DRI-326 for week of 9-1-13: Quantity vs. Quality in Economists

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Quantity vs. Quality in Economists

Students of economics have long complained that economics texts focus too much on quantity and not enough on quality when evaluating goods. The same issue arises when comparing economists themselves. The career of Nobel Laureate Ronald Coase, who died this week at age 102, is a polar case.

Economists advance by publishing articles in prestigious, peer-reviewed journals. The all-time leader in the number of articles published is the late Harry G. Johnson. Despite dying young at age 53, Johnson compiled the staggering total of 526 published articles during his lifetime.

The use of advanced mathematics and abstract modeling techniques has enabled economists to rack up impressive publications scores by introducing slight mathematical refinements that add little to the substantive meaning or practical value of their achievement. When asked to account for the comparative modesty of a list of publications only one-fourth the size of Johnson’s, Nobel Laureate George Stigler countered, “Yeah, but mine are all different.”

Coase stands at the other extreme. His complete list of articles numbers fewer than twenty, but two of those are among the most-frequently consulted by economists, lawyers and other specialists, not to mention by the general public. He published a long-awaited, widely noticed book in 2012 despite having passed his centenary the year before. His life is an advertisement for the value of quality over quantity in an economist.

Another notable aspect of Coase’s work is its accessibility. In an age when few professional contributions can be read and understood by non-specialists, much less by interested non-economists, Coase’s work is readily comprehensible by the educated layperson. Now is the time to rehearse the insights that made Coase’s name a byword within the economics profession. His death makes this review emotionally as well as intellectually fitting.

Why Do Businesses Exist?

At 26 years of age, Ronald Coase was a left-leaning economics student. He pondered the following contradictory set of facts: On the one hand, socialists ever since Saint-Simon had advocated running a nation’s economy “like one big factory.” On the other hand, orthodox economists declared this to be impossible. Yet some highly successful corporations reached enormous size.

Who was right? It seemed to Coase that the answer depended on the answer to a more fundamental question – why do businesses exist? Be it a one-person shop or a huge multinational corporation, a business arises voluntarily. What conditions give birth to a business?

Coase found the answer in the concept of cost. (In his 1937 article, “The Nature of the Firm,” Coase used the term “marketing costs,” but the economics profession refined the term to “transactions costs”.) A business arises whenever it is less costly for people to organize into a hierarchical, centralized structure to produce and distribute output than it is to produce the same output and exchange it individually. And the business itself performs some activities within the firm while outsourcing others outside the firm. Again, cost determines the locus of these activities; any activity more cheaply bought than performed inside the firm is outsourced, while activities more cheaply done inside the firm are kept internal.

Like most brilliant, revolutionary insights, this seems almost childishly simple when explained clearly. But it was the first lucid justification for the existence of business firms that relied on the same economic logic that business firms themselves (and consumers) used in daily life. Previously, economists had been in the ridiculous position of assuming that businesses used economic logic but arose through some non-economic process such as habit or tradition or government direction.

Today, we have a regulatory process that flies in the face of Coase’s model. It implicitly assumes that markets are incapable of correctly organizing, assigning and performing basic business functions, ranging from safety to hiring to providing employee benefits. To make matters worse, the underlying assumption is that government regulatory behavior is either costless or less costly than the correlative function performed by private markets. As Coase taught us over 75 years ago, this flies in the face of the inherent “nature of the firm.”

The “Coase Theorem”

In mid-career, while working amongst a group of free-market economists at the University of Virginia, Ronald Coase made his most famous discovery. It assured him immortality among economists. Just about the best way to make a name for yourself is to give your name to a theory, the way John Maynard Keynes or Karl Marx did. But in Coase’s case, the famous “Coase Theorem” was actually devised by somebody else, using Coase’s logic – and Coase himself repudiated the use to which his work was put!

To appreciate what Coase did – and didn’t do – we must grasp the prior state of economic theory on the subject of “externalities.” Tort case law contained examples of railroad trains whose operation created fires by throwing off sparks into combustible areas like farm land. The law treated these cases by either penalizing the railroad or ignoring the damage. A famous economist named A. C. Pigou declared this to be an example of an “externality” – a cost created by business production that is not borne by the business itself because the business’s owners and/or managers do not perceive the damage created by the sparks to be an actual cost of production.

Rather than simply penalizing the railroad, Pigou observed, the economically appropriate action is to levy a per-unit tax against the railroad equal to the cost incurred by the victims of the sparks. This would cause the railroad to reduce its output by exactly the same amount as if it had perceived its sparks to be a legitimate cost of production in the first place. In effect, the railroad “pays” the costs of its actions in the form of reduced output (and reduced use of the resources necessary to provide railroad transport services), rather than paying them in the form of a fine. Why is the former outcome better than the latter? Because the purpose is not to hurt the railroad as retaliation for its hurting the farmer, the way one child hurts another in revenge for being hurt. A railroad is a business – in effect, it is a piece of paper expressing certain contractual relationships. It cannot feel hurt the way a human being can, so the fine may make the farmer feel better (if he or she received the fine as proceeds of a tort suit) but does not compensate for the waste of resources caused by having the railroad produce too much output. (“Too much” because resources will have to be devoted to repairing the damage caused by the sparks, and consumers value the resources used to do this more than the farmer values the loss.) In contrast, when the costs are factored into the railroad’s production decision, everybody values the resulting output of railroad services and other things as exactly worth their cost.

