VOLUME 62, NO 2 MARCH 2012

Features6 How Government Distorts Labor Markets by Robert P. Murphy

10 The Politics of Health Care Rationing by Chidem Kurdas

16 Why the Titanic Is Sinking by James L. Payne

19 Never Mind the Gap by Max Borders

25 Of Constituents and Clans by Richard W. Fulmer

28 The Smoot-Hawley Tariff and the Great Depression by Thomas C. Rustici,Theodore Phalan, and Deema Yazigi

35 The Best Bet Is Freedom by Jason Riddle

37 The Volcker Rule by Warren C. Gibson

Columns2 Perspective ~ Lawrence O’Donnell and Government Job-Creation by Sheldon Richman

4 The Buffett Rule Will Create Jobs? It Just Ain’t So! by Roy Cordato

14 Our Economic Past ~ Are We Looking at the Wrong Depression? by Stephen Davies

23 Peripatetics ~ Fearing Hayek by Sheldon Richman

33 The Therapeutic State ~ Who Killed Michael Jackson? by Thomas Szasz

41 Give Me a Break! ~ Obamacare Abominations by John Stossel

47 The Pursuit of Happiness ~ The Case Against Sanctions on Iran by David R. Henderson

Book Reviews42 Adam Smith: An Enlightened Life

by Nicholas Phillipson Reviewed by Martin Morse Wooster

43 Homeschooling: A Hope for America

edited by Carl Watner Reviewed by Karen Y. Palasek

44 The Cultural and Political Economy of Recovery: Social Learning in a Post-Disaster

Environment

by Emily Chamlee-Wright Reviewed by Daniel J. D’Amico

45 Handbook on Contemporary Austrian Economics

edited by Peter J. Boettke Reviewed by George Leef Page 42

Page 10

Page 23

VOLUME 62, NO 2 MARCH 2012

The commercial seems like a parody, but that surelooks like Lawrence O’Donnell of MSNBC’s“Last Word.” In the spot O’Donnell mocks

politicians who say that “government can’t create jobs.”“The government created your job!” O’Donnell fires

back, smiling triumphantly.Imagine: In a battle of wits with a phantom politi-

cian, O’Donnell lost. Of course he doesn’t know it.On the off-chance this is not a “Saturday Night

Live” bit, let’s take a closer look.First—I don’t even know where to start—it’s so

ridiculous. How about this? The claim that governmentcan’t create real jobs is not refuted by the existence of politi-cians. Must that really be explained?

Perhaps O’Donnell would applaud a proposal tomake every adult American a member of Congress, paida salary drawn on the Federal Reserve. Unemploymentwould vanish overnight.

But maybe that wouldn’t satisfy him. He might wantat least some people working to make useful things.What do politicians make? Besides messes, that is.

But what things? Here’s where it gets tricky.Alas welive in a world of scarcity. People making widgets can’talso be making wudgets (a similar but not identicalproduct). Should the government create widget-makingjobs or wudget-making jobs? Neither? Some of each?How many? And how would the program administra-tors even go about making the decision?

In a freed market a process exists for answering thosequestions. Prices generated by free consumer purchasesand producer competition for inputs guide decisionsabout what to make, how to make it, and in what quan-tities. In contrast, government “job creation” is like fly-ing in a heavy fog without instruments: Prices—whatLudwig von Mises called the tools of economic calcula-tion—are absent.

It has to be said yet again: In economic terms a “job”is not mere physical or mental exertion for which onegets paid.As someone once put it,“A thing cannot havevalue, if it is not a useful article. If it is not useful, then

2T H E F R E E M A N : w w w. t h e f r e e m a n o n l i n e . o r g

Lawrence O’Donnell and Government

Job-Creation

Perspective

Published byThe Foundation for Economic Education

Irvington-on-Hudson, NY 10533Phone: (914) 591-7230; E-mail: [email protected]

www.fee.org

President Lawrence W. ReedEditor Sheldon Richman

Managing Editor Michael NolanBook Review Editor George C. Leef

ColumnistsCharles Baird David R. Henderson

Donald J. Boudreaux Robert HiggsStephen Davies John Stossel

Burton W. Folsom, Jr. Thomas SzaszWalter E.Williams

Contributing EditorsPeter J. Boettke Wendy McElroy

James Bovard Tibor MachanThomas J. DiLorenzo Andrew P. MorrissBettina Bien Greaves James L. Payne

Steven Horwitz William H. PetersonRaymond J. Keating Jane S. Shaw

Daniel B. Klein Richard H.TimberlakeDwight R. Lee Lawrence H.White

Foundation for Economic Education

Board of Trustees, 2012–2013

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The Foundation for Economic Education (FEE) is anonpolitical, nonprofit educational champion of indi-vidual liberty, private property, the free market, and

constitutionally limited government.The Freeman is published monthly, except for combined

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Copyright © 2012 Foundation for Economic Education, exceptfor graphics material licensed under Creative Commons Agree-ment. Permission granted to reprint any article from this issue,with appropriate credit, except “Obamacare Abominations.”

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P E R S P E C T I V E : L a w r e n c e O ’ D o n n e l l a n d G o v e r n m e n t J o b - C r e a t i o n

the labor it contains is also useless, does not count as labor,and hence does not create value” (emphasis added).

Karl Marx said that.Yes, Mr. O’Donnell, Karl Marxunderstood that exertion aimed at making things noone wants is not real labor.When I say “things no onewants,” I don’t mean intrinsically useless things. In aworld of scarcity, if we consumers believe we haveenough widgets but not enough wudgets, then effortsto produce more widgets at the cost of wudgets arecounterproductive. Inputs are transformed into thingswe want less badly (if at all) than other things thoseinputs could have been transformed into. Value isdestroyed when it could have been created.

Admittedly it is technically wrong to say, “Govern-ment cannot create jobs.” We must concede there issome slim chance that a government program couldfinance a project that would have been undertaken inthe freed market. But it would be pure luck, and wecouldn’t know for sure it had happened even after thefact because government, which procures its resourcesat the point of a gun and doesn’t have to offer its “serv-ices” to consumers free to say no, faces no market test.

Persistent high unemployment does not demon-strate a need for government to create jobs. On thecontrary, it demonstrates a need for government to getout of the way so the market process can undergo thecorrection called for by the earlier government-induced boom, which itself was an unsustainable jobs-creation program. Politicians aggravate an already badsituation when they generate a tax and regulatory envi-ronment in which anything can happen.

* * *

The Austrian theory of the business cycle famouslyblames the inflationary boom for causing malinvest-ment in the capital structure.What’s less often noticedis that the boom also creates a mismatch between thetype of labor supplied and the type demanded. RobertMurphy explores this aspect of the business cycle.

Unless the Supreme Court invalidates Obamacare,the multifaceted law will soon be kicking in. Medicalrationing, Chidem Kurdas says, is in our future.

With government spending out of control, thesearch for ways to rein it in goes on. James Payne has asuggestion to at least get people thinking about whatunderlies all government spending.

One thing on the minds of Occupy Wall Street protesters is the income gap between the superrich andthe rest of us. Is this something advocates of freedomneed to be concerned about? Max Borders takes a closelook.

James Madison’s warning about contentious factionsis often invoked. But despite his prediction a large-scalerepublic did not prevent special interests from using thelevers of power to obtain privileges at the expense ofthe people. Richard Fulmer ruminates on corruption inAmerica.

More than 80 years later a debate still rages over theinfamous Smoot-Hawley Tariff ’s role in the GreatDepression.Was it a major or minor factor? Or none atall? Thomas Rustici, Theodore Phalan, and DeemaYazigi make their own assessment.

Politics and Las Vegas casinos are filled with zero-sum games. Losers provide the winners with theirrewards. Not so in the free market, says Jason Riddle.

The new Dodd-Frank financial regulations fea-ture the Volcker Rule, proposed by a former FederalReserve chairman. What’s the rule about, and is it agood idea? Warren Gibson takes us through themaze.

Our columnists are on point as usual. StephenDavies thinks people compare the current economicquagmire to the wrong past depression. Thomas Szaszexplores self-responsibility and the law in celebritydrug deaths. John Stossel asks businesspeople about thecosts of Obamacare. David Henderson wonders aboutthe wisdom of economic sanctions against Iran. AndRoy Cordato, encountering the claim that the BuffettRule for taxing the rich will create jobs, responds, “ItJust Ain’t So!”

Book reviews this issue cover Adam Smith, home-schooling, post-disaster recovery, and Austrian economics.

—Sheldon [email protected]

In the Raleigh News and Observer last fall (tinyurl.com/84b7r43), David McAdams, associate profes-sor of economics at Duke University’s Fuqua

School of Business, claimed—contrary to even Keynes-ian economics—that President Obama’s proposed tax on millionaires would create jobs. The so-calledBuffett rule, named after billionaire investor WarrenBuffett, is supposed to ensure that “millionaires and bil-lionaires” pay no smaller a percentage of their incomein taxes than a middle-income family.

In a perverse twist on supply-side analysis of howmarginal tax rates affect economicgrowth, McAdams argues that theBuffett rule, while forcing very-high-income individuals to pay more intaxes, would lower their marginal taxrate, stimulate investment, and hencecreate jobs. In reaching this odd con-clusion, McAdams shows a level ofunderstanding of tax analysis that isshockingly pedestrian, if not sopho-moric, particularly for a professor atone of the most prestigious business schools in theworld. (McAdams is not a professor in Duke’s highlyrespected economics department.)

McAdams illustrates his argument with the follow-ing example:

Consider . . . a millionaire whose income consists of$1 million in capital gains and $100,000 from achain of hot dog stands. This millionaire pays taxesof 15 percent on capital gains and 35 percent on netincome from the hot dog stands, for a total of$185,000 ($150,000 plus $35,000).This amounts to

an average tax rate of 16.8 percent, less than the 25percent marginal rate paid by many middle earners.

Under the Buffett rule he would have to pay 25percent of all income in taxes, for a total of$275,000. However, he would be keeping 75 centsof every additional dollar generated by the hot dogstands, compared with 65 cents of every dollar without the Buffett rule. So this millionaire wouldhave more incentive to expand his hot dog business,hire more workers, and so on. For the millionaires itwould apply to, the Buffett rule would effectively

cut marginal tax rates 10 percentagepoints even as it raises the overall taxburden.

Let’s assume for the moment thathis example is analytically correct—which it is not—and the millionaire’smarginal tax rate for the year in ques-tion is lowered from 35 percent to 25percent. This result is completely anartifact of the hot dog vender’s partic-

ular situation during that tax year, and he could nothave known about it in advance. In other words hedoesn’t know that his marginal tax rate will be 25 per-cent going into the tax year. He discovers it only afterthe fact, when he does his taxes or, at best, speculatesthat it might be the case as the year draws to a close.

For the marginal rate of 25 percent to function as aneconomic incentive, a person would have to know thathis investments are going to generate a million dollars

The Buffett Rule Will Create Jobs?It Just Ain’t So!


B Y R O Y C O R D AT O

Roy Cordato ([email protected]) is vice president for research andresident scholar at the John Locke Foundation in Raleigh, N.C.

McAdams shows alevel of understandingof tax analysis that is shockinglypedestrian, if notsophomoric.

5 M A R C H 2 0 1 2

in capital gains before the market actually does so. Infact he would need to know that this would continueto be the case for a considerable length of time. Butobviously this knowledge is not available to anyone.

This millionaire-for-a-year hot dog stand ownerwould never make expansion decisions based on theexpectation of a continued marginal tax rate of 25 per-cent. In fact the only reasonable thing for him to dowould be to base his future investment on the (pre-sumed) statutory marginal rate of 35 percent.McAdams seems not to understand the difference, interms of incentives, between an ex ante marginal taxrate, which is all that matters, and an ex post marginaltax rate, which matters not at all.The fact that he conflates these twodoes not bode well for students atDuke’s Fuqua School.

Marginal vs. Average Rates

What is just as troublesome isthat he confuses marginal and

average tax rates. Before giving hisexample McAdams states:

[B]ut suppose “middle-class fami-lies” pay 25 percent of theirincome in taxes, which is themarginal tax rate for many mid-dle-income earners. If a “millionaire” already paysmore than 25 percent of his income in taxes, thechange won’t affect him. But a millionaire whoseincome derives from both capital gains, taxed at just15 percent, and business income, taxed at a marginalrate of 35 percent, may well be paying less than 25percent of his total income in taxes—and thereforewould pay more under the Buffett rule.

While McAdams is correct in saying that the mar-ginal tax rate for middle-class families is about 25 per-

cent, it does not mean those families “pay 25 percent oftheir income in taxes.” With a progressive income tax,the marginal rate is the percentage paid on the lastincrement of taxable income, not the rate paid on totalincome. A middle-class family pays 10 percent on thefirst $12,149 of taxable income and 15 percent onincome from $12,150 to $46,250. The 25 percentbracket applies only to taxable income between$46,250 and $119,400, after which the marginal rategoes to 28 percent.

Thus a family facing a 25 percent marginal rate wouldnot pay anything like 25 percent of its total income intaxes, as McAdams asserts. On an income of $75,000, the

average rate would be 18 percent. As Isaid, this is a sophomoric mistake.

The same would be true for the hot dog vendor earning $100,000.McAdams confusingly claims the vendor would face a 35 percent mar-ginal tax rate—wrong again—and pay$35,000 in taxes on the $100,000.Once again McAdams confuses mar-ginal and average tax rates. Further-more, not only is McAdams wrongabout the amount paid by the vendor,he also gets the marginal rate wrong.In fact he’s off by two whole taxbrackets and possibly three. A single

person earning $100,000 in taxable income faces amarginal tax rate of 28 percent, not 35 percent, and ifthat vendor is a family man, making it an apples-to-apples comparison with the “middle-class family,” hismarginal rate would be 25 percent. Because there is notenough information provided, it is impossible to goback to McAdams’s example and plug in the actualrates to see how far off his numbers really are.

Suffice it to say that when people write about taxa-tion and job-creation incentives, they really shouldmake sure they know what they are talking about.

T h e B u f f e t t R u l e W i l l C r e a t e J o b s ? I T J U S T A I N ’ T S O !

For a lower marginaltax rate to function asan economicincentive, a personwould have to knowin advance what hisinvestments weregoing to generate.

In a recent post at the ThinkMarkets blog(tinyurl.com/cld8pbm), Freeman author Gerald P.O’Driscoll cited Union Pacific Railroad’s labor

woes as an example of the mismatch between the skillsworkers possess and the skills potential employers areseeking. O’Driscoll argues that there has been anunsustainable boom in “human capital” characterizedby massive malinvestments, just as Austrian economiststypically claim for physical capital goods.This perspec-tive is a useful antidote to the Keynesian analysis of ourcurrent slump and leads to radically different policyrecommendations.

O’Driscoll based his post on a WallStreet Journal report that referred to“survey results showing that 83 per-cent of manufacturers reported amoderate or severe shortage of skilledproduction workers. . . . Wages forskilled labor are rising, in some casesat double-digit rates.”

He noted:“Malinvestment in labormarkets is the counterpart to malin-vestment in capital goods. Highereducation is a bubble, and colleges churn out graduateswith degrees that have no application in the workplace.Student borrowing to acquire such degrees is malin-vestment in the same way that construction loans tobuild homes in Las Vegas was malinvestment.”

And here is his policy conclusion: “There is nomechanism by which lowering interest rates (‘monetarystimulus’) or spending money on public workers (‘fiscalstimulus’) is going to cure the problem. Labor mis-match is a manifestation of a coordination failure. . . . Itis a microeconomic problem.”

O’Driscoll’s remarks underscore the stark theoret-ical contrast between today’s Keynesians and Hayekiansas they approach “macro” problems, notwithstandingrecent claims by Paul Krugman and others that Hayek’scontributions to the field were insignificant. (See pp.23–4 for details.)

Today’s economic problems do not emanate prima-rily from a shortfall in aggregate spending but ratherfrom a poor synchronization among all the millions ofindividual productive inputs (including labor) that typ-ically interact seamlessly to support our fantastic stan-dard of living. Once we recognize this as the

fundamental problem, the standardKeynesian medicine turns out to benot merely a placebo but a poison.

In the traditional exposition byLudwig von Mises and F. A. Hayek,the Austrian theory of the businesscycle explains recessions as theinevitable consequence of a precedinginflationary boom. The boom occurswhen the commercial banks (nowa-days acting in concert with the cen-

tral bank) issue new loans even though the public isn’tsaving more, thereby increasing the quantity of moneyand driving the interest rate below its “natural” level.The lower interest rates—“cheap money”—foster afeeling of euphoria, as businesses invest more andhouseholds consume more.

The Austrians argue that the boom is illusorybecause the banks can’t create genuine resources sim-

B Y R O B E R T P. M U R P H Y

How Government Distorts Labor Markets


Robert Murphy ([email protected]) is an adjunct scholar of theLudwig von Mises Institute and the author of The Politically IncorrectGuide to the Great Depression and the New Deal.

There has been anunsustainable boomin “human capital”characterized bymassive malinvestments.

ply by extending loans on their balance sheets. If theeconomy had previously been in a sustainable equilib-rium, it will now be “growing” on an unsustainabletrajectory.

When mainstream economists hear the Mises-Hayek explanation of the boom-bust cycle, they oftencharacterize it as an “overinvestment theory.”Yet Miseshimself took pains in Human Action (chapter 20) to clar-ify that this wasn’t the case:

The erroneous belief that the essential feature of theboom is overinvestment and not malinvestment isdue to the habit of judging conditions merelyaccording to what is perceptibleand tangible. The observer noticesonly the malinvestments which arevisible and fails to recognize thatthese establishments are malin-vestments only because of the factthat other plants—those requiredfor the production of the com-plementary factors of productionand those required for the produc-tion of consumers’ goods moreurgently demanded by the pub-lic—are lacking.

Mises goes on to make his famousanalogy, which remains the bestmetaphor yet for his theory:

The whole entrepreneurial classis, as it were, in the position of amaster builder whose task it is to erect a buildingout of a limited supply of building materials. If thisman overestimates the quantity of the availablesupply, he drafts a plan for the execution of whichthe means at his disposal are not sufficient. Heoversizes the groundwork and the foundations andonly discovers later in the progress of the construc-tion that he lacks the material needed for the com-pletion of the structure. It is obvious that ourmaster builder’s fault was not overinvestment, butan inappropriate employment of the means at hisdisposal.

