by Filip Palda
Coase, Ronald H. (1960). “The Problem of Social Cost.” Journal of Law and Economics. 3: 1–44.
Keegan, John. The Mask of Command. Penguin Books. 1987.
Pigou, Arthur C. The Economics of Welfare. First edition 1920. Fourth Edition 1932. Palgrave MacMillan. 2013 Kindle Reprint.
Polanyi, Karl. The Livelihood of Man. Edited by Harry W. Pearson. The Academic Press, 1977.
Stigler, George G. (1971). “The Theory of Economic Regulation.” The Bell Journal of Economics and Management Science. 2:3-21.
Temin, Peter (2006). “The Economy of the Early Roman Empire.” Journal of Economic Perspectives. 20:133–151.
Regulation
THE PREVIOUS CHAPTER DESCRIBED AN intellectual spat between Ronald Coase and Arthur Pigou. Coase thought that Pigou was too fond of prescribing government action whenever markets seemed to fail. Governments too could fail. You had to compare private with public transactions costs.
Coase started from the remarkable premise that pollution or any other harmful by-product of commerce was an opportunity for the mutual enrichment of both the polluter and the polluted. Acid vapors that poisoned a farmer’s crops were not to be mourned but rather to be celebrated. If the pollution rights resided with the farmer then he could charge the firm the costs of destroyed crops. The firm would adjust pollution-inducing production to the point where the added cost from the fine to be paid just exceeded the added profit from extra output of its poisonous by-product. Both firm and farmers exhausted the gains from trade to polluting by exchanging cash compensation for the permission to pollute to the point where the value of extra production no longer exceed the value of destroyed crops. Even without clear property rights it was possible for efficiency maximizing deals to be made. Here was Pareto-efficiency in action, but on a different stage than that envisaged by classical economic thinking which took for granted both bargaining and the institutions which were responsible it.
Coase though was not an apologist for free markets. He acknowledged that his argument for letting the private market take care of harmful “externalities” fell flat if the costs of bargaining, also known as transactions costs, between polluter and polluted were so large that no deal was done. In that case pollution would be excessive and a potential increase in societal wealth from reducing pollution would go unrealized.
Yet the failure of the market to guide people towards mutually beneficial outcomes did not imply that government would be able to do a better job. Governments also faced transactions costs. They needed to invest resources in weighing the claims of both parties. They also had to spend money to ensure that the government will was done. If you accepted Coase’s view that transactions costs determined whether Pareto-efficient outcomes could be realized then you could imagine that society would spend resources to devise “institutions” to bring down these costs. Research companies would invent measuring devices allowing farmers to determine the precise level of pollution on their land. An industry in mediation would crop up to spare all parties needless costs of litigation.
Understanding that there was a link between transactions costs and private institutional structure was the “aha” moment that rippled through the orthodox mode of economic thinking developed at the University of Chicago in the late 1950’s. Yet few appreciated that this thinking carried over to government.
A decade passed.
Then George Stigler started pushing Coasian reasoning to a new limit. He wanted to show that government power was skewed towards redistributing wealth towards groups in society whose political transactions costs were systematically lower than those of other groups. He also believed that this asymmetry in organizational advantage could be countered by revisions to the way in which power was distributed between different levels of government. That was pure Coasian thinking in action: tracing the line from transactions costs to institutional structure and divining what sorts of investments people would make to lower those transactions costs. His paper failed to close some loops that would have made of it a complete theory of power, but it contained almost all the ingredients necessary for his followers to finish the job.
Our job in this chapter is to clarify the Stigler-Coase view of government. We will have to wait until the next chapter to witness the complete theory. This chapter serves the same sort of function for the total theory of power that the hadiths serve in comprehending the Koran and that Christian critical scholarship serves in understanding the meaning of New Testament. Both Koran and Bible would seem remote and nearly incomprehensible if viewed solely from their foundational texts. The background to understanding the total theory of power needs to be painted here in a similar manner.
First we will ask the seemingly simple question “what is government?” What Stigler had in mind as government is quite different from what most people have in mind. He believed government was strictly a medium through which interest groups contest the control of resources in society. We will see that this view is not wrong, but also risks being overbroad. We will then see that he took the intellectual gamble of being overbroad in his interpretation of government in order to tease out the fundamental features of all governments, be they democratic or dictatorial. Then we will outline how economists thought about government before Stigler came along. We need to do so because much of Stigler’s thinking is in reaction to the previous economic orthodoxy on the subject. Stigler’s theory has a so-called “positive” aspect, which means that it seeks to understand how transactions costs between interest groups determine the use of power. But the theory also hints at conclusions about the Pareto-efficiency of governments that closely resemble the “normative” way of thinking about the role of government in society.
What is government?
