Keynes’s ghost has haunted the halls of the Bush II and Obama administrations, where various “stimulus” packages were concocted. The Keynesian arguments undergirding the fiscal stimulus froth over the past two years went remarkably unrecognized in the media for their one-sidedness. The basic stimulus argument goes something like this: If the federal government engages in deficit spending during a recession, the added government expenditures (unaccompanied by tax increases) will boost “aggregate demand.” Greater federal spending on a road, for instance, will create jobs for construction workers, who can be expected to spend some if not all of their additional income on, say, bread. Bakers now will have more to spend on, say, cars and so on.

National income stimulated by the initial government road project can grow by some multiple of the expenditure, the theory says. It can even be wasted on pork-barrel construction projects like bridges to nowhere, according to Keynes. He even dared to advocate that the government bury dollars in bottles. Entrepreneurs could then be expected to spend money digging up the bottles, unleashing the multiplier magic and reducing unemployment (in the same illusory way).

A stimulus package (and budget deficit) of, say, $1 trillion would morph in short order, stimulus backers have assured us, into a minimum of $1.5 trillion in additional national income—maybe even into $4 trillion or $10 trillion. Pick your multiplier, because no one in Washington or academe really knows what it is. Even the best of econometricians can’t accurately assess the multiplier when the current crisis is “unprecedented,” as widely claimed.

Fantastic, wouldn’t you agree? Keynesianism offers the proverbial free lunch several times over.

But if it sounds too good to be true, it is. If such income growth were possible, the country and the world would now be awash in prosperity, given that the federal government increased the national debt by $1.88 trillion in fiscal 2009 and could run deficits of $1.6 trillion and $1.3 trillion in fiscal 2010 and 2011, respectively. Between 2012 and 2015 it will add at least another $3 trillion to the national debt. Why not go for even greater deficit spending, if Keynesian theory worked so magically? Of course, many Keynesian enthusiasts have recommended stimulus packages two and three times what the Bush and Obama administrations sought two and three years ago, with little to no recognition that an escalation in the size of the deficit can, at least beyond some point, curb any multiplier effect (if there were the prospects of a positive one) as the budget deficit rises and crowds out expenditures in private sectors of the economy.

In the 1960s Keynesianism was followed as fiscal religion, but by the 1970s economists found it to be a snare and delusion for a simple reason: The political version of Keynesianism is a one-sided theory, with almost total emphasis on what the federal government spends. It pays virtually no attention to the potential private-sector offsets to the greater deficit spending by government or to how current fiscal policies could have negative long-run real income effects that can feed the current generation’s expectations of impaired futures. Keynesianism, in the form practiced in political circles, has no appreciation for how people’s expectations can affect their current spending and investing plans.

The late great economist Milton Friedman frequently peppered Keynesian enthusiasts in the 1960s and 1970s with a remarkably simple question that needs to be remembered today: Where does the government get the money it spends on roads (or bridges to nowhere)? Friedman followed with an equally revealing observation: When the government engages in deficit spending, it must borrow the extra funds from someone who could have spent them on private-sector projects. An increase in government spending could be totally offset by a decrease in—or a “crowding out” of—private spending, as lendable funds are diverted from private to government uses. The net effect can be no net increase in aggregate demand—and no multiplier effect. Indeed, with the inevitable waste in government stimulus projects, the multiplier effect could as easily be negative as positive.

Okay, in a down economy some of the funds the government borrows to cover stimulus expenditures might have remained idle, which can mean that the increase in government spending is not totally offset. But Friedman still has a point: The multiplier effect of greater government spending will be muted at least somewhat and maybe in large measure. Commentators who tout the glories of stimulus packages and bemoan the difficulty that small and large businesses and consumers have been having in finding credit never seem to make the causal connection that government borrowing can dry up, and has dried up, credit for nongovernmental purposes. Why should banks loan their available funds to people for risky private projects when they can loan their funds at little risk to the government, with 300-million-plus Americans it can tax to cover the debt?

The Piper Don’t Take Visa

Keynesian policy advocates rightfully assume that if the government hikes taxes along with expenditures, the stimulus effects of the added government spending will be seriously muted, maybe negated. The problem is that American taxpayers aren’t the fools the Keynesian advocates would like to think they are. With the potential of a doubling of the national debt over the next ten years, many not-so-stupid Americans can anticipate that the fiscal piper will have to be paid in the future—with higher tax rates on future incomes. The anticipation today of those higher future tax rates can dampen private demand, as people set aside savings for future higher tax payments and as they refrain from making all the investments that can translate into higher future incomes—which will be taxed at higher future rates. And higher tax rates imposed currently on the rich can affect many now poor Americans’ saving and investment plans because they expect to be not-so-poor, and maybe rich, in the future. In short, the anticipated future tax rates will be another offset to today’s stimulus expenditures.

Then you have the threat of future inflation from today’s fiscal profligacy. The anticipated higher inflation is seen as a wealth tax. If the government has little debt, it gains little by hiking the inflation rate to lower the real value of its debt. However, when the debt grows to enormous levels, as already budgeted, the government’s temptation to inflate away its own debt—and the wealth of bond holders—grows concomitantly. And we must not forget the lessons learned in the inflationary 1970s: Inflation, and inflationary expectations, can have debilitating effects on the real economy—in people’s real income and real income expectations and, thus, on current demand.

Of course, if debt holders begin to worry that the real value of their debt will depreciate due to any future orchestrated government inflationary policy, all those foreign bondholders—most notably, the Chinese and British—might lose confidence in the international value of the dollar, which can cause them to dump their dollar-denominated bonds on international money markets, which in turn can lead to a deterioration in the international value of the dollar and to a reduction in the real incomes of Americans across the board—and to contraction in private demand, yet another offset to government stimulus spending.

Perverse Politics

Even if Keynesianism had validity, we would still have to worry that the politics of the day would pervert the goal of reviving the economy as politicians fall over themselves to pack “stimulus packages” with pork, designed mainly to stimulate the private economies of their supporters and not the national economy. (Indeed, that is what happened). As economists James Buchanan and Richard Wagner argued long ago, Keynesian economics provides a grand excuse for politicians to do what they love to do: spend other people’s money without having to incur the current political costs of asking them to cover the expenditures with higher taxes. Make no mistake about it, Keynesianism has the potential of transforming the United States in the not-too-distant future into a financial basket case much like Greece, Spain, and Ireland are today.

