governments commonly levy comprehensive wage and price controls that prevent prices from rising at all. These are even more draconian than current anti-price-gouging laws. Governments print money to finance the expenditures necessary to conduct the war. When the printed money finds its way into the income stream, it forms the basis for additional demand for goods and services. Citizens attempt to bid up the prices for goods and services. But the price controls do not allow this to happen. The result is chronic shortages.

Economists know this process well. Every microeconomics textbook describes it. Buyers must incur substantial “shoeleather costs” associated with being first in line to get goods and services; failing to do so may frustrate their purchase desires. Those costs are an increase in the effective economic price paid for the good or service. The quality of goods and services is degraded as sellers try to reduce quality as an alternative to raising price. The existence of a shortage allows sellers to pick and choose the buyers who will be satisfied and those who will be disappointed. If sellers have a taste for discrimination, they can exercise it freely. In efficiently functioning competitive markets, on the other hand, this taste is severely constrained by the fact that market-clearing penalized a seller who discriminates against a willing buyers. The output not sold to that buyer may go unsold – either permanently or for a long interval.

Most pertinent to the example of anti-price-gouging laws is the case of black markets. A short-run shortage means that the highest price a consumer would be willing to pay to get one more unit of the good or service is well above the market-clearing price that would prevail if government had never slapped on the controls in the first place. Of course, that extra-high price is not a legal price. But in an emergency, some consumers will be willing to disregard legal niceties to get their hands on the good or service. And sellers will be willing to violate the law to earn the super-high rate of profit that this super-high price will generate. Thus, conditions are perfect for existence of a black (illegal) market.

By passing anti-price-gouging laws, governments deliberately create the ideal environment for black markets. When black markets flourish, politicians put on their sternest face and solemnly promise to punish the evil, greedy malefactors.

Recent Attempts to Rehabilitate Anti-Price-Gouging Laws

Opponents of free markets now control the political process throughout the world. They hold the upper hand in public discourse. Emboldened by their superior status, they have recently sought to rehabilitate the long-moribund intellectual case for anti-price-gouging laws. We can best summarize these attempts by quoting from a prominent source. Harvard University political philosophy Professor Michael Sandel’s book What’s the Right Thing to Do? argues that economists stress economic welfare and freedom at the expense of virtue.

“Emotion is relevant,” claims Sandel – thereby rejecting millennia of philosophical argument in favor of reason and against emotion. Proponents of anti-price-gouging laws reflect “something more visceral than welfare or freedom. People are outraged at ‘vultures’ who prey on the desperation of others and want them punished, not rewarded with windfall profits… Outrage of this kind is anger at injustice… Greed is a vice, a bad way of being, especially when it makes people oblivious to the suffering of others… Price-gouging laws cannot banish greed, but they can at least restrain its most brazen expression, and signal society’s disapproval of it.” Sandel champions the idea of “shared sacrifice for the common good.”

Sandel’s ideas encapsulate the quintessence of 20th-century liberal though – pure undifferentiated emotion, all logic and intellectual distinctions distilled out. If “emotion is relevant,” where do we start and stop in admitting it into the argument? Obviously, we start with the political constituents of liberals and stop when all its political opponents have been demonized. Subjective terms of opprobrium like “vultures,” “greed” and “windfall profits” have no objective correlative in science or logic. The behavior he complains of has specific economic value in achieving the goals of those he pretends to champion; that is, the greed of the vultures turns out to benefit the outraged sufferers and the windfall profits are the necessary by-product of their deliverance.

When goods and resources flow to the disaster area from the outside, people on the outside have fewer goods and services and those within the disaster area have more. This is real shared sacrifice in true economic terms, not the phony symbolic shared sacrifice Sandel pontificates about. This is the price system at work.

Are emergency-room doctors vultures? Do ambulance companies earn windfall profits? Are hotel owners greedy? They participate in everyday, routine market transactions in which prices rise in response to special, emergency circumstances. Why aren’t they accused of being evil and immoral?

