Crawl Across the Ocean

Saturday, November 04, 2006

Moving Up the Economic Ladder

A few weeks back, Andrew Sullivan posted this quote for the day from Milton Friedman,
"The maintenance of a free society is a very difficult and complicated thing. And it requires a self-denying ordinance of the most extreme kind. It requires a willingness to put up with temporary evils on the basis of the subtle and sophisticated understanding that if you step in to try to do them, you not only may make them ... worse, but you will spread your tentacles and get bad results elsewhere ...

The argument for collectivism, for government doing something is simple. Anybody can understand it. If there's something wrong, pass a law. If somebody is in trouble, get Mr. X to help him out. The argument for a free - for voluntary cooperation, for a free market is not nearly so simple. It says, you know, if you allow people to cooperate voluntarily and don't interfere with them, indirectly through the operation of the market, they will improve matters more than you can improve it directly by appointing somebody. That's a subtle argument, and it's hard for people to understand,"

One obvious problem with this argument is the sad intrusion of reality which demonstrates that people actually do generally end up better off when government helps them, but that's not what I want to talk about today.

Instead, I want to talk about Friedman's suggestion that resistance to the argument that government should never interfere with markets is based on people not understanding how the market works. I'm guessing that the kind of thing Friedman has in mind here is the microeconomic theory which suggests that if you raise the minimum wage, you'll just end up with more unemployment, so people will be worse off. Because, Friedman would argue, people just see someone is not getting paid much, they have a knee jerk reaction that government should help them and they pass a minimum wage law, and before you know it, all the low paying jobs disappear and the person who was low-paid before is now unemployed.

Friedman wrote that quote in 1975 so perhaps he was unaware at the time how easy it could be to instill in people a mindset that 'government is bad and markets are good', and how simple that philosophy, his philosophy, really was.

These days, the Friedman, 'government-bad, market-good' philosophy continues to drive much of our government agenda with regard to economic issues. For example, consider the drive by the Conservative government to eliminate the Canadian Wheat Board - classic 'government-bad, market-good' thinking.

So, in Friedman logic, there is a hierarchy:
On the first, bottom rung are people who think government should just fix every problem in society and don't understand the benefits the market brings.
And then on the second, top rung, there are those who have been enlightened with the knowledge of how it is always better to leave something to the market than to get government involved. This second position is embodied by the classical economist, and the mindset permeates any introductory economics text I've ever encountered.

But here's the problem, this second rung of classical economic enlightenment isn't actually the top rung. One level higher are those who have realized that, in many cases, economic activity is best left to the market, but there are a number other cases where there are good reasons (and lots of supporting empirical evidence) to believe that just leaving the situation to the market is not optimal.

There are lots of reasons why government involvement may improve over allowing he market to operate without interference. Externalities may disrupt the pricing mechanism in the market, collective action problems may drive counter-productive market behavior, information asymmetries may lead to inefficient use of resources, natural monopolies may allow small number of people to extract huge rents from the economy for little gain and so on.

But what often happens, in my opinion, is that people on the second rung, Friedman's 'government-bad, market-good' brigade, often end up removing government action dictated by a third rung understanding of the flaws in the market. And they do so while completely failing to address the reasons why the government was involved in the first place. And they can do so because they have convinced themselves, like Friedman, that those who oppose them do so, not because they understand how the market may fail in this particular instance, but because they oppose the market in its entirety. So the second rung folks write off their opponents as first-rung simpletons all the while destroying the benefits that had been created by those with a third rung understanding of why government intervention is helpful in that particular case.

These second rung folks look around at all the government involvement in the economy and it is incomprehensible to them, a seemingly random intrusion of government into all these different areas with no rhyme or reason. Without moving up to the third rung there is no way for them to understand. Why is there heavy regulation of, and government involvement in, utilities, media, education and health care, but little government involvement in retailing, electronics manufacturing or theme parks? The answer is that government is involved where government is needed, but the reason why government is needed varies from case to case, which is what makes this third rung more complicated than Friedman's second rung.

