Is Our Economic Freedom Slipping Away, and Can Competitive Federalism Reverse the Slide?

Free

Less Free

Somewhere In Between

The Heritage Foundation recently released its annual "Index of Economic Freedom" for 2014, developed in partnership with the Wall Street Journal.  (See here).  Authors of the index measure each country's performance in ten different variables grouped into four different categories.  Here are the four different categories along with the variables assigned to each category.

1. Rule of Law (Property Rights and Freedom from Corruption);

2.  Limited Government (Fiscal Freedom and Government Spending);

3.  Regulatory Efficiency  (Business Freedom, Labor Freedom and Monetary Freedom);

4.  Open Markets   (Trade freedom, Investment Freedom and Financial Freedom)

Here are the top fifteen, along with their scores on the index in question.

1) Hong Kong:         90.1

2)  Singapore:         89.4

3)  Australia:           82.0

4)  Switzerland:        81.6

5)  New Zealand:      81.2

6)  Canada:              80.2

7)  Chile:                 79.7

8)  Mauritius:           76.5

9)  Ireland:               76.2

10) Denmark            76.1

11) Estonia               75.9

12)  USA                   75.5

13) Bahrain               75.1

14)  UK                     74.9

15)  Netherlands        74.2

The United States, which ranked number 6 in 2009, fell out of the top ten this year, continuing a slide that began several years ago.  (See here for the 2013 rankings, here for the 2011 rankings, and here for the 2009 rankings.)  The US now ranks 12, with a score of 75.5.

It should be noted that such national rankings can be imperfect proxies for the extent of economic freedom that individual citizens enjoy in political systems, like the United States (and Canada), characterized by competitive federalism.  By limiting the power of a national government and devolving power to individual states or provinces, federalism may result in varying degrees of economic freedom throughout a nation, as states embrace and implement different philosophies on taxes, spending and regulation.

Take the category of limited government, which the Index equates with low government spending and low taxes.  While the US national government taxes and spends more per capita than any individual state, there are significant differences between the states on these variables, differences with important implications for economic freedom as measured by the Heritage index.    In California, for instance, the top income tax rate is over 13 percent.  By contrast, some states (Washington, Nevada, South Dakota and Florida) have no income tax at all, and some states (New Hampshire and Tennessee), only levy income taxes on so-called "unearned" income, i.e., interest and dividends.  (For a visual representation of how top tax rates differ between the states, see here.)  Of course, the gap between top income tax rates can overstate the difference in tax burdens between various states, as some states might rely more heavily upon sales taxes than others, for instance.   Still, no one doubts that, as previously explained on this blog, states like California generally tax and spend more per capita than states with lower top income tax rates.

The category of regulatory efficiency, which includes labor freedom, provides another example.    As previously explained on this blog, Federal Labor Law once allowed companies and unions to agree to compel individuals to provide financial support for unions they do not wish to join as a condition of pursuing their chosen vocation.  Fortunately, the 1947 Taft-Hartley Act allows states to opt out of this law by declaring themselves "Right to Work" states.   Moreover, while federal law sets a minimum wage applicable to most employees in the United States, several states mandate even higher wages, further reducing the liberty of employers and employees to strike bargains in their mutual best interest.   As a result, the extent of "labor freedom" differs significantly from state to state.    Some states (e.g. Georgia, Louisiana and Tennessee) have no minimum wage at all and have declared themselves "Right to Work" states, thus maximizing labor freedom to the extent possible given federal law.  (See here for a summary of minimum wage laws in the 50 states and here for a list of Right to Work states.)    Other states, e.g., New York and California, have imposed minimum wages that are higher than the Federal minimum and also declined to recognize their citizens' right to decline to support a union.  Some states are "in between," having declared themselves "Right to Work" states while still imposing a minimum wage.  Virginia is one example of such a state.  The Commonwealth is a Right to Work state but also imposes a minimum wage on employers not subject to federal law (with numerous exceptions) equal to the federal minimum.  Ditto for South Dakota.

It therefore appears that the extent of economic freedom varies significantly among various American states. Indeed, some have attempted to document this variation, albeit with somewhat different metrics than those employed by the Heritage Foundation Index.  For instance, the Mercatus Foundation affiliated with George Mason University has published the results of a study of "Freedom in the 50 States."  The report assesses various aspects of freedom on a state-by-state basis, including "economic freedom," "regulatory policy," "tax burden," and "fiscal policy."  It is no surprise that states like California and New York do quite poorly in these measures.  New York (whose flag is pictured above), for instance, is tied for last in economic freedom, 48th in regulatory policy and tied for last in both tax burden and fiscal policy.  By contrast, states like South Dakota, Virginia, and Tennessee perform very well on all such metrics.

As a result, the Heritage Index  likely overstates the extent of economic freedom enjoyed by Americans who live in states such as California and New York, while understating the extent of such freedom in states like Virginia, South Dakota and Tennessee, to name a few.

Some may wonder why, if economic freedom is so valuable, states such as California and New York are able to maintain their freedom-reducing policies in the face of competition from states such as Virginia, South Dakota and Tennessee.  Put another way, why has competitive federalism not prevented America's slide from 6th to 12th in the Heritage survey?  The answer is simple.   Competitive federalism requires limits on the scope of national power and an appropriate division of responsibility between states and the national government.  Where, by contrast, the national government exceeds its authority, imposing uniform solutions to local problems, states face distorted incentives, thereby undermining to some extent the operation of competitive federalism and unduly restricting economic freedom.