Because there’s no political profit in it, that’s why. So much for the “new” arguments for anti-price-gouging laws, same as the old.

If Governments Know the Truth, Why Do They Enact Anti-Price-Gouging Laws?

It is obvious that governments know the economic truth about anti-price-gouging laws – otherwise, they would not allow any price increases at all during emergencies. So why do they insist on enacting laws that can only hurt people without helping them?

The answer is depressingly clear. In the environment of big government and absolute democracy, governments exist to further their own power, not to serve the needs of the public at large. Proponents of anti-price-gouging laws are opponents of free markets. These people constitute a special interest. Government serves this special interest by serving its own interest; e.g., the interests of politicians, bureaucrats and government employees.

Politicians observe the protests of anti-free-market groups. They respond with alacrity by promising to restore “fairness” with anti-price-gouging laws. Of course, this will require new laws. The laws will require a new agency or expansion of an existing agency. This will require hiring more employees and more administrators, as well as a bureaucrat to oversee them. Legislators will oversee the budget of the agency. The agency will exert power over all the businesses in the state at any time designated as an “emergency.” Legislators have the privilege of deciding what constitutes an emergency, giving them additional power over those businesses. Politicians will curry favor with the public by posing as a public savior and benefactor during every emergency, rather than being excoriated for taking a “do nothing” stance.

Government is in the business of producing more government, not benefitting the public. It benefits only that subset of the public directly connected with itself. That general rule applies to anti-price-gouging laws as it does to all other aspects of government not strictly within its true, narrow province.

There is no objective crime or bad outcome called “price gouging.” But the laws enacted to prevent it do have objectively bad outcomes and therefore constitute an evil in themselves.

DRI-128 for week of 12-28-14: The Student-Loan Bubble: Blackboard Economics Strikes Again

An Access Advertising EconBrief: 

The Student-Loan Bubble: Blackboard Economics Strikes Again

The subjugation of print and broadcast news media by the Internet has changed many aspects of the news business, but crisis mode still predominates. The financial crisis gave the Great Recession its headline stories, the biggest of which were the housing bubble and accompanying subprime-mortgage loan scandals. Ever since then the New Media have been beating the bushes for their next big crisis. The front-running nominee seems to be the impending student-loan debacle.

News outlets across the political spectrum have vied for shrillest note of alarm in detailing the deplorable state of the student-loan market. In fact, this use of the term “market” is highly stylized, similar to its use in government bonds, home mortgages and military-defense. Ever since 2010, the federal government has effectively monopolized the market for student loans obtained for purchase of higher education. This monopoly operates in a manner analogous to the federal monopoly on home mortgages enjoyed by Fannie Mae and Freddie Mac. And a popular consensus has formed around the idea that the student-loan result will duplicate that in home mortgages; namely, a bubble with disastrous economic consequences for the economy at large.

The Outlines of the Disaster in the Making

Why is everybody all het up? Here are the outlines of the disaster as the various sources see it coming:

Between the years 2003-2013 college tuition has risen by almost 80%. To put this rise in perspective, consider that it is roughly double the rise in the average cost of medical care over the same time period. That sounds bad, but a price increase is not a bad thing ipso facto. Marked increases in quality can account for a higher price, for example, by causing increases in demand. Demand can increase for other reasons, too. Might higher tuition derive from these causes?

Surveys have demonstrated that tenured professors now average between six and nine hours of teaching per week at public universities, compared to the former average of nine to twelve hours. A majority of courses are now taught by non-tenured faculty, consisting of full-time, non-tenured faculty members, part-time adjunct faculty and graduate students. In order to believe that students are now receiving higher-quality teaching, we must believe that this motley mix are better teachers than the older, better credentialed tenured faculty members.

On its face, that proposition seems wildly far-fetched. In fact, it is not at all unusual to observe younger, non-tenured faculty members winning teaching awards and popularity polls. But this still doesn’t make a case for higher-quality education, for if it were generally true then it would argue for the separation of teaching and research altogether. And indeed, this may well be the optimal organization of labor in higher education. We will never know until we deregulate the industry, cutting off all government funds and allowing markets to determine the question.

