In a response to a forwarded post, a friend made the following argument (I am putting only its essence and in my own words, since I have not taken permission to make it public)

Market forces can produce outcomes that are worse off for everyone in the system. A social planner can, (in some cases at least) improve on the efficiency of the market. Pigouvian tax is an example.

In his response, he acknowledges that it might be difficult in practice for the social planner to obtain all the information required, but says that it would be very surprising if the social planners actions could never lead to efficiency improvement.

Consider the crux of the argument (emphasized above). There are three aspects to it that should be considered.

1) What are market forces? They are an abstraction that refers to all the judgements made by individuals interacting with each other under some conditions. If one is talking of a free market, these conditions are the absence of any coercion. Note that for the concept of coercion to be clear, a system of property rights (at the very least) needs to be in place (More on this in 3). If one is to prove the statement above (in a mathematical sense, which is what my friend meant), these market forces need to be modeled. This leads to 2.

2) How are choices evaluated? In actuality, every individual evaluates and weighs choices in a unique manner depending on the context of his knowledge, his hierarchy of values etc. This evaluation is neither necessarily rational nor quantitative. Yet if a mathematical result is to be obtained, both the evaluations and the decisions based on these evaluations need to be quantified. The evaluation (sometimes called “utility”) is quantified by assigning a monetary value to every “variable”. The decision making process is quantified by assuming that each individual acts to maximize utility (the sum of the monetary values of the results of all his choices).

3) What is the system? In actuality, the system is the set of laws that determine the kind of interactions that occur among individuals. In the model, this translates to assumptions that certain factors will remain constant over time.

Once these three aspects are modeled, one ends up with a set of equations that can be solved to determine what utility each individual will be able to achieve. The solution represents an outcome. In certain cases, feasible outcomes may exist that are better for each individual. (This usually happens when there are “externalities” which can be considered mathematically as non-linear effects). The most obvious problem with this argument is that it involves a huge number of variables, so man variables that no human (or computer) can solve the set of equations in any meaningful time. That however, is not my argument. My friend already acknowledges this fact and claims (plausibly) that in certain cases, a social planner may find an approximate solution that is still better than the free market one. My arguement is that: The fact that a (mathematically) feasible better solution exists, does not mean that it is possible to achieve in actuality. The reason is that the sort of actions required to achieve the feasible solution change the system (point 3) that was analyzed. In actual terms, such actions necessarily involve violating the property rights of individuals, thus changing the interactions between people, the monetary values they attach to different choices and the strategies they adopt to maximize their values. In plain language, attempts to achieve the “optimum” solution are lost in a host of unintended consequences. The information that says a better solution is feasible exists not with any single individual but with a vast number of individuals. To put that information to use, even if a social planner is able to approximate it, he needs to communicate it to all the people who will need to act on it. But force (and social planning is all about force) is a very destructive way of communicating. Successful communication is done with persuation and persuation is what the free market is all about.

Now consider a much simpler moral argument. Every value that man achieves is a result of using his mind. And the essential requirement for the mind to work is freedom. When man is free to act as his mind instructs him to do and is responsible for the consequences of his actions, his mind works the best. When he is forced to act against the judgement of his mind, his mind becomes passive and he loses the motivation to use his mind (something that never figures in a mathematical model). In the most fundamental sense of the word good, force can never be good for man.

In his response, following my post on propaganda, my friend clarified that what he meant by propaganda was a one-sided presentation of an idea that does not consider all sides of an issue. The moral idea (in the paragraph above) when supplemented with the practical arguments and all the evidence of the past century becomes a fundamental political principle. And there is no other side to the issue left. As I wrote in this post, as long as one is unsure of something and has not integrated ideas into principles, it is good to be circumspect and consider all pros/cons of all sides of an issue. But on issues on which it is possible to have relevant principles, there is only one side. Fundamental principles do not allow any evaluation in shades of gray. Whether I should be free to act on my own judgement or whether I should allow a social planner to force his whims on me or whether I should become a social planner myself is not an issue where I will weigh the pros/cons of the alternatives.

