Retracing Our Steps
America’s problems may seem insoluble today, but that’s mainly because the United States has gotten out of the practice of true social reform and problem solving. Once we start to diagnose our real ills and chart a course to solve them, practical problem solving will prove to be realistic after all. Despite all the challenges—budget deficits, financial scandals, lack of proper public education, corporate lying, impunity, antiscientific propaganda, and more—the U.S. economy remains highly productive and innovative. Even with the steep downturn after the 2008 crash, the average per capita income is around $50,000 per person, still the highest in the world in a large economy. There is no overall shortage of goods and services to go around. There is no deathly squeeze on food supplies, water, energy, or health care systems. There is a continued outpouring of new products.
Our challenges lie not so much in our productivity, technology, or natural resources but in our ability to cooperate on an honest basis. Can we make the political system work to solve a growing list of problems? Can we take our attention away from short-run desires long enough to focus on the future? Will the super-rich finally own up to their responsibilities to the rest of society? These are questions about our attitudes, emotions, and openness to collective actions more than about the death of productivity or the depletion of resources.
In the following chapters, we will retrace our steps as a nation. How did the world’s leading economy reach such a position of despair, and apparently in such a short period of time? We will diagnose America’s ills by studying four dimensions of the American crisis: economic (chapters 3 and 6), political (chapters 4 and 7), social (chapter 5), and psychological (chapter 8). By taking the economic, political, social, and psychological facets together, we can piece together an understanding of how America went from decades of consensus and high achievement to an era of deep division and growing crisis. That story will enable us to look forward toward solutions.
CHAPTER 3.
The Free-Market Fallacy
After decades of global economic leadership, America began in the 1980s to forget the basic lessons of economics, parroting slogans (typically about the wonders of the free market) while neglecting the art of economic policy. One of the most basic and important ideas of economics—that business and government have complementary roles as part of a “mixed economy”—has been increasingly ignored, to my amazement and consternation. This chapter aims to help make up the lost ground.
In this chapter I discuss the three main aims of an economy—efficiency, fairness, and sustainability—and show that the government must play an active and creative role alongside the private market economy to enable society to achieve them.
The Age of Paul Samuelson
Fortunately for me, I was well educated in the merits of the mixed economy during my student years (1972–1980), by intellectual giants who had done much to guide America’s economy after World War II. The era of economic thought from the 1940s to the 1970s can be called the Age of Paul Samuelson, the economic genius at MIT who personified the economics profession during the heyday of America’s global leadership. More than any other economist of his time, Samuelson provided the intellectual underpinnings of the modern mixed economy created in the United States and Europe after the Second World War.
As a freshman at Harvard College, I studied from Samuelson’s famed introductory textbook and his Newsweek columns, began a lifetime of reading his seemingly endless series of pathbreaking papers, heard wonderful stories about his scintillating intellect, and was able to attend his lectures or watch him in action at economics conferences. He was the undisputed doyen of American economic science and the first American winner of the Nobel Prize in Economic Sciences. He was also unfailingly kind and supportive to me as an aspiring young economist, as he was to generations of students.
His lifetime of remarkable scholarly output both established and epitomized five core ideas of modern mixed capitalism, which my fellow students and I imbibed in our introduction to economics:
Markets are reasonably efficient institutions for allocating society’s scarce economic resources and lead to high productivity and average living standards.
Efficiency, however, does not guarantee fairness (or “justice”) in the allocation of incomes.
Fairness requires the government to redistribute income among the citizenry, especially from the richest members of the society to the poorest and most vulnerable members.
Markets systematically underprovide certain “public goods,” such as infrastructure, environmental regulation, education, and scientific research, whose adequate supply depends on the government.
The market economy is prone to financial instability, which can be alleviated through active government policies, including financial regulation and well-directed monetary and fiscal policies.
Samuelson’s great synthesis called on market forces to allocate most goods in the economy, while calling on governments to perform three essential tasks: redistributing income to protect the poor and the unlucky; providing public goods such as infrastructure and scientific research; and stabilizing the macroeconomy. This approach appealed enormously to me as a young student of economics and helped me understand the complementary responsibilities of the market and the government. I found the concept of the mixed economy to be compelling, and I still do after forty years.
The ideas of Samuelson and his great contemporaries, including Nobel Laureates James Tobin, Robert Solow, and Kenneth Arrow, did not arise from pure theorizing. Many aspects of the mixed economy were put into place during the New Deal, World War II, and the early postwar period. Pure theory helped those great economists account for what they observed in the economy, and their ideas, in turn, shaped further economic policies. Ideas and history thereby interacted in a dialectical process. Pivotal historical experiences such as the Great Depression and World War II guide economic theory, while economic theory helps to shape the next steps of history. This is the great drama and thrill of economics: with a deeper understanding of events comes the chance to help the world on its historic arc toward greater well-being.
