Only the government can continually get away with this kind of wastefulness—a private insurance company that was this profligate would be driven out of business. Democratic Congressman Earl Blumenauer (Oregon) put it succinctly: “The federal government is aiding and abetting patterns of living that are unsustainable and draining significant resources.”19 By creating insurance programs with below-cost premiums, the government allowed its insurance clients to free-ride off the American taxpayers.
Many economists have pointed out severe problems caused by the government’s inability to set prices correctly. Indeed, some blame the bankruptcies seen during the savings and loan crisis of the 1980s on the extremely low prices charged by the government for deposit insurance at risky banks. The bailout ultimately ended up costing taxpayers over $175 billion.20
If charging too low a price will create market distortions, then handing out services for free—which the government often does—will really create some perverse incentives. For example, government search-and-rescue teams frequently decline to charge anything for their services. These expeditions can be extremely expensive, with use of a helicopter costing $10,000 per day.21 Even worse, free rescue services give hikers and mountain climbers an incentive to take more risks. In December 2006, a large-scale search and rescue operation was undertaken at Oregon’s Mt. Hood to find three climbers stranded on the mountain. Tragically, one hiker was found dead, while the other two were never discovered. In light of the incident, Oregon lawmakers floated the idea of requiring high-altitude climbers to wear electronic locators. The proposal was opposed by climbers, who argued the devices would cut down on the “adventure” and the “beauty” of the sport’s danger.22 Perhaps after getting stuck with a $10,000 rescue tab, climbers might think twice about the kind of risks they take.
The government’s difficulty in getting prices right is vividly illustrated in the application of eminent domain—laws that allow the government to confiscate homes in order to clear the land for other developments. The government—as well as private developers—face considerable economic problems when trying to clear out homes from a certain area. Suppose that a developer needs to tear down the houses on an entire block in order to build a skyscraper. The obvious approach would be to buy everyone’s house, but this doesn’t always work. Some homeowners with a sentimental attachment to their property will even refuse offers that far exceed the fair market value of their homes. In this case, developers who are unwilling to pay exorbitant amounts have little choice but to look elsewhere for their project.
Other homeowners might act strategically, hoping that by refusing early offers, they will entice much higher bids later. This presents a complex problem, for a single hold-out could stymie the project. Eminent domain seeks to solve this problem by forcing owners to accept the “fair market value” of their property. The government offers the fair market value—the price for which similar nearby houses have sold—and if the homeowner refuses, the government can pay this price anyway and seize the property. The recent U.S. Supreme Court decision Kelo v. New London decreed that eminent domain, until then usually invoked to allow for government projects such as highways and railroads, can also be enforced for private development projects if the local authorities determine that the projects will benefit the wider community.23
One of the main problems with eminent domain is that the fair market value is typically too low. If people only valued their homes at the market price, they would have already sold them before receiving the developer’s offer. The fact that they haven’t means that they value their abodes more than what is being offered on the free market. The real difficulty lies in figuring out how much more.
Fortunately, there is a solution that businesses used for years before they gained access to eminent domain. Whether they seek to build a pipeline, a road, or a building, companies almost always consider multiple possible locations. Koch Industries, the largest privately owned company in the United States, built 4,000 miles of natural gas and oil pipelines across the country without using eminent domain until relatively recently.24 Instead, it typically offers a contract to property owners along different possible routs; the deal goes to whichever complete set of property owners signs the contract first. The owners might be offered, for example, 25 percent above the fair market value. If they value their property more than that, they don’t have to sell. But this approach discourages people from indefinitely holding out for better offers. If homeowners don’t really value their property much more than the market value, they risk losing this 25 percent profit. The government should consider this market-based approach as an alternative to forced sales at prices that, in reality, are anything but “fair.”
Bill Dougan, former chairman of the Economics Department at Clemson University, devised a similar solution to a problem plaguing many academic departments.25 When a department is hiring a new professor, there will often be several candidates who are roughly equally good. The risk is that when the job is offered to one candidate, he many take weeks to decide whether to accept, often using the offer simply to try to get a better deal from another school. If the candidate ultimately signs on with a different school, the department may be left with nobody, since the other candidates may have already taken jobs elsewhere. Dougan’s solution? Offer the job simultaneously to all the top candidates, stipulating that the position goes to whomever accepts first. It’s a good thing these kinds of free market solutions are developing before someone suggests imposing eminent domain on hiring practices.