In a standard neoclassical growth model we couldmeaningfully speak of “overinvestment” leading tosuboptimal results. Specifically, if people for some rea-son (perhaps because they were cajoled by govern-ment policies) save a higher fraction of their incomethan they would have chosen in a neutral setting, thencapital goods will accumulate at a faster rate, and grossdomestic product (GDP) will grow at a faster rate.

However, this outcome is a bad thing—as judged bythe real preferences of the households in the model—because the higher investment and faster growth areachieved at too high a price in forfeited consumptionin the present and near future. If an eccentric gangster

has a standing threat to blow up afamily-owned business unless it rein-vests 99 percent of the profits for tenyears straight, on paper the businessmay actually prosper, but the familymembers are clearly harmed by thearrangement.

Yet this type of overinvestmentisn’t at all what Mises and Hayekhave in mind when discussing theunsustainable boom. As the quota-tions from Mises illustrate, the funda-mental problem is not that society(during a boom) leans too heavily tothe left side of the investment/con-sumption spectrum. Rather the prob-lem is that the investments are not insustainable lines.

The Wrong Tools

To give an exaggerated example, mainstream econ-omists—by classifying the Austrian theory as one

of “overinvestment”—have in mind that businessesproduce too many tools and not enough pizzas.Yet thistype of mistake wouldn’t require a recession; it wouldsimply mean that consumers would be trading off pres-ent enjoyments (which they valued more, by stipula-tion) for a higher income in the future made possibleby the productivity-enhancing tools.

Rather than being about making too many toolsand not enough pizzas, the Austrian story is more aboutbusinesses producing tools consisting only of thousands

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H o w G o v e r n m e n t D i s t o r t s L a b o r M a r k e t s

The fundamentalproblem is not thatsociety (during aboom) leans tooheavily to the left sideof the investment/consumptionspectrum. Rather theproblem is that theinvestments are not insustainable lines.

of screwdrivers and millions of nails. For a short while,especially if we just focused on a few of the factories,such an absurd economy would seem very “productive”indeed, poised on the verge of explosive growth. Butfrom a systemwide perspective it is obvious this econ-omy would soon collapse once its existing tools woreout and workers had to rely on the new batch. Whenthe crisis occurred it would be wrong to characterizethe problem as one of “too much investment in tools.”The fundamental problem would be malinvestments inthe composition of the stock of new tools.

Idle Resources

Because they lack the Austrian emphasis on thestructure of production, Keynesian economists

look at idle resources, or “excess capacity,” during arecession and see pure waste. Of coursethe market economy is malfunction-ing if factories are running belowcapacity and especially if workers aresitting at home watching TV. This iswhy (the Keynesians claim) a reces-sion calls for expansionary fiscal andmonetary policies to increase aggre-gate spending and put those resourcesback to work.

This simple-minded view is deadwrong in light of the Austrianexplanation. Continue with Mises’s master builder,who embarks on construction of a house using blue-prints that rely on an erroneous brick count. Whenthe builder discovers his error—he realizes he onlyhad 18,000 bricks in the beginning instead of the20,000 called for by the blueprints—what will be hisimmediate reaction? He will yell, “Everybody stopworking!”

The reason for this immediate stop order is clear.If every worker continued in what he had beendoing, the dwindling stocks of various resources(bricks, shingles, nails, window panes, and so on)would have been transformed into less “liquid” items.The builder obviously has to adjust the blueprints inlight of the new information; it is physically impossi-ble to complete the house as originally conceived.Therefore he needs to halt all activity until he decides

the best way to deploy the remaining inputs, all thingsconsidered.

Reintegration

Eventually more and more of the workers can grad-ually resume activity, but many of them won’t be

doing exactly what they were doing before, and some ofthem might be doing very different tasks.Also, some ofthe workers who were highly specialized might not beneeded at all for the remainder of the project. It madesense for them to show up at the site based on the orig-inal blueprints, but after the necessary revisions themaster builder realizes these particular workers serve no role.

The analogy with a modern economy should beclear. When an unsustainable boom collapses there is

an initial surge in unemployment ofboth human and physical resources.Gradually—especially if the govern-ment leaves the market process tooperate freely—more and moreresources are reintegrated into the(revamped) structure of production.The process unfortunately might beagonizingly slow for some resourcesand workers with highly specializedskills.

Notwithstanding the tragedy ofhigh unemployment, it is a necessary consequence of apreceding inflationary boom. Austrians stress that theboom is the problem; the bust is ironically the cure. Likemany types of medicine, recessions are not nearly asenjoyable as the activities that brought on the calamity.

Considerations such as these led O’Driscoll todescribe our current economic woes as “microeco-nomic.” Think again of the master-builder analogy.Before the discovery of his mistaken brick count theproblem wasn’t that the builder was “building tooaggressively.” It was that he was building a house withthe wrong proportions.Then, after the discovery of hismistake, the problem wasn’t that the builder was “build-ing too timidly.” Instead, the problem—if we want tocall it that—was that the remaining stocks of usableresources were ill-suited to complete the half-finishedhouse.


R o b e r t P. M u r p h y

Notwithstanding thetragedy of highunemployment, it is anecessary consequenceof a precedinginflationary boom.

In the master-builder metaphor the analog of expan-sionary policies would be to reassure the builder that hisbrick count is accurate after all. For example, a subordi-nate might not want the workers to “lose morale” andso he might keep moving tarps around, covering up thedwindling brick supply and lying to the master builderabout how many remain. This wouldkeep the “good times” rolling, at leastfor a while. Yet it will just make thecrisis that much worse when it finallyarrives, as it must. Moving tarpsaround can’t create more bricks, just asmoving bad loans around with TARPcan’t create more physical resources.

We’ve seen that even the canonicalexposition of Austrian business cycletheory involved labor, as it must if itis to explain high unemployment.However, the typical Mises/Hayekstory focused on malinvestments inphysical capital goods, which eventu-ally led to high unemployment in thelabor market. The twist O’Driscollgives is that the original malinvest-ments during the boom period mightthemselves be in “human capital.”

Boom Builders

Some of this malinvestment can betied directly to the housing boom. Just as too many

nails and shingles went to Las Vegas and Miami from2002–06, so did too many human beings move to thesecities and spend years developing skills in home con-struction. When the housing bubble popped, the nailsand shingles had been irrevocably devoted to housesthat never should have been built, while hundreds of

thousands of workers had a difficult-to-modify skill setthat never should have been learned.

There was a similar toll in financial services. Duringthe giddy years top-flight students with an aptitude in mathematics were drawn out of physics and other sci-entific fields and flocked to Wall Street to become rich

as “quants.” In retrospect we now real-ize that some of the brightest mindson the planet had literally spent yearsworking grueling schedules to (ineffect) devise various techniques toamplify the financial fallout from aneconomic downturn. This was hardlyan optimal use of scarce labor.

As O’Driscoll notes, even highereducation itself can be viewed as anunsustainable bubble in light of Aus-trian theory. The false prosperity ofthe boom years led to large increasesin education budgets, fostering erro-neous expectations of how many jobswould be available for future Ph.D.sin the “soft sciences” and other fieldsthat do not have a market outsideacademia.

The Austrian theory of the busi-ness cycle shows how monetary disturbances can lead to “real” imbal-ances in the structure of production.

The classical version of the theory focused on malin-vestments in physical capital goods, but the theory caneasily be amended to include the unsustainable devel-opment of human capital. In either case the best gov-ernment response is to eliminate the subsidies,low-interest loans, and other policies that encouragethe very problems under consideration.

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H o w G o v e r n m e n t D i s t o r t s L a b o r M a r k e t s

Some of the brightestminds on the planetliterally spent yearsworking gruelingschedules to (ineffect) devise varioustechniques to amplifythe financial falloutfrom an economicdownturn.This washardly an optimal useof scarce labor.

The Obama administration’s remake of the U.S.health care system stands on three legs. One, itmakes the purchase of insurance compulsory.

Two, it doles out new entitlements via expanded Med-icaid, subsidies, and certain coverage requirements.And three, it promises to control the growth of med-ical costs. These three parts differ in their implicationsand prospects. Thefirst leg may giveway altogether; thesecond is partiallyalready in place; thethird provides therationale for central-ized allocation ofresources in healthcare.

This summer theSupreme Court is todecide on the consti-tutionality of the2010 Patient Protec-tion and AffordableCare Act, whichfaces various chal-lenges to its thou-sands of sections.Moreover the centerpiece challenge to the individualinsurance mandate may invalidate other provisions aswell. In fact the uncertainties extend well beyond theSupreme Court decision and its consequences. Notonly the results of the 2012 presidential election butalso congressional and state elections may result inchanges to the law or to the way it is applied.

The individual mandate is interlinked with the stateinsurance purchase exchanges required by the law. Ifthe Supreme Court finds the individual insurance man-date unconstitutional, the exchanges will have fewercustomers and higher costs. Conceivably some form of exchange could survive as an insurance market for small businesses. Firms are required to make a con-

tribution towardemployee insuranceif they have 11 ormore employees—this employer man-date could endureeven if the individ-ual mandate doesnot.

By comparisonthere is greater certainty about the second leg ofthe restructuring.For instance therequirement thatparents’ insurancecover young adultsuntil age 26 hasalready been put in

practice and is unlikely to be reversed. That is, healthcare entitlements are expanding regardless of theSupreme Court decision and election outcomes. It was

B Y C H I D E M K U R D A S

The Politics of Health Care Rationing


Chidem Kurdas ([email protected]) is a financial journalist andeconomist in New York. She writes about investing forHedgeFundSmarts.com and about policy for ThinkMarkets.com.

obvious from the start that this expansion necessitatedand yet clashed with the goal of cost containment.

The title of the 2010 law proclaims affordable care asits aim, and commentators such as New York Timescolumnist Paul Krugman have cited a CongressionalBudget Office prediction that the act will keep downcosts and thereby help reduce the federal budget deficit.This claim, not very credible to begin with, looks evendodgier now that we start to see the initial impact ofthe coverage requirements.

Immediate Cost Increases

Much of the law will not go into effect until 2014.The insurance coverage requirements that have

been put in place already, though, have increased itscost. A Kaiser Family Foundation survey shows thatfamily premiums went up by 9 per-cent from 2010 to 2011, compared toa significantly lower 3 percent increasefrom 2009 to 2010.

To be sure, Obamacare require-ments such as the enrollment of mil-lions of adults in their parents’ plansaccount for a fraction of the recentincrease. But this is only the beginningof the law’s implementation. Higherpremiums inflate business costs and atleast in part are passed on to workers.The government attempted to limitthe growth of insurance premiumsthrough regulatory measures, such asrequiring insurance companies to spend less on admin-istration. But those measures will be exhausted as grow-ing demand pushes up medical costs and hence theprice of insurance.

While insurance coverage requirements show up aspremium increases for individuals and businesses, theother major new entitlement, wider Medicaid eligibil-ity, puts an added burden on taxpayers.This expansionwill require many states to spend significantly more onMedicaid at a time when government finances are pre-carious. In 2014 general revenue Medicaid expendi-tures will be 22 percent higher in Illinois, 13.5 percenthigher in Texas, and 9 percent higher in Florida,according to estimates by Jagadeesh Gokhale of the

Cato Institute. The increases are in addition to alreadyexpected increases.

The federal government is supposed to pay the fullcost of the Medicaid expansion the first three years butthis support may falter given large and persistent federalbudget deficits.The states understandably don’t want tobe left holding the bag for the Affordable Care Act—and so the Supreme Court will hear their challenge tothe Medicaid expansion.

Cost Containment and Rationing

Who is to pay is one big question; the other is howmuch. Liabilities have been created, with some

entitlements already effective and others to come. If the cost turns out to be unexpectedly large, Ameri-can health care will be in worse shape. Without effec-

tive cost containment, in time theexpense of the entitlements, includ-ing insurance coverage requirements,will put a growing burden on insur-ance buyers and taxpayers. State andfederal budgets will be squeezed evenmore than they already are by Medic-aid and Medicare. Hence the thirdaspect of the new system, cost con-tainment, is key to its viability.

The law entrusts this missionlargely to federal bureaucrats.To con-trol the long-term growth of costs,health care use is to be subject tocentral direction. The Department of

Health and Human Services (HHS) has started todefine “essential” medical goods and services to be cov-ered by the insurance exchanges run by states. How-ever, recently the administration modified the plan, aswe will see below.

To understand the full implication of rationing, con-sider Britain’s National Health Service (NHS), the gov-ernment system through which most health care isprovided in that country. The NHS keeps down costsby limiting access to certain resources such as specialistphysicians. Health care is rationed in this sense withinthe national system. People can go outside the systemand purchase what they wish in private transactions, butvery few do since they already pay for the NHS via

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T h e P o l i t i c s o f H e a l t h C a r e R a t i o n i n g

The law entrusts costcontainment largelyto federal bureaucrats.To control the long-term growth of costs, health care useis to be subject tocentral direction.

taxes. And of course modern medical technology isexpensive. If the NHS does not allow for a test or a visitto a specialist, then most people do without.

The United States is moving in a similar directionby determining what insurance should and should notcover.While outside the exchanges private insurers willpresumably be free to diverge from the defined pack-age, to offer less coverage would be to invite legal chal-lenge. Most insurers will likely gravitate to the package,so its effect will go well beyond the exchanges.

Advocates of expanding the government’s role inhealth care, such as Donald Berwick, head of the Cen-ters for Medicare and Medicaid Services through 2011,say private insurance companies ration access alreadyand it is better for the government to do this. Marketsin effect ration goods and services by making them avail-able only to those able and willing to pay. What Oba-macare facilitates is political rationing.

(Politically) Essential Health Care

Last October the Institute of Med-icine of the National Academies

produced a report on how to goabout defining “essential” health care.The Institute’s committee recognizedthat two competing goals are involved: “to providehealth insurance coverage for a wide range of healthneeds and to make it affordable. If it was not affordable,then many people would not be able to obtain it, evenwith government help, and this would conflict with thepurpose of the Affordable Care Act.”

The report uses the metaphor of grocery shopping.The committee recommends starting with “a firm ideaof what you can spend and to fill the cart carefully, withonly enough food to fit within your budget.” Any newitem added to the cart has to be within the budget,keeping in mind what small businesses and theiremployees can afford, as well as medical necessity. Oncethe cart is as full as the budget allows, adding a newitem requires removing an item.

Recall that the relevant shopper here is not you or me.It is mainly HHS that’s deciding what to put into the health care cart. However, we’ll be paying at thecheckout as taxpayers and consumers. Meanwhile thedepartment is expanding to perform additional functions.

The Institute of Medicine puts the veneer of expert-ise on this health care rationing.You can scream,“Deathpanel!” but the real eye-opener is how the “essential”package is already being shaped. The law and theadministration mandate certain benefits that were notpart of a typical insurance plan.These specific require-ments are in addition to broad mandated categories likepreventive services and hospital care.

Thus HHS Secretary Kathleen Sebelius has decreedthat insurers are required to pay for birth control,including contraceptive drugs, devices, and procedures.The administration says this is based on science underthe law’s mandate for preventive care. A religious insti-tution—say a Catholic charity—can get an exemption,but not if it employs a number of non-Catholics. Inthat case it has to finance employees’ birth control pillseven if this violates the organization’s religious princi-

ples. Catholic groups want greaterflexibility in the exemption, but con-gressional Democrats oppose this.

In other words, coverage isrequired for some products and serv-ices while others are left vulnerable to being removed from the cart. Moremoney for contraception, less money

for something else. These are political decisions. Whydid politicians prequalify contraception as essential andthus protected while other services have no such status?Women are relatively heavy users of medical servicesand pay more attention to health care than men do, sopoliticians can get votes—as well as campaign dona-tions from product suppliers—by appealing to women.

For the makers of contraceptive drugs and devices,the coverage requirement is worth a lot of moneybecause it will encourage people to buy more expen-sive products rather than use the cheap contraceptiveswidely available in drugstores.With the insurance cov-erage requirement, the consumer won’t be paying the price.

But this is also part of an ideological package thatfavors creating special privileges for groups officiallyregarded as victims. The law gave women’s health its own bureaucracy within HHS, headed by a deputyassistant secretary with a brief to establish objectives for issues of concern to women and provide advice,


C h i d e m K u r d a s

What Obamacarefacilitates is politicalrationing.

information, coordination, and other assistance to therest of the bureaucracy. I found no correspondingOffice of Men’s Health, although in fact men die earlierthan women and hence presumably have more urgentneed for attention to their health issues. Men’s healthproblems are evidently not a political and ideologicalwinner.

Last December the Obama administrationannounced it will let each state determine the essentialbenefits that insurance policies sold on the stateexchange will have to cover. This sounds like a majorchange but in fact the states remain subject to myriadrequirements. The categories specified in the law andby HHS have to be covered. In effect the law and thefederal government have decided most of what will gointo the shopping cart, but for nowthe states are to be allowed to adjustaround the edges.

This presumably defensive moveby Obama as the presidential electionapproaches makes the situation morefluid and uncertain. The states willbear the brunt of complaints if theydo not cover a certain benefit. Con-versely states risk spiraling costs ifthey make their mandates generous.The federal government faces lesspolitical fallout and can impose further requirementsonce the election is over. For the administration thepolitics work out nicely.

Whether at the state or the federal level, the bestguess is that ration-proof status will go to services ofinterest to suppliers or consumers with strong politi-cal influence. Health care companies had the secondlargest average political spending per million dollarsof revenue among S&P 500 corporations in 2010,according to a study by the Investor ResponsibilityResearch Center. Only utilities spent more on lobby-

ing by that standard. Health care is becoming a utility,as was pointed out in the run-up to the act.

What’s being established is a heavy regulatory over-lay that covers almost all aspects of health care—thelaw ranges from general mandates to a specific programof nutrition and exercise planning at communityhealth centers. One could describe the Affordable CareAct as a giant reallocation scheme that will channelresources from other uses to medical industries andwithin health care to favored areas. Suppliers of goodsand services want to maximize their share of the newentitlements on the one hand and, on the other, mini-mize the impact of cost controls on their businesses.Allmedical providers lobby to channel more goodies theirway—everybody is certain his services and products

are essential. But some lobby moreeffectively or with more resources.By all evidence this mode of opera-tion will continue.

