Basic Economics

  Modern trade associations can sometimes make collective decisions for an industry more efficiently than individual business owners could, especially when there are externalities of the sort used to justify government intervention in market economies. Such private associations can promote the sharing of information and the standardization of products and procedures, benefitting both themselves and their customers. Railroads can get together and standardize the gauges of their tracks, so that trains can transfer from one line to another, or hotels can standardize their room reservation procedures, in order to make travel reservations for their guests who are traveling on to another community.

  In short, while externalities are a serious consideration in determining the role of government, they do not simply provide a blanket justification or a magic word which automatically allows economics to be ignored and politically attractive goals to be pursued without further ado. Both the incentives of the market and the incentives of politics must be weighed when choosing between them on any particular issue.

  INCENTIVES AND CONSTRAINTS

  Government is of course inseparable from politics, especially in a democratic country, so a distinction must be made and constantly kept in mind between what a government can do to make things better than they would be in a free market and what it is in fact likely to do under the influence of political incentives and constraints. The distinction between what the government can do and what it is likely to do can be lost when we think of the government as simply an agent of society or even as one integral performer. In reality, the many individuals and agencies within a national government have their own separate interests, incentives, and agendas, to which they may respond far more often than they respond to either the public interest or to the policy agendas set by political leaders.

  Even in a totalitarian state such as the Soviet Union, different branches and departments of government had different interests that they pursued, despite whatever disadvantages this might have for the economy or the society. For example, industrial enterprises in different ministries avoided relying on each other for equipment or supplies, if at all possible. Thus an enterprise located in Vladivostok might order equipment or supplies that it needed from another enterprise under the same ministry located in Minsk, thousands of miles away, rather than depend on getting what it needed from another enterprise located nearby in Vladivostok that was under the control of a different ministry. Thus materials might be needlessly shipped thousands of miles eastward on the overburdened Soviet railroads, while the same kinds of materials were also being shipped westward on the same railroads by another enterprise under a different ministry.

  Such economically wasteful cross-hauling was one of many inefficient allocations of scarce resources due to the political reality that government is not a monolith, even in a totalitarian society. In democratic societies, where innumerable interest groups are free to organize and influence different branches and agencies of government, there is even less reason to expect that the entire government will follow one coherent policy, much less a policy that would be followed by an ideal government representing the public interest. In the United States, some government agencies have been trying to restrict smoking while other government agencies have been subsidizing the growing of tobacco. Senator Daniel Patrick Moynihan once referred to “the warring principalities that are sometimes known as the Federal government.”{651}

  Under popularly elected government, the political incentives are to do what is popular, even if the consequences are worse than the consequences of doing nothing, or doing something that is less popular. As an example of what virtually everyone now agrees was a counterproductive policy, the Nixon administration in 1971 created the first peacetime nationwide wage controls and price controls in the history of the United States.

  Among those at the meeting where this fateful decision was made was internationally renowned economist Arthur F. Burns, who argued strenuously against the policy being considered—and was over-ruled. Nor were the other people present economically illiterate. The president himself had long resisted the idea of wage and price controls, and had publicly rejected the idea just eleven days before doing an about-face and accepting it. Inflation had created mounting pressures from the public and the media to “do something.”

  With a presidential election due the following year, the administration could not afford to be seen as doing nothing while inflation raged out of control. However, even aside from such political concerns, the participants in this meeting were “exhilarated by all the great decisions they had made” that day, according to a participant. Looking back, he later recalled that “more time was spent discussing the timing of the speech than how the economic program would work.” There was particular concern that, if the president’s speech were broadcast in prime time, it would cause cancellation of the very popular television program Bonanza, leading to public resentments. Here is what happened:

  Nixon’s speech—despite the preemption of Bonanza—was a great hit. The public felt that the government was coming to its defense against the price gougers. . . During the next evening’s newscasts, 90 percent of the coverage was devoted to Nixon’s new policy. The coverage was favorable. And the Dow Jones Industrial Average registered a 32.9-point gain—the largest one-day increase up to then.{652}

  In short, the controls were a complete success politically. As for their economic consequences:

  Ranchers stopped shipping their cattle to the market, farmers drowned their chickens, and consumers emptied the shelves of supermarkets.{653}

  In short, artificially low prices led to supplies being reduced while the quantity demanded by consumers increased. For example, more American cattle began to be exported, mostly to Canada, instead of being sold in the price-controlled U.S. market. Thus price controls produced essentially the same results under the Nixon administration as they had produced in the Roman Empire under Diocletian, in Russia under the Communists, in Ghana under Nkrumah, and in numerous other times and places where such policies had been tried before.

