Regulation Fall 2018

Regulation Th e C at o Re v i e w o f B u s i n e s s a n d G o v e r n m e nt

How Public Lands Became Such Opportunity Costs P. 12 Is “Regulatory Leveraging” Good Governance? P. 22 Is “Common Ownership” of Competing Businesses a Problem? P. 28 FALL 2018 / Vol. 41, No. 3 / $6.95

The Man Behind Trump’s Tariffs Peter Navarro’s puzzling conversion to protectionism

DISPLAY UNTIL JANUARY 1, 2019

Volume 41, Number 3 / Fall 2018

CONTENTS

P. 12

P. 8

8

P. 22

P. 28

F E AT U R E S

D E PA R T M E N T S

LABOR

Briefly Noted

The Regressive Effects of Child-Care Regulations More strenuous requirements raise child-care prices but have little apparent effect on quality.

By Ryan Bourne PUBLIC LANDS

12 The Land of Many Opportunity Costs Constituent-group politics continue to dampen the public benefit from the federal estate.

By Gary D. Libecap S E C U R I T I E S & E XC H A N G E

18 Corporate Governance Oversight and Proxy Advisory Firms Do proxy advisors have too much power?

By Ike Brannon and Jared Whitley R E G U L AT O R Y R E F O R M

22 Be a Shame If Anything Happened to Your Merger…

“Regulatory leveraging” can be a useful tool or it can be an abuse of power.

By William E. Kovacic and David A. Hyman ANTITRUST

28 Calm Down about Common Ownership The evidence of anticompetitive harm from institutional investing is weak and the proposed policy solutions would be more harmful than the supposed problem.

By Thomas A. Lambert and Michael E. Sykuta

02 Trump’s Regulatory Legacy Will Be through Congress, Not Regulators

By Sam Batkins

4

Why Can’t Food Be Genetically Engineered and Organic?

By Henry I. Miller and John J. Cohrssen

In Review 44 Factfulness Review by Phil R. Murray

61 American Default Review by Gary Richardson

46 Bureaucracy in America Review by George Leef

66 How Democracy Ends Review by Pierre Lemieux

48 Political Tribes Review by Dwight R. Lee

68 What Makes a Terrorist Review by David R. Henderson

51 How the Other Half Banks Review by Vern McKinley 53 Blockchain and the Law Review by Greg Kaza 54 The Virtue of Nationalism Review by Pierre Lemieux 57 Free to Choose Medicine Review by Thomas A. Hemphill

70 The Case Against Education Review by Dwight R. Lee 73 Termites of the State Review by Pierre Lemieux 75 Collu$ion Review by Vern McKinley 77 working papers Reviews by Peter Van Doren

COMMERCE & TRADE

36 Peter Navarro’s Conversion The professor has changed and wobbled, but his current protectionist arguments are embraced by the White House and segments of the public.

By Pierre Lemieux

Final Word 80 Regulating All That Is Delightful

By Marni Soupcoff

COVER:

Illustration by Keith Negley

Regulation, 2018, Vol. 41, No. 3 (ISSN 0147-0590). Regulation is published four times a year by the Cato Institute (www.cato.org).

Copyright 2018, Cato Institute. Regulation is available on the Internet at www.cato.org. The one-year subscription rate for an individual is $20; the institutional subscription rate is $40. Subscribe online or by writing to: Regulation, 1000 Massachusetts Avenue NW, Washington, DC 20001.

Please contact Regulation by mail, telephone (202-842-0200), or fax (202-842-3490) for change of address and other subscription correspondence.

2 / Regulation / FALL 2018

Regulation EDITOR

Peter Van Dor en M A N AG I N G E D I TO R

Thomas A. Fir ey D E S I G N A N D L AY O U T

Dav id Her bick Design C I R C U L AT I O N M A N A G E R

Alan Peter son CONTRIBUTING EDITORS

Sam Batkins, Ike Br annon, Art Car den, Thomas A. Hemphill, Dav id R. Hender son, Dw ight R. Lee, George Leef, Pier r e Lemieux, Phil R. Mur r ay EDITORIAL ADVISORY BOARD

Chr istopher C. DeMuth

Distinguished Fellow, Hudson Institute

Susan E. Dudley

Research Professor and Director of the Regulatory Studies Center, George Washington University

William A. Fischel

Professor of Economics, Dartmouth College

H.E. Fr ech III

Professor of Economics, University of California, Santa Barbara

Robert W. Hahn

Professor and Director of Economics, Smith School, Oxford University

Scott E. Harrington

Alan B. Miller Professor, Wharton School, University of Pennsylvania

James J. Heckman

Henry Schultz Distinguished Service Professor of Economics, University of Chicago

Andr ew N. K leit

MICASU Faculty Fellow, Pennsylvania State University

Michael C. Munger

Professor of Political Science, Duke University

Robert H. Nelson

Professor of Public Affairs, University of Maryland

Sam Peltzman

Ralph and Dorothy Keller Distinguished Service Professor Emeritus of Economics, University of Chicago

George L. Pr iest

John M. Olin Professor of Law and Economics, Yale Law School

Paul H. Rubin

Professor of Economics and Law, Emory University

Jane S. Shaw

Board Member, John William Pope Center for Higher Education Policy

R ichar d L. Stroup

Professor Emeritus of Economics, Montana State University

W. K ip Viscusi

University Distinguished Professor of Law, Economics, and Management, Vanderbilt University

R ichar d Wilson

Mallinckrodt Professor of Physics, Harvard University

Cliffor d Winston

Senior Fellow in Economic Studies, Brookings Institution

Benjamin Zycher

John G. Searle Chair, American Enterprise Institute PUBLISHER

Peter Goettler

President and CEO, Cato Institute Regulation was first published in July 1977 “because the extension of regulation is piecemeal, the sources and targets diverse, the language complex and often opaque, and the volume overwhelming.” Regulation is devoted to analyzing the implications of government regulatory policy and its effects on our public and private endeavors.

B R I E F LY N O T E D

Trump’s Regulatory Legacy Will Be through Congress, Not Regulators ✒ BY SAM BATKINS

M

uch has been made of former U.S. Environmental Protection Agency administrator Scott Pruitt’s tenure—not only the scandals, but his deregulatory agenda. Based on press reports, one would think that if President Barack Obama’s EPA finalized a regulation, Pruitt’s EPA tried to undo it.

Despite the public perception that Pruitt and President Trump’s other regulators are working to reverse all that Obama’s regulators implemented, it’s arguable that the only lasting regulatory results of Trump’s time in office so far are products of Capitol Hill: 16 Congressional Review Act (CRA) resolutions of disapproval and modest legislation to amend the 2010 Dodd–Frank Act. There’s no debate that Trump’s deregulatory agenda has resulted in published regulatory savings for the nation. According to the American Action Forum, since 2017, regulators have published nearly 60 final rules that cut costs, including three that would reduce total burdens by more than $1 billion. However, for those to become real savings will require that the changes survive judicial scrutiny, and currently there is a host of lawsuits challenging virtually every major deregulatory action. The EPA alone has lost seven deregulatory attempts in the courts over the last 18 months.

The administration won’t lose every suit, but the president’s deregulatory legacy will be substantially muted by the courts and by Congress if Democrats retake control after this fall’s elections.

Obviously, a new occupant in the White House in 2021 will immediately seek to reverse the deregulatory posture of the Trump administration and his policies SAM BATKINS is director of strategy and research

at Mastercard. The views expressed in this article are his own.

could be an afterthought a decade from now. That’s a far cry from President Ronald Reagan’s record of regulatory reform.

CRA’s second act? / Before 2017, the CRA had only been invoked successfully once, to rescind an ergonomics rule in 2001.

But in less than two years of the Trump administration, 16 regulations have been axed, including five major rules. With total cost savings from CRA rescissions exceeding $4 billion, that’s a legacy of achievement in an environment where costs seemingly increase daily.

What is more noteworthy from a philosophical, partisan, and structural perspective, however, is that both Democrats and Republicans now look to the CRA to address rules from the executive of which they disapprove. Two years ago, some Democrats and progressives argued the CRA was unconstitutional and special interest groups still push for Congress to tie its own hands by repealing the CRA. But every Democrat in the Senate is now on record as wanting to overturn the Federal Communications Commission’s recent net neutrality repeal.

In CRA debates during the first few months of the Trump administration, some progressives were arguing the CRA was merely a cudgel to destroy important health and safety protections. Now Democrats have realized that it can also be a tool to check an executive they don’t like. Those instances will be rare for Democrats, but frequent enough that they might as well

FALL 2018

keep the CRA in play for regulations they view as overly noxious. Why any party in Congress would want to abdicate a powerful statutory check on the executive is a mystery, even if the CRA does have a perceived anti-regulatory bias.

Arguably more important than the bipartisan embrace of the CRA is its new use to revoke regulatory guidance, not just formal regulations. This spring, the Senate narrowly struck down the Consumer Financial Protection Bureau’s (CFPB) 2013 auto-lending guidance, marking the first time the CRA had ever been used to strike

that Congress could strike down guidance, even decades-old guidance, gradually gathered steam, culminating in a Government Accountability Office (GAO) opinion that the CRA could be used to strike down certain past guidance if it had never been submitted to Congress as the statute requires.

With its 51–47 vote on the auto-lending guidance, the Senate established Congress’s ability to review years-old administrative actions, rescind them (with presidential approval or a veto override), and ensure that they may never be reissued “in substantially the same form.” (See “Should We Fear

SAUL LOEB/AFP/GETTY IMAGES

In a February 2017 Oval Office ceremony, President Trump signed House Joint Resolution 41, removing some Dodd–Frank Act restrictions on oil and gas companies.

down a guidance document. The idea of using the CRA in this way was originally raised in a Wall Street Journal op-ed in 2017.

This was dismissed by some conservatives out-of-hand because of widespread skepticism that the CRA could apply to guidance beyond the 60-day legislative window, essentially the last six months of most presidential administrations. Supporters of the notion reminded critics that regulators rarely submit guidance to Congress, which means the 60-day clock doesn’t start ticking. Thanks to a public lobbying campaign by Sen. Pat Toomey (R–PA) and the Pacific Legal Foundation, the idea

‘Zombie’ Regulations?” Summer 2017.) The implications of Congress striking down this little-known CFPB rule will have to be examined further by scholars, but it is a near certainty that even Democrats will avail themselves of this power if they gain control of both chambers of Congress and the West Wing.

Yes, a Democratic president could have his agencies overturn a Trump guidance document, but using the CRA to prevent conservatives from issuing substantially similar guidance in the future is an incredible power that Congress has only begun to exploit. It may not be the talk of the town

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now, but the ability to strike down major regulatory guidance, indeed virtually every action of a president, is a notable shift in the balance of power between the executive and legislative branches. President Trump likely won’t tout this accomplishment as a regulatory landmark, but he should.

Dodd–Frank’s haircut / Finally, although there was intense lobbying in Congress over legislation (S. 2155) to amend Dodd– Frank, more politically salient events in D.C. largely swept this accomplishment under the rug. Although it wasn’t complete Dodd–Frank repeal, it was a notable achievement because of the narrow Republican majority in the Senate. Few probably expected the bill to get 67 votes in the Senate or for 33 Democrats to back the bill in the House. Lawmakers did this knowing they were paring back some of Dodd–Frank’s most notorious provisions: the Volcker Rule, tighter qualified mortgage standards, “Systematically Important Financial Institution” designations for banks with $50 billion in assets, and stress tests for most large banks. The bill essentially exempted many small- and medium-sized banks from Dodd–Frank’s most onerous regulations.

More importantly, Democrats did so in the wake of a publicity assault by Sen. Elizabeth Warren (D–MA) and other progressive groups. Many on the left pilloried Democrats who voted in favor of the regulatory change, arguing they provided a sop to the largest banks in the world, caved in on important financial safeguards, and bent to the will of Republicans and Trump (the more important political point). Warren even raised money off of Democrats who voted for the changes.

A more comprehensive Dodd–Frank reform bill that libertarians and conservatives truly wanted was never going to garner 60 votes in this political environment, much less 67 in the Senate. Nevertheless, it’s a remarkable feat that Democrats like Michael Bennett (D–CO), Jeanne Shaheen (D–NH), and Maggie Hassan (D–NH) voted for the bill when even seemingly noncontroversial under-secretaries struggle to get 52

4 / Regulation / FALL 2018 B R I E F LY N O T E D

confirmation votes in the Senate. Consider that Bennet votes with Trump’s position just 28% of the time according to FiveThirtyEight.com, Shaheen 33%, and Hassan 32%.

Yet, despite their opposition to the president and their perceived willingness not to frustrate fellow Democrats, they still voted to reform Dodd–Frank, albeit modestly.

With the passage of the amendment legislation, Congress did more to reform financial regulation than many perceive.

Volcker rule relief is now permanent for community banks. That might seem somewhat trivial, even as community banks slowly disappear, but just as it took four regulatory agencies years to give life to the rule, so it would take the coordination of those four to deliver substantial relief. This process would take years and could generate more delays through court challenges. Congress managed to provide relief in a few months and overturning the changes won’t be easy for a future Congress. That accomplishment shouldn’t be dismissed as small potatoes. Getting 67 votes on any regulatory reform package is rare, especially when it’s related to Dodd–Frank. Just ask House and Senate leaders how the slogging was on Affordable Care Act repeal.

Conclusion /

In regulatory policy, success can take years. Those gains can then prove fleeting once the next administration takes the reins. President Obama’s regulatory “tsunami” was viewed as one of the largest expansions of the regulatory state since Franklin Delano Roosevelt. Records were broken, entire new agencies were conceived, and—with plenty of progressives on the D.C. Circuit Court of Appeals—many assumed Obama’s regulatory achievements would be a legacy, not an ephemeral blip.

As soon as the Trump administration came to power, his underlings immediately attempted to press the “undo” button on every notable regulation from the past eight years. However, with progressive outrage and courts sometimes standing in the way, lasting progress through administrative action will be slow to achieve. That is why President Trump and fans of deregulation

should give Congress a pat on the back for their unheralded work reforming regulation. From striking down 16 rules to ensuring that Congress can scrutinize and rescind old regulatory guidance, there is a new era in congressional regulatory oversight, one Democrats could one day embrace as well.

The CRA is now entrenched as a tool both parties can use to check the excesses of the executive and his regulators. Congress also managed to produce a substantive, albeit limited, reform of Dodd–Frank.

These reforms delivered a broader constitutional balance between Congress and the president. Now, whenever new guidance

is penned, the executive will have to think twice about the implications for Congress down the road. Even conservative administrations will have to contemplate Democrats gathering the votes on a CRA resolution to strike down an executive action.

On January 20, 2017, few speculated that these achievements could become a reality.

Sure, some regulations would fall, but would Democrats embrace the CRA? Would guidance be up for grabs? Would 67 senators vote to upend parts of Dodd–Frank? One could argue President Trump cemented his regulatory legacy in his first 18 months in office, yet the public took little notice.

Why Can’t Food Be Genetically Engineered and Organic? ✒ BY HENRY I. MILLER AND JOHN J. COHRSSEN

T

he Organic Foods Production Act of 1990 directed the U.S. Department of Agriculture to develop national standards for the production of “organic foods.” The legislation came about because of consumer demand for food that was supposedly more healthful and produced with more sustainable farming methods than

regular commercial farming.

However, the national standards that were ultimately adopted in 2000 do not improve food safety, quality, or nutrition— nor were they intended to. When the final National Organic Standards were issued in 2000, then–agriculture secretary Dan Glickman said: “Let me be clear about one thing: the organic label is a marketing tool. It is not a statement about food safety, nor is ‘organic’ a value judgment about nutrition or quality.” One of his HENRY I. MILLER, a physician and molecular biologist, is a senior fellow with the Pacific Research Institute. He was the founding director of the U.S. Food and Drug Administration’s Office of Biotechnology.

JOHN J. COHRSSEN is an attorney who has served in a number of government posts in the executive and legislative branches of the federal government, including as counsel to the White House Biotechnology Working Group, associate director of the President’s Council on Competitiveness, and counsel for the House Energy and Commerce Committee.

successors, John Block, observed in 2014, “Yet USDA’s own research shows consumers buy higher-priced organic products because they mistakenly believe them safer and more nutritious.”

/ Despite the nonexistent health, safety, or environmental benefits and the higher prices consumers pay for these foods, those consumers often don’t even get the products they’ve been promised.

In a pair of articles last year, the Washington Post’s Peter Whoriskey reported on the apparent false-labeling of supposedly organic foods. In one article, he tracked a few milk producers to see whether they followed the USDA’s strict but weakly enforced guidelines for organic certification. Organic milk can cost twice as much as conventional milk and, as Whoris-

False labeling

BILL OXFORD / ISTOCK / GETTY IMAGES PLUS

FALL 2018

key observed, “If organic farms violate organic rules, consumers are being misled and overcharged.”

The Post surveilled Aurora Organic Dairy—a major milk supplier for house organic brands sold by retailers such as Walmart and Costco—and found that the company appeared to violate rules about how often their cows are grass-fed, a key differential between conventional and organic milk production. The Post had several organic milk samples tested to measure for two fats that are more prevalent in organic milk (although in amounts inconsequential to human health), and most fell short.

cultural imports. Most alarming is the importation of supposedly organic grains to be used as animal feed, from Ukraine, Turkey, India, and China—countries with dubious food-safety standards and enforcement.

The Post’s investigation shed doubts on the authenticity of these imported “organic” grains. Whoriskey reported on how 36 million pounds of soybeans from Ukraine, shipped through Turkey to California in 2016, “underwent a remarkable transformation” from conventional to organic. The fraud increased the value of the beans by $4 million because organic grains sell for more than non-organic.

Whoriskey reported that the integrity of the organic label rests on “an unusual system of inspections” that the head of the USDA’s organic program calls “fairly unique.” Organic producers pay a private inspector, approved by the USDA, to certify their products as organic; the agency checks in on those inspectors every few years. The USDA has only 82 certified inspection firms to supervise a massive organic supply chain of more than 31,000 farms and businesses worldwide. This leaves plenty of room for error and outright cheating and fosters a pay-to-play climate that benefits producers and inspectors at the expense of unwitting consumers.

The burgeoning organic market has also created a huge demand for agri-

Whoriskey found that at least 21 million pounds of the phony organic soybeans had already entered the food supply. And the Post reported on two other fraudulent shipments of organic grains in the past year that “were large enough to constitute a meaningful proportion of the U.S. supply of those commodities. All three were presented as organic, despite evidence to the contrary.”

Innovation /

The USDA reported that in 2016, U.S. farms and ranches sold $7.6 billion of (supposedly) organic commodities, up 23% from $6.2 billion the year before.

Of 2016 sales, 56% were for crops ($4.2 billion) and the remaining 44% were for livestock, poultry, and related products.

/ Regulation / 5

The growth of organic foods, however, has not been accompanied by a corresponding bump in innovation to improve safety, quality, or nutrition. In fact, evidence suggests the opposite: a lowering of food safety, quality, and nutrition, and continuing burdens of organic production on the environment, especially its excessive use of water and arable land. Moreover, organic crop yields are typically lower and their retail prices significantly higher.

While progress in organic agriculture has been largely stagnant, innovation based on precise molecular techniques for the genetic improvement of food crops and food processing has been occurring in much of the world. This genetic engineering—primarily of commodity crops but increasingly of some specialty crops—has contributed to more efficient, sustainable food production, and also to the introduction of traits appealing to consumers.

Crop plants have been genetically engineered to be fortified with important vitamins and minerals and to be drought-, flood-, pest-, disease-, and herbicide-resistant, requiring less spraying of insecticides and other inputs, and increasing yields and resilience. Likewise, animals can be genetically engineered to be more nutritious and disease-resistant, and to impose less stress on the natural environment—for example, by producing less-toxic manure. Such plant and animal innovations are critical not only to meet the global need for improved food quality and availability, but also for adaptation to the challenges of increasing population and a changing climate.

The original draft of the National Organic Standards proposed by the USDA did not exclude crops improved with molecular genetic engineering techniques from organic practices as long as they met the specified organic production standards. But ultimately, in response to a deluge of anti–genetic engineering public comments from organizations and individuals (including the organic industry, which sought to prevent market share gains by the nascent plant biotechnology companies), and because of anti-biotechnology sentiment in the USDA’s political

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leadership, the USDA used its discretion to exclude genetically engineered products from the definition of organic food.

Accordingly, by definition the 2000 National Organic Standards prohibit the use of the USDA Organic Label on food varieties derived from organisms created with molecular genetic engineering techniques, even when the foods are otherwise grown with complete fidelity to the requirements of organic production. That exclusion is perhaps the most irrational aspect of the organic standards. Except for wild berries and wild mushrooms, virtually all the fruits, vegetables, and grains in our diet have been genetically improved by one technique or another, including through what are called “wide crosses,” which move genes from one species or genus to another in ways that do not occur in nature. The newer molecular techniques are just more precise and predictable extensions of earlier techniques for genetic modification.

The prohibition of “genetically engineered, organically produced” crops denies consumers nutritionally improved foods, such as rice fortified with the precursor of vitamin A, canola oil with enhanced levels of omega-3 fatty acids, apples that don’t turn brown when cut, and potatoes that are bruise-resistant (and therefore, reduce waste) and have lower levels of the precursor of acrylamide, a carcinogen produced by cooking at high temperatures. Thus, the exclusion from organic agriculture of plants made with molecular genetic engineering forfeits the benefits of higher yields and lower environmental burdens—explicit goals of the Organic Foods Production Act of 1990.

Fear of ‘Frankenfood’ / A major reason for

the exclusion of genetically engineered products from the organic definition was to make organic food acceptable to consumers who did not want genetically engineered products at a time when the U.S. government did not require them to be specifically labeled. The U.S. Food and Drug Administration had determined

that the process by which genetically engineered plant foods were improved did not in itself raise nutritional or safety concerns and so labeling was not required unless safety issues were raised by the product. Thus, as far as the U.S. government was concerned, there was no compelling reason to label genetically engineered food products. Nevertheless, responding to pressure from activists and the organic and natural food industries, several states enacted laws requiring genetically engineered food labeling, thus creating disparate labeling requirements that would have created a significant problem for the industry. That led Congress to pass, in 2016, a preemptive disclosure law that required the USDA to establish a national policy for labeling “bioengineered” food.

The disclosure law does not in any way alter the current National Organic Standards, but it does provide an opening for the agriculture secretary to consider modifying the definition of organic to include genetically engineered food as originally proposed almost 30 years ago.

Sec. 293 (f ) of the law specifically requires the USDA to consider establishing consistency between — (1) the national bioengineered food disclosure standard established under this section; and (2) the Organic Foods Production Act of 1990 (7 U.S.C. 6501 et seq.) and any rules or regulations implementing that Act.

With the ongoing oversight of regulatory agencies and the disclosure requirements for bioengineered food products, arguably they should now be eligible for the USDA organic seal if they comply with the requirements of both the National Organic Standards and the new bioengineered-food disclosure standards. No longer would consumers be denied the choice of purchasing food that is both organic and genetically engineered. As noted above, many of the latter increasingly boast traits and characteristics with palpable benefits to consumers, including biofortification of plants with

vitamins and minerals, more healthful vegetable oils, leaner meats, and reduced levels of allergens.

The USDA’s proposed rule, the public comment period for which closed on July 29, posed questions relevant to the development of the bioengineered disclosure standard. However, those questions were formulated by the Barack Obama administration and it is unclear whether they represent the policy positions of the Trump administration. Not included in the questions was any consideration of how the disclosure requirements of Sec.293(f ) would relate to the National Organic Standards.

If consumers who protested the inclusion of bioengineered food within the “organic” definition three decades ago remain opposed, they could simply refuse to purchase organic products bearing the “bioengineered” label. There is no reason that others should be denied the opportunity to partake of “organic bioengineered” products.

Interestingly, the inclusion of geneediting techniques such as CRISPR, which does not usually involve the insertion of “foreign” DNA, has been endorsed by a prominent voice in the organic movement. Klaas Martens, a third-generation grain and livestock farmer who has farmed organically for more than a quarter-century, said he would be open to gene editing: “If it could be used in a way that enhanced the natural system, and mimicked it, then I would want to use it.”

The Trump administration should direct the USDA to comply with Section 293(f ) by amending the National Organic Standards to permit the inclusion of crops, animals, and microorganisms (for example, to produce yogurt or alcoholic beverages) modified with the most precise and predictable genetic techniques. That would firmly establish the United States as the world’s pacesetter in the creation of a new, welcome category of agricultural products that are both organic and bioengineered. It would also favor consumer choice and encourage more-sustainable agricultural practices.

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— Kimberley A. Strassel, Wall Street Journal Editorial Board

© Bob Wick, BLM CA

OUR VISION is a world where free market environmentalism is the default approach to conservation.

To make this vision a reality, our focus will always remain on results.

Through high-quality research, outreach, and applied programs, our ideas are changing the world of thinking.

Learn more at PERC.org

8 / Regulation / FALL 2018 LABOR

The Regressive Effects of Child-Care Regulations More strenuous requirements raise child-care prices but have little apparent effect on quality.

C

✒ BY RYAN BOURNE

hild care in the United States is expensive, but its cost varies greatly by region. Data from Child Care Aware of America, a nonprofit that works in child-care policy, indicate the average annual cost for full-time care of an infant at a child-care center in 2016 ranged from $5,178 in Mississippi to $23,089 in the District of Columbia. Even if we account for different income levels by state, these costs are very high. In Mississippi that infant’s child care is 24% of median income for a single-parent household, while in D.C. it is a staggering 89.1%. For households with two young children, the combined burden is higher still.

Child-care policy is left to state governments and wide variation exists regarding policies and subsidies to assist poorer families with these costs. Overall, data from the Organization for Economic Cooperation and Development (OECD) suggest U.S. out-of-pocket child-care costs for a lone parent working full-time are higher as a percentage of earnings than in any other OECD country. And there is less taxpayer support for U.S. child care than in other OECD countries.

This high cost can have a large negative effect on the poor and can fuel political demands for increased government intervention and spending on child care. Empirical research indicates that parents (poorer single mothers especially) are particularly sensitive to child-care prices when making decisions about entering the labor market. Evidence from a range of studies suggests mothers from poorer families and those with low levels of educational attainment are least likely to be working.

High prices for formal care also lead poorer parents to rely on informal care arrangements such as assistance from extended

RYAN BOURNE is the R. Evan Scharf Chair for the Public Understanding of Econom-

ics at the Cato Institute.

family. U.S. Census Bureau data show that among children with employed mothers, those living in poverty are more than twice as likely to be cared for by an unlicensed relative.

The long-term trend is for more mothers of young children to opt for work. According to data from the U.S. Bureau of Labor Statistics, in 1975 28.3% of mothers with a child under the age of 3 and 33.2% of mothers with a child under the age of 6 were employed; in 2016 those numbers were 59.4% and 61.5%, respectively. As a result, the high cost of child care is becoming a particularly salient issue, with pressure building for government to “do more” to support it, not least as a means of helping poor families.

WHY IS CHILD CARE SO EXPENSIVE?

Before adopting new subsidies or beginning direct government provision of child care, it is worth assessing the underlying causes of high child-care prices. There are good reasons to think these prices would be high naturally in a free market. Formal child care is a labor-intensive, personalized service entailing the care of something many parents regard as the most valuable aspect of their lives. There is a strong correlation between areas with the highest absolute money cost of child care and the cost of child care as a proportion of income. This suggests that child care is strongly “income-elastic,” meaning that as people get richer they become willing to spend relatively more of their income on it.

Yet economic evidence also suggests that child-care prices are driven up by existing variable state-level regulations and policies introduced to achieve other objectives. Input regulations designed to improve the “quality” of care, including requirements on the qualification levels of staff and/or the ratio of staff per child, appear to have a significant effect on child care prices.

These regulations tend to be justified on “market failure”

PHOTO-ILLUSTRATION BY DAVIDVHERBICK

FALL 2018

grounds. Some observers claim there are asymmetric information problems in the sector; parents ostensibly have difficulty ascertaining whether child-care providers are high-quality providers. Others claim there are positive externalities—broader social benefits—arising from “high-quality” child care in children’s early years, and those benefits are overlooked when child care is left to private transactions. These failures are said to justify ensuring providers meet minimum standards.

But these theoretical arguments of market failures have always been shaky. After all, direct parental care is an alternative to outside child care, yet there is no political movement for direct regulation of parents. And regulations can raise child-care prices, thereby reducing the spillover benefits from child care.

