If we were to apply the unmodified, uncurbed rules of the micro-cosmos (i.e., of the small band or troop, or say our families) to the macro-cosmos (our wider civilization), as our instincts and sentimental yearnings often make us wish to do, we would destroy it. Yet if we were always to apply rules of the extended order to our more intimate groupings, we would crush them.

—F. A. Hayek,
The Fatal Conceit: The Errors of Socialism

The widespread belief that markets are immoral is a major reason they are so poorly understood and so rarely appreciated. This belief is not easily overcome. The fundamental problem is that our instinctive sense of morality, which I shall call magnanimous morality (the morality of caring and sharing), makes it easy to see markets as morally flawed. Furthermore, the explanation economists give for what they see as the major advantage of markets reinforces the instinctive tendency to see them as immoral. Unless economists recognize the source of this hostility and acknowledge it is based on a praiseworthy morality—but one not fundamental to the success of markets—there can be little progress overcoming the view that markets are immoral. This would be a shame since there is a strong moral case to be made for markets.

Markets are based on a morality, which I shall call market morality, that helps to direct our actions into a global pattern of mutual assistance which appears to result from magnanimous morality but in fact could never be achieved by that morality. Because market morality lacks instinctive appeal, there is widespread support for attempts to create a more moral economic order by substituting magnanimous morality for market morality. Such attempts unavoidably erode the benefits from both moralities and lower the overall morality of the economy.

I wish to emphasize the difference between magnanimous and market moralities, showing that each supplements the other in contributing to a moral social order—but only if they are confined to their proper spheres of human action.

The Magnanimous Morality of Caring and Sharing

We instinctively think of morality as personally caring for and sharing with others. It can be defined briefly as satisfying three conditions: 1) helping others intentionally; 2) doing so at a personal sacrifice; and 3) providing the help to identifiable individuals or groups. Behavior of this sort is clearly beneficial to the well-being of small groups in which the members are in close personal contact and knowledgeable of the circumstances and concerns of one another. We spent most of our evolutionary history in small hunter/gatherer tribes fitting this description, so a strong affinity for magnanimous morality has been hardwired into our emotional makeup. Its presence or absence has predictable effects on how we view behavior and social arrangements.

The enduring popularity of Charles Dickens’s A Christmas Carol, published in 1843, illustrates the emotional appeal of intentionally caring for and sharing with identifiable people at personal sacrifice. Ebenezer Scrooge is introduced as “a squeezing, wrenching, grasping, scraping, clutching, covetous, old sinner” with no regard for the welfare of this employee, Bob Cratchit, his own family, or anyone else. But after Scrooge’s encounter with the ghost of his former partner and the three ghosts of Christmas he experiences a moral transformation. He finds true happiness in paying for the medical care needed by Tiny Tim, the Cratchits’ crippled son, raising Bob’s salary, and more generally using his wealth for the benefit of others.

The appeal of magnanimous morality is fully warranted and understandable. The relationships we have with family and friends are rooted in it, providing us with our greatest happiness and most satisfying and meaningful moments. It should be emphasized that magnanimous morality is not inconsistent with the proper functioning of a market economy. Success in market transactions depends on being sensitive to the concerns of others. And this sensitivity seems to extend beyond strictly market transactions. Based on experimental evidence from a number of countries with wide differences in the degree of integration into global markets, Herb Gintis concludes, “[S]ocieties that use markets extensively develop a culture of cooperation, fairness and respect for the individual” (quoted in Matt Ridley’s The Rational Optimist).

It should also be admitted, however, that the proper functioning of a market economy does not depend primarily on magnanimous morality. Indeed, the morality on which markets primarily depend is easily seen as rejecting magnanimous morality, and the way most economists make the case for markets encourages this view and the instinctive hostility that so many have for markets.

The Morality of the Market

Market morality is rather modest, with little if any emotional appeal; in fact, it scarcely seems to deserve the name “morality,” instead being commonly seen as a justification for behavior widely held to be immoral. This morality can be defined as following the general rules and norms of market exchanges, such as respecting property rights, honoring contractual obligations, and not harming others by violating their legitimate rights and expectations through force or fraud. Market morality can be achieved, according to Adam Smith in The Theory of Moral Sentiments, “by sitting still and doing nothing.” And while markets reward kindness and caring for those with whom we have personal exchanges, the vast majority of the exchanges we benefit from are impersonal; we neither know nor meaningfully care for those on the other side of the exchange.

Since these impersonal exchanges create enormous benefits from outcomes that emerge without conscious direction, people seldom give much thought to those benefits or the market morality on which they depend. Of course people do think about markets occasionally, but when they do it is seldom with appreciation for the benefits they are receiving. More often than not people think about markets when they are being inconvenienced by the market discipline—the requirements “imposed” on us, for example, in return for income—that makes their benefits possible. Few of us connect such discipline to the far greater benefits we receive as a consequence, particularly when we see others who appear to be reaping great rewards from the very discipline that is apparently making us so much worse off. Under these circumstances it is easy to conclude that we are imposed on unnecessarily by the greed of others. How easy it is to also believe there is something immoral with an economic system that not only tolerates greed but also rewards it.

When economists make the case for what they see as the most impressive feature of markets, they typically do so with the aid of Adam Smith in a way that reinforces the view that markets at best lack morality. Smith understood and appreciated magnanimous morality, as any reader of The Theory of Moral Sentiments, his first book, knows. But this would not be known to someone who knew only Smith’s “invisible hand” argument for markets in The Wealth of Nations. The advantage of markets, according to Smith, is that by pursuing their own interests in the marketplace, people unintentionally do more to promote the public interest (the interest of no one in particular) than if it had been their intention to do so. This argument ignores every requirement for magnanimous morality, and the way economists phrase the argument makes it easy for people to conclude erroneously that the argument for the market rules out the more personal caring and sharing in which our personal relationships are rooted.

I am not proposing that economists discard the invisible-hand explanation of the market. But to make the case for the morality of markets, economists should recognize the tendency for people to dismiss the benefits of the market for its apparent moral failing and counter that tendency by pointing out the inability of magnanimous morality to achieve the desirable economic outcomes expected of it.

Demanding More Than Magnanimous Morality Can Deliver

The belief that markets are immoral causes many either to fail to notice or to dismiss the benefits they realize from them. For example, while most people claim to value conservation and clearly benefit from the conservation that smoothes the availability of goods and resources over time, the nearly unanimous criticism of speculators, whose profit-seeking behavior makes this conservation possible, suggests that most people are unaware that this is a benefit of markets.

Even those aware that they are receiving a benefit from market activity commonly feel it is contaminated by the process providing it. This was illustrated after Hurricane Fran knocked out power in Raleigh, North Carolina, in September 1996. According to Michael Munger, four men from Goldsboro, North Carolina (an hour from Raleigh), rented two freezer trucks and drove to Raleigh with a thousand bags of ice, which they bought for $1.70 each. Customers quickly queued up to pay $8 a bag, with each limited to five bags. Some complained about the price, but no one refused to pay. With the line still long, the local police arrived in force, arrested the four men for price gouging, and confiscated their trucks and all the remaining ice—which was not distributed to those in line. Surprisingly, at least to economists, the frustrated shoppers applauded the police for arresting those whose activities would have made them better off; would the customers have been happier had the sellers not bothered at all? The applause strongly suggests that those in the line felt that the benefit for which they had lined up was contaminated by the profit motive.

Or consider the idea of getting consumers in developed countries to pay extra for “fair trade” coffee, bananas, tea, and chocolate to reduce the poverty of poor farmers in developing countries. Assuming the premiums paid for “fair trade” products go to the intended recipients and forgetting Gene Callahan’s economic analysis suggesting these recipients may be harmed even if they do (“Is Fair Trade a Fair Deal?,” Freeman, March 2008), it is clear that “fair trade” advocates are sincere in their belief that this approach will reduce poverty and hope that it will catch on with consumers. Yet many are conflicted by what has been described as a paradox in the “fair trade” movement resulting from the widespread hostility toward markets that pervades it. As described by Sarah Lyon and Mark Moberg in Fair Trade and Social Justice, “In seeking social justice . . . fair trade . . . pursues a market-based solution to the very problems developing from free markets.” When large corporations such as Starbucks, Nestlé, Walmart, and McDonald’s signed on to sell “Fair Trade” products, which would clearly increase sales and supposedly the incomes of poor farmers, many in the movement objected. Representative of these objections are those voiced by Pedro Haslam and Nicholas Hoskyns (in their contribution to The Fair Trade Revolution), who see these corporations motivated by “marketing success rather than ideology.” “[F]air trade certified farmers who sell to them [big corporations]. . . ,” they continue, “are still locked into the traditional supply chain dominated by the largest companies. This is not the vision of sustainability and community many of us started out with, where local family-owned businesses sell the products of small farmers and personal relations are maintained throughout the supply chain.”

