Necessary but not Sufficient

In my latest article for, I argue that the existence of a “market failure” is a necessary but not sufficient condition for government intervention in the economy.  A slice:

As with all economic questions, the answer is “compared to what?” Externalities, compared on an idealized hypothetical world where all information is known and transactions are costless, appear easy to solve via government regulation. However, when we compare a world of externalities to the real world, where costs and benefits are subjective and ultimately judgement calls must be made by analysts, we see that externalities are necessary but not sufficient justification for government intervention.


The Metric Fallacy

We often hear some proclamation, usually in support of subsidizing some activity, that some activity is desirable because it leads to success (for example: “Education is an investment in the future”).  But this is what I will henceforth call the “Metric Fallacy,” which is a specific form of the “ad hoc ergo propter hoc” fallacy.

The fallacy goes like this:

Some desirable outcome, X, is highly correlated with broad category Y.

Therefore, to achieve X, one should increase Y.

The first statement is true (X and Y are correlated).  The second statement, however, is fallacious.  A practical example will help:

It is true that higher education is correlated with higher levels of income.  According to the College Board, a person with even just some college education earns approximately 13% more than someone with just a high school degree.  Higher levels of education are correlated with higher levels of income.

But it is fallacious to, therefore, say that education itself is the cause here.  We need far more information.  The type of education matters a whole lot more.  A person in theology earns considerably less than a person in chemical engineering.  Ceteris paribus, a doctoral degree in a STEM field will earn a lot more than a doctoral degree in religion.

Thus, the Metric Fallacy is: to increase income, we need to increase education.

We see the Metric Fallacy all over the place and in high-ranking areas (Education and Economic Growth Theory and subsequently foreign investment, just to name a few).  Many government policies are based off this fallacy, including minimum wage, subsidized college loans, foreign aid plans that involve capital donations, and the like.  Indeed, probably the greatest lie I heard as a child was “if you want a good job, you have to go to college.”

My colleague and professor Chris Coyne writes a lot about this in his excellent book “Doing Bad by Doing Good,” and it is the main thesis of Bill Easterly’s book “The Tyranny of Experts.”

The other day, I wrote about discovering prices vs imposing prices.  Discovering prices means that we see what prices emerge from the price system, people acting in response to relative scarcity.  When prices emerge, they provide information.  A person in a profession who earns a high salary means there is a relative scarcity of that profession.  He is indeed made better off by this, but it also signals that we need more of that profession.  Prices allow us to discover this information.  But it is a fallacy to conclude that his higher wage is in some way desirable for anything other than this purpose (eg, the protectionist who might argue if he is made “worse” off because of competition, we all are made worse off).

Costs and Benefits are Culturally Dependent

futurama culture

The above screenshot is taken from Futurama.  Lrrr and his wife, Ndnd, rulers of the planet Omicron Persei 8, are aliens from a warlike race.  Violence permeates their culture.  While Lrrr himself is not particularly warlike (he half-heartedly invades Earth in one episode just to stop his wife from nagging him), the culture still is ingrained in him and much of his confusion regarding Earth is why it is not more warlike (another quote I could have chosen is when he is watching an episode of the in-show spoof of Ally McBeal called Jenny McNeil, he asks “if McNeil wants to be taken seriously, why does she not simply tear the judge’s head off?”).

Lrrr’s confusion stems from the two different cultures of Earth and Omicron Persei 8.  What is “foolish” behavior for him is normal behavior for the people of “ancient” Earth (Futurama takes place in the opening decades of the 3,000’s, so “ancient Earth” to him is the 90’s and 2000’s for us).  For Lrrr, there is a benefit to demonstrating strength before (or to) friends.  For the people of Earth, it is a cost.

This simple fact makes the job of the economist difficult when it comes to regulation.  The typical Econ 101 story for regulation is to do a cost-benefit analysis and, if the costs are less than the benefits, then regulation may be justified.  But this seemingly straightforward process is, as we can see above, actually quite complex.  What counts as a cost and benefit, as well as the relative values of those costs and benefits, are subjective.  It depends on the person observing the situation.  For us, Ross’ behavior is normal and praiseworthy.  For Lrrr, the exact same behavior is confusing and foolish.  And Earth observer might propose a regulation that rewards people who act like Ross.  And Omicron Persei 8 observer might propose legislation that punishes people who act like Ross.