The real source of tuition increases is not an organic increase in demand for higher education. Since 1999, the total volume of student loans has grown by 511%. Thus, the felt, effective demand for higher education has increased dramatically because it is an artificial, subsidized demand.

This has led to about $1 trillion being allocated to student loans – more money than is currently tied up on consumer credit-card debt. The so-called average individual owes about $24,000. This form of personal debt is very tenacious. Unlike most forms of personal debt, it cannot be discharged in bankruptcy. Only death can extinguish it.

Not surprisingly, the high rate, volume and burden of student-loan debt have produced defaults on that debt. Some $146 billion worth of student-loan defaults have been recorded to date. The default rate stands at its highest level since 1996.

Where there is default, there are those seeking to deflect it. There is even a term used to describe this practice; it is called forbearance. A Wall Street Journal op-ed (“The Hidden Student-Debt Bomb,” by Jason Delisle, WSJ 12/31/14) describes the practice and its spread.

Forbearance is the generic term for various means of avoiding on-time payment of student loans. Of the total $1 trillion in student loan debt outstanding, the amount in forbearance is $125 billion and rising.

The standard forbearance benefit is usually granted by the company servicing the loan. The student calls the company and requests forbearance. Upon receipt, the student receives postponement of payments for as long as three years. Since this benefit is granted at the discretion of the company, there need be no qualifying criteria, although there are sometimes income qualifications.

Forbearance can also be used to cure a delinquency status. As author Delisle notes, this becomes rather quaint – accrued interest and principal accumulates on the loan so that the initial too-onerous-to-pay amount is now bulked up considerably by the time the next payment is due. Really, then, Delisle argues, forbearances should be treated as equivalent to delinquencies and defaults rather than as a treatment for them. Thus, their steady upward march in recent years (12.5% of repayments in 2006, 13.3% in 2013 and 16% of the $778 million in repayment today) is reason for alarm.

Another technique bases forbearance on ability to repay, or income. At an income of 150% of a poverty-level income or less, payment is zero. As income rises, payments rise on an ascending scale to between 1% and 15% of income. At some point – either 10, 20 or 25 years, depending on the precise details of the program – remaining debt is forgiven completely and taxpayers pick up the remaining tab. The interesting feature of income-based programs is their separation from standard amortization principles of debt repayment. For example, the most generous income-program cases do not even cover the accrued interest on the student loan! Thus, there is really no pretense that the loan will ever be repaid under these circumstances – the program just gives the student a thin layer of epidermis in the game. According to Delisle, “the Obama administration estimated in 2012 that the average amount forgiven in income-based repayment plans will be $41,000 per borrower” (!).

Since those loans represent expenditures financed by the federal government, that means that the money was acquired by the federal government in one of the three standard (and exclusive) ways: by taxing, borrowing and “printing” (e.g., creating). That means that taxpayers have already paid for it or will pay for it in the future. If students do not repay their loans, that means that taxpayers will bear the burden. Then again, even if students do repay the loans, the only form of “repayment” taxpayers get is reimbursement to the Treasury, which defrays future expenses on some other boondoggle. But even if you discount the dubious notion that taxpayers are repaid by students, it is clear that the practice of forbearance encourages students to take on heavy debt loads and later shed them at taxpayer expense.

One obvious paradox is that the overall U.S. economy has been improving recently while the pattern of delinquency, default and forbearance on student loans has been increasing. This makes no economic sense. That makes Delisle wonder whether the purpose of student loans is political rather than economic.

Regular readers of this space should already have reached that conclusion by this point. Before broaching this issue fully, we should pause to ponder the question: Exactly what is the economic purpose of student loans for higher education underwritten by the federal government?