These statements reflect hostility for economies based on “marketing success” and impersonal exchanges between large companies and the suppliers they depend on. The statements, and numerous others from “fair trade” enthusiasts, express a yearning for economies based on personal dealings between consumers in developed countries and those in poor countries who supply them with products anonymously. In this they are like many others who are emotionally attracted to the idea of economies based more on the magnanimous morality of caring and sharing and less on the market morality of pursuing self-interest through impersonal market exchange.

While it is hard to imagine a life of meaning and joy without mutual caring and sharing, we shouldn’t demand more of magnanimous morality than it can deliver. Calls for a more moral marketplace—sometimes referred to as capitalism with a human face—are invariably motivated by the hope of substituting the instinctive morality of the small group for the morality of impersonal markets. When such a substitution goes beyond feel-good rhetoric and is actually attempted, the result is less morality and prosperity as political power replaces voluntary exchange.

Good economists see nothing wrong with caring and sharing. But they also see the opportunity to supplement that morality by extending our ability to help far more people than we can personally care about. The primary advantage of markets is that they provide each of us with the information and motivation to share with literally millions of people, without caring for them.

Of course some will say, “Yes, people are helping each other, but they are doing so for the wrong reason by considering only what’s in it for them.” Such people may never be convinced that self-interest is a legitimate motivation. But one would like to ask them if, when enjoying a good cup of coffee, reading a thrilling mystery on their e-reader, or boarding an airplane to visit a sick friend, they are troubled by the thought that all the many people who made those things possible were motivated primarily by a desire to improve their own conditions and the conditions of the families they love. I doubt they are, and for their sake I hope they aren’t.

The healthiest and certainly the most compassionate way to think about markets is by recognizing that they allow us to provide better for the few we genuinely do care about by doing more to serve and share with the multitude of those we don’t. This suggests that a strong moral case can be made for the market by explaining why the noble desires inspired by magnanimous morality are more fully realized when the urge to substitute that morality for market morality is resisted.

This isn’t surprising, given the usefulness of making simplifying assumptions in theoretical endeavors. Obviously no one is fully informed or perfectly rational, but the assumption that they are generates remarkably accurate predictions on issues that interest economists.

One of the most powerful implications of neoclassical economics is that the case for free markets doesn’t depend on people being fully informed and rational, as is mindlessly repeated in many principles textbooks. Quite the contrary, the case for markets is that they increase the rationality of economic decisions by providing information and motivation through prices, profits, and losses that cannot exist without markets.

With that as background, I review Animal Spirits by George Akerlof and Robert Shiller. Both Akerlof and Shiller have done creative and interesting work, much of it based on the anomalies highlighted in behavioral economics. They begin by considering how “animal spirits” affect economic decision making. That term originated with Keynes, who used it to describe emotional factors that enter into, and often distort, investment decisions that are necessarily made with incomplete information.

Akerlof and Shiller take a more expansive view of animal spirits, which they break into five categories: confidence, fairness, corruption and antisocial behavior, money illusion, and stories. The five chapters in Part 1 discuss those separately, showing how they can lead to irrational economic outcomes and how understanding them can help us design appropriate policies for correcting them. The remaining chapters look at how animal spirits may be responsible for the current economic downturn.

Not having the space to deal with each of these chapters individually, I’ll keep my discussion general. Although Akerlof and Shiller suggest that they appreciate the importance of markets, their emphasis is clearly on “market failure.” A few examples illustrate their tendency to qualify any positive statement about capitalism (emphasis in original): “Capitalist societies . . . can be tremendously creative. . . . On the other hand, left to their own devices, capitalist economies will pursue excess, as current times bear witness.” “But the bounty of capitalism has at least one downside. It does not automatically produce what people really need; it gives them what they think they think they need, and are willing to pay for.”

This last statement isn’t blatantly false, although it puts the free market in the worst possible light by suggesting that many consumers want “snake oil.”

A more balanced approach would have also pointed out that government doesn’t automatically provide what people need either; it gives everyone what the majority, or a politically influential few, think they need, whether or not they’re willing to pay for it. Such a comment is nowhere to be found. Akerlof and Schiller ignore the problems with the perverse outcomes of government actions.

Sometimes the authors show their bias with the tone of their statements. For example, they state that “[t]he proponents of capitalism wax poetic over the goods that it provides” (emphasis added). And they refer to Milton Friedman’s “sleight of hand” when describing his analysis of the fallacy behind the Phillips curve—analysis that undermined, at least intellectually, the fiscal excesses of government that brought us the stagflation of the 1970s.

Akerlof and Shiller use “animal spirits” to consider some important economic issues in different and potentially productive ways. But for this concept to realize its potential it would have to be used to develop hypotheses that are more discriminating and testable than anything found in Animal Spirits.

The authors give the impression that they see “animal spirits” as an all-purpose explanation to be trotted out to explain anything that cannot be readily explained with existing economic theory. Indeed, they seem to believe that the strength of their approach is that by explaining almost everything, it cannot be refuted.

“Animal spirits” are ubiquitous and surely play a role in much economic activity. When economic questions cannot be adequately answered with existing theory, however, the way to come up with better answers involves hard work in developing refutable hypotheses, then testing them. That isn’t what Akerlof and Shiller do. They use animal spirits as the answer to the questions they consider in much the same way oxygen can be used as the answer to the question, “What caused the fire?” The answer cannot be refuted, but it’s not very helpful

Ariely’s book is more interesting than most on behavioral economics because of the bold claims he makes. Most behavioral economists see their findings as suggesting some qualifications to utility maximization as the basis for describing economic behavior. But most are cautious in concluding that the irrationalities they observe make a case for relying more on government to direct economic decisions. One suspects that some behavioral economists favor more government direction, but they typically argue for what they see as a benign government role. (The best example is the argument Richard Thaler and Cass Sunstein make for “libertarian paternalism.”) Ariely shows no such restraint, saying that he wants more government regulation because irrationality renders markets unable to work properly.

Ariely’s chapter “The Fallacy of Supply and Demand” begins with the story of an entrepreneur who took black pearls of “dubious worth” and turned them into a high-priced luxury item. He then discusses some experiments that he interprets as showing that “initial prices are largely ‘arbitrary’” and influence “not only the immediate buying decision but many others that follow.” In other words, if businesses can get us to pay high prices initially then we, as irrational as we are, continue to find those prices acceptable.

But even if consumers are as irrational as Ariely would have us believe, they are still protected by private-sector competition that has driven down the real prices—while improving the quality—of televisions, electronic calculators, digital cameras, personal computers, life-saving medications, and a host of other products. If Ariely has given the effect of competition any thought, he keeps it to himself. Instead, he concludes that if we cannot depend on markets “to help us maximize our utility, then we may need to look elsewhere [meaning government]. This is especially the case with society’s essentials, such as health care, medicine, water, electricity, education and other critical resources.”

Even if people are irrationally willing to continue paying the prices they initially pay for a product, that hardly makes a case for more government intervention. Would anyone argue that the Post Office (or Amtrak or Social Security) does a better job of providing consumers, irrational or not, with lower costs and increasing quality than private firms? Markets clearly do far better than governments at revealing the cost of goods and services and thereby enhancing rational choices.

Ariely emphasizes how consumers are misled by what he calls “decoy” prices, and other types of private-sector pricing. But market pricing, even at its most deceptive, reveals information on costs far more accurately and understandably than government pricing. Does anyone know how much Social Security costs (including its effect on wages), or the cost of public education, or the ethanol in the gasoline they buy? Ariely has an entire chapter on the high cost to consumers of being convinced by businesses they are getting something for nothing. Nowhere, however, does he mention the free-lunch political promises that end up increasing the cost of the “free” goods.

One of the most interesting of Ariely’s chapters is on the importance of social norms and how they contrast with market norms. He does an admirable job pointing to the serious problems of applying market norms in situations involving families and close friendships. The problem is that he’s sympathetic to applying social norms to the extended and impersonal relationships in business transactions. Ariely’s concern with moving in the direction of treating businesses like a family is that businesses will fail to adhere to their social-norm responsibilities by laying off workers, cutting benefits, and reverting to market norms. He remains optimistic, however, that by doing it right, businesses can benefit from more reliance on social norms, citing Google as an example.

Ariely’s book would have been better, though probably not as popular, had he balanced his discussion of irrationality in markets with some Public Choice implications of perverse political behavior.

There are two fraudulent claims the federal government makes about Social Security that deserve special attention. By considering how these two claims interact with each other, it becomes clear that the politicians and pundits who defend Social Security are increasing the harm it is imposing on American workers.

Two Fraudulent Claims

Consider first that ever since Social Security was enacted in 1935 Americans have been told that their “contributions” are being deposited into their own account to pay for their retirement benefits. This claim has become more implicitly suggested than explicitly stated in recent Social Security brochures, but not in the statements of politicians when opposing any attempt to partially privatize the program. Al Gore, in his 2000 presidential campaign, assured the public that if he were elected our Social Security “contributions” would remain secure in a “lockbox” until our retirements. It was never made entirely clear whether we each had our very own lockbox or all the money was in one big lockbox.

