Naked Economics (12 page)

Obviously not all collective endeavors require the hand of government. Wikipedia is a pretty handy resource, even for those who don’t make voluntary contributions to keep it up and running. Every school, church, and neighborhood has a group of eager beavers who do more than their fair share to provide important public benefits, to the great benefit of a much larger group of free riders. Those examples notwithstanding, there are compelling reasons to believe that society would underinvest in things that would make us better off without some kind of mechanism to force cooperation. As much as I love the spirit of Wikipedia, I’m comfortable leaving counterterrorism in the hands of the FBI—the government institution we’ve created (and pay for with taxes) to act on our behalf.

Government redistributes wealth. We collect taxes from some citizens and provide benefits to others. Contrary to popular opinion, most government benefits do not go to the poor; they go to the middle class in the form of Medicare and Social Security. Still, government has the legal authority to play Robin Hood; other governments around the world, such as the European countries, do so quite actively. What does economics have to say about this? Not much, unfortunately. The most important questions related to income distribution require philosophical or ideological answers, not economic ones. Consider the following question: Which would be a better state of the world, one in which every person in America earned $25,000—enough to cover the basic necessities—or the status quo, in which some Americans are wildly rich, some are desperately poor, and the average income is somewhere around $48,000? The latter describes a bigger economic pie; the former would be a smaller pie more evenly divided.

Economics does not provide the tools for answering philosophical questions related to income distribution. For example, economists cannot prove that taking a dollar forcibly from Steve Jobs and giving it to a starving child would improve overall social welfare. Most people intuitively believe that to be so, but it is theoretically possible that Steve Jobs would lose more utility from having the dollar taken from him than the starving child would gain. This is an extreme example of a more general problem: We measure our well-being in terms of utility, which is a theoretical concept, not a measurement tool that can be quantified, compared among individuals, or aggregated for the nation. We cannot say, for example, that Candidate A’s tax plan would generate 120 units of utility for the nation while Candidate B’s tax plan would generate only 111.

Consider the following question posed by Amartya Sen, winner of the 1998 Nobel Prize in Economics.
¹³
Three men have come to you looking for work. You have only one job to offer; the work cannot be divided among the three of them and they are all equally qualified. One of your goals is to make the world a better place by hiring the man who needs the job the most.

The first man is the poorest of the three. If improving human welfare is your primary aim, then presumably he should get the job. Or maybe not. The second man is not the poorest, but he is the unhappiest because he has only recently become poor and he is not accustomed to the deprivation. Offering him the job will cause the greatest gain in happiness.

The third man is neither the poorest nor the unhappiest. But he has a chronic health problem, borne stoically for his whole life, that can be cured with the wages from the job. Thus, giving him the job would have the most profound effect on an individual’s quality of life.

Who should get the job? As would be expected of a Nobel Prize winner, Mr. Sen has many interesting things to say about this dilemma. But the bottom line is that there is no right answer. The same thing is true—contrary to what politicians on both sides of the political spectrum will tell you—with issues related to the redistribution of wealth in a modern economy. Will a tax increase that funds a better safety net for the poor but lowers overall economic growth make the country better off? That is a matter of opinion, not economic expertise. (Note that every presidential administration is able to find very qualified economists to support its ideological positions.) Liberals (in the American sense of the word) often ignore the fact that a growing pie, even if unequally divided, will almost always make even the small pieces larger. The developing world needs economic growth (to which international trade contributes heavily) to make the poor better off. Period. One historical reality is that government policies that ostensibly serve the poor can be ineffective or even counterproductive if they hobble the broader economy.

Meanwhile, conservatives often blithely assume that we should all rush out into the street and cheer for any policy that makes the economy grow faster, neglecting the fact that there are perfectly legitimate intellectual grounds for supporting other policies, such as protecting the environment or redistributing income, that may diminish the overall size of the pie. Indeed, some evidence suggests that our sense of well-being is determined at least as much by our relative wealth as it is by our absolute level of wealth. In other words, we derive utility not just from having a big television but from having a television that is as big as or bigger than the neighbors.’