Ultimately, the determination of regulatory behavior comes down to the subjectivity of the observer.  What this means is “optimal” regulation (such as a tariff, tax, wage, etc), while possible in theory, is practically impossible.  What may be an optimal tax for one observer may be too high/low for another and may be a subsidy for a third.

This subjectivity is why I adhere to a status quo bias and a presumption of liberty.  Legislative and legal changes should not be done casually, and even with great thought and analysis, should be undertaken only very carefully.

Today’s Quote of the Day…

…comes from pages 86-87 of Bruno Leoni’s 1961 work Freedom and the Law (3rd Edition, emphasis added):

Common citizens were the real actors in this respect [the formation of common law], just as they still are the real actors in the formation of the language and, at least partially, in economic transactions in the countries of the West.  The grammarians who epitomize the rules of a language or the statisticians who make records of prices or of quantities of goods exchanged in the market of a country could better be described as simple spectators of what is happening around them than as rulers of their fellow citizens as far as language or the economy is concerned.

JMM: The economist as a scientist is one who observes, records, and explains phenomena.  Our models and metrics work best when they are describing these outcomes.  To use them to be prescriptive fundamentally changes the nature of the being.  For example, to try to manipulate the price system to get higher wages (eg, a minimum wage) causes distortions: less labor is purchased, overall wages may drop, etc.  Tariffs, as a means to produce more profit for firms, lead to overall poverty.  It’s easy to boost some metric merely by monkeying about with its components.  But do not fall into the mistake of thinking that now higher metric is comparable to the metric one observed before.  GDP manipulated is not the same as GDP arisen from market transactions even though they superficially look the same.

The good economist, like the good jurist or the good grammarian or the good scientist, observes the world.  He does not try to impose his own viewpoints onto the data.  He is a discoverer of economic relations (or legal relations or grammatical relations etc), not a creator of one.

Somewhere along the line, this simple fact was lost.  Economists are all about “policy recommendations” now.  Optimal tariff this and carbon tax that.  They have ceased being economists and have become applied mathematicians.  Likewise, judges, lawyers, and legislators have ceased trying to discover the law (that the law is) and have moved toward telling us what the law should be.  As such, they have ceased being judges, lawyers, and legislators and moved into being commanders of humanity.  What they do can no longer be called law; it is a farce wearing the guise of law.

Today’s Quote of the Day…

…is from page 15 of Bruno Leoni’s excellent 1961 work Freedom and the Law: (emphasis in original)

It seems to be unquestionable that we should, on this basis, reject the resort to legislation whenever it is used merely as a means of subjecting minorities in order to treat them as losers in the field. It seems also unquestionable that we should reject the legislative process whenever it is possible for the individuals involved to attain their objectives without depending upon the decision of a group and without actually constraining any other people to do what they would never do without constraint. Finally, it seems simply obvious that whenever any doubt arises about the advisability of the legislative process as compared with some other kind of process having for its object the determination of the rules of our behavior, the adoption of the legislative process ought to be the result of a very accurate assessment.

JMM: So often in the field of economic policymaking, little thought is given toward whether an action should be taken.  It’s trivially easy to come up with models that show, under certain circumstances, this or that policy can be enacted and it will resolve a market failure.  But little thought is given to whether these policy prescriptions are prudent.  There are no general maxims of economic policymaking that stand to guide actions; economists rarely discuss these matters deferring them to legislators, lawyers, or philosophers.  

But economists are in a unique position to advise precisely on those general maxims.  We built the models after all.  Our job is to explore the kinds of processes that lead to rules of our behavior, and they are more than just the legislative.  The economist who designs models without consideration to their prudence does a disservice to himself, his profession, and science as a whole.

Where’s Mine?

In my Econ 385 class on Tuesday (International Economic Policy), an excellent discussion on student loan debt came up.  One of my students asked the probing question: “Student debt is approaching $1.8 trillion.  Everyone seems to recognize this is a bubble.  Why is there so much resistance to student debt forgiveness?” 

