by Filip Palda
The dividend of the peace of Pareto
Economists have been at pains to point out that Pareto efficiency is a concept, not a method. What they are getting at is that there are many ways to achieve Pareto efficiency. Nothing says that, in principle, a mad dictator with a cowlick and a jutting jaw cannot get the trains to run on time and provide jobs for all. Alternatively, nothing says that joint-stock companies raising venture capital in exchange for shares cannot convince a multitude of builders, suppliers, and holders of rights-of-way to construct railways of equal or greater precision than the dictator’s. Pareto efficiency can be an end state for both the dictator and the corporation, but it is not a road map. The question one must ask is how to get there, if such is our goal. Through centralized and absolute government control, or decentralized decision-making epitomized by a free market in property rights? Do we choose cowlicks and jutting jaws, or opt for top hats and joint-stock ventures?
The answers to these questions are, after many failed social experiments, starting to become conclusive. Consider nations that are so similar in their basic makeup that they could be thought of as twins. In 1953, Korea split in two after a civil war. North Korea came under a tyrant who saw enemies lurking at every turn. He resolved conflict by snatching the nation’s property and by abolishing human rights. People could no longer fight over property because it had been removed from their sphere of influence. Since then, generations of North Koreans have toiled in poverty and grown accustomed to famine and living in a climate of government-generated paranoia that distracts the people from the true cause of their woes. They have peace of a sort, but one that comes at a high price. South Korea, meanwhile, converted to a democracy. Its government allowed individuals the freedom to exchange private property under laws that were the same for all. It is now one of the richest countries in the world.
Less extreme, but similar differences can be seen between Pakistan and India. As Pakistan became increasingly authoritarian and arbitrary in its management of the economy during the late 1980s, its economic growth levels dipped and endemic violence began to simmer. At the same time, governments in India were weaning themselves from their addiction to centralized socialist planning of the economy. They tried to create a stable investment climate in which private individuals could determine how they would cultivate their resources. India now has a middle class while Pakistan remains in a condition of economic uncertainty. Haiti and the Dominican Republic share the island of Hispaniola, but they share little else. Haiti jumps from mob rule, to rule by corrupt dictators, and occasionally, to rule by ineffectual elected politicians, and is the poorest nation in the western hemisphere. The Dominican Republic is what the World Bank calls an “upper-middle income developing country” with reasonably secure property rights. Riots and tumult have no place in that country, and the average Dominican earns nearly ten times as much as the average Haitian. The list of twins goes on and includes the former West and East Germanys, and many sub-national jurisdictions.
These casual observations on the value of property rights have formal scientific support. In the late 1980s and early 1990s, under the impetus of economist and Fraser Institute founder Michael Walker, fellow economists Stephen Easton and Walter Block, and Nobel Prize winners Milton Friedman, Gary Becker, and Douglass North led several weekend retreats to determine how property should be measured and quantified into a single number. The method they worked out is now famously known as the Index of Economic Freedom. As they developed the index further, James Gwartney and Robert Lawson found indications that economic freedom and prosperity go hand-in-hand. While there are still many details to work out, these types of study are powerful enough to have attracted a fan club for property rights and to form part of the mission statement of the World Bank, which is “to help people help themselves and their environment by providing resources, sharing knowledge, building capacity, and forging partnerships in the public and private sectors.” By helping people to help themselves, the bank is talking as openly as it dare about the benefits of property rights.
Yet we need to keep an open mind. As impressive as the achievements of societies based on property rights are, these rights are not ideals. They are tools. The trick is to recognize which tool is the right one for the job. Under the right conditions, property rights can act as Pareto-efficient “instruments” of peace because they embody a “negotiating rule.” A negotiating rule is similar to an accounting procedure. Under Pareto efficiency, disagreements over the use of property must be resolved to the benefit of at least one party and should not harm any other party. Both seek to strike some balance in transactions. Accounts cannot be balanced without some sense of proportion at least, and a method for measuring at best. Property rights provide such rules.
The achievements of societies with secure property rights are impressive, but it is counterproductive to tout property rights as a panacea for creating wealth. Small, stable communities can dispense with elaborate notions of property and rely more on custom and tradition to resolve disputes over resources and balance social accounts. Their approach to dispute resolution is an efficient response to their economic reality. As Harold Demsetz, the pioneer of the study of the evolution of property rights explained in 2002,
A small isolated village within the boundaries of which residents remain for most of their lives is a setting in which collective decision making becomes practical. The community, in a team effort, can build a bridge over a local creek, and the effort can be enjoyable precisely because it is undertaken collectively. An economizing problem that is localized to a particular family is compact. Generally, the preferred method of resolving it will involve mutual assistance guided by sympathetic feelings, not explicit cash payments linked to third-party-enforced contractual agreements. (page 661)
In contrast to such informal means of resolving differences over how to use resources, sophisticated property rights systems are expensive to create and maintain. They require the protection of impartial courts and honest police, a political system that does not meddle with the courts, a cadre of professional lawyers and the educational infrastructure to train them, and precise instruments to measure and parcel out resources.