Finally for the sake of completeness, consider the Pigouvian tax/subsidy to correct for externalities. The first point to be noted is that most externalities go away when property rights are properly defined and implemented. And in fact a tax on pollution is actually quite close to what a property-rights solution to the “problem” of pollution would be. As for the subsidy on education, one can just look at the state of subsidised public education in the U.S. to see how it works. Externalities cause problems in model-based economics because they are non linear effects and most models are linear (eg, price = marginal utility) (for the simple reason that non-linear models are untractable). Man’s mind is not a linear device however, and a linear model does it no justice. Just think of the salesman who negotiates a price (= marginal utility?) or the investor who depends on a virtuous cycle where increase in supply creates a non-existant demand to recover his investment.

I recently found the time to read Henry Hazlitt’s book “Economics in One Lesson” (available online here). The book conclusively demonstrates that any attempts to coerce the free market can only result in the short term gains of special interest groups at the expense of everyone else and that even these short term gains are more than canceled out in the long term. The value to me in taking the time to read it was not in learning anything particularly new but in knowing that a detailed and very well-written explanation of a number of statist ideas exists in one place. Hazlitt writes that all statist fallacies essentially consist of considering only the immediate and visible consequences of a particular policy while ignoring the secondary and not-easily-visible consequences – an idea that was expressed by Bastiat long ago in 1850.

More than the book itself, what is interesting to me is the fact that the fallacies in statist ideas have been exposed long ago (Hazlitt’s book was published in 1946 and Hazlitt himself takes no credit for being original) and yet these ideas continue to be widespread among the general public as well as among trained economists and policy-makers. In fact, the financial crisis we are seeing at the moment is the inevitable result of some of these same fallacies (more on that in future posts) and the alleged cure is more of the same. The inescapable question then is: Are statist ideas really fallacies or mere rationalizations? Are they really held out of genuine ignorance and/or confusion or is there some other explanation? Hazlitt seems to think that they are genuine fallacies caused by the fact that the immediate consequences of interventionist and coercive policies are all too obvious while the secondary and long term consequences are not so obvious. I think that is a far too charitable view. It is inconceivable to me that simple arguments cannot be grasped by trained economists or intelligent laymen. Hazlitt also mentions how the paid spokesmen of special interest groups are able to drive out “dis-interested” writers simply because of their dis-interest (a mechanism also discussed by Zakaria in his book The Future of Freedom). While this is certainly part of the reason why special interest groups can control the government, it does not explain the support for statist ideas among the dis-interested public.

As an example, a few days back, I had a long and futile argument with some colleagues about the ineffectiveness of statist policies. Now these colleagues are certainly intelligent enough to grasp the fallacies inherent in statist ideas. Moreover they have no reason to support such ideas for any special interest. Yet they continue to defend them. And inspite of any concessions they may have made during the argument, I am sure that the same points will come up in the next argument. As one of them put it, (paraphrasing) “I am not opposed to capitalism, but I am a socialist at heart.” To me, that is the source of the persistence of these fallacies. Altruism is totally incompatible with the working of the free market. But as long as it is accepted, no amount of rational argument (such as the ones in Hazlitt’s book) can genuinely convince a person that collectivist and socialist ideas always achieve the opposite of their stated purposes.

Hazlitt shows how raising prices of a particular product (whether by tarrifs or other methods) to create employment penalizes all the consumers of that product (the public interest?), how lowering prices of a particular product drives out all the marginal producers (the disempowered?) and also creates shortages so that only those with more purchasing power can afford the product, how minimum wages cause unemployment by preventing people whose services are worth less than the minimum wage from being employed at all (the most needy?), how rent controls raise the rents in new buildings enormously (housing for the poor?) while simultaneously removing all incentive for (or even ability to) improve/repair existing buildings, how inflation – necessitated by deficit spending to fund all the welfare programs – essentially acts as a tax whose impact is felt highest by the poor etc, etc, etc… not to mention that all these measures also reduce the total product of the economy (the public interest?)

But the point is that the cure suggested by all these fallacies – regardless of any evidence – the free market, where every individual is free to pursue his own interests and is not legally responsible for the “welfare” of others is morally unacceptable to the altruists, and no amount of merely economic arguments can change that.

Simply Capitalism (feed) is a new blog on business, economics and free enterprise.

Here is an excerpt from their first post

Today, we live in a mixed economy made up of both semi-free markets and government controls. We live in a culture that views business and businessmen as a necessary evil. While the ability of capitalism to bring general prosperity is begrudgingly acknowledged, big business and naked “greed” are routinely blamed for the country’s problems. Calls continue for more government controls and regulations to fix a “broken” system. We think this view is flawed.