For example, utilities operate networks, which are natural monopolies (it doesn't make sense to have two or more companies running water piper around town, with two sets of pipes running down the same street, with the intakes from each house being re-routed every time someone switches from water company A to water company B). So water supply will generally be a monopoly and, if left unregulated, a monopoly can charge extremely high prices and make huge profits at little benefit to society - so it makes sense for government to regulate prices to ensure that people aren't exploited. This is just one example. The rationale for government involvement in education is different, and the rationale for government involvement in health care is different again.

Ian Welsh is fond of explaining the true small 'c' conservative mindset:
"when a reformer rushes up and says, "there's a fence down the middle of the road, that makes no sense! We need to tear it down!" a real conservative's reply is "tell me why the fence was put up in the first place and I might let you take it down."
In the context of this post, what it means is that when the second rung 'government-bad, market-good' folks come to town talking about how government should stop doing activity X, the proper question from the third rung is to say, why was government involved to begin with, and what has changed to no longer necessitate that intervention.

Which is not to say that the 'market-good' crowd never has a valid point. Take electricity. Electricity distribution is a natural monopoly, in the same way that water distribution is. So it makes sense for government to be involved in the distribution of electricity, and indeed government is involved. Historically, technological limitations made it impractical to separate electricity generation from electricity distribution so the government run/regulated company which distributed the power was the same one that generated the power. But with a modern grid, it has become technologically possible to separate these two functions.

So, if we can separate out the part which government has to be involved in (distribution) and the part where there is not the same need (generation) than it seems plausible that opening up the market for electricity generation might lead to benefits. And indeed, if you look at B.C. for example, the government has created a new organization, the British Columbia Transmission Corporation, for the purpose of making just such a split. Naturally, the small c conservative impulse suggests that this change is monitored for its empirical results (which haven't all been good in other jurisdictions which have tried this - see California, Alberta, Ontario) as bad results might suggest that there are other reasons - beyond the technical link between generation and distribution - why electricity generation shouldn't be opened up to market forces.

Let's consider another example. As I alluded to earlier, the 'market-good, government-bad' second rung crowd in the federal Conservative party has decided they want to do away with the Canadian Wheat Board. Take a look at this press release from the party website and see if you can spot what's missing.

That's right, there is nothing there about why the Wheat Board was set up in the first place, how well it is accomplishing those objectives, or what might have changed to make the Board no longer necessary. This is second rung thinking charging ahead and trying to get government out of the economy without thinking of the potential consequences. This CBC backgrounder on the Wheat Board only offers the fact that individuals farmers can now monitor prices over the internet as evidence that anything has changed since the Board was created, which seems like a pretty thin reed to base a change on. If nothing else, the fact that the U.S. is constantly arguing to have the Wheat Board removed because it is an unfair advantage for Canadian Farmers might lead one to consider the thought that farmers are better off with the Wheat Board in place.

Mapleleaf Web has a more detailed look at the Wheat Board, including an explanation of the rationale for government involvement:
"The basic concept behind the Canadian Wheat Board, that a single organization will have more power negotiating contracts for the sale and transportation of grain than individual farmers, is not a recent development; it has its origins in economics, and the law of supply and demand.

Wheat and other grains have what economists refer to as 'an inelastic demand': the price of the product has to rise or fall significantly for there to be a noticeable impact on demand for the product. For example, consumers' demand for bread (milled from wheat) tends to remain fairly constant. Accordingly, it would take a sharp increase or decrease in the price of bread to have a significant impact on the total quantity of wheat purchased.

The economics of farming mean that farmers do not necessarily benefit from a 'bumper' harvest. If the majority of farmers have a good harvest and there is a surplus of wheat, it takes a significant drop in prices for farmers to sell all their wheat. Further to this, individual farmers tend to sell wheat at the peak time of the harvest, when the supply is greatest. This is understandable, as farmers must pay their bills for the year, want to reduce interest charges on bank loans, and may lack sufficient storage capacity to store the grain and wait until the supply drops and prices rise to sell. However, it means they are unable to take advantage of any shifts in the price of wheat that may come later in the year.

Historically in Canada, however, while individual farmers were at the mercy of market conditions, elevator operators and other stock market speculators were able to take advantage of the situation through 'hedging' and 'futures trading' on the market. For example, elevator operators would buy the grain from the farmers, keep the grain in storage, and then sell to a buyer when prices rose."

