Business transactions among strangers are an essential part of a successful modern mass economy, which requires cooperation—including the pooling of vast financial resources from far more people than can possibly know each other personally. As for the general level of reliability among strangers in India, The Economist reported:
If you withdraw 10,000 rupees from a bank, it will probably come in a brick of 100-rupee notes, held together by industrial-strength staples that you struggle to prise open. They are there to stop someone from surreptitiously removing a few notes. On trains, announcements may advise you to crush your empty mineral-water bottles lest someone refill them with tap water and sell them as new. . . . Any sort of business that requires confidence in the judicial system is best left alone.{640}
Where neither the honesty of the general population nor the integrity of the legal system can be relied upon, economic activities are inhibited, if not stifled. At the same time, particular groups whose members can rely on each other, such as the Marwaris, have a great advantage in competition with others, in being able to secure mutual cooperation in economic activities which extend over distance and time—activities that would be far more risky for others in such societies and still more so for foreigners.
Like the Marwaris in India, Hasidic Jews in New York’s diamond district often give consignments of jewels to one another and share the sales proceeds on the basis of verbal agreements among themselves.{641} The extreme social isolation of the Hasidic community from the larger society, and even from other Jews, makes it very costly for anyone who grows up in that community to disgrace his family and lose his own standing, as well as his own economic and social relationships, by cheating on an agreement with a fellow Hasidim.
It is much the same story halfway around the world, where the overseas Chinese minority in various Southeast Asian countries make verbal agreements among themselves, without the sanction of the local legal system. Given the unreliability and corruption of some of these post-colonial legal systems, the ability of the Chinese to rely on their own social and economic arrangements gives them an economic advantage over their indigenous competitors, who lack an equally reliable and inexpensive way of making transactions or pooling their money safely. The costs of doing business are thus less for the Chinese than for Malay, Indonesian or other businesses in the region, giving the Chinese competitive advantages.
What economics professor William Easterly of New York University has aptly called “the radius of trust”{642} extends for very different distances among different groups and nations. For some, it extends no further than the family:
Malagasy grain traders carry out inspections of each lot of grain in person because they don’t trust employees. One third of the traders say they don’t hire more workers because of fear of theft by them. This limits the grain traders’ firm size, cutting short a trader’s potential success. In many countries, companies tend to be family enterprises because family members are the only ones felt trustworthy. So the size of the company is then limited by the size of the family.{643}
Even in the same country, the radius of trust can extend very different distances. Although businesses in some American communities must incur the extra expenses of heavy grates for protection from theft and vandalism while closed, and security guards for protection while open, businesses in other American communities have no such expenses and are therefore able to operate profitably while charging lower prices.
Rental car companies can park their cars in lots without fences or guards in some communities, while in other places it would be financial suicide to do so. But, in those places where car thefts from unguarded lots are rare, such rare losses may cost less than paying guards and maintaining fences would cost, so that rental car agencies—and other businesses—can flourish as they operate at lower costs in such communities. Those communities also flourish economically, as a result of attracting enterprises and investments that create jobs and pay local taxes.
In short, honesty is more than a moral principle. It is also a major economic factor. While government can do little to create honesty directly, in various ways it can indirectly either support or undermine the traditions on which honest conduct is based. This it can do by what it teaches in its schools, by the examples set by public officials, or by the laws that it passes. These laws can create incentives toward either moral or immoral conduct. Where laws create a situation in which the only way to avoid ruinous losses is by violating the law, the government is in effect reducing public respect for laws in general, as well as rewarding specific dishonest behavior.
Advocates of rent control, for example, often point to examples of dishonest behavior among landlords to demonstrate an apparent need for both rent control itself and for related tenants’ rights legislation. However, rent control laws can widen the difference between the value of a given apartment building to honest owners and dishonest owners. Where the costs of legally mandated services—such as heat, maintenance and hot water—are high enough to equal or exceed the amount of rent permitted under the law, the value of a building to an honest landlord can become zero or even negative. Yet, to a landlord who is willing to violate the law and save money by neglecting required services, or who accepts bribes from prospective tenants during a housing shortage under rent control, the building may still have some value.