It is not entirely clear how meaningful the concept of “quality” in child care is, even if it can be divorced from what consumers—in most cases, parents—want for their children. Child-care research tends to use the term “quality” to simply mean that the child care and/or caregiver is in compliance with various process regulations or that it achieves certain outcomes. But deciding what educational provisions are best for a particular child is a multi-faceted judgment dependent upon the child’s individual needs. Government may be able to use its centralized information to produce a regulation that generally improves outcomes in some particular average metric, but this is also likely to have unforeseen effects that may themselves have negative externalities.

Theory does not really get us very far in ascertaining the effects of regulations and any tradeoff between quality and affordability.

One reason for this is that true “quality” is likely to be subjective: for some parents, it may simply mean that the caregiver provides

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a caring, safe environment for their children; for others it may mean an environment conducive to robust cognitive development.

Another reason why regulations do not proxy well for overall quality is that the market for child care is competitive across types of care and includes homecare, informal care, and care by the parent directly. Regulatory policies affecting perceived quality and prices can therefore cause substitutions from one type of care to another.

A couple of examples make this clearer. Suppose a regulation increases the staff–child ratio or requires child-care workers to achieve higher qualification levels. The former could theoretically increase quality by increasing staff interactions with individual children, and the latter by increasing caregiver training. Yet at the same time, raising the staff–child ratio may restrict the wages of caregivers by restricting the revenue potential of each caregiver.

The lower wages, in turn, may result in lower-quality caregivers.

Child-care providers may also respond to higher government certification requirements on caregivers by lowering their standards for support workers or facilities. As a result, the overall effect on quality of both regulations is ambiguous.

Finally, it is not even theoretically obvious what the effect of these regulations will be on overall formal child care use. By increasing the cost of formal care, regulations may reduce supply and reduce the quantity demanded. But if parents believe that a regulation truly does ensure quality, then a “quality assurance” effect might increase the demand for child care overall. The important thing to remember in any analysis of the effects of the regulation on overall quality is to consider the effect on children whose par-

10 / Regulation / SUMMER 2018 LABOR

ents substitute them from one setting to another, either because of price or perceived quality changes stemming from the regulaton.

COST EFFECTS OF DEREGULATION

A burgeoning empirical literature attempts to shed light on these issues. One finding that appears robust across studies is that stringent staff-to-child ratios increase child-care prices substantially with little beneficial effect on observed quality.

Diana Thomas and Devon Gorry, for example, use variation in prices and state regulation requirements to estimate that loosening the staff–child ratio by one child across all age groups (regulations tend to vary by child age) reduces center-based care prices by 9–20% generally, or 2–5% for 4-year-olds particularly. This echoes an older result from Randal Heeb and Rebecca Kilburn, who found increasing the stringency by reducing the number of children in the allowed staff–child ratio by two raised the price of child care by 12%.

Applied to real-world child-care costs, the conservative end of these estimates suggests that relaxing the staff–child ratio by one child across the board in Mississippi and D.C. could reduce average child-care prices by $466 and $2,078 a year, respectively.

These numbers are extremely uncertain, of course, and the effect is likely to be non-linear in reality, with the price effect larger in states with the most stringent regulation.

But the indicative results are large. And further evidence suggests the poor suffer disproportionately. Thomas and Gorry show that a small but measurable number of mothers stop working altogether as a result of these regulations. One would imagine that these are likely to be relatively low-income people on the margins of the labor market.

A more comprehensive paper by Joseph Hotz and Mo Xiao supports the intuition that the effects are particularly regressive.

Using a panel dataset across three census periods and with extensive individual child-care center data, state data on day home care, and a host of control variables, they find tightening the staff–child ratio by one child reduces the number of child-care centers in the average market by 9.2–10.8% without increasing employment levels at other centers. This reduction in supply occurs wholly in relatively low-income areas and leads to lots of substitution to home day care. Increased stringency in the regulation actually increases childcare centers in high-income areas, probably because of the “quality assurance” effect, meaning the overall effect is highly regressive.

REGRESSIVE EFFECTS AND A SLIPPERY SLOPE

As with housing, child care is an example of a sector where government regulations restrict the supply of the service, to the financial detriment of the poor. Whereas zoning restrictions deter labor mobility, formal child-care regulations—by raising prices—reduce the payoff to work for groups with low levels of labor market attachment. In the case of staff-to-child ratios, there is no evidence of a net “quality” tradeoff, as restricting the number of children per staff member holds down potential

wages for child-care workers and causes demand substitution to perceived lower-quality child-care settings.

Other regulations have similarly large effects on price, although with more mixed consequences for quality. Thomas and Gorry find that requiring lead teachers to have a high school diploma can increase child-care prices by 25–46% percent. Hotz and Xiao likewise find that increasing the average required years of education of center directors by one year reduces the number of childcare centers in the average market by 3.2–3.8%. Again, this effect manifests itself overwhelmingly in low-income markets, with quality improvements (proxied by accreditation for the center) overwhelmingly occurring in high-income areas.

Policymakers should bear this in mind before continuing the push for further regulation of the sector. Yes, there is some evidence that increased teacher training in early childhood education can have positive effects on child development, but a host of input regulations appear to reduce the supply of available care, reduce access, and raise prices for the poor.

Yet some governments continue to heap regulations on child care. Last year, the D.C. city government passed new rules requiring that teachers at child-care centers and caregivers at homebased centers obtain a two-year degree in early childhood education, while assistant caregivers must obtain a newly created Child Development Associate certificate. Even if these measures raise quality in terms of outcomes for children whose families can afford care, the requirements will further constrict the supply of child care in a market where prices are already very high. That may explain why city leaders have delayed implementation of the new regulations and are engaged in new attempts to subsidize child-care provision.

The UK offers a cautionary tale of how government involvement begets government control over this sector. Intervention advocates appealed to the positive externalities of higher female employment and greater child achievement, but the resulting policies have left consumers facing high out-of-pocket costs and taxpayers facing higher subsidy payments, including government funding of “free” care for children ages 2–4. Commentators now cite the higher cost as justification for ever-greater government subsidy of child care.

The expanded UK government funding and intervention appear to have yielded little advancement on the stated policy goals. Research indicates that universal government-funded care for 3-year-olds raised employment levels by only 12,000 workers, at a cost of £65,000 (about $88,000) per new job (many of which were part-time). Though there did appear to be a small gain in educational attainment at age 5, that effect weakened by age 7 and completely disappeared by age 11, meaning the policies had no long-lasting benefit.

These meager results have not given policymakers pause; rather, many claim that “more needs to be done.” These days, the high cost of child care itself is seen as indicative of a market failure, even though that cost is partly the result of regulations and state crowd-out designed to achieve other objectives.

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CONCLUSION

The potential for huge unintended consequences from such regulation is clear. Policymakers seem to give little thought to the effect of these policies on child-care prices, parental preferences for care, and the availability of care for the poor. Leading indicators, in the form of debates on child-care policy in other countries such as the United Kingdom, suggest subsequent concern about high prices will lead to demands for universal government provision of care, funded by taxpayers.

The case for abandoning input regulations that raise prices without delivering higher quality is overwhelming in this economic and political context. Major European countries already do not bother with mandated staff-to-child ratios, for example, with apparently few ill-effects.

That does not mean the market need be “unregulated.” In fact, this kind of service sector seems ripe for within-market regulation. Parental preferences will likely provide binding constraints against inadequate staffing levels while allowing providers to find optimal scale. And formal providers might voluntarily choose to obtain qualifications as a reputational mark of quality. Intermediate institutions usually develop in a free economy to provide such quality signals.

More broadly, there is a philosophical argument that judging child-care “quality” should be left to the parents, especially given

/ Regulation / 11

the fact that they, themselves, are not required to obtain formal qualifications in child education in order to care for their children.

Existing empirical evidence suggests even a modest shift from government to within-market regulation on staffing could significantly reduce prices, with modest changes delivering savings of around $500 per year or more for families with children in full-time care. The net benefits to poor people’s well-being could be much greater still if lower child-care prices make it financially rewarding for them to return to work.

READINGS ■■ “Getting the State Out of Pre-School and Childcare,” by Ryan Bourne and Len Shackleton. Institute of Economic Affairs, Feb. 6, 2017.

■■ “Regulation and the Cost of Child Care,” by Diana Thomas and Devon Gerry.

Mercatus Center at George Mason University working paper, Aug. 17, 2015.

■■ “The Effect of Child Care Cost on the Employment and Welfare Recipiency of Single Mothers,” by Rachel Connelly and Jean Kimmel. Southern Economic Journal 69(3): 498–519 (2003).

■■ “The Effects of State Regulations on Childcare Prices and Choices,” by Randal Heeb and M. Rebecca Kilburn. RAND Labor and Population working paper, January 2004.

■■ “The Impact of Regulations on the Supply and Quality of Care in Child-Care Markets,” by V. Joseph Hotz and Mo Xiao. American Economic Review 101(5): 1775–1805 (2011).

■■ “Who’s Minding the Kids? Child-Care Arrangements: Spring 2011,” by Lynda Laughlin. Household Economic Studies (U.S. Census Bureau), April 2013.

Real Activism Real Results

JOIN TODAY IJ.ORG/ACTION INSTITUTE FOR JUSTICE

12 / Regulation / FALL 2018 PUBLIC LANDS

Constituent-group politics continue to dampen the public benefit from the federal estate.

E

✒ BY GARY D. LIBECAP

ighty-five percent of Americans have visited at least one national park. Others have seen the U.S. Forest Service’s (USFS) “The Land of Many Uses” signs for national forests or notices of entry into Bureau of Land Management (BLM) lands. These areas are advertised by the agencies as being “public lands,” implying that they are owned and managed in the best interest of U.S. citizens. Yet that is unlikely to be the case.

This would be of little importance except for the vast amount of land involved. In the lower 48 states, public lands encompass nearly 475 million acres, 21% of the land mass and more than the combined areas of France, Spain, Sweden, and Norway. (See Figure 1.) Adding the public lands in Alaska and Hawaii brings the total to about 640 million acres, 28% of the U.S. land area.

Most citizens are unaware of just how large is the federal estate.

THE COSTS OF FEDERAL LAND OWNERSHIP

There are several reasons why government ownership of this huge resource is detrimental to economic welfare and individual liberty.

First off, it is in sharp contrast to the plans of the nation’s founders and philosophical forebears. The importance of private ownership of land for advancing individual potential and autonomy, as well as land value, was emphasized by early political economists and philosophers, including Adam Smith, John Locke, Jeremy Bentham, Jean-Jacques Rousseau, John Stuart Mill, David Ricardo, Edward Wakefield, and Robert Torrens. The advantages of widespread private land ownership were championed by Thomas Jefferson, who claimed that “the earth is given as a common stock for man to labor and live on…. The small landholders are the most GARY D. LIBECAP is the Distinguished Professor of Corporate Environmental

Management at the Bren School of Environmental Science & Management and Distinguished Professor of Economics at the University of California, Santa Barbara. He is also a research associate of the National Bureau of Economic Research.

MORGANRY / ISTOCK / GETTY IMAGES PLUS

The Land of Many Opportunity Costs

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precious part of a state.� As he toured the new country in 1835, Alexis de Tocqueville observed that being freeholders changed the way in which Americans thought of themselves and the country’s political structure. The noted historian of the frontier Frederick Jackson Turner asserted in 1893 that America ultimately was shaped by private ownership and small-farm frontier settlement as the underpinnings for democracy, an independent citizenry, and generalized economic wellbeing.

In contrast, in the more modern period, the threats of private ownership for an authoritarian government were clearly understood by Karl Marx, Vladimir Lenin, Joseph Stalin, and Mao Zedong. They banned private property in land and placed it in state possession, jailing or executing previous owners. Even today in China, where private rights to intangible property such as stocks and bonds are tolerated, long-term, fee-simple title to land is prohibited. The state remains dominant in holding the most critical resources as its own.

From the colonial period through the late 19th century, the overriding aim of government land policies was to transfer land ownership as quickly as possible from the state to private citi-

/ Regulation / 13

zens. The attraction of America for immigrants was land. And they could get it in comparatively small parcels that supported individual farms. The Homestead Act of 1862 distributed federal land in 160-acre plots for free to claimants, and between 1863 and 1920 some nearly three million homestead claims were filed for more than 435 million acres, smaller than the government’s holdings today but larger than Alaska.

A land demarcation system was created to facilitate the measurement, location, trade, and productive use of land. The frontier societies that emerged were among the most egalitarian in the world. Capital gains from land ownership and sale were the primary sources of wealth creation, and the use of land as collateral encouraged widespread participation in and growth of capital markets. Agricultural production expanded and prosperous communities emerged. Private citizens with a stake in society invested in local public goods provision, particularly education, so that the United States became a world leader in general access to a practical education. Such a society was politically stable.

The long-standing emphasis on the private acquisition of government lands, however, ended in the late 19th century. In its

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place came the creation of the National Forests, now comprising more than 225 million acres, and the National Rangelands, covering almost 250 million acres, along with a permanent bureaucracy for administration and short-term distribution. As of Fiscal Year 2018, the USFS has some 37,000 career, tenured civil service employees and a budget of $1.75 billion, and the BLM has over 8,000 career employees and a budget of $1.1 billion.

Lost economic value / A second reason why so much land ownership by the state is detrimental is that much of it is misallocated and dramatically under-produces, diminishing general welfare.

Much poorer developing countries seek to have their natural resources provide employment and output for their citizens, but the United States locks more and more federal land away, ostensibly for preservation for future generations. There is no clear metric for assessing how those generations will benefit nor are the tradeoffs easily available for general citizens to assess. Decisions are determined by politicians and the bureaucracy in response to lobby pressures, and no party in that process bears direct costs from the associated resource allocation and use decisions.

This is not to say that areas of high amenity or cultural values should not be set aside. This description, however, does not characterize most of the federal lands. Currently, the National Park Service in the Department of the Interior administers a comparatively small 27 million acres in the lower 48 states and 80 million acres (12% of the total federal lands) in the United States overall, as national parks, national monuments, national preserves, national historic sites, national recreation areas, and national battlefields.

There are no aggregate measures of the opportunity costs resulting from mismanagement and allocation. Evidence suggests, however, that the costs could be very large given the size of the federal estate. Consider that while oil and natural gas production have jumped dramatically on private lands over the past 10 years, on federal lands output has been static or declining, even with favorable geologic deposits.

Similarly, timber production from the National Forests has fallen sharply to levels not observed since the 1930s, even though lumber prices are rising. Higher lumber prices contribute to upward shifts in housing costs that are of concern to many because of their equity implications. Poorer members of society are increasingly unable to afford to own homes.

Where comparable data exist in the Pacific Northwest, it is possible to examine output on private lands versus the National Forests. Timber harvest from federal lands has fallen, while harvest from private lands in the region is the primary source of output.

Withholding timber stands does not make them more valuable. As timber stands age, they grow more slowly, block new tree growth, and become more vulnerable to disease. It is often argued that the National Forests should be more aggressively thinned than they are now to better conserve scarce western water supplies and reduce the incidence and growth of wildfires.

Finally, as with other productive uses, livestock grazing on

federal lands has declined for nearly 50 years. The negative economic effect of reduced grazing on rangelands, particularly, is concentrated in semi-arid regions where there are few other land-use options and the federal share of land ownership is large.

For example, the BLM administers 85% of Nevada, 57% of Utah, and nearly 50% or more of Arizona, Idaho, and Oregon. With greater uncertainty associated with approval and maintenance of the grazing permits that ranchers depend upon, the lands’ economic value has fallen. Ranches have gone into foreclosure or been consolidated. Rural communities tied to ranching and lumbering have withered as the economic base surrounding them has deteriorated. As a result, opportunities for the young have plummeted, encouraging out-migration to urban areas. The relative weakening of rural economies and population declines are of growing concern in policy circles.

Locking away more land / As administrative reallocation and regulatory controls have led to the fall in the productive use of federal lands, more land has been placed into various types of preservation and recreation. Is this optimal? How much land should be locked away? Only a rich country could afford to set aside so much valuable real estate. This luxury could be temporary, however, if the costs rise and become more apparent to citizens.

To get a sense of what might be at stake, consider the decision to withhold oil and gas exploration and production in the 19 million-acre Arctic National Wildlife Reserve in Alaska since 1977. With reserves of 7.06 billion barrels of oil, priced at (a comparatively conservative) $50 per barrel, the estimated opportunity costs are $251 billion, a present value of $1,141 per adult citizen.

Across the entire federal lands, the costs of preserving so much land are apt to be orders of magnitude higher. Such losses likely affect gross domestic product growth, employment opportunities, and welfare for the overall population.

With competitive markets, private land is reallocated across uses routinely as prices shift on the margin. Land moves to its highest-valued use. Critical private lands needed for public infrastructure investment, preservation, or protection of amenity values can be acquired by the government. Proposed expenditures can be weighed against alternatives. Political/bureaucratic allocation and management of lands already owned by the state, however, do not work in this manner. Multiple constituent groups, ranging from environmental and recreational organizations to historic users—ranchers, timber companies, minerals and oil and gas producers—appear before congressional hearings and before the agencies to lobby for their favored policies. Outcomes depend upon the strength of the lobby group, whether they face competitors, and how politicians and agency officials respond to them.

Cost–benefit analysis of bureaucratic decisions, where used, often is not transparent and agency decisions are cloaked in publicgoods rhetoric. In this setting, citizens have little information to assess the net effect of the decisions made by the bureaucracy that manages the federal lands.

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A third reason why federal land ownership is damaging is that the allocation and reallocation of so large a resource stock through the political/bureaucratic process is socially divisive. Reallocation is not routine, but lumpy. Constituent groups compete to enlist the coercive power of the state on their behalf. Losers, unlike sellers, are not compensated, and winners, unlike buyers, do not pay for the value of the resource.

The losers resent the outcome and blame the winners, while the winners characterize past users and uses as inconsistent with the public interest. This process undermines social cohesion and civil discourse, both of which are essential for a functioning, stable democracy.

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Figure 1

THE FEDERAL ESTATE: PUBLIC LANDS UNDER THE USFS AND BLM

HOW DID THE FEDERAL GOVERNMENT RESERVE SO MUCH LAND?

To understand how the federal government came to withhold so Source: Bureau of Land Management much land given the past emphasis on private ownership, it is useful to consider the U.S. settlement process in the late 19th century. As the frontier moved west of the 100th meridian, far different conditions were encountered from those to the east. The land was more rugged and semi-arid, making it less economically viable for small farming. Logging, ranching, and mineral production were more appropriate economic uses. Land laws such as the Homestead Act could have been modified to allow for much larger, non-farming distributions, but they were not.

At the time, such changes in the laws seemed to limit opportunities for further land ownership by homesteaders, and there was no political support for them. In his Report on the Arid Lands of North America made to Congress in 1879, John Wesley Powell called for minimum 2,560-acre homesteads—16 times greater than the size of standard homestead allotments—to address the problem, but nothing came of it. In the late 19th century there was no conclusive evidence that small farms were not suitable for the region, especially if settlement changed the climate, if “rain follows the plow,” if new dry farming techniques could offset aridity, or if sufficient irrigation networks could be developed. In light of this, there was no concerted action in Congress to change the laws.

By the turn of the 20th century and advent of major droughts, however, it became clearer that only irrigation would save the small-farm objective. Congress was intensely lobbied to provide for subsidized irrigation via the 1902 and 1906 Reclamation

Acts. New federal dams and irrigation canals diverted water from western rivers, such as the Snake, Yellowstone, Salt, and San Joaquin, to adjacent lands for homesteading. Indeed, after 1902, the number of new homesteads jumped to totals larger than in any earlier period. Range and timber lands, remote from rivers and rugged, were not much affected by reclamation. Ranchers and timber companies continued to use them. These parties faced economies of scale, requiring operations far larger than 160 acres.

/ Ranchers claimed homesteads around water sources and then fenced the surrounding government rangeland to control their herds. The General Land Office that later became the BLM and was funded to process homestead claims opposed these enclosures and removed the fences. Grasslands that had been previously protected by fencing and livestock association patrols against trespassing reverted to common-pool resources. Overgrazing followed. By the 1930s, the Departments of Agriculture and the Interior pointed to rangeland depletion as indication of the need for government management. In 1934 the Taylor Grazing Act was passed, removing the rangelands from homesteading and placing them in permanent management by the new grazing service that became the BLM. Timber companies faced similar constraints. Unable to secure forest lands legally, timber operators hired entrymen to act as Withdrawing property rights

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homesteaders to file claims and purchase them under various land laws from the 1880s through the turn of the 20th century.

Homestead plots were then consolidated into larger timber parcels, but there was always the possibility that government inspectors would discover the false claims and cancel them. The added costs of staking fake homesteads and their assembly, as well as the uncertainty of securing private property rights, delayed titling by six years or more. This ambiguous property rights condition contributed to rapid, open-access harvesting and timber theft, as noted by conservationists and government officials at the time the land laws were being revised. They failed to recognize that the culprit was the lack of property rights, not harvest practices otherwise intrinsic in private production when rights were secure.

The withdrawal of federal range and timber lands from private claiming was spearheaded by members of the first environmental or conservation movement. Early conservationists and their political and bureaucratic patrons challenged the long-standing notion that private property rights and markets were key elements in the development of the American state, economy, and society. They saw private markets as inherently wasteful without the remedy of government ownership and management by professionals.

By the late 19th century, increasingly many such professionals were employed by the federal government as both the size and scope of the federal role in the economy expanded. Federal civilian employment was just over 130,000 in 1885 but grew by 258% to nearly 470,000 by 1913. A merit-based, independent civil service gradually acquired regulatory mandates, job tenure, and higher salary growth relative to the private sector.

To advance their objectives, federal agencies developed political agendas. The same advocates for retention of federal lands

ANIMAL UNIT MONTHS (Millions)

became leaders of the bureaucratic agencies that managed them.

Private property rights and constrained decision-making did not fit within their regulatory plans that called for rational, scientific management. Bernhard Fernow, head of the Division of Forestry in the U.S. Department of Agriculture from 1886 to 1898, and Gifford Pinchot, the first chief of the U.S. Forest Service, 1905–1910, were major leaders in the effort to create the National Forest Reserves, later the National Forests. They were assisted by outside lobby groups such as the Society of American Foresters, the American Forestry Association, and the National Forest Congress. Through their efforts and the backing of presidents William Harrison, Grover Cleveland, William McKinley, and Theodore Roosevelt, the Forest Reserve Act was passed in 1891, the Forest Management Act in 1897, and the National Forest Transfer Act in 1905, which moved the forest reserves from the Department of the Interior to the U.S. Department of Agriculture.

Fernow and Pinchot, educated in Germany and France respectively, advocated “scientific” forest management whereby harvest rates were to equal growth rates to achieve sustained-yield. The conditions underlying this “rational” management of European forests could not have been more different from those of North America. The United States was rapidly growing and demand drove rising lumber and timber (stumpage) prices. Interest rates were high. By the latter half of the 19th century, the United States was endowed with three major commercial old-growth timber stands—the white pine forests of the upper Midwest and Great Lakes, the yellow pine forests of the South, and the Douglas Fir forests of the Pacific Northwest and Northern Rockies.

The rapid private harvests in the United States to meet growing demand and shifting domestic supplies across the three regions were instrumental in shaping the views of Figure 2 Five Decades of Grazing on Bureau of Land Management early advocates of susand Forest Service Land tained-yield management and retention of 15.0M government lands.

Bureau of Land Management land I n p a r t i c u l a r, Forest Service land ( No data) 12.5M Fernow, Pinchot, and others pointed to what seemed to them to be 10.0M the excessive cutting of private timber stands 7.5M in the Upper Great Lakes as evidence of 5.0M the need for retained government ownership in the Pacific 2.5M No r t hwe st . T h ey argued that timber 0 companies harvested 1966 1970 1975 1980 1985 1900 1995 2000 2005 2010 2014 too rapidly, unconSource: Tay Wiles and Brooke Warren, “Federal-Lands Ranching: A Half-Century of Decline: How Grazing Fell from its Western Pedestal—and Fueled the Sagebrush YEAR Rebellion,” High Country News, June 13, 2016, https://www.hcn.org/issues/48.10/federal-lands-grazing. cerned about future

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supplies. Neither they nor subsequent sympathetic historians of the conservation movement have provided data to assess these claims, but there is reason for skepticism. U.S. lumber and timber (stumpage) price patterns between 1870 and 1930 do not reveal myopic behavior in private harvests. If companies cut their timber stands in ignorance of true supply conditions as alleged, once accurate supply information became available, prices that were too low would jump and companies would cut back harvest. But there is no evidence of such price shocks or production adjustments.

Prices generally moved smoothly over the period, implying that the private market was fully incorporating available information about timber supply and demand.

Conservationists and subsequent historians have pointed to timber theft in the Pacific Northwest as evidence of rapacious behavior by private timber companies. But as noted above, the problem lay in the politically inflexible land laws that raised the costs of obtaining title to land. Similar arguments by conservationists were made for the retention and management of federal range lands.

In securing enactment of National Forest legislation and the Taylor Grazing Act, proponents co-opted the very interests—timber companies and herders—that would have benefited from more liberal land allocation and that might have organized as effective political counters. Pinchot called for multiple use of federal lands rather than complete preservation. He and other conservation leaders offered timber companies harvest leases and subsidized access to forest lands. For the first time, those companies could secure the legal right of entry to forests through timber harvest leases that they had not been able to obtain under the old land laws. Similarly, herders were offered renewable grazing permits within newly created grazing districts.

What timber companies and herders failed to anticipate was that this was a Faustian bargain. Later, new demands for federal lands and subsidies emerged for species preservation, recreation, and other environmental applications that meshed with the long-term management objectives of the BLM and USFS. As these constituencies appeared, previous access and subsidies for production from federal lands became less secure and subject to continued administrative reallocation and regulation. Timber companies and ranchers did not recognize that the federal lands were constituent-group lands.

WHERE DOES THIS LEAVE US? ARE THERE REMEDIES?

The withdrawal of federal lands from private claiming and titling began with the General Revision Act of 1891 and continued with the Taylor Grazing Act of 1934 and subsequent legislation, including the Multiple Use, Sustained Yield Act of 1960 and the Federal Land Policy and Management Act of 1976. These laws assign broad access and use control to federal bureaucracies. They represent a fundamental shift in the roles of private property rights and the state, with implications beyond federal holdings.

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With the founding of the republic, reliance was placed on individual decisions regarding land use and allocation, decentralization, and a minimal role of the state. With the reservation of immense amounts of land by the federal government and permanent administrative management, reliance has been transferred to an unelected, professional, and tenured bureaucracy with centralized decision-making authority. The state has been elevated over the market. The argument made at the time of this transformation was that market failure required intervention in the public interest. This same argument drives expansion of federal and state environmental regulation of private property rights and land use in the 21st century.

The historical record regarding federal lands is clear that the inability to acquire property rights under the land laws to the remaining federal estate has become a major problem. Although there can be externalities and market failure associated with private decision-making when property rights are incomplete, the direct remedy would be to make property rights more complete as Ronald Coase argued, and not resort to government ownership, regulation, or taxes. Externalities are more likely to occur with resources that are difficult to bound and observe, such as the atmosphere or groundwater, rather than surface land. The concept of externality is an elastic one that can be made to justify almost any state intervention. Whether or not such actions are defensible requires assessment and evaluation, rather than uncritical acceptance of the call for greater intrusion into the economy and society by an ostensibly benign bureaucracy operating under multiple-use rhetoric.

Is there a remedy? In a currently wealthy country where interests vary, those parties that favor preservation of enormous areas for a variety of reasons are likely to sustain the present situation.

Their objectives generally coincide with those of agency officials whose regulatory mandates are advanced with sustained-yield approaches. Moreover, many agency officials are trained biologists in forestry and range management. They are only tangentially proficient in oil and gas production, minerals output, livestock raising, and timbering. These are economic activities that compete with preservation goals.

Private decision-making over resource use generally would not coincide with broad bureaucratic discretion. Influential environmental lobby groups for the most part applaud the existing arrangement. Moreover, those in communities close to federal lands that value low-cost access for hunting, fishing, and hiking also have their objectives met. This is politically based open access that can have predicted negative results for the resource stock.

Even so, a coalition of agency officials, environmental lobby groups, and recreation interests is a formidable one, regardless of the aggregate economic and social costs of the status quo. Only as costs of the contemporary arrangement rise and as competing interest groups appear will the general citizenry be made more aware of the negative consequences of bureaucratic management in the name of preservation and future generations.

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Corporate Governance Oversight and Proxy Advisory Firms Do proxy advisors have too much power?