The Orthodox Economic Case for Government Subsidies to Higher Education

The economic case for subsidies to higher education by government can be found in virtually every undergraduate economics textbook. It is cited as an example of a positive externality. Ordinarily, an economic transaction involves a buyer and a seller – the benefits of the good being purchased are confined to the buyer and the costs of production were incurred by the seller. Education, it is claimed, benefits everybody, not just the student. So, there are benefits “external” to the parties immediately involved in the purchase, making the externality a “positive” one. (The presence of external costs would be a negative externality; pollution flowing from a production site would be an example.) Because students take only their own future benefits into consideration when weighing an investment in their human capital, they will not purchase enough education. It is up to government to subsidize education to make up for this inherent flaw in the free market. True, you and I are forced to pay for the education of others, but that is justified by the benefits we receive from their education – better goods and services that they produce, better conversation that they make with us, better government that they give us and more.

Even the apostle of free markets and laissez-faire, Milton Friedman, gives lip service to this argument in his treatise Capitalism and Freedom. And just as Keynesians like Ben Bernanke cite Milton Friedman’s slightest obiter dictum as support for their loose-money policies, so have government spenders cited him in support of spending on higher education.

This is a classic case of what the late Nobel laureate Ronald Coase called “blackboard economics.” Teachers will develop an argument on the blackboard, “prove” it using the assumptions they assert under the terms of their model. Then – because they probably had a vested interest to promote in the first place – they proceed to promote policies that are based on its validity.

“Economic policy involves a choice among alternative social institutions, and these are created by the law or are dependent on it. The majority of economists do not see the problem in this way. They paint a picture of an ideal economic system and then, comparing it with what they observe (or think they observe), they prescribe what is necessary to reach this ideal state without much consideration for how this could be done. The analysis is carried out with great ingenuity but it floats in the air. It is, as I have phrased it, ‘blackboard economics.’ There is little investigation of how the economy actually operates, and in consequence it is hardly surprising that we find…that the factual examples given are often quite misleading.”

Coase cited two famous blunders by famous Nobel Prize-winning economists. Paul Samuelson, author of the all-time bestselling economics text, followed the precedent set by several generations of economists going back to John Stuart Mill in the 19th century by flatly stating that lighthouses were an example of a positive externality and could only be provided by government, never privately in a free market. In reality, private lighthouses flourished for centuries. James Meade declared that bee pollination of orchards could never be handled by free markets, blithely overlooking the fact that beekeeping in the U.S. had done just that for many decades at the time (the early 1950s) that he wrote. Ironically, despite his suggestive term, Coase never applied his logic to higher education itself.

Coase implies strongly that the problem with “blackboard economics” is a lack of empirical investigation. He was trained at the London School of Economics and taught for many years in the Law School at the University of Chicago. Thus, he was exposed to the influence of two famous philosophical positivists, John Neville Keynes (father of John Maynard Keynes) and Milton Friedman. Both men developed a school of economic logic and practice that was very widely taught and practiced within the profession. It preached that economists should not only develop hypotheses but test them empirically using formal statistical inference. Only those hypotheses that pass the tests – that is, the ones that are empirically sound – should be vetted for policy purposes.

This philosophy is purportedly based on the habits developed by the natural sciences – physics, biology, chemistry et al. It sounds – or, more precisely, sounded– attractive, which accounts for its onetime dominance of the profession. It now lies in ruins. Few theorists pretend to “test” economic hypotheses today, although everybody goes on mechanically employing statistical tools and looking for new ones. The concept of “statistical significance” today brings a blush to professional cheeks after its scandalous misuse by generations of social scientists.

Coase made a minor point, all right; economists were arrogant for not at least peeking out the windows of their ivory towers before applying the theories they formulated so carelessly. But the decisive point is theoretical, not empirical. The externalities argument is badly reasoned in the first instance. Coase himself proved this when he laid the groundwork for the so-called “Coase Theorem,” which shows that when transactions costs are disregarded, the existence of an externality does not make a case for government involvement. The two parties involved have an incentive to bargain their way to a solution.

The positive externality argument for government subsidies to higher education has an even bigger hole in it, one big enough to drive a truck holding $1 trillion through.

When Is An Investment Not An Investment?

