LACK OF KNOWLEDGE
Markets allow millions of individuals and businesses to coordinate their activities with each other. Prices are the key to markets, and they perform two functions. First, prices aggregate and communicate constantly changing information about resources, tastes, and technology. Second, prices create incentives for people to produce and consume efficiently. If a resource is expected to be in short supply, for example, the price rises and people start reducing their use of it while shifting to other products.
Vast amounts of such adjustments are made continuously, steering the economy toward higher levels of output and income. Investors and entrepreneurs direct their resources to the most promising industries. Workers figure out where to best use their skills and add value. Businesses strive to keep their production flowing and their customers happy. There are lots of mistakes, but prices are continually adjusting to keep everything on track and moving forward.
Unintended Consequences
When the federal government intervenes in the economy with subsidies and regulations, it throws a wrench into the price mechanism. Agriculture price supports, for example, are intended to help farmers, but they also prompt farmers to overproduce subsidized crops and underproduce other, more valuable, crops. Minimum wage laws are intended to help workers, but they raise the cost of hiring low-skill workers and so businesses hire fewer of them.
As with taxes, subsidies and regulations cause people to change their productive efforts, which imposes deadweight losses on the economy. Consider a welfare program. The higher taxes needed to fund the program will induce taxpayers to work less, while the spending itself will induce welfare recipients to work less. The late Sen. Daniel Patrick Moynihan of New York said, “It cannot too often be stated that the issue of welfare is not what it costs those who provide it, but what it costs those who receive it.”[i] Actually, it is both.
Consider the deadweight losses created by a farm subsidy program. In an unsubsidized market people buy, say, 100 million ears of corn for 50 cents each. Since markets are voluntary, we know that customers value those ears at 50 cents a piece or more, and we know that the cost of growing the ears is 50 cents a piece or less. Now suppose the government subsidizes farmers 10 cents per ear. Farmers would grow more corn and reduce their investments in other activities. The additional ears would cost more to produce than 50 cents, but they would be valued by consumers at less than 50 cents. The subsidy has thus destroyed value by generating production that costs more than it is worth. The amount of value destroyed is the deadweight loss.
We could make similar diagrams for hundreds of federal subsidy programs and regulations. Federal policymakers intend to help people, but their interventions induce people to change their behavior in ways that undermine the economy. Sometimes those negative effects ripple across the economy with numerous unintended consequences.[ii] In his book, Economics in One Lesson, Henry Hazlitt said that economics “is the science of tracing the effects of some proposed or existing policy not only on some special interest in the short run, but on the general interest in the long run.”[iii]
Consider farm subsidies again. The direct effect of farm subsidies is to increase the output of subsidized crops. A secondary effect is to push up the demand for cropland, which causes less fertile lands to be brought into production. Those lands may require more intensive fertilizer and irrigation use, which in turn may generate environmental problems. Another secondary effect may be that as the price of farmland is pushed up, it becomes harder for young farmers to break into the business.
Here is a sampling of some of the unintended harmful effects of federal subsidies and regulations:
- The minimum wage reduces employment of low-skill workers.
- Unemployment insurance reduces labor supply.
- Subsidized flood insurance induces people to live in riskier flood-prone areas.
- Irrigation subsidies cause overconsumption of water and exacerbates droughts.
- Subsidized loans for housing and college induce people to borrow too much.
- Traditional welfare encourages people to work less and form single-parent families.
- Ethanol subsidies reduce the cropland available for food and increase food prices.
- Trade restrictions designed to aid some industries harm others.
- Business subsidies undermine incentives for companies to innovate.
- Endangered species laws prompt landowners to rid their land of endangered species.
- Foreign aid empowers foreign dictators and stalls reforms.
- Food aid reduces the incentives for poor countries to feed themselves.
- Disability benefits encourage people who could work to drop out of the labor force.
- Social Security and Medicare discourage saving for retirement.
- Health mandates raise insurance costs and induce firms to drop coverage.
- Drug prohibition spawns organized crime and violence.
- Public housing creates negative social effects.
- Programs for the needy reduce private charity.
- Fuel efficiency standards result in more people buying smaller cars and more road deaths.
- Workers’ compensation induces workers to be less careful on the job.
Federal programs generate an endless amount of such negative effects. Consider Medicare. Under Parts A and B, the government pays doctors and hospitals a set fee for each service provided. That encourages them to deliver unnecessary services because they make more money the more services they bill. As an example, investigations have found that doctors are ordering many unneeded drug tests for seniors.[iv] Another problem is that doctors and hospitals are paid by the government regardless of the quality of service, so they have less incentive to reduce errors. Indeed, the system can pay more when there are errors if the errors lead to complications that require more services to be billed.