T

✒ BY IKE BRANNON AND JARED WHITLEY

he Securities and Exchange Commission requires that investment management funds submit proxy votes for all companies in which they own shares. Because of the vast number of stocks held by the typical institutional investor, hedge fund, or mutual fund, most of these investors draw on the research of a proxy advisory firm, which provides them some guidance in their task and allows them to focus on managing their portfolio.

But while their clients want to maximize returns, the objectives of proxy advisory firms may not be completely aligned with that goal. The opacity with which these advisory firms operate makes it difficult for investment management companies—and individual shareholders—to discern that alignment.

Proxies have become increasingly contentious in recent years as political activists have taken to leveraging shareholder proposals to pursue fashionable political goals in a variety of ways. Proxy advisors have themselves become more political in their support of some of these goals. Accordingly, these activities have been receiving closer scrutiny—especially from Congress, which is currently debating legislation to increase transparency at these proxy advisory firms. The SEC has also declared its concern with political activism in proxy voting and may pursue further action in this area.

These days, some investors perceive that the growing importance of proxy advisors to investment managers may be problematic as the number of proxy votes multiplies. The worry many have is that political or social agendas that may be peripheral—or harmful—to

IKE BRANNON is president of Capitol Policy Analytics and a senior fellow at the Jack Kemp Foundation. JARED WHITLEY is a senior communications consultant at Capital Policy Analytics.

long-run returns may be capturing undue priority, with potentially harmful ramifications for the interests of retail investors and other shareholders focused on value maximization. On such a basis, significant reform of the industry may be necessary CONFLICTS OF INTEREST IN PROXY VOTING

Few individual investors are aware of the role that proxy advisors play in guiding the activities of institutional investors—or that they even exist, for that matter. But as the use of proposals for political advocacy accelerates, their role is growing in importance.

Ordinary-course management proxy items typically include the retention of existing board members, approval of new members, or the ratification of the CEO’s pay package. However, companies are increasingly seeing proposals from shareholders that call on the company to take action on broader public policy proposals, both major and minor.

Proxy advisors are important because institutional investors— pensions, college endowments, and investment management companies—dominate shareholder voting. A recent analysis estimated that institutional investors control as much as 80% of the stock market. The SEC requires that institutional investors vote on corporate proxy matters but permits them to use recommendations from third-party proxy advisory firms. These frequently call on the company to take additional actions on environmental and social causes. The Economist magazine reported that there were 459 shareholder proposals submitted by early April of this year, a high proportion of which concerned climate change, racial and gender diversity, pay, and political spending. Given the increasing frequency of shareholder proposals that are tangential to the core activities of the company, the recommendations of proxy advisors

are becoming more important every year.

There is nothing inherently wrong with companies seeking guidance from a third-party source. The sheer number of proxy items makes it difficult for institutional investors to perform this activity themselves. However, three potential problems bedevil the proxy advisory industry.

The first is a lack of transparency on proxy firms’ methods and accountability for their recommendations. Proxy advisory firms have become, in some respects, akin to a self-appointed regulatory body, capable of making demands on public companies but without any actual statutory authority.

The second problem is that many in the investment community view proxy advisory firms as neutral arbiters, akin to referees in a sporting event. But in fact, these firms are for-profit enterprises with the potential for conflicts of interest no different than any other professional service or consultant. Without robust oversight or copious disclosure, regular investors may not understand the costs they impose on their investments.

A third problem is a practice called “robo-voting.” It is common for investment managers to simply and automatically heed the advice of a proxy advisory firm without giving the recommendations even a cursory review.

THE IMPORTANCE OF PROXY ADVISOR RECOMMENDATIONS

No one could have predicted how powerful proxy advisor firms have become. For instance, earlier this year financial journalist Michelle Celarier wrote in Institutional Investor about the proxy advisor Institutional Shareholder Services (ISS): That ISS has become the kingmaker in proxy contests between billionaire hedge fund activists and their multi-billion-dollar corporate prey is even more astonishing given that ISS itself is worth less than $1 billion and started out as a back-office sup-

port system, helping shareholders cast their ballots on what are typically mundane matters of corporate governance. Says one former ISS executive who now works at a hedge fund: “ISS sort of stumbled into this powerful role.”

ISS’s role now is so powerful the company and industry have drawn the attention of Congress. In May 2018, representatives from ISS and another advisory firm, Glass Lewis, sent letters to the Senate Banking Committee, which is considering legislation that has already passed the House of Representatives to address these longstanding concerns about their industry. Both companies downplayed their influence and the weight their recommendations hold, arguing that it is incorrect to paint them as anything but neutral arbiters or “data aggregators”—rather than for-profit influencers with numerous potential conflicts of interest.

They emphasized that their task is to identify the priorities of their clients—with the client’s assistance—in order to help them vote as they would if they had the time and resources to study the issue themselves. The crux of their argument is that if there’s any deviation from investment companies maximizing shareholder returns, it’s the fault of their clients. An industry trade group, the Council of Institutional Investors, explained it in a 2016 letter to the House Committee on Financial Services: ISS and Glass Lewis tend to follow investors on governance policy, not lead them.... Their franchises are built on credibility with investors. As a result, advisors’ views reflect those of many funds. Indeed, if there were a sharp divergence, we would expect to see advisors punished in the marketplace.

ISS claims that it plays only a marginal role in affecting the outcome of proxy votes, and that its recommendations only shift the vote by 6–10%. However, academic research suggests that the figure is more significant and may be as high as 25%. ISS also has its own corporate consulting arm, ICS Corporate Solutions,

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which is (somewhat opaquely) described on its website.

ISS leans heavily on its Registered Investment Advisor status to deflect criticism of its conflicts of interest, notes the Center on Executive Compensation. ISS argues that proxy advisory work constitutes “investment advice” under the Advisors Act, which would make the company a fiduciary and subsequently a “a disinterested fiduciary.” This description diverges from Glass Lewis’s view of itself in its letter to the Senate Banking Committee, which declares that it neither dispenses “investment advice” nor serves as a fiduciary.

The fact that ISS is registered as a fiduciary but Glass Lewis is not suggests a fundamentally different interpretation of their obligations and breeds confusion and uncertainty as to what the industry is and is not required to do. Given the SEC’s ongoing efforts to ensure transparency in the markets and to protect the interests of retail investors through Regulation Best Interest and other requirements, it is possible that this difference of opinion may prove problematic.

Glass Lewis tries to distance itself from ISS, in part because (unlike ISS) it does not have a consulting arm. But Glass Lewis also fails to offer any substantive, transparent insight into its guidelines and methodologies.

While proxy advisory firms provide advice on standard proxies for well-managed companies, they have in the past regularly failed to identify major problems on the horizon for the firms they analyze.

For instance, immediately prior to the recent Wells Fargo scandal involving the creation of fake customer accounts, which revealed a startling lack of management oversight, ISS recommended against removing any of the sitting board members even though most had been in place well beyond a time period normally considered prudent. Similarly, the company recommended a vote against a shareholder proposal to split the president and chairman of the board. ISS did subsequently recommend jettisoning incumbent board members, but not until well after the scandal came to light.

Efforts to push environmental, socially responsible, and good governance priorities via proxy battles are getting more traction these days. While the total number of votes pertinent to such issues have fallen slightly this year from 2017, the percentage scoring 50% approval doubled this year to 6% and the percentage scoring 40% approval went from 12% last year to 19%.

ROBO-VOTING AND ITS IMPLICATIONS

Institutional investors and large financial management companies have come to rely on the services of proxy advisors to help them decide how to vote on various shareholder resolutions. However, there is a moral hazard endemic in that decision-making process.

Certain investors—generally the largest ones—have sufficient personnel and resources to review the analysis and recommendations of their proxy advisors. But for most investment companies it is easier to simply concur without further review if both major proxy advisors make the same recommendation, a process referred to as “robo-voting.” The result is an overreliance on the recommendations of potentially understaffed and underqualified proxy advisor analysts.

Robo-voting is most common among smaller investors that lack the capacity or appetite to review individual reports and recommendations. Some of these investors have an arrangement with Glass Lewis and ISS that effectively dictates that they will automatically follow the recommendations provided, and that any deviation requires that a case be made to the internal investment committee. The extent to which these firms are effectively signing over their proxy recommendations has led some to question whether this might constitute a breach of fiduciary duty.

Given the number of clients they have (ISS claims over 1,900 institutional clients and Glass Lewis approximately 1,300) and the fact that many appear to have such arrangements in place, the two firms have significant influence on final voting outcomes.

For example, institutions vote as directed by ISS and Glass Lewis more than 80% of the time, according to a study by the American Council for Capital Formation.

THE TRANSPARENCY SOLUTION

The moral hazard that exists in the relationship between proxy advisors and investment management firms is the result of a government regulation mandating that they vote their proxies. That effectively coerces them into an over-reliance on firms whose influence exceeds their size, resources, and statutory authority.

Rep. Sean Duffy (R–WI) and Rep. Gregory Meeks (D–NY) introduced bipartisan legislation that would address many of these issues. The intent of HR 4015 is to enhance transparency in shareholder proxy systems, requiring proxy advisory firms to register with the SEC. Firms would also have to disclose potential conflicts of interest, codes of ethics, and methodologies for formulating recommendations and analyses. The House passed the bill in December 2017 but the Senate Banking Committee has not yet considered it, although it held a hearing on the issue in June.

In testimony at that hearing, Thomas Quaadman, executive vice president for the Chamber of Commerce Center for Capital Markets Competitiveness, described ISS and Glass Lewis as “the de facto standard setters for corporate governance in the United States.” Given that position, he suggests that both operate with conflicts of interest and a lack of transparency. He further alleges that each has made significant errors when developing vote recommendations. He also suggests that because Glass Lewis is owned by two somewhat politically active institutions—the Ontario Teachers’ Pension Plan and the Alberta Investment Management Corporation—it creates an inherent conflict of interest. Quaadman pointed out that the company may be able to exploit its influence to advance a broader agenda at the expense of investors.

At the same hearing, Darla Stuckey, president and CEO of the Society for Corporate Governance, also refuted the notion that ISS and Glass Lewis have no influence on how clients vote. She described how these firms “own and control the software platforms that send investor votes to the tabulator for a shareholder meeting.”

The issue is entirely created by the requirement that financial managers vote their proxies. Given that in the past most have

FALL 2018

been manifestly uninterested in doing so and have found the most expedient answer to this requirement to be outsourcing it as much as possible, it is worth asking whether the requirement makes sense in this day and age. Removing the requirement would likely give individual investors more weight in any proxy vote, which we suggest would be superior to the status quo. Allowing investment managers to vote proxies when and where they choose might make them more engaged in these issues than they currently are.

THE COSTS OF ACTIVISM ARE BORNE BY INVESTORS

There is recent precedent for government intervention when a perception develops that investors are being given short shrift. In 2015 the Obama administration called for more stringent rules overseeing investment managers. The administration pointed out that even a small reduction in the long-run return on an investor’s portfolio resulting from higher management fees can result in a large reduction in the value of a portfolio over a sustained period of time. This reality, according to the administration, necessitated closer government scrutiny of the actions of these advisors.

This is particularly relevant given the conflicts of interest apparent in the situation. Regarding proxy firms’ professed neutrality; for instance, the Manhattan Institute’s James Copland noted: ISS receives a substantial amount of income from labor-union pension funds and socially responsible investing funds, which gives the company an incentive to favor proposals that are backed by these clients. As a result, the behaviors of proxy advisors deviate from concern over share value, [suggesting] that this process may be oriented toward influencing corporate behavior in a manner that generates private returns to a subset of investors while harming the average diversified investor.

The actions of proxy advisors may be imposing a similar cost on investors, we submit. Given their conflicts of interest, shoddy guidance, and lack of certainty, they deserve the same scrutiny as fiduciaries, if not more.

FINANCIAL REGULATION: GETTING IT RIGHT

The federal government has painfully learned over the last two decades that effectively regulating corporate governance in financial markets is easier said than done. The pattern of legislative and regulatory action in this realm is best described as a punctuated equilibrium, with most activity taking place in direct response to a perceived change in the market environment.

The 2001 financial collapse of Enron brought the problem of shoddy corporate governance to the attention of Congress. By using accounting loopholes, special purpose entities, and myriad other tricks obscured by deficient financial reporting, the company’s executives hid billions in debt and failed deals. It became the largest corporate bankruptcy in U.S. history. Reacting to this debacle, Congress passed the Sarbanes–Oxley Act in an attempt to prevent similar calamities in the future. While the legislation compelled companies to provide substantially more information

/ Regulation / 21

to investors, it also increased compliance costs, which in turn reduced the number of Initial Public Offerings on American stock exchanges. That reduction still exists today.

In the aftermath of the 2008–2009 financial market crisis, Congress passed Dodd–Frank, a measure intended to prevent a similar disaster from occurring again. Dodd–Frank certainly has some merits: the increase in capital requirements and stricter regulatory oversight likely diminish the odds of another major financial crash or at least blunt the damage such a crash could inflict. But the legislation has major downsides as well: by increasing compliance costs for banks, Dodd–Frank has contributed to a marked reduction in banks across the country, with over 1,000 having been acquired or otherwise disappeared since the act’s passage. (See “Banking,” p.

77.) That outcome, many believe, effectively made access to capital more difficult for smaller firms operating in smaller cities and rural communities where community banks tend to dominate the financial market landscape. Because of this, the law may have contributed to the growing economic gap between rural America and the prosperous cities along the coasts.

Again, retail investors were the victims of legislation aimed to help them.

Addressing deficiencies in domestic financial markets in a way that mitigates the long-term economic effect on retail investors requires a measured, focused approach. Too little regulation can leave people out in the cold, while too much could exacerbate inequality, reduce economic growth, and make U.S. capital markets less competitive. The lessons that Congress and regulators have taken from 21st century financial incidents—act sooner rather than later, and do so judiciously but decisively—may apply to the current status of proxy advisors as well.

The potential conflicts of interest, factually inaccurate guidance, and lack of transparency that can arise from a reliance on proxy advisory firms tend to dilute the focus on stock price performance and maximizing returns in favor of other special interests. This ultimately hurts investors. Ending the requirement that investment funds vote their proxies would reduce the potential cost of this moral hazard problem.

READINGS ■■ “Bank Consolidation and Merger Acquisition Following the Crisis,” by Michal Kowalik, Charles S. Morris, and Kristen Regehr. Economic Review (Federal Reserve Bank of Kansas City) 2015(Q1): 31–49 (Summer 2015).

■■ “Politicized Proxy Advisers vs. Individual Investors,” by James Copland. Wall Street Journal, Oct. 7, 2012.

■■ “Proxy Voting Season Kicks Off on Wall Street.” The Economist, April 14, 2018.

■■ “Regulation and Bonding: The Sarbanes–Oxley Act and the Flow of International Listings,” by Joseph Piotroski and Suraj Srinivasan. Journal of Accounting Research 46(2): 383–425 (May 2008).

■■ “The Conflicted Role of Proxy Advisors,” by Timothy Doyle. American Council for Capital Formation, May 2018.

■■ “The Role of Proxy Advisor Firms: Evidence from a Regression-Discontinuity Design,” by Nadya Malengo and Yao Shen. Review of Financial Studies 29(12): 3394–3427 (December 2016).

22 / Regulation / FALL 2018 R E G U L AT O RY R E F O R M

Be A Shame If Anything Happened to Your Merger...

“Regulatory leveraging” can be a useful tool or it can be an abuse of power.

L

✒ BY WILLIAM E. KOVACIC AND DAVID A. HYMAN everaging—a firm’s tying together two or more of its products in order to boost sales—can be risky business. Firms that use substantial market power in one product to distort competition for a second product are attractive targets for claims of illegal tying and/or monopolization.

But what if the actor leveraging its market power is a government agency? Leveraging allows regulators to use their gatekeeping authority to secure concessions that they might not be able to achieve otherwise—and to do so quickly and cheaply. Should we applaud regulators for using a strategy that we would condemn when private parties do the same thing?

What kind of gatekeeping power makes regulatory leveraging possible? The most obvious example is the authority to grant or withhold approvals over something the regulated entity needs to function, such as a license to operate in a given market (e.g., the right to operate a radio station, cable system, or ferry) or the right to sell a particular product (e.g., a branded drug). A less obvious example is regulatory approval of a proposed merger. A common element in all of these settings is that if the regulator can attach conditions to the exercise of its gatekeeping authority, it can leverage outcomes that it might not be able to impose directly or could only accomplish at a much higher cost.

A concrete example may help in understanding the basic dynamics. Assume an agency uses its regulatory authority over mergers to extract concessions from the regulated entity on privacy and data security requirements. Does that raise any red flags? Does your reaction differ if the agency is using its authority over mergers to secure concessions that it could not obtain, or could realize only with great difficulty, if it focused

WILLIAM E. KOVACIC is a visiting professor at King’s College London and Global Competition Professor of Law and Policy at George Washington University Law School. He is also non-executive director of the United Kingdom Competition and Markets Authority. DAVID A. HYMAN is a professor at Georgetown University Law Center. The views expressed in this article are the authors’ alone.

PHOTO-ILLUSTRATION BY DAVIDVHERBICK

FALL 2018

solely on data security? What if the agency is using its authority over mergers to obtain concessions on data security that would be unconstitutional if it sought to impose them directly? Does it make a difference if the agency has no regulatory authority over data security? What if the agency does not have regulatory authority over data security, but a different agency that does have that authority has asked the competition agency to seek the concessions at issue? What if the agency is using its leverage to extract campaign contributions for favored constituencies or support for the priorities of agency leadership or their congressional masters?

REGULATORY LEVERAGING IN FIVE EASY PIECES

Is regulatory leveraging a normal, legitimate, and perhaps inevitable feature of agency design? Or is it hostage-taking that forces regulated entities to pay a sizeable ransom to be left in peace?

We present five brief case studies that give a sense of the circum-

/ Regulation / 23

stances in which regulators can engage in leveraging.

Leveraging across two antitrust domains / A regulator can leverage

its power across distinct areas within a single policy domain. In 2012, the Federal Trade Commission resolved two matters involving the international engineering and electronics firm Robert Bosch GmbH. The first involved Bosch’s proposed acquisition of SPX Service Solutions, which would have given Bosch a “virtual monopoly in the market for air-conditioning recycling, recovery, and recharge devices.” That issue was resolved with Bosch’s agreement to divest its automotive air-conditioner repair equipment business and make some licensing commitments.

The same FTC press release that announced the agency’s approval of the Bosch–SPX merger also announced that the FTC and Bosch had resolved a separate dispute over whether SPX had harmed competition by reneging “on a commitment to license key, standard-essential patents on fair, reasonable,

24 / Regulation / FALL 2018 R E G U L AT O R Y R E F O R M

and non-discriminatory (FRAND) terms.” Bosch agreed to abandon SPX’s claims for injunctive relief in those other cases, thereby resolving an ancillary matter that preceded the proposed merger.

It is not clear from the FTC’s press release how these two entirely distinct issues came to be settled simultaneously. Their appearance in the same press release certainly inclines us to believe that they were resolved as a package deal.

Is it possible that Bosch could have gotten the merger approved without conceding the dispute over SPX’s alleged abuse of FRAND terms? Of course. But Bosch had a huge incentive to give in on the SPX matter in order to obtain speedy approval of the proposed merger. FTC personnel knew that and could push hard for an immediate and outright concession. Even if FTC personnel never raised the subject, Bosch personnel were certainly aware that SPX was dealing with the FTC over the FRAND dispute—and it was a no-brainer for them to offer an outright concession to secure approval of the merger.

Cross-domain leveraging by a multipurpose regulator / In the second scenario, a multipurpose agency leverages power across distinct policy domains within its portfolio of duties. In recent years, the use of data about consumer behavior has become a major policy concern. Some commentators have suggested that merger approval is a useful mechanism to force firms to strengthen their privacy protections. The FTC confronted this issue in two merger reviews involving Google: in 2007 when Google sought regulatory approval for its acquisition of DoubleClick, and in 2010 when the FTC reviewed Google’s purchase of AdMob. The FTC had legal authority to review Google’s proposed acquisitions of DoubleClick and AdMob. It also had authority to investigate Google’s data protection and privacy policies. Agency personnel disagreed on whether the merger review should be used as an excuse/pretext/justification to delve into Google’s data protection and privacy policies. FTC personnel in the Bureau of Consumer Protection were keen to use the merger review process as a way of getting Google to adopt more privacy-protective practices. Conversely, FTC personnel in the Bureau of Competition were unenthusiastic about having the merger review process hijacked for a detour into consumer protection–land.

After some back and forth, FTC personnel decided not to use the merger review process to extract concessions from Google regarding its data protection and privacy policies. Indeed, the FTC’s closing statement in DoubleClick explicitly disavowed such strategies, noting that “the sole purpose of federal antitrust review of mergers and acquisitions is to identify and remedy transactions that harm competition.” But a more expansive conception of harm to competition would have allowed the FTC to leverage its merger review authority to achieve desired objectives across a broader swath of the regulatory space.

Leveraging across policy domains occupied by other regulators / In the third scenario, an agency leverages power to affect a policy domain it does not “own.” In 2013, Ally Financial was seeking approval from the Federal Reserve and the Federal Deposit Insurance Corporation to convert from a bank holding company to a financial holding company. It was also being investigated by the Consumer Financial Protection Bureau, an independent bureau located within the Federal Reserve. Although the CFPB has no regulatory authority over auto dealers, it decided to investigate whether the loan portfolios of indirect auto lenders such as Ally indicated that auto dealers were offering less favorable terms to minority borrowers.

According to Ally’s former CEO, the CFPB “threatened to derail [Ally’s] efforts to obtain key regulatory approvals if it didn’t agree to settle” by paying $100 million and begin offering belowmarket rates to minorities. He complained that the CFPB “absolutely knew they had tremendous leverage over us” and was trying to change the policies of an industry it did not have the authority to regulate. Internal CFPB memos confirm that agency personnel knew that Ally needed regulatory approval. The impending deadline to obtain that approval gave the CFPB a stronger hand than it would have had otherwise, notwithstanding significant weaknesses in the CFPB’s case against Ally.

Unsurprisingly, Ally folded, even though it had a strong case on the merits. It is impossible to know how the counterfactual would have played out, but it seems extraordinarily unlikely the CFPB would have been able to extract $100 million and a change in Ally’s business practices—let alone do so under the same time frame—except under conditions that gave the CFPB an extraordinary degree of regulatory leverage.

Leveraging with a “public interest” mandate / In a fourth scenario, an agency can use a public interest mandate to achieve commitments that are not authorized by more specific legal commands.

Many statutes delegate expansive regulatory authority by requiring an agency to consider the “public interest” in making decisions. For example, in evaluating proposed mergers, the Federal Communications Commission is required to evaluate whether the transaction will serve “the public interest, convenience, and necessity.”

Public interest standards are an open-ended invitation to engage in regulatory leveraging. In 2016, the FCC used the merger review process to strong-arm Charter Communications to adopt net neutrality standards that the FCC had been (to that date) unable to impose through direct regulation. Over the past decade, the FCC has used the same strategy to impose net neutrality constraints on multiple other companies, including AT&T, Verizon, BellSouth, and Comcast.

These tactics are not new. In the 1990s, the FCC used regulatory leverage to press Westinghouse into increasing the number of hours devoted to children’s educational programming on CBS. In 1971, the FCC released a list of songs that the commission believed promoted the use of illicit drugs—including “Lucy in the

FALL 2018

Sky with Diamonds” by the Beatles and “Truckin’” by the Grateful Dead. Some stations responded by discontinuing playing “Puff the Magic Dragon” by Peter, Paul, and Mary.

State and local regulators can play the same game. In 2016, the District of Columbia Public Service Commission conditioned its approval of the Exelon–Pepco merger on a host of ancillary provisions, including a commitment to relocate certain offices to D.C., the hiring of unionized workers, and at least $1.9 million in annual average charitable contributions to organizations located in D.C. or benefiting D.C. residents.

Everybody’s doing it! / Regulatory leveraging is a global phenomenon. Germany provides a recent, high-profile example. In December 2017, Germany’s competition agency announced that it had concluded that Facebook had abused its dominant position “by making the use of its social network conditional on its being allowed to limitlessly amass every kind of data generated by using third-party websites and merge it with the user’s Facebook account.” Obviously, this is a complaint about Facebook’s privacy policies with regard to the collection and use of data.

But strikingly, the German privacy regulators were nowhere to be found; the entire investigation was handled by the Bundeskartellamt, Germany’s antitrust authority. To some extent, the reticence of the German privacy regulators may have reflected perceived weaknesses in the country’s data protection remedies compared to the stronger sanctions available under Germany’s antitrust laws. Had the European Union’s new General Data Protection Regulation (GDPR) and its more powerful remedial scheme been in place two years ago, we presume that Germany’s data protection authorities would have taken the lead in addressing Facebook’s conduct.

Although the GDPR in one sense moots the dispute in question, the Bundeskartellamt’s Facebook investigation is a striking example of how competition law can create regulatory leverage that can be used in non-antitrust domains. In fairness, the original announcement of the Facebook investigation in 2016 disavowed the use of competition law to treat “every law infringement … [by] a dominant company.” But we can readily imagine many instances in which a dominant firm’s misconduct might distort consumer choice. In practice, that means the competition agency will become the backstop enforcer of a potentially large collection of non-competition-focused statutes and regulations.

The full implications of this approach were spelled out in an extraordinary proposal advanced by FTC Chairman Michael Pertschuk in 1977. He suggested that the commission could use its “unfair methods of competition” authority to challenge noncompliance with legal obligations governing environmental protection, immigration, and worker safety. The FTC never acted upon his theory, but a variation on the same theme seems to have been a factor in the German competition authority’s action against Facebook.

/ Regulation / 25

BENEFITS AND COSTS OF REGULATORY LEVERAGING

The most obvious benefit of regulatory leveraging is that it promotes more comprehensive settlements. In Bosch–SPX, the FTC already had an open file on SPX, and Bosch then came to the FTC with the proposed merger. Isn’t it more efficient to adopt one global settlement instead of maintaining two separate proceedings? If there are benefits in settlement (and there are), more comprehensive settlements must be better still.

Second, depending on the statutory language that is employed, leveraging may be an authorized delegation of legislative authority to regulate in a flexible way. Stated differently, Congress may have used “public interest” language to give the agency a hammer that could be deployed when a regulated entity comes to the agency for merger approval. But the agency can only use the hammer in carefully defined circumstances.

This structure keeps the agency from expanding its regulatory leverage beyond any given transaction, while giving it the flexibility to solve problems without going through the drudgery of rule-making or starting a separate case. And if the agency goes too far, the courts and the legislature stand ready to protect the rule of law.

Regulatory leveraging also involves real risks and disadvantages. For starters, it leads to less disciplined decision making by governmental agencies. Agencies have an incentive to ignore or downgrade the controls imposed by the substantive regulatory regime and use leverage to circumvent those restrictions.

Second, regulatory leveraging leads to less transparent and less accountable decision making. Merger review rarely ends up in court, so agency leadership need only persuade itself that its “wish list” is worth pursuing. Firms badly want to obtain immediate approval of their mergers, so agencies have them over a barrel.

Third, regulatory leveraging can be used for “good” or “evil.”

Readers may like the results of regulatory leveraging when an agency is run by their friends and political allies, but will they be quite so enthusiastic if the same power is turned over to their adversaries? Stated more concretely, what if the FTC and DOJ agreed they would both demand the following as a condition of approving a merger involving the listed companies: ■■ Apple

had to agree to unlock any iPhone provided to it by the Department of Homeland Security, the Central Intelligence Agency, the Federal Bureau of Investigation, the Drug Enforcement Administration, and the Bureau of Alcohol, Tobacco, Firearms and Explosives.

■■ Verizon had to agree to provide immediate and unrestricted access to the text messages associated with any subscriber’s number, without requiring a warrant or notifying the subscriber, upon request by any federal, state, or local governmental entity.

■■ Google had to create a backdoor to Gmail and turn it over to the National Security Agency.

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Salesforce had to fire its chief executive officer, who was the ringleader of corporate attempts to pressure Republican state lawmakers on social issues. For every dollar Salesforce had to pay its CEO to go away, it had to pay 10 times that amount to support the Tea Party.

■■ PayPal had to reverse its decision to cancel a $3.6 million operations center in Charlotte, NC in response to the state’s enactment of the “Public Facilities Privacy and Security Act.” PayPal also had to spend at least twice that amount endowing a center at the University of North Carolina for the study of the War of Northern Aggression. Finally, each member of PayPal’s board and senior management (including vegetarians, vegans, and those with religious objections to eating pork) had to spend a week eating only Carolina barbecue and drinking sweet tea, after which they had to personally hand-write a five-page essay on the virtues of that diet.