Of course, the catch is that somebody has to (1) realize the existence of the externality; and (2) calculate exactly how much tax to levy on the railroad to neutralize (or internalize) the externality; and then (3) do it. In the manner of a philosopher king, Pigou declared that this task should be assigned to a government regulatory bureaucracy. And for the next half-century (Pigou was writing in the early 1900s), mainstream economists salivated at the prospect of regulatory agencies passing rules to internalize all the pesky externalities that liberals and bureaucrats could dream up.

In 1960, Ronald Coase came along and gave the world a completely new slant on this age-old problem. Consider the following type of situation: you are flying from New York to Los Angeles on a low-price airline. You have settled somewhat uncomfortably into your seat, survived the takeoff and are just beginning to contemplate the six-hour flight when the passenger in front of you presses a button at his side and reclines his seatback – thereby preempting what little leg room you previously had. Now what?

This is not actually the example Coase used – it was used by contemporary economist Peter Boettke to illustrate Coase’s ideas – but it is especially good for our purposes. Using the same logic Coase applied to his examples, we reason thusly: It would be completely arbitrary to assign either of us a property right to the space preempted by the seatback. Why? Because the problem is not to stop bad people from doing bad things. Instead, we are faced with a situation in which ordinary people want to do good things that are in some sense contradictory or offsetting in their effects. On the airplane, my wish to stretch out is no more or less morally compelling than his to recline. The problem is that  we can’t do both to the desired extent at the same time without getting in each other’s way; e.g., offsetting each other’s efforts.

Indeed, this is true of most so-called externalities, including the railroad/farmer case. Case law usually treated the railroad as a nefarious miscreant imposing its will on the innocent, helpless farmer. But the railroad’s wish to provide transport services is just as reasonable as the farmer’s to grow and harvest crops. It is not unthinkable to enjoin the railroad against creating sparks – but neither should we overlook the possibility of requiring the farmer to protect against sparks or perhaps even not locate a farm within the threatened area. Indeed, what we really want in all cases is to discover the least-cost solution to the externality. That might involve precautions taken by the railroad, or by the farmer, or emigration by the farmer, or payment by the railroad to the farmer as compensation for the spark damage, or payment by the farmer to the railroad as compensation for spark avoidance.

 

In general, it is crazy to expect an uninvolved third party – particularly a government regulator – to divine the least-cost solution and implement it. The logical people to do that are the involved parties themselves, who know the most about their own costs and preferences and are on the scene. These are also the people who have the incentive to find a mutually beneficial solution to the problem. In our airline example, I might offer the man in front of me a small payment for not reclining. Or he might pay me for the privilege of reclining. But either way, we will bargain our way to a solution that leaves us both better off, if there is one. One of us would object to any proposed solution that did not leave him better off.

Of course, it would be useful for bargaining purposes to have an assignment of property rights; that is, a specification that I have the right to my space or that the man in front of me has the right to recline. That way, the direction of compensatory payments would be clear – money would flow to the right-holder from the right-seeker.

What if bargaining does not produce an efficient outcome, one that both parties can agree on? That means that the right-holder values his right at more than the right-seeker is willing to pay. But in that case, no government tax would produce an efficient outcome either.

On the airline, suppose that I value the leg room preempted by the reclining seat at $10. Suppose, further, that airline policy gives him the right to recline. If I offer him $6 not to recline, he will accept my offer if he values reclining at any amount less than $6 – say, $5. Notice that we are now both better off than under the status quo ante bargain. I get leg room I valued at $10 – or course, I had to pay $6 for it, but that is better than not having it at all, just as having the airline’s cocktail is better than being thirsty even though I had to pay $5 for it. He loses his right to recline, but he gets $6 instead – and reclining was only worth $5 to him. He is better off, just as he would be if he accepted an airline’s offer of $500 to surrender his seat and take a later flight, as sometimes happens.

We cannot even begin to estimate how many times people solve everyday problems like this through individual bargains. The world would be vastly better off if we were trained from birth in the virtues of a voluntary society where bargaining is a way to solve everyday disputes and make everybody better off. That training would stress the virtues of money as the lubricant that facilitates this sort of bargain because it is readily exchangeable for other things and because it is the common denominator of value. Instead, most of us are burdened by an instinctive tribal suspicion that money is evil and bargaining is used only to seek personal advantage at the expense of others. Experienced businesspeople know otherwise, but throughout the world the Zeitgeist is working against Coase’s logic. More and more, government and statutory law are held up as the only fair mechanism for resolving disputes.

University of Chicago economist George Stigler used Coase’s logic to devise the so-called Coase theorem, which says that when the transactions costs of bargaining are zero, the ultimate price and output results will be the same regardless of the initial assignment of property rights. This is true because both parties will have the incentive to bargain their way to an efficient improvement, if one exists. The assignment of property rights will affect the wealth of the bargainers, because it will determine the direction of the money flow, but economists are concerned with welfare (determined by prices and quantities), not wealth. No government regulatory body can improve on the free-market solution.

Coase disagreed with the theorem named after him – not because he disputed its logic, but because he foresaw the results. Economists would use it to look for circumstances when transactions costs were low or non-existent. Instead, Coase wanted to investigate real-world institutions such as government to compare its transactions costs to those of the market. He knew that real-world transactions costs were seldom zero but that government solutions almost never worked out as neatly in practice as they did on the blackboard. In fact, he invented the phrase “blackboard economics” to refer to solutions that could never work in practice, only on a theoretical blackboard, because real-world governments never had either the information or the incentive necessary to apply the solution.

Why China Became Capitalist

Ronald Coase devoted his last years to learning how and why China evolved from the world’s last major Communist dictatorship to the world’s emerging economic superpower. In Why China Became Capitalist, he and his research partner Ning Wang delivered an account that contravened the popular explanation for China’s rise. China’s ruling central-government oligarchy has received credit for the country’s emergence as the growth leader among developing nations. Since the Communist Party retained political control throughout the growth spurt, it must have been responsible for it – so the usual explanation runs. Coase and Wang showed that government’s presence as the agency in charge of political life does not automatically entitle it to credit for economic growth.