We cannot find any serious study that estimates how many people really believe that the taxes they pay to Social Security are being saved and invested to finance their retirement, instead of being spent immediately by politicians, as is actually the case. But it is clear that many do believe that they have a personal Social Security account containing the money to fund their retirement benefits. Alan Greenspan recounts in his recent book, The Age of Turbulence, a story told by former House leader Tom Foley. When Foley tried to inform his mother that there were no lockboxes containing the money to pay for Social Security, she told him, “I hope you will not be offended at how surprised and shocked I am to find that the majority leader of the House of Representatives knows nothing about Social Security.”

The other fraudulent claim made about Social Security (again, from the very beginning of the program) is that employees pay only half the cost, with employers paying the other half. This claim is widely seen as plausible because the legislation authorizing Social Security clearly stipulates that the required payments are to be split evenly between employees and employers. If this were true, then employees would now be paying 6.2 percent of their before-tax income up to $102,000 a year; employers would match that amount.

As any good student in an economic-principles course should learn, however, the amount of a payroll tax actually paid by employees and employers has absolutely nothing to do with what politicians mandate in legislation. It is true that each worker has 6.2 percent of his after-tax income deducted from his paycheck and sent to the Social Security Administration (SSA) and his employer sends in the same amount. But by altering the wages employers pay and workers receive, these payments change the supply and demand schedules for labor—at a given nominal wage, different amounts of labor will be supplied and demanded than before. (In the lingo of economics, the supply and demand curves shift.) Until we know how wages and salaries change in response to these shifts, we cannot tell how much of the Social Security cost is paid by the employees and how much is paid by employers. For example, if a worker’s salary is reduced by exactly the same amount that the employer sends to the SSA for her, then the cost to the employer is nothing (what he pays for the worker’s Social Security is offset by the lower salary) and the worker ends up paying the entire cost.

We are not going to work out the details for determining how the Social Security cost is divided between workers and employers. But having worked this out with graphical analysis in an October 2006 article in Economic Inquiry, we can provide a simple verbal explanation of how those who defend Social Security are adding to the harm it inflicts on American workers.

The employer requirement to send a check to the SSA for each worker equal to 6.2 percent of salary revises downward the firm’s demand schedule for labor according to the amount of this check. This reduction in demand, considered by itself, obviously reduces the salary the firm is willing to pay each worker. Similarly, the Social Security deduction from each worker’s paycheck reduces the labor supply by revising upward the supply schedule by the amount of this deduction, assuming that there is no expected benefit from Social Security.

But this overstates the reduction in labor supply if workers believe they are going to receive some benefit from Social Security. The more benefit workers expect to realize from Social Security (in present-value terms), the less the labor supply will decline. And indeed, if they expect to receive more in Social Security benefits than the amount deducted from their checks, then labor supply will increase out from the original level.

But this means that even if workers are receiving benefits greater than the amount being deducted from their paychecks, they are not necessarily better off. The decrease in labor demand and the increase in labor supply can result in a salary reduction greater than the amount Social Security benefits are expected to exceed paycheck deductions. In fact, as we show in our Economic Inquiry article, workers are made worse off by Social Security unless the benefits they expect and actually receive are at least equal to the total amount paid for Social Security by both the workers and their employers.

Defrauding Workers

We are now able to nail down our main point—that advocates of Social Security are defrauding American workers in two ways. First, claims which leave the impression that money paid into Social Security is being saved for our retirements lead workers to believe their benefits are more secure than they are.

Second, persistent claims that workers pay only half the Social Security tax lead them to believe their benefits cost them less than they really do.

These fraudulent claims clearly increase the political viability of Social Security by misleading workers into expecting larger benefits than they will receive. But it is worse than this. By generating exaggerated expectations of Social Security benefits, the two claims are actually reducing the net benefits workers receive by increasing the amount they are paying for them with lower wages.

It is ironic that those pundits and politicians who oppose even the most timid moves to privatize Social Security by downplaying, or denying outright, its Ponzi-scheme nature are widely seen as protectors of American workers.

In fact, everyone concerned with a clean and healthy environment—and that includes far more people than those vocally claiming to be environmentalists—should be enthusiastic fans of the internal-combustion engine because of the important contributions it has made to environmental quality. The environmental benefits we realize from the engine have long been clear to anyone who bothered to notice. And these benefits have become more obvious because of an article in The Independent, a respected British newspaper (http://tinyurl. com/ys5srd). The article was based on a study by the United Nations Food and Agriculture Organization (“Livestock’s Long Shadow—Environmental Issues and Options”), which found, quoting the newspaper, that “livestock are responsible for 18 percent of the greenhouse gases that cause global warming, more than cars, planes and all other forms of transport put together.” The problem begins in the digestive systems of livestock and ends up as flatulence.

The internal-combustion engine began improving the environment, however, long before global warming became a concern. Consider the fact that in 1900 a large percentage of the available horsepower really was horse power, or mule power, or ox power. As the power of the internal-combustion engine began to be substituted for animal power in the early 1900s, we began to substitute the emissions coming out of the tailpipes of cars and trucks for those coming out of the tailpipes of animals. The result was that the environment started becoming far cleaner and healthier.

Consider horse manure’s effect on the environment and health of New Yorkers in 1900. Robert Fogel, a Nobel Prize-winning economic historian, writes:

We complain a lot about air pollution today, but there were 200,000 horses in New York City, at the beginning of the 20th century defecating everywhere. And when you walked around in New York City, you were breathing pulverized horse manure—a much worse pollutant, than the exhausts of automobiles. Indeed in the United States, the automobile was considered the solution to the horse problem because pulverized horse manure carried a lot of deadly pathogens.

No serious person denies that photochemical smog from gas-powered vehicles is a health risk. It would be silly to do so. It would be even sillier, however, to deny Fogel’s observation that the air and water pollution from horse manure was a far greater health risk than the pollution from cars and trucks. Diseases such as cholera, typhoid, typhus, yellow fever, and diphtheria were responsible for the deaths of tens of thousands of Americans in the early twentieth century. As cars and trucks began replacing horses and other beasts of burden, these deaths began to decline dramatically. Medical improvements get some of the credit, but most of the credit during the early decades of the twentieth century goes to the reduced filth in the environment from animal waste.

The environmental benefits from the internal-combustion engine have not been confined to towns and cities. Before the power of internal combustion was harnessed, beasts of burden were adding greatly to the pollution generated by meat-producing animals, such as cows, pigs, and chickens in agricultural communities. By eliminating the need for horses, mules, and oxen on farms, tractors, trucks and other types of gas-powered farm machinery limited the problem of animal waste from agriculture almost entirely to feed lots that environmentalists, with justification, still complain about. It would be nice to hear them acknowledge that they would have even more to complain about without the internal-combustion engine.

Another environmental benefit that internal combustion seldom receives credit for is that it eliminated the need to grow food for millions of farm animals. It has been estimated that in 1910 about 25 percent of U.S. acreage devoted to growing crops was being used to grow food for the farm animals that were soon replaced by motorized farm equipment. Much of that land is now forestland, with the number of trees absorbing the greenhouse gas carbon dioxide much greater than it would have been without the internal combustion engine.

Based on the animal waste and the diseases that have been eliminated by the internal-combustion engine, plus the additional forestland it has made possible, environmentalists should be celebrating motorized vehicles on Earth Day instead of destroying them with sledgehammers. And the reason for celebrating internal combustion is even stronger now that we have evidence that by eliminating all those barnyard animals, the engine has also eliminated vast amounts of methane from animal flatulence—a gas with far more greenhouse potency than the carbon dioxide produced by gasoline engines.

No Credit Given

Yet with respect to the UN report, the mainline environmentalists are not giving the internal-combustion engine any credit for reducing greenhouse gases. Instead, they are pointing their fingers at meat eaters, with some recommending vegetarianism as the best way to combat global warming. From a report written for EarthSave International, we read, “Arguably the best way to reduce global warming in our lifetimes is to reduce or eliminate our consumption of animal products” (quoted in the February 20, 2007, Christian Science Monitor, http://tinyurl.com/3997wc). What is not mentioned is that if the vegetarian solution were taken seriously, it would increase the environmental benefits provided by the internal-combustion engine. Imagine the extra animal manure and methane that would be discharged if we had to grow all those additional vegetables without motorized farm equipment.

The internal-combustion engine is certainly not pollution free—as is always the case, there is no such thing as a free lunch. Before criticizing anything for being costly, however, one should always ask the question—compared to what? When this question is taken seriously, the environmental record of the internal-combustion engine is impressive by virtue of its being far less polluting than the animals it replaced. Furthermore, gasoline-powered engines are less polluting today than they were a few years ago, and they will be less polluting in a few years than they are today. And the less intrusive government is with yet more commands and controls in response to every problem, real or imagined, the sooner an even-less-polluting power technology will replace internal combustion. Until then, let’s give the internal-combustion engine the respect it deserves for its contribution to a cleaner and healthier environment.

