Is the Free Market Broken? Hardly.

Wants to Fix What's Not Broken

Senator Elizabeth Warren (pictured above) has convinced herself that the free market is "broken," thereby justifying intrusive and coercive regulation to fix market outcomes.  According to this article, the Senator has offered three examples of such disrepair: (1) student debt (apparently including both the amount of debt and the interest rates that students pay), (2) wages that are in some cases lower than necessary to support a family, large or small and (3) insufficient financial regulation.  She would have the national government repair the market by, for instance, coercively raising the minimum wage and lowering student loan interest rates to the rate that the Federal Reserve charges individual banks.   (See here and here)  This rate, the so-called "discount rate," is less than one percent. (See here).     Senator Warren's indictment of the free market does not withstand scrutiny and reflects confusion about the proper objectives of this critical social institution.  As will be seen, it will be useful to compare her views regarding the appropriate objectives of the market with those of Frank Knight, one of the most influential and thoughtful economists of the 20th Century. 

1. What Americans call "the market" is a social institution that depends upon various background legal rules, particularly private property, free contract and legal prohibitions on fraud and duress. Frank Knight ably described the free market system as follows:

"Ours is a system of 'private property,' 'free competition,' and 'contract.'  This means that every productive resource or agent, including labor power, typically 'belongs' to some person who is free within the legal conditions of marketing, to get what he can out of its use."

See Frank H. Knight, The Economic Organization, 11 (1951).

2. Any critique of a social institution must begin by identifying a plausible set of objectives society expects the institution to achieve. For instance, while society can (and should) expect its system of education to produce a literate populace, it cannot expect that system to produce a safe and abundant food supply.  Thus, while proof that many high school graduates cannot read or write would indict the educational system, proof that many people go hungry would not.

3. In the same way, any critique of the free market must begin by specifying the objectives that society legitimately expects the market to achieve.  Does society expect the market to defend the nation from foreign attack?  Eliminate cruelty to animals?  Prevent the spread of infectious disease? If the answer to any of these questions is "yes," the market is "broken," and coercive regulatory intervention is appropriate.  But of course, no rational society would expect the free market as such (as opposed to other social institutions), to achieve any of these objectives.  

4. What, then, can society properly ask of free markets? Frank Knight would have answered the question as follows: society should expect markets to allocate resources (including labor) and organize production efficiently so as to maximize the amount of "want satisfaction" that consumers derive from society's given endowment of resources and know how.  See generally Knight, The Economic Organization, at 9-10.   A secondary but related objective involves assuring what Knight calls "economic maintenance and progress."  See id. at 12-14.  In particular, a well-functioning market will ensure optimal allocation of resources toward capital investment (including investments in human capital) and technological progress.   In the medium and longer run, such investments can enhance the nation's overall productivity and thus its ability to produce goods and services that provide want satisfaction. 

5.  Of course, free markets sometimes fail to maximize such want satisfaction and/or ensure optimal capital investment and technological progress.  For instance, transaction costs can prevent voluntary private bargains from allocating resources to their highest valued use.  The classic example involves an activity that imposes costs --- what economists call "negative externalities" --- on individuals who are not parties to a given transaction.  The result can be be overproduction by the industry in question and thus overuse of resources that would produce more social value elsewhere.  Even the most dedicated adherents to laissez faire have long recognized that governments should intervene to correct such market failures and that such intervention should include, if necessary, coercive restrictions on output.  Moreover, high transaction costs can also result in positive externalities.  For instance, bargaining and information costs may prevent individuals contemplating investments in technological innovation from identifying and securing remuneration from other individuals who might reap the benefits of such investments.  Here again, some coercive intervention in the market, such as the creation of patent rights, might be necessary to ensure adequate investment in the creation of new technology and thus optimal increases in national productivity.

6.  None of Senator Warren's examples qualifies as a manifestation of market failure that somehow suggests that the free market is "broken" and thus ripe for coercive interference.  Take the minimum wage first.  Labor is an input in the production of goods and services, and firms purchase this input in the market, in the same way they purchase other inputs such as steel, electricity or bread.  The wage is simply the price for labor, a price determined by conditions of supply and demand.