The Keynesian recovery prescription never gets sillier than when, as noted, advocates claim that the economic merit of the funded government projects is of little consequence. What counts for them is more spending. That couldn’t possibly be true, given Keynesian insistence that private aggregate demand is inextricably tied to aggregate real income. If a bridge to nowhere is built, the bridge is obviously of no economic value, which means it adds nothing to national income. Its construction must draw resources at least some (if not all) of which could have been used to produce something of real value to people. Bridges to nowhere can only undermine any potential Keynesian multiplier effect. If anything, bridges to nowhere must have a negative multiplier effect through the effect of the impairment of long-term income growth over time through the depression of aggregate demand.

But Keynes and his followers failed to appreciate the extent to which the long-run effects of short-run policies can affect people’s wealth and income expectations, which in turn can undermine their current buying decisions. If people’s expected future incomes and wealth holdings are reduced (from what they would otherwise be), then surely Keynesians would, for the sake of consistency in argument, have to conclude that current private consumption and investment demand would also be suppressed, which would partially negate the so-called stimulus packages.

Finally, when a national economy gets seriously out of whack as happened over the last decade—with housing prices rising to unsustainable levels because of an unsustainable credit binge, with the rising housing prices fueling the demand for big-ticket consumer goods as homeowners used their houses as ATMs—then the only route to recovery is a painful one, with falling housing prices, lost jobs, and foreclosed homes. Ownership of houses, office buildings, and plants must be shifted from those who can no longer afford them to those who can afford them and can use them productively and profitably at the lower prices.

So much of what the government has done under the guise of stimulating the economy has been directed at retarding the required adjustments—and therefore preventing the recovery. The government has worked hard to prevent housing prices from falling as far as they must by offering tax credits to first-time homebuyers and slowing the pace of home foreclosures. The Cash for Clunkers program has been a policy clunker in itself, given that it caused a minor boom and bust in automobile sales, just as the homebuyer tax credit distorted sales of houses over time. These are hardly the kinds of stabilizing forces the economy needs in times of instability.

Then, of course, the federal government has chosen to fight the devastating consequences of the private credit binge of the last decade with a credit binge of its own (with nearly one out of every two recent budget dollars financed with debt, or leverage). If the private credit binge gave rise to the moral hazard of excessive risk-taking in the private sector (by banks, nonbanks, homeowners, and credit card holders), should anyone not expect the same excessive risk taking in the political sphere when the government heavily leverages its current spending? Such risk-taking shows up in the government’s adopting the mantra of Keynesian stimulus economics even when it has little promise of yielding the results promised and carries the nontrivial risk of damaging the future growth path of the private economy.

Given all the Keynesian hype over the past two to three years, one fact stands out: The recovery has been weaker than what would have been expected from the promises of Keynes’s devotees.

Nevertheless, a recovery (at this writing) appears underway, albeit more delayed than past recoveries. But, as argued here, everyone should harbor deep skepticism that the current weak signs of recovery can be traced to the stimulus packages of the last couple of years, especially since the rate at which displaced workers have been finding new jobs has been the most sluggish of all recessions since World War II. This is partially because government policies have gradually increased the long-term costs of firms hiring workers, with the most recent imposed burden being the effective nationalization of health care and health insurance.

Think the analysis here is pie-in-the-sky theory? Well, Harvard macroeconomist Robert Barro has estimated that the five-year effects of $600 billion in fiscal stimulus over the past two years will come at a cost of $900 billion in reduced private demand. That’s hardly the free lunch the country has been promised.

The Obama administration has not been shy in its first year about floating a variety of tax-hike proposals, supposedly for higher-income groups. And the expected federal budget deficits harbor threats of major future tax increases, as a growing list of researchers are finding. For example, the Congressional Budget Office projects that under current law (with marginal income tax rates unchanged), the national debt will almost double, rising by more than $11 trillion, between 2009 and 2020. Researchers at the Tax Policy Center figure, optimistically, that if the annual deficits are reduced to 2 percent of GDP between now and 2020 and if all tax rates are raised proportionately for all income groups, the lowest federal income marginal tax rate would have to rise from 10 to 15 percent and the highest marginal rate would have to rise from 35 percent to 52 percent. If the deficit were lowered only by raising the top two marginal tax rates, now 33 and 35 percent, those top rates would have to go 86 and 91 percent—which of course might actually worsen the deficits, given that the current “rich” and the “rich-wannabes” would have little incentive to work, save, and invest.

The country will learn anew an old lesson: Don’t count on the federal government to wave away the country’s economic troubles with some refurbished fiscal wand. The wand didn’t work in the 1960s and 1970s (it only contributed to “stagflation”). The wand is an illusion that should have died with Keynes long ago. We will also relearn the oft-repeated wisdom of Keynes when he wrote, “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

How true, how true! Regrettably.

Supporters of the proposed minimum-wage hike of all political stripes have, once again, fallen prey to a common delusion that government can, with a wave of its magic legislative wand, suppress competitive market forces in any way deemed desirable.

Nevertheless, any actual increase in the minimum wage will likely have a minimum effect on employment and overall earnings of covered workers. This is partly because the federal legislative wand has never proved very potent.

A couple of hundred econometric studies on the employment effects of minimum-wage increases over the last four decades show that modest hikes (say, 10 percent) tend to have little to no employment impact, even among the most vulnerable worker group—teenagers (with teenage employment falling no more than 3 percent and very likely less than 1 percent of those employed with a 10 percent wage hike).

As usual, in the short recent congressional debate both opponents and proponents of minimum-wage hikes pushed totally wrongheaded arguments, because both groups fail to realize that while mandated wage laws contain competitive pressures exerted on money wages, they do not materially suppress the overall force of labor-market competition that low-wage workers have to confront. With a higher minimum wage, competitive pressures will simply be felt in nonmoney-wage dimensions of employment contracts.

Proponents have argued (as did Steven Pearlstein in the Washington Post, January 10) that the proposed wage hike will have “minimal” to no effect on employment, partly because the higher wage will inspire a productivity jump among covered workers and/or the higher wage costs will be passed along to consumers in higher prices. If competitive forces have these effects, should we not also expect those same forces to pressure firms to contain their labor costs in all ways possible, including curbs in nonmoney forms of compensation provided workers, which can dampen firms’ need for productivity improvements and product price increases?