Some behavioral economists now seem intent on bringing their own rationality into question by advocating what appears to be a loopy idea—giving government more power over our decisions to make us better off, and doing so in the name of libertarianism. This “libertarian paternalism” sounds like an oxymoron, but two of its leading advocates—Cass Sunstein and Richard Thaler—assure us it is not. (Their 2003 University of Chicago Law Review article is titled “Libertarian Paternalism Is Not an Oxymoron.”)

Their argument is superficially plausible. But on closer examination it becomes clear that a big leap of faith in the integrity of the political process is required to embrace libertarian paternalism as a reasonable proposal. Fortunately there is a test of the compatibility of the political process with libertarian paternalism. I shall argue that this test should be given, and must be passed, before taking libertarian paternalism seriously. But, first, let’s consider what it means and the arguments for it.

The case for libertarian paternalism begins with a finding by behavioral economists of what can be described as the default bias. In many circumstances, most people will accept a default option rather than choose another even when the stakes are high and the other options seem far better. A commonly mentioned example is a matching, tax-deferred 401(k) plan at work. When employees have to explicitly decide to join, typically more than half accept the default of not participating even though signing up is easy and, with the employer’s contributions, assures an attractive return. On the other hand, studies show that if employees are automatically signed up unless they opt out, most remain in the program.

The next step in the case for libertarian paternalism gets us to the paternalism. Since in every choice there is a default option, it is a good idea, say advocates of the principle, to make it the option that is best for most people. And fortunately it is often possible for impartial experts with training in behavioral economics to know what the best option is. Therefore, if government frames the choice by requiring that the “best” option be made the default option, then the default bias would result in most people accepting this choice. But the libertarian part of the argument acknowledges that what is best for most people is not best for all, so anyone may choose something other than the default.

For example, an employee who is independently wealthy, or who isn’t expected to live long enough to retire, or who just doesn’t want to start a savings program can choose to have her name removed from the 401(k) plan. No one is forced to bend to the will of an authoritarian paternalist. The government experts, under the guidance of libertarian paternalists, will behave like libertarians by leaving the ultimate decision to the individual, but they will also be paternalists by exploiting the default bias and framing the decision in a way that makes people better off (in their view).

The obvious leaps of faith behind this proposal are in believing 1) that the political power required to implement libertarian paternalism would be limited to setting default options when the best default for most people is known and 2) that the choice of default will be guided only by the interest of the people whose choices are being affected. Without this faith in the political process the case for libertarian paternalism is wholly unconvincing. Can we actually expect that the political process will know what option is really best for most people in different situations and how a different default would affect decisions? Maybe behavioral economists are convinced that they know when they cannot pick a better default than already exists and what the best default is when they can. But even if this is true, behavioral economists will not be doing the picking. They may be brought in as advisers to the politicians and bureaucrats in charge of designing and implementing libertarian paternalism, but their advice will not always be taken. Others with more political influence and more narrowly focused interests than behavioral economists will also be giving advice—and will be doing so aggressively.

For example, if the authority to set the default on 401(k) plans is transferred to government, the financial industry will quickly recognize the potential profits in influencing how that authority is exercised. Indeed, the legislation giving that authority to government will be drafted with help from the financial industry. And there are ways to put some devil in the details of such legislation. The legislation could cover workers who, because they are young, part-time, and receive low pay, would not normally be offered 401(k) plans. Opting out could be made to require more effort than the libertarian paternalists have in mind. The type of investment people are put in if they accept the default option would be subject to political influences that have little to do with what is best for the employee. And, assuming the behavioral economists are correct and most people stay with the default, the political clout of financial firms (likely with the help of political restrictions on competition) could result in higher financial fees. (Concern over high financial fees was one argument used by those who successfully opposed President Bush’s attempts to partially privatize Social Security.)

Placement of Food

Libertarian paternalists use examples other than savings plans to illustrate what they have in mind. They often mention the placement of food in cafeterias, buffets, and grocery stores. Again they argue that the food items have to be placed somewhere, and behavioral economics has apparently shown that choices of what to eat are influenced by where food is placed. So food encountered sooner in cafeterias and most conveniently located in grocery stores can be thought of as default options—it is still possible, of course, for people to choose other options. As far as I know, no advocate of libertarian paternalism has yet recommended that government regulate the location of food in cafeterias and grocery stores. But if the principle achieves political traction, there are sure to be pressures in that direction—though maybe cautious and subtle at first. Who would have thought not long ago that governments would soon be imposing restrictions on where and how cigarettes are displayed in stores or what type of fat is permitted in fast food?

If government began moving toward using libertarian paternalism to encourage people to choose healthier diets, political competition among suppliers of grocery-store products would intensify. The fruit and vegetable suppliers, along with the organic-food farmers, would lobby regulators to have their products moved to the front of the store. The producers of soft drinks, candy, chips, bean dip, and a host of other processed foods would use their significant political influence to maintain their locations. Even the magazine publishers would join the fray. No one knows how this political competition would play out. But don’t expect that fruit, vegetables, tofu bars, and maybe cigarettes made with organically grown tobacco would soon dominate the shelves at the checkouts, with the candy and gum there now being moved as close as possible to the loading dock. Or that you would find serious reading material such as The Economist, Barron’s, The Nation, National Review, and The Chronicle of Higher Education in the checkout racks, with the magazines on dieting, fashion tips, and the latest activities of Hollywood celebrities relegated to where the tofu used to be.

Of course, a move in this direction cannot be ruled out. What we can be confident of is that more resources that could have been used to produce goods and services valued by consumers would be devoted to influencing political decisions. The financial well-being of government regulators and lobbyists would certainly be improved more than the dietary well-being of the public.

Some may think that this depiction of an overreaching political process powered more by organized interest than by the public interest is overstated. And perhaps even if the political process does possess the special-interest tendencies just discussed, an idea like libertarian paternalism has so much potential to serve the public interest that the ability of narrowly focused interests to sabotage it will be severely limited. If libertarian paternalists believe this, then they should not object to a test of the political process’s affinity for implementing libertarian paternalism primarily to benefit the public. There is such a test, and libertarian paternalists should require the political process to pass it as a prerequisite for their continued advocacy.

The Test

The test requires considering the many paternalistic regulations that governments now enforce in unlibertarian ways and recognizing that they could be made consistent with libertarian paternalism. A political process compatible with new regulations in the spirit of libertarian paternalism should be able to pass the test by modifying existing regulations to make them consistent with that spirit. Several examples of existing regulations and policies that can be used in this test come to mind.

First, the Bush administration’s plan to partially privatize Social Security would be a move in the direction of libertarian paternalism. The current Social Security system would remain the default option, but workers could reduce their payroll tax up to some specified amount that would increase over time by an amount equal to each dollar they put in a private savings program—with restrictions on accessing the savings before a certain age. There are obviously transitional issues involved in such a policy shift, but if libertarian paternalists and others cannot convince the federal government to establish even a limited private option to Social Security, it will not be an encouraging sign for the political feasibility of libertarian paternalism.

Second, taxpayers are now required to help the poor by having a certain percentage of their tax dollars transferred to them (a smaller percentage than most people believe) by various levels of government. Instead of requiring that those transfers be made through governments, we could make government transfers the default option, but with taxpayers allowed to reduce their tax payments by some significant percentage of the money they donate to private charities dedicated to helping the poor. This libertarian-paternalism approach has real potential for improving the way the poor are helped, since private charities are better than government agencies at assisting the poor without inducing dependency. But this potential depends on government’s being willing to accept competition from private organizations by allowing people to reject the default option. If governments reject this shift to a libertarian-paternalism approach, it would have to be seen as a failure on the test of governments’ willingness to properly implement libertarian-paternalism policies.

Third, smoking regulations suggest another way of testing governments’ willingness to exercise the tolerance for alternative approaches required of libertarian paternalism. An increasing number of state and local governments have outlawed smoking in privately owned establishments that serve the public. The purpose is to protect people against being involuntarily subjected to secondhand smoke. Of course, many people who frequent restaurants, bars, pool halls, bowling alleys, and other establishments enjoy their experience more if they can smoke, with secondhand smoke being an unobjectionable and trivial supplement to firsthand smoke. The preferences of these people are largely, if not completely, ignored by existing antismoking regulations. This situation would be improved by the libertarian paternalism approach. No-smoking could be the default policy, but the owner of a restaurant, for example, could opt out of that policy by making it clear to potential patrons that smoking is allowed. Plenty of options would remain for people to dine out in nonsmoking restaurants, but there would also be options for those who enjoyed smoking while dining, drinking, shooting pool, or bowling. If governments are sufficiently libertarian to offer this alternative to the default policy of no-smoking, it would be an encouraging sign for libertarian-paternalist policy. If governments resist options that let people enjoy smoking while in the company of other smokers and those who don’t mind secondhand smoke, it has to be considered a failure on the test.