I opened the discussion up to the class.  Lots of excellent, well-reasoned opinions were expressed.  Some argued that the schools have no incentives to keep their expenditures in check since the government is subsidizing the loans.  Some argued that the politicians do not bear the full costs of these loans, nor a default, so they have little incentive to address the issue.  Others noted that the banks would keep giving loans so long as they are backed by the government.  All of these are excellent points, which I’ll not rehash here (I wish I could take credit for teaching these students, but they were already smart before they came to my class).  

There is a larger issue I wanted to discuss, one which was not discussed in class (we were acting under the assumption, for the sake of the discussion, that forgiveness was the best option).  This issue is: who gets forgiven?

What is it about student loan debt that makes it worthy of being forgiven, but other forms of debt are not?  There’s credit card debt, housing debt, business debt, auto debt, etc.  All this debt can have the same effect as student loan debt.  True, student loan debt is larger than these other sources, but if that’s the case, that’s just an argument either for partial forgiveness, or for people to mount up other forms of debt.

If student loan debt is forgiven, the holders of the other forms of debt will wonder “why not me?  Where is mine?”  Indeed, recently a friend used exactly this line of reasoning when justifying tariffs for his own industry: “My competitors and suppliers get protection.  Why not me?”

This is the problem with most government handout programs.  Those that are designed to help a certain and arbitrary group can compel members of the out-group to seek their own rents.  If student loan debt is forgiven, business owners might lobby to have their debt forgiven (“I’m creating jobs!  if my debt is forgiven, then I can create more jobs!”).  Or automobile owners (“My car lets me get to my job!”).  Anyone could come up with various excuses.  

This rent seeking, of course, then results in wasted resources.  Resources that could have gone to productive uses are now trying to capture rents.  And there are other issues as well that I’ll not touch on here: the sanctity of contracts (will it become harder for people to get loans since the value of a loan contract will be reduced?), moral hazard problems (will former debtors seek even more debt since their previous amount was forgiven?).  These are all important issues to consider.

Expert Failure to Communicate

On Friday, Roger Koppl of Syracuse University presented his book Expert Failure at the Invisible Hand Seminar co-sponsored by George Mason University and the Institute for Humane Studies.  

The thrust of Dr. Koppl’s book is that, similar to market and government failure, experts can fail in their task as well.  Experts can give poor advice, he influenced by known or unknown biases, and react to incentives just like the rest of us.  An expert, for the purposes of this discussion, is anyone paid for their opinion (this is how Koppl defines expert in his book).

There is another aspect of expert failure which plays into the problem and that is a failure to communicate.*  Even if an expert does everything perfectly, if s/he cannot adequately communicate their message to the decision-maker, then expert failure can still result.  

This expert failure to communicate is a major issue in law & economics.  Economists are trained in statistics and empirical methods.  Lawyers and judges may not and juries almost certainly are not. In his 2009 textbook, Basic Concepts of Probability and Statistics in the Law, Columbia law professor Michael Finkelstein gives two examples were ambiguous wording by experts and misinterpretation of probabilities by juries led to false convictions (see pages 3-5).  These failures can lead to pro-prosecution bias in juries (or, alternatively, pro-defendant bias if other statistical fallacies are made).  In the two legal cases above, the convictions were overturned on appeal, but one has to worry about the error rate given the already confusing nature of statistical wording and hypothesis testing. 

In Expert Failure, Koppl discusses increased competition among experts as a means for solving expert failure.  A good expert can explain his argument in common-language and not necessarily hide behind jargon.  Competition between experts may indeed reduce this expert failure to communicate, but it ultimately rests on the head of the decision maker.  And indeed the more complicated a topic is, the more the reliance on expert opinion is needed, which increases the likelihood of expert failure to communicate.  

Ultimately, I think this all adds up to a rather strong presumption of liberty.  The more control experts have over our lives, the more likely it is for expert failure to occur.  Indeed, some of these highly complex functions, like contract issues or tort issues, may be best left to arbitrators rather than judges.  The more complex an issue is, the less one would want to centralize it.  

*Full disclosure: this point may come up in the book.  I have not read it, having ordered it shortly after the seminar

Market Power Does Not Equal Coercive Power

Below is an open letter to Bloomberg:

There is a lot to like in Mark Whitehouse’s op-ed from October 21 (US Labor Markets Aren’t Truly Free) .  However, one place he errs is where he writes (emphasis added): “Economists have offered various explanations, including labor-saving technology, weakened unions, and growing competition from lower-wage countries such as China. More recently, though, they’ve identified another: The job market has become less free. The consolidation of American business has left people with fewer places to work, shifting the balance of power to employers.