Opponents of minimum-wage hikes (for example, Gary Becker and Richard Posner writing for the Wall Street Journal, January 26) will magnify as best they can the employment effects of any mandated wage hike, not realizing that the available findings of little to no employment effects from modest minimum-wage increases actually support their more fundamental position, that government should not try to tamper with Mother Nature—or competitive market forces.

Menial workers are paid little not so much because of employer greed as because of their low productivity and competitive pressures in both their own labor markets and their employers’ product markets. Those competitive pressures do not subside when the minimum wage is increased. If the wage hike gives rise, initially, to more workers looking for jobs than there are jobs available (as both sides agree will happen), employers can respond simply by taking away fringe benefits and increasing work demands, thus largely reducing, if almost negating, the cost effects of the mandated money-wage increase. (This explains the minimal measured effects of any minimum-wage hike.) A number of research studies support such an outcome:

• Writing in the American Economic Review, Masanori Hashimot found that under the 1967 minimum-wage hike, workers gained 32 cents in money income but lost 41 cents per hour in training—a net loss of 9 cents an hour in full-income compensation. Several other researchers in independently completed studies found more evidence that a hike in the minimum wage undercuts on-the-job training and undermines covered workers’ long-term income growth.
• Walter Wessels found that the minimum wage caused retail establishments in New York to increase work demands by cutting back on the number of workers and giving workers fewer hours to do the same work.
• The research of Belton Fleisher, L. F. Dunn, and William Alpert shows that minimum-wage increases lead to large reductions in fringe benefits and to worsening working conditions.
• Mindy Marks found that workers covered by the federal minimum-wage law were also more likely to work part time, given that part-time workers can be excluded from employer-provided health insurance plans.
• If the minimum wage does not cause employers to make substantial reductions in nonmoney benefits and increases in work demands, then an increased minimum should cause (1) an increase in the labor-force-participation rates of covered workers (because workers would be moving up their supply of labor curves), (2) a reduction in the rate at which covered workers quit their jobs (because their jobs would then be more attractive), and (3) a significant increase in prices of production processes heavily dependent on covered minimum-wage workers. Wessels found that minimum-wage increases had exactly the opposite effect: (1) participation rates went down, (2) quit rates went up, and (3) prices did not rise appreciably—which are findings consistent only with the view that minimum-wage increases make workers worse off.

Quantifying the Harm

With the money-wage hike and the reduced benefits, workers can be left worse off since the fringes and slack work demands taken away were provided in the first place because workers valued them more highly than the wages forgone for those benefits. Given the findings of his own as well as other researchers’ studies, Wessels deduces that every 10 percent increase in the hourly minimum wage will make workers 2 percent worse off. This means that the enacted $2.10, or 39 percent, minimum-wage increase presumably can be expected to leave affected workers 8 percent worse off in terms of their overall “payment bundle” (including the money and nonmoney benefits of employment).

Employers facing strong competition will be forced to cut out workplace advantages to neutralize as much as they can (but not totally) the imposed money-wage cost increase. That will be necessary just to avoid losing market position to those employers who respond to competitive pressures by cutting out the costly extras. The workers whose jobs are most at jeopardy from any minimum-wage hike will be that small group of (truly desperate) workers whose only form of compensation is their money wages and who are working as hard as humanly possible.

The sad outcome from any minimum-wage hike is that both employers’ and employees’ welfare will be undercut. The better news is that the forces of market competition will ensure that the damage done by politicians will be smaller than critics of minimum-wage hikes have heretofore recognized.

Congress and the President, are doing of course, what is politically expedient. In the process they have once again failed to heed a lesson that many market-oriented economists have always taught indirectly, if not directly, in their writings: You can’t fool Mother Nature, and there is little constructive point in trying to fool competitive markets, even with the best of intentions.

It happened again. Republicans and Democrats recently locked political horns over President Clinton’s proposed one-dollar increase in the minimum wage. The political partisans repeated past claims with self-righteous fervor, but once again were off base on the consequences of the increase. (The measure was defeated—this time.)

President Clinton and his Democratic allies argued that the proposal would be an unmitigated blessing for the country’s low-wage workers who deserve an increase in their take-home income. Bob Herbert, a columnist for the New York Times and an avid minimum-wage supporter, quoted approvingly a study from the Economic Policy Institute (EPI) which found that the last hike raised the incomes of 10 million Americans: “The benefits of the increase disproportionately help those working households at the bottom of the income scale. Although households in the bottom 20 percent (whose average income was $15,728 in 1996) received only 5 percent of total national income, 35 percent of the benefits from the minimum wage increase went to these workers.”

Herbert is convinced that such findings should give minimum-wage critics reason to eat their words. He reminds his readers of what Cato Institute chairman William Niskanen said during the last debate over the minimum wage: “It is hard to explain the continued support for increasing the minimum wage by those interested in helping the working poor.”

Despite EPI’s claims, the Republicans argued, as they have in the past, that if Congress raised the cost of menial labor, several hundred thousand jobs would be lost. Some employers would not be able to afford as many workers, and other employers could be expected to automate low-skill jobs out of existence. Opponents backed up their claims with equally sophisticated statistical studies that showed that some low-skilled workers should be made better off (those who kept their jobs) but only because other low-skilled workers would be made worse off (those who are unemployed). For example, the EPI commissioned a study of a $1.35 increase in the minimum wage in the state of Washington and found that by 2000, the increase can be expected to destroy 7,431 jobs, causing the affected workers to lose $64 million in annual income.

Both Sides Are Wrong

Both sides to the debate were once again wrong in their assessments of the minimum-wage increase because they both failed to recognize that employers are a lot smarter than the political combatants seem to think. Neither side seems to realize that Washington simply doesn’t have the requisite power over markets to significantly improve worker welfare by wage decrees, no matter how well-intentioned the legislation may be.

Why is this so? The simple answer is that the labor markets for low-skilled workers are highly competitive, which explains the low wages paid menial workers in the first place. Many employers of low-skilled workers would love to be able to pay their workers more, but they have to face a market reality: if they paid more, then their competitors would have a cost advantage.

When Congress forces employers to pay more in money wages, it also forces them to pay less in other forms, most notably in fringe benefits. If there are few fringes to take away, employers can always increase work demands.

