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.

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

An Access Advertising EconBrief:

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-444: An Economist Sees the Light

The previous EconBrief spotlighted the great Ronald Coase, 101 years old and still going, as a shining beacon of truth in economics. It is altogether fitting that Coase should occupy the limelight. He has not only seen the light – he has shown it to the profession. It was Ronald Coase who restored the lighthouse to a place of respectability in economics.

The Traditional Role of the Lighthouse in Economic Theory

For over a century, the lighthouse held a unique place in economic theory. Some of the world’s leading theorists and textbook writers used its services as their prime example of a good that could not be provided privately and had to be provided by government and paid for out of tax revenue.

Generically speaking, the term economists use for this kind of good is a public good. Its status is predetermined by its unique characteristics. A public good is both non-rival and non-exclusive. “Non-rival” means that providing it for one consumer simultaneously makes it available for all. “Non-exclusive” means that there is no way to exclude those who refuse to pay for it from its benefits.

The best example of a public good conveys the concrete meaning of these properties. National defense cannot be provided for one citizen without making it effective for the remaining 315 million or so Americans. Any attempt to withhold it from (say) one conscientious objector would risk defaulting on the obligation to defend the other 314, 999,999. Only by assigning provision to the government and mandating payment in the form of taxation can this hurdle be overcome.

You might suppose that, with national defense just sitting there made to order, textbook authors wouldn’t need to scrounge for examples. But economists wanted more than just one perfect case. They yearned to picture public goods lurking under every bush. They longed for a homely, neighborhood example to contrast with the might and majesty of the federal government at work. They wanted to depict the government providing public goods off the shoals of Cape May as well as on the shores of Tripoli.

Proponents of the lighthouse as public good focused particularly on its alleged non-exclusivity. The lighthouse owner was surely not going to brave the seas by rowing or motoring out to a ship to collect a toll before switching on the lighthouse beam, right? If not, private lighthouse provision was doomed – the lighthouse would rapidly go broke if it couldn’t collect from the beneficiaries of its service.

Some of the world’s most distinguished economists said this – not as an obiter dictum, but as their go-to textbook example of a public good.

The Embarrassing Record

Let us now braise famous men. First to feel the heat is John Stuart Mill, the most influential (if not the best) economist of the 19th century. In his Principles of Political Economy (1851), he wrote: “…It is a proper office of government to build and maintain lighthouses… since it is impossible that the ships at sea which are benefited by a lighthouse… should be made to pay a toll on the occasion of its use. [N]o one would build lighthouses from motives of personal interest, unless indemnified and rewarded from a compulsory levy made by the state.”

That seems straightforward enough. Government has to build and operate lighthouses because the private sector cannot do so profitably. Why? Because they cannot collect tolls for the benefits received from the light dispensed. Thus, lighthouse expenses should be defrayed by taxes collected by government.

The name of Henry Sidgwick is unknown today, but was well-known over a century ago. He had his own Principles of Political Economy (1883), in which he declared that “the benefits of a well-placed lighthouse must be largely enjoyed by ships on which no toll could be conveniently imposed.” This puts lighthouses among “a large and varied class of cases in which …an individual [cannot] always obtain through free exchange adequate remuneration for the services he renders….” Likewise, A.C. Pigou (The Economics of Welfare, 1932) classified the lighthouse in the category of “uncompensated services.” Basically, Sidgwick and Pigou echo the arguments of Mill.

Nobel Laureate Paul Samuelson’s Economics: An Introductory Analysis (6th ed., 1964) is the most famous economics textbook of all time. In it, he informed us that “government provides certain indispensable public services without which community life would be unthinkable and which by their nature cannot appropriately be left to private enterprise.” (Emphasis added.) Samuelson’s examples were national defense and criminal and civil law, but a footnote alluded to a “later example of government service: lighthouses,” whose keepers “cannot reach out to collect fees from skippers” of ships.

In keeping with his role as economic scientist and modernist, Samuelson saw the lighthouse as a case of market failure owing to “external effects.” He lamented that, while “[the lighthouse’s] beam helps everyone in sight, a businessman could not build it for a profit, since he could not claim a price from each user. This certainly is the kind of activity that governments would naturally undertake.”

Coase pointed out an additional argument made by Samuelson. Because the cost of allowing an additional (marginal) ship to benefit from its light is essentially zero, the price charged to the marginal user of the lighthouse beam should equal its zero marginal cost. This bow to the principle of “marginal-cost pricing” – a principle first outlined by economist Harold Hotelling – is another characteristic feature of economic modernism.

And Now – the Truth About Lighthouses

In a landmark paper published in 1974, Ronald Coase ended a century’s worth of lighthouse foolishness perpetrated by economists. Coase did something amazing – he actually checked to see how lighthouses were provided in the past and present.

The earliest reference to lighthouses in the United Kingdom seems to be 1370. From the beginning, British monarchs authorized lighthouse construction and sanctioned toll collections from ships using the service. Coase discovered that the principal lighthouse authority in England and Wales was a private organization called Trinity House, whose origin dated back to the Middle Ages and which was incorporated in 1514. British lighthouses started springing up in the 17th century and became common in the 18th century. Although most of these were constructed by individuals not affiliated with Trinity House, the authority continued to assert its authority to control their activities. Most commonly, an area needing lighthouse services would corral a willing entrepreneur, who would apply for a patent from the Crown and supply a petition from shipowners and captains who would express willingness to pay tolls. The need for ships to utilize harbor facilities provided the occasion for toll collections.

This basic framework persisted until 1834, when existing lighthouses were consolidated under the aegis of Trinity House. This structural consolidation under an organization controlled by the Crown is the only element of British lighthouses that comes close to the public good model embraced by economics textbooks. There was private ownership and operation. There was no government ownership. There was no finance out of general tax revenues. There was no provision of service at zero price.