It is certainly true that free market determination of the price of labor sometimes results in wages insufficient to support an average-size family.  In the same way, prices for other inputs may be insufficient to guarantee any profit whatsoever to the owners of firms that produce such inputs.  A company that makes and sells high quality steel to automobile companies will earn negative profits and fail if automobile companies forgo steel for aluminum, for instance.  In such cases, the wages of some steel workers will fall to zero as steel companies cease to employ them.  To be sure, one can imagine situations in which such low wages reflect a market failure resulting from an employer's status as the dominant purchaser of labor in a particular market. However, the Senator's proposal to raise the minimum wage would apply to all employment relationships, including those in markets that are competitive, as most labor markets are. Far from exemplifying a broken market, wages in competitive markets reflect a well-functioning economic system at work performing its social function of allocating resources to their most efficient use. Society may in some cases view the resulting wages as unjust, either because they are too high or too low,  Indeed, employers may pay wages as low as the market will bear so as to increase their own share of the fruits of productive activity. However, coercive regulation setting different wages than those set by the market will undermine the market's chief virtue, namely, encouraging the economic actors to organize and allocate productive resources, including labor, in the most useful way possible. Here again Frank Knight is persuasive:

"It is assumed . . . that there is in some effective sense a real positive connection between the productive contribution made by any productive agent and the remuneration which its 'owner' can secure for its use.  Hence, this remuneration (a distributive share) and the wish to make it as large as possible, constitute the chief reliance of society for an incentive to place the agency into use in the general productive system in such a way as to make it as productive as possible.  The strongest argument in favor of such a system as ours is the contention that this direct, selfish motive is the only dependable method, or at least the best method, for guaranteeing that productive forces will be organized and worked efficiently."

See Knight, Economic Organization, at 11-12.

Ironically, then, Senator Warren's proposed "fix," state-determined wages, would itself injure the market and reduce the amount of wealth this critical social institution generates.

None of this is to say that society must stand idly by while some hardworking citizens earn only poverty wages.  On the contrary, there is one obvious method for alleviating such poverty, viz., the earned income tax credit, previously discussed on this blog.  By subsidizing wages, the EITC both makes hard work pay off and avoids the job-destroying impact of the minimum wage. It is thus no surprise that thoughtful experts such as Christina Romer, who once chaired President Obama's Council of Economic Advisors, have advocated the measure as an alternative to the minimum wage. This blogger has previously called on Congress to expand the availability of the EITC.

Of course, governments must find resources to pay for this subsidy. During a recession, governments that embrace the Keynesian economic paradigm can borrow unused private savings and spend the proceeds on a more robust EITC.   If the economy is near full employment, however, such a "borrow and spend" approach can be inflationary, with the result that governments should find the revenues for wage subsidies by cutting spending elsewhere and/or raising taxes.  One obvious source of such funds would be a tax on carbon  emissions.  As previously explained on this blog, such a tax would discourage pollution creating activity while generate revenue.  In this way society can have the best of both worlds:  a free market that generates as much wealth as possible and spending policies that reward work and alleviate poverty.
   
7.  What about the current system of students loans and resulting student debt and interest payments? Here again, the current system on financing higher education, including the student loan system, is not evidence that the marker is "broken." To be sure, a purely private market will produce insufficient investments in human capital, including higher education.  As previously explained on this blog:

 “The background legal framework prevents individuals who invest in education from granting creditors a security interest in their most valuable asset, namely, the human capital that a college education creates.  A creditor cannot “foreclose” on an individual’s college degree if the borrower defaults on a student loan.”

Moreover, as the same post also explained, state and federal income taxes, which combined produce top marginal rates of nearly 50 percent in some states (and more than 50 percent in California), prevent individuals from internalizing the full benefits of such investments.  As a result, individuals will generally under invest in human capital, even if lenders can perfectly assess the ability of such borrowers to repay and assure repayment when borrowers are able.  The state can respond to this under-investment in various ways, including by founding public universities that charge tuition that is far lower than the cost of the education provided, as every state does. (States could also, of course, provide college-age students with vouchers that students could spend at any qualifying institution, public or private.)  At the University of Virginia, for instance, full tuition covers just 52 percent of the cost of educating an in-state undergraduate student,    Indeed, some private and public universities do not charge tuition, fees or room and board to students from low income families. Some of these same schools provide significant discounts to middle class students as well.  To be sure, a significant proportion (far less than half) of America's students emerge from college with some debt; the average amount equals the cost of a new minivan.  To be sure, a subset of this subset of students graduates with significantly more debt than the average.  However, given the availability of below-cost public education and need-based financial aid, it stands to reason that some (though not all) students who emerge from college with larger than average debt loads voluntarily chose to attend relatively expensive universities in lieu of more modestly-priced options.  It's not clear why such voluntary decisions are evidence of market failure that calls for intervention by the national government.