The death of Mao Zedong in 1976 rescued China from decades of terror, famine and dictatorship. Mao’s designated successor, Hua Guofeng, was an economist who outlined a program of state-run investment in heavy industry called the “Leap Outward.” This resembled the various Five-Year Plans of Soviet ruler Joseph Stalin in general approach and in overall lack of results. Hua’s successors, Deng Xiaoping and Chen Yun, abandoned the Leap Outward in favor of an emphasis on agriculture and light industry. Although Deng was the political figurehead who garnered the lion’s share of the publicity, Chen was the guiding spirit behind this second centralized plan designed to spur Chinese economic growth. It placed less emphasis on production of capital goods and more on consumer goods. Chen allowed state-controlled agricultural prices to rise in an effort to stimulate production on China’s collective farms, which had failed disastrously under Mao, resulting in approximately 40 million deaths from famine. He also allowed state-run enterprises a measure of autonomy and private profit, heretofore unthinkable under Communism.

Although these central-government measures were the ostensible spur to China’s remarkable growth run, Coase and Wang assign actual responsibility to the resurgence of China’s private economy. Private farms had always existed as part of the nation’s 30,000 villages and towns, much as neighboring Russians continued to nurture their tiny private plots of land alongside the Soviet collective farms. And, just as was the case in Russia, the smaller private farms began to outdo the larger collectives in productivity and output. Mao fanatically insisted on agricultural collectivization, but his death freed private farmers to resume their former lives.  By late 1980, the Beijing government was forced to officially acknowledge the private farms. In 1982, China formally abandoned its costly experiment with collective agriculture and de-collectivized its farms. Official grain prices were allowed to rise and grain imports were permitted.

Agriculture wasn’t the only industry that flourished at the local level. Small businesses in rural China labored under official handicaps; their access to raw materials was not protected and they had no officially sanctioned distribution channels for their output. But they bought inputs on the black market at high prices and groomed their own sales representatives to scour the nation drumming up business for their goods. These local Davids outperformed the state-run Goliaths; they were the real vanguard of Chinese economic growth.

Growth was slower in China’s major cities. Mao had sent some 20 million youths to the countryside to escape unemployment in the cities. After his death, many of these youths returned to the cities – only to find themselves out of work again. They demonstrated and formed opposition political movements, sometimes paralyzing daily life with their protests. This forced Beijing to permit self-employment for the first time – another Communist sacred cow sacrificed to political expediency. This, in turn, created an urban class of Chinese entrepreneurs. This led to yet another government reaction in the form of Special Economic Zones, somewhat reminiscent of the U.S. “enterprise zones” of the 1980s. Economic freedom and lower taxes were allowed to exist in a controlled environment; Chinese officials hoped to encourage controlled doses of capitalist prosperity in order to save socialism.

Gradually, the limited reforms of the Special Economic Zones became more general. Increased freedom of market prices was introduced in 1992, taxes were lowered in 1994 and privatization of failing state-run enterprises began in the mid-1990s. For the first time, China began to replace local and regional markets with a single national market for many goods.

Coase and Wang identify perhaps the most important but least-known capitalist element to arise in China as the improved pursuit of knowledge. They accurately attribute the recognition of knowledge’s role in economics to Nobel Laureate F.A. Hayek and note the increasing popularity of books and articles by Hayek, his mentor Ludwig von Mises and classical forebears such as Adam Smith. The economics profession has pigeonholed the subject of knowledge under the heading of “technical coefficients of production,” but the authors know that this is only the beginning of the knowledge needed to make a free-market economy work. The knowledge of market institutions and the dispersed, specialized “knowledge of particular time and place” that can only be collated and shared by free markets are even more important than technical knowledge about how to produce goods and services.

The upshot of China’s private resurgence has been to make the country a “laboratory for capitalist experimentation,” according to Coase and Wang. That laboratory has brewed a recipe for unparalleled economic growth since the 1990s, leading to China’s admittance into the World Trade Organization in 2001. The final piece of the puzzle, the authors predict, is a true free market for ideas – the one thing that Western economies have that China lacks. When this falls into place, China will become the America of the 21st century.

Thus did Ronald Coase add a landmark study in economic history to his select resume of classic works.

Quality vs. Quantity

Never in the history of economics has one economist achieved so much productivity with so little scholarly output. Ronald Coase economized on the scarce resources of time and human effort (ours) by devoting the longest career of any great economist to specializing in quality, not quantity, of work.

DRI-300 for week of 7-28-13: Was Detroit’s Fall ‘Just One of Those Things That Happens Now and Then’ to ‘An Innocent Victim of Market Forces’?

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Was Detroit’s Fall ‘Just One of Those Things That Happens Now and Then’ to ‘An Innocent Victim of Market Forces’?

Last week’s EconBrief analyzed Detroit’s precipitous decline from America’s most prosperous city to Chapter 9 bankruptcy. The most popular explanation ascribes the event to 20th-century liberalism, which reigned unchallenged over the city throughout its financial death spiral. When a city is named the most liberal in America, as Detroit was by the BayAreaCenter for Voting Research, political philosophy becomes the prime suspect at its post-mortem.