Why would employers curb benefits and increase demands? First, they can do it, given that the minimum-wage hike initially will attract more workers and cause some employers to question whether they can hire as many workers unless adjustments are made. The forced wage hike also strengthens the bargaining position of employers, given that they can tell prospective workers, “If you don’t like it, I can hire someone else.” Second, the employers must cut fringes and/or increase work demands, or face the threat of losing their market positions to competitors who do so. Third, if employers don’t cut fringes and/or increase work demands, the value of the company’s stock will suffer, creating profitable opportunities for investors to buy the firm, change the benefit/work-demand policies, improve profitability, and then sell the firm at a higher price.

The net effect of the adjustments in fringes and work demands is that the cost impact of the minimum-wage hike to the employer will be largely neutralized. For example, when the minimum wage is raised by a dollar, the cost of labor, on balance, may rise by only five cents. That explains why studies have found that recent minimum-wage hikes have caused few (if any) job losses even among that group of workers—teenagers working at fast-food restaurants—whose jobs are most likely to be cut. Even the EPI study cited above shows a reduction in Washington state’s total employment of less than three-tenths of one percent for a proposed 26 percent increase in the state’s minimum wage.

This line of argument can also help us understand why workers who retain their jobs are unlikely to be any better off. They get more money, but they get fewer fringes and have to work harder for their pay. The only reason a sane employer would offer the fringes and reduced work in the first place is that the workers valued them more highly than they valued the money wages that they gave up to get them. And sane employers aren’t about to offer workers anything unless they get something in return, like greater production or a lower wage bill. When the minimum wage is hiked, therefore, the value of the resulting lost fringes and reduced work demands to the workers will be greater than the value of the additional money income.

Put another way, the workers who retain their jobs are made worse off (albeit marginally so) in spite of the money-wage increase. Employment in menial jobs may go down (albeit ever so slightly) in the face of minimum-wage increases not so much because the employers don’t want to offer the jobs (as traditionally argued), but because fewer workers want the menial jobs that are offered. Understandably, the voluntary quit rate among low-wage workers goes up, not down, when the minimum wage is hiked.

Seen from this perspective, the Economic Policy Institute figures on the added income received by 10 million workers are grossly misleading because they suggest that the affected workers are better off, which is unlikely.

Granted, economists might speculate that the job reductions have been small because the demand for menial labor is fairly constant, but that explanation makes no sense. The elasticity of demand for anything, including labor, relates to the number of substitutes: the more substitutes, the greater the elasticity. The problem with the explanation is that there is no labor group that has more substitutes than menial (minimum-wage) workers, especially now that firms have so much flexibility to automate jobs out of existence or to replace domestic workers with foreign workers by way of imports.

You can’t fool the market. It will outsmart the smartest of politicians.

[T]he knowledge which any individual mind consciously manipulates is only a small part of the knowledge which at any one time contributes to the success of his actions. When we reflect on how much knowledge possessed by other people is an essential condition for the successful pursuit of our individual aims, the magnitude of our ignorance of the circumstances on which the results of our action depend appears simply staggering. Knowledge exists only as the knowledge of individuals. It is not much more than a metaphor to speak of knowledge of society as a whole. The sum of knowledge of all the individuals exists nowhere as an integrated whole. The great problem is how we can profit from this knowledge, which exists only dispersed as the separate, partial, and sometimes conflicting beliefs of all men [emphasis added].^[6]

Those fundamental points are applicable to all mortals, independent of the shapes of their offices. So it is that we see the executive branch thrashing about in virtual administrative chaos, flitting from one policy agenda to the next, setting and then reversing one foreign policy strategy (and miscue) after another, and always covering its efforts in the rhetoric of what Hayek eloquently tagged as the “pretense of knowledge” about what Americans need and want.

Individual Differences

We have been led to believe that any new expansive government agenda should be imposed on the American people with precious little conflict, supposedly because people will all seek their common purpose. However, as much as leaders would like to simplify their planning and management problem, and assume that people want and need the same thing (supposedly, what is decided by the political process in Washington), people are different! They have different tastes and needs and are willing to make different tradeoffs, facts that are beyond the purview of the people in power. When so much is at stake—when government becomes deeply involved in the division of the income (or health-care) pie—we should not be at all surprised that Washington begins to look and feel like, to use economist Dwight Lee’s turn of words, “malice in plunderland.”^[7]

When the president sounds off about needed reforms in the nation’s health-care industry (or any other industry), I always wonder just how much he really knows—even can know—about what my daughter, who lives in Six Mile, really wants in the way of health care. I suspect that he does not know where Six Mile is, much less the details of the circumstances under which she lives. He certainly knows little to nothing about the trade-offs she is willing to make.

Policymakers need to appreciate the fact that their charted policy course jeopardizes the country’s future economic prosperity precisely because they seek, with unrelenting pressure, to restrict our future to what they can imagine it will be. They need to acknowledge that successful social and economic systems are not just created or recreated or reinvented at the shake of a presidential finger. If social and economic systems were invented by political leaders, the systems might not be messy, but they would certainly be limited in sophistication and complexity to that which the leaders and their few advisers—who know little or nothing about making pencils, or computers, much less productive and efficient healthcare systems—could construct. And their productivity would be somewhere between dismal and nothing.

Contrary to widely held belief, the case for giving power to private individuals through markets (as distinct from giving political power to their leaders) is not founded on a disdain for “government” per se. Governments can do some very important things right—if they restrict themselves in the range of what they are allowed to do. Rather, the case against government empowerment is grounded in the observed limitations of the human mind to know, that is, in our necessary individual ignorance. The wealth of nations is dependent upon our drawing on the limited intelligence of the multitudes in the hinterlands, not just the intelligence of the few leaders and their supporting staffs in the country’s political center. Markets are communication systems with prices being prime signals for sending messages. The people doing the communicating—each of whom knows some things, but, at the same time, is consumed in a sea of ignorance—are, however, able to coordinate their activities to mutually beneficial and ever more complex effect.

Recognition of that fact would be, as it has always been, the cornerstone of wisdom for our political leaders, the kind that the venerable Professor Hayek would recommend. []

1.   F. A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960), p. 22.

2.   Friedrich A. Hayek, The Road to Serfdom (Chicago: University of Chicago Press, 1944).

3.   The Constitution of Liberty, p. 23.

4.   Ibid., p. 26.

5.   Leonard E. Read, “I, Pencil,” reprinted in Imprimus (Hillsdale, Mich.: Hillsdale College, June 1992).

6.   Hayek, The Constitution of Liberty, p. 24.

7.   See Dwight R. Lee, The Political Economy of Social Conflict, or Malice in Plunderland (Los Angeles: International Institute for Economic Research, February 1982).