Take the minimum wage as an example.  Absent a national minimum wage, states would internalize the benefits of deregulating wage rates, attracting businesses that create jobs and individuals who want them.  However, in the United States, the national government has imposed a minimum wage that governs purely local businesses, so long as they generate sales of $500,000 annually, produce goods or services for interstate commerce, or handle, sell or work on goods that have moved in interstate commerce.  (See here for a description of the reach of the national minimum wage.)  Thus, a state that eliminates its own minimum wage will impact only a fraction of actual or potential business within its boundaries.  By contrast, states that maintain minimum wages equal to or slightly higher than the national minimum wage will risk losing very few employers to other states.   In the same way, the National Labor Relations Act, which authorizes the formation of labor cartels known as unions in purely local commerce, presumably preempts state laws that would treat such collective bargaining as unlawful price fixing.  Here again, national law discourages would-be state efforts to remove restraints --- in this case private restraints --- from the labor market so as to attract capital and productive citizens from other states. 

Federal tax policy also distorts competitive federalism.  In particular, the federal tax code allows citizens to deduct state taxes from their federal taxable income, thereby offsetting, in part, the impact of increased state income taxes.  As my colleague Nate Oman has explained, this provision allows states to export a portion of their costs to other states.  Moreover, as previously explained on this blog, the ability to export such costs insulates high tax states from the rigors of interstate rivalry.  After all, citizens in states such as California receive all of the benefits of new state spending while only paying part of the cost.  As a result, these citizens are less likely to exit such states despite what appear to be oppressive tax policies.  By contrast, states that reduce their taxes internalize only a portion of the benefits of doing so, as their citizens must pay higher federal taxes as a result.  Thus, when it comes to fiscal policy, the national government has distorted the "rules of the game" in a way that advantages high tax states vis a vis those that exercise fiscal restraint, thereby biasing the results of interstate competition against economic freedom as measured by the Heritage Foundation Index.

To be sure, basic principles of political economy teach us that states lack the appropriate incentives to address economic activity that produces significant and direct harmful or beneficial impacts on more than one state.  We should not, for instance, rely upon individual states to pass upon mergers between interstate railroads or set the rates for interstate carriage of goods.  See Northern Securities Co. v. United States, 193 U.S. 197 (1904) (holding that merger to monopoly between interstate railroads violated the Sherman Act regardless of the transaction's legality under state law); Wabash, St. Louis and Pacific Railway Co. v. Illinois, 118 U.S. 557 (1886) (voiding one state's attempt to regulate interstate railroad rates).  However, as the examples discussed in the previous paragraph demonstrate, much national legislation greatly exceeds this justification, regulating private conduct that produces few if any interstate spillovers or subsidizing purely local spending.    (For instance, it's not clear how low market wages in, say, Virginia produce harmful "spillovers" into other states.)   Unfortunately, the Supreme Court has often upheld such legislation, giving undue deference to the political branches' determination that the regulated conduct has significant impact negative impact in more than one state.  Until the national government confines its legislation to those activities beyond the regulatory competence of individual states, competitive federalism will not realize its potential to promote the economic freedom of the nation's citizens.     

Senator Paul Steps Up

Fortunately Senator Rand Paul of Kentucky (pictured above) stepped up to the plate earlier this week, repudiating hateful and disgusting remarks (which this blog will not dignify with a quotation) about President Obama by one-hit wonder Ted Nugent.   Here, according to Politico, is Senator Paul's statement:

"Ted Nugent’s derogatory description of President Obama is offensive and has no place in politics. He should apologize."

Well said, Senator Paul. 

In Praise of (Fettered) Capitalism, AKA Freedom

Opposes Unregulated Capitalism

 Ditto

Language in the first Apostolic Exhortation of Pope Francis, "Evangelii Gaudium," ("The Joy of the Gospel"),  has fueled the never-ending debate about the relative merits of alternative economic systems.  In particular, commentators on various parts of the political spectrum have critiqued or praised the Holy Father's supposed condemnation of "unfettered capitalism."   From the Right, Walter Williams has taken issue with the Pope's supposed claim that "unfettered capitalism" is "a new tyranny."   From the Left, John Nichols of the Nation has praised this supposed claim, asserting that the Pontiff has given an articulate voice to the Occupy Wall Street movement, which the Pope did not mention.  Numerous other commentators have also weighed in about the Pope's supposed comments.  (See here, here and here for examples).  One pundit even declared that "Liberation Theology is Back."   None of these pundits, so far as I am aware, has actually defined "capitalism" or "unfettered capitalism."

Ironically, as others have pointed out, the document does not include the word "unfettered" or "capitalism."  Instead, the Exhortation refers to the "absolute autonomy of the marketplace," which it blames for a widening income gap between rich and poor.  (See Evangelii Gaudium, 2.I.56 and 4.II.202).  Nonetheless, the term "unfettered capitalism" has taken on a life of its own and will likely play a significant role in our public discourse.  It therefore makes sense to develop a working definition of the phrase so as to facilitate a useful public discussion of the merits and demerits of "unfettered capitalism" and various alternative economic systems.  As will be seen, most proponents of free markets support some "fetters" on such freedom, fetters that help channel individual initiative in socially useful directions.  Thus, instead of deciding between a world with "fetters" or "no fetters," societies that wish to advance economic justice must choose among various possible fetters, some of which help create wealth and opportunity and some of which destroy both.