Still, there have been prominent dissenters. Former Michigan governor Jennifer Granholm called Detroit a victim of “free trade.” Presumably, she refers to the international trade in automobiles that increasingly brought foreign models – especially Japanese cars – to prominence in the U.S. Even more significant were the comments of Nobel laureate Paul Krugman, economist and columnist for the New York Times. In his column of 07/27/2013 entitled “When It Comes to Detroit, Greece Is Not the Word” and subtitled “Victims of Creative Destruction,” Krugman lamented the fact that Detroit’s bankruptcy would occasion comparisons to the financial default of Greece.

Greece’s circumstances were unique and not comparable to those of other countries, Krugman contended. Moreover, Greece’s small economy – “about 1 ½ times as big as metropolitan Detroit” – did not affect the rest of the world much. Consequently, it was wrong to use Greece’s problems as an excuse to cry wolf about government deficit spending. Thus, it must be just as wrong to cite Detroit as a model for municipal excess. For example, U.S. state and local government-employee pensions are only underfunded by about one trillion dollars, Krugman contended. He cited a BostonCollege study as his source for this figure, which is only about one-third the size of conventional estimates.

Having established Greece as an isolated case, Krugman appears poised to do likewise for Detroit – but no. “So was Detroit just uniquely irresponsible? Again, no. Detroit does seem to have had [sic] especially bad governance, but for the most part, the city was just an innocent victim of market forces.” Reading Krugman on Detroit’s political leadership suggests that, had Krugman strolled through Hiroshima the day after the atomic bomb was dropped, his reaction would have been that an especially large bomb seemed to have fallen in the middle of the city.

Krugman plays it coy about just which “market forces” victimized Detroit, but he has no scruples about reminding us that they can be brutal. “…Sometimes whole cities…lose their place in the economic ecosystem…,” he lectures sternly. And when that happens? That is when we pull out the big gun in the liberal arsenal: we need to “have a serious discussion about how cities can best manage the transition when their traditional sources of competitive advantage go away. And let’s also have a serious discussion about our obligations, as a nation, to those of our fellow citizens who have the bad luck of finding themselves living and working in the wrong place at the wrong time.”

Detroit, according to Krugman, isn’t “fundamentally a tale of fiscal irresponsibility and/or greedy public employees…it’s just one of those things that happen now and then in an ever-changing economy.”

It is deeply ironic that, of the two commentators, it was the politician who referred explicitly to international trade. After all, Paul Krugman won his Nobel Prize for work in the field of international trade theory. Yet he referred to that subject only obliquely in his column. That is the clue to the profound intellectual dishonesty of these two commentaries. The politician lied about a subject on which politicians lie reflexively. The economist avoided a subject in which he is supremely qualified because he had no intention of telling the truth and could not bear to trash his reputation by lying outright.

America’s Unfree International Trade in Automobiles
The effects of international trade in automobiles can be seen daily zooming across the roadways of America. The Toyota is one of the most popular automobiles in America. But this is hardly the outcome of free trade in automobiles. Free trade is defined as the absence of such impediments to international trade as tariffs (taxes) and quotas. No sooner did foreign-car makers such as France’s Renault and Sweden’s Volvo enter the U.S. market in the 1960s than they were besieged with tariffs at the behest of Detroit.

When Japanese automakers like Honda, Toyota and Nissan began to loosen the stranglehold of the Big Three on the U.S. market in the 1970s, Congress erected a tariff wall against foreign-car imports. This was even extended to include a quota of one million Japanese-car imports. Amazingly, tariffs remain in force to this day in the form of a 2.25% tariff on Japanese-car imports and a 25% truck tariff.

Doubtless Ms. Granholm was relying on the notoriously poor memories of Americans when she cited free trade as the cause of Detroit’s woes. But it isn’t necessary to be a student of U.S. commercial policy in order to know she is lying. Today, nearly two-thirds of Toyotas sold in America are not shipped to America from Japan. They are assembled right here in the USA in places like Tennessee and Alabama. Why did Japanese automakers take the time and trouble to build auto plants here in the U.S.? In order to escape our import barriers. Direct foreign investment is a classic ploy to overcome tariffs and quotas. Honda was the first Japanese automaker to build a U.S. plant, followed soon by Toyota in the early 1980s.

Not only do domestic manufactures escape the penalties levied on imported goods, they also escape the criticism often leveled at purchases of foreign goods. The same people who scream and holler about American jobs being exported to Japan by “globalization” (today’s pejorative buzzword for free trade) can hardly complain when the Japanese build a U.S. plant that employs U.S. workers. The same chauvinists who demand that we “buy American” can’t very well complain when we buy American-made Toyotas.

It is true that production tends to migrate to its least-cost locus. But transport costs have been falling, not rising, for decades – that is why containerization has become so popular. Before tariffs, the Japanese made cars in Japan and shipped them here. Only after tariffs were imposed did it become efficient to move production to the U.S., where the Japanese had to strain to acclimate U.S. workers to their legendary production methods.

Sharp-eyed readers noticed the word “assembled” used to describe the process by which automobiles are made. Today, the hundreds of parts that comprise an automobile are manufactured throughout the world. They are shipped to automobile plants for final assembly into the finished product. So-called “American” cars like Fords, Chryslers and GM products may well contain fewer American-made parts than do Toyotas and Hondas. To an economist, what matters is that the final product be produced at least cost and that all trade reflects the comparative or “opportunity” costs of producing the products traded. Free trade reflects those costs while tariffs and quotas distort them.

No, it wasn’t free trade that drove General Motors and Chrysler to virtual bankruptcy. It was a combination of factors, one of which was the ability of competitors to overcome the protectionist barriers thrown up by Detroit’s political influence.