I watched the Thomas/Hill hearings with a growing sense of apprehension. I feared that the American system is being perverted, and that I was observing a new and destructive form of legal harassment. Before the weekend was over, it was plain that both Thomas and Hill had been harassed beyond belief—legally.

Socialism has been, by any measure of economic success, a total failure. The hope of socialism was that it would promote wealth and distribute it fairly by transferring power away from capitalists interested only in profits and give more control to political representatives concerned with economic growth and social justice. That hope has been dashed. Socialism has succeeded only in providing special privileges to a few by imposing grinding poverty on everyone else.

With socialism a sinking ship, the goal in country after country that has been impoverished by the legacy of Karl Marx is to achieve the wealth-creating power of capitalism. The most dramatic examples of the rejection of socialism and the move to embrace capitalism have come from Eastern Europe and the Soviet Union, countries that have experienced the poverty of socialism firsthand. But countries in Africa, South America, and other parts of the world that have been beguiled by the false promises of socialism also are anxious to trade socialism for capitalism.

While the embrace of the market economy has been widespread, it has been cautious. Everyone wants the wealth created by capitalism, but at the same time the marketplace is seen as harsh, cal-1oused, and unfair. Isn’t the marketplace littered with the victims of those who have suffered the failures of bankruptcy, unemployment, and poverty at the merciless hands of market competition? Isn’t there some way to accept the wealth that capitalism offers without having to endure the constant failures it imposes? The calls have been for a market economy with a human face, or for a third way between the productivity of capitalism and the compassion of socialism. There is no end of proposals to reform the marketplace in order to protect its innocent victims.

It would, of course, be nice to unbundle the economic package known as capitalism or the free market, and keep the sweet while rejecting the bitter. It also would be nice if everyone had an above-average I.Q. and income. Unfortunately, the only way to avoid the failures that result from capitalism is to pass up the wealth created by capitalism.

Failures in the marketplace serve an indispensable function in the production of wealth: they provide information on the most productive use of resources and the motivation to respond appropriately to that information. Failures are part of the steering mechanism that directs an economy toward prosperity. Attempting to improve the marketplace by preventing economic failure is equivalent to attempting to improve an automo bile by removing the steering wheel. It is no surprise that socialistic economies that were applauded initially for eliminating Unemployment, bankruptcies, and economic failure of every variety have themselves been colossal economic failures. By allowing economic failures in the small, and converting these failures into useful information, market economies have produced economic success in the large. In economics, overall success depends on a constant supply of small failures.

Thus, the general economic failure that is most feared in all societies stems, paradoxically, from the fear of economic failure. The best antidote for this fear is an understanding that economic failure is a necessary ingredient in the market process that leads to higher overall living standards.

Understanding Failure

While economic failure is a positive force in the market economy, it is commonly converted into a destructive force in the political process.

Every economy is a political economy and, for the very reason that economic failure promotes wealth in the marketplace, it promotes political responses that can undermine market productivity. A public understanding of the importance of economic failure is the best way to moderate harmful political responses to that failure. The lack of understanding of the essential role of economic failure is the biggest political obstacle to achieving free market prosperity in formerly socialist countries. The same lack of understanding prevents the market process from yielding the full measure of its potential wealth in those political economies that are predominantly capitalistic.

It is easy to see the failures imposed by market forces as isolated occurrences rather than as an integral part of a wealth-creating process. When viewed in isolation, it is natural to see economic failure as unnecessarily harsh and unfair, and conclude that government can protect people against these failures without harming economic productivity. But government cannot protect everyone against failure. The best government can do is to protect a privileged few against failure by diminishing the opportunity for success of everyone else. Obviously such special interest protection is neither efficient nor fair.

Ironically, for the very reasons that the market economy is both more efficient and fair than alternative economic systems, it appears to be unfair to the superficial observer. Conversely, for the very reasons that the political process is typically less efficient and fair than the market process, it appears to be fair to the superficial observer. Unfortunately, harmful political policies are often fueled by superficial impressions.

The efficiency of the market process derives from the fact that it holds people accountable for the costs of their actions. This accountability is imposed in ways that are difficult to ignore, such as bankruptcy, unemployment, and other forms of economic failure. Although this market accountability conveys long-run benefits to all by promoting productivity, each economic interest group prefers special protections against the accountability of the market while benefitting from the accountability the market is imposing on others. The fundamental fairness of the marketplace is that it does not allow such flee-riding on the contributions of others. In the marketplace we all have to contribute to the general well-being by accepting the failure as well as the success that comes our way.

However, because the benefits from market accountability are general, they are easily ignored and taken for granted. Because the costs and failures of market accountability are concentrated, they easily dominate the public’s perception of the market and create the impression of unfairness. Indeed, the failures inflicted by the market appear all the more unfair against the backdrop of economic success made possible by those failures.

The inefficiency of the political process results from the fact that it provides opportunities for people to acquire benefits without being held accountable for the costs. Political action commonly concentrates benefits on a well-organized few while spreading the costs thinly over the general public. As opposed to the fairness of the market process, the political process encourages some to flee-fide on the contributions of others. Because political benefits are concentrated, however, they are easily noticed, greatly appreciated, and readily associated with particular policies and politicians. Because the costs are diluted over so many, they are easily ignored. The impression conveyed is that the political process motivates generosity and mitigates the unfairness of the marketplace. The larger the number receiving political benefits, and the more poorly the market operates because of the greater burden of government, the more it is that fairness seems to demand extending political benefits to yet additional recipients.

The impression that failure in the marketplace is unfair, and government action to moderate that failure is fair, is accentuated by special interest politics. No matter how well a group is organized politically, it isn’t likely to be successful in obtaining special interest subsidies, protections, and other exemptions from the discipline of market competition by arguing that its members want to benefit at the expense of the general public. A far more effective technique is for a special interest to claim that they, and the public interest, are being threatened with bankruptcy, job losses, and dislocations by unfair market forces. Whether it is farmers facing foreclosure, steelworkers facing indefinite layoffs, or the Chrysler Corporation facing bankruptcy, their chances of appealing to public compassion and obtaining political protections against market pressures are increased with a persuasive argument that those pressures are unfair.