But first, it should be noted that the term "capitalism" is itself a misnomer that often adds little to public discourse.  (Perhaps this explains why the Holy Father, pictured above in a photo taken by the official Brazilian press agency (see here), does not employ the term.)  As Frank Knight once explained, the free market is the natural result of society's recognition of private property, including each individual's ownership of his or her own labor.  Such ownership, Knight said is "a synonym for individual freedom," freedom that includes the right to exchange such property with a willing buyer.  See Frank H. Knight, Risk, Uncertainty and Profit, at 56-57 (1921).  Thus, what pundits call "capitalism" is often just a synonym for "freedom" or "liberty."  This is not always true, however.  In some cases systems that pundits call "capitalism" entail significant intrusions on liberty and property inconsistent with any plausible conception of freedom or liberty, as seen below.

With this caveat in mind,  here are several possible definitions of "capitalism," fettered and unfettered.

1.  Capitalism as State of Nature.  Under this model, there is no State.  Each individual is entirely free to acquire as much property as he or she can, whether by manual labor, trade, invention, or theft from others.    Having acquired such property, an individual can only retain it if he or she can ward off others who seek to acquire it by force. 

2.  Capitalism as the Common Law Baseline: Under this model, individuals reject the State of Nature and form a State so as to enhance the security of their persons and property.  The State, in turn, employs coercion (jail time, criminal fines and monetary damages) to deter and prevent individuals from harming others or invading others' property.  The State may also allow individuals to employ reasonable private force to defend their persons and property from invasion by others.   Such a society may entail less liberty in some sense than the State of Nature, as individuals are not "free" to injure others or steal others' property and suffer state-backed coercion if they do.  However, individuals may still prefer such a society to the State of Nature, because what liberty and property they do possess can be more secure and result in more prosperity, assuming, of course, that the State respects the Rule of Law and avoids arbitrary and selective enforcement of this baseline.   

3.  Capitalism as Wealth Maximization:  Under this model, the State employs coercion to enforce the common law baseline described in Model 2, above.  The State also employs coercion when necessary to overcome market failures that may arise because transaction costs prevent a wealth-maximizing allocation of resources.  Examples include contract law, which reduces the cost of transacting and thus facilitates wealth creation, corporate law, which facilitates the creation of large scale enterprises,  patent law, which ensures that individuals who invest in innovation can reap the rewards of doing so, and antitrust law, which prevents market actors from exercising market power that is not necessary to achieve efficiencies.  Such regulations steer individual conduct and initiative in wealth-creating directions.  This model also justifies expenditures on public goods such as national defense and education, because private actors will not be able to capture the benefits of investments in such goods and thus will under invest in their production.  This model also justifies state expenditures on public works such as highways and harbors, projects that private enterprises may not undertake because transaction costs make it difficult to employ the private market to amass property from numerous individual owners.   Finally, this model would empower the State to conduct macroeconomic stabilization policy, e.g., raising taxes and/or reducing public spending to slow an overheating economy and cutting taxes and/or increasing spending to stimulate a slow one. 

    It should be noted that the distributional consequences of Model 3 will depend upon how the State raises the revenue to pay for various public goods and public works, for instance.  The State could simply divide the cost of such expenditures equally among all of its adult citizens, in which case the distributional consequences could be neutral, depending upon how the State distributes its expenditures.  If, however, the States relies upon a sales tax or an income tax, for instance, Model 3 will redistribute income from rich to poor.  (An individual who pays the State 10 percent of a $100 million income will pay for a much larger share of the State's expenditures than one who pays 10 percent of a $10,000 income.  Unless the State spends 10,000 times more on public goods for the former individual than the latter, reliance on this "flat tax" to fund the State will redistribute income to individuals of modest means.  In the same way, so long as wealthy citizens spend more on consumption than those who are poor, the wealthy will pay more taxes under a sales tax regime, thereby resulting in possible redistribution.)

4.  Capitalism as Utility or Welfare Maximization.  Under this model, the State enforces the common law baseline and also employs coercion when necessary to overcome market failure, as in Model 3 above.  Operating within such a framework, individuals may, alone or in association with others, create great wealth.  Under Model 4, the State also relies upon coercive taxation to redistribute a portion of such wealth from well-to-do individuals to those who are less well off.   While the taxation necessary to accomplish such redistribution will reduce incentives to create wealth in the first place, the result might be an increase in overall welfare, i.e., society's total utility, assuming there is a diminishing marginal utility of wealth.    For instance, redistributing $100,000 from the annual income of a wealthy individual to ten poor persons could increase society's overall utility, if one assumes that these persons collectively derive more utility from that $100,000 than the wealthy individual would forgo because of the redistribution.   Model 4 is truly a "Welfare State," insofar as the State employs its legal and regulatory machinery with one goal --- enhancing society's overall welfare --- in mind.