University of Washington professor Jonathan Karpoff recently provided another striking example of how inefficient government enterprise can be. Karpoff studied the thirty-five government-sponsored expeditions, along with the fifty-seven privately funded voyages, that explored the Arctic, the Northwest Passage, and the North Pole from 1818 to 1909. Arctic exploration, like space missions, is an excellent example of a public benefit that many would assume could not be achieved privately. Much of the exploration is similar to pure scientific research that offers no immediate commercial benefit. Compared to their private counterparts, government expeditions to the Arctic enjoyed much better funding, bigger ships, and crews that were over four times larger (averaging seventy members versus seventeen for private voyages). Nevertheless, public expeditions were more likely to end in tragedy—an average of nearly six crewmen died on government voyages, compared to fewer than one on the average private trip. Furthermore, government expeditions lasting over a year suffered scurvy rates that were four times higher, while the chance of losing a ship was over double that of private expeditions.26 Despite their smaller crews and lower funding levels, the private teams accomplished five of the six major Arctic discoveries.27
Karpoff elaborated some of the reasons behind these results. Government expeditions had to operate by committee and political factors played a role in dictating their crews’ composition. Private expeditions, in contrast, were more efficient and much faster at learning from past experience. Perhaps most importantly, private voyages were more responsive to incentives for success—their decision makers directly bore the costs and reaped the benefits of their own actions.
These kinds of inefficiencies plague government efforts in realms ranging from welfare to education. Private charities ensure that 80 to 90 percent of donations get to those in need, while only 30 percent of government welfare spending actually reaches the intended recipients.28 Likewise, non-teacher costs make up over 40 percent of the budgets in public schools compared to less than 20 percent in private ones.29 Overall, the per pupil costs of public schooling are about twice as much as for private schools despite the fact that children typically learn much faster in private institutions.30 These statistics indicate that private charities and schools can provide better service than public ones even if they receive just half the funding.
The market isn’t perfect, of course. But the government is usually much further from perfection. Even when the state intervenes in the economy with the best
intentions, it frequently only succeeds in making things worse.
Diversified Stock Holding: A Free Market Approach to Keeping Corporate Peace
So what makes the free market superior to government planning? Part of the answer is that the market creates stronger incentives for people to consider the effects that their actions have on others. A clear example of this is seen in the growing practice of diversified stockholding. Some 5,000 stock mutual funds in the United States hold over $5.2 trillion in assets.31 It has become common knowledge that investors should hold a well-diversified stock portfolio, but most people do not realize that this practice also encourages cooperation among competing companies.32
Consider a simple example I came across when I was teaching at the Wharton Business School. Albert J. Wilson, then vice president and secretary for TIAA-CREF, a huge teacher’s retirement fund, gave an informal talk to some faculty in December 1992. Texaco and Pennzoil had previously been locked in a protracted, costly legal battle. Owning stock in both companies, TIAA-CREF was hurt by the litigation, which reduced the value of both firms. If one firm eventually won the dispute, it would not have benefited TIAA-CREF, since the result would just move a lot of money from one firm to the other. Lawyers were making a lot of money from the litigation, but unfortunately the retirement fund didn’t own any stock in the lawyers. Wilson told us that the pension fund had used its influence as a large shareholder in both companies to get them to settle their lawsuit. He also revealed that the pension fund had similarly helped to convince Apple and Microsoft to settle some mutual legal disputes.
While investors care about the value of each stock they own, they care more about the value of their total portfolio. If some corporate decision causes the price of one stock in an investor’s portfolio to rise but depresses the value of another of his stocks by an even greater amount, the investor will not be pleased. As stockholding in general and diversified stockholding in particular has risen over time, corporate decisions have increasingly come to affect other firms and their stockholders.
This phenomenon has been evident in Japan for decades. Japan’s keiretsu are a group of companies that cross-own stock in each other in order to promote cooperation among the constituent firms. The practice represents a kind of halfway point between total independence and a complete merger. In 1989, the Texan tycoon T. Boone Pickens purchased a large stake in Koito, a Japanese automotive lighting and air conditioning company that belongs to the Toyota keiretsu. Toyota works closely with Koito and other suppliers in designing products to fit its cars.
Pickens became upset that Koito was charging Toyota low prices. But the other companies in the Toyota keiretsu did not share his concern. Unlike those companies, Pickens only owned shares in one of the keiretsu’s firms. So he was only interested in maximizing Koito’s share price, while the other shareholders cared about the overall value of all the keiretsu’s companies. If Pickens had also owned Toyota stock, he wouldn’t have had much of an incentive to try to charge Toyota higher prices. In fact, the income he hoped to gain from raising Koito’s prices to Toyota would have been smaller than the loss imposed on Toyota.33
In the U.S., mutual funds and other financial institutions replicate some aspects of the keiretsu system. For example, a study I performed with Tuck Business School professor Bob Hansen found that 33 percent of IBM’s stock and 50 percent of Intel’s stock were owned by institutions that held stock in both companies. Likewise, 29 percent of Apple’s stock and 20 percent of Microsoft’s stock were possessed by institutions that were shareholders of both firms.34 Additionally, some aspects of venture capital funds also resemble the keiretsu system. Typically, such funds specialize in investing in a small number of industries. Like the TIAA-CREF, the funds have an incentive to use their position as stakeholders to encourage cooperation among the companies in which they’re invested and to discourage wasteful internecine disputes.