Of course, with public compassion being fanned by interest groups using economic failure as a pretense for capturing special privileges, the result is unlikely to be very compassionate. Certainly there are people who for reasons beyond their control are left behind in the marketplace, and who deserve our sympathy and help. Unfortunately those who need help the most are the ones whom political action in the name of compassion helps the least. Pointing to the problem of poverty has long been the most effective way of disparaging the market economy and persuading the public that in the absence of government programs the marketplace would be littered with the poor and the impoverished. What has been almost completely ignored is the government’s impotence in helping the poor. Indeed there is reason to believe that by lowering the productivity of the market place, government transfer programs have reduced the income of the poor. By concentrating attention on economic failure in the marketplace to justify the expansion of political control over economic decisions, the influence of special interest groups has grown and the scope of economic failure has been enlarged.

Unless economic failures are understood as integral to the successful performance of market economies, they will be seized upon by political interests as justification for expanding government action that stifles general economic productivity for the short-run advantage of the politically influential few. As long as the economic failures that impose the guiding discipline in market economies are widely perceived as unnecessary and unfair, a threat remains to the prosperity of existing capitalistic economies, and a roadblock stands in the path of economic progress in those economies that are trying to escape the blight of socialism.

The struggle to protect our liberty against the abuses of government is long-standing, and certainly one over which the defenders of liberty can declare no permanent victories. Yet, in recent tunes there seems to have been a shift in favor of liberty in the struggle between government suppression and individual liberation. The most dramatic evidence of this shift comes from Eastern Europe where the yoke of Communism has loosened with the fall of several totalitarian regimes.

But even in those countries based on democratic capitalism, in which the power of government has been limited, at least in a relative sense, the evidence justifies cautious optimism for believing that the threat of government has reached its zenith and has begun to recede. Marginal tax rates have been lowered, regulation has been reduced, privatization proposals are being implemented, and governments are finding it increasingly diffi cult to initiate new programs and controls. While the existing controls and intrusions of government certainly have not become irrelevant, there seems little doubt that they have become less relevant to the choices people make and the freedoms they exercise.

But why? Is the current retrenchment in government power an aberration, nothing more than a temporary fluctuation in the long-run trend of increasing state control? Or can we point to fundamental forces at work which are systematically shifting power from governments to individuals? In our view, it is the latter.

Changes taking place in the global economy, changes rooted in continuing technological progress, are reducing the threat governments pose not only to our liberty, but to our prosperity as well. The explanation of why technology is increasing the freedom of the individual, rather than the power of the state, requires an under standing of the importance of information and its coordination to a free and prosperous social order.

Freedom and Economic Prosperity

As Friedrich Hayek pointed out in 1945, economic prosperity depends on the ability of each of us to respond appropriately to an enormous amount of information, most of which no one person can possess directly. Economic progress requires the use of information that exists only as widely dispersed knowledge which each of us has about our own condition, circumstances, and preferences. Without the proper utilization of such seemingly trivial bits of information as the personal idiosyncrasies of those with whom we work, the peculiarities of a machine we operate, a shortcut on a delivery route, and our willingness to sacrifice a promotion for locational amenities, our ability to produce wealth would be greatly reduced.

This information is typically tacit; it is impossible even for those who possess it to communicate it in any meaningful way to others. The only way to make use of such locationally specific knowledge is by giving those who have it the freedom to act on it. Without freedom, the information that is essential for prosperity is rendered largely useless. Freedom is necessary for economic progress.

Yet, freedom is not sufficient for economic progress. For the localized information possessed by an individual to be utilized to best advantage, it has to be used in a way that is compatible with the use others are making of the localized information that they alone possess. No matter how appropriate individual decisions may appear when judged against the particular information each individual has, unless these decisions are somehow melded together into a coordinated pattern of consumption and production, the performance of the economy will frustrate the pursuits of all.

Economic Coordination

The seriousness of the problem of economic coordination cannot be overemphasized. The need to coordinate economic decisions if economic progress is to be realized is an undeniable fact, and has provided much of the rationale for those who favor restrictions on individual freedom in the name of “rational” economic planning by the state. Supposedly government planners with a broad social perspective, and the ability to gather economy-wide economic data, are necessary to coordinate the otherwise conflicting pursuits of individuals acting on only local information.

A crucial problem with central economic planning is that, by restricting the freedom of individuals with government commands and controls, much of the local knowledge so essential to economic progress is effectively destroyed. This is a problem that advocates of central planning have either: 1) ignored, 2) assumed could be overcome by advances in technology that would allow the collection of local information, or 3) seen as a necessary cost of solving what is perceived as the more important problem of economic coordination.

If it were the case that economic activity could be coordinated only through central direction, then the justification for central economic planning for the purpose of coordination would have merit. There would be a trade-off between the use of localized knowledge and the coordination of that knowledge. The individual freedom that increased the former would reduce the latter, and freedom would be insufficient for economic progress.

The fatal flaw in the case for central economic planning is the failure to recognize that the best way to coordinate economic activity is by giving individuals the freedom to act on the knowledge that only they have within the institutional setting of a free market. In a free market, characterized by private property and voluntary exchange, prices emerge which convey far more information and coordinate economic decisions far better than can the most diligent and dedicated team of central planners. Market prices convey to each individual the value that others place on the marginal units of those goods and services that are exchanged in the marketplace. Therefore, whether making a decision on how much of a product to consume or how much of a productive input to employ, each decision-maker, because of the market prices he faces, has both the information and the motivation to acquire additional economic resources only as long as these resources are worth as much or more to him than they are to others.

The result is a coordinated pattern of economic activity that directs resources and efforts into their highest value uses by giving individuals the freedom to utilize their dispersed and localized knowledge. When individual freedom is subject to the accountability of the marketplace there is no trade-off between the freedom and coordination upon which economic progress depends. Individual freedom, exercised within the constraints imposed by the private market, is a powerful and essential force for economic progress.