Where something has different values to different people, it tends to move through the marketplace to its most valued use, which is where the bids will be highest. In this case, dishonest landlords can easily bid apartment buildings away from honest landlords, some of whom may be relieved to escape the bind that rent control puts them in. Landlords willing to resort to arson may find the building most valuable of all, if they can sell the site for commercial or industrial use after burning the building down, thereby getting rid of both tenants and rent control. As one study found:
In New York City, landlord arsons became so common in some areas that the city responded with special welfare allowances. For a while, burned-out tenants were moved to the top of the list for coveted public housing. That gave tenants an incentive to burn down their buildings. They did, often moving television sets and furniture out onto the sidewalk before starting the fire.{644}
Those who create incentives toward widespread dishonesty by promoting laws which make honest behavior financially impossible are often among the most indignant at the dishonesty—and the least likely to regard themselves as in any way responsible for it. Arson is just one of the forms of dishonesty promoted by rent control laws. Shrewd and unscrupulous landlords have made virtually a science out of milking a rent-controlled building by neglecting maintenance and repairs, defaulting on mortgage payments, falling behind in the payment of taxes, and then finally letting the building become the property of the city by default. Then they move on to repeat the same destructive process with other rent-controlled buildings.
Without rent control, the incentives facing landlords are directly opposite. In the absence of rent control, the incentives are to maintain the quality of the property, in order to attract tenants, and to safeguard it against fire and other sources of dangers to the survival of the building, which is a valuable piece of property to them in a free market. In short, complaints against landlords’ behavior by rent control advocates can be valid, even though few of those advocates see any connection between rent control and a declining moral quality in people who become landlords. When honest landlords stand to lose money under rent control, while dishonest landlords can still make a profit, it is virtually inevitable that the property will pass from the former to the latter.
Rent control laws are just one of a number of severe restrictions which can make honest behavior too costly for many people, and which therefore promote widespread dishonesty. It is common in Third World countries for much—sometimes most—economic activity to take place “off the books,” which is to say illegally, because oppressive levels of bureaucracy and red tape make legal operation too costly for m
ost people to afford.
In the African nation of Cameroon, for example, setting up a small business has required paying official fees (not counting bribes) that amount to far more money than the average person in Cameroon makes in a year. The legal system imposes similarly high costs on other economic activities:
To buy or sell property costs nearly a fifth of the property’s value. To get the courts to enforce an unpaid invoice takes nearly two years, costs over a third of the invoice’s value, and requires fifty-eight separate procedures. These ridiculous regulations are good news for the bureaucrats who enforce them. Every procedure is an opportunity to extract a bribe.{645}
When laws and policies make honesty increasingly costly, then government is, in effect, promoting dishonesty. Such dishonesty can then extend beyond the particular laws and policies in question to a more general habit of disobeying laws, to the detriment of the whole economy and society. As a Russian mother said:
Now my children tell me I raised them the wrong way. All that honesty and fairness, no one needs it now. If you are honest you are a fool.{646}
To the extent that such attitudes are widespread in any given country, the consequences are economic as well as social.
Despite all the countries which have seen their economic growth rates rise sharply when they went from government-controlled economies to free market economies, Russia saw its output and its standard of living fall precipitously after the dissolution of the Soviet Union and the conversion of state-owned property into property owned by former communist leaders turned capitalists. Rampant corruption can negate the benefits of markets, as it negates the benefits of a rich endowment of natural resources or a highly educated population.
While a market economy operates better in a country where honesty is more widespread, it is also true that free markets tend to punish dishonesty. American investigative journalist John Stossel, who began his career by exposing various kinds of frauds that businesses commit against consumers, found this pattern:
I did hundreds of stories on such scams but over the years, I came to realize that in the private sector, the cheaters seldom get very rich. It’s not because “consumer fraud investigators” catch them and stop them; most fraud never even gets on the government’s radar screens. The cheaters get punished by the market. They make money for a while, but then people wise up and stop buying.
There are exceptions. In a multi-trillion-dollar economy with tens of thousands of businesses, there will always be some successful cheaters and Enron-like scams; but the longer I did consumer reporting, the harder it was for us to find serious rip-offs worthy of national television.{647}
Levels of government corruption not only vary greatly among nations, they can vary over time with the same nations. Corrupting an honest government may be easier than trying to change a corrupt way of life into an honest one. But even the latter can be done sometimes. Reporting on economic progress in Africa in 2013, The Economist magazine said, “our correspondent visited 23 countries” and “was not once asked for a bribe—inconceivable only ten years ago.”{648}
EXTERNAL COSTS AND BENEFITS
Economic decisions made through the marketplace are not always better than decisions that governments can make. Much depends on whether those market transactions accurately reflect both the costs and the benefits that result. Under some conditions, they do not.