Then there is one of the most controversial questions of all: Should government protect people from themselves? Should society expend resources to stop you from doing stupid things that don’t affect the rest of us? Or is that your business? The most important thing to realize is that the answer to this question is philosophical; the best economics can do is frame the range of defensible views. At one end of the continuum is the belief that individuals are rational (or at least more rational than government), meaning that individual citizens are the best judge of what is good for them, not the rest of us. If you like to sniff glue and then roll backward down the basement steps, good for you. Just make sure that you pay all your own health care costs and don’t drive a car after you’ve been into the glue.

The behavioral economists have provided plenty of ammunition for the opposite end of the continuum, where reasonable people argue that society can and should stop people from doing things that are likely to turn out badly. We have good evidence that human decision making is prone to certain kinds of errors, such as underestimating risk or planning poorly for the future. As a practical matter, those mistakes often do spill over to affect the rest of us, as we saw in the real estate collapse and the accompanying mortgage mess.

And there is a range of views in between (e.g., you’re allowed to sniff glue and roll down the steps but only while wearing a helmet). One intriguing and practical middle ground is the notion of “libertarian paternalism,” which was advanced in an influential book called
Nudge
by Richard Thaler, a professor of behavioral science and economics at the University of Chicago, and Cass Sunstein, a Harvard Law School professor now serving in the Obama administration. The idea behind benign paternalism is that individuals do make systematic errors of judgment, but society should not force you to change your behavior (that’s the libertarian part); instead, we should merely point you in the right direction (that’s the paternalism part).

One of Thaler and Sunstein’s key insights is that our decisions are often a product of inertia. If our employer automatically signs us up for some kind of insurance coverage, then we’ll stick with that, even if six other plans are offered. Conversely, we may not sign up for any plan at all if it requires some proactive behavior on our part—reading a benefits manual, filling out a form, going to a stupid human resources seminar, or doing anything else that involves time and effort. Thaler and Sunstein propose that inertia (and other decision-making foibles) can be used to some advantage. If policymakers are concerned about some individual behavior, such as inadequate retirement savings, then the libertarian paternalistic option is to make the default option one that automatically puts a decent amount of money from every paycheck into a retirement account. That’s the “nudge.” Anyone is free to choose another option at any time. But a shockingly high proportion of people will stay wherever you put them in the first place.

This idea has profound implications when it comes to something like organ donation. Spain, France, Norway, Israel, and many other countries have “opt-out” (or presumed consent) laws when it comes to organ donation. You are an organ donor unless you indicate otherwise, which you are free to do. (In contrast, the United States has an “opt-in” system, meaning that you are not an organ donor unless you sign up to be one.) Inertia matters, even when it comes to something as serious as organ donation. Economists have found that presumed consent laws have a significant positive effect on organ donation, controlling for relevant country characteristics such as religion and health expenditures. Spain has the highest rate of cadaveric organ donations in the world—50 percent higher than the United States.
¹⁴
True libertarians (as opposed to the paternalistic kind) reject presumed consent laws, because they imply that the government “owns” your internal organs until you make some effort to get them back.

Good government matters. The more sophisticated our economy becomes, the more sophisticated our government institutions need to be. The Internet is a perfect example. The private sector is the engine of growth for the web economy, but it is the government that roots out fraud, makes on-line transactions legally binding, sorts out property rights (such as domain names), settles disputes, and deals with issues that we have not even thought about yet.

One sad irony of September 11 was that one simple-minded view of government—that “taxpayers know better what to do with their money than the government does”—was exposed for its hollowness. Individual taxpayers cannot gather intelligence, track down a fugitive in the mountains of Afghanistan, do research on bioterrorism, or protect planes and airports. It is true that if the government takes money out of my paycheck, then there are things that would have given me utility that I can no longer buy. But it is also true that there are things that would make me better off that I cannot buy for myself. I cannot build a missile defense system, or protect endangered species, or stop global warming, or install traffic lights, or regulate the New York Stock Exchange, or negotiate lower trade barriers with China. Government enables us to work collectively to do those things.