When it becomes difficult to determine which effects are due to government interference and which are due to free market influences, our goal is clarity and proper identification. When we hear calls for pragmatism and “balance” in our approach, our goal is to find the principles that illuminate the proper course of action. When we see a system of political pull and coercive government replacing a system of merit, productivity and voluntary trade, our goal is to defend the individual rights that make the latter possible once again.

Among its contributors are two bloggers I have regularly followed for some time

Galileo Blogs, author of Property Rights and the Crisis of the Electric Grid

Kendall Justiniano who also blogs at The Crucible

I am looking forward to getting new insights and good discussion on this blog. Highly recommended for anyone who wants a better understanding of the economy.

Following the recent financial crisis, there have been three kinds of reactions in general

The socialists are on a rampage denouncing capitalism, free enterprise, greed and the profit motive. It is difficult to miss a note of glee in their screams. It is almost as if the financial crisis and the alleged role of capitalism in causing it helps them get over the failures of socialism. However loud their screams may be, socialism is so completely discredited today that their screams are irrelevant.

A small number of free market advocates are using principled arguments about the working of the free market and the nature of government interference in the economy to interpret the crisis as a failure of the unfree market. However well reasoned and sound their arguments may be, these are not the men who run things today and the immediate impact of their ideas is going to be small.

The most interesting reaction is the one by the pragmatists. They claim that the financial crisis demonstrates the failure of deregulation and that what is needed is better regulation, more in line with the modern realities of today’s markets. They claim that the focus of the debate should be not whether regulation is needed or not, but what sort of regulation is required. They reject any principled arguments as “just theory”. What is interesting about their reaction is that they are the ones who were in charge of the situation the whole time. These are the people who “believe” in free markets and the gold standard and fiscal discipline and claim to be protecting capitalism. By doing what? By chairing the federal reserve. The blatant contradictions do not bother them. After all Bernanke is supposed to have said “There are no atheists in foxholes and no ideologues in financial crises”. Even after a century of failed attempts at regulation, these pragmatists are still searching for better ways of regulating the economy. There is an old saying that goes “When you find you have dug yourself into a hole, the first thing to do is to stop digging”. But perhaps that too is “just theory” for these pragmatists.

Sadly, more regulation and more crises is what we are going to get, atleast until pragmatism gets discredited. For that to happen however, we need to learn that the way to get out of a crisis is not to renounce principles, but to discover, understand and practise them. Understanding the ideas in these piecies would be a good beginning.

In view of the fact that the United States political/economic system has turned into a mostly illiberal and highly regulated democracy, the question “Is capitalism inherently unsustainable?” deserves attention.

Politically, capitalism is a form of social organization based on the recognition of individual rights. Economically, it is a system where owners of capital exercise their property rights to trade with each other voluntarily, thus establishing a free market. The freedom refers to the principle that no individual or group (including the state) may initiate the use of force against anyone else. The implementation of this principle requires a proper social organization - a legal system to resolve disputes and a police force to prevent the initiation of force and implement the decisions of the legal system.

Economically, capitalism (the free market aspect of it) is the only system that has ever worked in practice – economies have resisted collapse to the extent to which elements of free markets were present. This fact is partially recognized today in the sense that a free market is held to be valuable but fragile and in the sense that total state control of the economy has been thoroughly discredited. The success of free markets is not surprising. In a free market, every individual exercises his own judgement and takes responsibility for the consequences. Good judgement necessarily wins in such a system. As the economy grows in size and complexity, better and more specialized judgement is required for success, making it impossible for the state to control the economy effectively. Although it is certainly difficult to predict the results of a particular decision in the higly interdependent and complex economies of today, the complexity is its own defense as long as the market is free. In a complex economy, the effects of a bad decision are larger and more widespread and can be noticed earlier than would be possible in a simple economy. As long as people are free to make their own decisions, they can distance themselves from the bad decisions and minimize their risks. But when the economy is regulated, the effects of decisions are artificially suppressed by penalizing good decisions and rewarding bad ones. This is true irrespective of the kind of regulation imposed. Consider some examples. When the state puts a cap on the price of a particular commodity, thus reducing the profits of the producers, it makes production less attractive for newcomers, raises the barrier to entry, encourages monopolies, keeps supply short and removes the possibility of the price being lowered by competition. When the state bans insider trading or short selling of stocks, it prevents the spread of information that would otherwise happen. When the state lowers interest rates, it reduces the value of good investments and raises the value of bad investments. A regulated economy is more stable in the short run, but the stability is spurious. It is achieved by constantly changing the rules of the game to equalize results. Regulation is like a teacher’s policy of awarding similar grades to students irrespective of their performance, reducing the motivation of the brighter students and instilling a false confidence in the duller ones. The students from such a class fail when they encounter a world outside the teachers influence, the brighter ones because they never learned to work hard, the duller ones because they never learned to work well. When the damage done by regulation goes beyond the ability of the state to control, the results are catastrophic (as we see today). The short-term stability from regulation comes at the price of a certainty of a catastrophic collapse, something that is unlikely (though not impossible) in a free market. It is not free markets but regulation and the mixed economy that is completely unsustainable. Free markets are inherently stable in the long term, simply by virtue of the fact that good ideas work.