5.  Corporatism Confused With Capitalism.  Under this system, the State enforces the common law baseline, employs coercion to overcome market failure and spends resources on public goods.  The State may also  engage in redistributive taxation in an effort to increase society's total welfare.  In addition, however, the State also structures taxes, subsidies and regulations so as to encourage particular industries and/or firms within such industries.  Often such rules might favor large, capital-intensive firms over smaller, labor intensive firms, thereby raising barriers to entry and fortifying the market power of incumbents.  See generally Oliver E. Williamson, Wage Rates as Barriers to Entry: The Pennington Case in Perspective, 82 Q. J. Econ. 85, 91-98 (1968) (explaining how imposition of minimum wages industry-wide can disadvantage smaller, labor-intensive firms).   The State may even reserve to itself the authority to approve entry into particular markets, consulting marketplace incumbents before allowing such entry.  The requirement that new entrants into the hospital market obtain a so-called "certificate of need" is one such example, discussed previously on this blog.      The State may also adopt rules, including exemptions from antitrust laws, that encourage the formation and operation of labor cartels known as unions, cartels that seek to obtain a portion of any market power that their employers possess.  Such cartels can rarely thrive, however, unless the State also prevents free entry into the industries subject to such labor cartels.  See generally Michael L. Wachter, Labor Unions, A Corporatist Institution in a Competitive World, 155 U. Penn. L. Rev. 581, 601-604 (2007) (describing NIRA’s support for collective bargaining).   Indeed, once society recognizes as legitimate legislation that bestows economic benefits on some at the expense of others, consciously picking economic winners and losers, economic actors will rationally invest scarce resources attempting to influence political decision makers to enact more and more such legislation.  Such "rent seeking," of course, diverts valuable economic resources away from productive economic activities that would otherwise increase society's overall wealth.   As previously explained on this blog, James Madison claimed that societies that consistently allow such legislation are akin to the State of Nature, given that both such societies allow the strong to united to oppress the weak.

* * * * *

The United States is perhaps best described as a mix of Models 4 and 5, with some Socialism thrown in "to boot."  For instance, the Constitution, at least as interpreted by the Courts and the political branches, empowers states and the national government to restrain economic liberty for the sole purpose of enriching some industries or groups of individuals at the expense of others.  (But see here for a discussion of a recent decision in the United States Court of Appeals for the Fifth Circuit rejecting such rent seeking as a valid basis for interfering with economic liberty.)     Certificate of need laws and unions are quintessential examples.  Ditto for the regulation of taxi cab markets, of all things.  In addition, states and the national government sometimes own the means of production themselves, the very definition of Socialism.  For instance, all states own and operate one or more colleges or universities, ownership that is not necessary to ensure an appropriate investment in education.  (States could, instead, simply provide their college-aged citizens with vouchers, as explained here with respect to primary and secondary schools.)  Moreover, the national government once owned General Motors, after an ill-advised bailout of two automobile manufacturers whose products have failed in the marketplace.         At the same time, governments do not always exercise their power to restrain economic liberty or own the means of production, partly because of a political culture that values competition, and partly because competitive federalism deters individual states from adopting policies that drive capital and productive citizens to migrate to other states.

Of these five models, only Models 1 and 2 can be characterized as "unfettered capitalism."  Model 3 empowers the State to impose any number of harm-reducing regulations ("fetters") and to "tax and spend" so as to produce various public goods, including education.    Moreover, Model 4 expressly empowers the State to employ additional coercion to redistribute wealth from some individuals to others.   Model 5 empowers the State to favor some industries or firms over others, favoritism that necessarily restricts the liberty of those firms and individuals not favored.  Model 5 also empowers the State to compel firms to recognize and bargain with labor cartels also known as unions. 

Very few individuals advocate Models 1 or 2 as organizing principles for an economic system.   Instead, most individuals, including most who support "limited government" or some synonym thereof, embrace Model 3 or even Model 4.  For instance, most prefer a world in which the State imposes the "fetters" necessary to protect individuals from others' harmful exercise of property rights and vice versa.  Most also prefer a world in which the State expends the resources necessary to produce public goods, using coercive taxation to raise the necessary revenue.  As noted above, States that rely upon a flat income tax, for instance, to fund such goods will redistribute income from the wealthy to the less well-to-do.  Finally, many proponents of limited government also endorse expenditures to provide the poor with basic services, education and even enough income to lift such individuals out of poverty and into the middle class.  For instance, Milton Friedman (pictured above at a White House ceremony), always a proponent of limited government, advocated both a negative income tax and school vouchers, both of which redistribute income from some to others.   See e.g. Milton Friedman, Capitalism and Freedom, 191-94 (1962) (advocating the negative income tax) id. at 85-100 (discussing proper government role in education).  See also this discussion of the negative income tax between Milton Friedman and William F. Buckley. 

