Dani and Milton

I respect Dani’s essay re-evaluating Milton Friedman’s legacy but I’d like to comment on this specific Rodrik quote;  “But Friedman also produced a less felicitous legacy. In his zeal to promote the power of markets, he drew too sharp a distinction between the market and the state. In effect, he presented government as the enemy of the market.”

When government “grows big”, too many strategic game theoretic issues arise as firms spend too much time lobbying for favors from government. I get grossed out when I hear that companies are moving their headquarters to Washington D.C.    Is that a “productive place” to be headquartered?

Economists love our perfect competition model and wish that capitalism would reorganize itself such all firms and consumers are “small price takers”.  The pricing mechanism sends signals of scarcity and self interested individuals and firms respond to these incentives.    Government is not “small” and thus when it gets involved issues of “game theory” arise.  There would be no “too big to fail” if government could commit to a rule of no bailouts of failed companies.  Part of Friedman’s worldview was embracing “rules over discretion”.     The “right companies” will grow big in competition but connected firms will be more likely to thrive when an active “big” government is calling the shots.  Would these “big companies” then have “monopoly power”?  No, as Microsoft and Detroit have both learned — you have to keep raising your game as new products will challenge your dominant market position.

Friedman believed in the power of competition in every market to protect us and to allow us to collectively achieve our diverse individual desires.  Steve Jobs grew rich by dreaming up and designing great products.   But, Steve Jobs is a pinch of a rarity.   Around the world, many individuals grow rich because of their ties to politicians who can hand them a gold mine or other favors.  This rent seeking has pernicious long run effects for growth.   Without growth, there is no freedom for the 7 billion people on the planet.

Friedman did care about the poor.  His support for the Negative Income Tax would have raised the poor’s standard of living without distorting the work incentive (the Earned Income Tax Credit is a cousin).  Don’t call Friedman cruel and don’t call him naive!

I recognize that in the real world that government has substantial discretion over what it does. It doesn’t follow “rules” such as a 3% money supply growth rule. Bernanke has a lot of discretion!   But, we don’t know what is the goal of government.  What is this diverse organization trying to achieve, what discretion does it have? Who self selects to enter it and how are they incentivized to do their job while serving?  Firms are much easier objects to understand. They seek to maximize profit.   Very hard game theory issues arise when you don’t allow Milton Friedman’s vision to be reality.  We don’t really understand how capitalism plays out when you have small firms and consumers and you have a resource rich government that can offer favors and regulatory protections to a subset of favored firms and consumers.    This is why the field of political economy is  such an exciting field today. 

 

 

Author: Matthew E. Kahn

Professor of Economics at UCLA.

26 thoughts on “Dani and Milton”

  1. Living in metro DC, it has been fun to have the city get zippy around me. The old John Kennedy line “a city with Southern efficiency and Northern charm” is long gone. Better produce, nicer restaurants, reasonable performance scene. The art scene is still more looking at museums, rather than people doing art. Corporate headquarters have been moving here in fairly large numbers, transparently because this is the best location to seek rent. What’s nice for me is not what’s good for the country, though; I agree that it was better for the country when this was something of a backwater and ambitious young persons went to New York, or LA, or Cleveland.

  2. “Firms are much easier objects to understand. They seek to maximize profit. ”

    In view of the name of this blog, don’t you think it would be a good idea to list some of the conditions necessary for this to hold in the real world?

    Principal-agent considerations, especially when the principals — shareholders — have (a) limited voice over decisions and (a) limited information relevant to important decisions would be one place to start.

    Another might be the massive misalignment of incentives for agents (which they often determine themselves): consider,in the last decade, those for employees of IBs and mortgage-issuing firms that contributed heavily to the financial crisis. Post-dating options comes to immediately mind, as do bonuses based on volume of mortgages issued, with little concern for quality of the mortgage. I’m sure others can rattle off additional examples, and additional problems with the statement.

    Pangloss, or a panglossian view of markets, gets us nowhere.

  3. What Marcel said. And wait, there’s more!

    The Milton Friedman formula was “firms should seek to maximize profit under the constraints of the law.” Given efficient breach theory, this is a license for doing whatever you can get away with. And the law, of course, is endogenous to firms’ profit-seeking goals.

    So in the course of maximizing profits, firms violate rules and suborn governments. Such firms are not very easy to understand. There is little transparency about the rules for efficient rule-violation, and tremendous endogeneity about the mechanisms of competitive subornation.