B
y now you are probably ready to extol the virtues of bureaucracy at your next dinner party. Not so fast. If government were so wonderful, then the most government-intensive countries in the world—places like North Korea and Cuba—would be economic powerhouses. They’re not. Government is good at doing some things and tragically bad at doing others. Government can deal with significant externalities—or it can regulate an economy to the point of ruin. Government can provide essential public goods—or it can squander enormous tax revenues on ineffective programs and pet projects. Government can transfer money from the wealthy to the disadvantaged—or it can transfer money from common folk to the politically well-connected. In short, government can be used to create the foundations for a vibrant market economy or to stifle highly productive behavior. The wisdom, of course, lies in telling the difference.

There is an old joke, one of Ronald Reagan’s favorites, that goes something like this:

A Soviet woman is trying to buy a Lada, one of the cheap automobiles made in the former Soviet Union. The dealer tells her that there is a shortage of these cars, despite their reputation for shoddy quality. Still, the woman insists on placing an order. The dealer gets out a large, dusty ledger and adds the woman’s name to the long waiting list. “Come back two years from now on March 17th,” he says.

The woman consults her calendar. “Morning or afternoon?” she asks.

“What difference does it make?” the surly dealer replies. “That’s two years from now!”

“The plumber is coming that day,” she says.

If the USSR taught us anything, it is that monopoly stifles any need to be innovative or responsive to customers. And government is one very large monopoly. Why is the clerk at the Department of Motor Vehicles plodding and surly? Because she can be.
What would your business look like if your customers, by law, could not go anywhere else?
It would certainly make me think twice about working late, or, for that matter, working at all on warm summer days when the Cubs were playing at home.

Government operations are often described as inefficient. In fact, they operate exactly as we would expect given their incentives. Think about the Department of Motor Vehicles, which has a monopoly on the right to grant driver’s licenses. What is the point of being friendly, staying open longer, making customers comfortable, adding clerks to shorten lines, keeping the office clean, or interrupting a personal call when a customer comes to the window?
None of these things will produce even one more customer!
Every single person who needs a driver’s license already comes to the DMV and will continue to come no matter how unpleasant the experience. There are limits, of course. If service becomes bad enough, then voters may take action against the politicians in charge. But that is an indirect, cumbersome process. Compare that to your options in the private sector. If a rat scampered across the counter at your favorite Chinese take-out restaurant, you would (presumably) just stop ordering there. End of problem. The restaurant will get rid of the rats or go out of business. Meanwhile, if you stop going to the Department of Motor Vehicles, you may end up in jail.

This contrast was illustrated to me quite sharply when a check I was expecting from Fidelity, the mutual fund company, failed to show up in the mail. (I needed the money to pay back my mother, who can be a fierce creditor.) Day after day went by—no check. Meanwhile, my mother was “checking in” with increasing frequency. One of two parties was guilty, Fidelity or the U.S. Postal Service, and I was getting progressively more angry. Finally I called Fidelity to demand proof that the check had been mailed. I was prepared to move all of my (relatively meager) assets to Vanguard, Putnam, or some other mutual fund company (or at least make the threat). Instead, I spoke with a very friendly customer assistant who explained that the check had been mailed two weeks earlier but apologized profusely for my inconvenience anyway. She canceled the check and issued another one in a matter of seconds. Then she apologized some more for a problem that, it was now apparent, her company did not cause.

The culprit was the post office. So I got even angrier and then…I did nothing. What exactly was I supposed to do? The local postmaster does not accept complaints by phone. I did not want to waste time writing a letter (which might never arrive anyway). Nor would it help to complain to our letter carrier, who has never been consumed by the quality of his service. Roughly once a month he gets “off” by a house and delivers every family’s mail to the house one door to the west. The point, carefully disguised in this diatribe, is that the U.S. Postal Service has a monopoly on the delivery of first-class mail. And it shows.