Intellectual Upheaval in the 1970s
Little did I realize in my student days that a huge intellectual storm was about to hit the field of economics: the consensus over the mixed economy was about to be jolted. In 1971, the year before I entered college, the Bretton Woods dollar-exchange system collapsed, basically because America’s inflationary monetary and budget policies during the Vietnam War era were destabilizing the world economy. The United States abandoned its monetary links with gold on August 15, 1971. Inflation soared worldwide as the major market economies searched for a new approach to the global monetary system. The situation was further complicated when the oil-exporting countries sharply raised oil prices in the midst of the global inflation. The surge of oil prices during 1973–1974 led to the combination of economic stagnation and inflation, christened the “Great Stagflation.” The subject of stagflation became a major focus of my own early research.1
The crisis of the world economy during the 1970s proved to be a decisive break in U.S. economic and political governance. The optimism concerning the mixed economy was assailed. Within academia Samuelson’s synthesis of market and government was under heated attack. Economics as an academic discipline was turned on its head by the ascendancy of a new school of thought led by Milton Friedman and Friedrich Hayek, one that deemphasized the mixed economy and played up the functioning of the market system. Though Friedman and Hayek were definitely not free-market zealots, as they supported a clear but limited role of government, they also expressed greatly increased skepticism about the role of government in the economy.
My preparatory economics education ended in 1980 with my PhD. I had entered Harvard as a freshman in 1972 during the Age of Paul Samuelson and joined the Harvard faculty as an assistant professor in the fall of 1980 at the start of the Age of Milton Friedman. That year, Ronald Reagan won the presidency on a
platform of rolling back the role of government. Across the Atlantic, the United Kingdom’s new prime minister, Margaret Thatcher, stood for the same. Together, Reagan and Thatcher launched a rollback of government the likes of which had not been seen in decades. Many of the measures of the Reagan presidency, notably the sharp cut in the top tax rates and the deregulation of industry, won support throughout the economics profession and the society.
The main effect of the Reagan Revolution, however, was not the specific policies but a new antipathy to the role of government, a new disdain for the poor who depended on government for income support, and a new invitation to the rich to shed their moral responsibilities to the rest of society. Reagan helped plant the notion that society could benefit most not by insisting on the civic virtue of the wealthy, but by cutting their tax rates and thereby unleashing their entrepreneurial zeal. Whether such entrepreneurial zeal was released is debatable, but there is little doubt that a lot of pent-up greed was released, greed that infected the political system and that still haunts America today.
The Case for a Mixed Economy
We need to understand precisely where the free-market ideology goes awry. A good starting point is the most basic functioning of the market economy, notably the law of supply and demand. It is when supply and demand stop functioning effectively that government must step forward.
In a competitive market, where there are large numbers of potential suppliers and consumers, the price of each good and service adjusts to balance the supply and demand. If at the current price firms want to supply more than is demanded by consumers, the price will decline, leading firms to cut back on their supplies and consumers to step up their purchases; if at the current price firms want to supply less than is demanded by consumers, the market price will rise, leading firms to increase their supplies and consumers to trim their purchases. When the balance of supply and demand is reached for each and every good or service, we say that the economy has reached “market equilibrium.”
The key idea of Adam Smith, the late-eighteenth-century founder of economic science, is that the market equilibrium is reached without a central planner and that it has desirable results for the nation, notably in the forms of high productivity and wealth. With every firm and household pursuing its own self-interest, the resulting market equilibrium can almost miraculously lead to the well-being of all. Smith gave a famous and enduring name to the process by which the individual actions of millions of individuals and firms combine for the common good: the “invisible hand,” encapsulating the paradox that self-interest in the marketplace can lead to the common good. As Smith famously declared:
It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages [in supplying what we demand as consumers].2
In modern scientific terms, the invisible hand of the marketplace is called a self-organizing system. The idea is that a highly complex and productive system can create an orderly division of labor—and a benefit for the entire population—through the self-interested actions of the individual actors of the system. There is thus no need for a central power to move the society’s resources here and there.
Smith brilliantly recognized that the self-organized market equilibrium is likely to result in a high level of productivity and therefore a high level of income and wealth of the population. In modern jargon, we say that the competitive market equilibrium is efficient, meaning that there is no waste of resources.3 Well-functioning markets squeeze out waste in the use of resources. A wasteful firm is outcompeted by a more efficient, lower-cost firm. An artificial scarcity created by one business is undone by the entry of a competitor. And so on throughout the economy, until waste is squeezed from the system.