  4. I’m also an economist, and I also admire the power of the model of perfect competiton. What troubles me, however, is when we move from using a model to understand how an economy operates (and, yes, we can still use the perfect competition model to do that–here’s a “base case;” how does reality differ from that?) to glorifying a model as a template for how an economy *ought to* operate. Which is, I’m afraid, what both Friedman and, in this post, Matthew Kahn have done.

    Perfect competiton does not exist, and has never existed. In the absence of a government with significant powers, it will not exist, and, indeed, the economy in a state of no government is (in my opinion) likely to wind up further from the economy as modeled by the perfect competation framework than is the economy in our current reality. What Friedman sought, it seems to me, was a government that would–and could–commit itself to a set of rules that he preferred and never change them (except, perhaps, in ways he would have approved of). In short, I would argue, he wished to substitute his preferences for those of others, which is an approach, and an attitude, that is inconsistent with his model of the economy.

  5. Wow a string of bad assumptions from an economist! People are not rational and neither are firms so the basis of Friedman’s clean economic theory is fantasy. He is naive because he believed his ideas had anything to do with reality, not because he dreamed up a neat solution to a poor set of assumptions. Regulatory capture is a problem, I agree, but rent seeking doesn’t begin or end with the government. Mortgage based rent seeking was totally unregulated and look how awesome that did.

  6. Big whoop, politicians aren’t altruists, either, and that makes a hash of most political theories, and pretty much all of them on the left. When the left finally comes to grip with public choice theory, they’ll be in a position to complain about economists who assume people are rational.

    1. “Other people have proposed other ideas about other things that are also wrong, so we shouldn’t worry about a pervasive and destructive economic philosophy.” That is your response? Note that I have not claimed that big government (as it is used in this post by Matt) is good, but simply that Friedman’s analysis isn’t relevant in the real world.

    2. Brett,
      “So’s your mama” might be considered effective discourse on a junior high school playground. We have slightly higher standards on this comment thread.

  7. I think it’s important to remember what economists mean by rational. “Rational,” to economists, does not mean “reasonable.” It means that decision-makers have goals, and they make the decisions that they expect (rightly *or wrongly*) will lead to their achieving those goals. Without any regard for what the goals are. Or whether a “easaonable” person would do that. So economists can speak, without contradiction, about “rational addiction” (see: Gary Becker). that’s a (maybe another) reason to take what economists say with some reservations.

  8. There would be no “too big to fail” if government could commit to a rule of no bailouts of failed companies.

    This post deserves some kind of prize for the sheer number of unwarranted assumptions, but this one is my favorite. I think everybody understood that there was an implicit government guarantee behind Fannie and Freddie, so there was potential for moral hazard there, but what about AIG? How was its behavior influenced by anticipating a government bailout that 1.)was by no means certain ex ante and 2.) didn’t really do much to bail out the actual actors behind the collapse?

    How does Lehman fit into this scenario? Not only was no bailout anticipated, but no bailout actually took place. I wonder how “bailed out” Merrill Lynch and Bear Stearns shareholders, executives and employees felt – yet their behavior was just as destructive as Lehman’s. Countrywide? Golden West/Wachovia?

    One of the very dangerous things about modern conservatism is that even its alleged intellectuals have simply stopped thinking.

  9. Don’t call Friedman cruel and don’t call him naive!

    Friedman believed, as Ebeneezer said, that “firms should seek to maximize profit under the constraints of the law.” He thought that that was their moral obligation.

    So imagine a firm that operates a factory in some place with loose or non-existent environmental laws. The factory can legally just dump its wastes into the river, killing the fish and making the water undrinkable. Or, at some expense, it can install equipment to treat its wastes in a safe fashion. Per Friedman, as I read this proposition, it would be wrong for the firm to spend money on the equipment. Better that it damage the health and livelihoods of those downstream, because that, after all, maximizes profits legally.

    Not cruel?

    1. Better yet, imagine a firm that spends its money, um, supporting legislators who agree to weaken existing environmental or worker-safety laws, or to put constraints on the court system that make it more difficult for those who are injured by its actions to get recompense. It’s the firm’s moral duty, as long as such behavior is legal and cheaper than obeying the existing laws, to change the regulatory regime in its own favor.