What Obamacare will do to med-ical costs is at best uncertain, with theexpanded coverage and Medicaid eli-gibility pushing up expenditures whilecost containment devolves on the lesspolitically protected. That Obamacarehas raised the income of lobbyists isclear, the President’s protests against

them notwithstanding.Some people prefer political rationing to free mar-

kets. Perhaps they honestly believe politicians andbureaucrats make better choices than the numerousplayers that constitute a competitive market. Or perhapsthey themselves are likely to do better under govern-ment rationing. But do they really want their medicaloptions dictated by the lobbying success of this or thatinterest group? Because that is what happens in thepolitical allocation of resources, whatever the pretense ofscience-based decisionmaking.

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T h e P o l i t i c s o f H e a l t h C a r e R a t i o n i n g

Obamacare willchannel resourcesfrom other uses tomedical industriesand within healthcare to favored areas.

B Y S T E P H E N D AV I E S

Are We Looking at the Wrong Depression?

Our Economic Past

Today a lot of people are looking to economichistory for help in understanding the currentworld economic situation and the options

open to us. (This includes economists, many of whomhave finally rediscovered an interest in economic history.)

Most of this attention is being paid to the GreatDepression of the 1930s. However, it is worth pointingout the important ways in which the present situationdiffers from that of the 1930s. Many observers (mostnotably Paul Krugman) argue that weare presently in a classic liquidity trap,where monetary policy has no pur-chase on the real world economy.Themain evidence for this is that despitemassive expansion of the basic moneysupply by the Federal Reserve andother central banks, there has notbeen the kind of inflation that manyhad predicted. The argument is thatthis situation is similar to the oneKeynes identified in the early 1930sand that therefore the same policyresponse—fiscal stimulus—is appro-priate.

Leaving aside whether the “Keynesian” analysis andprescription were correct in the 1930s (or indeedwhether that was the argument Keynes actually made),it is worth pointing out a number of big differencesbetween the events of the last four years and those of1929–32. Most important, we have not seen the kind ofdecline in prices that took place then; indeed therehave been short-term spikes in a number of prices,notably food and fuel. Furthermore, and fortunately,there has not been the kind of dramatic collapse in eco-nomic activity and employment that we saw in theentire world in the early 1930s. Although the presentunemployment situation in the United States is not

good, it is not catastrophic in the way it was by 1932. Inother parts of the world, notably the United Kingdom,job losses have actually been less than most economistsfeared and predicted. Moreover while there is eco-nomic stagnation or very low growth in the UnitedStates, Europe, and Japan, the world economy as awhole is still growing, even if at a slower rate than a fewyears ago. So far there has not been the kind of sharpand sustained decline in world trade and economicactivity that happened after 1930.

In other words what we are seeingis stagnation in large parts of theworld economy instead of a suddenand acute contraction globally.

Perhaps we are looking at thewrong “Great Depression.”

Until as late as the 1950s, “GreatDepression” in economic historygenerally referred to the periodbetween 1873 and 1879 (in theUnited States) or 1873 and 1896 (inthe United Kingdom and much ofEurope).When we look more closelyat those years, the likeness to where

we are now becomes noticeable. The “Long Depres-sion” (as it has come to be known) was sparked by aglobal financial panic in 1873, which arose from thebursting of several speculative bubbles, particularly inrailroads and real estate. The panic started in Europe,then had a second phase in the United States beforereturning to the other side of the Atlantic. What fol-lowed were 30 years of gradually declining prices(deflation) in most parts of the world. Agriculturalprices collapsed.This caused serious hardship for manyfarmers and peasants, and led to a massive movement


Stephen Davies ([email protected]) is academic director at the Institute ofEconomic Affairs in London.

So far there has notbeen the kind ofsharp and sustaineddecline in worldtrade and economicactivity thathappened after 1930.

of labor from agriculture and the hard-hit parts of theworld (such as southern Italy, Scandinavia, and Russia)to places like the United Kingdom, United States, andArgentina. Most historical GDP records show a signif-icant slowdown of growth in most of the world for atleast part of the period between 1873 and 1896. Onthe other hand there was not the kind of dramatic col-lapse seen after 1930.

However, this picture of prolonged stagnation needsto be severely qualified. One early observer who ques-tioned this widespread perception at that time was theAmerican economist and historian David Ames Wells.His argument, and that of many other economic histo-rians, was summed up in a short work by S. B. Saul, TheMyth of the Great Depression, 1873–96. Wells pointedout, among other things, that the yearsafter 1873 saw very large increases inglobal output of a number of keyproducts, not only in agriculture butalso steel and a range of manufacturedproducts. As Wells explained, this wasbecause of an unprecedented series ofinnovations in both technology andbusiness organization. In fact the 30 to40 years after 1870 saw the advent oftechnologies that would define mod-ern life, including electricity, theinternal-combustion engine, the telephone, the dieselengine, and the modern petroleum industry.

As a result, the official figures are seriously mislead-ing. While nominal wages stagnated or declined, realliving standards increased because of the falling cost ofproducts. Output increased, but this is not capturedunless one applies a GDP inflator to account for theincreasing value of money. So the Long Depression ofthe 1870s and 1880s was not a simple story of eco-nomic standstill.

So what happened? Essentially a set of innovationsin technology and business organization made in thelater eighteenth and early nineteenth centuries hadexhausted their potential to raise productivity andgrowth by the 1860s. This, combined with mistakenpolicies, had led to malinvestment and a significantbuildup of debt by the early 1870s in both Europe andthe United States.

What followed, Irving Fisher argued, was a crisisbrought about by the realization that many invest-ments were not going to pay enough and the conse-quent need for sustained “deleveraging” (paying backor writing off of debt). At the same time there was aburst of technological and organizational innovation.This increased productivity and created many newproducts but also led to large adjustments as olderindustries and forms of employment shrank, prompt-ing a large movement of labor. This took some time,so the costs of the transition in human terms were sig-nificant.

A shift in the focus of the world economy also tookplace—away from established areas such as the UnitedKingdom and France (both of which were more

adversely affected by the changes andfor a longer period than other partsof the world) toward the new devel-oping parts of the world, such asGermany, the United States, north-ern Italy, and Japan. Significant partsof the population in many placeswere worse off, but the majoritygained because of the rise in livingstandards brought about by technicalinnovation and the consequent“benign deflation.”

Increasingly it looks as though the world as a wholeis going through the same kind of experience: anexhaustion of profitable investment opportunity insome places and sectors, leading to an artificially stimu-lated bubble the bursting of which has triggered sus-tained deleveraging and a decline in growth in manyparts of the world. At the same time other parts of theworld are enjoying continued growth.This is not sim-ply “catch-up growth,” since much of it comes from ashift in activity brought about by the early stages of anew wave of innovation.There is going to be a changein the patterns and locations of employment, but a risein living standards for the majority because of the inno-vation and global growth.

This means that a fiscal stimulus would be ineffec-tive and wasteful, since the underlying problem is oneof a long-term economic realignment rather than asimple decline in demand.

15 M A R C H 2 0 1 2

A r e W e L o o k i n g a t t h e W r o n g D e p r e s s i o n ?

Increasingly it lookslike the world isgoing through a long-term realignment like that of the latenineteenth century.

Washington is now deep into the process of attempting to deal with the budgetdeficit, an exercise that leaves experienced

observers with a sinking feeling. Presenting plans to cutspending and balance the budget is like the proverbialactivity of rearranging the deckchairs on the Titanic. It involves alot of busyness but does notaddress the real problem.

We’ve been enacting plans tocontrol spending and balance thebudget for generations. One ofthe first efforts was the 1974Budget and Impoundment Con-trol Act passed in the Nixonadministration. Then we had theGramm-Rudman-Hollings Act,signed into law by PresidentReagan in 1985. A few yearslater, in 1994, feisty Republicanstook over both houses of Con-gress and provoked a governmentshutdown in the crusade for fis-cal responsibility.

The lesson of history, then, isthat you can’t cut spending bytrying to cut spending. It’s a hardpoint for budget makers to digest, because it seems todefy the rules of arithmetic. Well, when it comes tonational budgeting, these rules don’t apply. What mat-ters are the rules of political perception.

Most Americans perceive that government is aneffective provider of valuable services. They see it as asuper store that supplies education, medical care, retire-

ment income, housing, assistance to the needy, safedrugs, safe foods, scientific research, and so forth.That’swhy spending cuts can never be more than temporarilyeffective.As soon as the specifics of the cutting becomeapparent, the public will be reminded how very much

it likes government programs.Aspeople learn about the autisticchild who will be left unas-sisted, the hospital that willclose, and the food inspectorswho will be laid off, the publicclamors to fund these functions,and the campaign to cut spend-ing falters. We’ve been throughthis cycle many times.

The lesson is clear: The realcause of red ink is the wide-spread belief that governmentprograms are effective responsesto national needs. If you don’tcounter this belief, you cannever really cut governmentspending.

Where does this confidencein government come from? Onepossible answer is that it is basedon reality and that we have

numerous careful, unbiased, scientific studies that provegovernment is a cost-effective provider of services.

When the deficit committee is finished, these could userearranging.Sam Chua

B Y J A M E S L . PAY N E

Why the Titanic Is Sinking


Contributing editor James Payne ([email protected]) has taught politicalscience at Yale,Wesleyan, Johns Hopkins, and Texas A&M. His latest bookis Six Political Illusions:A Primer on Government for Idealists FedUp with History Repeating Itself. This article first appeared atTheFreemanOnline.org.

There are several difficulties with this position.Thefirst problem is there are no such studies.There are stud-ies that purport to evaluate government programs, butthey never include all the overhead costs. By my count,there are 14 overhead costs in the typical governmenttransfer program, seven involving taxation and seveninvolving disbursement. Such cost-benefit studies ashave been done include, at best, only three or four of these costs. Evaluations of government action areshallow and incomplete because the researchers arebiased. Before they attempt their study they alreadybelieve government action is beneficial. In other words,the cart—the belief that government is effective—comes before the horse—the evidence that it is.

Faith in Government

Historically, too, confidence ingovernment has preceded the

evidence that might justify such con-fidence.The modern faith in govern-ment as a problem-solving machineemerged in the late nineteenth cen-tury, decades before any interven-tionist policies had been attempted.For example, in 1888 Edward Bel-lamy published a hugely successfulutopian novella, Looking Backward,which posited a federal governmentin charge of everything, and solvingall problems of poverty, unemployment, old-age assis-tance, and so on. Bellamy and the thousands whoformed “Bellamy Clubs” all around the nation had noway of knowing if government programs in thesespheres would be cost-effective solutions.They took iton faith.

The belief in government efficacy is not empiricallybased. It is the product of illusions. When they firstnotice government, children tend to see it as a super-parent, an authority figure that has many virtues—including great wealth, foresight, objectivity, andmaturity—and is without ugly vices such as selfishness,irresponsibility, callousness, and a tendency to violence.This benign impression forms the basis of the popularview of government. Over time, as the result of actualexperience with government, people begin to over-

come this naive faith, but in most cases they do notmove far beyond the child’s view.They continue to seegovernment as a machine that can fix everything—ifonly the right people are put in charge.Telling a publicwith this naive confidence that spending should be cutis like trying to tell a child that a birthday cake shouldnot be eaten: It has no understanding of, or sympathyfor, the recommendation.

To restrain spending, therefore, one needs techniquesthat counteract the mistaken, illusion-based view of gov-ernment. These measures will not resemble traditionalspending reforms. They will not be laws that address the amount of spending. Instead they will address the per-ceptions underlying spending, since once those attitudesare corrected, the pressure for spending will abate. To

illustrate this approach consider thesimple idea of reminding peoplewhere government money comesfrom.

The Philanthropic Illusion

One misunderstanding that givesthe public a false view of gov-

ernment is the philanthropic illusion.This is the idea that government hasmoney, that it is like a wealthy philan-thropist with extra cash to give toneedy people and worthy causes. Infact government has no money of its

own. The money it spends has to be first taken awayfrom taxpayers, and if you do the arithmetic carefully,tracing out all the indirect and shifted burdens of taxa-tion, you will discover that everyone is a taxpayer.There-fore, to get money for its spending programs,government inflicts privation on everyone, includinglow-wage workers, college students, the homeless, andso on, and it drains resources from vital activities liketechnological innovation, medical care, job creation,and so forth.

Under the spell of the philanthropic illusion, politi-cians and the public downplay or forget the harm and injury of taxation. A simple device that will helpcounteract this myopia is the “Declaration of Gratitude.”Everyone who receives government money would berequired to sign this statement:

17 M A R C H 2 0 1 2

W h y t h e T i t a n i c I s S i n k i n g

The modern faith ingovernment as aproblem-solvingmachine emergeddecades before anyinterventionist policieshad been attempted.

“I realize that the funds I am about to receive comefrom the nation’s taxpayers, and I am grateful for thesacrifices they are making on my behalf.”

Its administration is simple. When you fill out thepaperwork for any government grant, subsidy, or pay-ment, you also must sign the statement, whatever thebenefit: food stamps, cotton subsidy, small business loan,government paycheck, research grant.

In monetary terms signing this statement doesn’tchange anything: Everyone gets whatever governmentdollars he was going to get. No one can be accused ofstarving grandma. What it does do is change the psy-chological climate. It destroys the assumption that gov-ernment spending harms no one. This frank reality iscovered up today.Take the Earned Income Tax Credit.This is a $50 billion welfare program, yet the people

receiving this benefit call it a “tax refund” when theyget their check. Most of them have no idea that this isa subsidy paid for by taxpayers.Well, if they had to signthe Declaration of Gratitude, they would know.

There is likely to be a lot of resistance to the Decla-ration of Gratitude idea. Most Americans seem to feelthemselves “entitled” to whatever government fundsthey get and are loath to recognize their dependent sta-tus. This entitlement mentality produces the bizarrecontradiction of a country with a national debt of$15,000,000,000,000 whose citizens believe they arepaying their own way.

But resistance or no, reforms that change the percep-tual climate are essential for national economic health.Sound fiscal policy will not be achieved until the publicattains a disillusioned view of government.


J a m e s L . P a y n e

The Wall Street occupiers are settling in to the pub-lic consciousness now, for better or worse. Some-where in the chanting is an inchoate worry about

the gap between rich and poor.According to the Congres-sional Budget Office (CBO), between 1979 and 2007,income grew by (tinyurl.com/43pwhb3):

• 275 percent for the top 1 percent• 65 percent for the next 19 percent• Just under 40 percent for the next 60 percent• 18 percent for the bottom 20 percent.

This seems like a damningpicture. Even if we were toargue that some of these datadon’t account for govern-ment goodies at the bottom(such as entitlements and taxcredits), it worries a lot ofpeople.

But in fact we should stopworrying about the so-called“gap” between rich andpoor.To make that case frommy perch here in the hum-bler part of the spectrum, Isuggest engaging in a thought experiment:

If you were dictator for a day and you could choosebetween two states of affairs, which would youchoose?

A: Permanently institute a policy that significantlyreduces the gap between rich and poor.

B: Permanently institute a policy that makes every-one better off, including the poor.

Notwithstanding this readership a lot of people outthere would choose A. Consider a few examples offolks I’d put in Group A, which we’ll call “the Atavists.”(Those who are unnerved by “the gap” are not so muchenlightened as in the grip of an inborn hoarding taboo.Most of us share this taboo to some degree becausewe’re all human. But for some of us it burns in theDNA and becomes expressed as indignation. That’swhy I call Group A “Atavists.”)

Famous atheist Sam Harris says, “Yes, we must cutspending and reduce inefficiencies in government. . . .

But this does not mean thatwe can ignore the astonishinggaps in wealth that haveopened between the poor andthe rich, and between the richand the ultra-rich. Some ofyour neighbors have no morethan $2,000 in total assets (infact, 40 percent of Americansfall into this category); somehave around $2 million; andsome have $2 billion. . . . Eachof these gaps represents athousand-fold increase inwealth.” Surely he means net

worth, not total assets.The New Yorker’s James Surowiecki believes “there’s a

yawning chasm between the professional and the pluto-cratic classes, and the tax system should reflect that. Abetter tax system would have more brackets, so that thesuper-rich pay higher rates.”

B Y M A X B O R D E R S

Never Mind the Gap

19 M A R C H 2 0 1 2

Max Borders ([email protected]) is a 2011–12 Robert NovakFellow. He is writing a book on the rich-poor gap.

Worrying about the wealth gap is a distraction from the real issue:making everyone better off.Clicsauris [Wikipedia]

Nobel laureate economist Joseph Stiglitz shares asimilar view in Vanity Fair: “Some people look atincome inequality and shrug their shoulders. So what ifthis person gains and that person loses? What matters,they argue, is not how the pie is divided but the size ofthe pie.That argument is fundamentally wrong.”

What ties these perspectives together?Atavists have a couple of things in common. First, they

share an automatic response any time they perceive asocial ill: Tax the rich.This elixir is offered before any othertreatments for what may be deeper, underlying diseases—diseases of which some inequality may be a symptom.

Then let us entertain a rather seditious question:Before deploying another IRS agent, why not first fixany policies that cause wealth disparity? Whether weidentify with group A or B, weshouldn’t tolerate transfers from poorto rich, and yet if we open our eyes,examples of such transfers are every-where:

• Corporate Welfare. From WallStreet bailouts to agribusinesssubsidies to “economic incen-tives” giveaways by states, politi-cians are doling out corporatewelfare at every level of govern-ment. (Solyndra comes to mind.)

• Regressive Regulation. Excessiveregulation makes goods and services more expen-sive for everyone and raises the costs of starting asmall business. Such policies deny poor peopleopportunities many rich can afford.

• Loophole Labyrinth. Our tax code is complicated,and it is easier for wealthier people than others topurchase the energies of CPAs and tax lawyers tofind loopholes.

• America’s Pyramids. Local boondoggles like lightrail and sports arenas mean higher sales taxes, aburden that falls disproportionately on the poor.(Developers make out like bandits.)