If people in a society are going to pay the price for property rights, the reason for doing so must lie in their utility. This utility becomes clear as a society grows and people in it become strangers to each other. Small, stable groups can dispense with formal property rights because they rely on intimacy and empathy to balance social accounts. In a large, fast-moving society these qualities are absent on a scale that encompasses everyone. A forum for exchange such as eBay could not work using informal agreements to pay or assurances that one day the purchaser will find himself in a position to help the seller. Instead, what is necessary to make eBay and other impersonal systems of exchange function in a large anonymous society are formal property rights protected by the law. Such rights are the basis of a flexible social accounting system. The resulting peace is Pareto-efficient, and its dividend is economic prosperity. This is not logically evident, but I will explain it in detail in the pages that follow.
When property rights fail
If property rights are nothing more than instruments for securing a certain type of peace, then we should maintain and even upgrade those instruments from time to time. This means ensuring that courts are honest, and that we are open to new technological advances in measurement and classification. Advances should allow for the establishment of previously unheard-of types of property rights. Examples are the creation of intellectual property rights, and new methods of measuring and tracking schools of fish by satellite that may one day allow trade to govern their exploitation rather than multi-national pirates who devastate marine life with impunity.
Yet sometimes there is no tool for the job. As the example of international fishing shows, sometimes property rights cannot be created. This is where it may be profitable and wise for government to step in and simulate Pareto efficiency. By recognizing the
potential and the limits of private property as a mechanism for peace, we get an idea of the proper extent and role of government intervention in our lives. The dividing line separates the domains of private and public initiative. The line we draw between the two should depend on the costs and benefits of defining and protecting property.
The costs and benefits of creating property rights are the only calculations that guide government’s existence in Pareto’s Republic. Fairness, social conscience, social justice, and other creeds have a role in the republic, but only as the result of voluntary private initiative. Government, which is the unique instrument of coercion, must use its muscle only to further Pareto efficiency. It may blunder in its quest, but the blunders should not systematically favour one group of people over another. Systematic favouritism sets people against each other in a way that upsets social accounts and ultimately leads not to peace, but to strife.
This seemingly narrow view of government’s role is not a prescription for small government per se. Government may still distribute money to the poor and build hospitals in Pareto’s Republic, provided these activities are what economists call “public goods.” This is but one of several paradoxical features of Pareto’s Republic. This book explains these paradoxes in the course of explaining the payoffs and costs of living in a Pareto-efficient society. As such, this book is not a biography of Vilfredo Pareto, the man who invented the concept, but an exploration of what might be his most important idea. In learning about what makes Pareto’s Republic, this book will take you on a tour of the key concepts of public choice, public finance, game theory, and institutional economics, as well as the foundational ideas of economics and some insights from history and sociology. No prerequisites are needed to understand it except a curiosity about a principle that might one day become humanity’s salvation.
PROPERTY
If peace is an ACCounting problem, who should balance the books? During most of the 20th century it was normal to think that government could take care of the ledger. The First World War saw governments of Western countries expand to manage, if not outright own, vast tracts of their economies. The Great Depression and then the Second World War saw further expansions of government. Crises were the immediate cause of these expansions, but later they gained intellectual legitimacy from Marxist thinkers in Russia, and Keynesians in Europe and North America. As economic stagnation began to afflict Western countries, the question arose as to whether big government, instead of helping the economy, could actually stifle it. The questioning grew more urgent during the collapse of the East Bloc in 1989. A different view of the relative roles of government and the private sector gained impetus partly from these developments, and partly from the award of the Nobel Prize in economics to economists, historians, and political scientists who clarified in a scientific manner the circumstances in which individuals could balance social accounts on their own and those in which government had to step in. As economist Robert Heilbroner wrote in 1992,
There is today widespread agreement, including among most socialist economists, that whatever form advanced societies may take in the twenty-first century, a market system of some kind will constitute their principal means of coordination. That is a remarkable turnabout from the situation only a generation ago, when the majority of economists believed that the future of economic coordination lay in a diminution of the scope of the market and an increase in some form of centralized planning. (page 75)
The thinkers responsible for this turnabout focused on how property rights, laws, and customs could serve as the medium through which individuals balanced social accounts in a Pareto-efficient manner. The point at which much of this reflection started was Pareto himself.