Similar logic defeats the comment made by another left-wing onlooker that “capitalism failed Detroit.” The Big Three benefitted from numerous federal-government bailouts even before 2008. Chrysler enjoyed one of the very first federal-government bailouts in 1980, thanks to the charisma and clout of Lee Iacocca. Of course, this was the antithesis of capitalism (but the epitome of “crony capitalism.”) Really, what Ms. Granholm means by “free trade” is freedom itself; e.g., the absence of government coercion and constraint. As we discover below, this is exactly what Detroit did not experience during its painful decline.

Why Krugman Could Not Say What He Implied
Krugman’s comments about “just one of those things” and “an innocent victim of market forces” conjure up images of Detroit buffeted by random shocks from outside the city involving supply, demand and prices of things like oil, raw materials, labor, machinery and technology. Of all the possible “market forces” involved, what could Krugman possibly mean if not the market for automobile production and sale? Surely Detroit and Battle Creek didn’t wage war over breakfast cereal dominance? The Great Lakes weren’t blockaded by Canada at some point, were they?

Krugman’s vague references are intended to allow his readers to believe that he means that the effects of international trade in automobiles are what did Detroit in. But he is not going to come right out and say that. For that would expose him as incompetent in his Nobel-Prize specialty. The problems experienced by the Big Three automakers couldn’t possible have caused Detroit’s bankruptcy and Krugman knows it. There is no alternative to conceding that the right wing is right – liberalism’s bankruptcy caused Detroit’s bankruptcy. And Krugman knows that, too.

Automobile companies located in Detroit certainly suffered losses of sales and profits from (mostly) Japanese competition. But these losses were not felt by “Detroit,” either by the citizenry at large or by municipal government coffers. Corporate profits and losses accrue to shareholders. In this case, that means a few million people who mostly don’t live in Detroit but rather are dispersed throughout the nation. They include private individuals, households, investment-company fund shareholders and pensioners. Some executives lost jobs and income, but they were comparatively few when mingled among the nation’s fourth-largest city. In principle, workers could suffer job and income losses – but in practice the UAW saw to it that they didn’t. The union’s unwillingness to make wage and benefit concessions to management was proverbial. Its legacy-benefit accumulations to retirees were legendary. To this very day, Japanese auto-plant workers continue to assemble cars more productively than do UAW workers in Big Three auto plants. Consequently, the Big Three were bled dry. This even continued during the Obama Administration’s bankruptcy bailout, when General Motors’s shareholders were stiffed in favor of the UAW, which split the spoils with the federal government.

Not only did municipal government not suffer, it was among the vampires. For years, the automakers paid millions to the city for so-called “riot insurance.”

That is not all. The losses suffered by auto-company shareholders must be counterbalanced by the greater gains in real income. After all, international trade produces gains that more-than-offset losses; that is why international trade is just as beneficial as intranational trade. Once again, those gains are dispersed throughout the nation. But there were surely more foreign-car drivers in Detroit than auto-company shareholders – UAW parking lots were often sprinkled with imports! – and the gains of the former were larger than the losses of the latter.

Upon analysis, the notion that foreign-car competition wrecked Detroit is ludicrous on its face. And Paul Krugman’s curiously oblique column now makes sense. He couldn’t endorse Jennifer Granholm’s ridiculous claim, thereby becoming the first Nobel Prize-winning economist to make himself a laughingstock in his own specialized niche. But his liberal credentials, syndicated-column status and unshakable personal arrogance demanded that he not concede even the clearest victory to the enemy. He cannot acknowledge a truth uttered by the right wing even when validated by the logic of his own profession.

Detroit’s Downfall Was Not Random
Krugman’s description of Detroit’s fate as “just one of those things” triggers memories of a popular song from Detroit’s glory days: “Just one of those things; just one of those crazy things; one of those bells that now and then rings; just one of those things.” In short, it implies randomness rather than the result of purposive acts, incompetence, bad judgment or corruption.

That is exactly the opposite of the truth.

Detroit’s political leadership was not a random variable. Its liberal pedigree was impeccable. The city’s last Republican mayor served from 1957 to 1961. His successor, Jerome Cavanaugh, was a young New Frontier Democrat cast in the mold of John F. Kennedy. Cavanaugh was determined to use government to lift up the poor and impoverished. He accomplished half his objective; he used government. But the poor and impoverished did not decline. Instead, a city that boasted America’s highest per-capita income in 1960 went steadily downhill to a household income of $26,000 in 2010. Unemployment stands today at 16%.

Krugman’s description of Detroit as “an innocent victim of market forces” is classic liberal rhetoric. Whereas liberals usually create “social wholes” or collectives from politically malleable blocs and cast them as victims, Krugman has escalated the use of this technique to encompass an entire city. As noted above, his unnamed market forces must refer to international trade. But as explained above, the widely dispersed losses suffered by the Big Three automakers from Japanese competition cannot begin to explain the highly concentrated losses felt by the fourth-largest and most prosperous city in the world’s wealthiest nation. When the gains from that international trade are factored in, Krugman’s implicit case disintegrates.

International trade does not explain the fact that one-third of Detroit’s acreage is either vacant or horribly blighted. Trade cannot account for the fact that houses sometimes sell for $500 or less. International trade did not cause Detroit’s population of nearly 2 million to shrink to roughly 700,000. These things were caused by the 20-year reign of a black-separatist mayor who declared that only white could people could be racist. When whites reacted by fleeing the city for Detroit’s numerous suburbs, Mayor Coleman Young continued to direct imprecations at the “racists in the suburbs.” The more whites left the city, the more politically potent Young’s black base became. This tactic of deliberately encouraging out-migration through ineffective government has been dubbed the “Curley Effect” (after Boston’s notorious Mayor James Curley) by economists Andrei Shleifer and Edward Glaeser.