• Medicare Monstrosity.Why should struggling youngpeople have to fund the health care costs of richerelderly people in Boca Raton? Medicare requiresjust such transfers.

• Cadillac Care. Duke Law professors Clark Hav-ighurst and Barak Richman write: “[T]he U.S.health care system operates more like a robberbaron than like Robin Hood, burdening ordinarypayers of health insurance premiums dispropor-tionately for the benefit of industry interests andhigher-income consumer-taxpayers.” Read: Peo-ple with good jobs get nice tax exclusions whilethe working poor have to fend for themselves inthe individual market where the cost of insuranceis not deductible from income.

I could go on. “Progressive” policies that have theside effect of enriching the wealthy at the poor’sexpense are just necessary evils, right? Besides, they say,

it’s easy to mitigate the effects ofthose policies: tax more and redistrib-ute!

But why not stop all this epicycli-cal thinking? Why not make the rulesapply to everyone equally instead oftilting the tax code more? Whyshouldn’t the first thought be toreduce the burdens of the State onthe poor? And why not let value cre-ators get rich honestly so they con-tinue to offer things people want?

To the Atavist, it doesn’t matterwhether you’re a maker or a taker.

You can be John Mackey, who offers wholesome foodsto health-conscious consumers, or Jeffrey Immelt, whogets rich by lobbying government for favors and con-tracts. If you’re superrich it’s all the same.What roils theAtavist is the very existence of the rich. Individuals,with their unique contributions, get reduced to slogansor plot-points on a distribution graph.

Venture capitalist Kip Hagopian picks up on thisproblem when he concludes: “The flaw in virtually allof the intellectual arguments on the issue of the pro-gressive income tax . . . is a lack of appreciation for howincome is determined.” Indeed, in a truly free market,for there to be any wealth to redistribute, there has tohave been an initial “distribution,” which is a prosaicway of saying somebody—through effort and ability—had to create the wealth to start with.


M a x B o r d e r s

But why not stop all this epicyclicalthinking? Why notmake the rules applyto everyone equallyinstead of tilting thetax code more?

Let’s call those who would choose alternative B the“Better-offs.” This group wants to improve the condi-tions of the poor even if that means the rich get richer.According to the Better-offs, things improve when it’spossible for successful investors and entrepreneurs toget rich. (This assumes they don’t use government togain their wealth.)

Differences in Perspective

Between the Atavists and the Better-offs, there arefive major differences in perspective.

1. Harming the rich or helping the poor. Concern aboutthe conditions of poor people is not the same as wor-rying about how much rich people have. Our thoughtexperiment teases out this difference. More straightfor-wardly:Would youimprove the condi-tions of the poorest people modestlyif it meant making the top 1 percentricher? “No” suggests one cares moreabout what the rich have than whatthe poor lack. An Atavist’s primaryconcern is equality of outcome.

Timothy Noah’s multipart series inSlate is Atavism on display (tinyurl.com/44cpwl5). The series includespassages like this:

All my life I’ve heard Latin Amer-ica described as a failed society (orcollection of failed societies) because of its grotesquemaldistribution of wealth. Peasants in rags beg forfood outside the high walls of opulent villas, and soon. But according to the [CIA], income distributionin the United States is more unequal than inGuyana, Nicaragua, and Venezuela, and roughly onpar with Uruguay, Argentina, and Ecuador. Incomeinequality is actually declining in Latin Americaeven as it continues to increase in the United States.Economically speaking, the richest nation on earthis starting to resemble a banana republic.

Gasp.A banana republic? Language like “grotesque maldistribution” isn’t

helpful. If any sense can be brought to such a phrase itwould come in the “how” questions of the “distribu-

tion”—namely, how did the rich get rich? Creatingvalue or bribing officials? Common sense diffusesNoah’s misuse of the Gini index, the standard measureof income inequality. If you define a banana republic interms of the gap, the United States, Hong Kong, andSingapore are all banana republics. By the same logic,then, North Korea,Venezuela, and Myanmar are verita-ble utopias. Measuring the wealth gap in a countrydoesn’t tell us anything about levels of poverty oropportunity. It only tells us the statistical spreadbetween richest and poorest.

2.Win-Lose or Win-Win. Despite the protestations of acouple of Nobel laureates who should know better, themarket is not a zero-sum arrangement.All this discussionof the gap obscures the fact that whenever people engage

in voluntary exchange, all parties ben-efit. Recall Stiglitz above: “So what ifthis person gains and that person loses?What matters, they argue, is not howthe pie is divided but the size of thepie.”This straw man doesn’t look likeanyone I know.The whole point of afree economy is that exchange ismutually beneficial. Only outside themarket (or in a government-riggedmarket) does one party gain becauseanother loses. In such cases, only oneof four things could have happened:force, theft, fraud, or some variation of

these sanctioned by government. Wealth transfers—whether from poor to rich or rich to poor—are inher-ently zero-sum.That means someone has to lose in orderfor someone else to gain. Better-offs want a “win-win”society. So it’s not just a question of the size of the pie,but how the pie gets baked.

3. Static Statistics or Real People. Sam Harris lamentsthat 40 percent of Americans have a net worth of lessthan $2,000. One problem with this factoid is thatabout a quarter of the population is under 18, whichleaves about 15 percent of adults with low net worth.I don’t know many kids with a net worth over $2,000,but I’m comfortable with the fact that my five-year-oldhas little more to his name than some Legos and Wiigames. Otherwise the remaining individuals in thislow-net-worth group may have wildly different cir-

21 M A R C H 2 0 1 2

N e v e r M i n d t h e G a p

There are some reallydestitute people outthere, to be sure. Butwe can’t simplyappeal to shoddystatistics as if theywere, well, Scripture.

cumstances. There could be those with high incomesbut debt, college kids with little besides ramen noodlesand a laptop, or people who gambled flipping houses in’08. There are some really destitute people out there,to be sure. But we can’t simply appeal to shoddy statis-tics as if they were, well, Scripture.

Steven Horwitz has explored data on wealth distri-bution more deeply. He says it’s true that the poor’sshare of total income today is less than 30 years ago. Butthat doesn’t matter, says Horowitz. Total income islarger today. So the poor’s income is still greater than inthe past. Absent government doing counterproductivethings like stimulus and quantitative easing, the totalalmost always gets bigger over time. Statistical snapshotscan also be misleading because most people areupwardly mobile.That doesn’t mean there aren’t peoplewho get stuck in the lowest income bracket throughouttheir lives. It means there are far fewersuch folks than critics like Harris careto admit.

4. Income or Well-being. A minute ofwork today buys you a whole lot morethan it did 20, 50, or 100 years ago.Poor people enjoy phones, fridges,TVs, food, and a far higher standard ofliving because their purchasing power is greater.

In 1920 a working stiff had to labor 37 minutes atthe prevailing wage to buy a half-gallon of milk. In1997 our working stiff only had to work seven min-utes. To buy a pair of Levi’s, one had to work 10.5hours. In 1997? Three hours, 24 minutes. And in 1997it took nine minutes to buy one MIPS (millioninstructions per second) of computing power. Nocomputing product was available in 1920. Zoom outfrom any pessimism about the near term, and thingslook better. Competition among firms to serve cus-tomers yields continuous improvement across taxbrackets. The really big gains, though tough to meas-ure, have gone to the poor. Philosophical economistDeirdre McCloskey says:

[A] rich man cannot, after all, eat much more thanhis chauffeur can, speaking of sheer volume andnutrients. Nor can he wear right now more thanone pair of Italian designer trousers, speaking ofmere leg-covering ability. Nor can he live in morethan one enormous room at a time, speaking ofgross roofage and wallage.

With just a little perspective the poverty picturechanges. By historical standards our poorest quin-tile today is much better off than at any other time inhuman history.

5. Compulsion or Compassion. Maybe we should thinkof a positive-sum society as a happy byproduct of goodinstitutions that protect freedom and property, asopposed to a policy goal per se. The original thoughtexperiment is designed to reveal people’s deeper com-

mitments. Atavists, for example, arecomfortable with compulsory com-passion: If you’ve got it and someoneelse needs it, the State should take it.Better-offs see things differently. Mostthink of compassion as a value, not apolicy. Compassionate acts flow fromthose who hold those values, which

can’t be passed by Congress or enforced by IRS agents.Now that we’ve identified these gaps in perspective,

what do they tell us? All this fretting about the gap is a big blinking dis-

traction. For when we pull back the moral mantle,concern about the gap between rich and poor reveals akind of aesthetic fetish. For all the talk of “social jus-tice,” it’s hard to ground an Atavist’s concerns in any-thing like concern for the poor.The further away fromindignation about the rich an Atavist moves, the closerhe gets to becoming a Better-off. Ask yourself hon-estly: Are you worried about the poor? Or are yousimply averse to wealth accumulation? An honestanswer could start a more productive conversationabout wealth and want.


M a x B o r d e r s

All this fretting aboutthe gap is a bigblinking distraction.

B Y S H E L D O N R I C H M A N

Fearing Hayek

Peripatetics

Economics and business reporter David Warsh(tinyurl.com/7fnsz76) is getting much attentionfor suggesting that F. A. Hayek, far from being

one of the two most prominent economists of the1930s—the other being Keynes—is rather more likethe woman who was thought to have won the Bostonmarathon in 1980 when in fact she had joined the race,mostly unnoticed, a half-mile from the finish line.

Hayek’s fans “have jumped a caricature out of the bushes late in the day and claim that their guy ran a great race,” Warsh writes.“But the fact remains thatHayek just didn’t contributevery much to the developmentof technical economics,” hecontinues.

Warsh, whom we mayjudge by the fact that he callsThe Road to Serfdom “anembarrassment,” nonethelessdoes have some positive thingsto say about the 1974 Nobellaureate:“With the publicationof ‘The Use of Knowledge inSociety’ in the American Eco-nomic Review in 1945, heessentially won on the ‘calcu-lation debate,’ conducted with Ludwig von Mises andOscar Lange, concerning the possibility of central planning.”

Considering how many respectable economistsfavored central planning—essentially the abolition ofspontaneous competitive markets—until fairly recently,that would seem to be no mean feat. He also said that“Hayek himself may yet turn out to have been a verygreat economist after all” because of his work showing“that markets are fundamentally evolutionary mecha-nisms. . . .”Warsh even suggests that Hayek may be mis-

judged today because (quoting David Colander) he“was running a different race” from most other econo-mists.We’ll get back to this point.

As McGill University professor Jacob T. Levy sur-mises, not everyone eager to dismiss Hayek as a light-weight read Warsh’s post to the end. Take PaulKrugman, ever ready to trash anyone who doubts thatKeynes was the fount of all wisdom: “David Warshfinally says what someone needed to say: FriedrichHayek is not an important figure in the history of

macroeconomics. . . . [T]heHayek thing is almost entirelyabout politics rather than eco-nomics. Without The Road ToSerfdom—and the way thatbook was used by vested inter-ests to oppose the welfarestate—nobody would be talk-ing about his business cycleideas.”

The Hayekian wing of theblogosphere has responded inforce, and properly so. A com-mon theme is that Hayek fur-nished the grounds for a properskepticism about macroeco-nomics, the branch of econom-

ics launched by Keynes that treats large statisticalaggregates (demand, income, unemployment, and soon) as though they were concrete entities that interactwith each other according to fixed quantitative rulesrather than historical “summations” of individual pur-poseful actions in a particular institutional context. AsHayek wrote,“Mr. Keynes’ aggregates conceal the mostfundamental mechanisms of change.” (See Steven Hor-witz’s “Mr. Keynes’s Aggregates,” tinyurl.com/35247k5.)

23 M A R C H 2 0 1 2

Sheldon Richman ([email protected]) is the editor of The Freeman.

Friedrich Hayek (right) with Ludwig von Mises.Archive photo

George Mason University (GMU) professor (and FEEtrustee) Peter Boettke wrote at Coordination Problem:

Hayek’s influence in modern economics is ubiq-uitous, even if sadly modern economics is not asHayekian as I would like it to be. Information eco-nomics, theories of dynamic competition, equilib-rium theory of the business cycle, and complexitytheory all owe a debt to Hayek’s economic contri-butions. The work on legal origins owes a debt toHayek’s work on law and political-social philosophyas well. Hayek impacts the DNA of economics andpolitical economy to such an extent that many areunaware of the pervasive influence. . . .

The final problem I have with both Krugmanand Warsh is that they don’t actually consult the his-torical record and the accounts of those who werethere in the 1930s when the battle was engaged orthe direct citation evidence from post-WWIIthinkers. . . . Instead they rely on impressionisticaccounts from their education and discourse com-munities, and cherry-pick from recent journalistichistories of economics.

And there’s this from GMU professor Alex Tabarrokat Marginal Revolution:

It is true that many of Hayek’s specific ideasabout business cycles vanished from the mainstreamdiscussion under the Keynesian juggernaut but whatKrugman and Warsh miss is that Hayek’s vision ofhow to think about macroeconomics came backwith a vengeance in the 1970s. . . .

Hayek was an important inspiration in the mod-ern program to build macroeconomics on micro-foundations.

GMU’s Russ Roberts responded this way at Café Hayek:

Was Hayek an important macroeconomist? Iwould argue that the macroeconomic skepticism ofthe later Hayek is more valuable than the macroeco-nomic theorizing of the early Hayek. But he wasn’t

an important macroeconomist in the mainstreamsense of the title. So what? That’s a badge of honor.He was merely a great economist, without any prefix.

There are others, but I will close with a post writtenby New York University’s Mario Rizzo, one of themost perceptive people I know, at ThinkMarkets.Remember the remark above that “It could have beenthat Hayek was running a different race”? That’s Rizzo’stake:

I think the real issue is this. Hayek’s approachattacks, root-and-branch, the macroeconomic way ofthinking. It is not simply a challenge to a particulartheory of the determinants of mass unemployment,inflation, business cycles and the like. Hayek is notaccepting the rules of the game or the parameters ofthe sub-discipline of modern macroeconomics. . . .

In short, he does not want to focus on aggregatespending and aggregate consequences. Hayek’sapproach says: Let us pierce the veil of aggregatesand look at the distortive effects on relative pricesand relative output produced by boom-time creditexpansions. Let us look at the distortive effects that booms leave us as we work our way through arecession. . . .

Suffice it to say this greatly erodes the intellectualcapital of a field of economics—although one notnoted for its successes. It mocks the claim that Keyneswas a true revolutionary in economic thought. Itopens the possibility that he was muddled, inconsis-tent and unaware of the contributions to monetaryand business cycle theory made by the “classicaleconomists” on the eve of the General Theory.

Hayek is important politically for demonstratingthe practical social necessity of individual freedom.But he is just as important for what he taught us aboutmarkets: They provide the only way for human beingsto overcome their individual deficiencies in knowl-edge, which would otherwise keep them from flour-ishing through social cooperation and the division oflabor.


S h e l d o n R i c h m a n

“Understanding Corruption,” an article byLawrence Rosen appearing in the March-April 2010 issue of The American Interest

(tinyurl.com/26372pz), explained how “corruption” isdefined differently in the Middle East from in the West.To an American it would be unethical for public offi-cials to steer government contracts to relatives, while toan Arab it would be unethical not to.

According to Rosen, in the Arabworld “[c]orruption is the failure to shareany largess you have received with thosewith whom you have formed ties ofdependence. Theirs is a world in whichthe defining feature of a man is thathe has formed a web of indebtedness,a network of obligations that provehis capacity to maneuver in a worldof relentless uncertainty.” (Emphasisin the original.)

Within a tribe such reciprocalrelationships and expectations areconstructive. When, as is typical in earlier, primitivesocieties, lives are lived with little material margin ofsafety, traditions based on mutual ties of indebtednessincrease the chances that a tribe will survive. If a huntgoes badly, the hunter and his family do not go withoutfood. Scaling up tribal mores is problematic, however.Trust is rarely extended beyond the tribe; in someancient languages, the word “stranger” was synonymouswith “enemy.”

The Western understanding of corruption is moreamenable to a large diverse nation of laws and institu-tions. In a nation of any size trust must extend beyondthe family, tribe, or clan, otherwise transaction costs will

escalate and trade will collapse.The problem of nation-building in a region dominated by the tribal ethos isprimarily one of forging trust between tribes and shift-ing loyalties from tribe to nation.

Consider trying to form a nation out of an area inwhich trust and loyalty remain confined to the tribe.Suppose a member of Tribe A becomes the newnation’s leader. He will select his lieutenants from

among those he trusts—members ofhis own tribe. In addition his tribewill expect to share in his good for-tune, which they can only do at theexpense of tribes B and C. If thenation is poor, gaining and keepingpower could literally mean the differ-ence between life and death, so elec-tions will be hotly, perhaps violently,contested. Coalitions between tribesmay form, but will be limited bymutual suspicion, lasting only untilone or more of the coalition believe

they have gained the upper hand and no longer needthe others.

Suppose, however, that Tribes A, B, and C manage to form a stable alliance by agreeing that Tribe X will pay the bills. This works only until members ofTribe X flee the country.What is needed is a new tribe(Tribe Z, say) that can neither outvote the coalition nor leave.

If the word “tribes” is replaced by “special interests,”we could be talking about the problem of sustaining the

B Y R I C H A R D W. F U L M E R

Of Constituents and Clans

25 M A R C H 2 0 1 2

Richard Fulmer ([email protected]) is a freelance writer inHumble,Texas.

In a nation of any sizetrust must extendbeyond the family,tribe, or clan,otherwise transactioncosts will escalate andtrade will collapse.

United States as a nation, not of nation-building in theMiddle East or Afghanistan. Make two additional termchanges: Replace “Tribe X” with “the rich” and “TribeZ” with “the unborn,” and the analogy is complete.

Factions and the Founders

America’s founders were very much concerned withthe problems that factions, as they called special

interests, pose to democracies. James Madison in Feder-alist 10 defined a faction as “a number of citizens,whether amounting to a majority or minority of thewhole, who are united and actuated by some commonimpulse of passion, or of interest, adverse to the rightsof other citizens, or to the permanent and aggregateinterest of the community.”