Enter Pareto
Every movement needs some kind of an apostle to give it a human face. A candidate for the apostle of this peace movement is an Italian railroad engineer who at the age of forty-five turned his interest to the social sciences where, according to Nobel Prize winning economist Henry Schultz, his range of interest embraced “… not only economics, but also sociology, history, mathematics, and other fields.” Among the founders of economics Pareto was not unique in the breadth of his interests or the seeming incongruity of his profession. John Stuart Mill was a civil servant for the East India Company and later a Member of Parliament. David Ricardo, the founder of trade theory, was a stock broker and also entered Parliament. Thomas Malthus began as an Anglican country curate, while Karl Marx alternated between journalism and political agitation, and William Stanley Jevons did an extended tour in Australia testing the quality of coinage for the mint. Schultz explains that those who read Pareto’s original writings
will be repaid a thousand fold, for they will then discover how incomplete and misleading is the discussion in most current texts of such fundamental subjects as utility, demand, marginal productivity, and maximum satisfaction, as compared with Pareto’s treatment of the same subjects. They will, in short, learn how classical economic theory has, chiefly through the labors of Walras and Pareto, been unified, amended, completed and surpassed. (page 740)
Schultz was writing in 1928 at a time when economists were just beginning to discover Pareto, and since then, Pareto’s reputation has continued its steady rise. Pareto might have been mortified to be called an apostle of anything, but might also have understood how the term might apply to him figuratively. What he might not have understood was the subsequent far-reaching application of a concept he developed in 1902 to settle an academic spat over the merits of free trade. In this debate with a young mathematician named Gaetano Scorza, Pareto was forced to come up with a definition of economic efficiency. For Pareto, an exchange of goods between two people was “improving” if it left at least one of the parties to the exchange better off and no one in society worse off. An exchange could go further and become Pareto-efficient if all parties concerned had exhausted all the potential “gains from trade.” Today, a Pareto-efficient exchange is taken to be the type of deal that once done, cannot be renegotiated in any way that would make one person better off without making at least one other worse off. Pareto-efficient exchanges squeeze the maximum out of what people can each profitably gain from agreeing to an exchange.
According to John Chipman, Pareto’s chief intellectual biographer and himself a prominent mathematical economist, the debate with Scorza on economic efficiency passed into obscurity, as most such arguments do. It was not until the 1920s that economists rediscovered the principle of efficiency that Pareto developed in 1902, and not until 1950 that it became widely acknowledged that Pareto was its originator, and while Pareto’s insight has spurred much new research, it is only now starting to become a part of the vocabulary of non-specialists. Perhaps economists are to blame for not advertising to a broader public what is one of the foundational ideas of their profession. The reason to market this idea is that it offers to the public several things everyone values: a sense of community, security, and even prosperity. A concept capable of doing this is worthy of attention.
The three pillars of Pareto efficiency
The French philosopher Pascal said that to understand a whole we need to start by understanding the parts. Pareto efficiency as a total concept is linked to prosperity, but before we can see why that is so, we need to examine what might be called the three pillars of Pareto efficiency. It is upon these pillars that prosperity rests.
The first pillar of Pareto efficiency is social mindedness. Societies geared towards generating Pareto efficiency have a strong impetus to short-circuit the conflict between individual and collective well-being. This is one of the first lessons we are taught as children. Do not butt ahead of others in line; do not leave a mess behind you. Children learn many such lessons in the long course of their socialization. The basis of the lessons is that the ego cannot expand without limit and that our limits are determined in part by the presence of others. Pareto efficiency embodies this basic childhood lesson explicitly. In a Pareto-efficient society, discussions about how to u
se resources tend to explore outcomes that benefit at least one, and perhaps all parties to the discussion, without hurting anyone. Pareto efficiency asks that the most extreme form of democracy underlie all decisions about property. A project must get a 100 percent vote of approval by all parties concerned, or the deal is off. Researchers working in the budding field of neuroeconomics, such as Paul Zak, believe that growing up in Pareto-efficient systems may not only moderate behaviour but may also shape the individual, enhancing his or her concern for others, thereby further enhancing Pareto efficiency, in a continuing “virtuous circle.” He writes that
Market exchange itself may lead to a society where individuals have stronger character values. The clearest evidence for this are the studies of fairness in small-scale societies conducted by Heinrich and his colleagues. They showed that the likelihood of making fair offers to a stranger in one’s society is more strongly predicted by the extent of trade in markets than any other factor they have found. Exchange is inherently other-regarding—both you and I must benefit if exchange is to occur. In this sense, exchange in markets is virtuous; one must consider not only one’s own needs but also the needs of another. (page xv)
The second pillar of Pareto efficiency is insurance against governments or any potentially rapacious force that would sacrifice some for the good of others. To understand this idea, take the opposite example of Marxists and their milder cousins, the socialists. Marxists were comfortable eliminating dominant economic classes for “the greater good.” Socialists accepted that the rich could be made to suffer in order to help the poor and that the rights of individuals could be trampled in order to favour certain groups, as is the case in the closed-shop union, where workers are forced to join the union and obey its rules in order to obtain employment. Marxist regimes, and to a lesser degree socialist systems of the mid-20th century, made no apology for their concentration camps, mass sterilizations, one-child policies, and family-wrecking expropriations of farms, all done in the name of “the people.” Decisions about human gain and loss were the stated business of such regimes. Today’s more benign versions of these movements have dialed down the rhetoric of violence but still accept a calculus that trades the well-being of some against that of others.