Naked Economics

by Wheelan, Charles

  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.

  Government need not run steel mills or parcel out bank loans to meddle in the economy. The more subtle and pervasive kind of government involvement is regulation. Markets work because resources flow to where they are valued most. Government regulation inherently interferes with that process. In the world painted by economics textbooks, entrepreneurs cross the road to earn higher profits. In the real world, government officials stand by the road and demand a toll, if they don’t block the crossing entirely. The entrepreneurial firm may have to obtain a license to cross the road, or have its vehicle emissions tested by the Department of Transportation as it crosses the road, or prove to the INS that the workers crossing the road are U.S. citizens. Some of these regulations may make us better off. It’s good to have government officials blocking the road when the “entrepreneur” is carrying seven kilos of cocaine. But every single regulation carries a cost, too.

  Milton Friedman, who was a delightful writer and an articulate spokesman for a less intrusive government (and a far more subtle thinker than many of the writers who haunt the op-ed pages these days purporting to have inherited his mantle), makes this point in Capitalism and Freedom by recounting an exchange between an economist and a representative of the American Bar Association at a large meeting of lawyers.4 The economist was arguing before the group that admission to the bar should be less restrictive. Allowing more lawyers to practice, including those who might not be the sharpest knives in the drawer, would lower the cost of legal services, he argued. After all, some legal procedures, such as basic wills and real estate closings, do not require the services of a brilliant Constitutional scholar. He argued by analogy that it would be absurd for the government to require that all automobiles be Cadillacs. At that point, a lawyer in the audience rose and said, “The country cannot afford anything but Cadillac lawyers!”

  In fact, demanding only “Cadillac lawyers” completely misses all that economics seeks to teach us about trade-offs (for reasons that have nothing to do with the fact that General Motors is a basket case). In a world with only Cadillacs, most people would not be able to afford any transportation at all. Sometimes there is nothing wrong with allowing people to drive Toyota Corollas.

  For a striking international example of the effects of regulation on the economy, consider the civil unrest in 2000 in Delhi, India.5 Delhi is one of the most polluted cities in the world. After the Su
preme Court of India made a major decision regarding industrial pollution, thousands of Delhi residents took to the streets in violent protest. “Mobs torched buses, threw stones, and blocked major roads,” the New York Times reported. Here is the twist: The protesters were supporting the polluters. The Supreme Court held the city of Delhi in contempt for failing to close some ninety thousand small factories that pollute the area. Those factories employed roughly a million people who would be thrown out of work. The headline on the story nicely encapsulated the trade-off: “A Cruel Choice in New Delhi: Jobs vs. a Safer Environment.”

  How about DDT, one of the nastier chemicals mankind has unleashed on the environment? DDT is a “persistent organic pollutant” that works its way into and up the food chain, wreaking havoc along the way. Should this noxious pesticide be banned from the planet? The Economist has made a convincing argument that it should not.6 Much of the developing world is ravaged by malaria; some 300 million people suffer from the disease every year and more than a million die. (Of course, malaria is not a disease that we are particularly sensitive to in the developed world, since it was eradicated in North America and Europe fifty years ago. Tanzanian researcher Wen Kilama once famously pointed out that if seven Boeing 747s, mostly filled with children, crashed into Mt. Kilimanjaro every day, then the world would take notice. That is the scale on which malaria kills its victims.)7

  Harvard economist Jeffrey Sachs has estimated that sub-Saharan Africa would be almost a third richer today if malaria had been eradicated in 1965. Now, back to DDT, which is the most cost-effective way of controlling the mosquitoes that spread the disease. The next best alternative is not only less effective but also four times as expensive. Do the health benefits of DDT justify its environmental costs?

  Yes, argue some groups—like the Sierra Club, the Endangered Wildlife Trust, Environmental Defense Fund, and the World Health Organization. Yes, you read those names correctly. They have all embraced DDT as a “useful poison” for fighting malaria in poor countries. When the United Nations convened representatives from 120 countries in South Africa in 2000 to ban “persistent organic pollutants,” the delegates agreed to exempt DDT in situations where it is being used to fight malaria.8

  Meanwhile, not all regulations are created equal. The relevant question is not always whether or not government should involve itself in the economy; the more important issue may be how the subsequent regulation is structured. University of Chicago economist and Nobel laureate Gary Becker spends his summers on Cape Cod, where he is a fond consumer of striped bass.9 Because the stocks of this fish are dwindling, the government has imposed a limit on the total commercial catch of striped bass allowed every season. Mr. Becker has no problem with that; he would like to be able to eat striped bass ten years from now, too.

  Instead, he raised the issue in a column for Business Week about how the government chose to limit the total catch. At the time he was writing, the government had imposed an aggregate quota on the quantity of striped bass that could be harvested every season. Mr. Becker wrote, “Unfortunately, this is a very poor way to control fishing because it encourages each fishing boat to catch as much as it can early in the season, before other boats bring in enough fish to reach the aggregate quota that applies to all of them.” Everybody loses: The fishermen get low prices for their fish when they sell into a glut early in the season; then, after the aggregate quota is reached early in the season, consumers are unable to get any striped bass at all. Several years later, Massachusetts did change its system so that the striped bass quota is divided among individual fishermen; the total catch is still limited but individual fishermen can fulfill their quota anytime during the season.

