POINT/COUNTERPOINT: Regulation of markets

Left: Why regulate free markets

John Horner

You know the geeks are back in town when they start debating esoteric economic concepts like Pareto Efficiency (PE). But the question of what makes an economy efficient and how efficiency can best be achieved is what separates liberals from libertarians and Republicans from Democrats, and often drives many economic debates.

  First, what is Pareto Efficiency? It is the standard measure of economic efficiency. It says that an economic system has reached peak efficiency if you cannot add value to someone without taking it away from someone else. PE is sometimes explained as not leaving any money on the table. If money is left unused, then we would all likely agree that someone ought to pick it up and use it. Therefore, by reaching PE, it is assumed that all wealth that can be created has been. But PE is not concerned with economic equality — PE can be achieved either by one person having all the money or by everyone splitting the pie evenly. And there are infinite ways for economies to reach PE. Every time someone makes a fair economic transaction, a PE economy has found a new way to reach peak efficiency!

Theoretically, a free-market system should achieve PE. Indeed, free and fair economic exchange is another way to describe PE. However, in the real world, there are many irregularities in free market systems that make achieving peak efficiency improbable. Whether governments should try to fix these irregularities and so make economies more efficient through regulation, or whether governments simply screw things up, is the underlying issue in many economic debates.

Why governments try to fix two of these irregularities is illuminating. One irregularity is simply cheating. Whenever someone does not receive his/her promised value in a purchase, PE is not achieved; that’s because someone gains at the expense of someone else. Governments try to discourage cheating through regulations that enact consumer protections and regularize some contracts.

Some free-market enthusiasts contend that the market itself will deal with cheaters by buyers “bewaring” of untrustworthy venders or through individuals enforcing contracts through the legal system. And in olden times, when all transactions were made face to face, this would have worked: normally you wouldn’t do business with someone who’d cheated you. But in a modern economy where you may never even meet the person you’re doing business with, reliance on this market mechanism is unrealistic. Is it better to have laws that set a basic level of food quality or to constantly worry about purchasing tainted food? Imagine too what it would do to consumer confidence to be in constant fear of being cheated. You think we live in a litigious society now, just wait until the onus is put on you to enforce all economic transactions through the courts. Yes, there’s a problem with government becoming paternalistic, but many free-marketeers seem less excited by the idea of a free and fair market than they are pining for a day when a sucker could be “born every minute.”

Another economic irregularity is known as externalities—that is where an economic transaction is fair, but comes at the expense of a third party. Prostitution and pollution are prime examples. If you pollute the air in the production of a commodity, even if you sell it fairly to someone else, third-parties are harmed in the transaction—thereby eroding peak efficiency in an economy. Modern governments have tried to lessen the effects of externalities by reducing the harm caused to third parties, or by charging penalties for harm incurred. Either is an attempt to make the real-world market more efficient through regulation than it would be otherwise.

  Opponents of government regulation often argue that regulations either don’t work or are counter-productive. Usually, they point to regulations that seem unreasonable. And there are many government regulations that are—often because our regulatory structure has yet to catch up with market changes. But to say that we cannot fix problems with economic institutions is to deny the power of human reason—the capacity to decide what is best, based upon a set of objectives. If you don’t believe that reason can work toward the betterment of an economic system, then I don’t expect you appreciate the air you breathe or the food you eat.

Readers can e-mail Horner at: jm.horner@yahoo.com.

Right: Markets are not perfect

Barry Fagin

The standard argument liberal intellectuals offer against free-market conservatives goes something like this. Economists agree on a definition of something called Pareto optimality, named after the guy who thought of it. Basically, it’s a state of affairs where any change makes someone worse off. There are also well-developed mathematical ideas for equilibrium and perfect competition. These all assume that human beings are perfectly rational.

My lefty colleagues in academia then point out the obvious: These are mere abstractions. The real world isn’t like that. Those who argue for less government either delusionally idealistic or blindly dogmatic. I’ve been accused of both.

This argument has more strawmen than a “Wizard of Oz” film clip. And as an economic argument, it deserves to be taken just as seriously.

First, I’m not even sure what “unregulated capitalism” means. To me, the regulations required for capitalism to function are an essential part of any society’s well-being, and should be considered as an integral part of capitalism itself. These include fair courts administering impartial justice, rules for protecting and enforcing property rights, sound accounting principles, punishment for fraud, stable currency, contract law, and tort law.

None of this is big news. The economists who study such things may quibble about the details, but they are in widespread agreement about the basics.

Americans take the existence of these institutions for granted, but you’d be surprised how few of the world’s population are fortunate enough to live under them.

But here’s the real fly in the markets-aren’t perfect ointment. Stay with me on this, because what I’m about to say is going to sound crazy. Are you ready? OK, here goes: Government isn’t perfect either.

You might think this is obvious, but ask yourself: How often do we actually consider the difference between politics in theory and politics in practice? Any high school economics student can quote half a dozen examples of market failure. How many know about political failure?

Although we seldom admit it, representative democracy has its idealized version too. It consists of smart, thoughtful voters electing wise, altruistic representatives appointing ever wiser and more altruistic public servants who have access to more knowledge than we do. They then use that knowledge to work tirelessly to solve the problems of our day.

And what kind of laws does this optimal system produce?  Thoughtful, incisive, and finely-tuned, of course.  Passed with a clear public purpose, they never benefit special interest groups.  Idealized government is like a surgeon with a scalpel, applied only where needed, sworn to first “do no harm” and then to solve the problem.  Nothing more.

So how often does legislation in practice differ from liberal-optimality?

Every single time.   Politicians do whatever it takes to get elected.  They pass laws that benefit specific groups. These laws have unintended consequences that last for years.  Regulatory agencies become dominated by the groups they’re supposed to regulate, making rules that subvert public interest in the name of private gain. 

These aren’t exceptions or aberrations. They are how the system actually works. And yet, markets get judged by failure, politics by success. Is that fair? That, as Hamlet says, is the question.

On behalf of all defenders of economic liberty, I hereby concede once and for all that markets deviate from the mathematical equations that have tortured students in economics courses since the beginning of time. Before I die, I’d like to convince one well-intentioned liberal that government suffers from the same deficiency.

Rampant capitalism, after all, cannot create a permanent underclass, run up trillions of dollars in debt, and waste the blood and treasure of our nation in fruitless attempts to reshape the world. That takes activist politics, a welfare state, central planning, and contempt for the idea of constitutionally limited government. These are all things the left has enthusiastically embraced since the Russian revolution.

Markets aren’t perfect. But guess what:  They don’t have to be. They just need to be better than the alternative.

Readers may contact Fagin at barry@faginfamily.net.