Factions, he said, are “sown in the nature of man”:“As long as the reason of man continues fallible, and heis at liberty to exercise it, different opinions will beformed. As long as the connectionsubsists between his reason and hisself-love, his opinions and his passionswill have a reciprocal influence oneach other; and the former will beobjects to which the latter will attachthemselves.”

The danger factions pose is thatgovernment, a nation’s sole legitimatewielder of force, may give itself toone or more factions, thereby grant-ing it or them coercive and arbitrary rule over others.The source of many if not most of the tragedies inAmerican history has not been differences in opinions,race, sex, class, talent, wealth, or religion. Rather it hasbeen that people divided along such lines were able tosubvert government’s coercive power to advance theirown ideas and interests through force.

Slavery could not have survived without govern-ment’s sanction and support; slave owners wereempowered by law to draft private citizens to huntdown and recapture runaways.The Salem witch trials of1692 were initially conducted by county magistratesand later by a special court established by the governorof Massachusetts. The federal government repeatedlyviolated treaties with Native Americans when thosetreaties conflicted with the interests of white settlers.

Private companies in the late 1800s and early 1900swere able to prevent their workers from organizingonly with the complicity, and sometimes active involve-ment, of both local police and the military. Between1907 and 1963 over 64,000 Americans were forciblysterilized under the “eugenics” laws of more than 30states as Progressives attempted to rid the population ofthe “feeble-minded” and other “unfit” human beings.Before the Civil Rights Acts whites were routinelyaccorded preferential treatment by state and local laws.More often than not government largess was, and is,bestowed on those in control of the two things electedofficials value most: money and votes.

Growing Incentives

As government grows in power, so grow incentivesfor factions to form and to try to bend that power

in their favor. Factions find ever-more niches amongthe various nooks and crannies of theever-growing, ever-more-complexbody of laws and regulations spewingfrom local, state, and federal institu-tions. The tribute paid to factionscomes from the pockets and free-doms of those lacking governmentfavor. As this exaction becomesincreasingly onerous, electionsbecome more important and morevigorously fought, by means both fair

and foul. Media outlets become increasingly tailored tothe tastes of self-interested parties, reflecting their opin-ions and providing them with their own “facts.” Theresulting information divide further intensifies interfac-tional disputes as people become convinced of theirown moral and intellectual superiority and less able tocomprehend other points of view.

As government grows, its employees become an everlarger constituency. In a democracy numbers translateinto power, and the power of public-sector unions isgrowing apace. As The Economist points out (January 8,2011),“Private-sector bosses are accustomed to playinghardball with unions because they know they can gobankrupt if they don’t. Politicians have no such disci-pline: they can always raise taxes or borrow from futuregenerations.”


R i c h a r d W. F u l m e r

As government growsin power, so growincentives for factionsto form and to try to bend that power in their favor.

Bipartisan cooperation, so cherished these days, canmore easily be achieved when politicians borrow to payfor their constituents’ demands. Everyone can be madehappy as long as costs are borne by the unborn. Even-tually, though, lenders dry up, bills come due, and gov-ernment is left with the choice of either printingmoney and impoverishing voters, or cutting spendingand enraging them.

Madison wrote that the Constitution’s restrictionson government were intended to ensure that issueswere decided “according to the rules of justice and therights of the minor party, [and not] by the superiorforce of an interested and overbearing majority.” His-tory, however, is made largely by the struggle over

power—power not to ensure justice but to plunder.Government power is the greatest prize of all because itenables legalized plunder. Factions have sought thatprize throughout our nation’s history. Two strategieshave been proposed for limiting this threat: decreasegovernment’s power, reducing the incentive to abuse it;or increase government’s power, eliminating the abilityto abuse it.The problem with the second strategy is thatpeople in government themselves constitute an inter-ested faction. Increasing their power means reducingthe power individuals have over their own lives and, inthe end, reducing the role of citizens to serving as eggsto be broken and stirred into the State’s collectiveomelet.

27 M A R C H 2 0 1 2

O f C o n s t i t u e n t s a n d C l a n s

Few areas of historical research have provokedsuch intensive study as the origins of America’sGreat Depression. From 1929 to 1933 America

suffered the worst economic decline in its history. Realnational income fell by 36 percent; unemploymentincreased from 3 percentto over 25 percent; morethan 40 percent of allbanks were permanentlyclosed; and internationalinvestment and tradedeclined dramatically.

The dimensions of theeconomic catastrophe inAmerica and the rest of theworld from 1929 to 1933cannot be captured fully byquantitative data alone.Tens of millions of humanssuffered intense misery anddespair. Because of thistrauma the Great Depres-sion has dominated muchof the macroeconomicdebate since the mid-twentieth century.

In 1930 a large majority of economists believed theSmoot-Hawley Tariff Act would exacerbate the U.S.recession into a worldwide depression. On May 5 ofthat year 1,028 members of the American EconomicAssociation released a signed statement that vigorouslyopposed the act.The protest included five basic points.First, the tariff would raise the cost of living by “com-

pelling the consumer to subsidize waste and inefficiencyin [domestic] industry.” Second, the farm sector wouldnot be helped since “cotton, pork, lard, and wheat areexport crops and sold in the world market” and the

price of farm equipmentwould rise. Third, “ourexport trade in generalwould suffer. Countriescannot buy from us unlessthey are permitted to sellto us.” Fourth, the tariffwould “inevitably provokeother countries to pay usback in kind against ourgoods.” Finally, Americanswith investments abroadwould suffer since the tariffwould make it “more diffi-cult for their foreigndebtors to pay them inter-est due them.” Likewisemost of the empirical dis-cussions of the downturnin world economic activitytaking place in 1929–1933put Smoot-Hawley at ornear center stage.

Economists today, however, hold a different view ofthe effects of Smoot-Hawley. While economic histori-

B Y T H O M A S C . R U S T I C I , T H E O D O R E P H A L A N , A N D D E E M A YA Z I G I

The Smoot-Hawley Tariff and the Great Depression


Thomas Rustici ([email protected]) is an associate professor of economics atGeorge Mason University and author of Lessons from the GreatDepression. Theodore Phalan ([email protected]) is pursuing an M.A.in economics and Deema Yazigi ([email protected]) is a third-year Ph.D.student in economics at GMU.

Contracting Spiral of World Trade, January1929 to March 1933:

Total Imports of 75 Countries

Monthly values in terms of old U.S. gold dollars, millions

Source: Charles Kindleberger, The World in Depression, 1929–1939(Berkeley: University of California Press, 1973), p.172.

ans generally believe the tariff was misguided and mayhave aggravated the economic crisis, the consensusappears to relegate it to a minor status relative to otherforces.We believe many modern economists are wrongbecause flawed modeling leads to two systematicunderstatements of the tariff ’s negative effects.The firstreason for this is that reliance on macro aggregates cansometimes mask serious underlying problems by dissi-pating their apparent impact over a broad area. Forexample, U.S. national income declined 36 percent inreal terms from 1929 to 1933, and the view held byprominent economists, ranging from University ofChicago Nobel laureate Robert Lucas and Yale econo-mist Robert Shiller to MIT economists Rudiger Dorn-bush and Stanley Fischer, is that since the foreign-tradesector was only about 7 percent of gross national prod-uct (GNP), the tariff (though misguided) could notexplain much of this decline.

Viewed at the level of “macro mag-nitudes,” critical micro connectionssuffer from a “dissipation effect” andalways look small. But size does notequal significance.While it is true thatforeign trade represented only a smallpercentage of the overall domestic andinternational economy, it does not fol-low that the tariff was insignificant inits effects.The Panama Canal containsbut a small fraction of the world’s ocean water, but if itwere closed the effects would be quite devastating toworld trade. A focus on aggregates risks missing thetrees for the forest, and not all trees are created equal.

Here’s a second way Smoot-Hawley is underesti-mated: If regulations or tariffs are studied in partitionedmodels, their interrelationships are missed and theirtrue impacts are trivialized. For example, recentattempts have been made to quantify price distortionscaused by the tariff. Mario Crucini and James Kahnhave tried to correct systematic underestimates of theharm of Smoot-Hawley found in a variety of macrostudies that ignored the effect of tariff retaliation on therate of capital accumulation. Using a general-equilib-rium model, they calculate that the microeconomicdistortion effects reduced U.S. GNP by only 2 percentin the early 1930s. Likewise economist Douglas Irwin

computed the general-equilibrium inefficiencies causedby the tariff at nearly 2 percent of GNP.

So when even ostensibly free-market, free-tradeeconomists such as Lucas, Irwin, and others downplaythe negative effects of the Smoot-Hawley Tariff, what’sthe verdict? Were the loud protests of over a thousandprofessors of economics just unsophisticated exaggera-tions? Were these pre-Keynesian classical theorists mis-guided because they lacked the tools of modernmacroeconomics and econometrics? Or did their visionremain unclouded for the same reason? Were theyChicken Littles or Cassandras?

Ignored Effects

Modern measurements of Smoot-Hawley oftenignore a wide range of important negative

effects. For instance, the secondary financial markets,such as the New York StockExchange, crashed twice during thelast eight months of Smoot-Hawley’slegislative history. Jude Wanniski andScott Sumner have linked concernover the impending tariff to theOctober 1929 crash and the June1930 crash.The Dow Jones IndustrialAverage fell 23 percent in the firsttwo weeks of June 1930 leading up toPresident Herbert Hoover’s signing

the bill into law. On June 16 Hoover claimed, “I shallapprove the tariff bill,” and stocks lost $1 billion invalue that day—a huge sum at the time.

Furthermore, if losses of GNP were not evenly distrib-uted across the economy but were concentrated (say, inexport-oriented states), the tariff most likely distortedmonetary conditions significantly.Two percent of GNPdoes not sound like a big change, but if it’s concen-trated in one-fifth to one-third of the states, it’s verylarge indeed. The tariff dramatically lowered U.S.exports, from $7 billion in 1929 to $2.4 billion in 1932,and a large portion of U.S. exports were agricultural;therefore it cannot be assumed that the microeconomicinefficiencies were evenly distributed. Many individualstates suffered severe drops in farm incomes due to col-lapsing export markets arising from foreign retali-ation, and it’s no coincidence that rural farm banks in

29 M A R C H 2 0 1 2

T h e S m o o t - H a w l e y Ta r i f f a n d t h e G r e a t D e p r e s s i o n

A focus on aggregatesrisks missing the trees for the forest,and not all trees arecreated equal.

the Midwest and southern states began failing by thethousands.

Agriculture was not the only export sectordestroyed by the tariff. The worldwide retaliationagainst U.S. minerals greatly depressed income in min-ing states and can be partially blamed for the collapse ofthe Wingfield chain of banks (about one-third of thebanks in Nevada, with 65 percent of all deposits and 75percent of commercial loans). U.S. iron and steelexports decreased 85.5 percent by 1932 due to retalia-tion by Canada. The cumulative decrease in thoseexports below their pre-tariff levels totaled $369 mil-lion. Is it any wonder that Pittsburgh saw 11 of itslargest banks, with $67 million indeposits, close in September 1931?How about U.S.-made automobiles?European retaliation raised tariffs sohigh that U.S. exports declined from$541 million per year to $97 millionby 1933, an 82 percent drop! Thusthere was a cumulative export declineof $1.57 billion from the pre-tariffvolume to 1933. Is it any wonder thatthe Detroit banking system (tied tothe auto industry) was in completecollapse by early 1933?

Let’s not forget World War I, whichmade America the world’s creditor.The center of the financial worldmoved from London to New York,and billions of dollars were owed tolarge U.S. banks.The Smoot-Hawley Tariff threw inter-allied war-debt repayment relations into limbo by shut-ting down world trade. An international moratoriumon debtor repayments to the United States froze bil-lions in foreign assets, thus weakening the financial sol-vency of the American banks. Specifically, over $2billion worth of German loans were obstructed byGermany’s inability to acquire dollars through trade torepay its debts.This same scenario played out in manyother countries as well. The tariff wars created wide-spread financial crises across America, Europe, and ahost of nations in South America. In September 1931England abandoned sound money; America would fol-low suit in 1933.The functional operation of the post-

World War I gold exchange standard was sabotaged byworldwide protectionism in reaction to Smoot-Hawley.

Historians of the Great Depression have overlookedimportant connections between trade conditions andmonetary collapse. The tariff and retaliations against itdestroyed the world trade system and demolished the inte-grated world financial structure operating under the gold-exchange standard as well.America’s monetary and capitalstructure from 1921 to 1929 was primarily shaped by sixfactors: first, a centrally planned monetary system; second,a decade of disguised inflation; third, branch-bankingrestrictions; fourth, state deposit insurance programs; fifth,agricultural subsidies; and finally, a plethora of taxes and

regulations.Smoot-Hawley placed enormous

pressure on the central banking sys-tem and capital structure. In additionit caused the dramatic loss of exportmarkets and declining farm income(due to foreign retaliation), renderingmuch agricultural capital useless.Thiswas responsible for widespread agri-cultural bank failures, which then ledto contagion effects. Due to theuncertainty of trade conditions, eachof the ten largest world economieshad their secondary financial marketscrash. It created international financialchaos leading to foreign debt repay-ment suspensions.As a result of thou-sands of bank failures, the U.S. money

supply dropped 29 percent from 1929 to 1933. (Theweighted average of the world money supply of theeight largest economies annually declined by doubledigits from 1931 to 1932).All of this, and much more—and yet only 2 percent of GNP? We think not.

Macroeconomic Thought and Smoot-Hawley

Modern macroeconomics falls into three broadschools of thought: Keynesian, monetarist

(including New Classical), and Austrian. While greatdifferences exist among the different theories of thebusiness cycle, all seem to agree that the tariff had littlecausal relevance to the severity of the Great Depression.For example, Keynesian Peter Temin never cites the tar-


T h o m a s C . R u s t i c i , T h e o d o r e P h a l a n , a n d D e e m a Ya z i g i

The tariff andretaliations against itdestroyed the worldtrade system anddemolished theintegrated worldfinancial structureoperating under thegold-exchangestandard as well.

iff once in his Did Monetary Forces Cause the GreatDepression? Likewise Milton Friedman and AnnaSchwartz delegate a mere footnote to Smoot-Hawleyin their massive treatise, A Monetary History of the UnitedStates, 1867–1960. To his credit Austrian economistMurray Rothbard at least devotes one and a half pagesto the tariff in America’s Great Depression.

As noted Smoot-Hawley can be directly linked tothe U.S. agricultural crisis of the early 1930s and the ini-tial banking crises in a variety of Midwestern agricul-tural states. Therefore trade policy may have indirectly,but severely, worsened monetary conditions. If the greatmonetary contraction was an important factor in theseverity of the Great Depression, then the Smoot-Haw-ley tariff must be held responsible inlarge part. Estimates that downplay thesignificance of the tariff on aggregateeconomic activity are dangerousbecause the correct lessons will not belearned. The relationship betweenmonetary policy and trade policy isnot a one-way street. Policymakersspeak of affecting the terms of tradeby manipulating the money, but theydo not realize that their money hasbecome vulnerable to the terms oftrade. Modern macro and micro mod-eling biases preclude economists fromseeing this full impact.

Smoot-Hawley and Bank Crises

In 1976 monetarist Allan Meltzer noted, “Given thesize of the decline in food exports and in agricultural

prices, it is not surprising that many of the U.S. banksthat failed in 1930 and in 1931 were in agriculturalregions.” Meltzer’s observation indicates that misguidedtrade policy may have triggered the bank failures andresulting monetary collapse in a significant way. Webelieve Meltzer’s insight gives us a better understandingof the Great Depression.

The most widely accepted theory for the beginningof the Great Depression is the monetarist narrative,which has the collapsing banking system as the primecausal factor.The empirical evidence suggests that a dis-guised monetary inflation throughout the 1920s was fol-

lowed abruptly by an open and severe deflation follow-ing 1929. The appreciable financial disintegration anddeflation caused by over 10,000 bank failures and animplosion of the inverted credit pyramid certainly hadvery real negative economic effects.

The thesis that a negative trade shock can impactmonetary policy fits these empirical puzzle piecestogether.The tariff not only closed off the U.S. exportmarket to farmers, it also left a vast volume of hetero-geneous and specific capital goods used in agriculturalproduction idle and suddenly worthless. Empty silosand buildings, rusting tools and machinery, and unusedacreage—all in particular geographical regions—led tosevere liquidations and farm foreclosures in the states

experiencing the first banking crisis,with the vast bulk of failures involv-ing small state-chartered rural banks.Economic historian Eugene White,who examined individual bank bal-ance-sheet data, identifies the agricul-tural distress in the Midwestern statesas a central reason for the pattern offailures.The Smoot-Hawley tariff wasa direct factor in both the pattern offailures and their geographic location.

Microeconomic Connections

Here is where the Austrian busi-ness cycle model can aid our

understanding of the crisis.The mon-etary theory of capital malinvestment arises from rela-tive price distortions and heterogeneous capital. Bothpoints are by and large absent from most macro mod-eling of business cycles.These microeconomic connec-tions are, however, fundamental. Disguised inflation inthe 1920s probably created a constellation of malin-vestments in need of liquidation, meaning that by 1929a business recession was likely inevitable. However, anextraordinary tariff war brought world trade to ascreeching halt.The tariff created additional malinvest-ment in a capital structure already in need of marketreadjustments. Both prior monetary inflation andrestrictive trade policy led to and exacerbated the eco-nomic downturn. They are not mutually exclusivealternatives.

31 M A R C H 2 0 1 2

T h e S m o o t - H a w l e y Ta r i f f a n d t h e G r e a t D e p r e s s i o n

Both prior monetaryinflation andrestrictive tradepolicy led to andexacerbated theeconomic downturn.They are not mutuallyexclusive alternatives.

Misguided public policies, such as state-run depositinsurance and branch-banking restrictions, created abanking system vulnerable to pervasive failures causedby adverse trade shocks. The moral-hazard problemsassociated with inaccurate risk-pricing—and thefragility of the system due to restrictions on geograph-ical risk diversification—would prove fatal.At the sametime that intervention was leading rural banks to com-mit capital to riskier loan portfolios, intervention wasexposing them to additional risk. When unexpectedchanges in regional economic conditions arise fromarbitrary interventions in the free-trade system, undi-versified banks will fail in large numbers. Smoot-Haw-ley, one of the most massive tariffs inAmerican history, destroyed an enor-mous portion of the vulnerable capi-tal structure.The resultant contagion,bank runs, and failures that followedshow that trade policy can affect mone-tary conditions.