Fourth, regulations against insider trading are another area where libertarian paternalists should be able to get government to liberalize its approach if their principle is in harmony with political incentives. The purpose of insider-trading prohibitions is to prevent outsider investors in corporate stock from being harmed by the trading of those with inside information. The objective is a good one, but prohibiting insider trading may not be the best way to achieve it in all cases. For example, regulation against half the perceived problem is unenforceable, since prohibitions against using insider information to decide not to trade cannot be enforced. Also, the price information created by insider trading can be useful to outsiders and can increase the general efficiency of financial markets. Instead of an outright prohibition, no trading on insider information could be the default policy for corporations, but they could opt out in favor of a policy allowing insider trading by making that policy clearly and widely known. This libertarian-paternalism approach would allow corporations and investors greater choice in how they operate and invest. In particular, outside investors could protect themselves against any harmful effects they perceived from insider trading by not investing in the firms that allowed it. And to the extent that investors did perceive harmful effects from insider trading, the relative price of stocks would compensate for those effects. How willing the Securities and Exchange Commission is to move to this approach would give useful information on how appropriately libertarian-paternalist policies in general would be implemented by government.

Organ Sales

A final example of a political libertarian-paternalism test (out of the many that could be considered) involves increasing the supply of organs for transplant. Currently in the United States people can choose to donate their organs on their death by indicating a willingness to do so, usually when they obtain or renew their driver’s licenses. Not making the “donate” choice means that a person has automatically chosen the default option not to donate. As behavioral economists predict, most people choose the default option. Libertarian paternalists don’t think this is the best choice for most Americans, and so they want to switch the default option to “donate.” Being the libertarians they are, however, libertarian paternalists would allow people to opt out by explicitly choosing not to donate.

As evidence from other countries suggests, this would significantly increase the number of Americans who choose to donate their organs. But one would think that real libertarians would want to allow people to sell their organs as another nondefault choice. This is more libertarian (indeed a policy restricting our choices to either keeping our organs or giving them away is not even remotely libertarian) and would probably increase the number of organs available to those who need them. Another advantage libertarian paternalists should see in adding the selling choice is that it would provide another measure of how much the political process could be trusted not to sabotage the other applications of the principle they are recommending.

None of these libertarian-paternalist alterations would bring perfect policies. But how good would they have to be to be better than what they replaced? And certainly they would result in policies more in the spirit of libertarian paternalism. If anything, libertarian paternalists should want to change some of the defaults from what is required by existing policies to options that would be paternalistically superior. But this is a test, and leaving the defaults where existing policies have placed them surely makes it easier for government to pass.

If those recommending libertarian paternalism really want to improve public policy, they should be anxious to subject governments to this and other libertarian-paternalism tests. If the governments pass, existing policy will be improved by bringing them more in line with libertarian paternalism. On the other hand, if governments consistently fail, this will provide libertarian paternalists with important information. Governments unwilling to alter existing regulations and programs so they conform to libertarian paternalism are unlikely to create new ones that satisfy the principle’s requirements. Far more likely is that the rhetoric of libertarian paternalism will be used to justify the expansion in government’s authoritarian paternalism.

Of course those claiming to be libertarian paternalists may object to the test because they think the existing regulations are acceptable as they are. But this would suggest that they are really authoritarian paternalists trying to pass themselves off as libertarian paternalists. So my test is not only a test of the political process’s compatibility with libertarian paternalism. It is also a test of the libertarian paternalists’ commitment to libertarianism.

Politicians can enact policies from two general categories to achieve desirable outcomes, including the creation of high-paid jobs: 1) policies that work, but in ways that do not benefit politicians, and 2) policies that don’t work (and typically make matters worse), but which create the mirage of working in ways that do benefit politicians.

Under prevailing democratic arrangements, electoral survival demands that politicians appear to promote desirable social objectives with direct and decisive action that caters to organized interest groups. Even when such special-interest policies are socially harmful, as they invariably are, they still do more to promote the interests of politicians than policies that would promote broad social benefits indirectly by creating a setting in which people can pursue their various interests through productive interaction. The political problem with the indirect approach is twofold: 1) the benefits are created so gradually and spread so widely that few will notice them, and 2) even if the benefits are noticed, it will be difficult, if not impossible, for politicians to claim credit for them. As F. A. Hayek pointed out in volume three of Law, Legislation and Liberty, politicians “who hope to be reelected on the basis of what their party during the preceding three or four years has conferred in conspicuous special benefits on their voters are not in the sort of position which will make them pass the kind of general laws which would really be most in the public interest” (emphasis added).

When we look at policies aimed at creating high-paying jobs, we easily find examples where politicians preferred conspicuous “benefits” that actually harmed the public to inconspicuous benefits that really were good for the public.

Many policies would increase the number of high-paying jobs indirectly, and many would appear to increase the number directly but actually reduce those jobs and lower wages. The former policies all do the one thing necessary for higher wages and salaries—increase labor productivity—while the latter policies all reduce, or retard, labor productivity, and so reduce wages below what they would be otherwise. The political bias against effective policies is readily apparent from the following list and brief discussion. Consider first some policies that would increase wages.

Eliminate restrictions on imports: One of the most effective things the federal government could do to increase labor productivity and wages is eliminate tariffs and restrictions on imports. Reducing import restrictions increases real wages in two ways. First, it reduces the price workers have to pay for those goods and services that could be produced at less cost in other countries than they can be domestically. Second, it increases the competition domestic producers face from foreign producers, which directs workers into those employments in which they are most productive–in which they have a comparative advantage.

Increased productivity is both necessary and sufficient to increase wages, at least in general. No serious person can deny that there are costs associated with workers moving to more productive jobs, or that a few people will be unable to find new jobs that pay as much as the ones they lost. But no economy can prosper without open competition, which keeps all resources, including labor, moving from less-valued to more-valued employments (in the eyes of consumers) in response to constantly changing conditions. And even those who end up with lower wages because of the particular adjustments they are required to make still earn far higher wages than they would in an economy where they, and everyone else, are protected against having to make such adjustments.

End corporate welfare: Import restrictions are a form of corporate welfare, but unfortunately not the only form. Eliminating all forms of corporate welfare would increase high-wage jobs by reducing taxes and their distorting influence (see below), and allowing both domestic and foreign competition to direct labor and capital into their most productive uses, as determined by consumers, not by politicians catering to their special-interest clients.

Lower marginal tax rates: No matter how efficient a government is, it has to raise revenue to finance its activities, and that means imposing taxes. Unfortunately, all other taxes reduce economic productivity by 1) putting a wedge between the price suppliers receive and demanders pay, thus preventing mutually beneficial exchanges from occurring, and 2) motivating people to make decisions to avoid taxes rather than create wealth. These distortions are commonly called deadweight losses and are an inevitable cost of taxes over and above the opportunity cost of the money raised. Reducing the deadweight loss from taxation increases the effectiveness of exchanges between employers and employees at directing workers to where consumers would value them most, and increases the general level of productivity, both of which increase the real wages of workers. So an effective way of increasing the number of high-paying economy jobs is by lowering the marginal tax rate and expanding the tax base by eliminating loopholes, reducing the deadweight loss of taxes for a given amount of revenue raised. The lower the marginal tax rate the smaller is the wedge between what sellers receive and buyers pay, and the fewer the tax loopholes (along with a low marginal tax rate), the less the tax benefit from diverting resources from high-valued production to low-valued tax avoidance.

Avoid inflation: The federal government can do a lot to increase high-paying jobs by avoiding inflation. Inflation erodes labor productivity and lowers real wages, just as surely as it erodes the value of the dollar. The most destructive thing about inflation is that it distorts the information communicated by market prices, reducing the ability of market exchange to direct resources, including labor, into their most productive uses. Just as a yardstick ceases to be useful for measuring and comparing distances if its length is subject to sporadic change, so market prices are less useful for expressing and comparing values when the value of money is subject to sporadic changes. Also, inflationary distortions make it almost impossible to know what interest rate is appropriate when people borrow and lend money to finance long-term investments. So in an inflationary environment, many efficient capital investments that would increase the future productivity of labor—and increase future wages—never get made.

Avoid the Pork

Reduce pork-barrel spending: There can be no doubt that reducing pork-barrel spending would increase real wages by increasing the productivity of the economy. A major portion of federal spending is motivated by the ability of particular congressional districts or organized interest groups to capture benefits by spreading the costs over the entire taxpaying public. With those receiving most of the benefits paying only a small portion of the cost, the pressure is expand spending well beyond the socially efficient level. Resources are transferred from higher-valued uses to lower-valued uses (for consumers), reducing the real value of salaries and wages. Excess government spending is a negative externality, just like excess pollution, and the former is no less to erode real wages than the latter. If politicians worried about the negative externalities of pork-barrel spending as much as they claim to worry about those of excess pollution, the result would be less wasteful government spending and more high-paying jobs.