There are two broader lessons to be learned from this. First, government should not be the sole provider of a good or service unless there is a compelling reason to believe that the private sector will fail in that role. This exclusion leaves plenty for government to do in areas ranging from public health to national defense. Having just lambasted the Department of Motor Vehicles, I must admit that issuing driver’s licenses is probably a function that should remain in the hands of government. Private firms issuing driver’s licenses might not compete only on price and quality of service; they would have a powerful incentive to attract customers by issuing licenses to drivers who don’t deserve them.

Still, that leaves a lot of things that government should not be doing. Delivering mail is one of them. A century ago the government may have had legitimate reasons for being in the mail business. The U.S. Postal Service indirectly assisted underdeveloped regions of the country by guaranteeing mail delivery at a subsidized rate (since delivering mail to remote areas is more expensive than delivering to a metropolitan area but the stamp costs the same). The technology was different, too. In 1820, it was unlikely that more than one private firm would have made the massive investment necessary to build a system that could deliver mail anywhere in the country. (A private monopoly is no better—and perhaps worse—than a government monopoly.) Times have changed. FedEx and UPS have proved that private firms are perfectly capable of building worldwide delivery infrastructures.

Is there a huge economic cost associated with mediocre mail service? Probably not. But imagine the U.S. Postal Service controlling other important sectors of the economy. Elsewhere in the world, the government runs steel mills, coal mines, banks, hotels, airlines. All the benefits that competition can bring to these businesses are lost, and citizens are made worse off as a result. (Food for thought: One of the largest government monopolies remaining in the United States is public education.)

There is a second more subtle point. Even if government has an important role to play in the economy, such as building roads and bridges, it does not follow that government must actually do the work. Government employees do not have to be the ones pouring cement. Rather, government can plan and finance a new highway and then solicit bids from private contractors to do the work. If the bidding process is honest and competitive (big “ifs” in many cases), then the project will go to the firm that can do the best work at the lowest cost. In short, a public good is delivered in a way that harnesses all the benefits of the market.

This distinction is sometimes lost on American taxpayers, a point that Barack Obama made during one of his town hall meetings on health care reform. He said, “I got a letter the other day from a woman. She said, ‘I don’t want government-run health care. I don’t want socialized medicine. And don’t touch my Medicare.’” The irony, of course, is that Medicare
is
government-run health care; the program allows Americans over age 65 to seek care from their private doctors, who are then reimbursed by the federal government. Even the Central Intelligence Agency has taken this lesson to heart. The CIA needs to be on the cutting edge of technology, yet it cannot provide the same incentives to innovate as the private sector can. Someone who makes a breakthrough discovery at the CIA will not find himself or herself worth hundreds of millions of dollars six months later, as might happen at a Silicon Valley startup. So the CIA decided to use the private sector for its own ends by using money appropriated by Congress to open its own venture capital firm, named In-Q-It (in a sly reference to Q, the technology guru who develops gadgets for James Bond).
¹
An In-Q-It executive explained that the purpose of the venture was to “move information technology to the agency more quickly than traditional Government procurement processes allow.” Like any other venture capital firm, In-Q-It will make investments in small firms with promising new technologies. In-Q-It and the firms it bankrolls will make money—perhaps a lot of money—if these technologies turn out to have valuable commercial applications. At the same time, the CIA will retain the right to use any new technology with potential intelligence-gathering applications. A Silicon Valley entrepreneur funded by In-Q-It may develop a better way to encrypt data on the Internet—something that e-commerce firms would snap up. Meanwhile, the CIA would end up with a better way to safeguard information sent to Washington by covert operatives around the world.

In the private sector, markets tell us where to devote our resources. While sitting in the center-field seats at a Chicago White Sox game, I spotted a vendor walking through the stands wearing what was prominently advertised as the Margarita Space Pak. This piece of technology enabled the vendor to make frozen margaritas on the spot; somehow he mixed the drinks in his backpack-like device and then poured them through a hose into plastic cups. The ostensible social benefit of this breakthrough technology was that baseball fans could now enjoy margaritas, rather than just beer, without leaving their seats. I suspect that some of our country’s top engineering minds—a scarce resource—devoted their time and effort to creating the Margarita Space Pak, which means that they were
not
spending their time searching for a cheaper, cleaner source of energy or a better way to deliver nutrients to malnourished children in Africa. Does the world need the Margarita Space Pak? No. Could the engineering minds that created it have been put to some more socially useful purpose? Yes. But—this is an important point—
that’s my opinion and I don’t run the world.