International trade did not give Detroit the worst crime rate in the nation and a murder rate eleven times greater than New York’s. It was Mayor Young who polarized the police force by laying off white officers to change the racial composition of the department. It was the mayor who refused to treat black and white criminality alike and called rioting “rebellion” when committed by blacks. International trade did not make 47% of Detroit’s citizens functionally illiterate, nor did it set Detroit’s public education system trudging toward the bottom rungs of the national achievement ladder despite an per-student expenditure of over $14,000.

Random market forces did not create a vast municipal bureaucracy, at one time comprising nearly 10% of the city’s working population. Market forces did not arrange for public-employee retirees to have 80-100% of their medical costs paid by their city retirement benefits. International trade did not cause 75% of municipal revenue to be devoted to salaries, benefits and legacy (retirement) obligations of municipal employees. Japanese competition did not force Detroit to burden its citizens with the highest per-capita tax burden in the state while still borrowing and spending lavishly enough to drive the city into bankruptcy.

International trade did not compel two of Mayor Coleman’s closest aides to separately steal over $1 million dollars, crimes for which they served jail terms. Trade did not seduce the “Hip-Hop Mayor,” Kwame Kilpatrick, into violating 24 federal statutes, including racketeering and mail fraud. The Japanese did not make the municipal bureaucracy virtually impervious to all attempts at reform, streamlining or simple day-to-day functional improvement.

International trade did not compel Detroit city government to smother small businesses with regulations such as the licensing requirements that threaten the existence of over 1,000 small businesses that make up some 10% of businesses and serve over two-thirds of Detroit residents. International trade did not dictate a city-imposed minimum wage exceeding $11 per-hour for public employees and businesses contracting with the city.

Krugman’s call for a “serious discussion…as a nation…about our obligations…to our fellow citizens…who have bad luck” is a thinly-veiled call for a bailout. But that was exactly the road Detroit followed under Coleman Young, whose explicit strategy was to “go to war with the city’s major institutions and demand that the federal government save it with subsidies.” Sure enough, up to one-third of Detroit municipal salaries were paid by federal-government salaries, according to researcher and write Tamar Jacoby. As Steven Malanga pointed out in The Wall Street Journal (7/27-28/2013), this strategy acquired the nickname “tin-cup urbanism.” Today, we are all holding tin cups and the federal government is robbing most of them in order to replenish favored cup holders.

No, there is absolutely nothing random about Detroit’s descent into bankruptcy. The forces causing it had virtually nothing to do with international trade. They were the forces of anti-capitalism, not capitalism. It is easy to see why Paul Krugman could only hint that international trade was involved without actually mentioning the subject, and why he had to distract his readers with the non sequitur of Greece. Detroit’s bankruptcy was caused by everything Paul Krugman believes in and continues to advocate today except for free trade. In other words, the fate of Detroit is Krugmanism in action.

DRI-358 for week of 10-7-12: More Expensive Free Lunches

An Access Advertising EconBrief:

 

More Expensive Free Lunches

 

Last week’s EconBrief developed the economic concept of the free lunch. “There’s no such thing as a free lunch” may be the most famous of all economic aphorisms. Often credited to Milton Friedman, it owes much to that late Nobel laureate’s astonishing talent for exposition. Friedman pointed out that the notion of a free lunch violated the principle of opportunity cost, which undergirds the very subject of economics. Since resources have alternative uses, anything produced using scarce resources must be costly. The highest-valued alternative output foregone constitutes the opportunity cost of production.

Neglect of opportunity cost is the hallmark of the free lunch. Another distinctive feature is the underpricing of a scarce good or resource on the pretext of improving welfare. The pretext obscures the true purpose of the free lunch, which is to grow government. Expansion of government regulation, agencies, bureaus and programs is another characteristic of the free lunch. Finally, the presence of unintended collateral damage – often the result of overindulgence in the underpriced “free” good – is an unmistakable sign of a free lunch.

 

Water Subsidies in the West

The lure of the free lunch acts as a sort of political Venus Fly Trap, tempting unwary citizens within range so as to swallow them up. Once gobbled up by the system, nobody emerges whole.

Farmers in the western United States were sucked in during the late 1800s and early 1900s. In this case, the lure was not a free lunch but a free drink – of water. The federal government built huge reservoirs and accompanying dams that it used to provide electric power. It made the water available to farmers in California’s Central Valley for purposes of irrigation.

As with free lunches to schoolchildren, the accompanying rhetoric was redolent with poetry and sentiment. The irrigation would “make the desert bloom.” And so it did. Eventually, farmers were able to grow crops on land that previously had little agricultural use. The federal government paid the farmers not to grow crops on the land, causing the farmers to set aside acreage and farm remaining land much more intensively, using larger amounts of water, fertilizer and pesticides. Then the federal government bought the crop surpluses produced by the farmers to artificially support crop prices, using taxpayer funds to pay for storage.

The tilled land was burned out by over-cultivation. Insects became resistant to the pesticides. Water shortages plagued the West. This was particularly irksome to farmers on better land located closer to the dams and reservoirs, who nevertheless needed some water for irrigation. Waterfowl and other wildlife species died by the tens of thousands as wetlands habitat dried up.

Acrimonious political divisions developed between Central Valley farmers and outsiders. Needless to say, farmers defended their subsidies, which had become a lucrative source of income.

Economists saw the problem as another free lunch gone wrong. The government undercharged Central Valley farmers for the water provided to them. Indeed, most communities through the U.S. and the world do not charge a true economic price for water. That is, a government-owned and operated water monopoly charges a flat rate for water usage instead of charging a price per unit of water consumed. This flat rate is economically equivalent to a price of zero.