In short, most members of society, whether they be Progressive, Conservative or even Libertarian, agree that Capitalism or individual freedom should be fettered in some way.  The much harder question is how many and what sort of fetters the State should impose.  It should also be clear that "not all fetters are created equal."  Some coercive regulations clearly enhance society's welfare, while others plainly reduce it.  Moreover, we must never lose sight of the fact that robust free markets produce the very wealth that many wish to redistribute to the less fortunate.  A society of "haves" and "have nots" may well be more just than a society in which everyone is (equally) destitute, particularly if the State uses its powers of taxation to redistribute some income from rich to poor.  As previously explained on this blog, individuals who create massive fortunes for themselves often do so by simultaneously enhancing the welfare of countless others, even before the State imposes redistributive taxes.   Finally, the existence of significant poverty in a nation such as the United States that allows some economic freedom does not thereby justify any and all additional restrictions purportedly designed to reduce poverty.  Instead, such poverty may be the predictable result of fetters already in place, the removal of which may actually increase wealth, opportunity and employment.  Labor cartels, minimum wages and state-protected monopolies are obvious examples of such wealth-destroying fetters that reduce opportunity and increase poverty.

The Minimum Wage As Economic Alchemy

 

 

Believed in (Chemical) Alchemy

 

 

Touts Economic Alchemy Instead

 

A few days ago President Obama issued an executive order requiring firms that provide goods or services to the federal government to pay employees working pursuant to such contracts a "minimum wage" of $10.10 per hour, substantially higher than the current federal minimum wage of $7.25 per hour. (See here for the story.)   The requirement will take effect slowly, over time, as new contracts are awarded and current contracts renewed in the ordinary course of business. 

The President also used the event announcing the order to advocate national legislation raising the minimum wage to the same level, $10.10 per hour, which he said, was "just like" what he had done with his executive order.  The President claimed that such legislation would "is not going to depress the economy.  It boost the economy [because] it will give more businesses more customers with more money to spend.  It will grow the economy for everybody."  (See here for a video of the President's remarks.)

Any parallel between the President's Executive Order, on the one hand, and the proposed increase in the national minimum wage is illusory.  Indeed, the juxtaposition of the two policies will help illustrate why raising the minimum wage applicable to private markets will, if anything, reduce overall employment and stunt economic growth.  Assertions to the contrary, as explained below, are reminiscent of arguments by alchemists that, with enough practice, humans could learn how to transform lead into gold. 
 

Take the Executive Order first.  Presumably such contractors will simply pass the costs of higher wages on to the federal government.  (The Secretary of Labor claims this will not be necessary, because paying workers more will increase their productivity.  But of course if this were true firms would increase wages voluntarily so as to reap such gains.).  The federal government, in turn, will spend more to receive the same services.  If one subscribes to the Keynesian macroeconomic paradigm, the net impact of such additional spending will depend upon the method of financing it.  For instance, the government could simply raise taxes or cut spending elsewhere, thereby offsetting the stimulatory impact of increased spending for the services provided by such contractors.  However, the government could finance such additional spending by borrowing, in which case the net impact of the Executive Order on aggregate demand could be positive, partly offset, of course, by the impact of higher interest rates resulting from more government borrowing.
 

What, though, about the proposed legislation raising the minimum wage to $10.10 per hour in private markets? Unlike federal contractors, other private employers cannot simply pass along the entire cost of higher wages to their customers who, after all, lack the power to raise taxes or issue ever-increasing debt.  Thus, as Nobel Laureate George Stigler explained long ago, basic price theory predicts that increasing wages by legislative fiat will reduce current employment. See George J. Stigler, The Economics of Minimum Wage Legislation, 36 American Econ. Rev. 358 (1946).   After all, firms will hire any employee whose marginal product equals or exceeds the prevailing market wage. At some firms, the marginal product of the firm's least productive employee will just equal or barely exceed the prevailing wage. Legislation that coercively raises the prevailing wage by a non-trivial amount will thus force some firms to pay one or more employees more than their marginal product, an irrational decision for firms free to lay off one or more workers. As a result, the minimum wage will cause some firms to discharge one or more employees, just as a state-imposed increase in the price of steel or electricity will cause firms to reduce their consumption of such inputs.  Thus, two economists recently estimated that a ten percent increase in the minimum wage would reduce employment among minimum wage workers by between two and four percent. See Eric French and Daniel Aronson, Product Market Evidence on the Employment Effects of the Minimum Wage, 25 J. Labor Economics 167 (2007).   Some individuals will lose their jobs altogether, while some will work fewer hours in the same jobs.  The President's proposal, of course, would raise the minimum wage by far more than that, namely, by thirty-nine percent.

Of course, some on the political left continue to resist the predictions of basic microeconomic science, claiming that raising the minimum wage will have little if any impact on employment for low wage workers.  A recent post by William Poole at the Cato Institute provides some additional confirmation of the predictions that some on the left reject, as if such confirmation was necessary.  In particular a recent paper for the National Bureau of Economic Research concluded, after surveying numerous studies of the impact of minimum wage increases, that such coercive increases reduce employment, particular for low-skilled workers.  Poole's post quotes from the abstract of the paper, which summarizes its findings:

"[T]he oft-stated assertion that recent research fails to support the traditional view that the minimum wage reduces the employment of low-wage workers is clearly incorrect. A sizable majority of the studies surveyed in this monograph give a relatively consistent (although not always statistically significant) indication of negative employment effects of minimum wages. In addition, among the papers we view as providing the most credible evidence, almost all point to negative employment effects, both for the United States as well as for many other countries. Two other important conclusions emerge from our review. First, we see very few - if any - studies that provide convincing evidence of positive employment effects of minimum wages, especially from those studies that focus on the broader groups (rather than a narrow industry) for which the competitive model predicts disemployment effects. Second, the studies that focus on the least-skilled groups provide relatively overwhelming evidence of stronger disemployment effects for these groups."  (emphases added).