■■ All companies seeking merger approval had to make large contributions to foundations created and administered by the FTC and DOJ. The funds may be used for any purpose the FTC and DOJ deem appropriate.

■■

As this list of horribles is intended to suggest, regulatory leveraging is not all upside. Indeed, there is significant risk of abuse.

Finally, because regulatory leveraging is firm-specific, it can create significant discontinuities in the applicable law. Only firms that have had a merger reviewed by the agency will be subject to regulatory leverage—and the details of the resulting settlements may well vary depending on the priorities of agency leadership at the time the merger was reviewed and the extent to which firm management was willing to give away the store to get the merger approved. These discontinuities make a mockery of the principle of equal justice under law and also create real frictions in the markets for corporate control.

SQUARING THE REGULATORY LEVERAGING CIRCLE

Some of the time, regulatory leveraging is a problem. And some of the time, regulatory leveraging is the only available solution.

This is not the kind of scenario that lends itself to a simple fix. But following in the steps of the late James Q. Wilson, we propose “a few modest suggestions that may make a small difference.”

If Congress wants agencies to engage in regulatory leveraging, it should explicitly authorize the process and identify some boundaries. Should agencies only engage in leveraging for substantive areas of law within their zone of regulatory authority or should they be allowed to range more widely? What criteria should an agency employ in deciding whether to engage in regulatory leveraging? An express congressional delegation of authority would go a long way toward legitimizing an agency’s use of regulatory leveraging.

■■ Clear grants of authority.

Agencies should be more explicit about what and how they leverage. This will simultaneously discipline their use of regulatory leveraging and force them to articulate and justify their conduct. If an agency believes that regulatory leveraging is a sensible way of solving a problem, it should forthrightly explain and justify its actions.

If an agency isn’t willing to brag about what it is doing, it probably shouldn’t be doing it. If regulators can’t stand the heat, they should get out of the kitchen.

■■ Fewer gates. More gates mean more gatekeepers and more opportunities for regulatory leveraging. The obvious solution is to be careful about creating new gates and revisit the necessity of existing gates. Before creating new gates, legislators should decide whether they are necessary—and if so, whether the responsible agency may engage in regulatory leveraging and under what circumstances the leveraging can occur. Legislators should also “sunset” all gates to force routine reconsideration of the need for each gate.

■■ Better norms. Regulatory leveraging is, at best, a thirdbest solution for dealing with policy problems. In some instances, internal agency dynamics will discourage the use of regulatory leveraging. But a robust government-wide norm against the use of regulatory leveraging could play a useful backup role.

■■ Ex-post review. We don’t know how often regulatory leveraging takes place, the circumstances under which it occurs, and how effective (or ineffective) it actually is. But there have been complaints about the exercise of regulatory leverage by multiple entities within the federal government. At the state and local level, many “takings” cases involve similar instances of regulatory exactions, including the compelled surrender of land to create bicycle or pedestrian paths and cash settlements to be controlled and disbursed by the regulators. And there are the long-standing arguments over “unconstitutional conditions” and the spending power.

■■ More transparency.

We don’t know nearly enough about the prevalence and results of regulatory leverage. Only a consistent practice of ex-post review can cast light on these issues.

CONCLUSION

Extortion schemes typically involve some variation on the theme: “Nice place you got here. Be a shame if anything happened to it.”

It is understandable why those on the receiving end of regulatory leveraging perceive themselves to be in a similar “Your money or your life” bargaining position.

Regulators like leverage, and some of the time it is the only available solution to a particular problem. But regulatory leverage raises very real risks and costs. That counsels for considerably greater caution than regulatory agencies have shown to date.

Stated bluntly, unless regulatory leveraging is properly disciplined, it invites lawlessness.

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28 / Regulation / FALL 2018 ANTITRUST

Calm Down about Common Ownership The evidence of anticompetitive harm from institutional investing is weak and the proposed policy solutions would be more harmful than the supposed problem.

P

✒ BY THOMAS A. LAMBERT AND MICHAEL E. SYKUTA

rominent antitrust scholars have recently sounded alarm bells about large institutional investors’ “common ownership” of competing businesses. Writing in the Harvard Law Review, Harvard Law School’s Einer Elhauge proclaimed that “an economic blockbuster has recently been exposed”—namely, a “small group of institutions has acquired large shareholdings in horizontal competitors throughout our economy, causing them to compete less vigorously with each other.” In the Antitrust Law Journal, Eric Posner of the University of Chicago and Fiona Scott Morton and Glen Weyl of Yale University contended that “the concentration of markets through large institutional investors is the major new antitrust challenge of our time.” Those same authors took to the pages of the New York Times to argue that “the great, but mostly unknown, antitrust story of our time is the astonishing rise of the institutional investor … and the challenge that it poses to market competition.”

Not surprisingly, these scholars have offered solutions to the alleged problem. Elhauge has called for using the Clayton Act’s Section 7, which precludes anticompetitive mergers, to police common ownership of minority stakes in competing firms. Posner et al. have proposed a government enforcement policy that would encourage institutional investors either to avoid holding stock of multiple firms in concentrated industries or to limit their influence over such firms by not voting their shares.

These scholars are getting ahead of themselves. There are serious difficulties with both the claim that small-stakes common ownership poses a significant competitive problem and the solutions the scholars have offered for that purported problem. We THOMAS A. LAMBERT is the Wall Family Chair in Corporate Law and Governance at the University of Missouri. MICHAEL E. SYKUTA is associate professor in the divi-

sion of applied social sciences at the University of Missouri.

show below that the problem’s existence has not been adequately established and that, even if it does exist, the proposed policy cures would be worse than the disease. First, though, we describe the alleged problem.

THE PURPORTED PROBLEM

Given the recent explosion in index investing, institutional investors that sponsor index funds—Vanguard, BlackRock, Fidelity, etc.—are now among the largest shareholders of most publicly traded companies. They frequently hold significant stakes in all the firms in an industry. Proponents of restrictions on common ownership theorize that this pattern of institutional investment could reduce market competition and they point to empirical evidence purporting to show that such theoretical harm is, in fact, occurring.

Theory of harm /

An investor in a single firm within a market— say, American Airlines—would prefer that the company try to win business from its rivals. By contrast, an investor holding stakes in all the firms in a market—American, Delta, Southwest, and United, if those were the only airlines servicing a particular route—would not want the firms to compete vigorously. After all, any gains to one competitor would come at the expense of other firms in the investor’s portfolio.

An investor that is “intra-industry diversified” in this fashion would prefer maximization of industry profits, whereas a singlefirm investor would prefer that its company maximize own-firm (i.e., just its own) profits. Corporate managers typically maximize own-firm profits by growing market share, and they do that by expanding output, enhancing quality, and discounting prices.

Industry profits, by contrast, are maximized when corporate managers collectively act like a monopolist by reducing output,

PHOTO-ILLUSTRATION BY DAVID HERBICK

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expenditures on product improvements, and discounts from the levels that would attain in vigorous competition. Because institutional investors tend to be intra-industry diversified, they prefer maximization of industry profits and therefore want their portfolio companies to pull their competitive punches.

But why would corporate managers defer to the interests of institutional investors when most of their companies’ shareholders are not intra-industry diversified? The theory is that institutional investors are better positioned to influence management decision-making. Relative to individual shareholders, institutional investors possess more extensive monitoring resources and greater expertise on matters of business strategy and firm policy.

They also hold larger stakes in the corporations in which they are invested, and they therefore have greater incentive to become informed before voting their shares in director elections and on shareholder proposals, executive compensation packages (“sayon-pay”), etc. What’s more, the votes of institutional investors often attract media attention, amplifying such investors’ power over management. Given their greater clout, institutional investors are in a better position to engage corporate managers, and anecdotal evidence suggests they regularly do so. For all these reasons, corporate managers often honor the preferences of institutional investors over those of individual, uncoordinated stockholders, even when the latter collectively own a greater proportion of company stock.

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Putting all this together generates the two main premises of the theoretical argument that common ownership by institutional investors softens competition in concentrated industries.

Those premises are: Intra-industry diversified institutional investors have an interest in maximizing industry profits and would prefer that corporate managers not engage in business-usurping competition that would enhance own-firm profits but reduce overall profits within the industry.

■■ Institutional investors have sufficient influence over corporate managers to induce them to refrain from own-firm profit maximization in favor of greater industry profits.

■■

Both of these premises ultimately prove to be flawed. However, before we explain those flaws, we first present the evidence often cited in support of the claim that institutional investing harms competition.

Evidence of harm / Two recent studies—one involving the U.S. airline industry, the other involving commercial banks—purport to demonstrate that institutional investors’ common ownership of competing firms has reduced competition and injured consumers in concentrated industries.

In “Anti-Competitive Effects of Common Ownership” (the

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airline study), co-authors José Azar, Martin Schmalz, and Isabel Tecu tested whether institutional investors’ common ownership of interests in domestic airlines raised airfares higher than they otherwise would be. To assess common ownership and the degree to which it changed over time, the authors employed a measurement known as “MHHI delta” (MHHI∆).

MHHI∆ is a component of the “modified Herfindahl– Hirschman Index” (MHHI), which, as the name suggests, is a modification of the Herfindahl–Hirschman Index (HHI), a wellknown measure used in evaluating the legality of business mergers.

HHI, which ranges from near zero to 10,000 and is calculated by summing the squares of the market shares of the firms competing in a market, assesses the degree to which a market is concentrated and thus susceptible to collusion or oligopolistic coordination.

MHHI endeavors to account for both market concentration (HHI) and the reduced competition incentives occasioned by common ownership of the firms within a market. MHHI∆ is the part of MHHI that accounts for common ownership incentives, so MHHI = HHI + MHHI∆.

Calculating MHHI∆ for a particular market is a bit complicated. (For an explanation, see Appendix A of our working paper listed in the Readings.) For present purposes, it will suffice to understand what MHHI∆ purports to measure and which variables determine its magnitude. MHHI∆ aims to assess the degree to which the managers of firms within an industry, on the assumption that they seek to maximize their shareholders’ portfolio returns, would cause their firms to avoid vigorous competition in an effort to maximize industry rather than own-firm profits.

The primary variables that determine MHHI∆ are: the degree of control intra-industry diversified investors exercise over the managers of their portfolio firms (the greater such control, the higher the MHHI∆) ■■ the size of the financial stakes intra-industry diversified investors hold in the firms within the industry, and the degree to which, for each such investor, those stakes are equal across firms (the greater the stakes of intra-industry diversified shareholders and the more equal those stakes across firms, the higher the MHHI∆) ■■ the degree to which the firms within the industry have nondiversified shareholders with control over firm management (the greater the financial stakes and control of investors who are not intra-industry diversified, the lower the MHHI∆) ■■ the market shares of firms that share common ownership (the greater their market shares, the greater the market effect of firm managers’ decisions concerning competitive behavior, and the higher the MHHI∆) ■■

In their airline study, Azar et al. first calculated the MHHI∆ on each domestic airline route from 2001 to 2014. The authors then examined, for each route, how changes in the MHHI∆ over time correlated with changes in airfares on that route. To

control for route-specific factors that might influence both fares and the MHHI∆, the authors ran a number of regressions. They concluded that common ownership of air carriers resulted in a 3%–7% increase in fares.

In “Ultimate Ownership and Bank Competition” (the banking study), Azar, Sahil Raina, and Schmalz attempted to assess how common ownership has affected service fees and interest rates in local markets for bank deposits. The authors correlated account fees, the minimum account sizes required to avoid fees (fee thresholds), and interest rates paid on deposits with the “generalized HHI” (GHHI), a metric similar to MHHI. They concluded that for interest-bearing checking accounts, a one-standard-deviation increase in GHHI increased fees by about 11% and fee thresholds by around 17%. For money market accounts, a similar increase in GHHI resulted in a 3% increase in fees and a 17% increase in fee thresholds. The authors also found that increases in GHHI reduced the interest rates paid to depositors.

PROBLEMS WITH THE PROBLEM

There are significant problems with both the theory that smallstakes common ownership causes competitive harm and the empirical studies purporting to support that theory.

Carefully parsed, common ownership critics’ theoretical argument proceeds as follows: Premise 1:

Because institutional investors are intra-industry diversified, they benefit if their portfolio firms seek to maximize industry, rather than own-firm, profits.

Premise 2: Corporate managers seek to maximize the returns of their corporations’ largest shareholders—intraindustry diversified institutional investors—and will thus pursue maximization of industry profits.

Premise 3: Industry profits, unlike own-firm profits, are maximized when producers refrain from underpricing their rivals to win business.

Conclusion: Intra-industry diversification by institutional investors reduces price competition and should be restricted.

The first two premises of this argument are, at best, questionable.

Inter-industry diversification /

With respect to Premise 1, it is unlikely that intra-industry diversified institutional investors benefit from, and thus prefer, maximization of industry rather than own-firm profits. That is because intra-industry diversified mutual funds tend also to be inter-industry diversified, and maximizing one industry’s profits requires supracompetitive pricing that tends to reduce the profits of firms in complementary industries. Vanguard’s Value Index Fund, for example, holds around 2% of each major airline (1.85% of United, 2.07% of American, 2.15% of Southwest, and 1.99% of Delta), but also holds:

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■■ 1.88%

of Expedia Inc. (a major retailer of airline tickets) of Boeing Co. (a manufacturer of commercial jets) ■■ 2.02% of United Technologies Corp. (a jet engine producer) ■■ 3.14% of AAR Corp. (the largest domestic provider of commercial aircraft maintenance and repair) ■■ 1.43% of Hertz Global Holdings Inc. (a major automobile rental company) ■■ 2.17% of Accenture (a consulting firm for which air travel is a significant cost component) ■■ 2.20%

Each of those companies—and many others—perform worse when airlines engage in the sort of supracompetitive pricing (and corresponding reduction in output) that maximizes profits in the airline industry. The very logic suggesting that intra-industry diversification causes investors to prefer less competition necessarily suggests that inter-industry diversification would counteract that incentive.

Manager incentives / Premise 2, the claim that corporate manag-

ers will pursue industry rather than own-firm profits when their largest shareholders prefer that outcome, is similarly dubious.

For nearly all companies in which intra-industry diversified institutional investors collectively hold a significant proportion of outstanding shares, a majority of the stock is still held by shareholders who are not intra-industry diversified. There are several reasons to doubt that corporate managers would routinely disregard the interests of shareholders owning the bulk of the company’s stock and pursue industry rather than own-firm profits.

For one thing, favoring intra-industry diversified investors holding a minority interest could subject managers to legal liability. The fiduciary duties of corporate managers require that they attempt to maximize firm profits for the benefit of shareholders as a whole; favoring even a controlling shareholder (much less a minority shareholder) at the expense of other shareholders can result in liability.

More importantly, managers’ personal interests usually align with those of the majority when it comes to the question of whether to maximize own-firm or industry profits. As sellers in the market for managerial talent, corporate managers benefit from reputations for business success, and they can best burnish such reputations by beating—winning business from—their industry rivals. In addition, many corporate managers are compensated in stock of the companies they manage. They maximize the value of that stock by maximizing own-firm, not industry, profits. It thus seems unlikely that corporate managers would ignore the interests of stockholders owning a majority of shares and cause their corporations to refrain from business-usurping competition.

Confusing institutions with fund holders / When confronted with

criticisms of their theory of anticompetitive harm, proponents of

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common ownership restrictions generally point to the empirical evidence in the two studies described above. The authors of the airline study, for example, greeted a criticism of their theory with the retort, “This argument falls short of explaining why, empirically, taking into account shareholders’ economic interests does help to explain firms’ product market behavior.”

Of course, to demonstrate “empirically” that institutional investors’ “economic interests” influence their portfolio companies’ “product market behavior” (i.e., cause the companies to charge higher prices, etc.), researchers would need to correctly identify institutional investors’ economic interests with respect to their portfolio firms’ product market behavior and establish that those interests cause firms to act as they do. On those crucial tasks, the airline and banking studies fall short.

In assessing institutional investors’ economic interests, the studies have assumed that if an institutional investor reports holding a similar percentage of each firm in a market—say, 5% of the stock of each major airline—then it must have an “economic interest” in maximizing industry rather than own-firm profits. Such an assumption is unwarranted. That is because each institutional investor’s reported holdings, set forth on forms it must submit under Section 13(f ) of the Securities Exchange Act, aggregate its holdings across all its funds. Such aggregation paints a misleading picture of the institutional investor’s actual economic interest.

For example, while Vanguard’s Section 13(f ) filing reports ownership of a similar percentage of American, Delta, Southwest, and United Airlines—suggesting an economic interest in industry profit maximization—the picture looks very different at the individual fund level: Vanguard’s Value Index Fund (VIVAX) holds significant stakes in American, Delta, and United (0.46%, 0.45%, and 0.42%, respectively), but holds no Southwest stock. VIVAX does best if United, American, and Delta usurp business from Southwest.

■■ Vanguard’s Growth Index Fund (VIGRX) holds a significant stake in Southwest (0.59%), but holds no stake in American, Delta, or United. Investors in VIGRX would prefer that Southwest win business from American, Delta, and United.

■■ Vanguard’s Mid-Cap Index Fund (VIMSX) and Mid-Cap Value Index Fund (VMVIX) hold significant stakes in United (1.00% and 0.321%, respectively), but hold no stock in American, Delta, or Southwest. Investors in VIMSX and VMVIX would prefer that United win business from American, Delta, and Southwest.

■■ Vanguard’s PRIMECAP Core Fund (VPCCX) holds stakes in all four major airlines, but its share of Southwest (1.49%) is twice its share of American (0.72%), nearly four times its share of United (0.38%), and seven-and-a-half times its share of Delta (0.198%). Investors in VPCCX would prefer that Southwest grow at the expense of American, United, and Delta.

■■

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They would also prefer that American win business from United and Delta, and that United win business from Delta.

We could go on, but the point should be clear: because returns to retail investors in the funds of Vanguard and similar institutions turn on fund performance, the competitive outcome that maximizes retail investors’ profits will differ among funds.

Mistaking institutional investors’ incentives / Proponents of restrictions on common ownership might respond that even if an institutional investor’s individual funds have conflicting preferences, the institutional investor as an entity must have some preference about whether to maximize industry profits or the profits of a particular company. Because it cannot honor all its individual funds’ conflicting preferences with respect to competitive outcomes, the institutional investor will settle on the compromise strategy that maximizes its individual funds’ aggregate returns: industry profit maximization. Such a strategy would be the first choice of the institution’s funds holding relatively equal shares of all firms within a market. And, while the first choice of the institution’s funds that are disproportionately invested in one firm would be to maximize that firm’s profits, those funds would do better with industry profit maximization than with the first-choice strategy of other of the institution’s funds, i.e., those that are disproportionately invested in a different firm.

But even if maximization of industry profits leads to the greatest aggregate returns for an institutional investor’s funds, such a strategy may not be the best outcome for the institutional investor itself. An institutional investor typically wants to maximize its profits, which will grow as it attracts retail investors into its funds versus those of its competitors and steers those investors toward the funds that earn it the greatest profits (fees less costs). To assess an institutional investor’s preferences with regard to the returns of its different funds, then, one must know the degree to which each fund’s attractiveness vis-à-vis rivals’ similar funds turns on portfolio returns, and the profit margin each fund delivers to the institutional investor.

For funds tracking popular stock indices, portfolio returns play little role in winning business from rival fund sponsors. (For example, higher returns on the stocks in the S&P 500 are unlikely to attract investors to BlackRock’s S&P 500 index fund over Fidelity’s or Vanguard’s.) Moreover, the fees charged on such funds, and thus the institutional investor’s potential profit margins, are extraordinarily low. For actively managed funds, portfolio returns are far more significant in attracting investors, and management fees are higher. The upshot is that an institutional investor, in determining what competitive outcome it prefers, will attach little weight to the competitive preferences of passive index funds and more weight to the preferences of actively managed funds, with that weight growing as the funds provide the institutional investor with higher profit margins.

It is quite possible, then, for an intra-industry diversified

institutional investor to prefer a competitive outcome other than the maximization of industry profits, even if industry profit maximization would maximize the aggregate returns of its individual funds. Consider, for example, an institutional investor that offers funds similar to the following Vanguard funds: Vanguard’s 500 Index Fund (VFIAX) holds near equivalent interests in American, Delta, Southwest, and United and would thus do best with a strategy of industry profit maximization. Its expense ratio (annual fees divided by total fund amount) is 0.04 percent.

■■ Vanguard’s Value Index Fund (VIVAX) holds similar stakes in American, Delta, and United but does not hold Southwest stock. Its expense ratio is 0.18 percent.

■■ Vanguard’s PRIMECAP Core Fund (VPCCX) holds a much higher stake in Southwest than in the other airlines and has an expense ratio of 0.46 percent, 2.5 times as great as the noSouthwest VIVAX fund and 11.5 times as high as the fully diversified VFIAX fund.

■■ Vanguard’s Capital Opportunity Fund (VHCAX) holds significantly higher shares of Southwest and United (1.74% and 1.55%, respectively) than of Delta and American (0.65% and 1.16%, respectively). Its expense ratio is 0.38, more than twice as great as the no-Southwest VIVAX fund and 9.5 times the fully diversified VFIAX fund.

■■

This institutional investor’s Southwest-heavy funds (those resembling Vanguard’s VPCCX and VHCAX funds) charge much higher fees than its fully diversified index fund (the one resembling VFIAX, for which fund returns are unimportant) and significantly higher fees than its funds that are more heavily invested in airlines besides Southwest (those resembling VIVAX).

Despite being intra-industry diversified at the institutional level, this institutional investor may do best if Southwest maximizes own-firm profits.

The point here is that discerning an institutional investor’s actual economic interest requires drilling down to the level of its individual funds, something the common ownership studies have not done. Thus, contrary to the assertion of the airline study’s authors, the common ownership studies have not shown “empirically” that “taking into account shareholders’ economic interests does help to explain firms’ product market behavior.” Simply put, they have never established what those economic interests are.

Endogenous measure / Even if institutional investors’ aggregated holdings accurately revealed their economic interests with respect to competitive outcomes, the common ownership studies would still be deficient because they fail to show that those economic interests caused portfolio firms’ “product market behavior.”

As explained above, the common ownership studies employ MHHI∆ (or a similar measure) to assess institutional investors’ interests in competition-softening. They then correlate changes

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in that metric with changes in portfolio firms’ pricing behavior.

The problem is that MHHI∆ is itself affected by factors that independently influence market prices. It is thus improper to infer that changes in MHHI∆ caused changes in portfolio firms’ pricing practices; the pricing changes could have resulted from the very factors that changed MHHI∆. In other words, MHHI∆ is an endogenous measure.

To see why this is so, consider the three-step process involved in calculating MHHI∆. The first step is to assess, for every coupling of competing firms in the market (e.g., Southwest/Delta, United/American, Southwest/United, etc.), the degree to which the controlling investors in each of the firms would prefer that it avoid competing with the other. The second step considers the market shares of the two firms in the coupling to determine the competitive significance of their incentives not to compete with each other. (The idea is that reduced head-to-head competition

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the other airlines. The market shares of the airlines in the high season are equal: 25% each.

On these facts, the increase in demand causes MHHI∆ to rise from 7,200 to 7,500. But the increase in demand is also likely to raise ticket prices. We thus see an increase in MHHI∆ that correlates with an increase in ticket prices, but the price change is not caused by the change in MHHI∆. Instead, the two changes have a common independent cause.

Endogeneity also creeps in during the third step in calculating MHHI∆. In that step, the “cross MHHI∆s” of all the couplings in the market—the metrics assessing for each coupling the extent to which common ownership will cause the two firms to compete less vigorously—are summed. As the number of firms participating in the market—and thus the number of couplings—increases, the MHHI∆ will tend to rise. While HHI (the market concentration measure) will decrease as the number of competing firms rises, MHHI∆ (the measure of common ownership pricing incentives) will increase.

For example, suppose again that five institutional investors hold equal stakes (say, 3%) of each airline servicing a market and that the airlines have no other significant shareholders. If there are two airlines servicing the market and their market shares are equivalent, HHI will be 5,000, MHHI∆ will be 5,000, and MHHI (HHI + MHHI∆) will be 10,000. If a third airline enters and grows so that the three airlines have equal market shares, HHI will drop to 3,333, MHHI∆ will rise to 6,667, and MHHI will remain constant at 10,000. If a fourth airline enters and the airlines split the market evenly, HHI will fall to 2,500, MHHI∆ will rise further to 7,500, and MHHI will again total 10,000.

This is problematic because the number of participants in the market is affected by consumer demand, which also affects market prices. In the market described above, for example, the third or fourth airline might enter the market in response to an increase in demand, and that increase might simultaneously cause market price to rise. We would see, then, a price increase that is correlated with, but not caused by, an increase in MHHI∆; increased demand would be the cause of both the higher prices and the increase in MHHI∆.

In the end, then, the empirical evidence of competition-softening from common ownership is not the smoking gun proponents of common ownership restrictions proclaim it to be.

It is improper to infer that changes in MHHI caused changes in portfolio firms’ pricing practices.

The pricing changes could have resulted from the very factors that changed MHHI.

by bit players matters less for overall market competition than does reduced competition by major players.) The final step is to aggregate the effect of common ownership-induced competition-softening throughout the overall market by summing the softened competition metrics for each coupling of competitors within the market.

Given this process for calculating MHHI∆, there are at least two sources of endogeneity in the metric. One arises because of the second step. To assess the significance to market competition of any two firms’ incentives to reduce competition between themselves, the market shares of those two firms must be incorporated into the metric. But factors that influence market shares may also influence market prices apart from any common ownership effect.

Suppose, for example, that five institutional investors hold significant and equal stakes (say, 3%) in each of the four airlines servicing a particular air route and that none of the airlines has another significant shareholder. The air route at issue is subject to seasonal demand fluctuations. In the low season, the market is divided among the four airlines so that one has 40% of the business and the other three have 20% each. The MHHI∆ for this market would be 7,200. When the high season rolls around, demand for flights along the route increases, but the leading airline is capacity constrained, so additional ticket sales go to

PROBLEMS WITH THE PROPOSED SOLUTIONS

Even if common ownership by institutional investors did cause some degree of competition-softening in oligopolistic industries, the solutions that have been proposed for the problem would not be justified.

Under Elhauge’s proposal to police common ownership

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using the Clayton Act’s Section 7 (which, by its literal terms, precludes stock acquisitions that tend to lessen market competition), liability would result from “any horizontal stock acquisitions that have created, or would create, a MHHI∆ of over 200 in a market with an MHHI over 2500” if “those horizontal stock acquisitions raised prices or are likely to do so.” Posner et al. advocate a more determinate, rule-based approach. They would have the federal antitrust enforcement agencies compile annual lists of oligopolistic industries and then threaten enforcement action against any institutional investor holding more than 1% of the stock in such an industry if the investor held stock in more than one firm within the industry and either voted its shares or engaged firm managers.

The administrative costs of these proposed solutions, coupled with the losses they would create by eliminating welfare-enhancing arrangements, would swamp any welfare benefits they secured.

Administrative costs /

Both of the proposed approaches would impose tremendous decision costs on business planners and adjudicators. Because institutional investors cannot prevent market prices from rising, institutional investors seeking to avoid liability under Elhauge’s approach would have to monitor MHHI and MHHI∆ in the markets in which they were invested to ensure that the relevant thresholds were not exceeded. The monitoring would have to continue perpetually, for MHHI and MHHI∆ change constantly based on factors beyond an institutional investor’s control (e.g., the market shares of the competing firms, stock ownership percentages of other investors). If the MHHI and MHHI∆ thresholds were crossed and a lawsuit filed, adjudicators would have to weigh complex evidence like that presented in the airline study to determine whether common ownership had caused or was threatening an adverse price effect.

Evaluating complicated econometric studies is beyond the competence of most judges and virtually all juries.

Posner et al.’s bright line approach might initially seem to reduce the decision costs for business planners, but because the approach says only when government enforcement actions will be brought, it would hardly reduce business planners’ burdens; they would still have to monitor MHHI and MHHI∆ to avoid liability in private antitrust lawsuits. Moreover, the Posner et al. approach would saddle enforcers with the herculean task of compiling, and annually updating, lists of oligopolies. Given that the antitrust agencies frequently struggle with the far more modest task of defining markets in the small number of merger challenges they file each year, there is little reason to believe enforcers could perform their oligopoly-designating duties at a reasonable cost.