Central Bank Illusion

Whether the Federal Reservecould have stopped the con-

tagion and subsequent bank failuresmisses the main economic point.Central-banking advocates sell an illusion of monetarystability, when in reality the system is wide open toadverse shocks and therefore is highly unstable overthe long run. A central bank can easily overexpand orovercontract the stock of money and credit. This isbest illustrated by the contrast of the Federal ReserveSystem to its freer Canadian counterpart. Canada didnot have antibranching regulations, socialized depositinsurance, or a central bank.This is significant becauseover 30 percent of Canada’s GNP originated in for-eign trade. Smoot-Hawley escalated tariff barriersbetween Canada and the United States, yet Canadadid not experience any bank failures or bank runs, andits money supply declined by only 13 percent (versus

29 percent in America). There is every reason tobelieve that a free-banking system most likely wouldhave prevented the disguised inflation of the 1920sand averted the geographical vulnerabilities alongwith the open secondary deflation characteristic ofthe 1930s.After World War I many countries tragicallyestablished central banks under the illusion thatmonopoly and central planning in money would leadto economic stability. History has rendered its verdicton central planning: Whether it be shoes, screws, ormoney, it always fails.

All of which brings us to today. While “welfare-warfare” states throughout the world are running huge

fiscal deficits, their central banks arerecklessly monetizing massive quan-tities of debt (inflation). Extraordi-nary volatility now characterizesfinancial markets amidst a worseningsovereign debt crisis. Major financialinstitutions throughout the worldhold mountainous portfolios ofworthless assets that governmentpolicy has steered them into hold-ing. Defaults threaten to destroy theworld monetary systems in spite ofall the short-run political machina-

tions of prime ministers and central-bank leaders. Andin these dangerous waters, what do we hear from thepoliticians, many already with their hands red? Tradeprotectionism!

When political agents denounce China on trade anddemand an appreciation of its currency, it is the func-tional equivalent of placing a tariff on each and everyChinese export.This type of protectionist saber-rattlingrisks igniting not only a destructive international tradewar but also, with the economy in the aftermath of acolossal bubble and the world’s banker growing restlesswith its hoard of depreciating IOU’s, vastly more dam-age than the world is prepared to handle. Have welearned nothing from the past?


T h o m a s C . R u s t i c i , T h e o d o r e P h a l a n , a n d D e e m a Ya z i g i

Whether the FederalReserve could havestopped the contagionand subsequent bankfailures misses themain economic point.

B Y T H O M A S S Z A S Z

Who Killed Michael Jackson?

The Therapeutic State

The blog WhyQuit.com asks:“How should yourfamily describe your cause of death? Was it sui-cide, murder, an accident or stupidity?” Playing

Russian roulette, engaging in extreme sports, takinglarge doses of soporific drugs, and many other activitiesfit each of these options. When do we blame suchdeaths on the deceased, and when do we not? Theanswer lies mainly in the language and setting in whichthe question is framed.

Our basic biological needs are air, food, water, sleep,and sex.We are provided with air by our normal envi-ronment. We trade food and water in the free market.Buying sex was generally legal in thepast, while selling it was often prohib-ited. Now in many “advanced” soci-eties selling sex is legal but buying it is penalized.

The trade in sleep belongs in a dif-ferent category. Most chemicals forinducing sleep are available only tomedical personnel for specific pur-poses, or to private individuals indi-rectly, with the assistance of licensedphysicians or drug dealers in the blackmarket.We must keep this legal-social context in mindif we wish to understand and judge certain contempo-rary “tragedies,” such as the deaths of two of the mostpopular American entertainers of their times, ElvisPresley and Michael Jackson.

Screaming into a microphone on a brightly lit stagein the evening in front of a wildly cheering crowd isnot conducive to sleeping soundly later that night.“Downers” in the evening and “uppers” in the morningmay be regarded as part of a popular entertainer’s pro-fessional equipment, as well as an occupational healthhazard for the profession. However, prescription lawsprevent performers from procuring the drugs theywant, turning them into dependents managed accord-

ing to what doctors deem they need, ostensibly for theproper treatment of their fictitious diseases. Thisarrangement makes doctors necessary for VIPs seeking“controlled substances” and endangers VUPs (veryunimportant physicians) willing to succumb to thetemptation to service them. In a free society adultswould pay for the drugs they want and would beresponsible for their use.

Elvis Presley started to use drugs early in his careerand, as his fame grew, became a big-time drug user. OnDecember 21,1970, when President Nixon receivedPresley in the White House and presented him with a

Bureau of Narcotics and DangerousDrugs badge, identifying him as anagent of the government’s drugenforcement apparatus, Presley washeavily drugged. He took the oppor-tunity to express his patriotism bytelling Nixon that the Beatles, whosesongs he regularly performed, exem-plified what he saw as a trend of anti-Americanism and drug abuse inpopular culture.After Presley died of adrug overdose on August 16, 1977, at

age 42, President Jimmy Carter issued a statement thatcredited Presley with having “permanently changed theface of American popular culture.”

In 1980 Presley’s personal physician, Dr. GeorgeNichopoulos, aka “Dr. Nick,” was indicted on severalcounts of “overprescribing drugs.” The jury acquittedhim on all counts. The Tennessee Board of MedicalExaminers then found him guilty of overprescribing,imposed a three-month suspension of his license andthree years’ probation, and then in 1995, permanentlyrevoked his license. Evidently it never occurred to the

33 M A R C H 2 0 1 2

Thomas Szasz ([email protected]) is professor of psychiatry emeritus atSUNY Upstate Medical University in Syracuse. His latest book is SuicideProhibition:The Shame of Medicine.

In a free societyadults would pay forthe drugs they wantand would beresponsible for their use.

Tennessee judicial authorities, or anyone else, to blamePresley’s death on his doctor and charge him withkilling his patient.

Contributory negligence is the legal defense againsta claim based on negligence, where the plaintiff/claimant, through his own behavior, contributes to theharm he suffers. The knowing and deliberate use ofprescription drugs—categorized as treatment for thedisease called “drug addiction”—fits that criterion per-fectly. In the past we did not demonize drugs; we calledpersons who traded in sedatives “druggists,” “pharma-cists,” “doctors,” or simply “sellers.” Now we call them“enablers,” another weasel word gen-erated by the therapeutic state.

In the 1950s and 1960s, whenPresident and Mrs. John F. Kennedywere “enabled” by the now-forgottenDr. Max Jacobson, aka “Dr. Feel-good,” the drug dispenser was not yetcalled an “enabler.” Jacobson’s cus-tomers, in addition to the Presidentand First Lady, included manycelebrities. Before the first debatewith Nixon on September 26, 1960,Jacobson injected Kennedy with acombination “of amphetamines,steroids and vitamins.Within minutesKennedy felt a surge of energy andoptimism. Kennedy then had sex witha young woman brought to his roomso that by the time he confrontedNixon, he was going to feel both energetic andrelaxed” (tinyurl.com/86ey8hz). Jacobson was also partof the presidential entourage at the Vienna summit in1961.

By May 1962 Jacobson had visited the White Houseto treat JFK 34 times. In 1972 Jacobson told New YorkTimes science writer Boyce Rensberger: “I workedwith the Kennedys; I traveled with the Kennedys; Itreated the Kennedys; they never could have made itwithout me.” In 1975 the New York State Board ofRegents revoked Jacobson’s medical license. Sic transitgloria pharmacopolae. (So passes the glory of the quack.)

No physician was blamed for the suicide-“murder”of Marilyn Monroe, one of JFK’s, and RFK’s, para-

mours. Indeed, Dr. Ralph Greenson—a prominent LosAngeles psychoanalyst who, qua psychoanalyst, was notsupposed to have used drugs in his practice but hadprescribed large quantities of barbiturates to her andwas one of the first persons to see Monroe after herdeath—was quickly exonerated as attempting to weanher off drugs. Neither he nor another physician whohad prescribed sedatives for Monroe was deprived ofhis license.

De facto, Michael Jackson killed himself or con-tributed heavily to his own demise. De jure, his physi-cian, Dr. Conrad Murray, killed him. Jackson was

exonerated of any role in his owndeath. Having medicalized suicide,we delude ourselves into believingwe have made large advances in thediagnosis and treatment of self-killing but are unaware of having lostour ability to see what’s in front ofour nose. In 1899 a certain Dr.Wardin Arizona observed: “I have neverbeen called to attend a case of Gila monster bite, and I don’t wantto be. I think a man who is foolenough to get bitten by a Gila mon-ster ought to die. The creature is sosluggish and slow of movement thatthe victim of its bite is compelled tohelp largely in order to get bitten”(tinyurl.com/6vwex6j).

After Murray was convicted hewas denied bail. “This is not a crime involving a mis-take of judgment. . . .This was a crime where the endresult was the death of a human being,” explained JudgeMichael Pastor. “That factor demonstrates rather dra-matically that the public should be protected.”

Dr. Ward disagreed that the public needed to beprotected from Gila monsters. I disagree that publicsecurity requires that Murray be incarcerated. Takingaway his license would suffice to accomplish that end.(This statement must not be interpreted as an endorse-ment of medical licensure laws. Here I address thedrug-related death of certain celebrities and the legalfate of their physicians. I have critiqued our drug lawselsewhere.)


T h o m a s S z a s z

De facto, MichaelJackson killed himselfor contributedheavily to his owndemise. De jure, hisphysician, Dr. ConradMurray, killed him.Jackson wasexonerated of anyrole in his own death.

As I was watching a recent GOP debate in LasVegas, I couldn’t help but think of the millionsof people who enter the casinos expecting to

beat the odds. Some do. Most do not.There is a reasongambling is a multibillion-dollar industry. Big profitsare made as relatively small amounts are lost by themasses trying to beat the system.Of course gambling may beregarded as entertainment, butthe relevant feature of gamblingfor present purposes is that it is a zero-sum game. One person’swinnings are necessarily another’slosses. Wealth is transferred, andthe house always wins so long asenough people play the game.

Similarly, politics operates as a zero-sum game. EconomistRobert Murphy points out thatour current political system isactually a negative-sum game, buteven if we could eliminate allbureaucratic waste, we cannotescape the simple truth that whenan individual wins political favor,he or she only benefits at the lessobvious expense of someone else.There is no such thing as a magical public fund fromwhich political gifts spontaneously generate. No matterhow noble the intention or the cause, the benevolentpolitician is not Santa Claus. All goods distributed bygovernment must first be created or produced by some-body.Whatever is given must first be taken.This is truefor corporate subsidies and bank bailouts, just as it is

true for transfer payments made to the very poorestmembers of society.

People by and large accept such a system becausethey believe they will be able to draw more in politicaladvantage than they lose by way of political plunder.This mentality keeps the population playing the game,

and like the casino, if enough peo-ple play the game, it is the politicalclass and the politically connectedwho always win.

The government spends more,regulates more, and interferes morein our lives each year—and theeconomy barely grows. Even withthe odds stacked against the averageperson, people still seem eager toplace their bets on the system bylooking for political solutions. InVegas they would call this a “suckerbet.”

To better the odds of reapingpolitical spoils, individuals withshared interests tend to jointogether to increase political influ-ence. Teachers, lawyers, laborunions, banks, farmers, defensecontractors, the elderly, and myriad

other identifiable individuals band together in groupsto maximize potential benefits for their special inter-ests. What seems to go unnoticed is that the govern-ment itself is one of the largest special interest groups of

B Y J A S O N R I D D L E

The Best Bet Is Freedom

35 M A R C H 2 0 1 2

Jason Riddle ([email protected]) is the cohost of Butler onBusiness, a free-market talk show in Atlanta.This article first appeared atTheFreemanOnline.org.

Government and poker are both zero-sum games, butat least in poker, you can walk away.Frisko [Wikipedia]

all, now comprising 15 to 17 percent of the total work-force.As Ludwig von Mises observed, “Seen from thepoint of view of the particular group interests of thebureaucrats, every measure that makes the government’spayroll swell is progress.”

The goal of politicians is to create the appearance ofproviding free goodies to the public. Lack of knowledgeabout the true costs of these goodies may be one expla-nation for mass participation in a system of grossexploitation.While the gambler’s winnings and losses arevisible, it is more difficult to identify the true costs ofthe political game. Even under the most transparent fed-eral budget, the costs of political programs are dispersedacross the population in amounts indiscernible to anysingle person. It is virtually impossible to calculate netpolitical profit or loss for any individual or group in thetangled web of taxes, subsidies, patents,regulations, transfer payments, serv-ices, and prohibitions.

Moreover, when resources areconsumed by any government pro-gram, there is the unseen cost of whatnever comes to be. For example,when lobbyists persuade politicians tospend millions every year to maintaina vacant desalination plant in Yuma,Arizona, that money is no longeravailable to be invested in the creationof products consumers want and jobs people need.When resources are diverted into subsidizing jobs in afailing industry, new jobs in a sustainable industry arenever created.This is the unseen cost of politics.

Not only are the odds of winning better at thecasino, but gambling is far more ethical than activelyseeking political loot.While both politics and poker arezero-sum games, the gambler bears the full risk of thebet. Through the political process people are able toprofit only when the costs and the risks are spread toothers.

Furthermore, all wagers made in the casino are vol-untary. It is difficult to make the case that you or I vol-untarily consent to having our money taken for WallStreet bailouts or even unemployment benefits. It is

even harder to make the case that children not yet bornoffer their consent to the debt burdens we incur today.

Some people may argue that shared sacrifice is sim-ply part of an implicit social contract. I find it less thanconvincing that a mad grab for the property of others isfundamental to civilization. Humans come together insociety because of the benefits reaped from the cooper-ative actions of knowledge sharing and the division oflabor. The degree to which societies have prospered isdirectly related to the degree to which individual prop-erty rights are respected.

Fortunately, there is a proven system where wealth isnot merely transferred in a win-loss fashion. In the freemarket wealth would be created and exchanged formutual benefit. It would not be a zero-sum game.Thefree market entails voluntary exchange and thus is also

the only moral arrangement becauseit is the only system that does notnecessitate violence, theft, or exploita-tion. Some argue that the free-marketprocess would be cold and compas-sionless, but as Penn Jillette explains:

It’s amazing to me how many peoplethink that voting to have the govern-ment give poor people money is com-passion. Helping poor and sufferingpeople is compassion. Voting for our

government to use guns to give money to help poorand suffering people is immoral self-righteous bully-ing laziness.

The greatest threat to the established political orderis for people to fully realize that whenever the force ofgovernment is used to obtain special privilege, it is doneat the expense of our neighbors, friends, and family. Allthat would be required to end political plunder wouldbe to cease asking politicians to do for us what wewould never ourselves do to our friends.The system ofvoluntary exchange offered by the free market does notclaim to offer utopia or immediate gratification of all ofsociety’s wants, but it is the only sure bet for incremen-tal progress toward human flourishing.


J a s o n R i d d l e

While the gambler’swinnings and lossesare visible, it is moredifficult to identifythe true costs of thepolitical game.

Paul Volcker is a man of considerable stature, andnot just because he’s six feet, seven inches tall.He gained a reputation for courage and plain

talk as chairman of the Federal Reserve System underPresidents Carter and Reagan because he broke theback of the 1970s inflation. He did so by (mostly) stick-ing to a tight monetary policy even though that meantsky-high interest rates andsharp back-to-back recessionsbefore the economy couldenter its vigorous recovery.Now 84, he has enjoyed acomeback in recent years asan adviser to PresidentObama. His Volcker Rule,prohibiting proprietary trad-ing by banks, was heralded asone way of preventing arepeat of the recent financialcrisis, and it became part ofthe Dodd-Frank Act signedinto law in July 2010.

Dodd-Frank’s full title,incidentally, is the Wall Street Reform and ConsumerProtection Act. Like most current legislation its namereflects hoped-for outcomes, not its actual provisions.Reading the act (tinyurl.com/3kxwrnl[PDF]) is not forthe faint of heart.There are 16 titles consisting of 1,601sections for a total of 848 dense pages. Only a lawyercould love sentences like this:

Any nonbank financial company supervised by theBoard that engages in proprietary trading or takes orretains any equity, partnership, or other ownership

interest in or sponsors a hedge fund or a privateequity fund shall be subject, by rule, as provided insubsection (b)(2), to additional capital requirementsfor and additional quantitative limits with regards tosuch proprietary trading and taking or retaining anyequity, partnership, or other ownership interest in orsponsorship of a hedge fund or a private equity

fund, except that permittedactivities as described in sub-section (d) shall not be subjectto the additional capital andadditional quantitative limitsexcept as provided in subsec-tion (d)(3), as if the nonbankfinancial company supervisedby the Board were a bankingentity.

Volcker initially outlinedhis proposal in a three-pagememorandum. It came to lifeas Section 619 of Dodd-Frank, expanded to 11 dense

pages. This section is supposed to prevent banks frombuying and selling securities for their own account, incontrast to brokering customer trades. It also prohibitsbanks from holding interests in hedge funds or privateequity funds or from sponsoring such funds.These pro-hibitions are supposed to lessen the need for futurebailouts like those that were provided to financial insti-tutions in 2008 and 2009.

B Y W A R R E N C . G I B S O N

The Volcker Rule

37 M A R C H 2 0 1 2

Warren Gibson ([email protected]) teaches engineering at Santa ClaraUniversity and economics at San Jose State University.

The Dodd-Frank Act was passed with only slightly more detailthan this.Wikimedia Commons

But Volcker is not happy.“I don’t like it, but there itis,” he said. “I’d love to see a four-page bill that bansproprietary trading and makes the board and chiefexecutive responsible for compliance.” On the otherhand Rep. Frank, former Sen. Dodd, President Obama,and all the other Dodd-Frank sponsors should behappy.They achieved their purposes when the act wassigned. They can now boast of having tamed the WallStreet beast so that the little people will never again bestuck with a bill for bailouts. But the full effects ofDodd-Frank won’t be felt until after this year’s electionbecause so much depends on how the bureaucracymakes the rules that give meaning to the act. Exagger-ating just a bit, one wag called Dodd-Frank a blankpiece of paper for rule-makers towrite on.