Why? Because it is unchanged whenever the consumer increases or decreases water consumption. Thus, the marginal sacrifice (in terms of consumption foregone) for additional water consumed is zero. Under these circumstances, people are moved to treat water as a free good, to consume the maximum amount of it. Water is not a free good; additional quantities of it must be discovered, pumped, purified sufficiently for human consumption and made available to the consumer. Thus, by lying to the public, government encourages people to consume water well past the point where the personal value people place on additional water consumption is equal to the cost of producing and supplying that additional water. Because the cost exceeds the value, we are made poorer by the government policy.

Once more, practically everybody loses from the government “free lunch” policy on Western water. The possible exceptions are Central Valley farmers and government employees in the Department of Interior. Members of the Bureau of Reclamation and the Department of the Interior have made careers out of serving their constituents in the Central Valley. And, of course, proponents of big government can point to the irrigation projects and blooming desert and harvested crops. What can opponents point to? About all they can do is point to the environmental blight, the dead and dying wildlife. But farmers can deny that this has anything to do with them – they are just hardworking farmers, tillers of the soil – hardworking, God-fearing families who developed the desert in good faith.

Once again, the pattern is clear. A form of subsidy that benefits a few at the expense of the rest becomes entrenched and cannot be eradicated. No wonder, then, that economists wince when these programs start up. No wonder they take such an irritating, unyielding, hidebound stance against them. Once the programs are in place, dynamite cannot dislodge them.

Road Use

Americans are accustomed to climbing in their automobiles and taking off across the open road without let or hindrance. Public ownership of most roads has contributed to the fiction that road use is free, a fiction assiduously promoted by government policy. Sometimes a toll is charged for the use of a particular road, but traditionally the toll merely amortizes the debt incurred in construction. Expenses of road maintenance and repair are covered by revenues raised from the tax on gasoline purchases.

In fact, road use is not a free lunch. Roads are a capital good that must be built, maintained and replaced. The resources required for this are scarce and have alternative uses. Not only that, my use of the road at any point in time precludes use by somebody else, which violates the economic definition of a free good.

Opportunity costs of road use arise in both production and consumption. The resources necessary to build, maintain, repair and replace roads have alternative uses. This argues in favor of a price to place a value on use of the road. Consumers could then compare their personal valuation to the value of the alternative output foregone by making the road available for individual use. Driving would occur as long as the personal value exceeded the value of the output foregone in producing a usable road. But what usually happens is that the “free-lunch good” is underpriced, causing overuse. That is particularly true of road use at certain places, times and locations.

The overuse causes congestion. This congestion causes all sorts of collateral damage, including time wasted sitting in traffic queues, delays, road damage, accidents, gasoline wastage and air pollution. The cumulative effect is hardly trivial, since the time lost to traffic delays is estimated to have quintupled in the last 30 years.

As always, the free lunch has served the ends of big government. The Department of Transportation owes its existence to it, as doe various sub-departments and bureaus like the Federal Highway Transportation Safety Administration. State highway departments dole out money for care, maintenance and policing of state highways.

The seminal problem with this free lunch is ownership. Public ownership of the roads implies that nobody has an incentive to earn profits from them, maintain them to conserve their profit-earning capability or price their services to serve the needs of consumers. The conventional thinking (as opposed to “wisdom”) has always been that profits are bad – and prices are bad because they lead to profits. Experience has taught us the folly of this line of thinking. Profits point to goods and services that consumers want more of. Prices allow consumers to compare their valuation of each additional unit to the value of the resources used to produce it (e.g., the value of output foregone due to production). Prices and profits are the rational tools markets use to govern economic life.

The best way to reform the public road system is to privatize it. The second-best way is to use free-market techniques within a government context. Lease public roads to private firms for conversion to toll roads. Institute time-of-day pricing, or congestion pricing, to charge higher prices for road use during rush hours. This will divert some traffic away from rush hours to off-peak hours, which is a cheaper and more efficient solution than building more roads with peak usage points that last only 2-4 hours per day.

These approaches are now being followed, albeit on a small scale. Various states have leased highways to private firms as toll roads. In the Manhattan borough of New York City, all fixed tolls have been converted to congestion tolls in an effort to divert some of the city’s fearsome rush-hour traffic to off-peak points.

Military Conscription – A Ghost of Free Lunches Past

The opportunity to discuss a failed government policy in the past tense is so rare that it should not be bypassed. Military conscription in the U.S. began with the Civil War and continued through two World Wars and various lesser conflicts. The practice became hotly controversial during the Vietnam War, when many young men of draft age left the country to avoid involuntary induction into the military. The unpopularity of the draft undoubtedly led to its discontinuance in 1973.

Today the all-volunteer military operates smoothly and accepts both men and women. Occasional calls for a return to conscription echo the arguments made for the practice during its heyday. Foremost among these is that conscription saves money by allowing government to force inductees to work for lower wages than they would accept voluntarily.

It is indubitably correct that conscription forces many recruits to work for less pay than they would otherwise demand in a voluntary setting. Whether this amounts to “saving money” is a semantic question. What it certainly does not do, though, is to reduce the economic cost of providing national defense. When it comes to acquiring enlisted personnel for the military, the cost of service is not simply the monetary payment received by those soldiers. It is the value of the output they could have produced in their highest-valued alternative occupation, or the value of their marginal product. In a competitive market, their wage will be bid up until it reaches this level.