  Nor was this particular policy unique politically in how it was conceived and carried out. Veteran economic adviser Herbert Stein observed, 25 years after the Nixon administration meeting at which he had been present, “failure to look ahead is extremely common in government policy making.”{654}

  Another way of saying the same thing is that political time horizons tend to be much shorter than economic time horizons. Before the full negative economic consequences of the wage and price control policies became widely apparent, Nixon had been re-elected with a landslide victory at the polls. There is no “present value” factor to force political decision-makers to take into account the long-run consequences of their current decisions.

  One of the important fields neglected as a result of the short political time horizon is education. As a writer in India put it, “No one bothers about education because results take a long time to come.”{655} This is not peculiar to India. With fundamental educational reform being both difficult and requiring years to show end results in a better educated population entering adulthood, it is politically much more expedient for elected officials to demonstrate immediate “concern” for education by voting to spend increasing amounts of the taxpayers’ money on it, even if that leads only to more expensive incompetence in more showy buildings.

  The constraints within which government policy-making operates are as important as the incentives. Important and beneficial as a framework of rules of law may be, what that also means is that many matters must be dealt with categorically, rather than incrementally, as in a market economy. The application of categorical laws prevents the enormous powers of government from being applied at the discretion or whim of individual bureaucratic functionaries, which would invite both corruption and arbitrary oppression.

  Since there are many things which require discretionary incremental adjustments, as noted in Chapter 4, for these things categorical laws can be difficult to apply or can prod
uce counterproductive results. For example, while prevention of air pollution and water pollution are widely recognized as legitimate functions of government, which can achieve more economically efficient results in this regard than those of the free market, doing so through categorical laws can create major problems. Despite the political appeal of categorical phrases like “clean water” and “clean air,” there are in fact no such things, never have been, and perhaps never will be. Moreover, there are diminishing returns in removing impurities from water or air.

  Reducing truly dangerous amounts of impurities from water or air may be done at costs that most people would agree were quite reasonable. But, as higher and higher standards of purity are prescribed by government, in order to eliminate ever more minute traces of ever more remote or more questionable dangers, the costs escalate out of proportion to the benefits. Even if removing 98 percent of a given impurity costs twice as much as eliminating 97 percent, and removing 99 percent costs ten times as much, the political appeal of categorical phrases like “clean water” may be just as potent when the water is already 99 percent pure as when it was dangerously polluted. That was demonstrated back in the 1970s:

  The Council of Economic Advisers argued that making the nation’s streams 99 percent pure, rather than 98 percent pure, would have a cost far exceeding its benefits, but Congress was unmoved.{656}

  Depending on what the particular impurity is, minute traces may or may not pose a serious danger. But political controversies over impurities in the water are unlikely to be settled at a scientific level when passions can be whipped up in the name of non-existent “clean water.” No matter how pure the water becomes, someone can always demand the removal of more impurities. And, unless the public understands the logical and economic implications of what is being said, that demand can become politically irresistible, since no public official wants to be known as being opposed to clean water.

  It is not even certain that reducing extremely small amounts of substances that are harmful in larger amounts reduces risks at all. Even arsenic in the water—in extremely minute traces—has been found to have health benefits.{657} An old saying declares: “It is the dose that makes the poison.” Similar research findings apply to many substances, including saccharin and alcohol.{658} Although high doses of saccharin have been shown to increase the rate of cancer in laboratory rats, very low doses seem to reduce the rate of cancer in these rats. Although a large intake of alcohol shortens people’s lifespans in many ways, very modest amounts of alcohol—like one glass of wine or beer per day—tend to reduce life-threatening conditions like hypertension.

  If there is some threshold amount of a particular substance required before it becomes harmful, that makes it questionable whether spending vast amounts of money to try to remove that last fraction of one percent from the air or water is necessarily going to make the public safer by even a minute amount. But what politician wants to be known as someone who blocked efforts to remove arsenic from water?

  The same principle applies in many other contexts, where minute traces of impurities can produce major political and legal battles—and consume millions of tax dollars with little or no net effect on the health or safety of the public. For example, one legal battle raged for a decade over the impurities in a New Hampshire toxic waste site, where these wastes were so diluted that children could have eaten some of the dirt there for 70 days a year without any significant harm—if there had been any children living or playing there, which there were not.

  As a result of spending more than nine million dollars, the level of impurities was reduced to the point where children could have safely eaten the dirt there 245 days a year.{659} Moreover, without anything being done at all, both parties to the litigation agreed that more than half the volatile impurities would have evaporated by the year 2000.{660} Yet hypothetical dangers to hypothetical children kept the issue going and kept money being spent.