Error costs / Even greater than the proposed solutions’ administrative costs are their likely “error costs”—i.e., the welfare losses that would stem from wrongly deterring welfare-enhancing arrangements. Such costs would result if, as is likely, institutional investors were to respond to the policy solutions by making one

of the two changes proponents of the solutions appear to prefer: either refraining from intra-industry diversification or remaining fully passive in the industries in which they hold stock of multiple competitors.

If institutional investors were to seek to avoid liability by investing in only one firm per concentrated industry, retail investors would lose access to a number of attractive investment opportunities. Passive index funds, which offer retail investors instant diversification with extremely low fees (because of the lack of active management), would virtually disappear, as most major stock indices include multiple firms per industry.

Moreover, because critics of common ownership maintain that intra-industry diversification at the institutional investor level is sufficient to induce competition-softening in concentrated markets, each institutional investor would have to settle on one firm per concentrated industry for all its funds. That requirement would impede institutional investors’ ability to offer a variety of actively managed funds organized around distinct investment strategies—e.g., growth, value, income etc. If, for example, Southwest Airlines were a growth stock and United Airlines a value stock, an institutional investor could not offer both a growth fund including Southwest and a value fund including United.

Finally, institutional investors could not offer funds designed to bet on an industry while limiting exposure to company-specific risks within that industry. Suppose, for example, that a financial crisis led to a precipitous drop in the stock prices of all commercial banks. A retail investor might reasonably conclude that the market had overreacted with respect to the industry as a whole, that the industry would likely rebound, but that some commercial banks would probably fail. Such an investor would wish to invest in the commercial banking sector but hold a diversified portfolio within that sector. A legal regime that drove fund families to avoid intra-industry diversification would prevent them from offering the sort of fund this investor would prefer.

Of course, if institutional investors were to continue intraindustry diversification and seek to avoid liability by remaining passive in industries in which they were diversified, the funds described above could still be offered to investors. In that case, though, another set of significant error costs would arise: increased agency costs in the form of managerial misfeasance.

Unlike most individual shareholders, institutional investors often hold significant stakes in public companies and have the resources to become informed on corporate matters. They have a stronger motive and greater opportunity to monitor firm managers and are thus particularly well-poised to keep managers on their toes. Institutional investors with long-term investor horizons—including all index funds, which cannot divest from their portfolio companies if firm performance suffers—have proven particularly beneficial to firm performance. Indeed, a recent study

by Jarrad Harford, Ambrus Kecskés, and Sattar Mansi found that investment by long-term institutional investors enhanced the quality of corporate managers, reduced measurable instances

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of managerial misbehavior, boosted innovation, decreased debt maturity (causing firms to become more exposed to financial market discipline), and increased shareholder returns. It strains credulity to suppose that this laundry list of benefits could similarly be achieved by long-term institutional investors that had no ability to influence managerial decision-making by voting their shares or engaging managers. Opting for passivity to avoid antitrust risk, then, would prevent institutional investors from achieving their agency cost–reducing potential.

CONCLUSION

Proponents of additional antitrust intervention to police common ownership simply have not made their case. Their theory as to why current levels of intra-industry diversification would cause consumer harm is implausible and the empirical evidence they say demonstrates such harm is both scant and methodologically suspect. The policy solutions they have proposed for dealing with the purported problem would radically rework an industry that has provided substantial benefits to investors, raising the costs of portfolio diversification and enhancing agency costs at public companies. Courts and antitrust enforcers should reject their calls for additional antitrust intervention to police common ownership.

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READINGS ■■ “A Proposal to Limit the Anticompetitive Power of Institutional Investors,” by Eric A. Posner, Fiona Scott Morton, and E. Glen Weyl. Antitrust Law Journal 81(3): 669–729 (2017).

■■ “Anti-Competitive Effects of Common Ownership,” by José Azar, Martin C. Schmalz, and Isabel Tecu. Journal of Finance, forthcoming.

■■ “Common Ownership Does Not Have Anti-Competitive Effects in the Airline Industry,” by Patrick Dennis, Kristopher Gerardi, and Carola Schenone. Working paper, February 2018.

■■ “Common Sense About Common Ownership,” by Douglas H. Ginsburg and Keith Klovers. Concurrences Review 2 (2018).

■■ “Do Long-Term Investors Improve Corporate Decision Making?” by Jarrad Harford, Ambrus Kecskés, and Sattar Mansi. Working paper, November 2017.

■■ “Horizontal Shareholding,” by Einer Elhauge. Harvard Law Review 129(5): 1267–1317 (2016).

■■ “The Case for Doing Nothing about Institutional Investors’ Common Ownership of Small Stakes in Competing Firms,” by Thomas A. Lambert and Michael E. Sykuta. Working paper, May 2018.

■■ “The Competitive Effects of Common Ownership: Economic Foundations and Empirical Evidence,” Pauline Kennedy, Daniel P. O’Brien, Minjae Song, and Keith Waehrer. Working paper, July 2017.

■■ “The Competitive Effects of Common Ownership: We Know Less Than We Think,” by Daniel P. O’Brien and Keith Waehrer. Antitrust Law Journal 81(3): 729–776 (2017).

■■ “Ultimate Ownership and Bank Competition,” by José Azar, Sahil Raina, and Martin Schmalz. Working paper, July 2016.

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Peter Navarro’s Conversion The professor has changed and wobbled, but his current protectionist arguments are embraced by the White House and segments of the public.

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n a July 20th editorial, the Wall Street Journal offered this pithy appraisal of one of the Trump administration’s top economic advisers on the negative consequences of the burgeoning U.S. trade war with the rest of the world: “Peter Navarro says the harm is a ‘rounding error.’ He’s out of touch.”

Navarro is an economist and director of the Office of Trade and Manufacturing Policy (OTMP), a White House agency created by President Trump. He is one of the rare economists to occupy a high-level advisory role in the White House. A Harvard University Ph.D., he is a stiff protectionist, which is rare among economists.

In June, the OTMP published a report titled “How China’s Economic Aggression Threatens the Technologies and Intellectual Property of the United States and the World.” It argues against the Chinese government’s rule-breaking mercantilism and industrial policy, which are deemed unfair, exploitative, and even extortionist. (Mercantilism includes both protectionism against imports and the promotion of exports.)

This raises the general question of what a national government’s trade policy should be toward a foreign country whose government pursues a mercantilist industrial strategy. A related issue is that Navarro himself was once a promoter of free markets and free trade (and was a contributor to this magazine in its early years). There is, of course, nothing wrong with changing one’s mind; if new evidence contradicts one’s theories, one should change one’s mind.

But is today’s protectionist Navarro right, or the young, free-trade Navarro of a few decades ago?

PROTECTIONIST EVOLUTION

In 1984, Navarro published a book titled The Policy Game: How PIERRE LEMIEUX ’s latest book is the just published What’s Wrong with Protectionism?

Answering Common Objections to Free Trade (Rowman & Littlefield, 2018).

Special Interests and Ideologues Are Stealing America. Reading it, I get the sense of a young Navarro who was a politically moderate and mainstream economist. He argued against the producers’ special interests that politically win out over consumers’ diffuse but more important interests. He blamed protectionist corporations and labor unions. He observed that protectionism “as a job program or form of income redistribution … fails miserably.” Invoking the Smoot–Haley tariff adopted at the beginning of the Great Depression, he pointed out the danger of retaliation and trade wars: “And as history has painfully taught, once protectionist wars begin, the likely result is a deadly and well-nigh unstoppable downward spiral by the entire world economy.” Elsewhere in the book he noted, “The biggest losers in the protectionist game are consumers.” He also warned against the danger of using national security as a justification for protectionism.

Fast-forward 23 years to Navarro’s 2007 book, The Coming China Wars: Where They Will Be Fought and How They Can Be Won. Largely devoid of economic analysis, it looks like a pre-write of the June OTMP report. In the book, he argues that China is a totalitarian and corrupt country on the verge of popular revolt, and that the Chinese government is trying to build an empire. Chinese producers, he charges, are guilty of unfair competition: they steal intellectual property, pay low wages, destroy the environment, and are subsidized and supported by their mercantilist government.

His fixation on the U.S. trade deficit and manufacturing industry dates from that book. He advocates environmental and labor standards for China. He speaks highly of trade unions, without which “exploitation cannot be far behind.” He lauds China’s 2006 Five-Year Plan, which was supposed to end that country’s “Adam Smith on steroids” attempt at market liberalization and replace it with government-managed “sustainable growth.”

He still wants to work within the system when he recommends

CHIP SOMODEVILLA / GETTY IMAGES

✒ BY PIERRE LEMIEUX

CHIP SOMODEVILLA / GETTY IMAGES

using international organizations and negotiations to pressure the Chinese government to reduce its protectionism. However, he does not exclude “military might to back up the prescriptions.”

He also advises the American government to stop running budget deficits that allow the Chinese government to buy Treasury securities and thereby fuel the U.S. trade deficit through upward pressure on the U.S. dollar.

He further developed and espoused his protectionist views in subsequent writings. Navarro contributed a chapter entitled “Benchmarking the Advantages Foreign Nations Provide Their Manufacturers” to the 2009 book Manufacturing a Better Future for America. The book was published by the Alliance for American Manufacturing (AAM), which describes itself as “a select group of America’s leading manufacturers and the United Steelworkers.”

Navarro’s chapter provides a rare glimpse into his current theoretical framework. He argues that the conception of free trade pioneered by David Hume, Adam Smith, and David Ricardo—which lies at the foundation of the modern economic analysis of trade—is inapplicable to today’s conditions for two reasons: First it is not true that “all free trading countries … refrain from the practices of either mercantilism or protectionism.” Second, not all trading countries have automatic adjustment mechanisms that prevent chronic trade imbalances. In other words, the world is protectionist and therefore America must be, too. Ricardo’s theory of comparative

advantage—a cornerstone of modern economic understanding of trade—is briefly mentioned and summarily dismissed.

Navarro’s 2011 book Death by China, coauthored with Greg Autry, an assistant professor of “clinical entrepreneurship” at the University of Southern California, argues that the United States and China are in an “undeclared state of war” and that a real, non-trade war between them is possible. Consequently, American industrial capacity must be protected against Chinese competition.

Navarro and Autry point out that countries in the “free world,” such as Japan, Mexico, and Germany, are “our real free trade partners.” Yet the book generally views trade and trade negotiations as analogous to war. Trade unions must protect jobs against shoddy and dangerous Chinese products. A companion documentary film, produced by Autry and partly financed by steelmaker Nucor, is even more radically protectionist.

In 2015, Navarro published Crouching Tiger: What China’s Militarism Means for the World. It deals mainly with a future military confrontation between the United States and China, and ways to prevent it if possible. It too has a companion documentary, subtitled “Will There Be a War with China?” In both, Navarro argues that the U.S. government must build a strong military advantage over China with the help of its allies. American consumers must stop financing China’s own military expansion with their purchases of Chinese goods. A “trade rebalancing” would “slow China’s

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economy and thereby its rapid military buildup,” according to the book. “It would also provide America and its allies with both the strong growth and manufacturing base these countries need to build their own comprehensive national power.”

Last June, the news and commentary website Axios prodded Navarro on why he had changed his opinions on trade so radically after The Policy Game. He explained that after China joined the World Trade Organization (WTO) in 2001, he realized that free trade cannot work when it is not fair—for example, when one of the countries involved practices “non–market economy industrial policies.”

“The traditional approach to evaluating tariffs,” he wrote for Axios, “ignores the external costs or ‘negative externalities’ associated with unfair trade.” These “externalities” include the loss of factories, jobs, and incomes, and their consequences in workers’ lives.

In his writings, Navarro makes five distinct arguments against open trade with China and other countries. They can be summarized as follows: We cannot compete against a dirigiste and even totalitarian country like China.

Trying to do so generates negative externalities.

■■ The fairness argument: “Unfair” trade is not free trade and is destroying the American economy.

■■ The trade deficit argument: The U.S. trade deficit is a serious problem that reduces gross domestic product and indicates unfair trade.

■■ The retaliation argument: Retaliatory protectionist measures are justified against protectionist countries; such retaliators are the real free-traders.

■■ The national security argument: Protectionism is required for reasons of national security.

■■ The impossible-competition argument:

Many of these arguments are now echoed by large groups of the America public. I examine each of them in the following sections.

THE IMPOSSIBLE-COMPETITION ARGUMENT

Navarro and others invoke China as an extreme case that authoritarian governments make for bad trading partners. Of course, he is right to describe the Chinese state as authoritarian and repressive, if not totalitarian.

In 2012, Nobel economics laureate Ronald Coase and coauthor Ning Wang of Arizona State University published a book titled How China Became Capitalist, describing the country’s economic evolution after the accession of liberalizer Deng Xiaoping in 1978. (See “Getting Rich Is Glorious,” Winter 2012–2013, and “The Power of Exchange: Ronald H. Coase 1910–2013,” Winter 2013–2014.) However, conventional wisdom holds that those reforms have been reversed in recent years.

Economic freedom in China / But things are not as simple as the conventional wisdom—and Navarro—suggest. Consider China’s scores on the Fraser Institute’s Economic Freedom of the World index (FTW). The index combines indicators of the size of government,

commitment to the rule of law and property rights, soundness of the national currency, freedom to trade internationally, and scope of regulation. An index like this must be used with caution, but China’s scores over time suggest the country continues to make progress—albeit sometimes haltingly—toward economic freedom.

Figure 1 compares China’s overall FTW score to the United States’ in recent years. Perfect freedom would get a score of 10.

Economic freedom in China increased markedly from 1980 (the first year available) through the years preceding the country’s accession to the WTO in 2001, with the exception of a dip around the time of the Tiananmen Square events and Deng’s retirement in 1989. Economic freedom in China has continued to rise since 2001, although more slowly.

In the United States, on the contrary, economic freedom as measured by the FTW has generally decreased since 2000. Obviously, freedom is much more advanced in America, but the comparative trend is interesting. (Another index of economic freedom, compiled by the Heritage Foundation, shows the United States dropping from the “free country” category to “mostly free” in 2010.)

Figure 2 charts the index component “Freedom to trade internationally,” which measures the absence of domestic barriers to trade. The figure suggests this freedom has been declining in the United States while, in China, it dramatically increased until 2001, and has remained more or less constant since. Over the whole period 1980–2015, the change in the freedom to trade more than explains the change in the total economic freedom index for both China and the United States. Given those trends, it is not clear that the Chinese government has become less of a free trader.

In their 2011 book, Navarro and Autry characterized the Chinese economic system as a “brand of state capitalism,” which is not false. But if we want to speak in those terms, it can be argued that the American system is another brand of state capitalism (or crony capitalism), as the current protectionist push illustrates. And Ning Wang remains optimistic for China; in comments to me he indicated his belief that “overall, China is still on its way to capitalism.”

Convenient scapegoat / Many arguments against Chinese imports are exaggerated. In Death by China, Navarro and Autry wrote that “China has stolen millions of American manufacturing jobs” and that “if we had held onto those jobs, America’s unemployment would be well below 5%.” In writing this they confounded macroeconomic factors and trade issues. In May 2016, five years after their book was published, the U.S. unemployment rate was 4.7%, and it has continued declining ever since.

How to explain the low unemployment given the jobs “lost” to China and elsewhere? They were replaced—and then some—by other jobs. During the so-called “China shock” between 1999 and 2011, when U.S. imports from China grew rapidly and job disruptions followed (in certain manufacturing industries), 5.6 million net jobs were created in the U.S. economy.

Jobs are a poor measure of worker welfare, of course; otherwise, destroying machines and computers would be good policy

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because more workers would then be required. What matters is note that outcompeting producers is not technically an “externalincome. During the same period, real U.S. income (real GDP) ity,” but the normal result of a free and flexible economy where increased by 26%. All this occurred despite the worst recession “creative destruction” occurs. If the result of competition is consince the Great Depression. sidered an externality, everything in economic life is an externality The value of the goods imported from China is also often exagand the concept becomes useless. gerated. According to research done at the Federal Reserve Bank of Economic disruptions can produce, in Navarro’s terms, “socioSan Francisco, the proportion of American consumer expenditures economic costs in the forms of higher crime rates, drug use, and that go to China, including the value of the Chinese inputs incorporated into what’s pro- Figure 1 duced in America, is 1.9%. This is because Economic Freedom of the World (FTW) Index Chinese goods occupy a big share only in relatively small categories of consumer expen10 China ditures (such as clothing and shoes, or furniUSA ture and household equipment), and because two-thirds of what Americans consume is 8 composed of domestic services—such things as health care, education, and housing.

Irrational fear /

But isn’t Chinese industrial policy a great threat? No. It is an error to believe, contra economic theory and history, that the controlled enterprises in a country dominated by a communist government can constitute a grave danger for efficient capitalist enterprises. No private car manufacturer would have feared import competition from Trabants, the shoddy East German cars whose production did not survive the fall of the Berlin Wall.

In the 1970s and 1980s, similar fears were expressed about Japanese industrial policy and the country’s supposedly all-powerful Ministry of International Trade and Industry (MITI). There was no comparison between Trabants and Japanese cars such as Hondas or Toyotas: Japanese cars were state-of-theart machines built by private companies. Yet the threat to the U.S. economy posed by the Japanese turned out to be greatly exaggerated.

If China is backsliding from a market economy, then Western producers have little to fear. And if China isn’t backsliding and its producers make advances in freedom and economic efficiency, then that is good for all of mankind. Competition from statedominated businesses, even if “unfair,” is not a big threat, and fair competition from capitalist firms can only be good, whether that competition is domestic or foreign.

Externality argument /

Navarro’s “externality” argument is remarkably shoddy. First,

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1980 ’85 ’90 ’95 2000 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 2010 ’11

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Source: James Gwartney, Robert Lawson, and Joshua Hall, Economic Freedom of the World: 2017 Annual Report, Fraser Institute.

This figure uses the panel dataset.

Figure 2

Freedom to Trade Internationally in FTW Index 10 China USA

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1980 ’85 ’90 ’95 2000 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 2010 ’11

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Source: James Gwartney, Robert Lawson, and Joshua Hall, Economic Freedom of the World: 2017 Annual Report, Fraser Institute.

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suicide rates.” Perhaps these sorts of costs can be considered externalities for affected communities. They may correspond to what many people view as the problems with free trade. But research has shown that international trade has accounted for at most 20% of the reduction of manufacturing employment in the United States and other developed countries; the rest is due to technological progress, which has reduced the need for labor. Technology is by far the main disruptive factor. A stagnant society without technological change would face different problems and costs, which most people would find far worse than the incidental costs of economic growth.

The costs of economic disruptions that are shouldered by the welfare state (through unemployment insurance, trade adjustment assistance, Medicaid, and such) seem to be another reason why some people object to free trade. But hasn’t the welfare state been created precisely to provide a safety net in a dynamic society?

People who object to free trade on that basis should also want to block any social, technological, and economic change.

THE FAIRNESS ARGUMENT

Perhaps what people resent is competition based on allegedly unfair advantages that create an “unlevel playing field.” This fairness argument may be the foundation of all other protectionist arguments, in the general public and among politicians. It’s an important argument that needs to be addressed.

In a June 21st, 2011 Los Angeles Times op-ed, Navarro argued that the Chinese manufacturing advantage “is actually a complex array of unfair trade practices, all of which are actually illegal under free-trade rules.” He mentions piracy and counterfeiting, the undervalued yuan, the “forced” transfer of technology from American companies engaged in joint ventures in China, and the lack of American-like environmental and labor regulation in China.

Intellectual property theft can be dealt with, at least partly, through the WTO and ordinary courts, even Chinese courts.

“American IP owners have in recent years enjoyed increased success in enforcing their rights in Chinese courts,” Stanford law professor Paul Goldstein has observed. New international treaties or rules can be devised to address ongoing concerns.

It is worth noting that, at the time of the American industrial revolution, the U.S. government did not protect foreign intellectual property. Not until 1989 did the U.S. government adhere to the 1886 Berne Convention for the Protection of Literary and Artistic Works. Moreover, a good argument can be made that the definition of intellectual property has been extended too far in the past few decades. (See “The Ideal Fox in the Ideal Henhouse,” p. 73.)

The transfers of technology that American companies are often required to accept when they establish joint ventures in China are certainly objectionable, but nobody is obliged to set up shop in that country if the costs imposed are higher than the benefits.

At any rate, this requirement violates the WTO rules, as Navarro admits, and eventually could be solved at that level.

If the Chinese yuan was once undervalued, the International Monetary Fund and most economists recognize that it is not so

anymore. From mid-2005 to late July 2018, the yuan increased in value 18% against the dollar, even counting the 8% drop since April 2018 when American protectionism started battering the Chinese currency. In its twice-yearly reports, the U.S. Treasury has continuously declined to declare the Chinese government a “currency manipulator.” At any rate, a national state cannot undervalue its currency for very long because doing so requires an increasing money supply, which generates domestic inflation and exerts an opposite effect on the currency. Otherwise, it would be a breeze for any mercantilist state to increase exports and decrease imports by simply inflating the currency, even if doing so would be illegal under WTO rules.

As for the lack of labor and environmental regulations in China, why should that be an issue? There were no such regulations in America and other Western countries when they started growing during the Industrial Revolution. Are rich Western producers (including trade unions) now going to dictate such regulations in developing countries? This sort of fairness looks rather self-serving and unfair.

China is still a relatively poor country, with a GDP per capita equal to 28% of the American level, about what it was in the United States in 1950. China’s remarkably high rate of growth since 1980 (about 5.5% per year) was due to an economic takeoff in a context of liberalization, more or less the same thing that happened in Western countries with the Industrial Revolution. In fact, China grew faster in a shorter amount of time because it had the advantage of being part of an already rich world. But such high growth will not continue for long if liberalization stalls. (And it should be noted that there have been questions over the years about the Chinese government inflating its GDP statistics in order to exaggerate the country’s growth.)

Unfair for whom? / In general, low wages in poor countries are not “unfair.” It is because of their low wages that they have a comparative advantage in some economic sectors. Advanced countries have a comparative advantage in sectors more intensive in capital—including the human capital of specialized workers.

This is a conclusion of the theory of comparative advantage that Navarro ignores as he focuses on helping and bailing out some producers, which is a way to undermine prosperity.

If Americans can consume more by producing something in which they have a comparative advantage and exchange it on world markets, they will generally be better off. The drop in the price of clothes, household appliances, and furniture during the past few decades is testimony to the benefits of international trade.

Producers will complain of unfairness when they are outcompeted in fields where they don’t have a comparative advantage, but there is no reason to yield to these special interests, as the young Navarro correctly argued.

If the Chinese government is more mercantilist than the U.S. government, for whom is this unfair? Certainly not American consumers, who obtain cheaper goods thanks to the hapless Chinese taxpayers who pay the subsidies. American producers—

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shareholders and workers in import-competing industries—will, of course, be affected and capital and labor will have to move to other industries, as we have seen in the case of old-style manufacturing. But consumption is the goal of production, not the other way around. And these subsidies help Americans to consume more, at Chinese expense.

Tariffs and other protectionist measures mainly hurt the poor, who devote a larger proportion of their incomes to physical goods.

In Crouching Tiger, Navarro admits that “reducing the flow of cheap, illegally subsidized ‘Made in China’ goods into American markets would hit the poorest segments of American society disproportionately hard.” Protectionism is unfair to the poor.

It is not unfair for American consumers to get bargains on goods from China or other developing countries. It is not unfair to let private firms, wherever they are, compete to satisfy consumers. What is clearly unfair is to use the power of government to protect a small number of American producers, like the 2,400 American workers (at most) occupied in manufacturing washing machines, plus the shareholders (not all American) of the few domestic washer manufacturers, to the detriment of 97 million American households. (See “Putting 97 Million Households through the Wringer,” Spring 2018.)

THE TRADE DEFICIT ARGUMENT

Navarro views the persistent U.S. trade deficit as another justification for American protectionism. Instead of just “free and fair trade,” he now calls for “free, fair, and balanced trade”—that is, an end to the trade deficit. But the trade deficit is a false problem originating from a faulty economic analysis, a statistical confusion, and a sort of logical prank.

The economic error is to assume, perhaps because “deficit” is a pejorative term, that a trade deficit is bad in itself. A trade deficit stemming from the decentralized actions of importers and exporters—the former buying more goods and services than the latter sell—raises no problem per se. The United States had a regular trade deficit—or, more precisely, a merchandise deficit—until the Civil War, and a surplus during the Great Depression and the two world wars.

The error is compounded when it is further assumed that a bilateral trade deficit—a deficit with a specific country—is bad, as if every pair of countries should, or could realistically, have a zero balance in their trade of goods and services.

There is nothing intrinsically bad about a global trade deficit, which implies that net foreign investment is coming into the country. Also, there is nothing intrinsically good in a trade surplus, which implies that net capital is leaving the country. A trade deficit, however, may be bad when, like is currently the case in the United States, it is due mainly to high federal budget deficits that attract foreign purchases of Treasury bonds.

In The Coming China Wars, Navarro subliminally suggests that China is to blame for the federal budget deficit because the Chinese buy Treasury bonds. Over the past five decades, the U.S. government has proven that it is quite able to run growing budget deficits by itself, which in turn invites trade deficits. As of May

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2018, Chinese holdings of Treasury bonds (no doubt mostly by the Chinese government) correspond to 7.7% of the federal debt.

Contrary to what Navarro argues, automatic adjustment mechanisms exist for trade imbalances. A trade deficit can’t grow larger than net inward capital flows. If it does, exchange rates will adjust—in the case of the United States, the dollar will lose value relative to other currencies—which in turn will reduce imports and increase exports. But foreign investors do want to invest in the attractive American economy.

Navarro falls for the journalistic canard that “net exports” (exports minus imports) reduce GDP by “simple arithmetic.” When the expression “net exports” is used, it is usually written in quotation marks, as Navarro and Autry do in Death by China, because it represents a mere statistical trick used by national statisticians to remove imports that were already included in the uses of GDP (in consumer, government, and investment expenditures). Imports have to be removed because they are not part of GDP, which is gross domestic production. (See “What You Always Wanted to Know about GDP but Were Afraid to Ask,” Winter 2016–2017.) Think about the guy on the scales who subtracts 1 lb. to factor in the weight of his shoes; his weight doesn’t change if instead he subtracts 2 pounds because on that day he is wearing heavier shoes. Likewise, American output doesn’t change because more imports are both added and subtracted. But Navarro and Autry overlook this when, in Death

by China, they quickly drop the warning quotation marks around “net exports,” and substitute “trade deficit.” Hocus-pocus! They can now claim that the trade deficit reduces domestic production as a matter of accounting arithmetic.

With all due respect to Navarro, George Mason University economist Don Boudreaux was right when he posted on Facebook, “If Trump trade advisor Peter Navarro knows any economics, he’s very skilled at giving no evidence of this knowledge.”

The logical prank comes from begging the question, what is the problem with a trade deficit? It reveals unfair trade practices, answer protectionists. But how does a protectionist determine that trade is unfair? By observing that it results in a trade deficit.

The evidence of a trade deficit and of unfair trade is self-referential.

THE RETALIATION ARGUMENT

The retaliation argument claims that protectionism and retaliation against a mercantilist country actually promote “real” free trade. Some people go so far as to say that the protectionists in the Trump administration are free-traders at heart. Such beliefs are contradicted by many declarations and actions.

In his AAM paper, Navarro eulogized NAFTA as “an almost textbook-like free-trade regime.” In Death by China, he and Autry contrast China with “our real free trade partners like Japan, Mexico, and Germany.” But the Trump administration’s tariffs have hit Mexico and Canada, which are part of NAFTA, as well as the European Union, which includes Germany. Trump specifically threatened German car imports. European countries are politically and economically similar to the United States and, as Navarro recognized in his

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AAM article, they and Japan, Mexico, and Canada “normally play by the rules set forth by the WTO and GATT.” Only real American protectionists would attack those countries. Yet now Navarro is one of the cheerleaders for Trump’s broad protectionist policies.

For all we know, Navarro himself is onboard with wall-to-wall protectionism. Remember that, in his opinion, “fair and free trade” has to be balanced too. That means trade will never be acceptable because there are always imbalances.

Even in the case of China, traditional “free trader” governments would think that fighting violations of WTO rules would require maintaining the WTO’s capacities to enforce them. In fact, the current U.S. administration refuses to approve replacements for departing judges in the WTO’s Appellate Body, which slows it down and will completely incapacitate it by the end of 2019.

With the protectionists in power in Washington, we now watch the amusing if not absurd scene of the Chinese government defending free trade. Last May, the Chinese ambassador to the WTO even quoted Adam Smith to his—probably mum—American counterpart. What a strange world if there ever was one!