Eliminate the minimum wage: This would increase wages by increasing the human capital that, for many young people, is best acquired through on-the-job training. Minimum-wage legislation clearly creates unemployment among young people who, for a variety of reasons, including being trapped in dysfunctional public schools, don’t have skills worth the legally imposed minimum wage. The result is not just unemployment, which may be a short-term problem, but a reduction in the opportunities for many young people to acquire the skills and attitudes that will make them more productive over the long run. Even those who do get a job at the minimum wage are less likely to get one in which the employer invests in them by providing training opportunities at the cost of some immediate output. The minimum wage prevents many young people with little opportunity to continue their formal education to develop the skills necessary to earn a good income in the future by working at a low wage when they have few financial responsibilities. Eliminating the law would make it legal for our less-advantaged youth to have much the same opportunity for higher-paying future jobs as more fortunate youth get through college subsidies.

Reduce the power of labor unions: Eliminating some of the legislative privileges that empower labor unions would be an effective way to increase wages. Labor unions can, and do, increase the wages of some workers. But they do so by reducing the wages of others by enough to reduce wages in general. Because of legal privileges that unions receive, it is difficult (and sometimes impossible) for workers to qualify for some jobs without being members of a union. Thus unions can increase some wages by restricting entry into some occupations and rendering those workers less efficient with rigid work rules.

All these practices reduce the productivity of the general labor force. Restricting entry into some occupations increases the wages of union members who work in those occupations, but it increases the number of workers in other occupations where their skills are less valuable. This not only lowers their wages, but reduces the productivity and wages of workers in general by preventing them from moving into their highest-valued employments. By reducing the flexibility of employers to shift workers from one task to another in response to changing conditions, rigid work rules also reduce the productivity, and wages, of workers.

Industry-wide labor unions have also lowered general economic productivity through cartelization of workers. If the firms in an industry explicitly agreed to reduce their output to increase their prices, they would be in clear violation of antitrust law (from which unions are exempt) and subject to harsh penalties—including prison time for senior managers. On the other hand, the firms in an industry have little to worry about if output is reduced because of a strike by its union. So both industry profits and union wages can be increased by the inefficiencies of a cartel “agreement” that remains within the law only because it is brokered by a labor union. (I am not arguing for antitrust laws. Even if antitrust laws could be rendered immune to political considerations, which they have never been and never will be, they would still reduce the competitiveness of the economy because of the static textbook notion of perfect competition on which they are based.)

All these union-induced inefficiencies reduce output below competitive levels and therefore reduce real wages. These inefficiencies would be reduced and the real wages of workers would be increased by reducing the power of labor unions.

As I have noted, all the policies discussed have one thing in common—they would increase wages by increasing economic productivity. They also have another thing in common—they would increase wages broadly, indirectly, and gradually by establishing an environment in which people productively cooperate with one another through markets in ways that best serve their collective interest. This means that the better jobs and higher wages will not be readily noticed, and even when they are, they will not be seen as the result of can-do government actions for which politicians can easily take credit. So the effectiveness of these policies at creating the type of jobs that politicians are constantly promising to provide does not translate into much political support for them. Politicians would rather receive credit for appearing to create better jobs with counterproductive policies than not get credit for policies that actually allow better jobs to be created. We now consider some policies that are politically popular because they give the appearance of increasing high-wage jobs while actually reducing them.

Policies That Reduce Wages

Restrict imports: When politicians argue for increasing an import restriction or against reducing a restriction, they invariably claim that they want to protect high-paying jobs. An import restriction does protect some high-paying jobs, but at the cost of reducing the emergence of other, even higher paying, jobs, because of the general reduction in productivity that lowers average real wages. But the protected jobs are currently held by relatively few identifiable workers who are typically well represented politically and are fully aware of the benefits they receive from politicians who vote for a trade restriction protecting them from foreign competition. The resulting loss of even more productive jobs can be safely ignored by politicians since it is widely dispersed and not easily noticed—it is hard to miss what we never had. And even if the loss is noticed, the cause—the import restriction—is not easily seen.

Put corporations on the dole: Politicians oscillate between attacking business and praising it, depending on the political issue and climate. But they are constant in dispensing large quantities of corporate welfare that the general public pays for through higher taxes and lower economic productivity. The most common justification for this welfare is that it creates jobs. And indeed it does, but only by destroying the chance for more productive jobs that would have emerged if competition had not been restricted and consumers had been allowed to spend the money paid in taxes to buy what they valued most instead of paying for corporate welfare. Unfortunately, the jobs that are created are visible and easily seen to be the result of government policy, while the higher paying jobs that don’t emerge are invisible—it is difficult to miss what never was created.

Raise taxes: Politicians often call for higher taxes as the best way to promote economic growth and create more and better jobs. Supposedly higher taxes will reduce the budget deficit, which will reduce interest rates by reducing government borrowing. The popularity of raising taxes to increase good jobs seems to contradict the thesis of this article. It suggests that politicians are willing to take an unpopular action—raising taxes—to provide a general benefit—widespread economic growth and job creation. But raising taxes is not an effective way to increase economic growth and create jobs. Even if raising taxes did reduce the federal budget deficit, it is not likely to have much effect on interest rates. Interest rates are determined in a worldwide capital market, with rates often falling when the federal budget deficit is increasing and rising when it is decreasing. Second, increasing taxes seldom reduces the budget deficit, at least not for long. Even when higher taxes raise more tax revenue, the additional money is invariably used to expand government spending and pork-barrel programs, with spending growth typically outpacing revenue growth. The effect is to substitute public spending guided by political influences for private spending guided by economic considerations—a sure prescription for reducing productivity and lowering real wages. Also, with higher tax rates, special interests are willing to pay politicians more for tax loopholes, which introduce more productivity-reducing distortions in the allocation of spending and investments. The political cost of increasing taxes is more than offset by the political benefits from the plausible pretense that good jobs are being created while securing more of the national income to buy more electoral support.

Increase government spending: The list of benefits from more spending on highway construction, recycling, education, agricultural subsidies, parks, airport expansion, water-diversion products, and so on always includes additional jobs. But the jobs created are a major cost of these spending projects, not a benefit. The jobs necessary to build a road or recycle aluminum cans are filled by workers who are not producing value in other activities. Unless this cost is considered, the jobs created will be destroying wealth at the margin, since the value created by workers on government-funded projects will be less than the value (in terms of consumer preferences) they could be creating elsewhere. Political incentives make this misallocation of labor inevitable.

Regulate labor markets: Politicians can take credit for protecting and creating jobs by imposing a number of productivity-reducing restrictions on labor markets. To list two: affirmative-action enforcement pressures employers to hire workers on the basis of the racial mix of the communities in which they operate and increases the difficulty of dismissing unproductive workers; politically mandated employee benefits reduce the flexibility of employers to adjust compensation in ways that attract the best mix of workers to their firms at the least cost. (We’ve already discussed the minimum wage.)

The advantage of the policies that would create more high-paying jobs indirectly is that they do so by creating a positive-sum setting in which people interact in increasingly productive ways.The same increase in productivity that raises real incomes also increases the general level of wealth, enhancing our lives in a host of ways. For example, as wealth increases, infant mortality decreases, life expectancies (and the quality of life) increase at all age levels, poverty declines, the environment becomes cleaner, access to the arts increases, more leisure time becomes available, and jobs become safer, more pleasant and higher paying.

The problem with policies that try to create more high-paying jobs directly is that they do so with government transfers and protections that are negative-sum. Yet this negative-sum approach is politically compelling because politicians receive much of the credit for the benefits, while receiving little of the blame for the larger losses.

The first reason is that it fails to recognize how higher gas prices (and higher prices in general) after a natural disaster greatly increase our ability to help others. The second reason is that the political process (as opposed to the market process) reduces our incentives to understand how best to help others, and exploits this lack of understanding to take more of our money to provide far less help than is possible. When these two reasons are considered together, the conclusion is that the most effective things we can do to help disaster victims are: (1) pay higher prices for gas and (2) abolish FEMA.

Of course, most people wanted to help the victims of hurricanes Katrina and Rita, but they wanted to do so effectively. One of the most effective ways of providing that help was by sharing badly needed products, such as gasoline, with those in the devastated area. And higher prices are the most effective way of motivating that sharing.

The higher prices we paid for gasoline reflected the fact that the hurricanes temporarily reduced gasoline supplies. After the hurricanes there was not as much gasoline available as consumers wanted at pre-hurricane prices. Furthermore, more gas was suddenly needed along the Gulf Coast to bring in rescue personnel, evacuate the homeless, help clear the rubble, and get on with reconstruction efforts. The higher gas prices motivated tens of millions of drivers to conserve gasoline, allowing more to be available where it was badly needed. No matter how much sympathy we expressed for the hurricane victims, it is naïve to think we would have reduced our gas consumption much, if any, without a price increase. Most people would have rationalized that their reduction wasn’t going to make any noticeable difference, so why should they make a sacrifice when hardly anyone else was?

