The theoretical demonstration of competition as the primary driver of capitalism is reinforced by strong empirical evidence. In Chapter 10, I demonstrated the highly statistically significant relationship between competition and the broadest measure of relative global economic success, real per capita GDP. Although competition works mainly through creating market flexibility, it also depends on a conviction on the part of market competitors that the price and wage outcomes of transactions that compose “competition” are “fair.”
PUBLIC VERSUS PRIVATE SECTOR ELASTICITY
In private organizations, one aspect of creative destruction that we experience is the painful process of cost cutting necessitated by a squeeze on profit margins. Companies have no choice. Public institutions, however, not subject to bankruptcy, are less concerned about getting the lowest price or cost than is a private institution. Public institutions directly and indirectly have access to sovereign credit and taxpayer funds. The response to price change of a private business ranges from high to modest. The response of a government, on the other hand, ranges from modest to none.
I observed this process first hand as Federal Reserve banks presented proposals, as required, to the Federal Reserve Board to replace the buildings that had almost all gone into operation at the start of the Federal Reserve System in 1914. I recall during the recession of 1989 that large numbers of commercial real estate properties were selling at substantial discounts. But Reserve bank building proposals were invariably for new buildings, despite their far greater cost. New buildings were recommended because Reserve bank buildings were presumed unique in that they needed an extra large vault in the basement. Virtually all Reserve banks eventually ended up with new, more costly buildings.
I often wondered whether the process would have been handled differently in the private sector. As diligent as we were at the Federal Reserve about saving taxpayer money, it is still the case that public budgets are chosen to be restrained, while private budgets are forced to do so by limited available resources.18
This is a classic case of inelastic demand and supply creating higher prices. I chose this example in particular because the people who were making these decisions were truly dedicated to keeping costs down. But subliminally they also knew that government was different from the private sector, where companies had to cope with the fact that funds might not be available to fund such projects under any circumstances.
If the Federal Reserve restricted its demand to new buildings only, prices of new buildings would rise relative to old ones. Restricting its choices, public sector demand for space was more price inelastic than in the private sector, where an institution, if forced by limited funds, might have found a previously unexplored alternative in refitting an older building with a vault, employing fewer real resources and increasing the elasticity of supply. In instance after instance, in my experience, government programs are far more price inelastic than comparable cases subject to private market competition. They produce a higher price and use more resources than would typically be the case in the private sector, while at the same time increasing the utility of our capital stock only modestly compared with the private sector model.
THE MARKET ADJUSTMENT PROCESS
Are free markets in general capable of adjusting more quickly to economic shocks than controlled markets? This is not an easy question to answer given the paucity of useful data, but in my experience, several noteworthy examples suggest that the answer is yes:
The 1973–74 oil shock,19 when companies forced to the wall reduced demand far more than most analysts expected, especially given the earlier history of inelastic demand for oil with respect to price;
A widespread notion in the late 1970s that bringing inflation down was too costly in terms of unemployment, a view that was proved mistaken;
Medicare Part D, where drugs turned out under competition proved to be far less costly than previous experiences had indicated, though as some contend, the original cost estimates may have been elevated.
Health care, especially under government fee-for-service subsidization, is an important case in point. Neither supply nor demand for medical services appears to respond to price change as readily as, say, the demand and supply at our corner grocery store. First, ease of entry for medical professionals is encumbered by a long and expensive period of schooling and certification. Hence, the supply of medical professionals does not easily respond to unexpected increases in demand. The result is higher prices. Similarly, physicians do not leave medicine very readily as the price of their services falls. In short, supply of medical services is relatively inelastic. The demand for medical services is also highly inelastic, conceivably more so than their supply. When confronted with serious illness, medical care is given our highest priority. Where subsidized, as in Medicare, demand is particularly unresponsive to price because it becomes a virtually free good to beneficiaries. Price generally does not inhibit individual patients.
This tendency is more or less evident in all goods and services whose supply, and especially demand, is affected by government-dependent private businesses. The result is less demand and supply elasticity in markets that governments attempt to favor. Government-dependent companies and services are particularly prone to politically determined entry—subsidies, guarantees, charters, price supports, controls, leases on government land, and all such government-sponsored actions that prevent markets from functioning in a fully flexible manner. When markets are flexible, monopolies cannot raise prices.
Of course, not all government policies promote increases in nonmarket-determined use of a product or service. Government is, on occasion, on the side of restraining market demand—promoting reduction in tobacco usage and innumerable drugs and foods, for example. But for the most part, government sponsorship promotes the use of products and services which, in conjunction with choosing political favorites (cronies), engenders inelastic demand and/or supply, artificially raising prices and lowering production, and in the end, reducing standards of living.