Medicare’s fee-for-service system is essentially a price-control system for thousands of services purchased from more than 400,000 doctors and about 7,000 hospitals and clinics.[v] When the government sets prices too low, it creates shortages, which is the case with primary care doctors. When prices are set too high, doctors and hospitals have incentives to provide too much, which is the case for advanced imaging services.[vi] The vastness of the system combined with its top-down nature have also made fraud rampant.[vii]
In sum, federal subsidies and regulations induce individuals and businesses to change their behaviors. Those changes undermine overall prosperity because resources are diverted from their best uses. It is true, however, that just because a federal policy creates unintended collateral damage does not automatically mean that the overall policy is a failure. Some federal interventions do generate higher benefits than costs. The important thing is that policymakers look beyond the intended effects of their programs, and consider how people and businesses may respond in negative ways over the longer term.
What Is Seen and Not Seen
In defense of federal policymakers, they have a difficult task. There are no clear cut metrics they can use to judge the success or failure of programs. The benefits are usually visible, but the costs are often unseen. In the marketplace, when consumers dislike products, sales and profits fall, which gives companies a strong signal to change course. There is no such built-in feedback for government programs.
Policymakers feel pressure to “do something” to solve society’s problems. It seems reasonable to them and many of their constituents that spending and regulations should be able to fix things. The benefits of government action are often immediate, while the costs are more distant and hard to understand. To make matters worse, politicians are usually not experts in the areas that they legislate in, so it is hard for them to understand the negative effects of their policies.
In “What Is Seen and What Is Not Seen,” Bastiat, the French economist, described how policymakers focused on benefits and ignored costs. He said that a common argument against cutting the military was the harm from the loss of military jobs, but what was ignored was the jobs that would be created as taxpayers kept more of their money and used it for other purposes.[viii] As another example, he described how iron manufacturers lobbied the “great law factory in Paris” to save mining jobs by imposing iron trade barriers. What was unseen were all the jobs that import barriers would destroy for metalworkers, nailmakers, blacksmiths, and cartwrights, who relied on imported iron.[ix]
Government intervention is not just an invisible job killer, it is an invisible knowledge killer. Market processes generate information about consumer needs, costs, production methods, and technologies, but intervention undermines those processes. When regulations block entrepreneurs from entering markets, we never learn what innovations they might have created. When taxes prevent companies from buying new machines, technological advance is slowed because new machines often incorporate new designs. When farmers receive subsidies, we lose improvements they might have discovered if they had faced the full rigor of the market. Hayek noted, “Freedom is important in order that all the different individuals can make full use of the particular circumstances of which only they know. We therefore never know what beneficial actions we prevent if we restrict their freedom to serve their fellows in whatever manner they wish.”[x]
What is often “not seen” by the government is how the market can solve problems by itself. A government analysis of an automobile fuel efficiency mandate in 2010 illustrated this blindness.[xi] The government estimated that the consumer savings on gasoline from the mandate would be far higher than the added costs of the more expensive cars that met the standard. The government assumed that this estimate justified its mandate. But if the estimate were correct, we would not need the mandate because consumers would buy more fuel-efficient cars by themselves to save money. The government simply assumed that markets would not work, which has been called a “planner’s paradox.”[xii] To the government, top-down mandates on paper look neat and tidy compared to the decentralized operations of markets.
When government intervenes, it preempts the development of market solutions, which is called “crowding out.” The federal government began providing flood insurance in 1968 because it thought that private companies would not provide it.[xiii] Over the years, the federal program has built up a large debt and created distortions. Meanwhile, insurance companies have made advances over the decades, including improved computer modeling, such that private flood insurance would probably work today. But the existence of the subsidized federal program has blocked it from developing.
What is not seen by policymakers are all the state, local, business, and charitable efforts that would exist today if the federal government had not grown so huge. The classic example is welfare. Milton Friedman said, “One of the major costs of the extension of government welfare activities has been the corresponding decline in private charitable activities.”[xiv] This point can be summarized simply as “state help kills self help.”[xv]
In sum, policymakers usually do not grasp the full effects of their programs. They seem to view the economy as a simple machine that can be easily manipulated. Adam Smith had a name for such policymakers: "The man of system … seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse to impress upon it."[xvi]
More than two centuries after Smith, governments are still full of “men of system.” They assume that regulations and subsidies can be used to organize society in a pattern of their choosing, like on a chessboard. Program after program coming out of Washington reflects an overconfidence in the ability of the government to solve problems. One of actor Clint Eastwood’s most famous lines is, “A man’s got to know his limitations.” The government does as well.
Beyond Central Control
If legislators were more diligent and more humble, couldn’t they carefully design regulations and subsidies to improve on markets? After all, there are areas—such as fixing externalities—where government can, in theory, intervene to generate net value.