Inter-Agency Squabbling

Four federal regulatory agencies arecharged with writing the Volcker

rules. Those agencies are supposed toplay nice with one another—a 94-word sentence on page 247 ordersthem to do so. But a squabble hasalready broken out between the Fedand the Federal Deposit InsuranceCorporation. Recently Bank ofAmerica moved some derivativesfrom its Merrill Lynch subsidiary to asubsidiary that holds insured deposits.The Fed favored this move as a way ofproviding relief to the bank’s holdingcompany, while the FDIC, which would have to pay offdepositors in the event of a failure, objected.

Last October the four agencies issued a tentative setof rules extending to 298 pages, inviting publicresponses to about 400 questions.A sample:“Should theAgencies use a gradual, phased in approach to imple-ment the statute rather than having the implementingrules become effective at one time? If so, what prohibi-tions and restrictions should be implemented first?Please explain.” This is a pretty basic question, suggest-ing that regulators are in over their heads and are tryingto get private parties to rescue them.This would be nosurprise given their daunting task plus the fact that the

smartest financial people can make a lot more moneyon Wall Street than they can working for regulatoryagencies.

The draft rules are full of exemptions, which caughtthe attention of Ted Kaufman, former senator fromDelaware and now a Duke University Law School pro-fessor. “We’ve been through this before,” he said.“I know these folks, these Wall Street guys. . . . [T]hey’resmart as hell.You give them the smallest little hole andthey’ll run through it.”

Loopholes and Ambiguity

Why the exemptions? Have the bankers bulliedthe regulators into line? Maybe, but the rule

writers seem to recognize that pro-prietary trading isn’t so easy to recog-nize and may not always be a badthing. Prop trading can actually helpkeep markets running smoothly byproviding liquidity. The exemptionsfall into several broad categories thatare fraught with loopholes and ambi-guity.

First, trading on behalf of cus-tomers is exempt. But when a firmseeks a buyer for a customer’s securi-ties, it may have possession of thosesecurities for some period of time,during which it is exposed to marketrisk just as if it were conducting pro-prietary trading. How long must theseintervals become before the transac-

tion becomes a proprietary trade? If the regulators triedto pin this down they would very likely suppress someperfectly good trades while letting others through thatreally should be called proprietary.A big ambiguity here.

Hedging is also exempt.This is the practice of takinga secondary position to offset the risk of another invest-ment. For example, if I expect to receive a million eurosnext year but fear that the euro will decline before I getpaid, I can hedge by entering a contract obligating meto deliver a million euros next year at an exchange rateagreed on today. But sometimes hedges only partiallyoffset a particular risk. Hedges are another big ambigu-ity in the rules.


Wa r r e n C . G i b s o n

The full effects ofDodd-Frank won’t befelt until after thisyear’s electionbecause so muchdepends on how thebureaucracy makesthe rules that givemeaning to the act.

Underwriting and market-making are exempt. Afirm that makes a market for some security usually car-ries an inventory of it, and that means risk. It is entirelypossible that a firm could label an asset as inventory forits market-making operation when in fact its real moti-vation is speculation for its own account. Motives can be elusive.

Finally, the feds have issued a blanket exemption forproprietary trading of their own securities. No surprisehere. We all know that Treasury securities are free ofrisk—or are they? If you buy a ten-year bond yielding1.8 percent and then two years later the rate for suchbonds rises to a more normal 3 percent, your bond’smarket value will decline by nearly one-fifth. If you hadborrowed 80 percent of the bond’sprice, you would have lost all yourequity.Trading Treasury bonds, even ifconsidered free of default risk, can berisky in terms of market price.

Rule makers accepted commentsthrough January 2012 and have untilJuly to finish the rules.They may wellmiss that deadline, but Dodd-Frankwill take effect all the same. Thennobody will really be sure of what itmeans. Business uncertainty willincrease, and prospects for robust eco-nomic recovery will dim.

Phantom Deregulation

Obama recently said that “ofcourse” there had been too little regulation

during the recent financial crisis. Really? Notwith-standing some deregulation in recent years, bankingand finance remain more heavily regulated thanalmost any other industry. Such deregulatory changesas we have had, like the opening of interstate bank-ing, have been overwhelmingly beneficial and are notthe source of the recent financial crisis. (See “TheRise and Fall of Glass-Steagall” in The Freeman,October 2010, tinyurl.com/2btnngm.) Problems inthe financial system will not be solved by piling onmore layers of regulation. Better qualified or morededicated regulators, if such could be found, can’t doit either.

Should we get rid of all regulation? In its broadestsense, to regulate an activity simply means to make itregular and orderly. Regulation by government agen-cies will always be problematic. For one thing, as Kauf-man observed, those who are subject to governmentregulation will find ways around the rules, and theresult is invariably a call for yet another layer of regula-tions. Government regulators, no matter how well-intentioned, cannot possibly acquire the detailedknowledge of dozens or hundreds of individual firms.They usually have no choice but to rely on those man-agers, as shown by the question quoted above. If theirrelationship is at all cordial, the regulators tend, perhapsunconsciously, to take on the perspective of the regu-

lated firms rather than the customersthey are supposed to protect. This iscalled “regulatory capture.”

Can greedy managers be trusted toregulate themselves? First, greed isnothing new, and it’s not going away.Second, the question implies thatmanagers must be trusted to walk anarrow path and avert their eyes fromtemptation. This is a false alternative.In fact free-market institutions, ifallowed to operate, will “regulate”greedy managers more strictly andmore effectively than governmentagents can. Free markets offer long-term rewards to those who earn thetrust of customers while keeping

managers focused on the fear of failure.

Market Regulation

We have to emphasize that markets must operatein a proper legal framework, one that does not

tolerate theft or fraud. These activities must always besanctioned and, when uncovered, be met with restitu-tion and punishment.

So without the Volcker Rule or similar regulations,what would stop bank managers from dumping riskyassets into government-insured banks? In a free marketthere wouldn’t be government deposit insurance.Theremight be private insurance, but the providers would bepowerfully motivated to ride herd on the insured. Bank

39 M A R C H 2 0 1 2

T h e Vo l c k e r R u l e

Rule makers haveuntil July to finish therules.They may wellmiss that deadline,but Dodd-Frank willtake effect all thesame.Then nobodywill really be sure ofwhat it means.

managers, with or without insurance, would have toearn depositors’ trust.And depositors would have to payattention to the soundness of the banks they patronize.How can ordinary individuals judge the soundness ofinstitutions as complex as banks? The same way wejudge the quality of all kinds of providers these days: bylooking online for five-star ratings.

Without government depositinsurance, might bank failures some-times result in depositor losses? Yes!Occasional failures would put the fearof God into managers and depositorsalike. Customers who would avoidrisk altogether could seek pure custo-dial banks rather than loan banks. Butthen they shouldn’t expect freechecking or free ATMs. At the sametime, customers seeking high returnsand willing to accept the necessaryrisk would be happy to see their fundsdeployed in assets like the derivativesthat Bank of America recently moved.Perhaps such risk-taking institutionswould no longer be called banks.

“Creative destruction” sounds harsh, and indeed itcan be. But the benefits of free markets cannot be hadwithout the possibility of failure, and in the end, failuresare benefits too.

A dramatic tale of failure has unfolded before oureyes just now: MF Global declared bankruptcy lastOctober.There are allegations that the firm misappro-priated customer funds, a serious charge that has notbeen resolved at this writing. We are not concernedhere with any criminal behavior but rather MF’s

errors of judgment and the fate of its shareholders and creditors.

This publicly held firm was headed by JohnCorzine, former boss of Goldman Sachs, former gover-nor of New Jersey, and a former U.S. senator. MFtraded sophisticated securities, such as futures andoptions, both for its own accounts and on behalf of

clients. On taking the reins of MFGlobal, Corzine decided the firmshould assume more risk, and nevermind the 2008 collapse, which hadsobered most financial managers.Thefirm bet heavily and wrongly onEuropean sovereign debt securitiesand paid with its corporate life. MFwas engaged in risky proprietarytrading, but because it was not abank, it would have been exemptfrom Dodd-Frank’s Volcker provi-sions even if they had been in effect.MF Global’s missteps provide a text-book illustration of what shouldhappen when a firm conductsunwise proprietary trading or any

other sort of excessive risk. No trading prohibitionswere necessary, and the consequences of management’serrors fell just where they should. Shareholders werewiped out, management is unemployed, and creditorswill line up in bankruptcy court.

Notwithstanding the MF story there is little cause tohope for a turn to market regulation any time soon.Therules will be written, Dodd-Frank will take effect, andnew crises will arise. More legislation will be proposedand the cycle will repeat.


Wa r r e n C . G i b s o n

“Creative destruction”sounds harsh, andindeed it can be. Butthe benefits of freemarkets cannot be hadwithout the possibilityof failure, and in theend, failures arebenefits too.

B Y J O H N S T O S S E L

Obamacare Abominations

Give Me a Break!

Business has learned the truth.Three successful businessmen explained to me how

Obamacare is a reason that unemployment stays high.Its length and complexity make businessmen wary ofexpanding.

Mike Whalen, CEO of Heart of America Group,which runs hotels and restaurants, said that when heasked his company’s health insurance experts to sum-marize the impact of Obamacare, “the three of themkind of looked at each other and said, ‘We’ve gone toseminar after seminar, and, Mike, we can’t tell you.’ Ithink that just kind of sums up the uncertainty.”

Brad Anderson, CEO of Best Buy, added that Oba-macare makes it impossible to achieve even basic cer-tainty about future personnel costs:

“If I was trying to get you to fund a new business Ihad started and you asked me what my payroll wasgoing to be three years from now per employee, if Iwent to the deepest specialist in the industry, he can’ttell me what it’s actually going to cost, let alone whatI’m going to be responsible for.”

You would think a piece of legislation more than athousand pages long would at least be clear about thespecifics. But a lot of those pages say:“The secretary willdetermine. . . .”That means the secretary of health andhuman services will announce the rules sometime in thefuture. How can a business make plans in such a fog?

John Allison, former CEO of BB&T, the 12thbiggest bank in America, pointed out how Obamacareencourages employers not to insure their employees.Under the law an employer would be fined for that.But the penalty at present—about $2,000—is lowerthan the cost of a policy.

“What that means is in theory every companyought to dump their plan on the government plan andpay the penalty,” he said. “So you don’t really know

what the cost is because it’s designed to fail.”Of course, then every employee would turn to the

government-subsidized health insurance. Maybe thatwas the central planners’ intention all along.

An owner of 12 IHOPs told me that he can’texpand his business because he can’t afford the burdenof Obamacare.

Many of his waitresses work part time or changejobs every few months. He hadn’t been insuring them,but Obamacare requires him to. He says he can’t makemoney paying a $2,000 penalty for every waitress, sohe’s cancelled his plans to expand. It’s one more reasonwhy job growth hasn’t picked up post-recession.

Of course we were told that government health carewould increase hiring.After all, European companies don’thave to pay for their employees’ health insurance. If everyAmerican employer paid the $2,000 penalty and theirworkers turned to the government for insurance, Ameri-can companies would be better able to compete withEuropean ones.They might save $10,000 per employee.

That sounded good, but like so many politicians’promises, it leaves out the hidden costs.When countriesmove to a government-funded system, taxes rise tocrushing levels, as they have in Europe.

The law’s impenetrable complication does almost asmuch damage.Robert Higgs of the Independent Instituteis right: If you wonder why businesspeople are not invest-ing and reviving the economy, the answer lies in all thequestion marks that Obamacare and other new regula-tions confront them with. Higgs calls this “regime uncer-tainty.” It’s also what prolonged the Great Depression.

No one who understands the nature of governmentas the wielder of force—as opposed to the peaceful per-suasion of the free market—is surprised by this.

41 M A R C H 2 0 1 2

John Stossel hosts Stossel on Fox Business and is the author of Myths,Lies, and Downright Stupidity: Get Out the Shovel—WhyEverything You Know is Wrong. Copyright 2012 by JFS Productions,Inc. Distributed by Creators Syndicate, Inc.

President Obama says his health care “reform” willbe good for business.

Book Reviews

Adam Smith: An Enlightened Life

by Nicholas PhillipsonYale University Press • 2010/2012 • 352 pages • $32.50hardcover; $23.00 paperback

Reviewed by Martin Morse Wooster

Anyone who reads AdamSmith’s The Wealth of Nations

or The Theory of Moral Sentimentswould want to know more aboutthe author of those classic works.The Library of Congress says thereare at least 300 works in several lan-guages about Smith, but only abouta dozen biographies, including

James Buchan’s The Authentic Adam Smith (2006).There are two reasons there aren’t many Adam

Smith biographies. First, Smith, like so many intellectu-als of his time, was not a man who enjoyed baring hissoul in print. He didn’t like letter writing, for example,and relatively few of his letters survive. But Smith’s ret-icence went further than that of most thinkers of hisday. In 1787, three years before his death at age 67, heordered his friends to destroy all his papers and lecturenotes except for seven philosophical essays, which werepublished posthumously. Smith’s friend and literaryexecutor, Dugald Stewart, observed that Smith “seemedto have wished that no materials should remain for hisbiographers, but what were furnished by the lastingmonuments of his genius, and the exemplary worth ofhis private life.”

Although Smith could have his own papersdestroyed, he couldn’t stop his friends (including Stew-art) from writing about him. In addition, extensive lec-ture notes compiled by Smith’s students in the 1760sprovide evidence of how his ideas emerged andchanged. Using all the available archives, Phillipson, alecturer in history at the University of Edinburgh, hasproduced an elegant and forceful biography.

It should be noted that Phillipson doesn’t care muchhow Smith discovered the importance of free markets.

He is far more concerned about how Smith saw him-self, as a philosopher who was the foremost disciple ofDavid Hume, a man whose goal was “to develop philo-sophical accounts of the principles of law and govern-ment which would be of use to the rulers of modernEurope.”

Consider Phillipson’s description of the legacy ofThe Wealth of Nations. He sees Smith’s book as “thegreatest and most enduring monument to the intellec-tual culture of the Scottish Enlightenment.”The book,he adds,“was a call to his contemporaries to take moral,political and intellectual control of their lives and thelives of those for whom they were responsible. It is insuch context that the Wealth of Nations needs to be readby historians. The rest can be left to his disciples andcritics.”

Phillipson signals to his readers that he is neither adisciple nor a critic of Smith’s work. Readers inter-ested in Smith’s libertarian development should lookto other books.What Phillipson is best at is describingSmith’s life and his ideas. In doing that, he offers manyclues as to why Smith was so successful. Phillipsonshows that the reason Glasgow and Edinburghattracted so many smart people in the eighteenth cen-tury can be traced to free trade. In 1707 Scotland andEngland formally merged to form the United King-dom. Scottish merchants agreed to that to have freeaccess to English markets.

The wealth created by those traders not only gener-ously endowed the University of Glasgow and the Uni-versity of Edinburgh, but also allowed some merchantsto hire professors for special projects. One of them,Henry Home, hired Smith in 1748 to deliver lectureson rhetoric and in jurisprudence. His public lectureswere so popular that Smith repeated them in 1749 and1750.Those lectures not only convinced the Universityof Glasgow to hire Smith to teach logic and meta-physics, they also proved to be highly profitable—Smithearned 100 pounds per year from his lectures, whichwas more than most professors earned.

In 1751 Smith began his career as a university lec-turer. He was so popular that students flocked to Edin-burgh just to hear him. One of his best-known studentswas James Boswell, who wrote in 1759 that Smith “hasnothing of that formal stiffness and Pedantry which is


Book Reviews

too often found in Professors. So far from that, he is apolite well-bred man, is extreamly [sic] fond of havinghis students with him and treats them with all the easi-ness and affability imaginable.”

Smith spent 13 years at the University of Glasgow,then left in 1764 to become the private tutor to theDuke of Buccleuch. The Duke was so grateful forSmith’s skill as a teacher that he paid him 300 pounds ayear until 1778, when Smith became a customs com-missioner. Buccleuch’s investment gave Smith the timehe needed to produce The Wealth of Nations.

Phillipson’s book will not tell you why Adam Smithbecame a great economist. But it superbly shows howSmith became important and why The Wealth of Nationsremains significant.

Martin Morse Wooster ([email protected]) is a writer and editorliving in Silver Spring, Maryland.

Homeschooling: A Hope for Americaedited by Carl WatnerThe Voluntaryists • 2010 • 258 pages • $19.99

Reviewed by Karen Y. Palasek

In his foreword, John TaylorGatto, the New York City

Teacher of the Year from 1989through 1991, raises the followingquestion: “What would happen ifwe let the imagination and energyof the young free again—as it wasin Ben Franklin’s day—free to addvalue directly to the world around

them as the young did when America was coherent? . . . What if they were taught the truth of thingsinstead of having their heads filled with sound bites?What if they learned hard skills instead of ‘subjects’?”Reaching back in time is reaching forward in Ameri-can educational, economic, and civic value, Gattoargues. To get back what has largely been lost or leftbehind, we must abandon the ongoing “trophy”approach to schooling, along with its anti-entrepre-neurial, feel-good leveling effects.

Government schools have failed. They are in anycase not designed to deliver authentic education. If we

are sincere about regaining coherence and preservingour free society, we must arise from complacency andtrain young people not in “subjects,” but rather in les-sons of personal integrity, self-responsibility, and self-control. Homeschooling is the best means of achievingthat objective, and Carl Watner’s book Homeschooling:AHope For America offers a collection of essays, analyses,and perspectives on education inside and outside ofgovernment-run schools. The book serves as a broadintroduction to an array of freedom-oriented educa-tion topics and provides an interesting and valuablesection of references. Readers will find discussionsappropriate for new homeschooling families; for thoseconsidering homeschooling but who need some his-tory, a rationale, or a track record to present to skepti-cal friends and family; and for seasoned homeschoolersas well.