ANY THEORY OF power needs to talk about government. However by the late 20th century scholars from an intellectual school, known today as public choice, began to speak of collective action and choices rather than speaking of government. The reasons are not clear but perhaps they felt discomfort at the ambiguity of the term. This is certainly the theme of Peter Leeson’s work on Caribbean pirates. Were they private entrepreneurs in theft, with warehouses, stockyards, and international agreements on the distribution of their stolen goods? Or were they proto-governments with leaders, cabinets, elections? A way of thinking about pirates is as a group of people confronted with challenges that affected them all in a similar manner. Since the threat was collective, one could expect that an efficient response would also emanate from the group.
No matter what the historical period nor the type of collective enterprise being discussed, the defining feature of all collective decisions is that ultimately they rely on mechanisms of enforcement and discernment. Enforcement deals with shirkers, dissimulators, thieves, and other non-conforming parties to an agreement who must be kept in check lest all come to naught. Economists call such people “free riders”. When their numbers reach a critical level even normally obedient people decide to lessen their efforts. Brave soldiers are the stuff of myth but they still keep an eye on the ranks to see if desertions are so high that it no longer makes sense to keep one’s place in formation. In democracies governments must deal with citizens who cheat on their income tax.
Discernment deals with the problem of knowing what people in the collective wish to achieve. There is rarely a unanimous opinion on all proposed actions. This is seldom a problem for private firms because employees are chosen for their commitment to making money. Those who enforce collective action can forcibly extract money from some to give it to others. People will be tempted to exaggerate their needs. Others will protest. Some will simply try to use the power of government to grab resources from others.
Thus all collective forms of action face transactions costs. Keeping shirkers and tax evaders in line is a costly business. Knowing what your public desires calls for the aid of experts in opinion formation and measurement. These costs in turn determine the form that collective institutions will take. As one can see, by going b
eyond the simple use of the word “government” one can being to see how Coasian theory may be applied to problems of a collective nature.
A mixed bag
THE JUMP FROM Coasian analysis of private markets to its application in collective action is exhilarating but lands one in a muddied pond. Collective action requires both a means of determining objectives and rousing people to attain them. Unlike in private markets, where no agreement takes place without unanimous consent, collective action, or politics if you will, may deal with opposing interests resolved through the application of force. It also deals with people who share a common interest but who cannot realize it through private agreement. They turn to some collective enforcement mechanism, perhaps government, to impose a coordinated solution in everyone’s favor. It is no wonder then that understanding how governments function is harder than understanding how private markets function. In markets, individuals cluster in self-satisfying groups with common goals and beliefs. In politics people may either be unable to cluster to realize a common objective or they may actively exercise force upon each other to nab resources belonging to others.
Yet out of this muddle of mixed-motives some clarity has emerged over the last two thousand years. Cicero distinguished between public interest groups (partes) and groups seeking their private interests (factiones). Political science taught these practical, descriptive distinctions in first year classes. As we shall see, Stigler viewed these classifications as a physicist might view subatomic particles fused into a larger atom. Stigler thought of power as an extractive relationship between atoms of political interest. Each subatomic unit might follow its own rules, but when fused to others it produced an entity that engendered quite a different theory of power than earlier thinkers had imagined.
The orthodox economic view of government
STIGLER’S EFFORT TO think of political power as the result of transactions costs influencing the formation of interest groups was like a strange animal rooting at the fringes of established economic thinking about government.
The mainstream economist’s thinking about government intervention held that government was an instrument for correcting malfunctions in the private sector. The theory on how to correct these blips was there. All that needed to be done was for enlightened leaders to apply it. This theory of interventionism had begun with Pigou in the 1920’s. He argued that externalities such as pollution could be corrected through a tax or subsidy to bring the market back to a Pareto efficient state. In the 1930’s John Hicks and Nicholas Kaldor went a step further to argue that governments could simulate the private market not just in correcting aberrant prices but also in funding projects in the public interest that for some reason the private market failed to take up. A public road might help some and hurt others but on balance be good for society. Provided the benefit, as measured by the willingness of beneficiaries to pay, exceeded the costs, there would exist a surplus from which losers could be compensated. The process was different from that of a private market but the result would closely resemble the attainment of Pareto-efficiency.
These compensating payments sounded suspiciously like Coasian bargains being struck. This sort of linkage between Pigovian interventionist thinking and Coasian decentralized market reasoning was a long way from being understood. What seemed to be understood was that government could attain Pareto-efficiency through coercion. Here was a truly original thought. Free market thinkers had believed they had a monopoly on Pareto-efficiency. Cost-benefit analysis revealed such thinking to be incomplete. Provided government could provide its coercive services at the same administrative cost as the cost of striking Coasian deals then maximum efficiency would be attained.