The reality is that improving on markets is difficult to achieve. Government usually does not have enough knowledge. It only has access to a fraction of the information that is distributed across our society. Unlike governments, markets are able to tap into a vast amount of localized knowledge.[xvii] It is “knowledge of the particular circumstances of time and place,” Hayek observed, which “never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess.”[xviii]
This sort of knowledge is tacit and subjective, so it “cannot be conveyed to any central authority in statistical form,” said Hayek.[xix] A recent article by Cato scholar and practicing surgeon Jeff Singer on electronic health records (EHRs) illustrates Hayek’s point. The federal government mandated EHRs without adequately studying them in the real world. Singer has found that the one-size-fits-all mandate harms his practice: “This rigidity inhibits my ability to tailor my questions and treatment to my patient’s actual medical needs. It promotes tunnel vision in which physicians become so focused on complying with the EHR work sheet that they surrender a degree of critical thinking and medical investigation.”[xx]
Rather than being a chessboard—as Smith’s man of system assumed—the market economy is more like a natural ecosystem that has subtle and hidden relationships that keep things in balance. Hayek coined the phrase “spontaneous order” to describe ecosystems in human society. A spontaneous order is a set of complex, evolutionary patterns or rules that come from bottom-up relationships. Other than the market economy, language is perhaps the best example of a spontaneous order. The idea that dispersed actions of individuals could create overall order was developed by Adam Smith and other thinkers of the Scottish Enlightenment.[xxi]
One of the features of both spontaneous orders in society and natural ecosystems is that they are not easy to successfully manipulate from the top down. Australian officials brought cane toads to their continent in the 1930s to control agricultural pests. As it turned out, the toads were not effective at controlling pests. But worse, the toads multiplied beyond control, and have become major pests themselves damaging the nation’s biodiversity.
A recent Washington Post story described similar episodes. One regards parrotfish in the Pacific Ocean: “A decades-long conservation program there has led to a boom in parrotfish numbers, so much so that they are now harming local populations of corals and other species.”[xxii] The Post story goes on, “This is not an isolated case: Ecologists are facing similar dilemmas with elephants in a South Africa reserve that are killing trees in the savanna and with protected sea turtles in the Bahamas that are harming meadows of invaluable sea grass. These instances show how even the best-thought-out conservation efforts can have unintended effects on the environment…”[xxiii] That sounds a lot like government intervention in the economy.
Economist Dan Klein compared the spontaneous order of the market to the complex coordination that occurs on a skating rink.[xxiv] Each skater is looking out for her own interests, and she meshes in with other skaters and tries to avoid collisions. She makes rapid and ongoing adjustments. She traces her own unique path, yet an overall order of skaters is achieved. The rink manager may set a few rules, but the coordination is almost all bottom-up. Mistakes are made, and people fall down. But others respond, some by making a wide berth around the fallen skaters and some by helping skaters get up.
Suppose that the manager wanted to centrally plan the skating. He could shout orders to individual skaters, telling them each movement to make and what speed to go. But it would not work; it is too complex and fast changing. Only individuals know their own skills, know when they are getting tired, and know when they are losing balance. In his central planning efforts, the rink manager might try to slow everyone down and impose tight regimentation, but that would ruin the fun. The result would be that skaters “would not find the joy and dignity that come from making one’s own course.”[xxv]
Perhaps the rink manager could control a very small number of skaters, but as the numbers increased, his task would become impossible. The lesson, says Klein, is that the more complex an economy or society, the stronger is the case against government intervention.[xxvi] Hayek made a similar point: “The more complicated the whole, the more dependent we become on that division of knowledge between individuals whose separate efforts are co-ordinated by the impersonal mechanism for transmitting the relevant information known by us as the price system.”[xxvii]
In our economy today, markets guide billions of decisions based on fast-changing information across the globe. Prices, profits, and other market signals inform people about the adjustments they should make. Entrepreneurs try new strategies in millions of trial-and-error processes. Individuals and businesses sometimes fail, but they have strong incentives to get back on track. Markets are a process of ongoing change and discovery.
By contrast, government does not have enough knowledge to make good decisions, and it lacks the flexibility to change direction when it makes mistakes. If government enacted an alternative energy program in order to combat high oil prices, but then oil prices plunged, the program might become worthless, but it would probably live on for years. Bastiat said that a “public service” provided by government often becomes a “public nuisance” because it gets entrenched even as conditions change.[xxviii]
Conditions are always changing, and always catching governments by surprise. Consider how inaccurate macroeconomic projections are. Economist Edward Lazear calculated that over a 15-year period, CBO projections of real growth in the U.S. economy for the following year were 1.7 percentage points off, on average.[xxix] That is a giant error given that the average growth rate during the period was 2.1 percent. If the government cannot predict the future, it will be hard pressed to successfully manipulate the future, especially because it is such an inflexible institution.