Yet for the very reason that individual freedom can be so productive, it is also vulnerable to suppression. The advantages we realize from individual freedom derive from the fact that it will be exercised in a wide variety of unpredictable ways. As Hayek has pointed out, “If we knew how freedom would be used, the case for it would largely disappear,” and “the benefits I derive from freedom are thus largely the result of the uses of freedom by others, and mostly of those uses of freedom that I could never avail myself of.” There is a tendency in all of us, however, to view with suspicion the decisions of others when those decisions deviate from those that we would make. Suspicion quickly turns into intolerance when the freedom of others results in decisions which conflict with our own pursuits. The only hope for maintaining the tolerance required for freedom to flourish is a market setting in which the freedom exercised by each in pursuit of his objectives takes account of, and facilitates, the pursuits of others.

Tolerance for freedom requires that people be accountable for their actions, and in the absence of accountability through the general rules of the market, one can be sure that more detailed rules will be imposed on individual behavior. It should come as no surprise that in those countries in which reliance on private property and exchange is officially frowned upon, one finds not only the poorest economic performance, but also the most blatant violations of basic human rights and freedom.

Government as Protector and Pirate

Ironically, the market setting that allows for freedom is one that cannot long remain viable without coercion. The productive accountability and coordination of the marketplace depends upon people obeying the general rules of private property and exchange. These rules are not self-enforcing. The benefits of economic productivity and tolerance for freedom that result from respect for the rules of the market are general benefits. When respect for property fights is widespread, the general advantages of the marketplace that result accrue to all in the country, including those who transgress against the property rights of others. Therefore, those who promote the general advantage by exercising restraint find themselves victimized by those who do not. It is this which justifies granting to government the coercive power to enforce the rules of the market. Without such enforcement the market order, and the freedom and productivity it allows, cannot long remain viable.

Unfortunately for the very reason government is needed to enforce the general rules which are the foundation of a social order based on freedom and responsibility, a persistent tendency exists for government to expand, and then undermine both freedom and responsibility. The existence of government power creates the opportunity for people to benefit legally at the expense of others in ways that are analogous to the illegal practices that it is the primary purpose of government to prevent.

The accountability imposed by the market, although providing general benefits, is seen as an inconvenience from the perspective of each individual. Being held accountable to the whims of consumer preferences creates problems for producers that from their perspective are best resolved by having government interfere with the social coordination of the marketplace. When government uses its coercive power to give a particular firm and its employees exemption from the rules of the marketplace, the general benefits of market coordination are diminished. Like the thief who violates rules of private property and voluntary exchange, those who benefit from government infringements of those rules live, as a consequence, in a less productive and free society.

This cost does little, however, to dampen enthusiasm for government action that reduces the accountability of the private market. As with the thief, those who gain advantages from preferential governmental treatment receive all the benefits while the costs (in terms of diminished freedom and productivity) are spread over the entire population.

Government can become the means by which everyone is engaged in the activity of “political piracy,” or in the words of Frederic Bastiat, “the State is the great fiction through which everybody endeavors to live at the expense of everybody.” Obviously this situation is collectively destructive. Piracy can be a profitable activity when the pirates are few and the victims are many. But when everyone is a pirate, everyone is also a victim, making it possible for all to gain by a reduction in piracy.

Pessimism comes easy when considering the relentless pressures for governments to expand and, by so doing, destroy the general benefits it is government’s duty to protect. Aided by single-issue dedication, organizational advantage, and a rationally ignorant public, special interests are able to dominate the general interest in the com petition for political influence.

The intellectual force of classical liberalism that guided the drafters of the United States Constitution was undeniably a major factor in the establishment of a government that was largely limited to maintaining an environment conducive to freedom and economic progress. But while this intellectual force hasn’t been destroyed, it has been overwhelmed by the relentless and increasingly entrenched political influence of special interests.

Technology and the Power of the State

While not denying the power of special interests and the strong and unrelenting pressure for government expansion that is destructive of our freedom and prosperity, pessimism is premature. The world is changing in ways that are imposing constraints on government power that reinforce (or supersede) those of written constitutions, and prodding unmistakable evidence that the classical liberal model of limited government and decentralized markets allows far more freedom and prosperity than state dominance and centralized economic direction. There are reasons for optimism that these two forces are in the process of interacting in a virtuous cycle of reinforcement that will expand the scope of human liberty and economic progress around the globe. The force initiating this cycle of freedom and prosperity is technology.

In the past it was widely believed that technological advances would expand the control of the state, with some being appalled by this prospect and others welcoming it. Whether one feared the Big Brother of George Orwell’s 1984, or looked forward to the day when government could gather the information necessary to calculate efficient socialist prices, the expectation was that technology would shift control from the level of individuals to that of central authorities.

This expectation was not completely unfounded. Certainly technological advances have increased the ability of government to monitor private activities, to gather information on the economy, and to solve the huge systems of simultaneous equations called for by the schemes of the rational socialist “calculators.” Moreover, this new technology might be used to destroy the economic freedom that is incompatible with the directives of central planners.

The initial effect of the technology that ushered in the Industrial Revolution was to increase the power of government. This technology created tremendous advantages resulting from the exploitation of economies of scale. Economies became characterized, and landscapes dotted, by huge plants and factories. Efficiency was increased by building yet more massive units of physical capital and by bringing yet larger numbers of workers in close physical proximity in order to coordinate their use of that capital. Such large concentrations of productive wealth create tempting targets of opportunity for political exploitation through regulation, taxation, and central direction. Also, the large productive facilities called for by economies of scale created the illusion that large sections of the economy could be efficiently concentrated and controlled by central planners.

Certainly governments have used technology to increase control over their populations. It is possible to point to many cases in which this control has seemed almost complete. And the experience with increased state control is far better characterized by Orwell’s Big Brother than by the socialist fantasy of the calculator of efficient socialist prices. The primary accomplishment of totalitarian governments has been to snuff out both individual freedom and economic prosperity.

Technology continues to progress, however; and as it does there are reasons for believing that it is becoming more a force for liberation than for suppression. The atrocities of state power that have characterized so much of the 20th century are likely to be the darkness before the dawn.

Technology as a Force for Freedom

Recent technological progress has altered the production of wealth in fundamental ways, and by so doing has reduced the ability of government to control and exploit the productive process. The most cost-effective plant is no longer the largest plant. Small machines are now able to produce a host of products more efficiently than formerly was the case with large machines. Just-in-time delivery systems based on more rapid communication and transportation are reducing the warehousing space needed for inventorying productive inputs. The productive activity of a large number of people can be supervised and coordinated without having them in close physical proximity to each other. And increasingly it is knowledge and creativity embodied in human, rather than physical, capital which is the decisive factor in the creation of wealth.