When we stand back and view the positive externality argument and today’s reality of student-loan spending by government in some sort of perspective, it is blindingly obvious that something is missing. Something vital was overlooked all along in the mad rush to get money in the hands of students. What was it, exactly?

After Forbes Magazine published one of the cautionary articles referred to earlier, a young student sent in a dissenting response. His economic arguments were chillingly naïve: Since the loans are made and supported by the government, the private sector is “protected” against the fallout from default, unlike the case with the mortgage default on subprime loans; the loans are not securitized via derivative assets and thus have less potential for harm. But most telling of all is his closing comment that “after all, education is not a cost, it is an investment.”

Incredible as it seems, this is the same hazy-crazy-lazy blue-skies frame of mind with which economists themselves have approached the subject. Let us rectify this carefree, careless approach with some incisive thinking. Education is a good. The purchase of education by an individual is an investment that entails a cost. The cost is the highest-valued alternative foregone by that individual in the purchase as it is viewed BY THAT INDIVIDUAL. The benefit is the discounted present value of the future benefits expected to accrue from the human capital created as they are viewed BY THAT INDIVIDUAL. Nobody else’s views matter in evaluating this investment. Nobody else can evaluate the benefits because they are his or her benefits – nobody else’s. Nobody else can evaluate the cost because it is his or her cost – nobody else is foregoing the alternative(s).

Are there other people who gain in some way from that individual’s education? Fine – let them subsidize his or her education, if they want to. If they want to run the risk that he or she will purchase too little education, let them run it. If they don’t perceive sufficient benefit to them from his or her education to subsidize it, then the only sensible policy is to treat that external benefit as negligible. In practice, we see various people and institutions willing to subsidize the educations of others.

Now the shortcoming of the current system sticks out like the proverbial sore thumb. As it stands out now, the education decision is NOT an investment – because the individual making it considers only benefits, not costs. By manipulating the system, the student-borrower can slide out from under a very substantial proportion of the nominal cost.

And that’s not all. The investment decision is further distorted by the fact that, when the buyer perceives the cost to be zero or very low, the quantity demanded will be very high. Thus, the price – tuition – will be driven artificially high. Expansion of capacity – that is, supply – comes rather slowly because public funding to build more universities or expand existing ones comes from legislatures, while private universities are funded largely from endowments.

The Political Basis of the Current System

Delisle’s conjecture about the political basis of the current system is well-founded. Conservatives sometimes act as if sin originated with the election of Barack Obama in 2008, though, and iniquity in public education goes back over a century. The economists who formulated the positive externality theory worked for the government, as do most economists today. The 20th century saw education become a captive of the state. The subjection of students via student loans is only the latest foray by a marauding government.

The current design of student-loan programs is not the result of laxity or well-meaning over-generosity, but of political calculation. The concept of “predatory lending” has absolutely no meaning in a private, free-market economy because private, profit-seeking businesses have no incentive to write bad loans. But government does and the student-loan program is the locus classicus of predatory lending a la government. Its purpose is to entrap students in loans from which they have no alternative except to default. Government is both their benefactor – for “giving” them a college education – and their savior – for rescuing them from financial ruin and penury with forbearance. Thus, government has now created a built-in, guaranteed constituency. Moreover, this new constituency comes complete with an army of bureaucrats that also owe their jobs to government. Bureaucrats first of all to administer the loans in the first place – fill out the forms and check eligibility (as if!) and recruit new borrowers and keep the loans flowing; bureaucrats later on to administer the forbearance phase in which de-facto defaults are carefully managed and nurtured to their soft landings.

Both these new constituencies will vote for big government forever.

And “forever” lasts just as long as it takes for the money to run out and the ultimate financial debacle to take down the whole monetary and financial system.

Bust Up the Blackboard 

Most utter debacles come about in spite of economic theory and logic. This one was carefully engineered with the aid of economics and economists. We cannot fine-tune out way out of this disaster. The only way out is to privatize education at all levels. Severing the financial lifeline of these subsidies is the only way to kill this two-headed student-loan beast that devours our real income with each mouth.