An Airtight Rationale for Markets?

Offline someone remarks: "I remain very interested in learning more about an airtight rationale for market theory."

A few thoughts:

The law of supply and demand, or that people respond to incentives, is the basic market insight: all else is elaboration. But much of that elaboration is unexpected and surprising in its implications.

The economic theory of regulation, for instance, tells us that regulators will tend to prefer regulations that are simple to apply and that do not appear to be controversial (i.e. the cost of applying the regulations is low). This results in regulatory structures that are not identical to the public interest and, because these regulatory structures are made at the administrative level, beneath public debate, this propensity in the direction of regulation is usually invisible (see http://www.mercatus.org/pdf/materials/560.pdf for a great article on this).

Thus insofar as people judge proposed public policies based on the ostensible arguments made in public debates, those arguments fail to capture the fact that policies are almost never implemented in the manner originally debated. This application of economic theory is known as "public choice theory," or the theory of government failure, and it is a potentially devastating critique of most proposed legislation.

My understanding of public choice theory was the single factor most inclining me to simple rule-based market solutions rather than command-and-control government solutions. Ironically, many critics of capitalism point to the ways in which corporations corrupt government to promote their self-interest. The public choice theorists agree, and go one step farther: One can make confident social science predictions to the effect that corporations (or unions or environmental groups or any concentrated special interest) will be more effective at promoting their self-interest than are voters. Sometimes one hears the witticism "If one wants to keep one's appetite one should not observe the making of laws or sausages too closely." Public choice theorists have spent decades watching how legislation actually gets passed and implemented, and conclude that concentrated interests will always get their way, if not in the legislation then in the administration.

Scientific American and others argue that the FDA should be more independent in their reviews of drug policy. The public choice theorists look at such moral exhortation ("The FDA should . . . ") and see it as short-sighted naivete. Even if, due to a flurry of op-ed exhortation by Scientific American and others, the public forces the FDA to be more independent for a few months, over time the attention of the public and the pundits will go elsewhere. But the attention of the drug companies never, ever goes elsewhere. They have billions of dollars riding on FDA decisions and, as a consequence, they are very, very focused on what happens at the FDA and how. And, meanwhile, small innovators in health and medicine have absolutely no hope of getting an innovation through the costly FDA apparatus. This state of affairs is known as "regulatory capture," which means that the vested interests inevitably "capture" the regulatory apparatus in order to promote their own interests. And economists point out that the asymmetry of incentives is what makes this process inevitable: Inevitably the drug companies have an incentive to focus on legislation that is often millions of times greater than that faced by others. Complaints about "greed" are impotent to change this fact.

This is one of several arguments against the FDA.

But in the absence of the FDA, won't the drug companies do bad things like promote and sell thalidomide? Yes, sometimes they will, and mid-wives and doctors will make bad medical decisions that result in deaths, and the promoters of dietary supplements will encourage people to take remedies that result in death and disease, and spiritual gurus will promote quack cures for cancer, and so forth. The relevant question is not "Will bad things happen in the absence of the FDA?" The relevant question is, on net, will things be better or worse without the FDA?

Which leads me to another argument against the FDA, and for freedom: Regulatory agencies not only tend to protect vested interests, they also cause immense harms by preventing innovations. Most European countries make drugs available far more quickly and far more cheaply than does the FDA. Insofar as delays in availability of drugs mean that people die who, statistically speaking, probably would have lived, economists estimate that the FDA is responsible for far more than 50,000 deaths (http://www.fee.org/vnews.php?nid=4725).

In the absence of government regulation, bad things will happen. In the presence of government regulation, bad things will happen. The question is, on balance, under which circumstance is it more likely that more bad things will happen?

Moreover, it is important to remember that there are voluntary regulatory structures such as Consumer's Union that can fulfill the positive role of regulatory agencies without the negative consequences (the FEE article cited above explores this).

As someone who is an aggressive believer in the power of innovation, I suspect that we vastly underestimate the harms that exist due to the absence of opportunities to innovate. EBay is now one of the largest economies on earth, larger than many nations. It is also one of the most democratic economies on earth: anyone with a computer and an internet connection has instant access to this economy. Millions of women can now earn an extra income at home selling on EBay. And yet in France EBay was originally illegal because auctioneers were required to be licensed. Had this been the circumstance in the U.S., none of us would have received the immense benefits due to EBay.