The result is not only productive units that are far smaller than in the past, but far more mobile as well. Increasingly the tax base that governments were able to treat as captive have become fugitive. The governments of countries are now finding themselves facing the same type of competition that governments of local jurisdictions have always faced.

No claim is being made that this competition will ever rival that faced by grocery stores or pizza parlors. But the gap that can exist between the attractiveness of the tax and service packages of different governments without adversely affecting the tax base of the least attractive is diminishing. As measured by the discretion governments have to tax, regulate, and exploit the productive process for political ends, technological advance is reducing the control of governments.

Of course governments have always recognized a threat in the emigration of productive resources, and those governments pursuing the least “competitive” policies have never hesitated to employ brutality in order to limit that emigration. But technological advance is making government attempts forcefully to prevent capital flight less likely to be successful; and increasingly futile even if successful. The increasing mobility of capital goes a long way in explaining the difficulty of preventing capital flight. The changing nature of capital explains the futility of attempts to overcome this difficulty, even if successful.

Productive capital has become increasingly dependent upon intellect and creativity. As George Gilder has expressed it, “innovation tends to devalue the materials of the established system and create a new means of production with a higher content of intellect and ideas. The displacement of materials with ideas is the essence of all real economic progress:”

How Governments Undermine Creativity

Attempts by central authorities to confine, control, and manipulate creativity are sure to destroy creativity. Those governments that have been most successful at imposing internal controls over their populations in order to prevent the exodus of capital (both human and physical) have succeeded only in destroying the creative process upon which a productive capital base ultimately depends.

Technology is shifting the advantage even more than in the past to decentralized economies based on the coordination of the marketplace. For reasons discussed earlier, the market has always dominated central planning in the utilization of localized information and in coordinating that use into an overall pattern of efficient production and consumption choices. But it is important to recognize that, by accelerating change and further fragmenting the distribution of knowledge, technological advances are rapidly increasing the dominance of market-based economies.

In an economic setting characterized by completely static production processes and preferences, and a few huge production units, central economic planning might work tolerably well. In such a setting there would be fewer units to coordinate, and maybe some semblance of coordination could be realized by repeated iterations toward a stationary target. It is not surprising that those who dream of economic progress through industrial policy controls find comfort in the thought of mega-sized corporations (see, for example, John Kenneth Galbraith, The New Industrial State) and see disruption rather than progress in the spontaneous changes that are leading to a dynamic global economy (e.g., Robert Reich, The Next American Frontier).

But the thought of central economic control becomes a complete absurdity in a world in which large corporations are losing ground to creative entrepreneurs, who, armed with the latest technology and a relatively few employees, outperform their rival Goliaths at innovating, manufacturing, and marketing. Smaller organizational units whose productive power has been enhanced by technological advances possess far greater agility in responding to the rapid changes brought on by those technological advances.

The greater productive power of smaller organizations comes from superior use of localized knowledge and increased specialization, and depends completely upon the information flows that can be collected and distributed only through markets. The information that pulses through the market in the form of prices, profits, and losses is information that is being utilized to ever greater advantage in decentralized economies and which is being neutralized and destroyed in centralized economies.

The same technology that is driving the production and rapid distribution of goods, services, and information in those countries that are plugged into the global market is ensuring that those who live in economically stagnant and politically repressive regimes are becoming increasingly aware of their plight. All regimes based on central economic and political control are being under mined by “the three most powerful political factors at work in the world today: democracy, market economies, and the microchip.”

When the theory and experience of democratic capitalism is presented to those whose political and economic lives are subject to the detailed control of unelected authorities, those authorities soon begin losing their grip. When people couple improved knowledge of alternative systems of political economy with greater ability to vote for these systems both with their feet and their capital, the power of governments over their citizens is further weakened. By quickening the flow of information and increasing the mobility of capital and populations, recent technological advances are ushering in a new era in which the prospects for individual liberty and accelerating economic progress are greatly improved.

Summary and Conclusion

Genuine economic progress isn’t possible without the freedom of individuals to use the localized knowledge that only they can possess. Yet individual freedom is a force for economic progress only when subject to the accountability imposed by the market institutions of private property and voluntary exchange. Somewhat ironically, the freedom of the marketplace depends upon the coercion of government. In the absence of government enforcement of the rules of private property and exchange, temptations exist that convert individu ally rational behavior into collectively destructive outcomes.

Unfortunately, the power to protect freedom is also the power to destroy freedom by undermining the accountability of the marketplace. And the use of government power to undermine market accountability is exactly what numerous special interest groups see as individually rational. Each such group realizes private advantage at public expense by being exempted from the discipline of the marketplace.

Yet, there is cause for optimism. Technology seems to have entered the struggle between government power and individual freedom on the side of freedom.

The concern has long been that the power of government is undermining the freedom and productivity of the market. This remains a concern. But there is reason to believe that the threat is turning, and we are now observing the freedom and productivity of the global market in the process of undermining the power of governments around the world.

1.   Friedrich A. Hayek, “The Use of Knowledge in Society,” American Economic Review, 1945, pp. 519-30.

2.   Friedrich A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960), pp. 31-32.

3.   Frederic Bastiat, “The State,” reprinted in Ideas on Liberty (Irvington-on-Hudson, New York: Foundation for Economic Education, 1955).

4.   George Gilder, Microcosm.. The Quantum Revolution in Economics and Technology (New York: Simon & Schuster, 1989), p. 63.

5.   Even in a static economic setting with only a few production units, localized information would remain important and market coordination still would be superior to bureaucratic coordination. Also, it is unrealistic to assume that central authorities are motivated to take the task of economic coordination seriously. The reality of central economic planning is that it requires concentrations of coercive power that always are exploited for private advantages which generally conflict with public-interest objectives such as economic coordination.

6.   See the editorial “China Globalized” in The Wall Street Journal, May 22, 1989.

This is especially true when we address the problems of low-income Americans. However, the main problem of low-income workers is a lack of job skills, which leaves them little choice but to accept low wages and low ben efits. Mandated benefits will do nothing to solve the problems of these workers, indeed, by wiping out employment opportunities, mandated benefits are counterproductive, especially for the most disadvantaged in labor markets. Mandated benefits will not supplant the welfare state; mandated benefits, instead, will hasten the growth of an even larger welfare state—to take care of those banished from constructive employment.