  With environmental safety, as with other kinds of safety, some forms of safety in one respect create dangers in other respects. California, for example, required a certain additive to be put into all gasoline sold in that state, in order to reduce the air pollution from automobile exhaust fumes. However, this new additive tended to leak from filling station storage tanks and automobile gas tanks, polluting the ground water in the first case and leading to more automobile fires in the second.{661} Similarly, government-mandated air bags in automobiles, introduced to save lives in car crashes, have themselves killed small children.

  These are all matters of incremental trade-offs to find an optimal amount and kind of safety, in a world where being categorically safe is as impossible as achieving 100 percent clean air or clean water. Incremental trade-offs are made all the time in individual market transactions, but it can be politically suicidal to oppose demands for more clean air, clean water or automobile safety. Therefore saying that the government can improve over the results of individual transactions in a free market is not the same as saying that it will in fact do so.

  Among the greatest external costs imposed in a society can be those imposed politically by legislators and officials who pay no costs whatever, while imposing billions of dollars in costs on others, in order to respond to political pressures from advocates of particular interests or ideologies.

  In the United States, government regulations are estimated to cost about $7,800 per employee in large businesses and about $10,600 per employee in small businesses.{662} Among other things, this suggests that the existence of numerous government regulations tends to give competitive advantages to big business, since there are apparently economies of scale in complying with these regulations.

  This is not peculiar to the United States. In some Islamic countries, getting lending practices to comply with the requirements of Islamic law can require more complex and more costly financial arrangements than in Western countries. However, once a financial institution in the Islamic world has had one of these legal documents created at great cost, that same document can be used innumerable times for similar transactions—far more often than a smaller business can, because the smaller business has fewer transactions. As The Economist magazine reported:

  Financiers can recycle documentation rather than drawing it up from scratch. The contracts they now use for sharia-compliant mortgages in America draw on templates originally drafted at great cost for aircraft leases.{663}

  While government regulations may be defended by those who create them by referring to the benefits which such regulations provide, the economically relevant question is whether such benefits are worth the hundreds of billions of dollars in aggregate costs that they impose in the United States. In the marketplace, whoever creates $500 billion in costs will have to be sure to create more than $500 billion in benefits that customers will pay for. Otherwise that producer would risk bankruptcy.

  In the government, however, there are seldom any incentives or constraints to force such comparisons. If any new government regulation can plausibly be claimed to solve some problem or create some benefit, then that is usually enough to permit government officials to go forward with that regulation. Since there are also some conceivable benefits that might be created from other government regulations, and costs will be paid by the taxpayers, there are incentives to keep adding more regulations and few constraints on their growth. The number of pages in The Federal Register, where government regulations are compiled, almost always keeps increasing. One of the rare times when there was a reduction was during the Reagan administration in the 1980s. But, after the Reagan administration was over, the increase in the number of pages in The Federal Register resumed.

  Just as we must keep in mind a sharp distinction between the goals of a particular policy and the actual consequences of that policy, so we must keep in mind a sharp distinction between the purpose for which a particular law was created and the purposes for which that law can be used. For example, President Franklin D. Roosevelt took the United States off the gold standard in 1
933 under presidential powers created by laws passed during the First World War to prevent trading with enemy nations.{664} Though that war had been over for more than a dozen years and the United States no longer had any enemy nations, the power was still there to be used for wholly different purposes.

  Powers do not expire when the crises that created them have passed. Nor does the repeal of old laws have a high priority among legislators. Still less are institutions likely to close up on their own when the circumstances that caused them to be created no longer exist.

  When thinking of government functions, we often assume that particular activities are best undertaken by government, rather than by non-governmental institutions, simply because that is the way those activities have been carried out in the past. The delivery of mail is an obvious example. Yet when India allowed private companies to deliver mail, the amount of mail carried by the government’s postal service dropped from 16 billion pieces in 1999 to less than 8 billion by 2005. India has also been among the many countries which have had government-owned telephone companies but, after this field was also opened up to private companies these companies have “driven the quality of service up and rates down on everything from local to long-distance to cellular service to Internet connections,” according to the Wall Street Journal.{665}

  Neither particular powers nor particular activities of government should be taken for granted as necessary to be performed by government simply because they have been in the past. Both need to be examined in terms of their incentives, constraints, and track records.

  Quite aside from the particular merits or demerits of particular government policies or programs, there are other considerations to take into account when expanding the role of government. These were expressed more than a century ago by John Stuart Mill: