Although it was an up-and-down 2006 for the Japanese economy, there have been signs of an emergence from its long recession. Unlike previous recoveries that proved short-lived, this one shows every indication of being permanent. There are obvious markers of renewed success and some more subtle signals that are possibly more significant.

First, the headlines. The Nikkei closed at above 17,000 at year end. It had reached that figure in April, only to fall back, but now all informed observers are confident that the rise can be maintained in 2007. Furthermore, the giant car producer Toyota has overtaken General Motors as the world’s biggest automaker. And of course its profits are much healthier than its American rival, long the world’s leader. Production, mainly automobiles and high-tech products, was up in November, the second month running, and consumption increased. The Bank of Japan raised interest rates slightly in February.

But the more elusive pointers to Japan’s renewal relate to the changes that are taking place in Japanese business practice: The economy is being Americanized. This is a process that was pioneered by the recently resigned prime minister Junichiro Koizumi with his privatization of the Japanese post office, which will free up to $6 trillion in assets for investment in the private sector. And in the private sector itself there are signs that that much-neglected figure in Japanese business, the shareholder, is becoming the focus of attention. Long the victims of poor returns and exclusion from management of the companies they nominally own, shareholders have for decades been the helpless victims of managerial incompetence and irresponsible arrogance. And it was this protection of management from normal market pressures that did so much to fuel the country’s recession. But things are changing: Dividends are up, and the long-cosseted bosses are feeling the pressure of resurgent stockholders.

Oddly enough, evidence of the change can be gleaned from two business scandals that have rocked the normally staid world of Japanese commerce. First, there was the much-publicized Takafumi Horie case. He was a radical financier who upset conservatives with outrageous takeovers via his Livedoor Corp. Of course, his very success provoked the authorities anxious to preserve the respectable Japanese way of making money by making things, like cars, refrigerators, and washing machines. His trial for fraud and “window dressing”—inflating the profits of corporate raiders to make them attractive suitors in a bid—began in September and ended in late February. The result was guilty, and Horie was sentenced to two and a half years in jail. He protested his innocence to the end and is now appealing.

A not-dissimilar case, that of Yoshiaki Murakami, has been much less publicized in the West but is perhaps even more significant. A former civil servant, Murakami was head of M&A Consulting, worth $3.6 billion, which was explicitly designed to press for stockholders’ interests. Both revered as a shareholder champion and reviled as an asset stripper, he constantly pressured managers, demanding better performances that were to be reflected by higher dividends. Under constant surveillance by the authorities, he finally confessed to insider dealing, ironically in connection with the bid for Nippon Broadcasting that Horie’s Livedoor had made. While confessing, he claims he was guilty only of a technicality: He simply heard about the bid and bought stock on his instinct without being in a relationship of trust with either company.

The Horie and Murakami cases certainly herald a new era of business in Japan. This can be seen in the rapidly expanding mergers-and-acquisitions market in which the American financial giant Citigroup has been recently active after it was hit by some setbacks in the early years of this century. In 2006 Citigroup completed deals with a total value of $38.2 billion in Japan. It is bringing American banking practices to the country and is increasing the competition with rival local banks. Of course, the Japanese mergers-and-acquisitions market is much smaller than in America. In 2006 merger deals in Japan were worth $127.6 billion, while in America there were 10,200 with a value of $16 trillion. Still, the Japanese car industry was once much smaller that America’s, and now look at Toyota.

All this new business activity must be good news for Japan. It will lead to a more efficient allocation of capital and render the country’s economy more flexible and better able to cope with the opportunities of globalization. The Japanese are learning that there is more to making money than making things.

However, as I shall show, these promising signs must not be misunderstood as indications of permanent improvement, for the conditions that caused Europe’s decline—rigid and inflexible markets, too-high public spending, and excessive taxation—are still there. The long-term survival of the European “social model,” with its massive welfare spending, will ensure that the continent will lag behind America, much to the chagrin of the chauvinistic French. The increasing hold that the policies of European Union (EU) institutions have on the member states will guarantee that the familiar anti-market strategy will be pursued. Indeed, one method for opening up Europe’s markets—the admission of former communist regimes of Eastern Europe that have pioneered low taxation and deregulation—will be weakened as they are compelled to adopt the standard inefficient European practices. The EU has never valued competition either in product markets or the markets for regulation and taxation. The most disappointing case of all is the United Kingdom: for a long period it was the least “European” of the member states and something of a free-market beacon for the continent. But under the allegedly nonsocialistic New Labor, the country has drifted toward the European “social model” while doggedly remaining outside the euro currency area.

To maintain my argument that signs of a European economic recovery are premature, I shall look at the major economies, Germany, France, Italy, and the United Kingdom, in some detail since they set the standards for the continent as a whole and illustrate its many weaknesses and few strengths. They also dominate the institutions of the EU, which are endeavoring to set common continental economic standards.

Germany. This is the most interesting and instructive country, for in its postwar history it has revealed both the strengths and lamentable weaknesses of European economies. It is still the world’s third-biggest economy, after the United States and Japan, but seems to have lost the secret of that success. Germany’s economic greatness came in the immediate postwar period when it adopted the Sozialemarktwirtschaft (Social Market Economy) under Finance Minister, and later Chancellor, Ludwig Erhard. It tried to combine the requisite free-market efficiency with a measure of state welfare. Thus it accepted Bismarck’s welfare state but vowed it would not introduce a Scandinavian version. Welfare measures should be marktkonform, designed so as not to disturb the efficiency features of the free market.

But the “philosophy” of the Social Market Economy extended beyond the welfare imperative into the organization of the capitalist economy itself. Postwar Germany did not have a shareholders’ economy. It included other “stakeholders,” that is, non-owners who were considered to be equally important, such as trade unions and banks. Thus the two-board system of company management included a supervisory board with heavy union representation. Also, investment was funded not only by share issues but by bank lending. This gave the banks inordinate influence on company policy and shielded the managers from shareholder pressure; it eventually brought a loss of competitiveness to German industry. Not surprisingly, the Social Market system became popular across all political parties, including the former Marxist Social Democratic Party (SPD).

Over time the behavior of successive governments brought about the very thing the founders of the Social Market Economy did not want: a Scandinavian welfare state. Unfunded pensions were extended, as were unemployment benefits, so that it became irrational to work at all. State-funded education was generous enough to encourage students to stay at school past 30. The elimination of shareholder pressure from business protected incompetent managers—takeovers were rare and foreign acquisitions almost unheard of. A combination of all these factors led to the decline of the German economy, exacerbated by the costs of reunification, which involved the partial extension of the welfare benefits to the former communist East.

Not surprisingly, the German economy found it difficult to cope with globalization, especially with competition from the Far East. It has remained a manufacturing economy, but its rigid labor market was easily outperformed by the newly marketized China. The once-powerhouse of Europe became the weakest-growing EU economy between 1994 and 2003. When unemployment hit 5 million, over 10 percent of the workforce, even the Social Democrats realized something had to be done. Under Gerhard Schroeder they introduced mild reforms of the labor market, but they met with intense trade-union opposition. Hopes rose with the election in 2005 of the Christian Democrat Angela Merkel, who had a more radical market-oriented program. But she has been hampered by the fact that she was compelled to form a coalition with the SPD, which has representatives in the top economic positions in government.

Not All Bad

But things are not all bad for Germany, and there has been some improvement in recent years. Economic growth has resumed, albeit falteringly, and the flow of capital to more hospitable countries has been stemmed though not stopped. Many employers’ organizations are now saying that Germany is a good place to invest. While still a manufacturing economy, the proportion has fallen from almost 27 percent in 1992 to 22 percent in 2002. Much of the improvement has come about not from government’s relaxation of the labor laws but rather from voluntary agreements between employers and unions. Economic reality has dented the woolly optimism of the politicians.

There is still a long way to go before Germany restores its economic greatness. Politicians could make a start by reading up on the conditions that led to Erhard’s success and remembering that he was never happy with the inclusion of the word “social” in his model. And before Germans get too optimistic about their recent recovery, they should remember they face a hefty value-added-tax (a kind of European consumption tax) rise of 3 percent fairly soon—another confrontation with the reality of big government.

France. This is not a country that we look to for a free-market past to inspire its present and future. It is true that in the Fourth Republic the economy modernized itself, largely because no government was in power long enough to do lasting damage. De Gaulle’s Fifth Republic was tied up with the Algerian problem and foreign affairs in general to either extend or foul up its basically market economy. The trouble really started with the election of François Mitterrand in 1982 and his extreme socialist program of nationalization and redistribution. Some sort of order was restored with the election of Jacques Chirac in 2000, but France remains a dirigiste (directed) country, whoever is in power. Today the government is still involved in banking, energy, automobiles, transport, and telecommunications. Unemployment was at 9.1 percent last July, down from 10 percent, but it is still a big problem, and public debt is at 6 percent of GDP, way above the mandated EU limit of 3 percent. The country is weighed down by a welfare state and a minimum wage of almost $10 per hour.

There have been some measures to address unemployment, especially among the young. These include some minor tax cuts and a serious attempt to break the rigidity of French labor laws with the “First Employment Contract” (known as CPE), which would have allowed employers with more than 20 workers to dismiss them at will for the first two years of the contract. Adequate safeguards were built in to help the “victims,” but the proposed law still met with tremendous opposition from the left and the unions, no doubt fearing that something worse would follow. As a result, Prime Minister Dominique Villepin felt compelled to abandon it. That was bad news for free marketeers in France; for such a mild measure to meet with such opposition, and for the government to cave in so abjectly, indicated that France remains a socialist country even under a conservative administration.

Some other minor measures have been introduced to tackle unemployment but nothing substantive or structural. French productivity has been badly affected by the law limiting work to 35 hours per week. It was introduced allegedly to create jobs. One can almost hear the great French laissez-faire economist Frédéric Bastiat say: “Why not make it 10 hours per week. Think how many jobs that would create!”

The European Disease

France is afflicted by the European disease more than any other country. This is the illusion that wealth can be created by laws, that poverty can be solved by administrative decree, and that happiness and prosperity are a function of goodwill rather than reward for effort. Although there once was a radical free-market tradition in France, this is now but a distant memory. Formal Marxism might be dead, but it still casts a long shadow. Trade unions may be weak in the private sector, but they are still powerful in the government sector and capable of great economic damage. One might ask: how does France survive at all? Well, despite the dirigiste government the French workforce is educated and highly productive, and growth is picking up. But both taxation and government spending are far too high for long-term economic success. There is a big public deficit, but the idea persists that it can be dealt with by high taxes and not reduced spending.

If the government won’t do anything about this nightmare, the people will. Thousands are already flocking to hated England and are taking up well-paid jobs in the equally hated City of London.

Perhaps the saddest thing about France is the lack of any serious debate about the free market. There was once a politician, Alain Madelin, who understood it. He ran for president and served in Chirac’s government, but he has been mute in recent years.

Italy. It is always a pleasure to visit this country, and even to write about it. That legendary Italian cynicism about politics is a welcome dampener on the euphoria of the Europhiles. A prominent Italian conservative said to me last April of Silvio Berlusconi, the former conservative prime minister: “He may be a crook but he is at least he is our crook.” But Italians can be a little pleased at the moment. They will record a growth rate of 6 percent for 2006, the best in years. They have a socialist government but carry on making money. They are impossible to regulate and difficult to tax.

I am sure they won’t get too carried away by their current success, for trouble is just around the corner. As the Italian finance minister Tommaso Padoa-Schioppa recently said: “A recovery must last for years not just six months.” And will it last? Probably not. Retail sales have recently dipped; public debt is still above the recommended EU figure; and business confidence has recently taken a knock. Moreover, there is a serious long-term problem: the emigration of its skilled workers. Graduate emigration quadrupled relative to total emigrants in the 1990s. Economic conditions must be pretty bad for qualified people to want to leave such a wonderful country, and they will probably get worse in the future. The current growth rate is unlikely to be sustained next year, and Italians are facing serious tax rises. Like other European countries, Italy is trying to solve a government debt problem by raising taxes rather than by cutting spending.

The United Kingdom. It is always a puzzle to talk about Britain in the context of Europe since it is never clear that it wants to be in the EU anyway. The conservatives are definitely Euroskeptic, and some would leave the EU. The tragedy is that the country is moving in a European social-democratic direction without being proper Europeans. Some Europhiles regard the country as an outpost of hated American free-market capitalism.

How then is Britain moving in a European direction? Answer: one man—the current chancellor of the exchequer and soon-to-be prime minister Gordon Brown. Okay, he doesn’t believe in old-fashioned nationalization, but he does believe in tax and spend just like the Europhiles. Since his tenure began, government spending has reached 45 percent of GDP, up from 37 percent, and taxes have gone up on 63 occasions. And still government debt is about $39 billion and threatening to go even higher—largely to pay for the 800,000 new civil servants he has hired. Brown writes articles of a Euroskeptic persuasion for the Wall Street Journal and takes his vacations in the United States. But that does not make him seriously pro-capitalist. Under Brown the United Kingdom has whittled away the Thatcher legacy.

The Delusions of Europe

A glance at the four major economies of Europe shows that the continent is far from recovery. It is still social democratic in its outlook. Its current moderate success conceals deep problems brought about by the earlier adoption of discredited economic policies, and its only hope is to reverse the trend and follow the strategies of its new member states. I am thinking primarily of the Baltic states: Latvia, Lithuania, and Estonia. They now have flat taxes of something over 20 percent, completely privatized economies, and almost no agricultural subsidies. Therein lies the future, not in old Europe. And I have not mentioned the looming pension problem that threatens to engulf Germany, France, and Italy. Neither have I mentioned the two successful economies of old Europe, Spain and Ireland, both of which have pursued market policies. No wonder the Europhiles rarely mention them.

He was born in Enfield and educated in conventional state schools. He went to Hull University to read for a degree in American Studies in 1969. After university it would have been easy for Chris to take a normal postgraduate course and get a job in those breeding grounds of Marxism and all forms of state parasitism, the polytechnics. Not for Chris—he was against the state and certainly wouldn’t work for it. He worked for a number of freedom think tanks and affiliated organizations, including the Institute of Economic Affairs and FOREST (the Freedom Organisation for the Right to Enjoy and Smoke Tobacco), and he managed the free-market bookstore in Covent Garden, the Alternative Bookshop, from 1979 till 1985. Through difficult times he managed to keep up a publications record that would shame most conventional academics. 

He was first introduced to free-market economics via the Austrian school, which is the only part of economic orthodoxy that has a firm commitment to capitalism. Chris soon became expert in the works of Menger, Mises, and Hayek, and the most sophisticated contemporary proponents of free-market economics, Murray Rothbard and Israel Kirzner. 

Although Chris was well aware of, and could demonstrate with ease, the efficiency of property rights and free markets, this was not the sole reason for his enthusiasm for capitalism. The right to exchange simply flowed from the moral right to liberty, as did the right to property. These things were not merely necessary adjuncts to liberty but an expression of it, however rich they made us. In all of this Chris was directly influenced by the novelist and philosopher Ayn Rand and her Objectivism, whose moral anti-statism he found so compelling. But unlike Rand, Chris’s arguments for liberty were always graced with impish humor. Liberty was serious, but it could also be fun. 

Although never part of the established academic community Chris was a prolific writer. He was a scholarly enquirer into the history of classical liberalism, writing on Adam Smith, the Scottish Enlightenment, and Austrian economics. He also delighted in rediscovering previously neglected figures in the history of the freedom movement; his most important work here was his resurrection of the “old” liberal J. M. Robertson. For his scholarly contributions to the field he was awarded a Ph.D. by Middlesex University . Working to the end, at his death he was engaged in his vast Bibliography of Freedom. 

But we will remember Chris for his charismatic personality and relentless optimism. When he was manager of the Alternative Bookshop it became a meeting ground for libertarians who just wanted somebody to talk to. And that was normally Chris. Most of the customers seemed also to be authors; others had just come in to hear Chris’s tapes of Elvis that brightened up the shop. He was a great fan of rock music and jazz. 

We shall remember Chris as the leading figure in the halcyon days of the libertarian movement, the 1980s, when even conservatives were entertaining radical ideas about freedom and markets. He had little time for the current generation of Tories, who are more interested in office than ideas. As he would ruefully remark, they are not even good at that. He was diagnosed with a particularly aggressive form of bone cancer in July 2005, but he bore his affliction, and all its pains, with courage and humor. He was too ill to attend a ceremony in 2006 by the Centre for the New Europe at which he was granted the Adam Smith Lifetime Achievement award. 

Libertarianism is rich enough to survive the death of Chris Tame—ideas do outlive people—but it will be a much poorer movement.

Last year’s election results in Japan and Germany are not only important for those countries but also have wider lessons, for they herald a decisive defeat for a once-fashionable doctrine—the Third Way. This was adopted by socialists in despair of the abject failure of “really existing socialism” but desirous to pre­serve their anti-capitalist credentials. They assumed we could secure all the benefits of the free market, in terms of its higher productivity and liberal social framework, without its unpleasant concomitants—excessive individualism, companies’ concern with shareholder value, the use of the takeover mecha­nism for industrial reorganization—all summed up by the morally loaded term “greed.” Fortunately for Third Wayers there were two economies that appar­ently evinced different virtues and were highly successful, the second and third biggest economies in the world, Japan and Germany. Indeed, at one time all America was frightened of Japan’s stu­pendous economic virility. The Japanese car industry, spearheaded by Toyota, Nissan, and Honda, was on the brink of taking over from Detroit, and although the Japanese were not great innovators, they could copy and make cars, washing machines, and com­puters more efficiently than the West. And Germany was the dominant economic power in Europe, whose industries, like Japan’s, were heavily geared toward exports. In both countries the shareholders were squeezed out of running companies they nominally owned and industry was geared toward serving the community more than the owners’ interests. Thus the huge Japanese corporations played a significant welfare role, and nobody ever lost his job. Even though private ownership was sedulously maintained, Germany and Japan did not have Anglo-American capitalism as exem­plified on Wall Street and in the City of London.

But both economies have been mired in recession for the past two decades and have begun to question their own economic models, as was seen in the election results, Japan more than Germany. What went wrong? Briefly, both countries became dominated by interest groups that used the political system to divert income created by others to themselves (“rent-seeking”); both had too much state welfare; and neither economy was flexible enough to cope with the demands of globalization. Overall, Japan and Germany have political systems that offer every incentive for political parties to preserve the current inefficient system and none for anyone who tried to break out of it. It was a classic “social dilemma”: everybody knew they would all eventually be better off if they dumped the obstructive labor laws, cramping regulations, and costly welfare, but political parties were beholden to interest groups that benefited from the preservation, indeed expansion, of the prevailing system. Mancur Olson, who analyzed the dilemma in immense detail and sophistication once suggested that it could only be overcome by a national catastrophe such as defeat in a major war.¹ And Japan and Germany had their economies devastated by defeat in World War II yet managed to make amazing recoveries in the early postwar years, while among the victors Britain languished until Margaret Thatcher. Britain, of course, was dominated by interest groups, especially trade unions.² I shall look at Japan first, and in more detail, because it appears as if it is getting over the aforementioned social dilemma better than Germany.

Japan has had a dominant party, the Liberal Demo­crats (LDP), which has been out of power only once since 1955, briefly in the 1990s.Yet it has no coherent program. It is really a bunch of pressure groups that profit from the bur­geoning state. There is no serious socialism in Japan, and it still has a rel­atively small public sector, but the Democratic Party of Japan, formed by disenchanted LDP members, is slight­ly more left-wing and under the influ­ence of trade unions. They know where the rents are.

Japan has always had a market economy, but it was not Anglo-Amer­ican. Shareholders were paid derisory dividends and kept out of annual meetings; companies were run by “stakeholders,” that is, managers and banks. Firms were also more interested in market share than profit, and the whole nation was mobilized to promote exports, not consumption. Companies themselves, if not socialistic, were certainly communitarian: they provided welfare benefits and lifetime employment. It was a rigid and inflexible system, but it worked well enough to make Japan the second biggest economy in the world—until 1990, when the stock market began to fall—from a high of 39,000 on the Nikkei to below 10,000, its nadir. The real economy went into a steady relative decline. Investors originally benefited from capital gains, but mil­lions of Japanese housewives, who had spent the family income buying up stocks, were badly hit by the fall in the 1990s. The country was at the same time building up a huge government debt—now 160 percent of GDP.

Prime Minister Junichiro Koizumi although from an establishment Japanese political family, knew something had to be done if the country were to get out of the stagnation of the 1990s. Japan had been very good at copying Western electronics, but he realized it would have to copy Western economic models too. Elected in 2001, he set his sights on the Japanese postal system. It is not only important in itself, but is also indicative of the Japanese malaise. He wanted to privatize it. His plan was defeated by the upper house of the Japanese Diet (Par­liament) early in the summer of 2005 (the lower house had barely approved it), which was the immediate cause of the election.

Privatization was not to improve the delivery of letters and parcels. I can speak from extensive personal experi­ence that, despite being state-run, the postal system is efficient. The real rea­son for privatizing the post office is that it is also a huge savings bank and provider of nationalized insurance. The Japanese have a legendary propensity to save, and they tend to put their sav­ings in the post office—at present it controls assets of $3 trillion. And where does that money go? It funds huge and mainly unnecessary public works. There is a medium-sized town near Tokyo that has two airports, which together have ten flights a day. All this is a gift to the LDP, which benefits from the useless jobs and wheels out the votes at election time. The post office has 400,000 employees. What Koizumi wants to do is to free up all this capital to be invested in the still-productive private sector.

Of course, all this upset the LDP establishment, and it defeated Koizumi’s first attempt at privatization. But he daringly called an election last September, fired dissi­dent LDP members, and sent in “assassins,” handpicked glamorous media personnel, to fight them at the elec­tion. He won an overwhelming victory: even if the upper house continues to oppose post-office privatiza­tion, he has enough votes from the lower house, with his coalition partners, the Komei, to use the constitution and override it.

Public Choice Defied

Koizumi’s victory was remarkable because it defied the lessons of Public Choice theory: it is normally impossible to defy an electorate that consists largely of rent-seekers. The future benefits of necessary reform are insufficient to compete with the attractions of short-term advantage. But Koizumi is an astute, possibly hon­est, politician, and he campaigned as if the election were a referendum on the privatization. If he had run on a regular manifesto it is almost certain his opponents could have defeated him on a rent-seeker’s program. He also has some charisma, unusual in Japanese politics.

But progress is likely to be slow in Japan—the priva­tization is not scheduled for completion until 2017. And the rent-seekers are likely to defeat him if he tries to reform the costly welfare system. The immediate problem is that Japan has an aging population and a declining work­force. That will also bring forth the need for increased health expenditure. Fur­thermore, Koizumi has to leave his post by next September; the LDP rules limit the leadership of the party to two terms, and there does not seem to be anybody with the drive and commitment to reform to take his place. However, there are already moves underfoot to persuade him to carry on. If Japan is to continue to defy the well-established theorems of Public Choice, the country will need somebody of his determination.

Germany

Germany has the world’s third biggest economy, and it has gone through an experience not unlike Japan’s. From being the powerhouse of Europe the economy is now almost shrinking, with over 11 percent unemployment. After World War II Germany established the “social market economy” under Ludwig Erhard, first as finance minister, then (unsuccessfully) as chancellor.³ The “social market economy” seemed to combine mar­ket-led economic progress with compassionate welfare policies, though in the last 30 years the social element has inexorably displaced the economic element in the model. (It is not at all clear that Erhard himself would have approved of this.) The original Bismarckian welfare state was extended, first to expanded pensions (unfund­ed and dependent on a rising birth rate) and then to conditions of employment. But the German birth rate has dramatically fallen; private pensions are virtually nonexistent; and rising nonwage labor expenses have made the costs of doing business unsustainable—much German capital is leaving the country. This can only worsen under globalization. German business is like Japan’s, with powerless shareholders. Takeovers are rare.

All this has been known for a long time, but entrenched interest groups made the political system more or less immobile. No political party dare risk offending these groups with serious reform. The parties are in an unconscious cartel, but while cartels are nor­mally overcome in private competitive markets, it is not so easy in the ersatz competition of representative democ­racy. Germany is in an insoluble social dilemma, and Erhard has been virtually forgotten.

Some progress was made, however, with the emergence of Angela Merkel as leader of the Christian Democratic Union (CDU). Unable to form even a tiny majority in alliance with the small but more free-market Liberal Demo­cratic party, Merkel has been forced into a “grand coalition” with the Social Democrats. That means the same inter­est-group immobility will continue for some time. A good example is tax reform. Merkel’s pro­jected finance minister is an obscure academic, Paul Kirchhof, who achieved notoriety by suggesting replacement of the complex German tax system, with its myriad exemptions, with a lowish flat tax of 25 percent. Immediately all those groups that benefited from the prevailing system protested and the scheme was quietly forgotten during the campaign. No German commen­tator seemed to realize that a carefully designed flat tax will actually increase government revenue through less tax avoidance and tax evasion, and the operation of the Laffer curve. A flat tax is not just for the rich, but bene­fits everybody, except tax accountants. It is a way of get­ting over the social dilemma.

Frau Merkel has suggested that laws on hiring and firing will be relaxed so that it will be easier to dismiss redundant workers, and her welfare reforms would remove the temptation not to work, the bane of German welfare policy. However, even the Social Democrats under Gerhard Schroeder offered tame versions of these policies, only to water them down even further after relentless opposition from Germany’s still powerful trade-union movement. Of course, Germany has certain unique problems, especially the cost of reunification, but this should not dis­tract us from the fact that the country illustrates all too well the universal problems of representative democracy, especially the ability of entrenched groups to prevent the pursuit of the genuine public good.

The experience of both Japan and Germany should alert us to the seductive but ultimately lethal properties of the Third Way. By locking ever more people into the state, especially through generous welfare policies, it only strengthens powerful interest groups and makes reform almost impossible. Perhaps only by the Swiss system of referenda on particular issues can the dilemma be got round. Indeed, the fact that Koizumi almost turned the Japanese election into a referendum on the post-office privatization supports this position. It is possible that if the flat tax were put to a referendum in Germany it would be approved.

And by restricting the power of shareholders the Third Way weakens the corrective mechanisms of the mar­ket and strengthens the managements of companies and banks, neither good defenders of free markets. There is only one form of successful capitalism, that is free-market exchange with a very limited state. As the president of the Czech Republic, Václav Klaus, once famously said: “The Third Way is the Third World.” Japan, which is on its way to recovery, might have resisted Public Choice tem­porarily, but Germany certainly has not.

Notes

1. See Mancur Olson, The Rise And Decline of Nations (New Haven, Conn.:Yale University Press, 1982).
2. See Norman Barry, “What Kind of Conservatism?” Margaret Thatcher’s Revolution, ed. Subroto Roy and John Clarke (New York: Continuity Books, 2005).
3. See Norman Barry, “The Social Market Economy,” Social Philosophy, vol. 10, 1992.

From obscurity and complete intellectual unfashionability throughout the 1950s and 1960s, Seldon and a distinguished cadre of writers managed to influence a whole generation of economists and writers on the market and limited government. At a time when the intellectual world was dominated by the Keynesian-collectivist consensus, Seldon successfully educated a new generation into a fresh way of thinking and introduced to a British audience such “foreign” economists as Milton Friedman and F. A. Hayek. And though not naturally a conservative—he always called himself an Old Liberal—he was a great influence on Margaret Thatcher, and indeed many of her policies originated in Lord North Street, Westminster, London, home of the IEA.

Born in 1916 into relative poverty to Jewish immigrant parents in the East End of London, Seldon worked his way into the London School of Economics (LSE), where he came under the influence of Hayek, a recently appointed professor. It was an influence that was never to desert him. He quickly learned that almost everything the government does the market and the private sector could do better. Most important, he realized that if you want to advance the interests of the working class, free-market capitalism always beats the government. This was the beginning of a lifelong campaign against state welfare. From his earliest days he understood that spontaneous working-class organizations like the friendly societies provided better health care, old age pensions, and unemployment benefits than the vast state bureaucracies that replaced them.

The IEA was set up in 1957, with the backing of a prosperous chicken farmer, Antony Fisher. Fisher, a convinced free-marketer, had learned from Hayek that to influence events, it is better not to go into politics, but rather to produce ideas. That is why he financed the IEA and many other free-market think tanks throughout the world.

As editorial director, Seldon quickly set about recruiting some of the best names in free-market ideas. He created a “house style” that was remarkable: he managed to persuade writers to communicate in simple, concise prose without in any way sacrificing the rigor of their arguments. As one who was a little frustrated at seeing his virginal text almost violated by the red pen of Arthur Seldon, I quickly came to realize that he was right all along and that he had transformed yet another dreary academic paper into something that might even attract the attention of the conventional left-wing press.

Someone very receptive to Seldon’s approach was Milton Friedman, who always had a genius for conveying complex ideas in lucid prose. Friedman led the IEA’s onslaught on Keynesianism from the early 1960s. One of the many reasons for the “New Right’s” eventual triumph over the Old Left was the clarity, as well as the perspicacity, of its arguments. Compared to the turgid and incomprehensible style of the typical unreadable Oxbridge academic publication, a piece from the IEA was always intellectually exciting and extraordinarily well-written.

Ever anxious to keep his readers up to date with new thinking, Seldon quickly saw the significance of Public Choice theory, which was emerging in the 1960s. Distrustful of politicians, he never believed that they were disinterested promoters of the public good, but rather were self-interested utility maximizers beholden to interest groups that made their careers possible. So naturally he was attracted to American theorists like James Buchanan (a Nobel Prize winner in 1986) and Gordon Tullock. In fact, some of their book-length works were published in easily accessible form by the IEA.

Seldon was a natural anarchist who delighted in offending the statist establishment. This reached its apogee in 1968 with the publication of Mike Cooper and Tony Culyer’s The Price of Blood. This presented the quite shocking idea that shortages in hospitals would be solved if that precious human commodity were bought and sold like any other good. This argument offended the sentimentalists, who believed that an inexhaustible supply of altruism was just waiting to be tapped, and the welfare establishment, which did not want the intervention of the tasteless and unruly market into an area that was the exclusive preserve of the well-meaning state.

Seldon himself was a prolific writer. His best work was probably on welfare policy, in which he relentlessly exposed the denial of choice and the dull inefficiency that the state produced in health and pensions. His first paper for the IEA was a stunning piece on the inequities and inefficiencies of the state pension system, a subject that was to bother him all his life. In the 1980s he published some remarkable research which indicated that the British public preferred more choice and private provision in welfare and was prepared to pay for it. All this is concealed in the vote-maximizing practices that go on in regular elections. He was an indefatigable proponent, with his wife, Marjorie, of Friedman’s idea of vouchers in education. Again, this illustrated his desire that state bureaucracies and trade unions should be removed from decisions that affect ordinary people and their families. But perhaps his finest work was the sadly neglected book Capitalism (1990). Here he celebrated not only the market system’s efficiency, but also its contribution to human freedom. He was working to the end against the state. His seven-volume works are being completed by the IEA, and only then will a full evaluation be possible.

Seldon was a prominent member of the Mont Pelerin Society and an honorary fellow of the LSE and the private University of Buckingham, which was fathered by the IEA. He will be sadly missed.

New Labour said it was different. In 1997 it claimed it had abandoned all that twentieth-century socialism. It changed its constitution to say that it had given up on the nationalization of the means of production and exchange even as a long-term goal for some state-planned utopia. It promised not to tax and spend, or persecute business. It had a prudent chancellor of the exchequer, Gordon Brown, who had all the Scottish parsimony and caution that would guarantee long-term prosperity. He was even born near Adam Smith’s home. After the election of 1997 people believed him. I myself, for the first time in my life, went to bed thinking I would not wake up in the old East Germany under a Labour government.

To be fair to Mr. Brown, he began well. He gave the Bank of England its (de facto) independence so that interest rates would not be set to benefit the government of the day and monetary policy would not be the plaything of party politics. Equally important, Mrs. Thatcher’s reforms, especially in relation to the trade unions and privatization, looked safe. Even big business was happy to cooperate with a Labour government, though we should have been warned—big business has always liked big government.

And the dangers were already there. They were just a little slower in coming round this time. Labour has always hated financial success. It thinks that wealth only comes from digging holes in the ground or bashing metal. So it slapped a retrospective, one-off £5 billion tax on those financial institutions that had made money out of Thatcher’s privatization program. Worse still, the Labour government increased the tax burden on private pension funds to the tune of £5 billion a year forever. Reform of state pensions had been one of Margaret Thatcher’s greatest achievements. She had inherited a costly long-term plan to provide earnings-linked unfunded pensions to the workforce, paid for by unwilling and unconsulted future generations. She unwound all this and managed to put the majority of the workforce in privately funded schemes. Compare this to social-democratic Europe, where there are riots every time the French government tries to introduce much-needed reforms to unsustainable pension promises.

And on it went. Brown, chancellor of the exchequer and Blair’s presumptive successor, became less prudent by the day and began to raise taxes that impinged on ordinary people as well as the rich. But he kept his promise not to raise the income tax, so nobody noticed the other 63 taxes he hiked, including a significant raise in National Insurance (aka social security) and the stamp duty on house purchases. In total, public spending is now 42 percent of GDP, up from 37 percent. There is a gaping hole of £14 billion in the public accounts, which is set to widen. And there are 800,000 more state employees, all Labour voters, doing useless jobs since 1997. So it really is the same old Labour, but with a different presentation. It at least got that from capitalism.

Brown likes to present himself as an adherent of Anglo-American capitalism, as distinct from the beat-up European social-democratic version. He has even written articles for the Wall Street Journal on those lines. But he is not to be believed. He is an old-fashioned socialist who taxes and regulates as much as the Europeans. He is a Euroskeptic, but like the old Soviets, he wants “socialism in one country”: the United Kingdom. Blair has at least tried to reform the public services, against Brown’s opposition, but has not succeeded.

Britain has probably the worst health-care system in the civilized world, evidenced, in part, by many preventable deaths from heart disease and cancer. The reason: it is entirely tax-financed with a monopoly supplier, the National Health Service (NHS). True, it is free at the point of treatment, but it is hard to get treated. Labour has poured billions of pounds into state medicine, yet there are still poor service and long waiting lists for operations. At least the Europeans have a complex social-insurance system, not as good as private insurance but better than general tax funding.And they have competitive suppliers too. That is why many Brits take vacations in Germany just to get ill. (There are reciprocal health agreements between member states of the European Union.) At least Blair tried to open up the closed UK system with the creation of foundation hospitals, independent of the NHS, which could raise their own funds. But the proposal was emasculated in Parliament, largely at Brown’s behest.

Similar reforms were blocked in the education system, so that parents continue to have little or no influence influence on their children’s schooling and the unions remain de facto owners and managers of the schools. Blair also worked hard to raise tuition for university students. It is a disgrace that rich parents should get virtually free higher education, and it is even more of a scandal that the Conservatives should support this inequitable system. Blair only just managed to get a small raise in fees passed after ferocious opposition from his own party and the self-seeking and opportunistic Conservatives. They represent too many rich parents with children in the state universities, which is all except one.

Failed Socialist Road or Complete Thatcher Revolution?

So the British should think carefully when they savor the Labour victory. Do they want to continue to revert to the failed socialist road or complete the revolution begun by Mrs. Thatcher? Since the Conservatives have not yet produced a new blessed Margaret, serious capitalists and free marketers were hoping for a big Blair victory last May. Mrs. Thatcher’s successors have shown no interest in school choice, privatization of the health service, or serious tax cuts. So now it is Blair or real socialism. Blair needed a big victory to give him the confidence to fire Brown and save the country. He didn’t get it, so it is socialism all the way under Brown when he takes over at the end of the next Parliament. Blair’s own real flaw was his obsession with Europe and its new “Constitution,” but it looks as if the British will get all that, whoever wins the battle for the leadership of Labour, New or Old.

Americans should think on the British experience. There is no feasible alternative to real capitalism. The “Third Way” is the Third World, where the United Kingdom is headed under Gordon Brown. He has positioned himself very well. While not dissociating himself from Blair’s controversial pro-American foreign policies, he has been sufficiently distant so as not to offend Labour’s traditionally visceral anti-Americanism. And in domestic policy he has consistently massaged Labour’s millions of voters who live parasitically off the productive private sector. Labour won’t nationalize anything much, but it will exploit the private sector and expand the government’s role, especially in education and health. And taxes will rise.

This approach is a bit more subtle and is immune from the empirical refutations that destroyed old-fashioned socialism. But the effect of the new critique could be as deadly as the familiar anti-capitalist nostrums. And it cannot be denied that capitalists themselves have been the main source of the new critique. Because of the business scandals of recent years, the opposition has been aided by the behavior of personnel in the business system. As I shall demonstrate, the problems of business today relate to some familiar quirks of the capitalist system, and naturally the critics have got it all wrong.

There are some easy targets. Unrestrained capitalism, it is said, produces unadulterated greed, and its problems can only be alleviated by yet more government regulation and more restraints on entrepreneurship, the creative driving force of business. And, of course, parallels are already being drawn between today’s malfeasance and the infamous “decade of greed,” the 1980s. But although both eras involve the same business problems, the mechanics of business change and behavior are rather different.

One of the greatest achievements of capitalism was the invention of the limited-liability, or joint-stock, company; its easily exchangeable shares and legal personality led to that flexibility which is the envy of markets that have not developed it. There are indeed two types (at least) of capitalism: the Anglo-American system, which emerged from the common law of contract, and the European system, which is the product of code law.

The Anglo-American theory of the corporation, despite legislative and judicial depredations, endures.¹ The managers of a corporation have a fiduciary (strict) duty to advance the interests of the owners, the stockholders. In the European model of capitalism, other groups, known as stakeholders, are thought to have a significant role in decision-making in the corporation. This is best exemplified in the German company, which has the two-board management system in which trade unions and others, often politicians and public figures, can be decisive. The statute that created the limited-liability company in 1870 decreed this. Though not eliminated, owners’ rights are reduced. That is why takeovers are rare.

But the Anglo-American corporation, despite its many virtues, has been afflicted by one problem since its beginnings. It was first identified by Adam Smith and is known as the “agency” problem. The owners are the principals, the managers the agents.² The question is: how do we get the agents to observe their fiduciary duties and not run off with company assets, shirk on the job, and pursue their self-interest. They do have considerable discretion, especially in America under the “business judgment” rule, by which courts are prepared to accept almost anything done by managers as being in the interests of the company. Smith thought that the only viable form of business enterprise was the owner-managed firm.

If we compare the 1980s with the early years of the 21st century, we see the same problem but with widely different answers. It is a serious mistake of the critics of capitalism to bundle the two eras under the common name—greed. They are very different.

The 1980s saw a really significant shift in wealth and power from the managers to the owners. This was a response to the earlier accumulation of wealth and power by corporate executives. True, takeovers took place in the earlier period, but they were not designed to advance stockholder value. Rather they were to increase the wealth and power of the managers. This led to the creation of unwieldy conglomerates that held back American economic progress. Clever entrepreneurs like T. Boone Pickens and adroit financiers such as Michael Milken broke them up. Companies were captured by raiders, only this time to advance stockholder value. They were often taken private; management was slimmed down; and the companies were brought back to market to yield even more profits. The personnel involved in this were despised and their methods excoriated, yet the whole experience underlay the remarkable American prosperity at the end of the twentieth century. This was the result of the spontaneous evolution of capitalism.

Victims of Managerial Power

The very opposite happened at the beginning of this century. Stockholders had become the victims of a new era of managerial power. And, in comparison to the much-despised 1980s, which were characterized by rather high levels of probity, there was massive cheating by executives. They deceived the stockholders at every turn and rigged the stock market, and that much-prized value, transparency, which should be the main feature of good corporate governance, descended into a mystifying opaqueness. It was difficult for stockholders to know what was going on until it was too late.

Of course, the market eventually wreaked its revenge, and big companies all but collapsed under a sea of debt. The market does eventually punish wrongdoers, but a lot of people lose serious money on the way. A crucial feature here was the decline in effectiveness of the auditors and accountants. Supposedly independent of management, they are charged with the duty of providing stockholders with essential information about the company. But they were also engaged in lucrative consultancy work for the company. This obviously gave them an incentive not to reveal vital information. It would obviously have a deleterious effect on the price of the stock.

None of this had much to do with today’s morality. Indeed, the people involved in scandals had high moral profiles. They gave money to charity (though that was often company money), practiced affirmative action in the workplace, and generally followed the dictates of conventional business ethics. But what the aberrant companies did in the last five years was to breach those conventions of good business practice that had grown up independently of statute and departments of moral philosophy at Ivy League universities.

Enron Collapses

Enron collapsed with massive debts in December 2001.³ It was a hugely successful energy-trading company, though it began as a small gas firm. Its problems arose because it had embarked on highly ambitious schemes and engaged in complex derivative trading and various offshore ventures. It had managed to conceal its difficulties from the public and investors, and was still getting good reports from the press right up to its demise, although the credit-rating agencies always thought it a risky company.

The virtue of Anglo-American capitalism is that Enron-type disasters are avoided, or their worst effects mitigated, through constant stockholder pressure, either through “voice” (harassing management at annual general meetings) or “exit” (selling their stock to a raider). These are checking devices that have emerged spontaneously to solve the agency problem. But to be effective they require transparency on the part of companies.

In the Enron case, stockholders were deceived about the true state of the company. This was done in a number of ways, the most important being the creation of Special Purpose Entities (SPEs). These are a kind of partnership within the firm, and they have the advantage, for someone anxious to conceal the truth, that their figures do not appear in the company’s books. SPEs are not illegal. However, they are certainly imprudent, and in Enron’s case their existence enabled the managers to evade the responsibility of telling the truth to investors.

Enron executives were distinguished by the fact that the bulk of their income came from stock options. This gave them an incentive to keep the price of the stock artificially high. Their auditors, the now-ruined Arthur Andersen company, helped them in this. The auditors were not defenders of the stockholders’ assets, but were conspiring with the managers.

Neither federal nor state law was any help to the stockholders. The federal Williams Act of 1968 made it difficult for outside stockholders to organize tender offers and threaten management with surprise bids. Equally significant was the fact that all 50 states had passed their own anti-takeover laws in response to the boom of the ’80s. This was largely at the behest of incumbent managers worried about their jobs. These laws were designed to protect the allegedly defenseless employees and investors. They did precisely the opposite, entrenching management instead.

Perhaps one of the most questionable acts of the Enron executives was to persuade workers to keep on buying stock in the company when the executives knew it was in desperate trouble. They were unloading shares at what was then a high price. One, CEO Kenneth Lay, has been charged with insider dealing (and other federal criminal offenses), a law of which I have written critically in the past: but this was not the real error in the case. It has been cogently suggested that Lay had good reasons for selling his Enron stock and that his sale was not merely a preemptive response to a future fall in its price.⁴ But the appropriate remedy here for any wrongdoing should have been civil action. Enron executives were in breach of their fiduciary duties to the firm and its investors (especially the workers). However, the Justice Department has become adept at turning civil wrongs into serious criminal offenses. It is clear that that the action against Lay is more political than legal, and the long delay in bringing him to trial suggests this. Like other “white collar criminals” in the past, he has been so publicly vilified that a jury is unlikely to be impartial. Of course, the government wanted someone to blame. And the workers, through their representatives, were remiss in not demanding more information. No doubt they were misled into thinking that regulation would save them.

The WorldCom Case

The scandal at WorldCom, whose bankruptcy in 2002 matched that of Enron, revealed similar features of business malpractice. This was a small telecommunications company that became a world leader, largely through some spectacular takeovers. But it had suffered from bad investment decisions and some extraordinary extravagance by employees. Its founder and former chief executive, Bernard Ebbers, was said to have “borrowed” up to $408 million from the company. All the time information was withheld from the market so that investors could not make informed choices. An example was the company’s representing as working profit $2 billion put aside for bad debts. These malfeasances had been going on since 1999, when Arthur
Andersen was the auditor, and were only revealed by the replacement firm, KPMG.

Another great scandal that shocked the Anglo-American corporate world was the affair at Tyco International. This did not involve the complexities of corporate finance that Enron featured. It was more a case of straight theft from the firm. But it illustrates the familiar agency problem. Its chief executive, Dennis Kozlowski, and the chief financial accountant, Mark Schwartz, treated the company like a personal cash cow. Kozlowski is said to have spent $1 million of company money on his wife’s birthday celebration and, equally notoriously, $6,000 on a shower curtain for his home. The pair eventually faced a 32-count indictment, including charges of grand larceny. A mistrial was eventually ordered because of witness tampering, but the defense argument that the expenditure had board approval and that there was no criminal intent may prevail, bizarre though that seems.

The lesson drawn by some business observers is that stockholders should be more active in the running of publicly quoted companies. But that is a little misleading, for traditionally the ultimate exercise of ownership rights, selling out to a raider, had been sufficient to keep management in line. In normal circumstances it is not in the rational self-interest for small owners to be involved in management. However, the aforementioned federal and state laws restricting takeovers have blunted that weapon; so a new form of stockholder activism might be required. And here there is clearly a role for big equity owners to take an interest in the company. They can see more clearly the effect of management on the value of their stock. Already this is happening. The huge public-sector pension organization, the California Public Employees Retirement System (CalPERS) is active in corporate governance and the practice is spreading throughout the Anglo-American capitalist world. After all, managers of pension funds have fiduciary duties to their members.

Limits of Morality

But in all these issues it is important to understand the nature and limits of morality. Moral philosophers have been far too anxious to stress supererogatory duties, that is, those that are worthy but not compelling, and have underplayed the basic rules by which we all live. The latter may not be glamorous, but successful business would be impossible without their observance.

The eighteenth-century Scottish philosopher David Hume was acutely aware of the dangers of a strident morality. He said that ethics has no basis in reason and was entirely a function of the passions. But this did not make him an immoraliste, for he believed that human experience shows how strict conventions (the basic and uncomplicated rules of morality) come to be adopted, especially for law, property, and economics.⁵ By playing “repeat games” we overcome the absence of trust in human affairs so that self-interested utility-maximizers advance their own goals by cooperating. He was worried that morality had a tendency to become an “enthusiasm” detached from human experience. He would regard modern business ethics as one such enthusiasm. All the recent business scandals have involved clear breaches of fiduciary duties. We don’t need a new moral philosophy to tell us that corporate theft and lying to stockholders are wrong. We only need to understand conventions.

European Capitalism

Just as the Europeans were preening themselves on their virtue in the light of American business scandals, they were suddenly shocked by the revelation that Parmalat, the huge Italian company, was facing bankruptcy with losses of 14.5 billion euros. This was in the Enron and WorldCom class for corporate chicanery.

Part of the original European claim for financial probity was that companies there were not primarily vehicles for the enrichment of greedy stockholders. European companies are “stakeholder driven” organizations in which a variety of groups essential to the business have a share in its governance. Owners (stockholders) are simply one of them. The influence of stockholders is further reduced because most investment capital is raised by bank loans rather than share issues. Since banks are also considerable equity holders, unlike in the United States or the United Kingdom, this gives them excessive influence in company policy. The banks are important figures on the supervisory boards of German companies, enabling them to put together coalitions of interests to resist the sanitizing effects of corporate raiders. Banks also act for minority stockholders. Since the restless search for stockholder value has not been a feature of German business, the significance of ownership is less than in the Anglo-American corporation.

However, as Italian experience reveals, the stakeholder system, so far from “democratizing” the corporation and making it responsive to demands of groups other than stockholders, has entrenched the management of a small group of self-interested insiders. True, Italian companies are quoted on the stock exchange, but they are effectively controlled by families. The Agnelli family’s reluctance to cede control of Fiat, which has slid near bankruptcy, is the classic example. Italians have not developed the Anglo-American style of corporate governance because they have not developed a notion of trust (or reliance on Humean conventions). The anonymity of large-scale capital markets, as opposed to the intimacy of family ties, is alien to them. Italy is the heartland of “crony capitalism.”

If crony capitalism is bad for business, as it unquestionably is, then the Parmalat case took it to new heights of venality.⁶ Despite the absence of a love interest, a diva, and a dagger, it was worthy of a Verdi opera. Parmalat was originally a successful company specializing in dairy products. But gradually it lost interest in milk and cheese and acquired worldwide holdings in a variety of unrelated products.

Parmalat was able to carry on without restraint because of the absence of any checking mechanisms, least of all from stockholders, in the company. It was effectively controlled by one family, the Tanzi, and the dominant figure was Castilio Tanzi. He ruled the company like a medieval tyrant, and corporate governance was abysmal. Extensive bank loans were raised and companies bought at inflated prices. And unlike in American takeovers, the companies were not turned into viable business enterprises, but became the personal property of the Tanzi family. When disaster struck, Parmalat was an incomprehensible, impenetrable, and debt-ridden colossus with no discernible business strategy.

Stakeholders Silent

And what did the legendary stakeholders do about all this? Precisely nothing, except blame one another. The crisis could have been averted if investors and bankers had taken action. As it turned out, they were silent and inactive and lost large amounts of money. There were culpable individuals involved, but the whole culture was rotten. In Italian business the importance of family control is so strong that the checking bodies are reluctant to stand up to them. That had not been too serious in the past, but the successful spread of globalization requires a notion of trust that extends beyond family members. And indeed, Parmalat’s problems emerged when it became a globalized company.

Only in Germany are there signs of stockholder activism. Although the country had established a full-fledged market system under Ludwig Erhard in the 1950s, it had never adopted Anglo-American business techniques. Firms were always run by stakeholders, especially bankers, and stockholders had little influence. The apogee of German stakeholderism was reached in 2001 with the defeat of the hostile bid for Krupp by Thyssen. It was turned into a tame merger.

But the successful bid for Mannesmann by Vodafone in 2002 was a significant blow for Anglo-American capitalism.⁷ The case had a curious aftermath. Mannesmann executives awarded themselves massive American-style “golden parachutes.” This angered stockholders and caused great controversy in German business. The executives were eventually charged with criminal offenses, and although they were acquitted, the whole saga marked a turning point in German business. There are other cases pending, and German stockholders are now demanding, vociferously, an Anglo-American-style of business with a new emphasis on stockholder value.

Despite their obvious differences, recent events in American and European business reveal a remarkable similarity: the shift in wealth and power to company executives. In America the investors were the losers, and in Europe other stakeholders suffered as well. In the 1980s the threat of a takeover kept agents (company executives) in line. Sadly, that has been seriously weakened through legislation, and in Europe it has always been moribund. But the natural, self-correcting mechanisms of the market are the only secure devices against fraud and the exploitation of the owners by managers.⁸

Notes

1. See Norman Barry, “The Theory of the Corporation,” in Ideas on Liberty, March 2003, pp. 22–26, www.fee.org/~web/0303iolpdf/feat5.pdf
2. See Adolph A. Berle and Gardner C. Means, The Modern Corporation and Private Property (New York, Macmillan, 1932) for a critique of capitalism from this perspective.
3. See William A. Niskanen, A Preliminary Perspective on the Major Policy Lessons from the Collapse of Enron, Cato Institute, July 2002.
4. William L. Anderson and Candice E. Jackson, “Is Ken Lay a Criminal?” Ludwig von Mises Institute Daily Article, August 16, 2004, www.mises.org/fullstory.aspx?control=1589 Mises.org.\5. See Norman Barry, “Political Morality as Convention,” Social Philosophy and Policy, vol. 21, 2004, pp. 266–92.
6. See Financial Times, April 13, 2004.
7. Norman Barry, “The Logic and Morality of Takeovers,” Ideas on Liberty, July 2000, pp. 33–37.
8. The Sarbanes-Oxley Act of 2002 got some things right. For example, auditors must rotate every five years, and they cannot be consultants. But it also imposed heavy compliance costs on companies. However, companies could have done these things themselves, and were going to, without the heavy regulatory burdens.