There were price increases for other products urgently needed in the stricken area, and those higher prices also motivated us to conserve so more would be available to the hurricane victims. We didn’t notice the higher prices for most of these products as much as we did for gasoline because their supplies were not disrupted to the same degree. But there were a host of price increases that resulted from the shortages along the Gulf after the hurricane, and these prices provided the necessary incentives for all of us to adjust our consumption in ways that helped the victims.

The help we provided by paying higher prices was indirect, and not as easily seen or emotionally satisfying as shipping resources directly to people in need. But we shouldn’t let this blind us to the facts.

Of course the victims of Katrina and Rita needed more than extra gas and other products. Many lost not just their homes, but also their jobs and the ability to pay for what they needed. Their very survival often depended on direct shipments of food, bottled water, rescue equipment, medical supplies, and building material. This help is what we are going to pay for with higher taxes that few people complained about because, according to what they say, they don’t mind paying what it takes to help people in distress. But there is another reason people don’t complain about the amount they pay to finance government relief efforts, and this reason explains why these efforts are less effective than they should be. Almost no one has any idea how much he is paying for relief efforts, and even if he did, he would have little reason to consider whether the relief is being provided cost-effectively.

It is doubtful if anyone really knows how much he pays in taxes. If you prepare your own taxes, you might remember how much you paid in state and federal income taxes last year. But politicians have been masterful at disguising and delaying taxes in ways that make it impossible to really know what our tax bill is and what our money goes for. Who knows how much he paid in sales taxes, or excise taxes, or import taxes (in higher prices), or corporate-profit taxes (also in higher prices), or in inflation, or what the present value is of his future tax increases resulting from current spending, or his share of the productivity losses caused by the excess burden of taxation? Nobody knows.

But even if we did know our total tax bill,we would still have no idea how much of what we pay goes for particular government programs and services, such as relief efforts, or how much more we will pay in taxes because of a natural disaster like Hurricane Katrina. Indeed, few of us are aware of more than a small fraction of the government activities we are paying for. So when the cost of a government activity, like providing relief for hurricane victims, goes up, people simply aren’t aware of, or don’t register, the increase.

It’s not just our ignorance of how much our taxes are and what they are going for that allows politicians to provide us with services that are poorly designed and incompetently delivered and then charge us more than they would be worth even if they were efficiently provided. There is also the problem that individuals can do little about the situation. No one can switch his patronage, and tax dollars, from FEMA to a competitive relief agency.

The Problem with Getting Our Gas from Tax Mart

If gas were paid for and provided as government disaster relief is, an increase in the cost of gas would motivate few if any complaints because the increase would go largely unnoticed. Unfortunately, any motivation for people to adjust their consumption appropriately in response to the higher cost of gasoline would disappear right along with the complaints about cost. Misallocation and waste in the use of gasoline would be guaranteed.

The problems would extend beyond those caused by the lack of consumer information on the cost of gasoline. If gas were provided like disaster relief, we would have to pay through our taxes; gas would then be available at a price of zero at Tax Mart gas stations in quantities determined politically. If you wanted to buy your gasoline from a private supplier, or buy more than your Tax Mart quota allows, you could do so, but your tax bill would remain the same. No one would be surprised if the service and gas were noticeably worse at Tax Mart than at private gas stations. Tax Mart bureaucrats wouldn’t have to worry about budget cuts despite lousy service and poor quality gas, since people would continue to put up with its poor performance—the only alternative would be to pay twice for gas. Indeed, Tax Mart’s budget might be increased in the futile hope of improving its operation. There would surely be complaints about the quality of the service, but many would confront the cognitive dissonance brought on by their continued patronage of Tax Mart despite its inadequacies by coming up with rationalizations for its problems.

So we shouldn’t be surprised that few people complained about the cost of the government’s efforts to provide relief for the victims of natural disasters. Neither should we be surprised that the complaints that these relief efforts are generally carried out ineptly, and not infrequently (as was the case with Hurricane Katrina) with almost criminal negligence, do little to motivate improved performance next time.There is little, if anything, any individual taxpayers can do that would noticeably motivate government officials to use tax dollars more efficiently to help victims of natural disasters. With no sense of empowerment, taxpayers have little reason to pay more than passing attention to the inadequacies of disaster relief. Some might become agitated enough to vote against the politicians supposedly in charge, and they might be defeated. But such changes at the top seldom result in fundamental changes in the bureaucratic incentives that ultimately determine the performance of government programs. No matter what group of politicians wins the next election, as long as taxpayers have no idea how much they are paying for disaster relief and have no control over how much they pay whether or not they are satisfied with how well the relief is provided, there is little reason to expect the next relief effort to be any better than the last.

Abolish FEMA

Helping large numbers of people after natural disasters is complicated, made more so by the damage to the physical and social infrastructure needed to provide the help. No relief effort will be flawless. But if those paying the bill for disaster relief knew the price and had some control over how the money was being spent, improvements would be made in the effectiveness and efficiency of the help. Taxpayers can never have the same degree of information and control as they have when buying gasoline. They can be given more information and control than they have now, however, and do more to help disaster victims. How? By abolishing FEMA and getting the federal government out of disaster relief.

The immediate response to the recommendation that federal government quit providing disaster relief is that private responses would be woefully inadequate because of the free-rider problem. Without the federal government forcing everyone to contribute to disaster relief through taxation, people would contribute little if any to private relief organizations (such as the American Red Cross, Salvation Army, United Way, and many other reputable charities), attempting to free-ride off the contributions of others.

The free-rider problem no doubt reduces voluntary contributions below ideal levels after natural disasters. But the question is not whether voluntary contributions are a perfect solution to the disaster relief, but whether the addition of FEMA to voluntary contributions and private relief efforts makes things better or worse. Despite free-rider problems, Americans give generously to private charities to address a host of social problems, and they are particularly generous after disasters, natural or otherwise. U.S. charities raised over $2.2 billion after the 9/11 terrorist attacks, and nearly $1.3 billion for the victims of the 2004 tsunamis. But according to The Chronicle of Philanthropy, as of about a week after Katrina hit New Orleans, the pace of private charitable giving to victims was greater than that following these previous disasters.² Also, private giving would surely be greater if people were able to keep more of their income and were not lured into believing, as many are, that their tax dollars were taking care of the problems.

It is doubtful, of course, that private charitable contributions would come very close to the amount spent by the federal government. When comparing relief efforts funded by the federal government and those financed by voluntary contributions, however, it is a mistake to concentrate solely on the free-rider problem associated with the latter. The waste, delays, and incompetence that characterize FEMA are the result of a free-rider problem inherent in all federal spending programs. Taxpayers can be forced to pay for FEMA, but they cannot be forced to contribute to those collective actions needed to prevent FEMA from taking too much of their money and spending it in ways that provide too little help for disaster victims and often make things worse. (The current level of government spending for disaster relief undoubtedly increases the harm to life and property. Subsidized insurance and government-financed rebuilding programs lower the private cost of building in areas highly vulnerable to hurricane and flood damage. Making less money available for such subsidies would result in more rational patterns of development, save lives, and reduce property damage in the future.)

Taxpayers and victims of disasters would be better off if each (1) contributed to efforts to monitor FEMA and report on the cost and effectiveness of its activities, and (2) communicated to their political representatives that the resulting information was going to influence how they were going to vote in the next election. But this isn’t going to happen because of the government free-rider problem. This problem seldom gets discussed, even though it is probably a bigger obstacle to helping disaster victims today than the free-rider problem associated with private giving would be if FEMA were abolished.

No one denies that contributors to private charities also fail to monitor those charities diligently and that those charities often fail to make the best possible use of the money they spend. But there is an important difference. If the word gets out that the American Red Cross, for example, is not making good use of donations, people can shift their contributions to other private charities that are doing a better job. We don’t have this option with FEMA. Instead of getting less money because of its poor performance, FEMA will almost surely get more, with the justification that more is needed to do a better job.

The contrast between the public’s response to gas prices after the hurricanes and its response to the cost of government efforts to help the hurricane victims is instructive. The lessons this contrast teaches, if given some thought, are (1) gasoline suppliers were doing a good job serving the public interest because gas prices forced people to accept the harsh realities and motivated them to respond in ways that helped the hurricane victims, and (2) because people had no idea what the government relief effort cost and had no effective way to respond to the cost even if they had known what it was, government did a poor job helping the hurricane victims. Once the fundamental and intractable problems of helping disaster victims by forcing people to fund FEMA are considered seriously, abolishing the agency doesn’t seem like such a radical proposal.