Thus, minimum wage legislation will, to paraphrase the President, mean fewer, not more, "customers with money to spend."

One might still argue that raising the minimum wage will, despite these disemployment effects, still stimulate the economy.  After all,  raising the federal minimum wage will increase the income of some of those employees fortunate enough to keep their jobs.  Such increased wages may even reflect a more just remuneration for these individuals' hard work than a purely competitive market would products.  Perhaps increased spending by these workers will offset the reduced spending by those who lose their jobs.

Unfortunately, legislation that raises the minimum wage does not magically create the money necessary to pay those employees who retain their jobs higher wages.  If it did, Congress should increase the minimum wage to $25 per hour or more!   Instead, to pay higher wages, business must reduce their profits (assuming they have profits), increase their prices (and suffer reduced sales), or both.  In other words, even if one assumes away negative employment effects,  increasing the minimum wage is  a zero sum game.  Yes, some workers will have more money to spend.  However, businesses and their customers will have less money to spend.  To be sure, low wage workers may spend a higher percentage of their income than business firms or their consumers, but even this is not certain. After all, many minimum wage workers are members of middle class or even upper middle class households. Indeed, according to one study, a significant majority of minimum wage workers are in the middle and upper classes, with the result that low income individuals receive only a small fraction (fifteen percent) of the benefits of higher wages, even assuming no negative employment effects.

In short, basic economic science informed by empirical evidence predicts that increasing the minimum wage will reduce employment, thereby reducing the number of customers "with money in their pockets."  Moreover, additional spending by those employees who retain their jobs will not offset the combination of reduced spending by those who lose their jobs, businesses who see profits fall and consumers who pay higher prices.  Arguments to the contrary rest on some form of economic Alchemy, whereby legislation that does not increase output or income but instead reduces employment magically rearranges purchasing patterns of consumers and business so as to increase aggregate demand.   The theory of chemical alchemy did not work for Rudolf II (pictured above) who, as Holy Roman Emperor, subsidized research on the topic.  Nor will it work for President Obama and those members of Congress who vote for such legislation, once again rejecting economic science.  (See also here.)

One need not rely solely upon scientific theory to rebut the claim that increasing the minimum wage will stimulate the economy. After all, the Nation has in the past experimented with the manipulation of wages as a means of inducing economic recovery, and the results were not encouraging. In particular, during the Great Depression, Congress, via the National Industrial Recovery Act ("NIRA"), imposed so-called "Codes of Fair Competition," including minimum wages, on over 500 American industries.  By coercively raising wages, it was said, enforcement of the Codes would increase "purchasing power" and thus increase workers' demand for goods and services, stimulating the economy and counter-acting the Depression.

While the Supreme Court unanimously invalidated the NIRA in 1935, see Schechter Poultry v. United States, 295 U.S. 495 (1935), Congress doubled-down on this approach to macroeconomic stabilization,  passing the National Labor Relations Act that same year.    The Act, whose preamble asserted that free market wage setting had the effect of  "depressing wage rates and the purchasing power of wage earners" required private firms to allow employees to form unions --- labor cartels --- if they wished, as a means of increasing purchasing power and thus aggregate demand.   Three years later, Congress passed Federal minimum wage legislation as part of the Fair Labor Standards Act.

While there was some popular enthusiasm for these policies, those who knew better predicted they would make things worse.   For instance, a report commissioned by Columbia University concluded that the NIRA "would make for general impoverishment and would solve the problem of 'poverty in the midst of plenty' by removing the plenty."  See Economic Reconstruction: Report of the Columbia University Commission, 20 (1934).  Moreover, as previously explained on this blog, in an open letter to President Roosevelt, John Maynard Keynes argued that the NIRA probably impeded recovery and that FDR's sympathizers in England wondered "whether some of the advice you get is not crack-brained."  Henry Simons at the University of Chicago also argued, again in 1934, that labor unions and other monopolistic combinations exacerbated the Depression by artificially raising wages and prices.   See Henry Simons, A Positive Program for Laissez Faire (1934). 

Empirical research by economic historians confirms the prediction by the Columbia Report, Keynes and Simons.  For instance, President Obama's first Chair of the Council of Economic Advisers, Christina Romer, concluded that the NIRA raised prices and wages and thus slowed economic recovery. See Christina D. Romer, Why Did Prices Rise in the 1930s?, 59 J. Econ. Hist. 167, 187-93, 197 (1999).   More recently, two UCLA economists, Harold Cole and Lee Ohanian, concluded that various New Deal policies, including the NIRA and NLRA, both deepened and lengthened the Great Depression, particularly by artificially increasing wages. Indeed, these scholars conclude that these policies prolonged the Depression by seven years.  (See also pp. 1664-66 of this source summarizing the findings of Professors Romer, Cole and Ohanian.)