The consolidation of American businesses does not necessarily mean the job market is less free.  So long as workers are free to move jobs or relocate, then the job market remains free regardless of its concentration.  So long as transactions are coluntarily entered into and there is no outside interference, the exact structure of a market does not matter when determining freedom.

It is not from the concentration of the market that the lack of freedom arises, but rather the other factors Mr Whitehouse identifies: property zoning, non-poaching agreements, etc.  The industry concentration may be a symptom of these lack of freedoms, but they are not the cause thereof.

Be Skeptical of Regulations Because Knowing the Market is Difficult (Even for Experts)

Given how much money business consultants make, one would think they have pretty good insight into a given industry or market.  And sure, they may have lots of information unavailable to most people, but does that necessarily imply they are better?

All data received, we must remember, is context-dependent.  Data never, ever, speak for themselves.  Interpreting and developing models for given market structures is extremely difficult in this regard because it requires certain assumptions.

Consider the following real-world example: when the guys from Xerox (the copy machine company) wanted to start selling their machines to businesses, they met stiff resistance from consultants and financial backers.  “Why would anyone spend thousands of dollars on a copy machine when we have a perfectly good, cheap substitute: carbon paper?  Copy machines will never sell.”  Prima facie, this criticism seemed legitimate.  Firms and experts observed secretaries and typists using carbon paper to make copies for distribution.  There didn’t seem to be any demand for copy machines.

Undeterred, the Xerox guys pressed on.  They decided to give companies the hardware, toner, and paper for free up until the first 2500 copies per month.  Firms jumped at the idea.  After all, how were they ever going to use 2500 copies a month?

Well, the rest is history.  Xerox is still around.  Carbon paper is not.

Why?  What did the experts get wrong?

They got wrong the scope of the market.  Copy machines weren’t for people writing letters.  They were for people receiving and distributing letters!  The market for copy machines was for the owner who got a letter from his lawyer who wanted to distribute it to the rest of the team.  It was for the product manager who needed to itemize his costs for different departments.  Etc etc.

There is an implicit conceit in economics that we know the market, the shapes of demand and supply curves.  But the reality is, we never do.  We have only data points in a certain context which may or may not provide useful information about other contexts.  This implicit conceit becomes vitally important when we start talking about regulation or “optimal taxes,” which require knowledge of the scope and shape of the market.  Knowledge we simply do not have.

Today’s Quote of the Day…

…is from page 14 of the 3rd edition of Bruno Leoni’s 1961 book Freedom and the Law:

Subsituting legislation for the spontaneous application of nonlegislated rules of behavior is indefensible unless it is proved that the latter are uncertain or insufficient or that they generate some evil that legislation could avoid while maintaining the advantages of the previous system.  This preliminary assesment is unthought of by contemporary legislators.  On the contrary, they seem to think that legislation is always good in itself and that the burden of the proof is upon the people who do not agree.  My humble suggestion is that their implication that a law (even a bad law) is better than nothing should be much more suppored by evidence than it is.

JMM: Note that Leoni’s comment is not the same as doing a cost-benefit analysis, a requirement of current legislation in the United States.  It’s an even higher bar to clear than that: legislation is, essentially, the only way to accomplish something, not that it is merely a way to accomplish something.

The application of legislation, because it requires coercion and, therefore, forces all members of the group to abide by it, should be used as sparingly as possible.  Negative thou shalt not legislation (eg, thou shalt not murder) is preferable to positive thou shall legislation (eg, thou shall give preference in manufacturing to Americans or pay a fine).  Negative legislation has the advantage of being less oppressive; so long as you do not break the rule, you are free to do as you wish.  Additionally, it has the advantage of being general.  For example, the rules of justice are negative: thou shalt not harm another person.  These rules are followed in a million different ways: staying in bed, reading a book, holding a door open, being a recluse, driving defensively (and aggressively), etc.  They do not constrain behavior to a significant degree.

The bar for legislation should be set high, indeed very high, given its potential for abuse.  Negative legislation, as opposed to positive, should be preferred.