Other than its status as a personal alternative togovernment education, there is no single “right” modelfor homeschooling. Indeed the broad outline of whatis legally possible is the province of each individualstate and sometimes also of local school authorities.Homeschoolers need to know the legal landscape.Once past the legal considerations, homeschoolingoffers a virtually infinite assortment of possibilities andthus its appeal to and fit with the individualist, thefreedom-minded, the creative, the educationallyunorthodox as well as the very orthodox, the patriot,the libertarian, the anarchist, and any number ofunique configurations of civic, religious, social, ethnic,family, economic, political, or other personal circum-stances or styles.

Most readers probably will not read the book coverto cover. Instead they will find within each of its sixsections a collection of articles that cover fundamentalideas in that area.A majority of the articles are authoredby the editor and originally appeared in his publication,The Voluntaryist. Many read like conversations and are infact parts of larger conversations on the subject.

Section I, “Homeschooling!” is an initiation intothe what and why of homeschooling.Titles reflect typ-ical areas of concern: the legal defense of homeschool-ing, an intellectual and moral justification, and parentalrights and responsibilities. For families thinking of get-ting their feet wet in homeschooling, the articles

43 M A R C H 2 0 1 2

Book Reviews

included give a brief idea of what the water is like,who is already in that water, some of what has drawnthem (and their children) to that shore, and how a freesociety requires that children receive a genuine educa-tion.

The next two sections of Watner’s volume offeressays that recount the history of government schoolsand take the reader through critiques of governmentschools’ operations and effects. In those sections thereader encounters comments on morality, propaganda,the development of the intellect, and the poor outlookfor freedom as products of the government schoolingsystem.

The role of parenting and family values is the focusin “Family—Why Parenting Matters” and “A Pot-pourri of Hope for America” (sections IV and V,respectively). From Bryce Christensen’s essay, “Abolishthe Family?” we get this explanation for the hostilitytoward homeschooling among “liberals”: “Individualfreedom counts for little, but traditional family auton-omy counts for even less, since the family is an obsta-cle to social engineering.”

A short catchall section (“Aphorisms”) concludesthe book.

In sum Watner’s book lays out some of the reasonsfor which families have taken their children back fromthe State, back into their homes to educate them. Thetopics and conversations ask parents to examine whatthey believe and why. As Gatto writes, “We need, Ithink, to reach backwards in time to the better open-source educational way America enjoyed when wedominated the inventiveness of the world; back to thetime before the rigid, militaristic procedures of univer-sal schooling foreclosed our imagination.”

That journey backwards in time is the journey toAmerica’s best hope for individual freedom—back tohomeschooling.

Karen Palasek ([email protected]) is a leadership and organizationaldevelopment consultant in North Carolina who homeschooled her daughter.

The Cultural and Political Economy of Recovery:Social Learning in a Post-Disaster Environmentby Emily Chamlee-WrightRoutledge • 2010 • 240 pages • $145

Reviewed by Daniel J. D’Amico

Emily Chamlee-Wright’s latestbook, The Cultural and Political

Economy of Recovery, has beenawarded the F. A. Hayek Prize fromthe Atlas Economic ResearchFoundation, and rightly so.

A professor of economics atBeloit College, Chamlee-Wrightdraws insights from a variety of dis-

ciplines to explain the processes of recovery endured inthe Gulf Coast region after Hurricane Katrina. Shesynthesizes insights from social network theory, Aus-trian economics, cultural economics, and the growingliterature on natural disasters to make meaningful thiscomplex mix of human decisions and social behaviorsthat will forever be a part of American history. In theprocess she makes a valuable contribution to refocusingthe social sciences on their proper object of inquiry:people as individuals and in groups.

In The Counter Revolution of Science, Hayek describedwhy and how the physical sciences purged humanismfrom their disciplines. Presuming that physical phe-nomena operate like people acting intentionally canlead to serious error.Thunder does not result from theanger of the gods.

Hayek explained that this purging unfortunately alsoaffected the social sciences. Positivism, scientism, formalmodeling, and empirical measurement became thedominant techniques to assure objectivity in economicsand most other social disciplines. But to purge thehuman element from social science is to ignore theessence of the very subject matter we seek to under-stand—real human behavior and decisionmaking.

Nobel laureate Vernon Smith coined the term “con-textual rationality” to describe behaviors that, althoughseemingly costly and/or irrational, are on closer reflec-tion effective reactions to unique environmental con-straints. The ability of outside observers to recognizerationality is restricted by their own limitations in rec-


Book Reviews

ognizing the incentives, knowledge, and constraintsfaced by an actor.

Chamlee-Wright’s version of social science, likethose surveyed above, is one that recognizes the reasonsso many people since Katrina have endured extremecosts, forgone significant alternatives, and in manycases have carried significant risk to return and rebuildthe city of New Orleans. Though an imperfect para-phrase, she describes the recovery as a symbiotic rela-tionship amid flux. The citizens contribute to a stockof social knowledge and social value that feeds theircommunity’s identity, culture, and economic welfare.Vice versa, the city provides a navigable network ofsocial, pecuniary, and intangible benefits to those whoreturned to her.These people loved their families, theirneighbors, their places of business, and the city of NewOrleans.

Knowing what actors hold as their abstract goals andknowing what they believe to be their optimal strategieshelps reveal the rational character of their behaviors.What better way to start than by simply asking them?

Chamlee-Wright’s most innovative contribution tohumane economics is her unique method and sourcematerials. Her own form of introspection is a microcomplement to Deirdre McCloskey’s. As McCloskeytunes into literature, culture, and folk narrative to allowsociety to reflect on itself, Chamlee-Wright allows realpeople to self-reflect by offering personal testimonies.Her open-ended interviews expose the procedural ele-ments of recovery, discovery, innovation, and adaptationthat “mainstream” perspectives often overlook. Whereconventional political economy models, such as mar-ket-failure theory and public-goods logic, presume anecessary role for central planning in disaster recovery,Chamlee-Wright’s subjects seem not only capable ofserving their recovery needs themselves; they are alsoingenious discoverers of solutions that governmentbureaucrats would never recognize.

I have lived in New Orleans since 2008. Like Cham-lee-Wright I am fascinated by my neighbors’ narrativesabout government failure after the storm. I trust thatNew Orleanians themselves know the best ways tostructure their lives within their unique city.

Early in the book Chamlee-Wright quotes ThomasSchelling, who offers the opinion that “[t]here are classes

of problems that free markets simply do not deal withwell. If ever there was an example, the rebuilding ofNew Orleans is it.” I believe most of the residents sheinterviewed would read her book and say somethinglike,“If free markets are just people, Chamlee-Wright ismuch more correct about New Orleans than Schelling.”

Not many residents would think that more FEMAactivity would have made things better. I’d go so far asto bet that many would find it insulting to suggest thatgovernment assistance made the revival of the city andits culture today possible.The reality is that the return-ers have worked very hard to rebuild the city they lovedand have done so through their own efforts. Credit isnot due to government help and planning. That is thebig message of the book—free people can and willrecover from natural disasters through the voluntarymechanisms of the market and civil society.

Daniel D’Amico ([email protected]) is assistant professor ofeconomics at Loyola University in New Orleans.

Handbook on Contemporary Austrian Economicsedited by Peter J. BoettkeEdward Elgar • 2010 • 174 pages • $165.00

Reviewed by George Leef

Why are many young econo-mists drawn to the Austrian

school? George Mason Universityprofessor and FEE trustee Peter Boet-tke, the editor of this volume, explainsit this way: “I once described Aus-trian economics as humanistic in itsmethod and humanitarian in its con-

cern.This is what attracted me to the school. It promisedphilosophic understanding of the complex world aroundus and when combined with some basic concepts ofmorality produces a powerful argument for a society offree and responsible individuals.”

That’s a strong calling card, and readers of Boettke’sbook—consisting of ten essays written by relativelyyoung Austrian scholars—will find many more reasonsto investigate the Austrian school. The book is brim-ming over with insights into Austrian analysis, alongwith some jousting with non-Austrians.

45 M A R C H 2 0 1 2

Book Reviews

In the first essay, “Only Individuals Choose,”Anthony Evans explains that individuals are the build-ing blocks of the social sciences.That is why Austriansinsist on approaching economics through methodolog-ical individualism. Only individuals can act, not aggre-gates or collectives. Evans attacks the competingnotion of methodological holism, which accounts forindividual agency by appealing to “society.” Evansargues that the real debate is among differing concep-tions of individualism.

In the second essay, “Economics as the Study ofCoordination and Exchange,” Christopher Coyne con-trasts two approaches to economics—one that centerson optimizing resource allocation and the other thatcenters on exchange relationships. Why does that dis-tinction matter? Coyne writes that under the former,“the study of economics becomes one of computationand maximization instead of focusing on purposefulhuman action and the process through which individu-als interact and coordinate their plans and goals.”

The book’s third essay, “The Facts of Social ScienceAre What People Believe and Think” by Virgil HenryStorr, shows that the “data” of economics are subjectivein character.We can only comprehend economic phe-nomena by trying to comprehend individual beliefs,not through the crunching of numbers, as non-Austri-ans would have it.

Edward Stringham elaborates on subjectivism in hisessay, “Economic Value and Costs Are Subjective.” Heargues that economists can believe in subjectivism indifferent ways and to differing degrees, and concludes,“Exactly how much one embraces economic subjec-tivism is likely to influence the types of policies one iswilling to support.”

The book’s fifth essay, “Price, the Ultimate Heuris-tic” by Stephen Miller, argues that the free market doesnot magically cause people to overcome their cognitivelimitations, but has the virtue of getting them “to dis-card their counterproductive biases and mental short-cuts.” That is, the price system encourages rationalbehavior by compelling individuals to examine moreinformation than they might otherwise have done.

Scott Beaulier contributes the next essay, “WithoutPrivate Property There Can Be No Rational EconomicCalculation.” He introduces readers to the most famous

Austrian dispute with non-Austrians—the calculationdebate—and elaborates on it.“Since property rights arecrucial for the coordination of economic activities,” hewrites,“the central question for economists and policy-makers becomes how to gather accurate informationabout the scarcity of resources in a world with imper-fect property rights.” Beaulier shows how that problemis especially important in efforts at privatizing Stateenterprises and functions.

In “The Competitive Market Is a Process of Entre-preneurial Discovery,” Frederic Sautet explores theimplications of the Austrian approach to competition.“To compete means to be entrepreneurial,” Sautetwrites. He traces the history of economic thinkingabout the nature of market competition and concludesthat “[p]rofit opportunities and knowledge gaps in themarket are one and the same thing.”

The final three essays all deal with macroeconomicissues. J. Robert Subrick’s “Money Is Non-neutral”explores the trouble that stems from the Monetarist andKeynesian ideas that money is, at least in the long run,neutral. Subrick shows that changes in the money sup-ply have both short- and long-run consequences thatlead to malinvestment, shifting resources away fromtheir optimal uses and thus reducing national prosper-ity. Benjamin Powell’s essay, “Some Implications ofCapital Heterogeneity,” explores Austrian capital the-ory, especially the importance of coordinating invest-ment with consumer desires. Powell also elaborates onthe Austrian theory of the business cycle and the follyof “stimulus spending.”

The book’s concluding essay is by Peter Leeson:“Anarchy Unbound: How Much Order Can Sponta-neous Order Create?” It asks whether the self-inter-ested activities of individuals could generate enoughlaw and order to make the State unnecessary. Leeson’sanalysis is fascinating, and I encourage readers toimmerse themselves in it.

Those who are new to economics will find theseessays rather difficult, but students who are already famil-iar with economic issues and language (and I should addthat the writing is mostly in plain English) will find themto be most enlightening and thought-provoking.

George Leef ([email protected]) is book review editor of The Freeman.


Book Reviews

Our Economic Past

47 M A R C H 2 0 1 2

B Y D AV I D R . H E N D E R S O N

The Case Against Sanctions on Iran

The Pursuit of Happiness

When I was a kid, Glen, the boy next door,once played a nasty trick on my brother,Paul. Glen held his cat in his arms, brought

it within a few inches of Paul’s face, and pulled its tail.The suddenly angry cat bit Paul’s face. My brother andI were upset; we both thought the cat, if it bit anyone,should have bitten the perpetrator.

When governments impose economic sanctions onpeople in other countries, they too are pulling the cat’stail. Glen’s intent was to get his cat tobite my brother. His plan worked.Theintent of a government that imposessanctions is to get the people in thetarget country to “bite” their govern-ment. That typically does not work.Why? People are smarter than cats.

For the last few years the U.S. gov-ernment and some other govern-ments have wanted to dissuade Iran’sgovernment from pursuing nuclearweapons.To do so they have imposedincreasingly stringent sanctions onIran. In May 2011, for example, theU.S. government imposed sanctionsto try to reduce the supply of gaso-line. Drying up gasoline supplies toIran—which, surprisingly, importsmuch of its gasoline—has been amethod favored by those who want to hurt Iranians.

It’s not clear how effective such sanctions can be.The companies and governments that the U.S. govern-ment threatens to penalize if they export gasoline toIran might just be replaced by companies over whichthe U.S. government has little leverage.

But let’s assume that the sanctions can do real harm.What happens next?

One thing we can be sure of is that President Mahmoud Ahmadinejad, who, according to Hoover

Institution scholar Bruce Bueno de Mesquita, isapproximately the 18th most-powerful politician inIran, and Ali Khamenei, the most powerful politicianthere, are not doing without gasoline. No. The peoplewho do without gasoline, or with less gasoline, areeveryday Iranians who have approximately zero say inthe policies that the U.S. government wants to change.

So what is the U.S. government hoping for? It hopesthat Iranians—like my neighbor’s cat—will lash out at

whoever’s face is right in front ofthem. The idea is to induce Iraniansto see their own government as theenemy so they will put pressure on it.

But when Iranians suddenly findgasoline in short supply or moreexpensive, so that even getting towork or to the store is a challenge,they will wonder who is responsible.It won’t be hard to find out.Althoughthe government of Iran has a greatdeal of power to censor newspapers,radio, and television, one piece ofinformation that it’s sure not to censoris the role of outside governments inthe country’s economic distress.

Of course, the government willexaggerate the harm done by thesanctions.Although socialism is what’s

killing poor people in Cuba, for example, Fidel Castrofor almost 50 years blamed Cuba’s economic problemson the “blockade,” his word for the embargo imposedby the U.S. government in the early 1960s. But he canplausibly make this claim because the embargo exists.

David Henderson ([email protected]) is a research fellowwith the Hoover Institution and an economics professor at the GraduateSchool of Business and Public Policy at the Naval Postgraduate School inMonterey, California. He is the editor of The Concise Encyclopedia ofEconomics (Liberty Fund, 2008) and blogs at econlog.econlib.org.

When Iranianssuddenly findgasoline in shortsupply or moreexpensive, so thateven getting to workor to the store is achallenge, they willwonder who isresponsible. It won’tbe hard to find out.


D a v i d R . H e n d e r s o n

Likewise, much of the Iranian people’s pain is caused bytheir own government’s intrusive limits on economicfreedom. In the annual index of economic freedom,published in Economic Freedom of the World, Iran droppedfrom 80th of 141 countries in 2006 to 112th in 2007, abreathtaking drop for one year. It inched up slightly to105th in 2009, but that still places Iran low on eco-nomic freedom.Although, as in Cuba, this lack of eco-nomic freedom is the most important cause of Iran’spain, sanctions cause further pain.And the Iranian gov-ernment will be sure to tell its citizens who imposedthe sanctions.

What do people in embargoed countries do whenthey find out that foreign govern-ments threaten them? They want to dowhat my neighbor’s cat would not do:bite the perpetrator.The idea that onecountry’s government can, by inflict-ing pain on people in another coun-try, cause them to pressure theirgovernment to change is simply wish-ful thinking.

To understand this, ask yourselfhow you would feel if another coun-try’s government imposed sanctionson Americans that were seriousenough to cause us real harm. Is yourfirst instinct to be upset at your owngovernment? If it is, you are unusual.I’d bet you would feel some animosity toward that for-eign government.

The further tragedy in the case of Iran is that thereappears to be a strong moderate element that wouldlike better relations with the United States, as well aswith other people and governments in the West. Bytightening the screws on Iran, the U.S. government isnipping this movement in the bud.

Do I have the solution to stop the Iranian govern-ment from developing nuclear weapons? No, I don’t.But for three reasons it doesn’t matter for the issue ofsanctions.

First, the Iranian government does not appear to bedeveloping nuclear weapons. If you have read other-wise in U.S. newspaper headlines, then read beyond

the headlines. In 2007 and 2011 U.S. intelligenceagencies concluded that Iran scrapped its weaponsprogram in 2003. The International Atomic EnergyAgency (IAEA) late last year certified that Iran hasdiverted no uranium to weapons purposes. Moreover,investigative journalist Gareth Porter has debunkedsome well-publicized but unsubstantiated claims madein the latest IAEA report. Just one example:The Russ-ian scientist identified by the IAEA as a nuclear-weapons expert who helped Iran’s governmentconstruct a detonation device is in fact not a nuclear-weapons expert. Instead, in Porter’s words, he “hasworked solely on nanodiamonds from the beginning

of his research career.”Second, even if the Iranian gov-

ernment were to develop nuclearweapons, that in itself would not be athreat to Americans. It would noteven be much of a threat to Israel.Although the Israeli government hasnever acknowledged having nuclearweapons, everyone knows it does.AnIranian government that “nuked”Israel would face a second-strikeresponse from Israel’s nuclear-armedsubmarines—and the Iranian govern-ment officials know it.

Third, if a proposed measurewould harm innocent people and not

even achieve its goal, that’s a sufficient argument againstthe measure. Yet instead of even asking themselves iftheir proposed measures will be effective, officials resortto a way of thinking so common among politicians—one that was parodied in the British comedy show Yes,Prime Minister:“Something must be done.This is some-thing.Therefore, it must be done.”

But I do have a partial solution: Have the U.S.government end all current sanctions on Iran, end sub-sidies to all countries in the Middle East, and pull alltroops out of the region.These actions, more than anyothers, would go a long way toward convincing Irani-ans that the U.S. government is not a threat. Otherwise,many of them will think, justifiably, that it is like mycruel neighbor.

The idea that onecountry’s governmentcan, by inflicting painon people in anothercountry, cause themto pressure theirgovernment tochange is simplywishful thinking.

Documents

VOLUME 62, NO 2 MARCH 2012