It doesn't seem to me that any of that has really changed recently.

Anyway, to get back to my main point, Friedman is right: there are people who just have a knee-jerk reaction that government should fix things and there are indeed people who are anti-markets and it's true that many of these people don't understand the benefits that a market brings to an area of economic activity by setting prices and encouraging competition.

But the real problem is that there is a far larger, much more powerful group of people (e.g. our current federal government) who have a knee-jerk reaction that the best solution is to leave everything to the market and get rid of government involvement in every area, even those areas where they lack an understanding of why government is involved in the first place and where empirical evidence shows the concrete benefits of government involvement.

As a footnote, it's worth noting that, while I think my post captures a bit of what goes on in terms of the ideological debate around government involvement in the economy, as a practical matter, corporations are their supporting interest groups are powerful enough in our society that much of what I've written is overwhelmed by a drive to make life easier for corporations, mixing more or less government involvement in the economy according to whatever happens to benefit large corporations in each instance.

For example, consider the Conservative government's stance on intellectual property. If they really were possessed of the simple minded 'market good, government bad' attitude that they display with regard to the Canadian Wheat Board, then you would think that they would be hostile to government intervening in the economy to enforce widespread monopolies. But nothing could be further from the case. And I'm sure once Bev Oda, recipient of significant donations from corporate interests supporting extending intellectual property rights, and also Canadian Heritage Minister, introduces updates to copyright law, it will be more of the same.

It is hard to make the case that a government that wants to abolish a monopoly that helps farmers but is at the same time actively extending a monopoly which helps pharmaceutical companies at the expense of the health of Canadians is being driven by a consistent ideology.


  • And the fourth rung is made up of people who realise that just because there is trouble with the market it doesn't mean that problems with a government monopoly etc. (inherent in government intervention or inherent in the market-confounding situation) will just go away

    By Anonymous Alan E. Dunne, at 4:24 PM  

  • I don't know, I figure it's the appreciation of the flaws with government involvement that get people to the second rung. You don't lose that when you move to the third one, you just balance the market's flaws against the government's.

    By Blogger Declan, at 9:34 PM  

  • "It says, you know, if you allow people to cooperate voluntarily and don't interfere with them, indirectly through the operation of the market, they will improve matters more than you can improve it directly by appointing somebody. That's a subtle argument, and it's hard for people to understand,"

    The subtle point is that the improvement doesn't necessarily include any specific goals you might have. It's basically a statement of the reality of opportunity cost. When you set out to solve a particular problem, there is a loss of economic utility. You can argue the nature or degree of loss or gain of social utility. An extreme example (of waste): if sufficient thousands of dollars are provided to a drug addict to enable him to meet the needs of his habit, save him from his recurrent health crises, and still have money left over for food and shelter, does the utility of feeding and sheltering and healing the addict for his short life equal the utility the thousands of dollars might have achieved if spent by the taxpayers?

    Also, as the unforeseen and unintended negative consequences are revealed, more economic utility is lost fiddling about.

    There is also just plain bureaucratic waste. A private corporation with excessive head count (or any variation on too many unbillable hours of employee time) will have difficulty maintaining solvency. Governments aren't subject to market pressures to remain efficient.

    By Blogger AwaWiYe, at 3:30 PM  

  • Excellent post, Declan.

    I think a lot of people understand these issues intuitively, but I'm jealous of your knack for articulating the points.

    By Anonymous famousringo, at 2:21 PM  

  • Declan,

    Agreed and excellent post but I think you post script ought to be highlighted further. Corporations, espicially large multinationals with natural (or otherwise) monopolies are as bad as government for interfering with the voluntary exchange Friedman talks about. In fact, corporations themselves are the unnatural product of government edict, but I digress. I think there is a somewhat consistent ideological drive in our Conservatives - government bad, markets good, so long as its only corporate donors playing in that market.

    After all, cooperatives and unions can certainly be voluntary participants in a free market, but the Conservatives are certainly not friendly to these.

    I think 'corporatist' rather than conservative.

    By Blogger Mike, at 11:15 AM  

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