Errors of retaliation / Trade retaliation is almost always a bad idea. First, as Adam Smith noted in The Wealth of Nations and the young Navarro concurred in his 1984 book, it rarely succeeds in opening trade; on the contrary, it risks starting a trade war in which everybody loses.

Second, retaliation is unnecessary because, one way or another, exports must always equal imports plus net foreign investment.

Dollars paid for imports always come back. The foreigners who receive them in payment for their exports will convert them into local currencies. The ultimate recipients will then use the dollars to either import from America or invest in America, if only in Treasury securities, which are deemed as good as cash and pay interest.

Third, retaliation is self-detrimental. A domestic tariff (or another form of import restriction) hurts domestic consumers, who have to pay more for the targeted good regardless of whether it is imported or domestically produced. Domestic producers want protection precisely in order to charge consumers more for products. Importers reimburse in higher prices what (or most of what) foreign producers pay in tariffs. A tariff is thus a tax on domestic consumers. As British economist Joan Robinson remarked, retaliation is as sensible as it would be “to dump rocks into our harbors because other nations have rocky coasts.”

Contrary to what Navarro preaches, trade is not like war. In fact, nations or countries do not trade; individuals do, often through corporate intermediaries. Any trade is beneficial to all trading partners; otherwise, one party would walk away from the exchange.

Individuals and private bodies should be left free to make their own bargains. The goal should not be to stop China from growing but, on the contrary, to not interfere with its people as they become richer and freer, just as Americans simultaneously do.

A recent analysis in the Economic Synopses of the Federal Reserve Bank of St. Louis concludes that “a trade war with China can nei-

ther stop the decline in American manufacturing employment nor eliminate the U.S. trade deficit, but it could significantly reduce the welfare of American consumers by making U.S. imports of Chinese goods more expensive.” The same goes for trade with other countries.

Bronson Jones, the CEO of a metal products manufacturer harmed by Trump’s steel and aluminum tariffs, sees them as part of a negotiating strategy. Such tariffs, he said, are “short-term pain for long-term gain” (New York Times, July 23rd, 2018). In fact, they are short-term gains for politicians in exchange for economic pain, possibly long-term, for nearly everyone else, a standard result of government interventionism.

A national government should declare unilateral free trade if it wants to act in the best interest of its citizens. Multilateral free trade is the first-best outcome because multiple countries’ citizens benefit, but the second-best is unilateral free trade. It is very risky if not outright self-defeating to use the third-best—protectionism and retaliation—in a dubious effort to reach the first-best. Just because citizens of other countries don’t have free enterprise and consumer sovereignty is no reason for our government to similarly deprive us by controlling which goods or services we import, whom we import capital from, or how we invest abroad.

Economists as ideologically diverse as Paul Krugman, a Nobel prizewinning economist, and Jagdish Bhagwati, a famous trade economist, think in terms of unilateral free trade. Practical instances of unilateral free trade can be found in the United Kingdom after the abolition of the Corn Laws in the middle of the 19th century, Hong Kong today, and the large number of national governments that currently don’t charge the maximum (or “bound”) tariffs allowed by the WTO. For example, the Mexican government applies (to non-NAFTA countries) an average tariff of 7.4% instead of the bound rate of 35% it is allowed.

THE NATIONAL SECURITY ARGUMENT

The national security argument is really just a protectionist excuse.

If steel, aluminum, or cars imported from, or available in, allied countries raise security problems here in the United States, then everything from food to clothes does also. Nobody can wage a war naked or hungry, after all. By this logic, the government should slap national security tariffs on these goods as well. Yet it doesn’t because policymakers realize that having foreign sources for these goods to complement domestic supply is beneficial to defense (not to mention most everything else). As the young, free-trade Navarro argued, “It is highly possible that our defense capability might actually be enhanced—not damaged—by import competition.”

We may add that future wars may be won as much with electronic wizardry as with traditional hardware. In a similar vein, Robert Work, deputy defense secretary until 2017, “argues that the West’s most enduring military advantage will be the quality of the people produced by open societies” (“When Weapons Can Think for Themselves,” The Economist, April 26, 2018). The quality of people and goods will be higher in a free society, and a free

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society implies freedom to trade.

It is also worth noting that national security is arguably undermined by the conflicts that protectionism creates with allied governments and their populations. The free-trade Navarro suggested this very idea in his 1984 book.

It is trivially true that any foreign country that becomes richer could represent a more serious military threat because its government can extract or requisition more resources for war purposes.

But it is no less true that wealthier people are likely to be less willing to go to war because they have more to lose economically.

Thus trade can help prevent war. Making pariahs of the Chinese will harm, not improve, national security.

Contrary to what Navarro now claims, American consumers of Chinese goods (or the trade deficit) don’t finance the military means of the Chinese government as much as they use Chinese resources to produce export goods for Americans. More Chinese exports to America, fewer resources left to build war machines (other things equal, of course). In the process of trade, both sides get richer. Today’s Navarro does not seem to remember the benefits of exchange that his younger self understood well.

His current focus on “protecting” U.S. manufacturing is probably as outdated from a national security viewpoint as it is from a narrower economic viewpoint. Remember that in America as in other advanced countries, two-thirds of consumer expenditures are devoted to services. Another reason why the proportion of employment in the manufacturing sector has been declining for six decades is that productivity has increased to the point that real American manufacturing output has nearly tripled since 1972.

Old-style manufacturing has moved to developing countries, but complex manufacturing has progressed in America. Protecting old manufacturing amounts to “bailing out our failing industries,” as Wharton School economist Ann Harrison puts it.

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Zakaria Floats Away.” A former Time editor, Zakaria is a CNN host and Washington Post columnist. By defending China, they claim, he makes no allowance for the fact that the elimination of Chinese competition would help “our good neighbor Mexico and Zakaria’s home country of India.” “Well, Fareed,” they conclude, “that’s just plain cold. Have you forgotten your own roots and the slums of Bombay?”

CONCLUSION

Writing for Foreign Policy in March 2017, journalist Melissa Chan depicts Navarro as motivated by his love of media attention and his longing for political fame. He ran for public office several times, always unsuccessfully, and “morphed from registered Republican, to Independent, to Democrat, and back to Republican.” According to Chan, he is derided by well-regarded China analysts. Disregarding psychological and political speculations, one thing is sure: his arguments are not based on economic analysis.

To summarize my arguments, economics strongly suggests that the best trade policy is not to have one, to leave citizens alone to import or export as they wish. That’s true whether the country’s trading partners are free-traders or dirigistes like China. Free enterprise and economic freedom are not only efficient, they are what fairness is or should be about. There is no reason to be concerned with the trade deficit, except to the extent that it is caused by federal profligacy, in which case the solution is to solve the root cause of the problem. Retaliation only compounds other countries’ protectionism. National security is an easy protectionist excuse. Building a war economy in peace time is not acceptable in a free society.

The maintenance of economic freedom at home—which includes the freedom to import what one wants if one finds the terms agreeable—is the only individualist, coherent, and realistic policy. The young Peter Navarro seemed to understand that. Sadly, today’s Navarro does not.

EMOTIONAL AND POLITICAL ARGUMENTS

READINGS

Our original question was whether Navarro’s conversion to protectionism provides good reasons to share some popular doubts about free trade. It appears that the answer is no. His conversion to protectionism relies very little on economics. Instead, he seems motivated by military fears and nationalist emotions.

These motivations appear perhaps most clearly in Chapter 15 of Death by China. There, he and Autry lead a pamphleteer’s charge against what they call “China apologists.” Among their foils are “liberals” (in the American sense) as well as many “conservatives” (they don’t distinguish conservatives and libertarians) who show “a blind faith in the principle of free trade.” “It is virtually impossible to reason with them,” Navarro and Autry add. The “apologists” include the Cato Institute, the Heritage Foundation, and some “turncoat” CEOs. Reflecting on the Wall Street Journal’s fear of a repeat of Smoot– Hawley protectionism (a concern the young Navarro shared in The Policy Game), Death by China claims “it is all so much cow manure.”

Navarro and Autry’s criticisms are especially nasty for journalist Fareed Zakaria, whose name adorns the chapter’s subtitle: “Fareed

■■

Essays in the Theory of Employment, by Joan Robinson. Blackstone, 1947.

■■ “How China Unfairly Bests the U.S.,” by Peter Navarro. Los Angeles Times, June 21, 2011.

■■ “Growth, Trade, and Deindustrialization,” by Robert Rowthorn and Ramana Ramaswamy. IMF Working Paper WP/98/60, International Monetary Fund, Washington, D.C., March 1999.

■■ “Intellectual Property and China: Is China Stealing American IP?” by Paul Goldstone with Sharon Driscoll. SLS Blogs, April 10, 2018.

■■ “Peter Navarro’s Journey from Globalist to Protectionist, in His Own Words,” by Erica Pandey and Jonathan Swan. Axios, June 24, 2018.

■■ “The Myth and the Reality of Manufacturing in America,” by Michael J. Hicks and Srikant Devaraj. Center for Business and Economic Research, Ball State University, 2015.

■■ “Trading Myths: Addressing Misconceptions about Trade, Jobs, and Competitiveness,” by Charles Roxburgh, James Manyika, Richard Dobbs, and Jan Mischke.

McKinsey Global Institute, May 2012.

■■ “Trump’s Top China Expert Isn’t a China Expert,” by Melissa Chan. Foreign Policy, March 13, 2017.

■■ “Understanding the Trade Imbalance and Employment Decline in U.S. Manufacturing,” by Brian Reinbold and Yi Wen. Economic Synopses (Federal Reserve Bank of St. Louis) 2018(15), 2018.

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Challenging Our Grim Biases ✒ REVIEW BY PHIL R. MURRAY

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actfulness is a family effort. Hans Rosling, who passed away in 2017, was a physician, “a global health professor,” a statistician, a dynamic lecturer, and—a crowd-pleasing element of his lectures—a sword swallower. Ola Rosling is his son; Anna Rosling RÖnnlund is Hans’s daughter-in-law. The trio founded Gapminder,

a Swedish foundation that they describe as “a fact tank, not a think tank,” intended to fight “devastating misconceptions about global development.” When Hans’s death left the book unfinished; Ola and Anna stepped in, writing in Hans’s voice.

By “factfulness,” the authors mean “a set of thinking tools.” Likewise, Factfulness “is about the world and how to understand it.”

Gap instinct / How much do you know about the world? The Roslings offer a quiz to test your knowledge. Consider one of their questions:

In all low-income countries across the world today, how many girls finish primary school? a. 20% b. 40% c. 60%

The answer is (c), yet the Roslings found that on average just 7% of respondents picked that answer. Note that if people randomly selected an answer, 33% would choose the correct one. The results are similar on other questions. The Roslings summarize: “Everyone seems to get the world devastatingly wrong. Not only devastatingly wrong, but systematically wrong.”

The typical Gapminder survey asks 12 such questions, each accompanied by three possible answers. (Test yourself: www.gapminder.org/test/2017.) Again, if answering randomly, the average test-taker should get four of the 12 questions right. The Roslings quizzed thousands of people, who achieved PHIL R . MUR R AY is a professor of economics at Webber International University.

a mean score of 2.2 correct answers. Because 2.2 is statistically significantly below the expected value from guessing, we must conclude that people are not just uninformed, but biased. The Roslings call this bias an “overdramatic worldview” and recommend a “fact-based worldview.”

They argue that the overdramatic worldview is based on 10 pitfalls in the way we think. Take the “gap instinct,” which they describe as “that irresistible temptation we have to divide all kinds of things into two distinct and often conflicting groups, with an imagined gap—a huge chasm of injustice—in between.” We think in terms of rich versus poor. “When people say ‘developing’ and ‘developed,’” they explain, “what they are probably thinking is ‘poor countries’ and ‘rich countries.’” Other divisions include “West/rest [of the world],” “north/ south,” and “low-income/high-income.”

In their terminology, there are “four income levels.” One billion of the world’s population live at what they designate as Level 1, with no more than $2 in income per day. Three billion live on Level 2, with between $2 and $8 per day. Two billion live on Level 3, with between $8 and $32 per day. Finally, 1 billion live on Level 4, with at least $32 in income per day. Thus, the greatest majority—5 billion of 7 billion, or 71% of the world’s population—live on Levels 2 and 3, receiving between $2 and $32 per day. The Roslings claim that recognizing there are four income levels is the “most important part of your new factbased framework.” Hans persuaded the World Bank to classify countries according to the four income levels, though his campaign took nearly two decades.

Perhaps the reader, who the Roslings guess has an income on Level 4, is unaccustomed to thinking in terms of daily income. Note that the midpoint of Level 4, $64 per day, amounts to $23,360 per year.

If that seems like a modest income, imagine living on Level 1, with $2 per day. What we imagine will be skewed. The authors liken imagining what life is like on Levels 1, 2, and 3 from a viewpoint on Level 4 to standing on top of a skyscraper and estimating the heights of objects below.

“When you live on Level 4,” they observe, “everyone on Levels 3, 2, and 1 can look equally poor, and the word poor can lose any specific meaning.”

To achieve a proper perspective, they recommend traveling. Owing to the impracticality of travel, Rosling RÖnnlund developed the website Dollar Street “to teach armchair travelers about the world.” Visitors to www.dollarstreet.org may view pictures of families around the world, their incomes, possessions, and more. “What the photos make clear,” the Roslings say, “is that the main factor that affects how people live is not their religion, their culture, or the country they live in, but their income.” Dollar Street helps to overcome the gap instinct.

Getting better / Many people think the state of the world is regressing. Ask Grandma and Grandpa what’s worse about today’s society compared to the past, and don’t be surprised if they say crime. To the contrary, the Roslings show that the absolute number of crimes in the United States has fallen from about 15 million in 1990 to about 10 million in 2016 despite the population increasing by nearly 30%.

Most people around the world do not know that the percentage of the world’s population whose daily income is below $2 (real) per day is steadily declining. The Roslings show that it has fallen from 85% in 1800 to 9% last year. Most people are wrong about the state of the world because we suffer from “the negativity instinct: our tendency to notice the bad more than the good.”

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In reality, many diverse indicators of that, the Roslings offer interesting lessons human flourishing, such as cellphone in demographic history and future trends. ownership, availability of clean water, and They begin by showing a picture of the vaccination, are trending up. And many world population over the very long run indicators of human suffering, such as that looks similar to the “hockey stick of hunger, pollution, and disease, are trend- human prosperity.” (See “From the Repubing down. “In fact,” the Roslings note, lic of Letters to the Great Enrichment,” “almost every country has improved by Summer 2018.) The population was essenalmost every measure.” This does not mean tially flat for millennia; then it zoomed all is well: “things can be both bad and bet- upward in the 19th century. Demographers ter” than before. This reviewer adds, things now predict that this exponential populacontinue to get better. tion growth will stop. In what the Roslings Recall Adam Smith’s observation, call “the most dramatic” data they present, “There is much ruin in a nation.” The female fertility plunged from five babies per Roslings’ 21st century twist is, “Expect woman in the 1960s to 2.5 today. Demogbad news.” That’s one way raphers expect that number of countering the negativity will fall to about two chilinstinct. Setbacks, such as dren in the future. They prethe number of deaths from dict the world’s population a given natural disaster, tend will increase from 7 billion to be tragic, noticeable, and today to 11 billion in 2075 reported. For example, the “mainly because the children Roslings remind us that an who already exist today are earthquake in Nepal in 2015 going to grow up,” But then killed 9,000 people. Those the population will plateau. of us who watch the news When parents simply replace saw that. Advances, such as themselves with two children, a decline in the number of population growth will halt. deaths from natural disas- Factfulness: Ten The Roslings attribute ters over time, tend to be Reasons We’re Wrong the decline in the fertility rate about the World—and slow, unnoticed, and unre- Why Things Are Better to rising incomes. Higher ported, but they are both real Than You Think incomes enable more children and important. One of the By Hans Rosling with to survive, reduce the demand Roslings’ charts shows that Ola Rosling and Anna for child labor, increase the the death toll from natural Rosling RÖnnlund demand for education, and disasters fell from 971,000 342 pp.; Flatiron pay for birth control. The lesin the 1930s to 72,000 in Books, 2018 son in particular is that the 2010–2016. That decline was world population will eventuprobably not in the news, but ally level off; we may someday it certainly is noteworthy. Acquiring a per- see doomsday books warning of impending spective of “factfulness” requires study. underpopulation. The lesson in general is An informed citizen of the world knows to expect current trends to change course. that the world population is over 7 billion and rising. He or she may have Malthusian Markets / This reviewer thinks markets notions about that. That is, the typical work well in general. When a market is citizen expects the world population to malfunctioning, he suspects government continue growing geometrically, and rea- intervention is the cause. Remove the sons that at some point so many people intervention and expect the market to will cause problems. The error in this view work better.

This sort of thinking is what the is “the straight-line instinct”: assuming that something increasing will continue Roslings call “the single perspective to increase at the same rate. Countering instinct”: a “preference for single causes

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and single solutions.” They disapprove of this perspective: “Being always in favor of or always against any particular idea makes you blind to information that doesn’t fit your perspective. This is usually a bad approach if you like to understand reality.”

They put forth the following fact as inconsistent with a free-market proponent’s view of the world: “The United States spends more than twice as much per capita on health care as other capitalist countries on Level 4—around $9,400 compared to around $3,600—and for that money its citizens can expect lives that are three years shorter.” If Americans devote more resources to health care, why do they have lower life expectancy? The Roslings think they know the answer: It is the absence of the basic public health insurance that citizens of most other countries on Level 4 take for granted. Under the current US system, rich, insured patients visit doctors more than they need, running up costs, while poor patients cannot afford even simple, inexpensive treatments and die younger than they should.

Maybe I’m blinded by free-market ideology, but doesn’t exempting health care compensation from taxes induce consumers to choose more health care relative to other goods? Aren’t U.S. government officials spending a significant share of the total spent on health care—and spending it primarily on the poor and elderly? Isn’t health care subject to many government regulations?

Despite the Roslings’ conviction that a larger role of government in health care would produce better results in the United States, they also see problems in the government provision of health care. “The challenge,” they write, “is to find the right balance between regulation and freedom.”

They convince this reviewer that they genuinely appreciate freedom.

Readers of Factfulness will learn of many reasons to be optimistic about the world.

Hans Rosling nevertheless described himself as a “possibilist,” not an optimist. By the former he meant a realist, and he was

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realistic that humanity still faces many challenges.

According to the Roslings, these issues deserve our attention: “global pandemic, financial collapse, world war, climate change, and extreme poverty.” Their recommendations for each are brief. To contain worldwide outbreaks of disease, they recommend widely available medical care and an active World Health Organization. To prevent financial crisis, they wonder whether a “simpler system” would help. They do not describe what that system would look like.

In order to avoid war, “We need Olympic Games, international trade, educational exchange programs, free internet— anything that lets us meet across ethnic groups and country borders.” They do not name the nations they consider at particular risk of conflict, but this line gives us insight into their thinking: “It is a huge diplomatic challenge to prevent the proud and nostalgic nations with a violent track record from attacking others now that they are losing their grip on the world market.”

Global warming, in their estimation,

“poses an enormous threat,” yet they do not explain why global warming is costly, let alone perilous. They trust the United Nations to manage the problem.

To maintain progress in reducing poverty, the authors endorse these “solutions: peace, schooling, universal basic health care, electricity, clean water, toilets, contraceptives, and microcredits to get market forces started.” Despite the implication that the introduction of those “solutions” is sufficient for economic development, the authors realize that development is challenging.

The Roslings do not explicitly mention rational ignorance to explain why we do not know the good news about the world.

They allude to it, however. We may infer that we have more to gain by learning the story of human progress than we must expend to learn it. Becoming literate in the field of human progress is becoming as crucial as old-fashioned literacy and numeracy. The Roslings’ story-telling, innovative displays of data, and enlightening lessons are a fine place to start.

The Constitution vs. the Bureaucracy ✒ REVIEW BY GEORGE LEEF

O

ne of the most controversial books to come out of the legal academy in many years was Columbia law professor Philip Hamburger’s Is Administrative Law Unlawful? (See “The Rise of Prerogative Power,” Summer 2015.) In it, he argues that the vast administrative state—that maze of regulatory agencies that now exerts

so much power over our lives—is simply incompatible with key elements of our constitutional order. Those agencies combine law-making, executive, and judicial functions that the Founders were adamant must be kept separate. The separation of powers was essential to their plan of limiting government and thereby protecting citizens’ liberty and property.

GEORGE LEEF is director of research for the James G.

Martin Center for Academic Renewal.

Hamburger’s case rested largely on his account of British history, particularly the battles against royal prerogative. Some scholars have argued that he isn’t always right in his interpretation of those events, leading them to suggest that his whole thesis on the legitimacy of the modern administrative state is mistaken. They purport to find that early Americans were fairly content with administrative authority and therefore conclude that the fuss over the

power of today’s agencies is unwarranted.

In Bureaucracy in America, political scientist Joseph Postell of the University of Colorado at Colorado Springs pushes back strongly against the idea that our forebears were not concerned about administrative power. In his broad historical overview, he shows that early Americans were in fact deeply concerned about keeping administration within constitutional bounds through electoral accountability, decentralization, nondelegation, separation of powers, and the rule of law. Moreover, as the administrative state began to develop late in the 19th century, arguments were constantly made that agencies such as the Interstate Commerce Commission had to accomplish their legitimate objectives within our constitutional framework.

While the progressives eventually won out and, especially under Franklin D. Roosevelt, were able to create administrative agencies that combine legislative, executive, and judicial functions under one politically unaccountable roof, many Americans, including some prominent liberals, remained opposed. Today, constitutional arguments over the proper scope of administrative power still ring out in Congress and the courts, and rightly so.

Constraining the fourth branch / Postell makes it clear that colonial Americans did not generally hold a laissez faire view regarding the enforcement of laws and norms, but they insisted that such enforcement be done through officials who were accountable for their actions.

In the system they adopted, judicial officers enforced laws enacted by their representatives in the legislature. Crucially, those judicial officers were subject to common law damage suits if they committed wrongs against individuals. Those early Americans would have been aghast at today’s concept of law enforcement by appointed minions who are above the law.

As Postell puts it, “Colonial Americans refused to subject themselves to potentially arbitrary authorities that could make, execute, and adjudicate law against individual citizens.”

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After securing independence from Brit- and repaired were enacted not by the Board ain, Americans proceeded to write their itself but by the legislature.” views on the proper creation and adminIn Democracy in America, Alexis de Tocistration of law into the Constitution. The queville noticed how Americans insisted men who drafted it took pains to ensure on dividing government power. Postell that governmental power would only be quotes him: Americans diminish govused for the public good and their belief ernment power “by dividing the use of was that the best way to achieve that would [society’s] forces among several hands…. be to maintain an immediate connection In partitioning authority in this way, one between the lawmakers and the people renders its action less irresistible and less they represent. For that reason, delega- dangerous, but one does not destroy it.” tion of power to make and enforce the In this manner, “authority is great and law was forbidden. Defendthe official small, so that sociers of today’s administrative ety would continue to be well state cannot plausibly claim, regulated and remain free.”

Postell argues, that there That commitment to is “a hole in the Constituconstraining administration” regarding the “fourth tive authority did not abate branch” of government. The during the nation’s rapid Founders foresaw the trougrowth following the Civil bles that would arise if govWar. In the 1880s, two sigernment authority was not nificant bills were enacted constrained by that immedithat, some claim, sowed the ate connection to the people seeds of the modern adminand crafted the Constitution istrative state: the Pendleton Bureaucracy in America: to prevent them.

Act of 1883 (creating a civil The Administrative As the United States State’s Challenge service system based on comto Constitutional moved into the 19th cenpetitive examination rather Government tury, problems not dissimithan political favor, as had lar to modern ones began By Joseph Postell previously been the case) and to surface, including relief 403 pp.; University of the Interstate Commerce Act for the poor, the building of Missouri Press, 2017 of 1887 (intended to control infrastructure, public health perceived abuses by railroads). concerns, regulation of comPostell rejects that claim, writmon carriers, and the supposed need to ing, “The Pendleton Act and the ICC Act help business and agriculture with subsi- did not reflect a commitment to the idea dies. All of that called for efficient admin- of an administrative state, nor were they istration, but Americans insisted on the intended to eventuate in the modern separation of powers and official account- administrative state we have today.” The ability in doing it. States established, for former simply represented widespread disexample, boards of health and sanitation. gust at the corrupt political patronage sysThe administrators who ran them had to tem and the latter “was a cautious reform follow legislated or common law rules; aimed at providing for expertise in invesunlike today’s administrators, they were tigating abuses, without doing damage not autonomous. to established constitutional principles.”

Pennsylvania’s Canal Board is illustrative. Once established, the board was Progressive breakthrough / It was not until authorized to set tolls on canals, but the early decades of the 20th century that within a few years the legislature decided advocates of the administrative state to strip that power from it and set tolls by began to break down those constitutional statute. And, Postell writes, “Other regula- principles and create the kinds of agentions regarding how canals were to be built cies that progressives wanted—agencies

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staffed with experts who were empowered to scientifically direct society to its optimum. They argued that the Constitution was outmoded and should be scrapped in favor of centralized power necessary to cope with contemporary problems. Their breakthrough, Postell shows, came with the Hepburn Act of 1906, which gave the Interstate Commerce Commission the power to set railroad rates and adjudicate any controversies. Not long afterward did courts begin to retreat from adherence to the Constitution, adopting a posture of deference toward the actions of administrative agencies.

Despite that breakthrough, many Americans, including some famous legal scholars who were sympathetic to progressive aims, worried that the new system was undermining the rule of law. Most notably, Ernst Freund and Roscoe Pound raised concerns about the danger of centralized, unaccountable power. Their arguments, however, fell mostly on deaf ears and by the time FDR assumed the presidency, the table was set for rapid growth of the modern administrative state. During the New Deal, he established a host of agencies combining lawmaking, executive, and judicial power.

Constitutional pushback / Nevertheless, the old notions about separation of power and nondelegation persisted. In the 1935 Schechter Poultry case, which struck down the National Industrial Recovery Act on those grounds, liberal Justice Benjamin Cardozo decried “delegation run riot.”

Justice Louis Brandeis told a group of FDR’s insiders, “I want you to go back and tell the President that we’re not going to let this government centralize everything.”

The constitutional ideas couldn’t be killed.

Dissatisfaction with the administrative state led to bipartisan action in Congress: the 1946 Administrative Procedure Act (APA), meant to rein in the agencies and compel them to abide by fair processes subject to judicial oversight. Rep. Samuel Hobbs of Alabama spoke for many when he said, “It seems to me that the Constitu-

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tion has divided the powers of Government into three coordinate branches, the legislative, executive, and judicial. These have been swallowed up by some administrators and their staffs who apparently believe that they were omnipotent.” Although the APA has had less effect on the bureaucracy than many of its supporters hoped, it did show the widespread dissatisfaction with the despotism of “fourth branch” bureaucrats.

The 1960s and early 1970s saw a profusion of new federal agencies devoted not to economic but rather social regulation, such as the Environmental Protection Agency, Occupational Safety and Health Administration, and Equal Employment Opportunity Commission. When Richard Nixon tried to assert more control over those (and the older) agencies, he was annoyed to discover that key personnel had been drawn into the orbit of their agendas and resisted presidential influence.

About the same time, however, the left took notice of the tendency for administrative agencies to become captured by the interests they were expected to control.

That gave them a serious case of, as Postell writes, “buyer’s remorse.” Realizing that the administrative state didn’t necessarily produce the results they had expected, leftists began to demand that courts stop deferring to agency procedures and decisions, but instead vigorously oversee them.

According to Postell, Their remedy was not to return to the earlier, nineteenth-century approach to regulation and administration but, rather, to use procedural requirements and new standing doctrines to democratize the administrative agencies, preventing them from being captured and turning from the public interest.

Conservatives, on the other hand, did an about-face of their own, calling for the courts to show more deference to the agencies. That’s the origin of the muchdebated “Chevron deference” doctrine.

Conclusion /

Postell has written a deeply researched, provocative book on the history of administrative power in America.

After it, the argument that the administrative state was somehow implicit in our governmental arrangements all along simply won’t hold water. The administrative state emphatically does run contrary to our constitutional principles. Just as important, the book suggests that modern Americans shouldn’t accept our administrative state as inevitable and permanent.

Why couldn’t Congress stop delegating, and itself take responsibility for writing whatever laws might be necessary? It used to. Why can’t administrative officials be held responsible for wrongful conduct?

They used to be. The progressive sea change in our political structure could be reversed and Bureaucracy in America is a good foundation for such a project.