CREATIVE DESTRUCTION
The dark side of capitalism is that wealth20 is created only when obsolescent technologies and companies are allowed to fade out and are replaced. There is inevitable pain in this process. Only economic growth, low unemployment, and new job availability can assuage the economic angst, at least in part. There is no way to fully eliminate the pain experienced by those who are the market casualties of creative destruction. If standards of living are to rise, productivity must grow. But that requires that the “new” are constantly displacing the “old” low-productivity capital assets and the jobs associated with them. Government policies that try to limit the pain and stress of economic adjustment by propping up stagnant or failing low-productivity companies against the pressures of creative destruction suppress economic growth and, ironically, in the end the jobs that the economically displaced were seeking. In recent years, too many companies that should have been allowed to fail (and restructure) or shrink have been propped up by regulation or tax payer–funded bailouts.
It is economic growth that is essential to new job creation. Businesses hire, not out of the goodness of their souls, but because they have no other choice in periods of economic growth. Economic growth requires economic flexibility to alter a company’s mix of resources. It implies creative destruction. The purpose of competitive excellence is to be a survivor. But if there is a survivor of the battle of competition, there must also be a casualty. Pain is thus a regrettable by-product of creative destruction and economic progress. Economic growth that creates new job openings does assuage the pain of job loss, but only up to a point. Through much of the twentieth century, we sought ways to contain the pain of the capitalist process. The most universally advocated was job retraining for job losers. In 1992, President Bill Clinton, however, described such government initiatives at the time as a “confusing array of publicly funded training programs.”21 Regrettably, my experience is that the political issue is not the outcomes of job training
programs but whether the politician who advocates them gains electoral popularity as a result. This is the reason why there have been so many different overlapping job training programs on the books that lost their relevance years ago and should have been discarded. Community colleges appear to be doing a much better job (see The Age of Turbulence, page 402).
CAPITALIST “FAIRNESS”
Following the Civil War, criticisms of the “fairness” of markets began to surface when highly subsidized, newly built railroads were able to expand across the Great Plains to the West Coast, leaving the unsubsidized competitors of the railroads (stagecoaches and riverboats) unable to profitably follow them and compete for farmers’ business west of the Mississippi. It added to the already widespread discontent among those farmers suffering high shipping rates charged by these railroad monopolies. It was that sentiment that eventually led to the Interstate Commerce Act of 1887, the first federal law in the United States to regulate private industry.22
By and large, early nineteenth-century markets were dominated by agriculture, whose pricing was largely local and competitive (almost all, of course, east of the Mississippi). Government’s role in this process, as I noted in Chapter 6, was largely restricted to enforcing contracts and, in later years, antitrust and pure food and drug laws. But the world of virtually wholly free markets changed with the advent of the Great Depression and the New Deal, especially the National Industrial Recovery Act. It dictated prices and wages until it was struck down by the Supreme Court in 1935. A slew of regulatory agencies were spawned in those years that exist to this day and are best known by their acronyms: SEC, FDIC, CCC, NLRB, FHA, FCC, and many others.
Markets in the United States prior to the Civil War were generally considered “free” and, in the context of the ethos of the time, therefore “fair.” Even today, when we shop at a retail store where prices are listed, we can either choose to forgo the purchase or pay the list price. Alternatively we can haggle on the issue of price. But in the end, the transaction is voluntary, and this matters in a society that believes there are rights to property as well as person. Indeed, we define a “free market” as a market where the vast majority of transactions are deemed by both sides of the transaction as voluntary and not subject to coercion by monopolists or the state. If we do not have enough money, we do not buy. But we do not expect the retailer or any other private individual to supply our needs for free. The principle extends all the way from the corner grocer to the purchase of homes and industrial companies. Very few consider these voluntary exchanges to be other than “fair.”23, 24
Many agree that free markets do maximize the material values sought by consumers, but it is a system not of one citizen, one vote but of one dollar, one vote, and hence a value system skewed in favor of the wealthy. In that same sense, it is considered “unfair.” There is probably no system by this reckoning that is both productive and fair. Capitalism’s inequality of wealth, of course, reflects the variations of economic talent among our populations, and the prevalence of inherited wealth. As I note in Chapter 1, the propensity to favor children and relatives over strangers passes wealth within a family from one generation to another. Moreover, wealthy individuals concentrate charity on those institutions that support the values of the givers.
Since its inception in the late eighteenth century, the capitalist system thus has always been considered “unfair” by part of our population. Critics, ranging from Karl Marx and William Jennings Bryan in the nineteenth century to the Latin American economic populists of the twentieth century, have always argued that as a consequence of economic power, standards of living are “unevenly” distributed. But none of these critics have proffered a system that, when tried, has produced the material standards of living that capitalism has produced, even for our lowest income recipients.