Internationally, this pattern was mostly followed. Significantly, the International Association of Lighthouse Authorities, established in 1957 to promote information and coordination for global navigation, was non-governmental.

Lighthouses in America

LIghthouses in America evolved along lines similar to those in England and Wales, with variations. The American colonies collected tolls from ships, in the form of light dues or shipping taxes, by using customs inspectors as tax collectors.

In 1789, Alexander Hamilton imposed his vision of lighthouses on the new nation. This entailed federal ownership and control and service provided “free as the air,” apparently for purely political reasons.

Beginning early in the 20th century, tended lighthouses started to disappear. This trend accelerated in the 1960s and 70s, culminating with a selloff by the Coast Guard of remaining (untended) “light stations” early in this century.

Ratio frequency and GPS technology has virtually replaced light as the guide for coastal shipping. The lighthouse is now suffering the fate of such other “public goods” as landline telephone service and first-class mail delivery – technological obsolescence.

The Lessons of the Lighthouse

The point of the lighthouse episode is not to make fun of great economists because they made a mistake. Nor is it to deplore the fact that the source of that mistake was ideological. Great scientists have made mistakes throughout human history. Ideology has led men astray since the day when we first began to use our reason.

Mill, Sidgwick, Pigou and Samuelson fell victim to their own arrogance. Moreover, that arrogance was not so much personal as systemic. They were determined to treat the economic system as a mechanism that could be built to order and manipulated by those in the know. This philosophy has been aptly characterized by F. A. Hayek as constructivism – the belief that mankind can control its own evolution by shaping social institutions according to a blueprint. Constructivists see themselves as the draftsmen.

Classical economists have traditionally been viewed as devotees of laissez-faire. But Mill leaned ever more toward socialism as he aged; indeed, Hayek claimed in a biography that Mill may have influenced more economists toward socialism than any one else. Pigou was a famed exponent of government taxes and subsidies as correctives for external costs and benefits imposed or conferred by production decisions. Samuelson was diehard liberal and Keynesian whose faith in government economic intervention was surpassed only by his faith in his own intellectual superiority.

These men were not partisans of unfettered capitalism. Free markets do not require frequent, large-scale intervention by government. Without government intervention, there would be no call for wise economist philosopher-kings to plan and superintend the intervention.

In order to justify government intervention, there had to be lacunae in the operation of free markets. That explains the creation of the category of the public good, something that could never be supplied by private markets. In order to justify large-scale intervention, the lacunae had to be numerous. A small handful of major exceptions, like national defense, would not suffice for the constructivist purpose. That explains the public-good designation of plain, ordinary, garden-variety goods like lighthouses. Ostensibly, public goods were everywhere – we needed big, powerful government to cope with their omnipresence.

The combination of arrogance and anxiety bred carelessness. Left-wing economists took one look at lighthouses through the filter of their ideological preconceptions and decided that this service couldn’t possibly thrive under free-market conditions. They didn’t even glance at the historical record, let alone at the industrial organization of lighthouses in their own day.

One might suppose that such colossal incompetence would have severe professional repercussions. Hardly. Mill, Sidgwick and Pigou had shuffled off to Buffalo, mortality-wise, by the time Coase’s research was published. Nobody had even bothered to check up on their veracity. Samuelson was so firmly ensconced on academic Olympus that this peccadillo was little more than a blotch on his resume. His critics soon found even larger fish to fry. Successive editions of his textbook predicted that the Soviet Union would soon surpass the U.S. in economic growth – right up to the time when the Soviet empire imploded in a bloodless, spontaneous upheaval fueled by the economic impotence of the system.

Coase’s Own View of the Lighthouse Episode

We should note that Coase’s own conclusions were narrower in scope than those above. He maintained that lighthouse operations were likely to be more efficient and less wasteful when they were sponsored and funded by shipowners, who had a direct interest in their efficacy and economy. He pointed out that Samuelson’s argument for marginal-cost pricing of service was negated by the fact that light dues were collected in Britain only for the first several voyages in the calendar year. While he expressed wonder at the propensity of “…great men” to “make statements about lighthouses which are misleading as to the facts… unclear [and] …very likely wrong [as to] …policy conclusion…,” he accused them of nothing more than a desire to “provide ‘corroborative detail, intended to give artistic verisimilitude to an otherwise bald and unconvincing narrative.'”

Coase drew the same professional moral here as in his investigation of social cost; namely, economists should conduct “studies of how… activities are actually carried out within different institutional frameworks.” These should reveal “the richness of the social alternatives among which we can choose” – in other words, they should hammer home the vastly enhanced flexibility of marketplace mechanisms compared to non-market alternatives. Coase concludes that “economists should not use the lighthouse as an example of a service which could only be provided by the government.” Thus, he ended on an understatement characteristic of his native land, his profession’s better nature and his personality.

The Proper Posture of the Economist

Ronald Coase shone a light on the economics profession with his exploration of the lighthouse in economic theory and history. That light reveals the failing of the mainstream economist. It was defined by the ancient Greeks as hubris, the sin of overweening pride. The proper posture for an economist, Coase’s posture, is that of humility in the face of markets. Ironically, John Maynard Keynes himself once remarked that economists would do better to regard themselves in the same light as dentists.

Markets are an evolutionary response to the needs of mankind. They are not intractable physical structures like rocks or trees. When their initial formations prove inadequate, they adjust (or are adjusted). Those who fail to appreciate the inherent flexibility of markets end up in the dustbin of history. It is surprising how many economists there are in the bin.