The whole enterprise foundered on an apparently technical point on voting rights in the Council of Ministers, the legislative body of the European Union (EU). However, Euroskeptics should not relax. The European constitution seemed doomed until dramatic events in Spain led to its resuscitation. The bombings in Madrid produced the surprising election of the socialists. They are very much “old Europe” and are keen to ally themselves with France and Germany, with their crypto-socialistic, heavily interventionist model. Spain immediately withdrew opposition to the constitution and was quickly followed by Poland. With June’s intergovernmental conference out of the way, it’s now up to the member states to ratify the constitution. But it will take a long time, and there is every chance it won’t happen.

It is opportune then to step back and look at where we are now and examine critically the principles that have driven the European experiment in the last 47 years. As we shall see, from not-unpromising beginnings it has proceeded toward a new superstate at an even faster pace than America departed from its equally auspicious origins.

Originally, the most significant event was the founding Treaty of Rome (1957). European countries, nearly ruined by two world wars, wanted to put all this nationalistic bellicosity behind them, especially the deadly rivalry between France and Germany, and establish an international rule of law to make the world safe for commerce. Equally important, they wanted to face the Soviet menace while not openly conceding they were free-riding on American defense.

The first name for the new venture was the European Economic Community and that is what it was: an attempt to break down trade barriers between European countries. Though Europeans have had little interest in world free trade, it was a step in the right direction. Whatever success it had was due almost entirely to the fact that it did not have a constitution. Also, because of the unanimity rule in the Council of Ministers, there could be little centralization of laws and regulations. Any country could veto proposed laws. There was unformulated jurisdictional competition.

But the subsequent history of Europe is the story of inexorable centralization, significantly court driven, under the superficially alluring aegis of “ever closer union.” Ironically, some of this had theoretically free-market credentials. In the early years some member states had used jurisdictional competition to hold up the advance to free markets; they had imposed limits on the movement of capital and labor. Apparently, the market had to be promoted by European-wide law, and therefore the Single European Act was adopted by treaty in 1986. At the time, most free marketeers, myself included, were under the illusion that liberty was best advanced by constitutionalism, despite evidence to the contrary from America. And the Single European Act, true to form, so far from freeing the market, licensed the imposition of strict regulations across the continent, and the veto was significantly reduced.

Since then, the centralization of Europe has proceeded apace with the gradual removal of jurisdictional competition. This has reached its apogee with the proposed constitution. A good indication of what its content would be can be found from a glance at the composition of the constitutional convention. The delegates were not in any way representative of the “people,” as the men of Philadelphia were, but were European rent-seekers (seekers of wealth through political means). The European Commission (the instigator of European law) was inordinately represented, and there were aging ex-prime ministers, ex-presidents, and ex-ministers of the member states in attendance.¹ All had an interest in greater centralization. They had an agenda before they started their deliberations.

Supreme European Law

The constitution proclaims the supremacy of European law over that of the member states, presaged as long ago as 1964 with the Costa v. ENEL decision from the European Court of Justice (ECJ). This, with no authority from the Treaty of Rome, struck down an Italian statute that happened to conflict with an EU regulation on the ground that European law was superior to domestic legislation. It was the beginning of the activism of the ECJ.

But this did not establish unequivocally the priority of European law. There was the problem, for example, of the sovereignty of parliament in Britain and the binding constitution in Germany. Thus in Macarthys v. Smith (1979) the British courts held that since Britain’s accession in 1973, the country’s laws were subservient to Europe, but Lord Denning also said that if parliament deliberately and consistently breached European law, “it would be the duty of our courts to follow the statute.”² In 1994, although the German constitutional court upheld the (centralizing) Maastricht Treaty, it also said that Europe was a confederation of autonomous legal systems and that European law was subordinate to the Basic Law (Germany’s constitution).

One might have thought that classical liberals would favor the superiority of the burgeoning international law of the European Union. Hadn’t unlimited parliamentary sovereignty been the principle by which socialism was introduced in Britain? But that would be a naïve view of politics and indicative of an unwarranted faith in constitutionalism to constrain the excesses of democracy. Of course, it would be acceptable if a written constitution, embodying property rights as well as civil rights, were to be consistently and accurately interpreted by a dependable judiciary. But we know from American experience that this does not happen. Written documents are no more than “parchment protections” subject always to the fashionable whims that appeal to the judiciary. Americans now have a “living Constitution” in continuous creation by the Supreme Court.

The first victim of this ineluctable process is economic liberty. In a proper federal system, with considerable power devolved to the component units, competition would generate less-restrictive laws and lower taxes. But since 1986, successive European treaties have reduced the effectiveness of the veto at the Council of Ministers, and the proposed constitution carries this process further. Some Euro-fanatics would eliminate the veto altogether and make everything subject to simple majority rule.

The European constitution aims at eliminating legal autonomy, as in Britain and Germany, by making the changes a matter of an international treaty that binds everybody. They also wish to create a Europe with its own legal personality and recognized in international law as a “state.” As we shall see below, it is by no means a minimal state. Sovereignty has not been eliminated, it has simply shifted its venue—to Brussels, the “capital” of Europe.

When we come to the substantive content of the constitution, our worst fears are confirmed. The major problem in a federal system is the division of responsibilities between the center and the component units. As the anti-federalists in America rightly feared, once you create a central authority, no matter how limited its powers might be on paper, it will inevitably swallow up the member states. But at least the Founding Fathers made an attempt. The Tenth Amendment of the American Constitution explicitly says: “The powers not delegated to the United States by the Constitution, nor prohibited by it to the states, are reserved to the states respectively or the people.”

We all know that that limitation on federal power has been emasculated, culminating in Garcia v. San Antonio Metropolitan Transit Authority (1985), but a strict delineation is not even attempted in the European constitution. It is true that a few basic powers are reserved exclusively to the central institutions, but instead of the rest going to the member states, the constitution-makers have invented something called “shared competencies.” They, in fact, cover a wide range of public policy and leave the European Commission the freedom to initiate laws binding on all member states. If there is any dispute between the Union and the member states over which has authority to regulate, it will be settled by the ECJ, hardly a reliable protector of economic rights and liberties. The constitution is replete with all sorts of emollient phrases, such as the Union’s competence to “coordinate economic and employment policies of the Member States” and the general power to supervise “all objectives set by the Constitution.”³ This will undoubtedly include labor-market regulation precisely because the bigger member states, especially Germany, wish to impose their heavy non-wage labor costs on all the Union. There is also an extremely costly Charter of Fundamental Rights.

What Is a Constitution?

It is important to distinguish here between two concepts of a constitution—it can be understood as a constraint or a license. If it is the former, it puts specific limits on what the government, or one branch of it, can do. The first ten amendments to the U.S. Constitution embody constraints. It is important to stress that the constraints here apply to the majority. In the modern world, the imprimatur of the word “democracy” around any public-policy proposal has allowed an escape route from most constraints.⁴ Traditionally, amendments to a constitution require super majorities. However, if a constitution is interpreted as a license it becomes a document that permits governments to do things. And with activist courts, the list of permissions becomes endless; they can always find something in the wording that allows governments to act.

In America, the constraints are now interpreted as licenses. The original commerce clause (granting Congress the power to regulate interstate commerce) was designed to prevent the states’ imposing tariff barriers against one another, but it eventually became the license for the federal government to regulate intrastate commerce, that is, to impose common standards across America (see especially, Wickard v. Filburn, 1942). Also, the Fourteenth Amendment, although it looks like a constraint, became a license to enforce highly controversial things, such as affirmative action. Perhaps the most permissive license ever known to political man is the phrase “ever closer union,” appended to all European treaties. It has become the legal means by which the centralization of Europe has proceeded.

The ostensible reason for the collapse of the European constitution in 2003 was the proposed reduction of the qualified-majority rule at the Council of Ministers from 72.3 to 60 percent. (The rule is fixed according to the populations of the member states.⁵) The rule had been originally introduced in the Single European Act for good public-choice reasons. Under the then-prevailing unanimity rule some member states had resisted the introduction of much-needed free-market reforms.

But the attraction of that original rule change was only superficial because it led to a mania for the “harmonization” of regulations. Harmonization was not used to overcome the holdout tactics of some member states (its original rationale), but to impose uniform standards across the whole of the Union. Poland, in its opposition to the constitution, in effect spoke for all the former communist countries whose only possibility of catching up with the richer European countries was to offer much less restrictive regulations. Some countries, especially Germany, were anxious not to give a competitive advantage to the new states.

In fact, the constitution was unlikely to succeed for other reasons. Britain had already laid down certain “red lines”—mainly to do with tax, social-security, and foreign policy—which could not be crossed. Furthermore, a number of the member states had constitutions that required referendums if the European constitution were to be adopted. In fact, resentment against the European Union had been building up for some time: the pay and other emoluments of politicians and officials were blatant examples of rent-seeking. There were serious allegations that these common political practices had slipped into corruption and crime. The European Commission had been forced to resign en masse in 1998 for its failure to clamp down on, and its possible involvement with, dishonesty.

But despite the new confidence of the constitution-makers following events in Spain, they are unlikely to succeed. At least seven member states have referendum provisions, and these have now been joined by Britain. Despite his early trenchant opposition to a plebiscite, Prime Minister Tony Blair has dramatically bowed to public opinion; one will now be held, and he is most unlikely to win it. If one member state rejects the constitutional treaty, it is inoperative. Denmark and Ireland have already rejected treaties by referendum. It is true that the referendums have been rerun until the benighted people got it right, but Blair has already said that the first vote would be decisive. However, it would be unwise to trust politicians.

The Democratic Deficit, Referendums, and Federalism

There is repeated talk in Europe about the “democratic deficit,” and indeed, in many areas decisions are made by non-elected bureaucrats. But in present circumstances, the deficit is to be welcomed: at least what remains of the veto can be used to resist the anti-market policies that, ultimately, emanate from the European Commission. And it is absurd to suppose that the European Parliament can control the executive. With a future population approaching 450 million, the “rational ignorance” of the electorate will guarantee that the European institutions—the Council of Ministers, the Commission, and the ECJ—will have virtually a free hand. They will be dominated by pressure groups.

This was a point picked up by the anti federalists in their objections to the new American constitution.⁶ They realized that the new, extended powers given to the federal government would not solve the problem of factions, James Madison’s name for pressure groups. His much vaunted “extended republic” proved to be even more vulnerable to them than the several states. Who can say the anti-federalists were wrong given what now goes on in Washington?