I see this as a vignette for millions of amazing stillborn innovations that, had our government in the last 40-70 years been less regulatory, would now be making our society a much better place. As you know, first and foremost among these stillborn liberations in my view is the educational system that could have been had we not had the government system that has so damaged us for the last 70 years (the timing of the onslaught of universal government-controlled secondary education in the 1930s). The scale of benefits due to the cycle of creation, innovation, and entrepreneurship is unbelievably immense. In the absence of this cycle, life would still be nasty, brutish, and short for all of us. I am certain that if we had more freedom, life would be significantly less nasty, brutish, and short than it still is.

I wouldn't say that there is an "airtight rationale for market theory." I would say that once one understands the insights of public choice theory and regulatory capture, and how government intervention no matter how well-intentioned tends to support the status quo and tends to thwart innovation, if one also believes in the creative powers of innovators, then the relative advantages of government action begin to decrease and the relative prospective benefits due to markets increase. For me, especially as I have focused more and more on creative possibility, this imbalance has become immense.

Likewise, rather than spend a lot of time arguing for markets, I believe that if we simply cultivate and promote young creators and social innovators, they will demand freedom to do good. Arguing, the professional work of academics, tends to favor theoretical solutions to problems that appear to be constructive, but which fail to take into account human realities. Such was the tragedy of communism, the favorite political theory of intellectuals for 100 years.

Sometimes "free markets" are destructive. There have been straightforward problems with the ways in which markets have been structured in the past. If companies (or individuals) can get away with polluting at no cost, whereas it is costly to stop polluting, companies and individuals tend to pollute. The "market" solution is to find a way to include the cost of polluting in the calculations made by the companies (or individuals) so that they have an incentive to reduce the extent to which they pollute. This is a complex area, but the simple insight is that markets do need to be structured so that the costs of pollution are internalized and, where this is not the case, pollution is rampant. Ultimately FLOW supports a combination of engineers, lawyers, economists, and scientists working on creative solutions to internalize externalities. The outcome is more likely to be a combination of innovative property rights, innovations in liability and contract law, and innovations in science and engineering rather than traditional command-and-control regulation.

In obtaining an understanding of how we think about markets it is helpful to review a brief history of common understandings of markets:

1. In 1776 Adam Smith made the case that free markets bring wealth to society.

2. In the 19th century tremendous wealth was indeed created by markets, but many people recognized that there were nonetheless tremendous social problems despite this wealth creation. (Including the erroneous belief that in the 19th century the "rich got richer and the poor got poorer." In fact, throughout the industrial revolution the poor also got richer. It was because of the amazing novelty of a world-historical increase in wealth that the age-old discrepancy between rich and poor suddenly received the attention of social reformers on a widespread scale for the first time.)

3. Economists in the early 20th century developed a theory of market failure to explain why markets did not always make things better: Monopolies, the failure to provide public goods, externalities, and consumer irrationalities and short-sightedness were used to justify government interventions. In the meantime, many leading intellectuals were enthusiastic admirers of communism, and much of history, journalism, and academic research in the social sciences was written from a more-or-less communist-friendly perspective.

4. Economists in the late 20th century developed a theory of government failure to explain why government was not successful at solving the problems of markets. They also began developing an understanding of the pre-requisites to the successful functioning of markets to explain why in some cases markets worked well and in some cases they did not.

Because most of the history textbooks, journalism, and policy analysis that most of us learned from are relics of step 3 of this historical process above, part of the task of FLOW will be to disseminate the newer understandings of step 4. Indeed, most tenured professors in academia, outside of the field of economics, are still stuck in stage 3: They were educated in the 1970s when Step 4 was still being developed in specialist economics journals.

Step 4 is far from complete; we are still trying to understand and articulate exactly why markets work well in some circumstances and do not work well in others, as well as where and when and what kind of government actions might be successful, and how the media contributes to this cycle. But step 4 is most certainly a more mature and balanced perspective than we have had in the past.