If a conscript is forced to accept a draftee wage of (say) $20,000 per year instead of the $30,000 per year he could have earned in civilian life, this is not really a fiscal victory for the draft. The government has merely levied an implicit tax on his labor, with the incidence of the tax falling on the conscript and the rest of us. The conscript earns $10,000 less than he would have otherwise; we receive military services that are less valuable than the civilian goods or services he could have produced instead.

Conscription has traditionally been portrayed in purely emotional terms. Proponents cite submission to compulsory military service as a patriotic duty. Those unwilling to defend their country are unworthy to enjoy the rights and privileges of citizenship. Opponents perceive state compulsion of its citizens as immoral; why should people be forced to fight and die for a cause they reject?

Economists cut this philosophical Gordian knot. Patriots want to win wars. The best way to do that is to put the best and most willing fighters on the front line, the best strategists in the war room and the best suppliers in the factories. Conscription completely louses up efficient resource allocation by forcing the unwilling and training the less able to fight; by making sergeants out of factory superintendents and officers out of the politically connected. More technically, conscription makes unskilled labor artificially cheap, encouraging the military to use too much of it and not enough capital goods (skilled labor and sophisticated weaponry). Indeed, this argument applies just as forcefully in peacetime.

The problem with the arguments of moralists is that they are neither necessary nor sufficient to deal with the problems posed by war and the necessity of raising and keeping a military force. In this pinched worldview, there is no stopping point between conscription on the one hand and unilateral disarmament and full-blown pacifism on the other hand. But voluntarism respects the arguments of the moralists while still allowing for optimal prosecution of war and national defense.

That conclusion is not merely theoretical. The record of the U.S. military in armed combat worldwide since the changeover to a voluntary force has been nonpareil. Recruits are now better educated – almost all are high-school graduates – and grade higher on aptitude tests at enlistment than under conscription. The military exhibits better morale, discipline and experience as a voluntary force. The logic developed above has been borne out in practice. If we were to revert to conscription, as is occasionally proposed, the resulting lower quality of recruits would raise the pecuniary costs of training to offset any monetary benefits accruing from lower wages.

In its heyday, conscription fit the free-lunch pattern like a glove. The opportunity cost of the conscript’s labor time – his or her civilian output – was ignored. The conscript’s work was underpriced, thereby distorting his or her use by government. Conscription contributed to the growth of big government in the form of the Veteran’s Administration, a massive bureaucracy devoted to processing, caring for and subsidizing citizen-soldiers rather than an army of professionals. And the collateral damage of the draft included not only the inefficiency of the armed services, but the contempt that it brought upon them and the lives it blighted.

Government Money Creation

Long before there were public schools to provide free lunches to, the foundations of the free-lunch concept were poured by the oligarchs of antiquity. They clipped coins, adulterated the metallic content of the money stock and generally debased the exchange value of the monetary media.

With the advent of paper money in the age of the printing press, monetary manipulation came into its own. Governments could pretend to create wealth by creating money – working the printing presses overtime creating currency for the public to spend. Prosperity is no farther away than the printer’s office. Happy days are here at last.

Unfortunately, money is not wealth. It merely allows the holder to acquire title to goods and services. Rapid money creation by government merely causes a mad scramble by holders of money to exchange it for the things they really want. Since the short interval between distribution of printed money and purchase does not allow for wholesale expansion of output, the result is more and more money holders waving currency and chasing a fixed supply of goods and services. The effect is to bid up prices.

The term “inflation” has come to be associated with the effect of money creation on prices when it might better be applied to the cause of the process; namely, the inflating of the money supply. The distinction is crucial, but we are only belatedly realizing that. It is sometimes true that the inflating of the money supply causes only some prices to rise. Even when all prices rise, they virtually never rise in perfect synchrony. And the world is now experiencing the most unusual case of all – a vast increase in government money creation with comparatively little effect on prices of goods and services (as of yet) but considerable effect on interest rates and the pattern of investment.

Governments today perceive virtually no monetary cost in money creation, since it is now effected by computer keystrokes to bank reserve accounts. The opportunity cost is that money that would otherwise be efficiently used in exchange and investment is now used inefficiently. Not only is its general purchasing power diluted – an effect that holds for all or most good, services and assets – but the distortion of relative values distorts specific markets such as housing, real estate, agriculture and many more. Once again, we see overuse of the free good whose value has been artificially cheapened by the free-lunch policy. As the supply of money rises, the urgency heightens to spend it before its value declines further.

And once again, we see the growth of government as beneficiary of the free lunch. The U.S. Federal Reserve was created in order to afford government control over the supply of money and credit. The Fed’s tentacles have spread until it now controls the banking and investment sectors, usurping not only private functions but even some functions of other government agencies.

Trying to sort out the direct from the collateral damage is somewhat arbitrary. For example, the entire financial crisis and ensuing Great Recession can be viewed as the collateral damage of the Fed’s money creation earlier in the decade, since the crisis would have been unthinkable in the absence of the monetary excess. But no matter how you allocate it, the overall damage has been enormous.

How Many Free Lunches Can We Afford?

As we have seen, the worst thing about economic free lunches is that they cost so much. That is the paradox of the free lunch – that it inherently promises what it logically cannot deliver. If this were all, perhaps we could write off the free lunch as a noble experiment. But the attempt to get something for nothing carries with it a big price tag. First there is inefficiency – neglect of opportunity cost means that resources are wasted and we become poorer. Then there is collateral damage – water shortages, water and air pollution, slaughter of wildlife, land devastation, road damage, highway gridlock, rush-hour tie-ups, inflation, malinvestment, unemployment add up to a gruesome butcher’s bill for just the four cases we discussed.

The Western world is currently undergoing a protracted financial crisis traceable to government overspending and debt. The crisis has its origins in the expensive free lunch.