LIVING TOGETHER
Our current political clash over the extent of the size of our government—the size of our welfare state—and economic fairness has been brewing at least since the New Deal of the 1930s. The roots of the issue of economic fairness, rarely discussed outside the halls of academia, date back to the long-simmering debate about who among the multitude of economic participants in the interconnected capitalist production process has valid claims on shares of its output. To this day, it remains an issue in dispute. The socialist movement that emerged in the nineteenth century, to a greater or lesser extent, held that the output of a market economy is jointly produced and that the product each individual produces cannot be disentangled from the total. In effect, all producers are equally indispensable to the creation of the whole. The higher incomes received by some individuals are not theirs by right. Therefore, duly elected government should be the custodian of the national income and the arbiter on how it is distributed. This was the implicit substance of William Jennings Bryan’s Cross of Gold speech, which riveted the nation in 1896. Karl Marx went further and argued that much of national income was not only unearned but the product of the exploitation of the working class by the capitalist class. Even though Marxism has been widely rejected as an explanation of the way democratic capitalist systems work, “fairness” of income distribution continues to be a matter of fierce debate.
Classical and neoclassical economists argue that in a free competitive market, incomes earned by all participants in the joint effort of production reflect their marginal contributions to the output of the net national product. Market competition ensures that their incomes equal their “marginal product” share of total output, and are justly theirs. That view largely prevailed in most of the developed world through the nineteenth century and through World War I. The income tax, as a potential purposefully redistributive vehicle, did not emerge in the United States until 1913.
Former French conservative prime minister Édouard Balladur was dismissive of free-wheeling market competition when he analogized the process to one governed by the law of the jungle, a highly pejorative but eloquent description. “What is the market?” he asked. “It is the law of the jungle, the law of nature. And what is civilization? It is the struggle against nature.” We cannot get around the fact that there is a Spencerian “survival of the fittest” aspect to market adjustments. We can no more change that than we can change its root: human nature. Such a view of the economic world dominated much of nineteenth-century America and beyond. It is not an accident that Charles Darwin and Herbert Spencer, with their stark views of human nature, dominated much of the discourse of the second half of the nineteenth century. The values of self-reliance and rugged individualism square with that starkly deterministic view of economic life. We can choose to buffer the competition’s “losers” from the extremes of suffering and want, but we cannot eliminate the competition and the trade-off between productivity and such buffering.
WE MUST CHOOSE
The choice we are being forced to make is simply this: What type of society do we wish to live in? One in which self-reliance is the ethos, where government has little role aside from setting the legal conditions of political freedom, such as the rights of minorities spelled out in the first ten amendments to the U.S. Constitution? Or a society and government whose primary function is to “entitle” citizens beyond the individual freedoms defined in our constitution, providing all forms of income transfers crafted to elevate the least privileged members of society to equality of opportunity, if not equality of economic outcomes? In short, do we wish a society of dependence on government or a society based on the self-reliance of individual citizens? Which, if either, given human nature, is the most efficient in serving the society as a whole? This is at the root of the political debate between a welfare state and something far short of that.
With increasing economic abundance through the nineteenth and twentieth centuries, the inherent economic necessity of the prudence associated with an ethos of self-reliance began to fade and morph into our current age of entitlements. But the conflict within each of us between dependence and self-reliance is made even more acute by the t
yranny of economic arithmetic. We cannot expect to consume virtually all of current production and still create ever-rising standards of living. The math doesn’t work.
THE POLITICAL RESPONSE: TOO BIG TO FAIL
As we’ve seen, the events of 2008—a record postwar collapse of economic activity and the historically unprecedented breakdown in the ability of a number of financial markets to operate (money market mutual funds, commercial paper, and trade credit, for example)—spawned a rapid political response that invoked massive bailouts and reregulation based on the presumption that these heretofore extremely rare economic outcomes were to become commonplace in the future. While deeply worrisome, this unprecedented response should not have come as a surprise. Economic policy had morphed since Paul Volcker and his Federal Reserve embarked on his then-very controversial tightening of monetary policy in 1979 that tilted the U.S. economy into its greatest recession of the postwar years. The Fed’s goal: future economic stability. The reasoning was the same behind the Resolution Trust Corporation’s gutsy decision to incur the wrath of Congress when in 1989 it began auctioning the remnants of the deteriorating illiquid inventories of the 747 failed savings and loans at deeply discounted prices, an action that eventually saved the American taxpayers many tens of billions of dollars.
Both the Fed and the RTC sought long-term benefits for the American economy at significant short-term political cost. That type of trade-off appears no longer acceptable. Today’s policy makers are no longer allowed to incur short-term risks to increase the probability of success in achieving long-term gains. The consequence has been the emergence of a notion that, prior to 2008, had lain largely dormant in the backwaters of economic policy: that a business, especially a financial institution, had become “too big to fail” (TBTF). Its collapse, it is argued, could, because of its interconnectedness with critical sectors of the economy, bring down large segments of our economy along with it. Coupled with the current heavy bias toward government responding with a “solution” to every conceivable shortcoming of our economy, real or imagined, the doctrine of TBTF is a recipe for economic stagnation.
The Map and the Territory Page 22