When someone buys a table or a tractor, the question as to whether it is worth what it cost is answered by the actions of the purchaser who made the decision to buy it. However, when an electric utility company buys coal to burn to generate electricity, a significant part of the cost of the electricity-generating process is paid by people who breathe the smoke that results from the burning of the coal and whose homes and cars are dirtied by the soot. Cleaning, repainting and medical costs paid by these people are not taken into account in the marketplace, because these people do not participate in the transactions between the coal producer and the utility company.
Such costs are called “external costs” by economists because such costs fall outside the parties to the transaction which creates these costs. External costs are therefore not taken into account in the marketplace, even when these are very substantial costs, which can extend beyond monetary losses to include bad health and premature death. While there are many decisions that can be made more efficiently through the marketplace than by government, this is one of those decisions that can be made more efficiently by government than by the marketplace. Even such a champion of free markets as Milton Friedman acknowledged that there are “effects on third parties for which it is not feasible to charge or recompense them.”{649}
Clean air laws can reduce harmful emissions by legislation and regulations. Clean water laws and laws against disposing of toxic wastes where they will harm people can likewise force decisions to be made in ways that take into account the external costs that would otherwise be ignored by those transacting in the marketplace.
By the same token, there may be transactions that would be beneficial to people who are not party to the decision-making, and whose interests are therefore not taken into account. The benefits of mud flaps on cars and trucks may be apparent to anyone who has ever driven in a rainstorm behind a car or truck that was throwing so much water or mud onto his windshield as to dangerously obscure vision. Even if everyone agrees that the benefits of mud flaps greatly exceed their costs, there is no feasible way of buying these benefits in a free market, since you receive no benefits from the mud flaps that you buy and put on your own car, but only from mud flaps that other people buy and put on their cars and trucks.
These are “external benefits.” Here again, it is possible to obtain collectively through government what cannot be obtained individually through the marketplace, simply by having laws passed requiring all cars and trucks to have mud flaps on them.
Some other benefits are indivisible. Either everybody gets these kinds of benefits or nobody gets them. Military defense is an example. If military defense had to be purchased individually through the marketplace, then those who felt threatened by foreign powers could pay for guns, troops, cannon and all the other means of military deterrence and defense, while those who saw no dangers could refuse to spend their money on such things. However, the level of military security would be the same for both, since supporters and non-supporters of military forces are intermixed in the same society and exposed to the same dangers from enemy action.
Given the indivisibility of the benefits, even some citizens who fully appreciate the military dangers, and who consider the costs of meeting those dangers to be fully justified by the benefits, might still feel no need to voluntarily spend their own money for military purposes, since their individual contribution would have no serious effect on their own individual security, which would depend primarily on how much others contributed. In such a situation, it is entirely possible to end up with inadequate military defense, even if everyone understands the cost of effective defense and considers the benefits to be worth it.
By collectivizing this decision and having it made by government, an end result can be achieved that is more in keeping with what most people want than if those people were allowed to decide individually what to do. Even among free market advocates, few would suggest that each individual should buy military defense in the marketplace.
In short, there are things that government can do more efficiently than individuals because external costs, external benefits, or indivisibilities make individual decisions in the marketplace, based on individual interests, a less effective way of weighing costs and benefits to the whole society.
While external costs and benefits are not automatically taken into account in the marketplace, this is not to say that there may not be some imaginative ways in which they can be.{650} In Britain, for example, ponds or lakes are often privately owned, and these owners have every incentive to keep them from becoming polluted, since a clean body of water is more attractive to fishermen or
boaters who pay for its use. Similarly with shopping malls: Although maintaining clean, attractive malls with benches, rest rooms and security personnel costs money that the mall owners do not collect from the shoppers, a mall with such things attracts more customers, and so the rents charged the individual storeowners can be higher because a location in such malls is more valuable than a location in a mall without such amenities.
While there are some decisions which can be made more efficiently by individuals and other decisions which can be made more efficiently through collective action, that collective action need not be that of a national or even a local government, but can be that of individuals spontaneously organizing themselves to deal with external costs or external benefits. For example, back during the pioneering days in the American west, when cattle grazed on the open plains that were not owned by anyone, there was the same danger that more animals would be allowed to graze than the land would support, as with sheep on the commons, since no given cattle owner had an incentive to restrict the number of his own animals that were allowed to graze.
In the American west during the pioneering era, owners of cattle organized themselves into cattlemen’s associations that created rules for themselves and in one way or another kept newcomers out, in effect turning the plains into collectively owned land with collectively determined rules, sometimes enforced by collectively hired gunmen.