None of this is to say that States or even the national government should stand idly by while some individuals are unable to earn enough income to lift themselves and their families out of poverty.  Instead, in the opinion of this blogger, society should take steps to increase the rewards that individuals receive for work.  Fortunately, society has already put into place a mechanism to do just that, namely, the Earned Income Tax Credit.  Indeed, according to this tax calculator, an individual with two children who earned the minimum wage at a full time job would pay no federal income tax and also receive a $5,372 refundable tax credit in 2012.  The same individual would also receive $2000 in refundable child tax credits combined,  thereby increasing his or her effecive wage to over $10.00 per hour and household income by more than 40 percent.  It is thus no surprise that, in a 2013 Op-Ed, Professor Romer, mentioned above, endorsed increasing the Earned Income Tax Credit instead of increasing the minimum wage.  Such an approach would also help stimulate the economy, at least according the Keynesian paradigm, so long as the government borrowed the money necessary to pay for such increased spending.   Hopefully "cooler heads will prevail," and Congress and the President will follow Professor Romer's advice instead of clinging to economic theories that, like Alchemy, were debunked long ago.
 

When Free Riding is Good

Frowned on Free Riding

 

 

Ditto

 

Free riding often reduces economic welfare by discouraging the production of public or collective goods.  A classic example is national defense.  If one individual invests resources in defending the nation from invasion, others will reap the benefits without contributing anything to such defense, thus free riding upon the first individual's investments.  If all individuals reason this way, none will invest in national defense, as each individual hangs back and waits for others to do so instead.  As a result, and because of this free riding, a private market will not produce an optimal level of national defense, that is, will not induce some investments in such defense that are cost-justified.  In these circumstances, only coercion by the State or other central authority can raise and expend the resources necessary to produce an optimal level of such defense.

Advertising and promotion by retailers provides a more mundane example.  Assume that a manufacturer sells its product to numerous independent dealers that serve the same base of customers.  Like individual expenditures on national defense, advertising expenditures by individual dealers will benefit several dealers, each of whom might benefit some from enhanced consumer interest in the product.   Like national defense, then, promotion and advertising of the good in question will be beset by free riding, as each dealer hangs back, hoping that other dealers will educate consumers, consumers that the shirking dealer who incurs no advertising expenses can attract with cut rate prices.   Various contractual arrangements known as intrabrand restraints can overcome this market failure and encourage more optimal levels and types of promotion and advertising, increasing the nation's output.  

 

However, a case currently before the U.S. Supreme Court illustrates how free riding can actually be good and how regulation designed to reduce such free riding can thus reduce society's economic welfare.  The case in question is Harris v. Quinn, No. 11-681.  (Go here for a collection of the briefs.) In Harris several individuals who provide in-home care for disabled persons, usually family members, are challenging an Illinois law that treats such individuals as employees of the State and coerces them to provide financial support to a union of public employees they do not wish to join.  Between 1985 and 2003, Illinois law sensibly provided that such individuals were not state employees at all, but instead independent contractors who provided services to patients whose care was reimbursed by the State.  However, in 2003 then-Governor and now convicted felon Rod Blagojevich, whose mugshot appears above, issued an executive order declaring such individuals to be employees of the State of Illinois.  (It should be noted that Mr. Blagojevich has appealed his conviction.)   The order paved the way for the unionization of thousands of such workers by a union that had contributed hundreds of thousands of dollars to Mr. Blagojevich's campaign.    The petitioners have declined to join this union, which has sought to compel them to contribute their "fair share" to the union's coffers.  The petitioners object to subsidizing an organization that will, under the aegis of collective bargaining, advocate higher government spending contrary to their political beliefs.
 

Illinois concedes that the First Amendment precludes it from forcing individuals, including union members, to support a union's political speech.   See Knox v. SEIU Local 1000, 132 S. Ct. 2277 (2012); Abood v. Detroit Board of Education, 431 U.S. 209 (1977).  However, it claims, with some support in Supreme Court precedent, that it may nonetheless compel non-union employees to provide financial support to subsidize a union's collective bargaining activities over wages, working conditions and the like.  While recognizing that such compulsion interferes with the liberty of non-union employees, the State nonetheless claims that such compulsion serves a "vital interest."  That is, Illinois contends that such coercion will prevent  "free riding" by employees who purportedly derive benefits from collective bargaining in the form of higher pay and enhanced benefits whether or not they pay fees to subsidize such bargaining.  (See pp. 45-48 of the State's brief, here.)

Illinois may well be correct that allowing employees to opt out of support for collective bargaining will result in free riding and thus smaller investments in collective bargaining and reduced wages and benefits.  Indeed, allowing such opt-outs could undermine collective bargaining altogether, as more and more employees realize they can decline to contribute to the union.   However, such a demonstration would not itself establish the wisdom of the coercion the State seeks to defend.  After all, some free riding increases the nation's welfare and thus should be encouraged.  Imagine, for instance, that the  Congress is considering new legislation that will prevent inefficient pollution.  Imagine further that the affected industries are fragmented and unable to organize effective opposition to the proposed legislation, because of free riding by the industry's firms on each other's lobbying efforts.  Such free riding will increase the nation's welfare by dampening opposition to beneficial legislation.
 