In Europe the only way to get round this is by the restoration of decision-making to the member states and repeated use of the referendum. The best hope for the free market is a system of competitive jurisdictions where law and regulation are chosen in the way that soap and cars are. If implemented, the new constitution will more or less eliminate what remains of legal competition in Europe.

In fact, the solution to Europe’s problems was right in front of the constitution makers’ eyes—Switzerland. It is perhaps the most prosperous and civilized country in Europe, and it is outside the Union. It is the only genuine federal country in the world, with considerable powers retained by its component units, the cantons. They still spend more than the federal government. The achievement of Switzerland in preserving localism is almost entirely due to repeated use of direct voting at the cantonal and the federal level: for example, it requires only 100,000 signatures to challenge a federal law by referendum. The Swiss have resisted every move toward closer involvement with Europe, despite the blandishments of their federal politicians who are no doubt motivated by the rents they will capture if the country were to join the European Union.

It is remarkable, but not surprising, that the Swiss experience had absolutely no influence on the European constitution makers. The Swiss system for closing the democratic deficit will not be at all welcome to the Eurofanatics; it is not the sort of popular control that they have in mind.

Notes

1. See Paul Robinson, “Historical Lessons for Europe’s Future in the Wake of the EU Convention,” Economic Affairs, March 2004, p. 14.
2. Quoted in Norman Barry, “Sovereignty, the Rule of
Recognition and Constitutional Stability in Britain,” Hume Papers on Public Policy, vol. 2, 1994, p. 19.
3. See Roland Vaubel, “The Constitutional Proposals of the European Convention: an Appraisal and Explanation,” Economic Affairs, March 2004, p. 29.
4. See Norman Barry, “What’s So Good about Democracy?”
Ideas on Liberty, May 2003, pp. 44–48.
5. See Vaubel, p. 29.
6. For a discussion of Europe in the context of the American debate, see Norman Barry, “Constitutionalism, Federalism and the European Union, Economic Affairs, March 2004, pp. 5–10.

We have read a lot about former Soviet regimes struggling to shake off the last remnants of communism. It has not been easy. Even Czechoslovakia (now the Czech Republic), when first led by the free-marketeer Vaclav Klaus, had difficulties with privatization (why were the banks left in public hands?), and Poland, despite successes, found itself with a reformed socialist party in charge.

Indeed, in most of these regimes the old communist parties simply changed their names and got back into power. But at least they were engaged only in simple rent-seeking (the acquisition of wealth through politics), rather than attempting to restore communism. All of eastern Europe is united in its contempt for anything approaching the “nationalization of the means of production, distribution, and exchange.”

As you might expect, the most successful of the “transition economies” is the one least talked about. I refer to Estonia, a tiny Baltic country, just opposite Finland, with a population of less than 1.4 million and a tragic history in which it was the plaything of two totalitarian superpowers, Nazi Germany and the Soviet Union. The loss in the twentieth century of Estonia’s liberty and independence imbued its citizens with a determination to re-establish its own indigenous freedom. It is working spectacularly well.

A little bit of history is relevant here. Estonia is a separate country from the other Baltic states, Latvia and Lithuania, and has its own language, culture, and history. It was originally ruled by the Russian tsars, but between 1918 and 1939 it was an independent nation, precariously wedged after 1933 between the barbaric regimes of Nazi Germany and the Soviet Union. It was a victim of the cruel cynicism of the pre-war pact between these two and was occupied first by the USSR in 1939 and then the Nazis between 1941 and 1944. From 1944 to 1990 it was again the victim of Soviet communism. Nearly all the elements of the hitherto thriving Estonian civil society were repressed, and the country became little more than a province of the Soviet Union.

When the Soviet regime began to disintegrate in the late 1980s, Estonia was in the vanguard of the dissent. It had emotional, intellectual, and cultural capital that had not been entirely depleted by communism. And there was a touch of romance in its successful bid for freedom. In 1988 there occurred what became known as the “singing revolution.” Vast numbers of the inhabitants of this tiny country simply stood before the public buildings and other symbols of communism and sang their traditional songs. Had Gorbachev used Soviet tanks against such united opposition, one suspects they would have been powerless to preserve communism. Free elections were held in 1990, and a new constitution (based on earlier experiments in law and liberty) was formulated in 1991. Estonia adopted the German Civil Code, which is quite protective of property and contract. Estonia could now construct its own future. It chose liberty in its polity and in its economy too.

It quickly set about the task of dismantling the communist state. A more or less complete privatization had been achieved by the mid-1990s. There are competing political parties in the country, and there are fierce local battles between them, but there is no real division on the crucial issues. All agreed that Estonia must be a real market-based Western economy and have an independent judiciary determined to protect both economic and civil liberty. It has achieved those goals.

Economic Progress

For much of the postwar period, Estonia had been connected to the Soviet economy, but it quickly sloughed off these links. Those elements, industrial and agricultural, that depended on state support were left to survive on their own in the market. There are now no subsidies. Estonians quickly saw the advantages of free trade and opened up their markets to world competition. Free trade was established with the European Union (EU) in 1993, and two completely free ports were created, Munga and Sillamae. The connection with Europe proved particularly advantageous in 1998, when Russia defaulted on its debts. As we shall see, that connection has its downside, but for a nation newly emerging from communism, it was invaluable. Estonia now has one of the freest trading systems in the world. Apart from a period in the mid-1990s, it has enjoyed steady economic growth.

What was truly remarkable was Estonia’s rapid adaptation to economic reality once the ruinous Russian inheritance had been shelved. The country has become much more of a service economy: taxes have been kept low, and economic interference has been virtually nonexistent. There is now a single personal flat tax at 26 percent. A plan supported by all parties would reduce this to 20 percent by next year. Also, to encourage more foreign investment, all reinvested corporate profits were exempted from the corporate income tax beginning in January 2000. Without a repressive and exploitative tax system, the government has managed to balance its budget.

As a further gesture to modernity, virtually the whole country has become electrified.¹ Around half of the population has computers at home, and of those, nearly 75 percent have access the Internet. Almost everybody in the country has easy use of modern communication methods. This makes Estonia’s labor force highly mobile and adaptable.

All this has made Estonia a desirable place to invest. The growth rate now exceeds 6.4 percent per year, after falling back a little during the Russian financial crisis; unemployment is now 10 percent and declining. Labor is virtually free and ready to quickly take up new opportunities. Estonia is a member of the World Trade Organization, but one wonders why it bothered. The country had already done what all free-market theorists say a country should do: it simply declared unhindered commerce as its unbending policy. Per capita GDP is now $5,000 (up from slightly under $3,000 in 1997). That is not great, but it is very good by east European standards and comfortably ahead of Turkey (less than $4,000), a country that has a much longer experience with a modern market economy.

All this progress by market methods has attracted little attention from Western observers, I guess because it was too simple and straightforward. The privatization process was much more transparent than the complex and only partially successful one in Czechoslovakia, and it had none of the crime associated with the Russian advance to capitalism. Estonia was undoubtedly helped by the fact that it is a small country with an integrated social structure, which provided informal constraints on excess. The country was recently ranked sixth out of 161 countries in the Heritage Foundation Index of Economic Freedom.

The free-market world might have been remiss in its attention to Estonia’s unglamorous journey to freedom, but the (moderate) left has been predictably critical of some of its alleged failings. Naturally, social policy has drawn most of the fire. While unavoidably retaining elements of the Soviet welfare system, especially old-age pensions, the new free Estonia has not been at all extravagant in social spending. Hence, the critics. There was a complaint that only 1.5 percent of GDP was spent on children and the family, and critics argued that welfare payments in general were too low.² Apparently it lagged behind other eastern countries. It never crossed the critics’ minds that Estonia’s neglect of welfare may be one reason for its success.

An early European Commission report on the country praised its successful transition from communism, but commented on its backward level of social services and its poor record on gender-equity issues. Critics seem to forget that Estonia’s small size and intricate and intimate social structure make self-help and communal spirit much more effective at ameliorating poverty and social deprivation than an expensive and inefficient welfare state. It is also probably learning from the West’s mistakes.

Hidden EU Danger

All east European countries that successfully applied for membership in the EU in 2003 have approved of it by referendum. Estonia had a 66.84 “yes” vote in September, though there is evidence that support is deeper in the intelligentsia and the middle classes than in the working class. One can see why the politics of the EU should be superficially attractive to eastern Europe. These countries had been under Soviet tyranny, and, in some cases, Nazism, and one can appreciate their desire for security in a greater Europe. But there is a hidden danger in EU membership that will one day dampen the enthusiasm.³ Some of the regulations and social policies of the EU might put their newly won freedoms at risk. Of course, the EU’s regulatory socialism is a long way from communism, but its rigorous enforcement will delay the transition to a full-fledged market economy. It is too early to say what the effect will be.

The most dangerous feature of the EU legal structure is the enforcement of aquis communautaire, according to which new members are obliged to accept all its existing laws, regulations, and policies, as well as new ones. The new states of course had no part in the making of these, and they can only be altered by the unanimity of a treaty, an almost impossible task.

How will this affect Estonia? It is difficult to say, but things are not promising. The EU has the ludicrously inefficient Common Agricultural Policy, which shuts out cheaper foreign food and keeps some people tied to the land. Estonia does not have a large agricultural sector and may escape the worst of this. Then there is the European Social Policy, which contrasts markedly with Estonia’s meager arrangements; as we have already noted, Estonia is under pressure to increase its welfare expenditure. There is also the future danger of tax harmonization, which would boost EU taxes way above Estonia’s current levels.

The worst of the EU would emerge if its constitution were to be adopted because that would create a whole new set of “rights” (mainly welfare “rights” guaranteed by the state) and new stultifying regulations, and would abolish jurisdictional competition. However, the European constitution in its original form is virtually dead and, looking optimistically, the new member states may slow the union’s progress toward statism and excessive regulation.

But it is never wise to be optimistic about Europe, and one day Estonians may come to regret the sacrifice of their burgeoning free market for an overvalued political respectability.

Notes

1. See Newsweek, March 11, 2002.
2. “Gender and Social Policy: Comparing Welfare States in Central and Eastern Europe and the Former Soviet Union,” Journal of European Social Policy (10) 2000, pp. 240–66.
3. See Norman Barry, “A Classical Liberal’s Conception of Political Liberty: America and Europe Compared,” The European Journal, vol. 9, no. 3, 2001, pp. 13–16.

Almost every country in the economically advanced world is worried about nationalized pensions. American statisticians have some grisly fun predicting on what day of the week and in what year the Social Security system will finally go bust. Or whether Medicare will be broke first. And most young Americans think that there is as much chance of picking up Social Security when they retire as there is of a sighting of Elvis.