The final posts in the Pigouvian edifice were erected by Paul Samuelson and Arnold Harberger in the 1950’s. Samuelson showed that markets could also fail by not providing an exotic product he called a public good. It was a gargantuan lapse in the ability of private individuals to roust themselves in public projects benefitting all. Harberger showed that government intervention through taxes created its own special cost known as a deadweight loss. Here was the other side of the ledger. After these architectonic contributions most attention settled on the practical manner in determining how much people were willing to pay for goods which were not transacted in any market. The trick was to infer from closely related private markets the “shadow prices” required for to see if a project was going to be in the black.
Cost-benefit analysis was thus born out of the need to correct market failures. This is simply jargon for prescribing government coercion as a means of mobilizing people to work in their own interests. Cost-benefit analysis held that coercion was the answer to the lack of coordination that was leading to a breakdown of mutually beneficial cooperation. For some reason private institutions were not getting the job done and supposedly government had inferior costs of mobilizing resources and determining what was needed for the public.
Few in the public today understand the lasting legacy of the cost-benefit program for government intervention in the economy. Keynes gets most of the attention as the high priest for dirigisme. Certainly his followers believed that to have been his inclination. But Keynes was a uniquely British intellect upon which labels attached themselves awkwardly. He seemed to some a socialist, to others a conservative. Whatever he was is less easily classified than what he believed. He believed in a government response to social problems that could in part be guided by theory but should also be restrained by the wise counsel of cautious gentlemen such as himself. He had no formal program for government intervention. For that you needed a theory of value. Keynes was perhaps too pragmatic to think he could come up with such a thing. I base these statements on my reading of Keynes’ celebrated critique of econometrics as practised by Tinbergen who was one of his admirers. The critique is statistically astute and full of common sense reasoning. It is no way endorses the full scale Tinbergen program of government intervention based on econometric policy evaluation that was to dominate economic policy until the late 1970’s. Milton Friedman also gave a televised interview in which he lamented that it was a tragedy that Keynes had died so young. For had he lived, Friedman ruminated, he would have checked the excesses to which his followers pushed his theories.
Cost-benefit economists had no such reticence about government intervention. Their theory of value was based on market economics and a mastery of sophisticated mathematical tools used to calculate the degree of government intervention necessary. Supply and demand were the basic tools of social accounting in the modern world. When markets failed to coordinate people into exhausting all the possible gains from exchange, then a government schooled in the social accounts of supply and demand could set markets right through corrective taxes, subsidies, or outright building programs that coerced people into cooperating with each other in their own interests.
First of the realists
THE PIGOU-HICKS-KALDOR-SAMUELSON-HARBERGER PARADIGM was so powerful and radiated so naturally over all economics that cost-benefit analysis took on the mantle of a “settled science”. Economists fully believed their own propaganda about the need for government intervention to restore Pareto-efficiency when markets fail.
They seemed unaware of the Darwinian economic ecology into which they were seeding their ideas. By potentially confusing what ought to be with what actually was, economic advisors could facilitate the very outcomes they sought to prevent.
George Stigler was among the first to point out the dangers of naïve economic policy advice. In 1971 he wrote in his article on regulation “Until the basic logic of political life is developed, reformers will be ill-equipped to use the state for their reforms, and victims of the pervasive use of the state’s support of special groups will be helpless to protect themselves. Economists should quickly establish the license to practice on the rational theory of political behavior.”
The economists behind cost-benefit analysis had never thought to take out such a license. Doing so would have led th
em down from the cool esthetic peaks of the differential calculus, upon which Hicks-Kaldor theory was based, to the Coasian lowlands where intuition and a certain form of economic street-smarts reigned. On these streets one compared the costs of different institutional structures to understand how any kind of institution, private, or government, took shape.
To fully understand the contrast in thinking between cost-benefit analysis and Coasian institutional logic, one must mind the tension between idealism and realism. Cost-benefit analysis dealt with what ought to be. The existence of an “ought” implies the existence of an unrealized opportunity. Markets could fail to create wealth that was evidently there for the taking. Governments could pick up what Mancur Olsen famously called “big bills left on the sidewalk”, simply by bending over. Coasians admitted that government intervention might be required when markets failed. Markets fail when private agents are unable to coordinate their activities to realize some mutual advantage. The costs of transacting deals that benefits everyone are too high. Yet Coasians warned that governments as well as private markets also faces costs of coordination. Pressure groups interact with politicians to determine how public needs shall be met. Such a complex process of reaching agreement takes effort, negotiation, and in other words cost.
Are these institutional costs low enough to justify the benefits from intervention? That question was never posed in cost-benefit analysis. A Panglossian view of government prevailed. Cost-benefit analysis ignored the processes by which public demands shape policy. This amounted to treating government intervention in the public interest as a free good. Here was a claim worthy of being challenged.
Government as a wealth-grab