The Bitter Angels of Our Nature ✒ REVIEW BY DWIGHT R. LEE

T

he first six chapters of Yale law professor Amy Chua’s new book Political Tribes focus on the failure of American foreign policy to consider political tribes when trying to spread political democracy and economic prosperity. This discussion, which makes up more than half of the book, will find support among most on the

American political left and many on the right, especially the libertarian right.

Capitalism and democracy are mentioned in broad generic terms. Chua sees them as desirable complements, but she faults American foreign policy for considering them in terms of ideological battles—Capitalism versus Communism, Democracy versus Authoritarianism, the “Free World” versus “the Axis of Evil”—[that blind us to] more primal group identities, which for billions are the most powerful and meaningful, and which drive political upheaval all over the world.

To illustrate, she quotes President George W. Bush’s comment that “freedom and democracy will always and everywhere have greater appeal than the slogans of hatred.” Remaining bipartisan, she also quotes President Barack Obama’s “unyielding belief” DW IGHT R . LEE is a senior fellow in the William J. O’Neil

Center for Global Markets and Freedom, Cox School of Business, Southern Methodist University. He is a coauthor of Common Sense Economics: What Everyone Should Know about Wealth and Prosperity, 3rd edition (St. Martin’s Press, 2016), with James Gwartney, Richard Stroup, Tawni Ferrarini, and Joseph Calhoun.

that all people yearn for certain things: the ability to speak your own mind and have a say in how you are governed; confidence in the rule of law and the equal administration of justice; government that is transparent and doesn’t steal from the people; the freedom to live as you choose. Those are not just American ideas, they are human rights, and that is why we will support them everywhere.

Chua’s fundamental argument is that the “great Enlightenment principals of … liberalism, secularism, rationality, equality, free markets—do not provide the type of tribal group identity that human beings crave and have always craved.”

After applying her views on the emotional appeal of tribal identities internationally, she focuses on the influence of tribalism in American politics in her last three chapters, including her epilogue. For example, without completely dismissing the influence of Occupy Wall Street, she sees it as a failure because it “attracted so few members from the many disadvantaged groups it purported to be fighting for.” Instead, “the participants of Occupy

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were not the hungry or exploited, but how much truth it holds, at least for cerrather relatively privileged self-identified tain major segments of the population.” activists … [and] Occupy offered a mean- “Even today,” she admits “the aftereffects ingful tribe to such people.” of slavery still haunt America in the form Among other interesting, of systemic inequality and and often frightening, impliinjustice.” Yet she sees in a cations of political tribalism “seemingly contradictory in America that she considers, way … [that] through the some of the most troubling alchemy of markets, democdeal with identity politics. For racy, intermarriage, and indiexample, after quoting the vidualism, … America has New Yorker that the Woman’s been uniquely successful in March of January 21, 2017 attracting and assimilating was “‘so radiant with love diverse populations.” and dissent, that’ the ‘coming It seems natural for Amertogether’ of all marginalized icans to ask, if “immigrant groups ‘seemed possible,’” she Political Tribes: communities from all sorts adds some realism by point- Group Instinct and of background have become ing out that “below the sur- the Fate of Nations ‘Americans’; why wouldn’t By Amy Chua face, however, political-tribe Sunnis, and Shias, Arabs, and tensions plagued the march.” 304 pp.; Penguin Press, Kurds all similarly become She explains the tensions (and 2018 ‘Iraqis’”? Our ability to overinsults) the “radiant love” look tribal differences is motivated between black and rooted in some of America’s white women, as well as other provoca- “noblest ideals: tolerance, equality, inditions between other tribes, shouldn’t be vidualism, the power of reason to triumph surprising given negative-sum competition over irrational hatred, and the conviction motivated by identity politics. that all men are united by their common The book focuses on politics rather humanity and love of liberty.” Unfortuthan economics, but public choice econo- nately, it also “predisposes us to ignore mists will connect Chua’s discussion to ethnic, sectarian, and tribal divisions in the related insights. To me her book indicates countries where we intervene.” why a sound economic argument that Chua closes out this chapter by higheconomists routinely make to criticize lighting one “successful” intervention government policies is commonly unper- that soon became a disaster that U.S. State suasive.

Department officials wanted to forget. In the glow of “success” after toppling Libyan Ethnically oblivious / In her opening chapstrongman Muammar Gaddafi by a U.S.ter on “American Exceptionalism,” Chua led coalition in 2011, President Obama chronicles America’s deficiencies in mat- declared, “One thing is clear—the future ters of race. She makes the paradoxical of Libya is now in the hands of the Libyan argument that “what’s so peculiar about people…. It will be the Libyans who will America [is that] we have been both excep- build their new nation.” tionally racist and exceptionally inclusive.”

She quotes President Woodrow Wilson’s Market-dominant minorities / Chua’s first statement that “you cannot become thorough detailed discussion of the failure of U.S. Americans if you think of yourself in groups. foreign policy concerns the Vietnam War. America does not consist of groups” (Chua’s People still debate how America, with the emphasis). She recognizes that Wilson most powerful military on the planet, was a hard-core racist and sees his state- managed to “lose to what Lyndon B. ment as “remarkable not only because Johnson called ‘a piddlying pissant little of how false it was, but also because of country.’” Chua’s answer is “millennia-old

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ethnic conflict” and “political tribalism.”

Without attempting a detailed account of her discussion of each American foreign-policy blunder in the book, it is useful to describe a common condition in developing countries, the ignorance of which helps explain many of those blunders. The condition is “market dominant minorities,” a term Chua coined in 2003. The term describes a situation in which an ethnic minority tends, under market conditions, to dominate economically, often to a startling extent, the poor “indigenous” majority around them, generating enormous resentment among the majority, who see themselves as the rightful owners of the land under threat from “greedy” exploitative outsiders.

Market-dominant minorities “include Chinese throughout Southeast Asia, Indians in East Africa and parts of the Caribbean, Lebanese in West Africa and parts of the Caribbean, … whites in South Africa, whites in Zimbabwe, whites in Namibia, Croats in the former Yugoslavia, Jews in post-Communist Russia, … —[and] the list goes on.” In these and other examples, “intense ethnic resentment is almost invariable, leading frequently to confiscation of the minority’s assets, rioting, violence, and, all too often, ethnic cleansing.

In these conditions, the pursuit of unfettered free-market policies makes things worse.”

If those conducting American foreign policy during the Vietnam War were aware of these “ethnic realities,” there’s no evidence of it. The portion of the $100 billion–plus the United States spent on the war that reached the local population “ended up wildly disproportionally in the pockets of the ethnic Chinese,” the market dominant minority of Vietnam.

The blunders created by the U.S. invasions of Afghanistan and Iraq are also illuminated by the ethnic realities in those two countries that were largely ignored, at least initially. Chua provides an interesting explanation of the success of the 2007 surge in Iraq as “a concrete example

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of what a more effective, tribal-politicsconscious U.S. foreign policy might look like.” She doesn’t explicitly mention market dominant minorities in her chapters on Afghanistan and Iraq, or in her following chapter on terrorism, but it is implicit in her emphasis in these chapters on the tribal satisfaction humans receive from dehumanizing outsiders and engaging in savagery that few of us would consider when acting alone.

A market dominant minority plays a clear role in Chua’s chapter on Venezuela and the political success of Hugo Chavez.

The chapter begins with an interesting discussion of feminine beauty, which arguably is Venezuela’s most prominent industry after oil. Featured is Irene Saez, a Miss Venezuela who went onto win the Miss Universe title. Like all Miss Venezuelas up to that point, she was “light skinned with European features, bearing little resemblance to Venezuela’s darker skinned masses … [which make up] the vast majority of the country’s population.”

In 1998, the year Chavez was elected, “it was inconceivable [both in Venezuela and the U.S. State Department] that a person with Chavez’s complexion and ‘African’ features could become Miss Venezuela or the country’s president.”

Why did Chavez win? Because it was an election between “Venezuela’s dominant ‘white’ minority and its long-degraded, poorer, less educated, darker-skinned, indigenous- and African-blooded masses.

Even today, partisan finger pointers in the United States have little understanding of the origins of the autocratic havoc now engulfing the country.” Maybe those finger pointers didn’t realize that Chavez’s opponent when he won the presidency in 1998 was the former Miss Universe, Irene Saez.

An important issue that Chua does not consider when discussing market dominant minorities is whether the poor are made better off by government policies that harm those minorities by imposing government restrictions on markets for the stated purpose of helping the poor.

In Venezuela, for example, the rich were

creating wealth for the most part through market activity. Though that wealth was distributed far less equally than in the United States, it still provided more benefits to the poor than the economically destructive policies of Chavez (and now his hand-picked successor, Nicolás Maduro) even when considering the short-run benefits the poor received from government transfers. Yet it is surely true that many of the poor still have strong tribal affection for Chavez because of his resentment and ridicule of the market-dominant minorities they felt had stripped them of their wealth and dignity.

The bitter angels of our nature /

In her last three chapters, Chua turns her attention to tribalism in America. The message is that it doesn’t take social gaps as large and rigid as those existing in many poor and developing countries to spawn political tribes. And those tribes can motivate emotions that render politically irrelevant the question of whether harming the wealthy helps the poor or hurts them.

In some respects, Chua’s argument in Chapter 7, “Inequality and the Tribal Chasm in America,” is puzzling. First, she states that inequality is fracturing our nation. But just as America’s foreign policy establishment repeatedly fails to understand the group realities that matter most to people abroad, America’s elites have been blind to—or dismissive of—the group identities that matter most to ordinary Americans. If we want to understand our current political turmoil, we need to open our eyes to the vastly different group identities of America’s rich and poor.

Are there really many Americas who haven’t heard about income inequality in America? Obama did his part to “open our eyes” by claiming “the defining challenge of our time” is growing income inequality and a lack of upward mobility. Few issues have been more effectively used in recent years to justify identity politics. The result has been more people being treated as

members of victimized groups, with “social justice” requiring government programs and regulations directing attention and benefits on such groups, supposedly at the expense of the privileged. The problem Chua sees is “that the groups America’s have-nots belong to are often ones that elites view as antisocial, irrational, or even contemptible, if they even know about them at all.” Unfortunately, identity politics is more likely to tear us apart than to bring us together in ways that Charles Murray recommends in his 2013 book Coming Apart.

So is it inequality that is “fracturing our nation” as Chua indicates, or is it the political response to inequality that rewards the formation of tribes in ways that foment resentments and scorn between them?

No doubt, both have worked together to explain the “tribalism in America [that] propelled Donald Trump to the White House.” She obviously understands the problems with tribalism, yet believes we have “to acknowledge the impact of inequality and the wedge it has driven between America’s whites.”

Whatever one blames for tribalism, no one can deny it exists and is motivating additional tribalism. According to Chua: The Left believes that right-wing tribalization—bigotry, racism—is tearing the country apart. The Right believes that left-wing tribalization—identity politics, political correctness—is tearing the country apart. They are both right.

Yet, she doesn’t believe the “United States is in … immediate danger of actually breaking up.” Hopefully she is correct.

There is always an element of anger and contempt reflected in political debate, and American politics is no exception. But few would deny that the anger and contempt in political discourse has increased along with the growth in identity politics. Chua recognizes that identity politics is a product of both the Left and the Right, and the result is increased hostility between groups fighting for political advantage with complete confidence in the righteousness of their demands.

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Unfortunately, those who see themselves fighting for righteous causes invariably also see themselves as facing evil enemies, with justice requiring harming those enemies even at the expense of harming themselves. As Chua points out, In recent years, whether because of growing strength or growing frustration with the lack of progress, the Left has upped the ante. A shift in tone, rhetoric, and logic has moved identity politics away from inclusion—which had always been the Left’s watchword—toward exclusion and division.

Exclusion and division harm everyone, including those promoting exclusion and division. She contrasts this with Martin Luther King’s ideals, “the ideals that captured the imagination and hearts of the public and led to real change—transcended group divides and called for an America in which skin color didn’t matter.” The heartland supporters who propelled “Trump to the White House” were reacting against the “Coastal elites” whom the heartlanders see as “a kind of market dominant minority” who rig the economy against them and dismiss them as deplorable. The result is a level of resentment that justifies harming the elites even if it means also harming the heartlanders with trade restrictions.

There is nothing new about “cutting off one’s nose to spite one’s face,” and people are quite capable of such selfinflicted harm when acting out of anger and resentment as individuals. But there can be no doubt that tribal anger and resentment are particularly dangerous when people act politically. Political action greatly reduces the sense of individual responsibility and cost of going along with a crowd to harm others even if it means harming one’s self.

Political action makes it more likely that we will yield to the urging of the bitter angels of our nature, who tempt us more than we like to admit. Those angels, I suspect, explain why economists have been less persuasive than we wish when emphasizing the negative-sum consequences of government policies.

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Getting Government More Involved in Banking? ✒ REVIEW BY VERN McKINLEY

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n banking policy circles, there are issues that are argued over and over for decades on end. The fight over Glass–Steagall restrictions is one such example. The act was passed during the early 1930s, slowly reduced in scope during the 1970s and 1980s, and finally most of its restrictions were repealed with the Gramm–Leach–Bliley Act of 1999 (GLBA). The financial crisis less than a decade later reanimated the conversation on banking activities, with many fingering the changes up to and including the GLBA as one of the causes of the financial crisis.

Another issue with a similarly long shelf life is the argument over allowing the post office to provide banking services. University of Georgia law professor Mehrsa Baradaran is one of the most high-profile advocates for a modernized version of a postal bank and she lays out her vision in How the Other Half Banks. Previously, she wrote The Color of Money: Black Banking and the Racial Wealth Gap. Baradaran refers throughout How the Other Half Banks to a “social contract with the banks.” This contract has evolved over time, but its history shows that “banking policy has always been deeply intertwined with politics.” As an example, she points to the financial safety net for banks, which includes federal deposit insurance, the ability to borrow from the Federal Reserve, and government bailouts. Those interventions, she argues, justify policies to help the unbanked: “Many describe modern banks as private enterprises but this is illusory….

To be sure, individual banks are private companies, but each of these private banks sits atop a foundation of state support.”

The implication is that financial institutions cannot survive without some form of government backstop.

V ER N MCK INLEY is a visiting scholar at George

Washington University Law School and coauthor, with James Freeman, of the new book Borrowed Time: Two Centuries of Booms, Busts and Bailouts at Citi (HarperCollins).

Emotional appeal /

The title of the book is a clever twist on How the Other Half Lives, Jacob Riis’ 1890 photojournalism exposé of abysmal living conditions in New York City during the Gilded Age. The book was a classic example of muckraking journalism intended to appeal to people’s emotions to bring about social change. Similarly, Baradaran’s goal is to present the dire situation that the unbanked and underbanked face in order to trigger changes in the way policymakers approach banking policy.

She presents data that the average unbanked family has an annual income of $25,500. Nearly 10% of that income is spent on fees related to financial transactions.

For many of these families that translates to more than they spend on food. Many of these expenses are incurred through non-bank outlets that specialize in check cashing, money orders, remittances, payday lending, and pawn brokering.

Banks with a soul / To delve deeply into why

the unbanked and underbanked have very few options in the formalized banking system, Baradaran traces the history of financial institutions that were intended to address the needs of the entire population, not just cater to those at the top.

For example, originally “credit unions cut out the owners and the profits in order to serve the poor. Their motto was ‘Banks of the people, by the people, and for the people.’” These “banks with a soul” included savings and loans, Freedman’s Savings Banks, building and loans, Morris Banks, and industrial loan companies. But in

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each case they either ceased operation or percentage rate comes in at about 400%. no longer serve the masses as they used to.

Some states have reflexively and paterIn the case of credit unions, the industry nalistically banned such loans because boomed in the postwar decades, growing they consider them usurious. Baradaran from 3,372 credit unions serving 640,000 makes clear that the borrowers desperately members in 1935 to over 16,000 credit need these loans and an outright ban is unions serving 8.1 million members in extremely harmful: 1955. But Baradaran argues that over time These are real people who live and work credit unions’ focus on the poor eroded in cities and towns, poor and “the nature of the moveneighborhoods and wealthy ment had changed greatly … ones…. They borrow to pay and developed more of a midfor things that are widely dle-income orientation than considered essential. They one devoted to lower-income borrow with forethought and groups.” Large and profitable with care…. And fringe lenders credit unions became much are the only ones meeting more common in the 1970s this large market demand and 1980s. Today, credit because banks, credit unions, unions are much like mainand other mainstream lenders stream banks. Her conclusion have chosen not to. from this recitation of busiShe rails against “paternalness models of old is: How the Other Half Banks: Exclusion, istic financial advice against The movements that sucExploitation, and the debt, which is based on the ceeded in serving the poor Threat to Democracy assumption that if people received heavy support

By Mehrsa Baradaran only realized how bad debt from the federal govern336 pp.; Harvard was, they would not take out ment. And they only sucUniversity Press, 2018 loans.” She lectures that “it (reprint edition) ceeded in achieving their is especially unfair to mormission insofar as they ally oppose the use of fringe remained committed to a lending when there are no public purpose and explicitly rejected a meaningful options.” purely profit-oriented model.

Exploitation and paternalism / So what options do the unbanked and underbanked have as they struggle with executing financial transactions on a day-to-day basis? Baradaran begins with a lengthy history of usury, the practice of lending money at unreasonably high interest rates. This leads to the inevitable focus on payday loans, where “the borrower must have a regular paycheck against which she borrows, usually up to $500, with a typical term of anywhere from a week to a month.” Ideally, borrowers would pay the loans back and that would be the end of them, but typically such loans are rolled over or otherwise extended. According to Baradaran, a borrower supports the loan with “either a postdated check or permission for direct withdrawal.” The annual

Why not banks? /

Baradaran claims that commercial banks largely ignore the unbanked, citing studies that the annual administrative cost of a checking account is $250 to $300. But she also criticizes the profit motive for the high overdraft and other fees charged: Several barriers keep mainstream banks from serving the poor—the most important is simple math. Banks can make much higher profits elsewhere. The poor may need banks, but banks most definitely do not need the poor. Banks’ transaction and overhead costs are much the same whether they lend $500 or $500,000, but, of course, the larger loan yields a much higher profit.

Where banks do offer services, she fur-

ther claims that high fees related to bank accounts somehow manage to give banks a twofer: “These fees are used both as a way to repel and punish low-balances and as a significant source of revenue.”

/ So we are left with 70 million Americans without a bank account or access to traditional financial services. The climax that every reader knows is coming at the end of the book is the introduction of postal banking as the answer to the struggles of the underbanked and unbanked.

The idea is not unprecedented in the United States. President Ulysses S. Grant’s postmaster general, John A.J. Creswell, proposed a postal bank in 1871. After four decades of back and forth in Washington, it finally became law under President William Howard Taft in 1910. (Democrats resisted.)

The United States Postal Savings System (USPSS) was born. The USPSS was popular everywhere, especially among immigrants who apparently had a great deal of confidence in the government because of postal banking’s European roots. But after World War II, the deposits flowed out of the USPSS and into the commercial banks, which could pay higher interest rates. The USPSS was abolished in the late 1960s.

In her final chapter, Baradaran argues that it is time to revive “a public option in banking,” as it is consistent with the centuries-long social contract between banks and the government. She claims that “the post offices could offer these services at a much lower cost than the banks and the fringe industry.”

In a final section, she anticipates critiques of her plan. Amazingly, she cites Fannie Mae and Freddie Mac as good examples of how government involvement in financial markets can achieve social policy.

Notwithstanding the fact that Baradaran recognizes the role of politics in banking policy, a gaping hole in her defense is that she ignores how a postal bank would politicize credit allocation even more than it already is. The combination of a postal bank along with an economic recession

The postal option

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would surely lead to political intervention on many fronts. There would likely be demands for forbearance in addressing past-due loans and calls for greater lending to juice the economy. Private market solutions, such as expanded powers for Walmart and others to compete and mobile and peer-to-peer banking options, which she mentions briefly, would be much better alternatives. Equality banks, which facilitate cost-sharing among small banks in order to help them provide shortterm, small-dollar loans, also hold some promise but she does not mention them.

The past 100 years have seen the government get progressively more involved in the banking industry. During that same time and by many measures, we have more instability in our financial system and greater disparities between banking services for the haves and the have-nots. If readers truly believe that more government is the answer, they will find Baradaran’s prescriptions to their liking. Everyone else should still find of interest her history of the provision of credit to the underbanked and unbanked and her analysis of banning payday lending.

The Blockchain Revolution ✒ REVIEW BY GREG KAZA

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argued in the late 20th century that encryption was a tool to protect individual liberty.

In 1976, Stanford cryptographers created the concept of “public–private key cryptography” to address the need for secure key distributions. In 1978, MIT cryptographers created an algorithm to securely broadcast private keys using prime factorization. With Bitcoin, participants must solve a mathematical puzzle using a solution that meets the system’s protocol. This “consensus algorithm” is security against fake transactions or altered records emerging in Bitcoin’s blockchain. The blockchain uses economic incentives: Bitcoin miners receive a Block reward” (piece of Bitcoin) each time they create a legitimate hash.

Depository free from regulators / There are

private (permissioned) and public (permissionless) blockchains. The authors magine an electronic spider web. It’s built around a spreadsheet— focus on the latter, arguing their “pseudonymous nature” cause concern when regularly updated to facilitate commerce—and spread across a “deployed in heavily regulated areas” such computer network. The network becomes active when someone as banking. They contend blockchains sufrequests a transaction. It adds the transaction to the existing network fer from “one important drawback: trust once it is verified. is fickle.” Pseudonymity “may embolden The preceding is a simple explanation tion bundles of electronic data grouped parties” to buy drugs, launder money, or of Blockchain, a developing technology into “blocks” that are linked together to commit tax evasion.

Blockchain’s “tamper-resistant” nature that some associate with cryptocurrencies form “a sequential, timestamped chain” and others with supply chains. The process of information. Each block contains a creates “complications” for regulators. database “header,” the components of Yet blockchains “handle basic economic is novel and not without critics. transactions at lower costs, Blockchain technology is often associ- “a unique fingerprint (or with higher degrees of reliated with Bitcoin, a decentralized digital a hash) of all transactions ability and potentially greater currency that emerged a decade ago. Yet ... along with a timestamp speeds.” They “store data, blockchains are more than electronic skel- and—importantly—a hash of messages, votes, and other” etons for cryptocurrencies such as Bitcoin the previous block.”

Hashes are generated information in digital format, or the faster Ethereum. They are commerusing cryptographic funccreating “a shared deposicial systems used by public companies. tory of information” that Unfortunately, in their new book Block- tions invented by the could “crack open the flow of chain and the Law, Primavera De Filippi and National Security Agency information, powering new Aaron Wright do not chronicle this recent that bundle transactions “in peer-to-peer file-sharing applicommercial history. Rather, they focus on a block as a string of characcations, decentralized comthe technology, organization, and potential ters and numbers ... uniquely associated with that block’s Blockchain and the Law: munication platforms, and regulation at the heart of this innovation. transactions.” Ultimately, The Rule of Code social networks.” They “could How it works / The authors’ description of cryptocurrencies are “just a By Primavera De affect governance itself,” supblockchain-based “smart contracts” is the series of bits stored in the Filippi and Aaron porting organizational strucWright highlight of the book. They describe the memory of one or more tures that “promote more 312 pp.; Harvard technology in detail. Bitcoins are transac- machines.” democratic and participatory University Press, 2018 Blockchain relies on decision making.”

GR EG K A ZA is executive director of the Arkansas Policy Foundation. cryptography. Cypherpunks Blockchains are “particu-

I

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larly potent” as algorithmic systems integrating storage and computation layers.

They can store other information, including computer programs known as smart contracts that allow parties to “enter into a binding commercial relationship” using code and software “to manage contractual performance.” The authors envision a future where existing bureaucratic systems would be replaced by technocratic systems relying on “code-based rules that ultimately constrain human behavior and discretionary choice.”

Ethereum was the first blockchain to enable smart contracts, while eBay and Craigslist use them “to support and coordinate the sale of goods.” Blockchains increase the transparency of over-thecounter derivatives markets. Financial firms “memorialized the economic terms of credit default swaps using a blockchainbased system to provide parties with insight into trade details, counterparty risk metrics, and potential financial exposure.”

More ambitious projects could emerge in the future. A smart contract has controlled a drone’s trajectory “without the need for a centralized middleman to manage the device.” Robust blockchain property rights systems could manage and control devices on the “Internet of Things”—the internet connection of such devices as home appliances—supporting “autonomous and self-sufficient” objects.

Blockchain may lead to “autonomous machines that do not rely on any central operator,” resulting in “emancipated, AIdriven machines, which could be used for either positive or dangerous ends.”

Blockchain and government /

Smart contracts can also be used to create alegal systems. Yet regulation creates its own unique challenges. Regulating “too soon” would provide markets’ guidance but “stamp out potential benefits.” By contrast, waiting “too late” may allow “socially objectionable aspects ... to emerge.”

The authors attempt a risk–reward balance, arguing blockchains “exhibit dual, competing characteristics.” Risks include digital currencies that “have gained a foot-

hold with those seeking to evade existing laws and regulations” and reduced privacy if governments censor commercial or political activity. This issue is “exacerbated by the fact that, once data has been stored on a blockchain, it can no longer be unilaterally modified or deleted.” The internet “could become progressively more unruly” in a blockchain-dominated world.

Commercial banks could suffer if digital currencies shrink balance sheets, “depriving them of needed revenue.”

Rewards include blockchain’s appeal to entrepreneurs in nations without stable currencies, businesses seeking efficiencies, and shareholders interested in facilitating consensus. They also appeal to government units, protecting against cybersecurity attacks, managing Illinois’s land registry and Estonia’s birth and marriage records system. Tax collection could be “streamlined.”

De Filippi and Wright acknowledge all “regulatory approaches discussed here are

incomplete solutions.” They cite Harvard law professor Lawrence Lessig’s “pathetic dot theory”: individual actions can be “controlled or affected” via laws, social norms, market forces, or architecture.

Potential laws include “blockchain neutrality” and “extensive regulatory constraints on software development.” Governments could shape social norms within a blockchain community. The authors cite the end-to-end principle: networks should be as simple and general as possible, leaving intelligence at the network’s “edges.” Regulators could respect the principle or “adopt a more restrictive regulatory regime.”

De Filippi and Wright conclude that the best way to regulate a code-based system “is through code itself.” They worry that Blockchain liberation could cause us to live “under the yoke of the tyranny of code,” yet they leave unanswered the crucial question of whether regulators have the knowledge to write code, let alone balance the myriad issues raised in this book.

A Bridge to Collectivism ✒ REVIEW BY PIERRE LEMIEUX

Y

oram Hazony’s The Virtue of Nationalism is a well-written and challenging book. While today’s Trump supporters would likely agree with its main theses and conclusions, classical liberals, small-government conservatives (perhaps), and libertarians will be troubled or disagree.

The author is a philosopher and president of the Herzl Institute in Jerusalem.

According to its website, the institute’s mission is “to contribute to a revitalization of the Jewish people, the State of Israel, and the family of nations through a renewed encounter with the foundational ideas of Judaism.” As we will see, this is congruent with the ideas expressed in The Virtue of Nationalism.

Hazony warns us at the outset that he will not “waste time trying to make nationPIERRE LEMIEUX’s latest book is the just-published What’s Wrong with Protectionism? Answering Common Objections to Free Trade (Rowman & Littlefield, 2018).

alism prettier by calling it ‘patriotism’” because they are the same. Fair point. He defines the nation as an association of tribes “with a common language or religion, and a past history of acting as a body for the common defense and other largescale enterprises.” As opposed to primitive tribes—the “tribes of Israel” that we meet in the Bible, for example—it is not always clear what today’s tribes are, although we can imagine many. Nationalism stands for “a principled standpoint that regards the world as governed best when nations are able to chart their own independent course, cultivating their own traditions

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Liberalism is much more cautious and pursuing their own interests without toward a world state than Hazony assumes. interference.”