The Europeans are not that realistic: they really do think that they will be as well looked after in old age as their parents have been. That is why, just to make sure, French workers went on strike when reform was first threatened in 1995 and again, in May of this year, when the changes looked a little more serious. They might now be compelled to work an extra two and a half years, but will still retire on 70 percent of salary.

The problem with state schemes is that they cannot repeal the laws of nature. The laws of nature relevant here are longevity and relative infertility. The European and American schemes are financed on a “pay as you go” (PAYG) basis: this working generation promises to pay the retirement costs of the currently aged on the understanding that a succeeding generation will return the favor to it, and so on indefinitely. But if people live longer and do not reproduce at the same rate as before, the alleged “contract between the generations” cannot be kept.¹ One generation in particular will lose out: those people who will have to pay the costs of the existing retirees while saving for their own retirement when reality finally breaks in and governments are compelled to fund their promises with real money.

Most European countries have very generous old-age pensions. In France, Italy, and Germany, among others, people retire at an early age, often below 60, and with pensions, as in France, that amount to 70 percent of their salaries. These are the same countries that are experiencing alarming reductions in the birth rate. In Italy and Germany it is rapidly heading toward the non-replacement rate; that is, their populations will suffer a net fall. Elderly Germans are advised to cross the road carefully when young drivers are around. Americans face the same problem, and the figures are only slightly more encouraging. There will be a drop from an astonishing 40 workers per retiree, as there were in 1945, to just over two when the baby boomers retire after about 2010. But at least they don’t expect the state to honor its promises. The Europeans do. It always has, hasn’t it?

Americans have had compulsory old-age pensions since 1935. The system was originally intended to be self-financing, paid out of the Social Security (payroll) tax, but it is now a full-fledged PAYG scheme and has been from its early days. Like all socialist schemes, it has steadily got more costly. The combined employer and employee contributions now amount to 15.3 percent of income. (It was originally 2 percent.) Of course, the payments are so meager that many Americans have made private arrangements, with welcome tax concessions.

President Reagan produced a scheme that would eventually build up a fund from which future generations could draw. But this has not been allowed to happen, and by the middle of the 21st century there will be nothing for those generations other than future taxpayers’ generosity. Indeed, when the budget deficit finally began to be reduced in the mid-1990s and the returns from the payroll tax began to swell, that fund was deliberately used for other government spending. If the PAYG system continues, it is quite likely that the future will feature, in America and Europe, a war between the generations far more intense than any class war predicted by Marx.

Politics and the Aged

Let us not forget that the elderly are politically powerful. The American Association of Retired People (AARP) is one of the most important pressure groups in the country, and its officials are eager to highlight any threat to Social Security posed by either of the two political parties. It is a tribute to the hidden power of the AARP that no serious threat has ever arisen. Indeed, there is a great disparity in federal and state spending between the young and old.² There is an implicit and unexamined prejudice in political debate on behalf of the elderly. To question that prejudice is a sure sign of immorality and egoism. This automatic prejudice undoubtedly springs from the fact that there was once a close connection between being old and being poor, so that welfare measures designed to alleviate suffering would help the aged disproportionately. But this is no longer true. In all advanced Western democracies the retired are quite well off, certainly in comparison to their predecessors.

Equally important, advocates of the retired have managed to persuade American public opinion that Social Security isn’t welfare; it has been paid for by past contributions. But it hasn’t. And although Americans think Social Security is not generous, they still get more than they paid in. It has the feature of all welfare policies—redistribution. As Carolyn Weaver said, in discussing the raising of the payroll tax: “a decision to increase the tax rate represents a collective decision to alter the distribution of rates of return between generations.”³

But politicians know very well that the old vote in greater proportion than the young. And the spokesmen for the aged seem immune from the normal criticism that occurs in political and ethical argument. Thus how many of the contemporary advocates of “social justice” for the aged ever realize, least of all point out, that Social Security operates against blacks? But it clearly does. They do not live as long as whites and therefore draw less from the system. This kind of inequity is bound to occur in a socialist system.

Oddly enough, the United Kingdom has been rather virtuous in this matter. One of the many unheralded achievements of Margaret Thatcher’s reign was the privatization of the bulk of pensions. There is still a basic, very low, unfunded pension, but the potentially ruinous State Earnings Related Pension Scheme (or SERPS, a full implementation of which would have ruined the economy) was run down and people were given incentives to leave it. Now nearly 70 percent of the workers (well over 40 percent of actual pensioners) are in privately financed schemes. SERPS has been replaced by the Second State Pension, but the problem here is that the original aim of getting everybody out of a second state pension has wavered a little in recent years. People are now being encouraged to contract back into it.

It is true that the British are in a bit of trouble at the moment because of the fall in the stock market, and the number of people privately covered has recently begun to fall. But this is because another social phenomenon is taking over: “moral hazard.” The basic flat-rate pension is so derisory that those solely dependent on it have to have their incomes topped up from extra welfare payments. So they are now saying, quite rationally: “I will get paid anyway, so why should I save”? Of course, the moral hazard could be alleviated if the supplementary payments were not so generous and if there were greater incentives for people to get covered privately. But the situation in Britain is still very much better than in mainland Europe, where in most countries only 10 percent of workers are in private plans.

Alas, Britain’s prudence faces a new threat—and it is not from demography. The Europeans are now engaged in a pale imitation of Philadelphia 1787: they are trying to construct a constitution. What has such heady metaphysics got to do with the tedious actuarial problems of pensions? A lot, actually. The document has something deadly tacked on the end: a Charter of Fundamental Rights, which includes welfare rights, in particular, entitlements to social security benefits and protection in maternity, illness, and old age (Article 34). These are not anodyne ideals but legally enforceable claims.

It is worth noting that, despite having welfare, Americans do not have a constitutional right to it. If they did the 1996 reforms would never have survived in the Supreme Court. But a European from any country in the Union will soon have the right to take his government to court if, say, he is not provided with a pension of 70 percent of his salary and if he is made to work till he is 65. Who will pay for such largess? It is likely that Britain’s funded pensions will be invested in a European-wide pension scheme. Isn’t that what “ever closer union” (the mantra of the Europhiles) means?

The Logic of Pensions

The whole pensions business illustrates all too well the dangers of government involvement in what is essentially a private decision: how much to save for old age. In a free society this is a consequence of time preference. How much does each person value the future over the present? A person with a high time preference does not value the future all that much and will spend his present income on immediate consumption. But most people do care about the future and save accordingly. Indeed, our time preferences begin to fall as we get older.

The original rationale for state involvement in pensions was that people’s time preferences were too high, which would present the state with a massive welfare bill in their old age. Yet to pay it would produce another moral hazard by rewarding the failure to save.

Moreover, it’s the politicians who have time preferences that are too high. They do not think beyond the next election, and when in government they build up debt that future generations will have to pay. Moreover, they do not use revenue wisely. It has been calculated conclusively that if money collected for Social Security had been invested in the stock market it would have yielded a significantly higher return than the current payments.⁴

The real danger of PAYG pensions is that they involve the imposition of “promises” that cannot be kept on behalf of unwilling generations. The longer a state-run system has been in operation, the more expensive it is to wind up, unless we are willing to see people who have paid their taxes (no doubt unwillingly) suffer in their old age. It is difficult morally to leave people who have been forced into a system unprotected when we, rightly, want to end it.

One of the many achievements of the much-maligned Pinochet regime in Chile was its solution to the country’s burgeoning pensions problem. Chile was one of the earliest countries with a PAYG scheme, established in 1924. By the 1970s it was getting extremely costly, but it was calculated that the cost of winding it up, if historic commitments were to be honored, was 3 percent of gross domestic product.

Nevertheless, a radical reform was successfully introduced.⁵ All people entitled to the existing pension could keep it or go private (as 90 percent did). All new workers, however, would have to join one of the new competing private pension funds and save at least 10 percent of their incomes so that eventually the state scheme would wither away. Now almost everyone is covered privately, with the returns from their investments exceeding the state pension by 40–50 percent. No one has been hurt by the changeover, and thanks in part to the privatization of state-owned assets, it was carefully worked out so that it did not lead to a tax rise.

It should be possible to reform similarly the American and European systems without too many, if any, people being made worse off. George Bush once promised to liberalize partly the American old-age provisions.

During the last presidential election he announced plans to allow citizens to invest a proportion of their Social Security taxes in the private market. It was an anemic imitation of the Chilean scheme, but it does not seem to have got very far.

In Europe the prospects are even dimmer. Yet there is an oddity here. The French and Germans are used to paying for health care out of an (almost) fully funded social-insurance system with competing suppliers. It is not genuine private insurance, and it is compromised by all sorts of statist interventions. But health care is not funded from general taxation, like the British system, an (almost) entirely state monopoly of which Stalin would have been proud. Yet it seems to be as hard to persuade Europeans of the absurdity of their almost entirely state monopoly on pensions as it is to convince the British of the inefficiency and injustice of their socialized medicine. If they are still speaking, the British, French, and Germans can learn from each other.

One way out of the present imbroglio is mass immigration. America has the advantage here for one of the keys to its economic success has always been the continued inflow of immigrants. The European Union is expanding, but one of the fears of its citizens is that immigrants will only come into the countries to take advantage of their ruinously generous welfare systems. As a prelude to the abolition of all welfare programs in America and Europe, a condition for immigration should be the forgoing of all welfare claims, including pensions. I can’t imagine that rule being a serious disincentive to the industrious Chinese and other Asians anxious for a Western lifestyle. Such a policy would lead to two things essential for free societies: unrestricted movement of labor and the end of the welfare state.

Notes

1. For a philosophical critique, see Norman Barry, “The State, Pensions and the Philosophy of Welfare,” Journal of Social Policy, 14, 1985, pp. 468–90.
2. See Norman Barry, “The New Right and Provision for the Elderly,” in Grant Jordan and Nigel Ashford, eds., Public Policy and the New Right (London: Pinter, 1993), pp. 257–59.
3. “The Economics and Politics of the Emergence of Social Security,” Cato Journal, Fall 1983, p. 364.
4. Martin Feldstein, “Social Security, Induced Retirement and Aggregate Capital Accumulation,” Journal of Political Economy, 82, 1974, pp. 905–26, and Peter J. Ferrara and Michael Tanner, A New Deal for Social Security (Washington D.C.: Cato Institute 1998).
5. See Eamonn Butler and Madsen Pirie, The Fortune Account (London: Adam Smith Institute, 1995), pp. 7–9.