  The key to thinking like an economist is recognizing the trade-offs inherent to fiddling with markets. Regulation can disrupt the movement of capital and labor, raise the cost of goods and services, inhibit innovation, and otherwise shackle the economy (such as by letting mosquitoes escape alive). And that is just the regulation inspired by good intentions. At worst, regulation can become a powerful tool for self-interest as firms work the political system to their own benefit. After all, if you can’t beat your competitors, then why not have the government hobble them for you? University of Chicago economist George Stigler won the Nobel Prize in Economics in 1982 for his trenchant observation and supporting evidence that firms and professional associations often seek regulation as a way of advancing their own interests.

  Consider a regulatory campaign that took place in my home state of Illinois. The state legislature was being pressured to enact more stringent licensing requirements for manicurists. Was this a grassroots lobbying campaign being waged by the victims of pedicures gone terribly awry? (One can just imagine them limping in pain up the capital steps.) Not exactly. The lobbying was being done by the Illinois Cosmetology Association on behalf of established spas and salons that would rather not compete with a slew of immigrant upstarts. The number of nail salons grew 23 percent in just one year in the late 1990s, with discount salons offering manicures for as little as $6, compared to $25 in a full-service salon. Stricter licensing requirements—which almost always exempt existing service providers—would have limited this fierce competition by making it more expensive to open a new salon.

  Milton Friedman has pointed out that the same thing happened on a wider scale in the 1930s. After Hitler came to power in 1933, large numbers of professionals fled Germany and Austria for the United States. In response, many professions erected barriers such as “good citizenship” requirements and language exams that had a tenuous connection to the quality of service provided. Friedman pointed out that the number of foreign-trained physicians licensed to practice in the United States in the five years after 1933 was the same as in the five years before—which would have been highly unlikely if licensing requirements existed only to screen out incompetent doctors but quite likely if the licensing requirements were used to ration the number of foreign doctors allowed into the profession.

  By global standards, the United States has a relatively lightly regulated economy (though try making that argument at a Chamber of Commerce meeting). Indeed, one sad irony of the developing world is that governments fail in their most basic tasks, such as defining property rights and enforcing the law, while piling on other kinds of heavy-handed regulation. In theory, this kind of regulation could protect consumers from fraud, improve public health, or safeguard the environment. On the other hand, economists have asked whether this kind of regulation is less of a “helping hand” for society and more of a “grabbing hand” for corrupt bureaucrats whose opportunities to extort bribes rise along with the number of government permits and licenses required for any endeavor.

  A group of economists studied the “helping hand” versus “grabbing hand” question by examining the procedures, costs, and expected delays associated with starting up a new business in seventy-five different countries.10 The range was extraordinary. Registering and licensing a business in Canada requires a mere two procedures compared to twenty in Bolivia. The time required to open a new business legally ranges from two days, again in Canada, to six months in Mozambique. The cost of jumping through these assorted government hoops ranges from 0.4 percent of per capita GDP in New Zealand to 260 percent of per capita GDP in Bolivia. The study found that in poor countries like Vietnam, Mozambique, Egypt, and Bolivia an entrepreneur has to give up an amount equal to one to two times his annual salary (not counting bribes and the opportunity cost of his time) just to get a new business licensed.

  So are consumers safer and healthier in countries like Mozambique than they are in Canada or New Zealand? No. The authors find that compliance with international quality standards is lower in countries with more regulation. Nor does this government red tape appear to reduce pollution or raise health levels. Meanwhile, excessive regulation pushes entrepreneurs into the underground economy, where there is no regulation at all. It is hardest to open a new business in countries where corruption is highest, suggestin
g that excessive regulation is a potential source of income for the bureaucrats who enforce it.

  India has over a billion people, many of whom are desperately poor. Education has clearly played a role in moving the nation’s economy forward and lifting millions of citizens out of poverty. Higher education in particular has contributed to the creation and expansion of a vibrant information technology sector; however, a recent shortage of skilled workers has been a drag on economic growth. So it’s no great economic conundrum as to why a pharmaceutical college in Mumbai would seek to use empty space in its eight-story building to double student enrollment.

  The problem is that this action turned the college administration into criminals. It’s true—the Indian government imposes strict regulations on its technical colleges that protect against something as reckless and potentially dangerous as using empty space to educate more students. Specifically, the law stipulates that a technical college must provide 168 square feet of building space for each student (to ensure adequate space for learning). That formula precludes the Principal K. M. Kundnani College of Pharmacy from teaching more than 300 students—regardless of the fact that all the lecture halls on the top floor of the building are padlocked for lack of use.

  According to the Wall Street Journal, “The rules also stipulate the exact size for libraries and administrative offices, the ratio of professors to assistant professors and lecturers, quotas for student enrollment and the number of computer terminals, books and journals that must be on site.”11

  Thankfully, governments sometimes roll back these kinds of regulation. In November 2008, the European Union acted boldly to legalize…ugly fruits and vegetables. Prior to that time, supermarkets across Europe were forbidden from selling “overly curved, extra knobbly or oddly shaped” produce. This was a true act of political courage by European Union authorities, given that representatives from sixteen of the twenty-seven member nations tried to block the deregulation while it was being considered by the EU Agricultural Management Committee.12