Why Markets Need Government
Unfortunately, free markets by themselves are not able to ensure the efficiency of the economy. Governments are needed to provide certain public goods, such as highways, that markets by themselves will either not provide or not provide to the right scale. Private markets work well when there are many suppliers and consumers, as is the case for goods and services such as clothing, furniture, automobiles, hotel services, restaurants, and the like. They begin to misfire when economic logic calls for a single supplier, for example to operate the police force, fire department, army, court system, highway network, or electricity distribution system.
In such cases, society basically needs just one supplier or at most a very small number, rather than many. We don’t want competing armies or competing police and fire departments in our cities. Similarly, we need just one highway and power line from city A to city B, not several competing highways each offering the same route.
Free markets also fail when producers cause adverse spillovers to the rest of society, such as by polluting the rivers with toxic chemicals or emitting climate-changing carbon dioxide into the air from a coal-fired power plant. In such cases, the private economy tends to oversupply the goods in question, unless there are specific regulations or levies imposed on the offending actions. We say that the market needs “corrective pricing,” such as a tax levied on the pollutant, in order to reduce negative spillovers.
Private markets fall short in the case of scientific research as well, where spillovers of knowledge occur. Scientists don’t—and shouldn’t—own the rights to their basic scientific discoveries. Imagine if Isaac Newton’s estate held a patent or copyright on the gravity equation. The implication is that one of humanity’s most important activities—scientific discovery—needs to be promoted in ways other than the pure profit motive. This is done through status (such as receipt of the Nobel Prize), financial support from philanthropists, government grants (for example, through the National Science Foundation and the National Institutes of Health), government prizes, and other nonbusiness approaches (such as volunteer work and open-source creations such as Linux and Wikipedia).
Free markets also need governments to help regulate the marketplace when information between buyers and sellers is “asymmetric.” When sellers have inside information unavailable to buyers, fraud and waste are rife. In the lead-up to the 2008 financial crash, for example, Wall Street sold toxic assets to unsuspecting German banks, thereby extending the bubble and increasing its ultimate cost. In a different sphere, some doctors increase their fees by prescribing medical tests and procedures that are not needed, while patients and insurers are unable to second-guess the medical advice. In both cases, the implication is the need for government regulation: of securities markets to prevent financial fraud and of health care insurers to prevent medical fraud.
It’s worth recalling that all great promoters of the market economy, including Adam Smith, John Maynard Keynes, Paul Samuelson, Friedrich Hayek, and Milton Friedman, were fully aware of the reality of public goods, environmental spillovers, and asymmetric information and therefore of the need for the government to be deeply engaged in public education, road building, scientific discovery, environmental protection, financial regulation, and many other activities. None ever denied a major role for government in a market system. That’s true not only of Keynes and Samuelson, who are famous for their championship of the mixed economy, but also of Hayek and Friedman, who are known for their advocacy of unfettered markets. It is only the present-day free-market acolytes of Hayek and Friedman who neglect the key role of government in ensuring the efficiency and fairness of a market system.
Hayek noted in The Road to Serfdom that we should not confuse the opposition to central planning with “a dogmatic laissez faire [free market] attitude.” The correct position, said Hayek, lies
in favor of making the best possible use of the forces of competition as a means of coordinating human efforts, not an argument for leaving things just as they are. It is based on conviction that, where effective competition can be created, it is a better way of g
uiding individual efforts than any other.… Nor does it deny that, where it is impossible to create the conditions necessary to make competition effective, we must resort to other methods of guiding economic activity.4 (Emphasis added.)
Hayek acknowledged, as had Adam Smith before him, “a wide and unquestioned field for state activity” in the economy. Indeed, Hayek reminds the reader of The Road to Serfdom that Adam Smith himself called on the government to provide those services that “though they may be in the highest degree advantageous to a great society, are, however, of such a nature, that the profit could never repay the expense to any individual or small number of individuals.”5 In other words, Hayek sides with Adam Smith in recognizing the importance of government provision of public goods.
Fairness and Sustainability
Though efficiency is a great virtue, it is not the only economic goal of interest to the society.6 Economic fairness is also crucial. Fairness refers to the distribution of income and well-being, as well as to the ways that government treats the citizenry (including fairness in levying taxes, awarding contracts, and distributing transfers).
Most people would regard as unfair a market equilibrium in which some individuals are super-rich while others are dying of extreme poverty. In such a circumstance, most people would regard it as fair (or “just” or “equitable”) for the government to tax the super-rich in order to provide basic resources for the poor such as food, shelter, safe water, and access to health care. Indeed, a solid 63 percent of Americans concur that “It is the responsibility of government to take care of people who can’t take care of themselves.”7 The sentiment that government should help the poor who cannot help themselves has been an enduring value in American society.
The Price of Civilization Page 3