Hansen and I found that stock diversification also helps to explain other corporate behavior, such as the prices that firms bid in mergers. While merger announcements usually increase the stock price of the firm being acquired, there is substantial evidence that the stock price of the buyer actually falls. Furthermore, the size of this drop has been increasing over time. This can be explained by stock diversification: when shareholders own both the acquired and acquiring firm, they care much more about whether the merger will increase the total value of the two firms than they do about which firm’s value increases and which decreases. If shareholders own both companies, a higher bid simply means more money going from one of their pockets to the other. If there are diversified shareholders and multiple suitors, then shareholders will care not about the size of the bid, but rather that the total value is maximized.35
During a merger, shareholders will only be indifferent to the buyer’s stock price when they also hold shares in the target. When the target is a private, closely-held firm, you usually won’t see this disinterest. In such acquisitions, a firm will only make a bid if the merger would increase its own value. Thus, in mergers involving a publicly-held company taking over a privately-held one, the buyer’s stock price will usually rise upon the bid’s announcement.36
The overall benefits we gain from stock diversification are another example of the market acting effectively when it’s left alone. Sometimes these innovations take some time to evolve, but the inexorable direction of the market tends toward ever greater efficiency.
State Predators and Private Lambs
What kind of company comes to mind when you think of a corporate predator? The textbook example is John D. Rockefeller’s Standard Oil company, which ruthlessly gobbled up and closed down competitors in the late 1800s and early 1900s until the firm was ordered broken up by the Supreme Court.37 More recently, American Airlines was the defendant in a high-profile predation case that was eventually tossed out by the courts. Inevitably, it is large, private companies that are associated with predation in the public mind. This is quite unjust, for it is government-run companies—not private firms—that have the biggest incentives to act like predators.
As noted in Chapter One, predation—the lowering of a company’s prices below cost—usually proves too costly to be successful. After crushing a competitor, the threat of further predation has to be credible enough to keep new firms from entering the market. How is this threat issued? A typical predator has to convince potential competitors that it values something—perhaps overall sales or market share—more than it does profits, which can suffer dramatically while a firm is engaged in predation. This is usually a difficult threat to make convincingly—after all, the overall goal of any private company is to make money.
But government-owned companies are seldom geared primarily toward making profits. Because they are frequently motivated by extraneous factors such as maximizing employment, state-owned firms can make much more credible threats of predation. What’s more, state-owned firms often don’t need to drive their competitors out of business for predation to be successful; predation can work merely by allowing state-owned firms to expand their market share or create more jobs. Public firms also frequently enjoy state financing and tax advantages that give them the financial resources needed to sustain predation-related losses much longer than private companies can. Finally, because they often don’t have freely trading stock, state-owned companies are typically immune to the stock-shorting strategy that makes it profitable for firms to enter a market dominated by a predator, as previously discussed.38
Airbus, the giant European aircraft maker, provides a telling example. Many European governments have an ownership stake in the firm, which lost billions in 2006 due to a two-year delay in the manufacture of its A380 super-jumbo. Nevertheless, the Germans worry that the French want to increase their stake in the company by up to 15 percent because “if France has the upper hand in [the company] boardroom, Germany fears it could be forced to bear the brunt of any [labor force] cut-backs.” The UK has similar concerns.39
Look
ing at Airbus’ production methods, we see how jobs are prioritized over profits:The contribution of the United Kingdom taxpayer alone towards the A380 program is 530 million [British pounds]. In return for that, Broughton [in England]...got to make the wings. But it also means that each completed set of wings has to make a remarkable journey to the final assembly site in France by way of container ship, river barge and specially adapted road trailer. With the main fuselage having to travel from Germany and the tailfin from Spain, no wonder Christian Streiff, the man who was drafted in to head Airbus in July [2006], commented that there must be a simpler way.40
Because many state-run firms likewise refuse to prioritize profits, they make ideal predators. For example, weather forecasting offers a good case study in the effectiveness of public predators. During the 1980s, private meteorology services saw a chance to make money by providing television stations with specialized forecasts that the National Weather Service hadn’t been offering. But soon after the private companies began providing this service, the National Weather Service started giving stations the same specialized forecasts for free, thus driving the private forecasting companies out of the business.41 According to Jeffery Smith, executive director of the Association of Private Weather-Related Companies, “many commercial meteorologists have been reluctant to take an increased role in forecasting because of the constant threat of government provision of these specialized forecasting services. Private firms do not know what service the government will choose to offer next for ‘free.’”42
Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't Page 10