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1. Once the news started reporting on the delays and inadequacies in FEMA’s response, I did hear people complaining about its poor performance. The complaints were not about the costs, but about the people and party in charge of the relief effort and how the right people would have done a far better job.
2. Nicole Lewis and Nicole Wallace, “Americans Have Given at Least $670 Million for Victims of Hurricane Katrina,” The Chronicle of Philanthropy, September, 9, 2005, http://philanthropy.com/ free/update/2005/09/2005090801.htm. The Associated Press later reported that $1.3 billion had been raised privately (http://www.washingtonpost.com/wp-dyn/content/article/2005/09/28/AR2005092801529.html).

But I’m having second thoughts about presenting only the negative side of our national retirement program to the youth of America. I’ll be eligible to begin collecting Social Security payments in a few years, so I’ve decided to take a more positive attitude. The Social Security taxes I have already paid are sunk costs, and therefore are not costs at all. Only the future taxes and income from Social Security are relevant to my return on the program, a return that is getting better all the time. What a shame to jeopardize that return by turning the taxpayers of the future against the Social Security program, which can also be there for them some day if only they consider the bright side of the financial mugging heading their way. In the hope that the young people of today can be encouraged to stay the course with their Social Security “contributions,” I am writing them an open letter telling them the rest of the story. You see, Social Security is about more noble objectives than achieving financial success.
—DRL

Dear Young People,

There simply is no better feeling in the world than sacrificing for the benefit of others. That is particularly true when your sacrifice benefits me. I want you young college students to keep that in mind the next time you hear someone criticizing the Social Security system. I will be retiring about the time you are paying large sums into Social Security, and your tax payments, I mean contributions, will be sent directly to my buddies and me so we can afford to drive enormous motor homes to the local shuffleboard courts. None of it will be invested into your own personal account for your retirement.

Some of you may be asking, but then what kind of financial return can I expect from Social Security? That is the type of question we have to expect from those who, because of the damaging effects of natural selection, insist on thinking of themselves first. But let me consider the return a college graduate about to enter the work force can expect from Social Security. The news is better than some of you believe, especially those of you who believe an invasion by the space aliens who kidnapped Elvis Presley is more likely than Social Security being solvent when you retire. Let me give you my unwritten, but completely unenforceable, guarantee: you will receive Social Security checks when you retire. That is assuming you live past age 67, which you probably will because of a wonderful incentive built into the Social Security program for your benefit. Because of this incentive, your rate of return can be far better than the experts are now predicting. Let me explain.

Assume you work from age 22 to 67 and make only the median family income during your career. In this case your Social Security contribution will be about $3,000 a year, recognizing that you will generously help your employer with his contributions to your Social Security by accepting wages lower than you would otherwise have received. These contributions will make you eligible for Social Security payments at age 67. How much will you get? The maximum you can receive (as I write this) is $23,868, which assumes that your spouse is still alive, or at least appears to be, and also 67 or older. When you are 67, 45 years from now, the payments will be higher, assuming they keep up with inflation (your Social Security contributions will also increase with inflation, but let’s ignore that minor inconvenience). Let’s be optimistic and assume they will. Assuming a 3.1 percent inflation rate (the average over the last 70 years), then your annual income from Social Security will be $91,453 at age 67. And you thought Social Security was a lousy deal.

I’m tempted to rest my case right here, except someone is probably asking, “But how better off would I be if, instead of contributing to Social Security, I put the $3,000 a year into the stock market for the next 45 years? At the risk of encouraging people to think of Social Security only in crass financial terms, I will answer this question.

Over the last 70 years the stock market (as measured by the Standard & Poor’s 500 index) has grown at an average annual rate of 10.9 percent. At that return, your $3,000 a year will be worth $3,182,779 when you are 67. With that amount of money, you could buy a lifetime annuity that pays over $356,000 a year. So a cynical, but completely accurate, conclusion is that the Social Security system will bamboozle you out of over $264,547 a year (the difference between $356,000 and $91,453) during your retirement.

But why be so negative? After 45 years of 3.1 percent annual inflation, $264,547 will be worth only about $69,000 in today’s dollars. Also, think of the incentive Social Security gives you to take good care of yourself. You can make Social Security pay if you live long enough. The present value of your Social Security income will be worth the $3,182,779 your private investment would have provided, if you simply refuse to die until you are 125 years old. (This assumes that your annual Social Security income of $91,453 grows at 3 percent a year—good luck—and you discount the future value of that income stream by 5 percent—ask your favorite finance professor why discount is necessary.)

So Social Security is right up there with conferences on global warming as a way of promoting long life. I’m certainly keeping myself in peak condition in anticipation of benefiting as long as possible from your Social Security contributions. I don’t want to go face down in my oatmeal until you young folks retire.
Sincerely,
Dwight R. Lee
Ramsey Professor of Economics

And the evidence is clear that individual freedom disciplined by market incentives is closely connected to widespread wealth. Markets and the freedom they allow are far more important to the prosperity of nations than natural resources. Many countries rich in natural resources have been impoverished by the substitution of government compulsion for market freedom (consider Argentina, Russia, India, China, and any number of African countries). There are also many countries poor in natural resources that have prospered by relying primarily on market forces (Japan, Hong Kong, Switzerland, and Singapore).

But if the market is so superior to government, why do people respond to almost every problem, real or imaginary, by demanding a government solution? Why have governments relentlessly taken ever more responsibility for their citizens’ welfare, and ever more of their paychecks, in unsuccessful attempts to make everyone better off at the expense of everyone else? No complete answer to these questions can be given in a short column. But at the heart of any answer is an irony—markets are criticized for the very reason that they create wealth, and governments are applauded for the very reason that they destroy wealth.

Markets work their wonders by creating in each of us an intense interest in taking actions that increase the welfare of others. Few of us give much thought to the well-being of more than a few of the hundreds of millions of people who in various and indirect ways benefit from our work and investments. But we are vitally concerned with the salaries we are paid and the profits we receive, and in markets our salaries and profits rise or fall with the value of our contributions to others. So by adjusting our efforts and investments to improve our conditions, we also improve the conditions of countless others.

The well-known implication of this is, as Adam Smith pointed out in 1776, that though each person “intends only his own gain, . . . he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” But immediately before this famous statement, Smith made another, less celebrated, observation that each individual “neither intends to promote the public interest, nor knows how much he is promoting it” (emphasis added). Because the benefits from our efforts are so dispersed over so many people in so many ways, we can never know how much we benefit others, even if we cared. And because the benefits we realize from others are similarly spread over so many, none of us notice, or can identify, the particular contributions others are making to our welfare. The benefits generated through markets are largely unappreciated because they are distributed so broadly and impersonally. And even when these benefits are appreciated, people seldom understand that they are made possible only by the cooperation created by market incentives.

Little Credit Given

While the market receives little credit, or appreciation, for the benefits it provides, it is constantly attacked for the very thing that makes those benefits possible. The inevitable consequence of the market’s rewarding those who do the most to benefit others is that it imposes losses on those who don’t. Firms suffer losses and bankruptcy when they fall behind the competition in catering to consumers, releasing scarce resources to those making better use of them. Similarly, those who invest in, and work for, firms that aren’t continually giving consumers better products at lower costs find their portfolios shrinking and their jobs disappearing, again shifting resources (including labor) to more productive activities. Although everyone, including those who suffer these costs, is better off living in an economy that imposes them unrelentingly, the pain that results is undeniable. And because the pain is concentrated it is easily seen, readily associated with the market forces that caused it, and invariably criticized as a market failure that calls for corrective government action.

So the success of markets is easily overlooked, or taken for granted, while the discipline that makes that success possible is easily depicted as an unnecessary and unacceptable cost. We have all seen the nightly news lamenting the horrible disruption people suffer when the major employer in their communities goes out of business. But how many have seen a follow-up on the millions who are a few dollars a year better off because the bankruptcy freed up resources to produce more valuable goods and services elsewhere in the economy? We have become wealthy because these adjustments create more benefits than costs. But because the benefits are dispersed and the costs are concentrated, the market is seldom given credit for the former, but constantly blamed for the latter.

On the other hand, government programs destroy wealth because their benefits are typically concentrated, and therefore easily noticed, while their costs are widely dispersed and easily ignored. The political benefit-cost ratios of these programs are greater than their social benefit-cost ratios, so they are invariably expanded far beyond the point where their marginal value covers their marginal cost. Obviously, the group receiving most of the benefits from a program will appreciate it, know which politicians support it, and reward them for expanding it. Even taxpayers who pick up the tab for wasteful special-interest programs commonly favor them because the benefits are so apparent and easily connected to the particular program that provides them, and the cost of any one program to any one taxpayer is typically too small to notice.

Finally, political authorities like providing government benefits even when doing so destroys far greater benefits in the market. Politicians and bureaucrats are in the business of taking credit for things, and they cannot take credit for the benefits generated through the market, and receive little if any blame when programs reduce those benefits.

We shouldn’t laugh at the dog that bites the hand that feeds it. When expanding government programs that distort and discard market incentives, we are not only biting the hand that feeds us, we are also feeding the hand that bites us.