As previously explained on this blog, government subsidized student loans can also be part of the response to the sort of market failure that results in under-investment in human capital.  Such loans, already provided at below-market rates, further subsidize investments in human capital.  Indeed, under recent reforms, many student loan payments are capped at a percentage of the debtor's income, still further reducing the actual cost of borrowing.  Some borrowers are even eligible for complete loan forgiveness if such capped payments do not suffice to pay off the loan over 20 years.

So far as this blogger is aware, Senator Warren has not explained why the one-two-three punch of (1) below-cost tuition at the nation's public universities, (2) below market interest rates and (3) income-based repayment and possible forgiveness does not suffice to counteract the unfettered market's admitted tendency to produce insufficient investments in human capital.  The existence of a market failure does not justify the adoption of every conceivable policy response to that failure.  Her own proposal --- interest rates of less than one percent for long term student loans already subject to repayment caps and possible forgiveness --- could, when combined with numerous other subsidies for such investments, result in the allocation of too much scarce capital to investments in human capital, further increasing demand for higher education and exacerbating increases in tuition.  Here again, Senator Warren has not made the case that the market, supplemented by public universities and the current system of student loans, is in need of further repair.

8.  What, though, about financial markets?  Surely insufficient federal regulation resulted in the financial crisis and resulting recession in 2008, thereby establishing that the free market is "broken" and in need of additional intrusive regulation,  Here again the Senator has not made her case.  After all, the financial system extant in 2008 hardly exemplified the free market in action. Instead, the national government had intervened in financial markets in various ways that predictably caused market failure and distorted market outcomes.  For instance, the nation's policy of "too big to fail" resulted in dangerous moral hazard, as large banks did not internalize the potential downside of risky investments.  Banks quite predictably made non-optimal investments as a result.  Moreover, the national government encouraged lenders to develop financial products (e.g., no money down mortgages) that extended credit to individuals that did not meet traditional lending standards.  Banks were all too happy to extend such credit, knowing that they could immediately resell many mortgages to the Federal National Mortgage Association (FNMA), which was itself deemed "too big to fail" and thus lacked adequate incentives to examine the quality of mortgages it purchased.  The FNMA, in turn, would either hold these mortgages itself or guarantee their repayment and use them as backing for so-called "mortgage backed securities" that it issued.  (See here for a description of the mechanics of the FNMA's role in the mortgage market.)  Regulators encouraged banks to hold these securities to satisfy capital reserve requirements, even in lieu of other securities.  While federal regulations required banks to hold $4 in high quality reserves (e.g., U.S government bonds) for every $100 in lending, banks could avoid this requirement by holding $1.60 in mortgage-backed securities instead, thereby signaling the national government's confidence in the FNMA's guarantee of the mortgages that backed these securities. Little wonder, then, that, according to this same source, banks held half the outstanding debt backed by sub-prime loans when the financial crisis broke out.  Simply put, the 2008 financial markets were rife with various forms of federal intervention and involvement that produced market failure, moral hazard and also set the table for the 2008 financial crisis.  That crisis hardly qualifies as evidence that the market is broken.

9.   In sum, free markets have great potential but they also have limits.  Critics must take care lest they attribute to markets objectives they cannot plausibly achieve.  To be sure, transaction costs sometimes result in market failure, including negative or positive externalities.  In such cases, society properly steps in with coercive regulation to correct such failure.  However, failure to achieve distributive justice is not a shortcoming of markets.  On the contrary, markets produce the very wealth that its opponents wish to redistribute, and society can employ taxation to redistribute income for social justice purposes.  Moreover, the presence of some market failure does not thereby justify the simultaneous adoption of every imaginable policy response.  Finally, markets sometimes "fail" because ill-considered regulation or other forms of state intervention distort private incentives and thus induce market actors to engage in wealth-reducing economic activity.  Such state-induced market failure is hardly a justification for even more coercive regulatory intervention. 