Consider the lead up to the last economic recession. The housing bubble peaked in 2006 and then began deflating. Government experts did not recognize that falling housing prices were beginning to cause a broad-based economic implosion. Even with its sophisticated computer models, CBO completely missed it. In January 2008, CBO projected that growth would strengthen from 2.0 percent in 2008, to 2.3 percent in 2009, to 3.4 percent in 2010.[xxx] Actually, the economy fell through the floor in 2009, shrinking 2.8 percent.
What then should governments do? Adam Smith advised them to adopt the “simple system of natural liberty.”[xxxi] By removing interventions,"the sovereign is completely discharged from a duty, in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of the society."[xxxii]
Policymakers have just as many delusions today, and given the complexity of the modern economy, their knowledge is even less sufficient. In his book examining federal performance in recent years, Yale’s Schuck concluded that the government’s “endemic failure is rooted in an inescapable, structural condition: officials’ meager tools and limited understanding of the opaque, complex social world that they aim to manipulate.”[xxxiii]
[i] Quoted in Nicholas Eberstadt, “American Exceptionalism and the Entitlement State,” National Affairs 22 (Winter 2015).
[ii] The secondary effects rippling outwards from subsidies and regulations may or may not cause further deadweight losses beyond the immediate market. It depends on whether other markets have distortionary aspects that prevent them from adjusting. See Hines, “Three Sides of Harberger Triangles.”
[iii] Henry Hazlitt, Economics in One Lesson (Norwalk, CT: Arlington House Inc., 1979), p. 191. Originally published 1946.
[iv] Christopher Weaver and Anna Wilde Mathews, “Doctors Cash In on Drug Tests for Seniors, and Medicare Pays the Bill,” Wall Street Journal, November 10, 2014.
[v] Number of doctors and hospitals from Fred Schulte, Joe Eaton, and David Donald, “Code Creep Costs Medicare $11 Billion,” Washington Post, September 16, 2012.
[vi] Government Accountability Office, “Higher Use of Advanced Imaging Services by Providers Who Self-Refer Costing Medicare Millions,” GAO-12-966, September 2012.
[vii] Chris Edwards and Michael Cannon, “Medicare Reforms,” DownsizingGovernment.org, Cato Institute, September 2010.
[viii] Bastiat, “What Is Seen and What Is Not Seen,” p. 5.
[x] F. A. Hayek in the introduction to Bastiat, “What Is Seen and What Is Not Seen.”
[xi] Dudley, “OMB’s Reported Benefits of Regulation.”
[xii] Brian Mannix, “The Planner’s Paradox,” Regulation 26, no. 2 (Summer 2003). And see Dudley, “Reducing Unnecessary and Costly Red Tape.”
[xiii] Chris Edwards, “The Federal Emergency Management Agency: Floods, Failures, and Federalism,” DownsizingGovernment.org, Cato Institute, December 2014.
[xiv] Friedman, Capitalism and Freedom, p. 191.
[xv] Albert Venn Dicey quoted by Friedman, Capitalism and Freedom, p. 201.
[xvii] F. A. Hayek, “The Use of Knowledge in Society,” American Economic Review 35, no. 4 (September 1945): 519–30. See also Gerald P. O’Driscoll Jr. and Mario J. Rizzo, The Economics of Time and Ignorance (New York: Basil Blackwell, 1985).
[xviii] Hayek, “The Use of Knowledge in Society,” p. 519.
[xx] Jeffrey A. Singer, “ObamaCare’s Electronic-Records Debacle,” Wall Street Journal, February 17, 2015.
[xxi] Ronald Hamowy, The Scottish Enlightenment and the Theory of Spontaneous Order (Carbondale, Ill: Southern Illinois University Press, 1987). Bernard Mandeville, writing in the early eighteenth century, is also credited with developing these ideas.
[xxii] Gayathri Vaidyanathan, “Sometimes, Protecting One Species Harms Another,” Washington Post, February 2, 2015.
[xxiv] Daniel B. Klein, Knowledge and Coordination: A Liberal Interpretation (Oxford, UK: Oxford University Press, 2012), chap. 1. I have expanded on Klein’s story.
[xxvii] Hayek, The Road to Serfdom, p. 36.
[xxviii] Bastiat, “What Is Seen and What Is Not Seen,” p. 19.
[xxix] Edward Lazear, “Government Forecasters Might as Well Use a Ouija Board,” Wall Street Journal, October 16, 2014.
[xxx] Congressional Budget Office, “The Budget and Economic Outlook: Fiscal Years 2008 to 2018,” January 23, 2008. See also Chris Edwards, “CBO Forecast Accuracy,” Cato at Liberty (blog), Cato Institute, February 6, 2012.
[xxxi] Smith, The Wealth of Nations, p. 208.
[xxxiii] Schuck, Why Government Fails So Often, p. 412.