When government controls some element of the economy, scarce resources are allocated by autocrats or bureaucrats or politicians rather than by the market. In the former Soviet Union, massive steel plants churned out tons of steel, but the average citizen couldn’t buy soap or decent cigarettes. In hindsight, it should not have been a surprise that the USSR was the first to send a rocket into orbit (and equally obvious that it would not invent the Margarita Space Pak). The government could simply mandate that resources be spent on the space program, even if people would rather have had fresh vegetables or tube socks. Some of these resource allocation decisions were tragic. For example, Soviet central planners did not consider birth control to be an economic priority. The Soviet government could have made contraceptives available to all; any country that can build intercontinental ballistic missiles has the know-how to make a birth control pill, or at least a condom. But contraception simply was not where central planners chose to channel the country’s resources, leaving abortion as the only form of family planning. In the years of communism, there were roughly two abortions for every single live birth. Since the collapse of the Soviet Union, Western contraceptives have become widely available and the abortion rate has fallen by half.

Even in democratic countries, the political process can devote resources to some pretty strange places. I once interviewed a technology expert about the government’s plans at the time to build a high-speed particle accelerator (a good example of basic research). The accelerator would bring jobs and federal money to the location that landed the project. This was in the early 1990s, and the two leading sites were northern Illinois and somewhere in Texas. According to the fellow I was speaking with, Illinois was the more attractive site because it already had a particle accelerator and a major federal laboratory. Much of the scientific infrastructure was in place and would not have to be duplicated. Despite that, the project was sited in Texas. “Why?” I asked. This guy looked at me as if I were some kind of idiot. “Because George [H. W.] Bush was president,” he answered, as if there could be no more obvious reason to put a giant particle accelerator in Texas. In the end, the government spent roughly $1 billion on the project and then abandoned it.

The private sector allocates resources where they will earn the highest return. In contrast, the government allocates resources wherever the political process sends them. (Consider a front-page headline in the
Wall Street Journal:
“Industries That Backed Bush Are Now Seeking Return on Investment.”)
²

Is that because Republicans are particularly prone to this kind of money-grubbing political influence? Perhaps. But that wouldn’t explain this more recent
New York Times
headline: “In Washington, One Bank Chief Still Holds Sway.” The story began, “Jamie Dimon, the head of JPMorgan Chase, will hold a meeting of his board here in the nation’s capital for the first time on Monday, with a special guest expected: the White House chief of staff, Rahm Emanuel. Mr. Emanuel’s appearance would underscore the pull of Mr. Dimon, who amid the disgrace of his industry has emerged as President Obama’s favorite banker, and in turn, the envy of his Wall Street rivals. It also reflects a good return on what Mr. Dimon has labeled his company’s ‘seventh line of business’—government relations.”
³

There is nothing inherently wrong with this. Politics is a necessary but imperfect process, and everyone has a right to seek influence. Military bases get built or closed in a way that reflects the makeup of the Senate Armed Services Committee as much as or more than the military needs of the country. A private army is not an option, so this is the best we can reasonably expect. But the less the economy is left to politics, the better. Powerful politicians should not be deciding, for example, who gets bank credit and who does not. Yet that is exactly what happens in autocratic nations like China and in democratic countries like Indonesia where politicians play “crony capitalism.” Projects that have the potential to be highly profitable do not get financing while dubious undertakings sponsored by the president’s brother-in-law are lavished with government funds. Consumers lose in two ways. First, their tax money is squandered when projects that never should have been funded in the first place go bust (or when the whole banking system needs to be bailed out because it is full of rotten, politically motivated loans). Second, the economy does not develop as quickly or efficiently as it might because credit (a finite resource) is channeled away from worthwhile projects: car plants don’t get built; students don’t get loans; entrepreneurs don’t get funding. As a result, resources are squandered and the economy does not perform anywhere near its potential.