"Right to Work" is no Misnomer

Half Right

Did Not Volunteer For This

As previously explained on this blog, so-called "right to work" laws ban collective bargaining agreements that require all employees, under threat of termination, either to join a union or, in the alternative, pay union dues pursuant to so-called "agency security agreements."  The 1947 Taft-Hartley empowered states to pass such bans, thereby repealing that portion of the 1935 National Labor Relations Act that had empowered firms and unions to negotiate so-called closed shop agreements that required individuals to join a union as a condition of employment at the firm governed by the collective bargaining agreement.   As discussed earlier this week, Michigan recently joined Indiana as a "right to work" state.

Over at the Washington Post, Ezra Klein takes issue with the term "right-to-work," claiming that laws like those recently passed in Michigan protect no such thing.  As Klein points out, employers impose all sorts of contractual requirements on employees, including dress codes, bans on employees working for a competitor, and even regulations governing what employees may or may not tweet.  If an employee violates these terms, Klein says, a firm can fire the offending employee, and no one would claim that such termination violates the employee's "right to work."  After all, Klein says, the employee agreed to such terms when she accepted employment.  If he or she does not like them she can exercise her "right to work" elsewhere.  In the same way, Klein says, closed shop or agency shop agreements are simply contractual terms to which individuals have agreed by going to work for a unionized firm.  Thus, he concludes, the term "right to work" is a misnomer; no one has a "right to work" at a firm while ignoring contractually-imposed working conditions.

On the one hand, Klein's argument contains a refreshing articulation and defense of the right to enter and enforce contracts in a free society.   He is absolutely right that society should generally respect and enforce agreements between employers and employees over the terms of employment.  He is also right to point out that terminating an employee for breaching such a freely-entered contractual provision does not offend the employee's "right to work."  Individuals hold "rights" against the government, and not against other private individuals or firms to whom they have made voluntary contractual promises.   In the same way, an individual who voluntarily agrees not to criticize his employer as a condition of employment cannot invoke the First Amendment (the "right to speak") when fired for tweeting disparaging comments.   Ditto for an employee who voluntarily works for a firm that does not provide the exact form of health insurance the individual desires.  Those who argue to the contrary confuse "freedom" with "power."   The "right to work" or "freedom" does not grant an individual the power force employers to hire an employee on the latter's unilateral terms.

Klein goes astray, however, when he analogizes garden variety contractual provisions such as dress codes to closed shop and agency shop agreements.  This analogy fails for two independent reasons.

First, while firms impose and enforce dress codes and similar provisions voluntarily, the same cannot be said for collective bargaining agreements.  Many firms have no desire to enter such agreements in the first place, but federal law gives them no choice.  In particular, the National Labor Relations Act, mentioned above, requires firms to retain employees who join or seek to organize unions, whether the firm wants to or not.  Moreover, the Act also bans so-called "yellow dog contracts," that is, agreements whereby an employee agrees not to join a union.  The Supreme Court held that the NLRA is within Congress's Commerce power, even when applied to manufacturing, in NLRB v. Jones and Laughlin Steel, 301 U.S. 1 (1937).   As a result, the institution of collective bargaining very often infringes upon the very freedom of contract that Klein invokes.  Thus, closed shop and agency shop agreements are often the result of State-amplified union power, which impells firms to enter them, and not voluntary contractual agreement.  Such provisions do not amount to the sort of labor-instigated violence dramatized in films such as "On the Waterfront," which called attention to the plight of American workers victimized by their own union.  Nonetheless, such provisions function as a State-imposed tax on the "right" of an employee to choose for whom to work, indistinguishable from a tax on a decision to publish a book, attend a church or write a blog post.  While employees do "volunteer" to abide by dress codes, they do not volunteer to enter agency shop "agreements," any more than Terry Malloy, played by Marlon Brando, volunteered for (much worse) physical abuse at the hands of Johnny Friendly and his thugs.

To be sure, some firms might wish to enter collective bargaining agreements, regardless of federal coercion to do so.  Ironically, however, the mandatory nature of the NLRA makes it impossible to distinguish  (potentially) voluntary from involuntary agreements.

Second, unlike dress codes, collective bargaining agreements impact third parties who are not privy to the agreements.  In particular, such agreements, like other cartel agreements, reduce the output of labor below the competitive level and thus distort the allocation of resources, reducing society's overall output.  Any benefits that union members derive from such agreements are more than offset by the harm that such agreements impose on the rest of society.   Thus, to the extent that agency security agreements, for instance, pad union coffers, the ability to impose such contracts via collective bargaining agreements will increase the payoff from unionization and thus encourage the formation of more cartels.