Politically, however, capitalism is unstable. The success of capitalism depends on a proper understanding of individual rights – most importantly property rights. This is impossible without a sound philosophical grounding – most importantly ethics – and difficult in any case. When the state enacts laws that violate someones rights, it turns from a protector of men into a looter. Unlike the action of the free market which corrects itself, violation of rights turns a difficult problem – how to objectively define and protect rights – into an impossible one – how to dispose of loot in a just manner. These difficulties exist even when a state recognizes its role as being limited to a protector of individual rights. They are enormously compounded when this recognition is absent. A state that actively oversteps its role is fundamentally corrupt and the corruption inevitably increases. Left to itself, such a state necessarily degenerates into an autocracy, constantly expanding its powers and violating rights, until its economy collapses and the state is forced to change its political principles. But a collapse does not necessarily mean that capitalism will be established (The example of Russia is a case in point). Establishing and even maintaining a system of proper well defined rights requires active, principled and continuous effort. As Thomas Jefferson put it “The price of freedom is eternal vigilance.”

However unstable the political aspect of capitalism may be, it is the only system that is proper to man – the only system that recognizes that man requires freedom to succeed, that the standard of truth is reality and not consensus, that the proper purpose of man’s life is his happiness, that the proper principle for interaction among men is trade, and that the standard for mutually beneficial trade is profit. Just as sustained effort is required to achieve any goal that man may set for himself, sustained effort is required to keep a society capitalist – effort to understand a proper code of ethics, to understand the principle of rights, to apply these principles to concrete situations, to establish and maintain objective laws based on these applications and most importantly to reverse or correct any mistakes that might be made along the way.

This post was written as a response to a comment that capitalism is unsustainable because of an innate desire for security in most men. The claim about the desire for security might well be true. However it is not these men who make the world or set its terms. The world is made by the men of vision who dare to think and plan beyond the short term – by the scientists who spend years on their research, by the businessmen who invest their money without expecting returns for several years, by the activists who can project a better future, and most importantly by the philosophers who devise theories and set the direction of the activities of men. Capitalism has declined not because of a desire for security, but because the principles underlying it have never been fully understood, and consequently the effort to sustain it has either been absent or misguided.

Here is a hilarious post on the nuclear deal that makes the point that “common people” have no clue of what the whole nuclear issue is all about.

And that is as it should be. Issues such as “energy security”, the extent of availability, nature and feasibility of various energy sources cannot properly be the concern of “common people”, i.e, those who are not involved with the energy industry. All that common people need to do is to vote with their money for the best producer of energy and these complex issues will be taken care of by those who are best equipped to deal with them - the energy producers in a free market – who have the necessary information, the ability to understand and interpret it and most importantly the motivation to do so. 

That these issues are going to be decided by the political circus that is going on is not as it should be. No matter what decision the government takes, the right of some people (companies) to act on their economic judgements will be violated. This fact has gone unnoticed in all the commentary and debate that the nuclear deal issue has raised, mainly because energy is usually considered far too important to the nation’s economy to be left to the free market. But as Ayn Rand eloquently noted in this speech in Atlas Shrugged

“When money ceases to be the tool by which men deal with one another, then men become the tools of men.“

An industrial economy cannot survive without trade. The only choice that a society has is whether the trade is in money, goods and services in a free market or in favors, cabinet seats and MP’s. And once the latter is chosen, the original issues lose significance. The issues shift from ”What is to be done?” to “Who gets to decide?”. That is the irony of this debate – the debaters who want a voice they have not earned in the running of an industry they know very little about have made the result of the debate inconsequential.