Shaky cartels provide another example of beneficial free riding.  Assume that an  industry's firms have entered a collusive agreement or engaged in tacit coordination that requires each firm to reduce its output 15 percent below what each would produce in a competitive market.  Judge Elbert Henry Gary, pictured above, famously orchestrated just such an arrangement between U.S. Steel and the rest of the steel industry early in the 20th century via so-called "Gary Dinners."  It is, of course, in the industry's collective interest for each firm to maintain that output reduction, thereby increasing prices above the competitive level and enhancing each firm's profits.  At the same time, each firm will have an individual incentive to cheat on the arrangement, secretly discounting its product slightly below the cartel price and increasing output, thereby taking advantage of the cartel price.

Such cheating is a form of free riding, as it depends upon an assumption that other firms are adhering to the agreement and thus maintaining output below and prices above the competitive level.  While such free riding will reduce the welfare of the industry by undermining collective output reduction, society should applaud this behavior, which will increase output, enhance the allocation of resources and increase society's economic welfare.

The example of the steel cartel sheds important light upon the social consequences of the sort of free riding Illinois is trying to stamp out.  According to Nobel Laureate George Stigler, and as previously noted on this blog, labor unions are simply cartels of employees.  George J. Stigler, The Theory of Price, 279 (4th Ed. 1987) ("The labor union is for the labor market the equivalent of the cartel for the product market.").    Moreover, unlike the steel cartel discussed above, labor cartels known as unions are perfectly lawful and thus more stable than cartels in the product market.  Indeed, the National Labor Relations Act, which the Supreme Court upheld in 1937, compels private employers to bargain with such cartels against their will.  As previously explained on this blog, such cartels deepened and lengthened the Great Depression and distort the allocation of human capital in the labor market by inducing firms to substitute capital for labor.  Given these anti-social consequences of unionization, wise public policy would encourage, and not discourage, free riding, for the same reasons that society would applaud free riding by members of a steel cartel and without regard to whether the prevention of "free riding" is a "vital interest" within the meaning of the Court's free speech jurisprudence.  A ruling that the Illinois scheme violates the First Amendment would thus have the incidental effect of encouraging such free riding and increasing the nation's welfare.


 

 

A Geography Lesson for Bob Dylan and Fiat

Both Made in America

Not Exactly

Chrysler's Super Bowl commercial featuring Bob Dylan has generated significant controversy, with some claiming that Dylan "sold out" and compromised his anti-establishment principles by accepting money to sell automobiles.   (See here, here, here and here for stories or commentary on the topic.)  (John Mellencamp, it should be noted, spurred analogous controversy when he licensed his superb song "Our Country," to Chevrolet, which featured portions of the song prominently in several advertisements for its trucks.)  Perhaps because I am not an expert on Mr. Dylan's principles, this blogger found the content of the advertisement more intriguing and perhaps more controversial.  In particular, the advertisement, which began by asking "is there anything more American than America ?" was a straightforward and well-conceived argument that Americans should buy purported American cars, particularly Chryslers.  A self-described "obsessive Bob Dylan fan" blogging for the Washington Post put it quite well:  "Dylan [was] telling us, in as many words — America rules. Buy an American car. Specifically, buy this Chrysler." 

The advertisement is thus intriguing because Chrysler is, for all intents and purposes, an Italian company.  For more than two years now, Fiat, has owned a majority interest in Chrysler, an arrangement the United States encouraged pursuant to the ill-advised bailout of the failed and defunct firm in 2009.  (See also here.)    Moreover, in early January of this year, Fiat announced that it had purchased the remainder of Chrysler from the United Auto Workers.  Apparently unbeknownst to Mr. Dylan, Fiat is headquartered in Turin (Italy, not Georgia) and also incorporated in Italy.  The firm recently announced that it will declare the United Kingdom as its seat for tax purposes.  In short, Chrysler is no more an American company than, say, Volkswagen Group of America.  The latter, while incorporated in New Jersey and headquartered in Virginia, is a wholly-owned subsidiary of the Volkswagen Group,  incorporated and headquartered in Germany.  To be sure, Fiat still manufactures automobiles in the United States that display the Chrysler trademark. However, like many other foreign manufacturers, Volkswagen also produces automobiles in the United States, including at a billion dollar plant in Chattanooga, Tennessee that employs 3,200 Americans.  (Is there anything more American than Chattanooga?)  Would such cars suddenly become "American" if Volkswagen renamed them for a now defunct American company, e.g., Studebaker or Checker?  If not, then Chryslers are no more "American" than Volkswagens.  If so, then any company that manufactures cars via a wholly-owned subsidiary in the USA can characterize their cars as "American" and appeal to consumers' patriotism as Chrysler has done.  Perhaps next year's Super Bowl will feature several similar commercials touting the virtue of "American" automobile companies such as Toyota (which manufacturers cars in Kentucky), Honda (which manufacturers cars in Indiana), and BMW (which manufactures cars in South Carolina), to name just a few. 

This blogger hastens to add that he is a big fan of free trade and would gladly buy a Fiat, for instance, if such a car otherwise satisfied his needs at a reasonable price.  Moreover, in a free society, individuals should feel completely at liberty to purchase cars wherever they are made and without arbitrary interference by the State.  Such freedom includes the freedom to confine one's purchases to "American" cars out of a sense of patriotism or obligation to one's fellow citizens who own American companies and work for them.  To make such choices, however, Americans and citizens of other nations need accurate information about the nationality of the companies from which they purchase.   Dylan's "Chrysler" commercial will likely do more to confuse such consumers than inform them.