      This example, by the way, also calls into question Kahn’s original assertions about the problem being that the government is “too big” a player. As long as there is any law whatsoever prohibiting some deliberate injury of less-powerful third parties in pursuit of profit, or allowing them reasonable access to courts to get recompense for such injuries, there will be a financial incentive — and hence under simplified Friedman a moral imperative — for companies to treat with the government to get that law altered in their favor.

      1. Paul,

        Good point.

        To take it a step further, suppose there are no relevant laws in place, and some are proposed. Now the firm should act politically to stop these bills from passing. If the firm succeeds, then it has been handed just as much of a favor as the firm granted some sort of special concession. Maybe using influence to stop the government from acting could be seen as “rent-seeking” just as much as inducing it to act. The rents after all impose costs on society in either case.

        1. True. So it pretty much follows that any government bigger than a basement-dwelling libertarian’s ideal of a few courts, a few police officers and a tiny-but-preternaturally-effective army is “too big”.

      2. Ok, now imagine a politician who spends his power promoting legislation which will hurt certain industries or firms, and then offers to relent if they give him money.

        Seriously, you see money going one way, and legislation going the other, and it never occurs to you that you could be witnessing a shakedown as often as you’re witnessing bribery?

        1. And that matters how to the point that the size of government is irrelevant to the idea that corporatons claim to be morally obliged to capture it?

  10. Anyone who thinks “too big to fail” is a product of government guarantees needs to think a little bit more about the agency problem, and about what kinds of private mechanisms you would need to constrain traders and managers from taking on more risks than their shareholders or lenders could handle. And remember, your mechanism has to work all the time, not merely “with notably rare exceptions”.

    1. Anyone who thinks “too big to fail” is a product of government guarantees needs to think

      You coulda stopped right there.

  11. There would be no “too big to fail” if government could commit to a rule of no bailouts of failed companies.

    This misses the point. A TBTF company should not be defined simply as one the government decides to bail out. It should be defined as one whose failure would have large negative effects on the economy. So a company TBTF is one where a bailout is the better of two unattractive choices. So I don’t think that your rule really eliminates the problem.

    1. As it happens, we visited this very area last summer. I had no idea of the history behind the sight of the huge stack. This is a wonderful article, very much worth reading, and I thank you for the link.

  12. politicalfootball says:

    “There would be no “too big to fail” if government could commit to a rule of no bailouts of failed companies.

    This post deserves some kind of prize for the sheer number of unwarranted assumptions, but this one is my favorite.”

    Once there are large corporations, whose failure could be catastrophic, either politicians do a bailout, or we have regular catastrophes.

    Now, in a certain sense, crashing the economy in an undeniable way in October-November 2008 would have had certain advantages. We could have purged all Republicans from the government, and could have guillotined Wall St. And Chicago, AEI/CEI/CATO/Heritage/Hoover/Manhattan/George Marshall/WSJ, George Mason, and a number of other intellectual br*thels.

  13. Barry,

    Once there are large corporations, whose failure could be catastrophic, either politicians do a bailout, or we have regular catastrophes.

    Exactly right. TBTF is not a government policy. It is a characteristic of certain types of corporations.

  14. Barry, Byomtov – I keep trying to work out how someone educated in economics can say something so plainly contradicted by reality. Am I reading him uncharitably. Here’s how he starts that paragraph:

    Economists love our perfect competition model and wish that capitalism would reorganize itself such all firms and consumers are “small price takers”.

    This could be read to say that economists have a preference for the perfect competition model that, alas, is too simple for some circumstances and can lead one to false conclusions like “There would be no ‘too big to fail’ if government could commit to a rule of no bailouts of failed companies.”

    Is that a plausible reading? It doesn’t seem to be, because Kahn then goes on to praise Friedman for believing “in the power of competition in every market to protect us and to allow us to collectively achieve our diverse individual desires.”

    Had I not read Kahn previously on this blog, I’d be compelled to assume he couldn’t possibly be this silly. Is there some reading of this post that doesn’t render it nonsensical? I can’t find it.

  15. The solution is simple. Economists can have their competition if we let companies, no matter what the size, fail, thus making sure that survival of the fittest brings about market competition. We can however bailout the faultless employees by supporting them until they find new jobs. This creates an atmosphere where the economy decides which businesses rise and fall but the government ensures that we don’t enter a demand shortfall through massive unemployment or loss of personal spending.

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