The book’s argument can be summa- (He generally takes “liberalism” to mean rized as follows: The choice of an interna- classical liberalism.) Some liberals did favor tional political order is between national a world state: one was Ludwig von Mises, states on the one hand and imperial or as Hazony notes. Others were continental world government on the other. This liberals and Enlightenment thinkers that Nobel economics prizewinner choice parallels the distincFriedrich Hayek blamed for tion between nationalism and their constructive rationalism liberalism: nationalism claims and their false individualism. that each nation should (See his “Individualism: True be independent in order to and False,” 1945.) pursue its own interests, Hayek himself, whom aspirations, and purposes; Hazony calls “the most liberalism “assumes that important theoretician of libthere is only one principle eralism of the last century,” of legitimate political order: defended a theory of “the individual freedom,” and that Great Society,” an abstract this universal principle can be order guided only by the imposed on all nations. Conimpersonal rule of general trary to rationalist liberalism, The Virtue of Nationalism laws. On the basis of a 1939 nationalism is consistent article, Hazony blames Hayek with man’s natural loyalty to By Yoram Hazony for proposing a world governhis own kind, from the fam- 304 pp.; Basic Books, 2018 ment to establish this order. ily, the clan, and the tribe, up In his 1960 “Why I Am Not to the nation. The nation can a Conservative,” a postscript better ensure external security than tribal anarchy can, and better to The Constitution of Liberty, Hayek was elicit the loyalty of its citizens than other prudent. He did argue that nationalism sorts of states. Independent national states “provides the bridge from conservatism promote diversity and experimentation, to collectivism.” But, he wrote rather wishcontrary to empty universal principles and fully, “until the protection of individual homogenizing empire. A national state is freedom is much more firmly secured also the only formula capable of nurturing than it is now, the creation of a world state probably would be a greater danger to and protecting free institutions.

Each of these claims is doubtful at best. the future of civilization than even war.”

Most liberals in the Anglo-American wing Underestimating liberalism / The national of liberalism did not and do not favor a state and world government do not world state. exhaust the possibilities for the world Hazony must be troubled by Hayek’s order. On the axis of political power, there liberalism, which is based on the same are many alternatives between ideal anar- Anglo-American tradition of empirical chy with zero political power and an ideal historicism that The Virtue of Nationalworld-state with potentially total power. ism claims to represent. Hayek proposed For example, there are non-world impe- a liberalism that is both respectful of rial states, and everything that is not a evolved traditions and against the morals pure national state is not an empire. The of the tribe.

European Union, we are told, “is a German imperial state in all but name,” but Tribe vs. Great Society / Hazony does not it’s a strange imperial state if a national only provide a bridge to future collectivstate can legally secede with a two-year ism, he also has deep roots in past collectivism, in the loyalty of tribe members. withdrawal notice!

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They recognize “the aims of the collective” as their own. The nation gains its cohesion from a similar loyalty.

The collectivism that Hayek blamed conservatives for sharing with the socialists is quite visible in The Virtue of Nationalism. Speaking about “clan, tribe, and nation,” Hazony states that “these collectives are of the same kind as the family, albeit on a greater scale.” The nation is presented as an organism with its “own interests,” its “aspirations,” and “its own unique purposes.” Nations can even “develop attachments to other nations.”

He explains, a bit laboriously, that these are not only metaphors.

In reality, social organisms don’t exist.

And collectives can only be understood with methodological individualism—that is, by starting from the individual to understand social phenomena. Methodological individualism is what separates Hayek’s historical empiricism from the Hazony variety.

Collective preferences don’t exist, unless everybody in the collective has similar preferences. Nobel laureate Kenneth Arrow demonstrated that if all individual preferences are admitted, there is no way to build consistent collective preferences on the basis of individual preferences.

(See his Social Choice and Individual Values, 1951.) There will always be some individuals whose preferences are not taken into account. In other words, collective choices are authoritarian. The Virtue of Nationalism shows no trace of this line of research.

The tribal psychology underlying Hazony’s political theory is the exact opposite of Hayek’s Great Society, where abstract and mostly impersonal relations allow each individual to pursue his own goals. (See “Against Tribal Instincts,” Spring 2018.)

Individual choices can incorporate the welfare of family or friends, but they are not coercively subordinated to the goals of other individuals. The abstract order of the market, in which we cooperate with unknown persons with different goals, is one dimension of the Great Society; so is the rule of law. Only such abstract order can allow the production of wealth typical of liberal societies since the 19th century.

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Hazony’s psychology is incompatible with modern society. Individuals are as disobedient as they are social. Loyalty to the national state is largely a product of state propaganda. The flags, symbols, and pomp of the nation-state are designed to elicit tribal loyalty. I submit that there is not much virtue in that.

Rousseau in disguise? /

With the Enlightenment, a new concept of individual liberty emerged, as opposed to collective liberty—or “collective self-determination,” as Hazony would say. He cleverly avoids the concept of sovereignty, but defends it with other words. The author of The Virtue of Nationalism remains a believer in ancient liberty. National states are the locus of collective liberty. On the contrary, we should not renounce the virtues of the Enlightenment, including individual liberty. (See “From the Republic of Letters to the Great Enrichment,” Spring 2018.)

One can imagine a world where collective liberty would work flawlessly. Imagine that the world is divided into sets of identical individuals (with the same preferences and values), each of these sets contained in a contiguous territory. Each set forms a national state. Any collective choice in a national state would, by construction, represent the unanimous choice of all its citizens. (I disregard the possibility that different circumstances could lead an individual to wish he could make a different choice: “I would love to participate in our war, but my wife just delivered our baby.”) Each individual would literally feel the pains and pleasures of the state as his own, like Hazony imagines.

Such a world is romantic and unrealistic. The national state is not a big family. However much Hazony blames Jean-Jacques Rousseau’s rationalism, the tribal Rousseau makes a return in The Virtue of Nationalism. Hayek wrote about “the Rousseauesque nostalgia for a society guided, not by learned moral rules which can be justified only by a rational insight into the principles on which this order is based, but by the ‘natural’ emotions deeply grounded on millennia of life in the

small horde” (Law, Legislation and Liberty, Vol. 2, 1976).

Rousseau may hide elsewhere in The Virtue of Nationalism, where “the freedom of the individual is seen to depend … on the freedom and self-determination of the collective to which he is loyal.” But what if an individual is persecuted by his free collective? This seems impossible in Hazony’s theory. Would we say that an individual persecuted by his own tribe or nation is free or, as Rousseau wrote in On the Social Contract (1762), that he is “forced to be free”?

Politics with romance / The rest of Hazony’s argument—on security, diversity, and free institutions—mostly rests on an idyllic view of the democratic state.

James Buchanan, another Nobel prizewinning economist, described the approach of politics by public choice theory as “politics without romance.” This school of economic and political analysis takes individuals as they are, as self-interested in the public sphere as they in the private sphere. By contrast, Hazony does politics with romance. He ignores how the state works in practice, with rationally ignorant voters, and interest groups and state bureaucracy grabbing a large share of state power. He underestimates the constant danger of Leviathan.

Consider the argument that the national state is the best protector of security. It ignores the possible exploitation of citizens by their own national states—especially, but not only, if they are a minority of a different nationality. The national state may reduce the risks of outside attacks; in many ways, though, it increases the security risk from inside because it combines the power of the state with nationalist emotions. Haven’t we observed that often?

Another weakness in the security argument is that the national state is a natural way toward empire, as Nazi Germany illustrated. Hazony underestimates that risk, seeing in the national state only the “national.”

Bertrand de Jouvenel’s argument in On Power (1947) is very relevant to national

states, which have made wars more devastating. Helped by the power of nationalist propaganda and emotions, the state has claimed jurisdiction on all the “national resources,” including conscripted men.

Noncombatants have been brought into the ambit of war. The summit was reached with the bombing of civilian populations in World War II. Isn’t an enemy state “the nation as a whole” (an expression used

by Hazony many times)? Let’s bomb the nation as a whole!

Diversity and liberty /

Hazony argues that independent national states promote diversity and experimentation, as opposed to homogenizing empire. This is probably true globally, but not within each country.

Most national states undermine diversity within their borders. Hazony’s argument for diversity is incomplete: it does not consider the need for constraining state power.

Similarly, most national states crush free institutions instead of nurturing them. By “free institutions,” Hazony means the institutional structure that generates or protect the “rights and freedoms” of the individual, including generally free markets. Even without speaking of immigration (a more difficult topic), national states nearly always restrict free trade in goods and services, a power Hazony supports. He also seems to believe that the state should promote the country’s traditional language and religion. Taken seriously, collective liberty can only clash with individual liberty.

Readers of The Virtue of Nationalism will sometimes get the impression that the author does not dislike individual liberty, but that he lacks some important analytical tools to understand it. For example, he presents “the World Trade Organization as an authoritative body regulating the economies of nations as a condition of their participation in international trade.”

Doesn’t he understand that unilateral free trade—that is, letting a country’s residents import what they want at the best conditions they can get—would allow any nation or, to speak properly, individuals

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in any country to participate in international trade? Does he understand how that works?

The main argument for independent states—not necessarily national states—is a public choice argument related to the danger of an international Leviathan, which would be much more difficult to escape than local tyrants are. This argument is based on the intrinsic danger of the state as a monopoly of force, and on the value of individual dignity and flourishing. Don’t forget individuals! The idea that a system of independent states is a less dangerous system than a world empire—at least for those who do not live under the worst tyrants—must not prevent one from dissenting against his own Leviathan. It is not a license to glorify nationalism.

The Virtue of Nationalism is anchored in the Hebrew Bible, that is, the Old Testament, and in the political history of the Jews in biblical times. “I have been a Jewish nationalist, a Zionist, all my life,” the author writes in the book’s introduction.

We can understand and sympathize with the plight of Jews in history, from the early tribes of Israel and the kingdoms of Israel and Judah, to the diaspora, the constant discrimination against Jews, the Holocaust, and the contemporary refuge that the state of Israel represents for them. We can also admire the millennia-old Jewish traditions (when they are not too stifling), as well as the major contribution of Jewish culture to Western civilization. But that’s not a reason to hold the Hebrew Bible as the ultimate book of political philosophy.

Lessons / I think that two qualified lessons can be drawn from The Virtue of Nationalism. First, it reminds us of the danger of a world state. A world state would likely have killed the experiments that led to the discovery of individual liberty and classical liberalism. Hazony would not weep for the latter, but perhaps he does not understand it well.

Under a world tyrant, islands of liberty would be very difficult to establish and defend. But note how these islands of liberty have also been busy destroying

themselves under national states with growing power.

Second, nationalism does not always turn into national socialism or other monsters. Hazony shows that nationalism can sometimes be useful. We know many Western national states under which individual liberty has flourished in different degrees. Yet, these liberty-bearing societies were probably those whose elites had the most cosmopolitan outlook. Note also how open these countries were historically to trade or immigration. Immigration constantly changed the “tribes” of America.

A more general reflection is that we—we who think that individual liberty is the main political value—must accept both that it is a universal value and that prudence requires not to trust a world state

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to impose and protect it. This does not preclude international treaties between national governments. Another way to express the general idea is that we must marry cosmopolitan values with the preservation of separate states, of which some will hopefully become islands of liberty.

Incidentally, unilateral free trade is one way to achieve that: it would leave individuals in the unilaterally free-trading country free to import, export, or invest abroad, even if foreign states don’t recognize the same liberty for their own subjects. (See “How Is Your Trade War Going?” Summer 2018.)

If there is something that could persuade a cosmopolitan intellectual of the virtue of nationalism, this book would be it. It doesn’t succeed, though, because of its collectivism and romantic politics.

Is the Era of ‘Free to Choose’ Medicine Upon Us? ✒ REVIEW BY THOMAS A. HEMPHILL

O

ver a decade ago, Bart Madden unveiled the genesis of his “Free to Choose Medicine” concept in the pages of Regulation (see “Breaking the FDA Monopoly,” Summer 2004).

He developed those ideas in the monograph Free to Choose Medicine, the third edition of which was released this April. Just a few weeks later, President Trump signed “Right to Try” legislation giving terminally ill Americans greater access to investigational drug treatments that have undergone Food and Drug Administration Phase I safety and early efficacy testing but have not completed the full FDA testing regimen and are not yet available to the public.

Madden’s arguments support policies like “Right to Try,” but there is much more to what he proposes than simply giving terminal patients access to experimental drugs. In this review, I sketch out his proposal and offer some practical suggestions THOMAS A. HEMPHILL is the David M. French Distinguished Professor of Strategy, Innovation and Public Policy at the University of Michigan, Flint. He is an affiliate of the Heartland Institute and has discussed some of the points in this review with Madden.

for increasing the possibility that it will one day become law.

Need for Free to Choose Medicine /

On the first page of the first chapter, Madden states the purpose of his Free to Choose Medicine concept: This book makes the case that we need to be free to make informed decisions about whether to use not-yet-approved therapeutic drugs—that is, new drugs that have successfully passed initial safety trials, generated preliminary efficacy data, and may offer us the opportunity to improve our health or even save our life.

He believes that the result of the 1962

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federal legislation expanding the FDA’s The drugs-to-patient system / Madden monopoly authority to test drugs and applies a systems theory approach in his judge whether they are “safe and effec- analysis, one that elevates the goal of protive” has been ever-increasing prescrip- viding more drugs to more patients and tion drug prices. He argues this is because that focuses on eliminating questionable of the agency’s continuing demand for constraints on those drugs. He believes more expensive and time-consuming his systems approach “produces genuine clinical trials to minimize the likeli- insights that reveal a path to true reform.” hood of injury and death (and adverse The existing FDA drug approval syspublicity for the FDA) and tem consists of two primary expand understanding of stages: the pre-clinical stage the experimental drugs’ and the clinical trials stage. effects. More importantly, he Historically, for every 5,000 argues powerfully that these substances that drug comlengthy clinical trials come panies initially investigate, at a steep cost in the unreabout 250 enter the formal ported “invisible graveyard” preclinical research and testof patients with serious or ing stage where there is basic immediately life-threatening evaluation for patient safety. conditions who die while the This stage typically takes drug undergoes the extenthree to six years to comsive testing necessary to be Free to Choose plete. Only about 10 of those brought to the U.S. market. Medicine, 3rd ed. substances exhibit enough He gives four reasons By Bartley J. Madden promise to induce a pharwhy there has not been a 83 pp.; Heartland maceutical company to file growing grassroots move- Institute, 2018 an Investigational New Drug ment demanding reform of (IND) Application with the the FDA in order to make FDA to move on to Phase experimental drugs more readily available. I testing where they are safety-tested on First, it’s easier to observe (and the media healthy volunteers. Roughly eight of those report on) adverse side effects (including substances then enter Phase II safety and death) from approved drugs as well as new efficacy clinical trials where they are tested information from extensive trials. People on volunteers who have the condition the assume that unapproved drugs would substance is intended to treat. Only about be even riskier, which results in politi- three of those substances move on to cal pressure for even stricter regulation. Phase III efficacy clinical trials, involving Second, the FDA and its supporters sin- larger testing groups. Finally, only about cerely believe they possess the moral high one drug out of those original 5,000 subground; pharmaceutical companies that stances successfully achieves FDA New would be inclined to question FDA poli- Drug Application approval. cies are, unsurprisingly, fearful of antagoMadden views the key bottleneck in the nizing the regulators whose decisions can drugs-to-patient system as “the FDA and mean the difference between company fail- its narrow focus on ever more refined (and ure and success. Third, most Americans expensive) clinical trials.” Research shows are unaware of what economists call the that in 1980, the typical drug underwent “opportunity costs” of not being free to 30 FDA clinical trials involving about 1,500 make an informed choice about the best patients. By the mid-1990s, the typical drug treatment for ourselves. Fourth, only drug had to undergo more than 60 clinia small percentage of people at any one cal trials involving almost 5,000 patients. time realize they are experiencing pain, suf- Because the FDA is the monopoly gatefering, and the prospect of death because keeper for the American market, it is able of denied access to new drugs. to “disregard evidence of its failure and

the pleas of suffering and dying people who are being denied potentially life-saving treatments” in the later clinical phases of the seemingly interminable drug evaluation process.

The FDA’s defense /

FDA staffers respond to this criticism with a simple question: Do you want citizens to have safe and effective drugs and for public knowledge about drug effects to increase? Since no one would dare not answer this question affirmatively, the FDA requires that new drugs pass an extensive battery of randomized clinical trials (RCTs) in which subjects are randomly assigned to control and test groups, with the former receiving the current standard of care (or a placebo) and the latter the substance under investigation. RCTs are considered the “gold standard” in empirical testing. They also are incredibly costly in time and resources.

Thus, FDA staffers successfully lobby for “greater FDA power and a bigger budget to get the job done,” even as the drugs move slower and slower through the testing pipeline.

Since no drug is 100% safe, argues Madden, the FDA’s goal of “safe and effective drugs” deflects attention from the fundamental tradeoff that the agency faces: More extensive and hugely expensive testing can reduce the probability of unanticipated adverse side effects from an approved drug. But that same mindset greatly increases drug costs to consumers and, most importantly, causes suffering and premature deaths from delayed access. That’s the tradeoff dilemma.

While he agrees that the RCT is a powerful tool in determining if drugs are safe and effective, it is only one tool of many in the growing medical knowledge base.

He also notes that many physicians and medical ethicists consider RCTs unethical because they require the participation of ill individuals. In essence, the control group is barred from receiving a potentially superior treatment. Madden makes a case for using observational data versus RCTs. As

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evidence, he points out that observational data, or “real-world data,” are contained in physician communications when considering the “pros” and “cons” of off-label use of FDA-approved drugs. Observational data and the associated inferences of cause-andeffect expand the knowledge base through daily life experiences.

What are the costs of the FDA’s reliance on RCTs? It can take up to 12 years, on average, for a new drug to successfully complete the FDA review process. In addition, according to a 2014 Tufts University study, total development costs of a new drug are estimated at $2.9 billion. Madden believes that the FDA needs competition to its existing monopoly regulatory position to eliminate this “critical bottleneck” in the nation’s health care system.

Two tracks / As a solution, Madden offers a “dual approval track” plan. Under the first track, patients choose to only use drugs that have gained approval through the traditional FDA approval process. Under the second track, the Free to Choose track, the FDA would have “competition,” which I’ll describe below. Madden’s hope is that this competition will provoke the agency to streamline its clinical testing and approval requirements, thus allowing smaller, cashstrapped pharmaceutical companies to bring their drugs to market much sooner.

The Free to Choose track would allow patients (under the care of their physicians) to access not-yet-approved drugs.

Specifically, this would provide access to drugs in Phase II of FDA clinical trials after the drug’s completion of one or two trials.

In the drug discovery stage, which precedes the Phase I trials, basic safety of the drug is established. In Phase I of clinical trials, 20–80 healthy volunteers are used to establish a drug’s safety profile; this process usually takes one year. In Phase II of clinical trials, 100–300 patient volunteers with the condition the drug is intended to treat are used to better assess the drug’s safety. Because these trials are randomized, researchers find indications of its efficacy; this phase can take up to two years to complete. Phase III (involving further

testing of 1,000–3,000 volunteers afflicted with the condition) better assesses efficacy and gathers other information about the drug’s effects, and can easily take up to five additional years before the FDA grants final approval. All told, that’s 12 years of evaluation. In contrast, Madden believes the Free to Choose track can reduce the evaluation period to just six years.

As an integral part of the Free to Choose track, physicians would be required to input treatment results anonymously (although including pertinent genetic data and biomarker information) into an internet-based Tradeoff Evaluation Drug Database (TEDD). TEDD would become a valuable database of up-to-date information about the risks and effectiveness of drugs qualified for early access on the Free to Choose track, enabling patients and their physicians to make informed decisions about what is in a patient’s best interests. Madden believes that TEDD would be invaluable for medical researchers, greatly accelerating further pharmaceutical innovation through faster learning and more effective allocation of research and development funds. TEDD would be operated independently of the FDA within a public/private organizational structure.

TEDD would be useful. The question is, would it provide anywhere near the information on drug effects that Phase III RCTs do. The great value of RCTs is that they control for unobserved differences in test subjects that cannot be controlled for in observational studies. The resulting information is important, and there have been many cases where it has been out outright revelatory.

To attain it, the current FDA system uses coercion—people can’t obtain an experimental drug unless they participate in a trial, and then they still may be assigned to a control group. The Cato Institute’s Michael Cannon has proposed that, instead of coercion, test administrators pay subjects to participate in RCTs (and maybe receive the experimental drug). With the Free to Choose track, Madden risks losing a significant chunk

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of this information, though TEDD may provide some of it and the traditional tract may ultimately provide all of it (if enough desperate patients don’t select the Free to Choose track). In essence, he makes a values choice to increase access at the risk of less information—but then, Congress and the FDA made a values choice to increase information at the loss of some access, and Cannon makes a values choice to increase information and access at a public financial cost.

Drug developers would have the choice to use either track, or both, to bring their drugs to market. To institute the Free to Choose track, Madden argues that new federal legislation would be needed to provide drug developers sufficient immunity from strict product liability laws to ensure their active participation in this track. There is also a strong assumption that health insurance companies would respond favorably to a drug that has a low price and shows safety and effectiveness under the Free to Choose track, and that these drugs would likely receive insurance reimbursement.

As to patient safety, Madden notes that technological advances make preclinical testing by drug developers, as well as the FDA’s Phase I safety trials, far superior to the testing used during the 1960s when the thalidomide disaster took place in the United Kingdom.

Traversing the public policy gauntlet

/

When evaluating Madden’s proposal, it is important to begin the process with clear parameters on what the author is not proposing. First, he is not calling for the elimination of the FDA; instead, he wants to reform the agency. The FDA status quo is, in fact, a complement to his proposal because the agency’s drug approval process would remain in place.

Second, to reinforce the first point, RCTs would be an integral part of the Free to Choose proposal up through the early part of Phase II. This includes through all of the basic safety protocols and initial testing for effectiveness of the drug on the affected population. Third, Madden’s proposal does not eliminate mandatory

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reporting of the affected population after initial Phase II testing. TEDD requires physicians to report to a designated third party on the effects of Free to Choose– track pharmaceuticals on their patients.

Yet reforming the FDA (a laudable and challenging undertaking) and getting the “newest life-saving drugs faster at lower cost” to Americans vulnerable and in need would require confronting and ameliorating formidable public policy challenges involving a myriad of stakeholders. Toward that end, here’s a five-point strategy: While Madden relates deeply moving examples of people with life-threatening diseases who are not able to access experimental drugs, his Free to Choose track leaves the decision on patient eligibility entirely up to the patients (in consultation with their physicians).

This is a position entirely in line with a libertarian philosophy supporting the broadest freedom of individual choice; however, from a public policy perspective, acceptable eligibility limitation is essential to successfully enacting this federal legislation.

For example, FDA Commissioner Scott Gottlieb recommended to Congress that Right to Try legislation define the term “terminal illness” as “a stage of disease in which there is a reasonable likelihood that death will occur within a matter of months.” Similarly, since his proposal is especially intended to help alleviate suffering from “lifethreatening” diseases, federal legislation should emphasize developing a workable definition of such diseases—that is, one that includes reasonable and politically justifiable qualifications for patient eligibility.

An example of such a disease would be ALS, better known as Lou Gehrig’s Disease, a “life-threatening” neuromuscular disease with no known cure.

The overwhelming majority of people diagnosed with ALS die from respiratory failure within three to five years of diagnosis. In contrast, many chronic

diseases can be “life-threatening” yet medically managed through existing treatments, e.g., diabetes. Therefore, a proposed rubric useful for “defining a life-threatening” disease may be “reasonable likelihood” of death within 10 years of diagnosis with no known treatment available to successfully manage the disease and prevent death.

This would coincide with potential patient benefits accruing from the Free to Choose track, which is expected to reduce the length of time required for drug approval by six years.

■■ Define the target population.

Pharmaceutical manufacturers are held to strict product liability for adverse effects on patients under U.S. tort law (with the exception of in Michigan, where citizens do not have the right to sue pharmaceutical companies unless the drug maker withheld or misrepresented information to the FDA that would have led to non-approval, or bribery was involved). Strict liability is the imposition of liability on a party without finding of fault, such as negligence or tortious intent. In other words, the aggrieved party—i.e., the patient—need only prove that the tort occurred and the drug company was responsible. Madden correctly argues that the trial bar would lobby intensely against a patient waiving liability by explicitly consenting to engage in what can be reasonably construed as “a risky activity.”

Establishing a written waiver of “consent” releasing the pharmaceutical company from any liability—short of gross negligence or willful misconduct—would require the establishment of a legislative tort liability “safe harbor” for participating pharmaceutical companies. Realistically, to create this safe harbor would require that Free to Choose drugs be made available only to patients having serious, life-threatening diseases without a known cure.

Expanding the definition of patient eligibility would require widening the

■■ Tort liability reform.

safe harbor, potentially nullifying the legal protection of strict liability and thus making it exponentially more difficult to acquire congressional support for legislative passage.

Physicians whose patients want to use Free to Choose medicines may worry that they could still be held liable for negligence under “duty of care” obligations. Since physician licensure is regulated at the state level, a state authority could declare physician complicity contrary to ethical standards (“physician do no harm”) for medical practice, thus placing a physician’s licensure in jeopardy. Physicians would need a clear legal standing regarding their personal liability.

While establishing a similar safe harbor (through model state legislation) allowing for a defense of willful consent by the patient may eliminate civil negligence liability, the question of ethical conduct is one that could play out differently among 50 state licensing boards.

■■ Physician liability.

“We’re going to be cutting regulations at a level that nobody’s ever seen before,” President Trump vowed in a meeting with pharmaceutical industry executives in January 2017. So would Commissioner Gottlieb support a decision contrary to the existing agency philosophy for a drug made available to a non–FDA participating trial patient before extensive testing for efficacy (in Phase III trials)? If he is not supportive, and if Free to Choose legislation were enacted over FDA protest, would pharmaceutical companies be willing participants in making access available to patients?

The agency could, after all, sanction participating drug makers by slowing approval of drugs the makers have submitted to the traditional process.

Perhaps such risk was behind PhRMA, the major drug industry association, saying it was “neutral” on Madden’s Free to Choose idea.

■■ Combat FDA resistance.

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In addition, would health care insurers be as open to patient eligibility (and thus financial remuneration) of such pharmaceuticals (after one or two Phase II trials) knowing that many of the drugs will ultimately prove to be ineffective and some may have adverse effects? Furthermore, could an adverse effect from an investigative drug potentially leave a patient without health insurance coverage, resulting in unpaid medical bills?

■■ Promote and continue to improve the

Expanded Access Program. The FDA

has a lengthy history of supporting patient access to investigational new treatments through the agency’s Expanded Access Program. (The seminal regulations for the program were issued in 1987.) In 2009, after enactment of amendments to the Federal Food, Drug, and Cosmetics Act, the FDA revised its regulations to consolidate the provisions concerning the use of investigational drugs and biologics for expanded patient access where no existing FDA approved alternatives exist. The FDA reports that, in recent years, the agency has received over 1,000 applications annually for expanded access to treat patients with these investigational drugs and biologics, and subsequently authorized 99% of the requests. In addition, the agency makes “meaningful changes” in approximately 10% of these cases to enhance patient safety.

Yet program critics note that, in the past, physicians were required to file full investigational new drug (IND) applications with the FDA, as if they were company sponsors undertaking clinical trials. The FDA reported that it took an estimated 100 hours to complete this paperwork, a daunting task for physicians who are time-strapped. (Because of this, we should qualify the 99% authorization statistic; many potential applicants likely were discouraged by the onerous paperwork demands.)

Obviously, the small number of actual applicants—as well as anecdotal stories of Americans traveling abroad to acquire unapproved drugs—offer support for this criticism.

However, the FDA recently announced revisions to the Expanded Access Program, as required in the FDA Reauthorization Act of 2017 and the 21st Century Cures Act. Such revisions will ostensibly allow the prescribing physician to submit a “single patient IND,” which the FDA claims will take as little as 45 minutes to complete, and the subsequent agency review will usually be completed within 24 hours of submission. The FDA’s performance on this will need close monitoring by Congress, health

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care interest groups, and the executive branch.

Unlike the Right to Try legislation, which was characterized as “toothless” by many critics (as pharmaceutical companies have little incentive to provide access to experimental drugs that have not been approved by the FDA), Free to Choose Medicine could be “game changing” for eligible patients. In this well-written monograph, Madden advocates convincingly for his approach. Yet Free to Choose Medicine has many hurdles to vault before it becomes a viable regulatory solution to alleged FDA government failure. Many vulnerable patients must hope that Madden and other Free to Choose advocates “get it right” on both the policy and the politics.

Did FDR Default on U.S. Debt? ✒ REVIEW BY GARY RICHARDSON

T

he risk-free rate of return on investments is often considered to be the yield on U.S. government debt. “The risk-free rate is hypothetical,” Investopedia states, “as every investment has some type of risk associated with it. However, T-bills [U.S. Treasury debt obligations with a maturity of 52 weeks or less] are the closest investment possible to being risk-free.” One of the reasons for this is “the U.S. government has never defaulted on its debt obligations, even in times of severe economic stress.” Similar statements appear in Wikipedia’s entry on the risk-free interest rate as well as in scores of economics and finance textbooks used around the world.

University of California, Los Angeles economist Sebastián Edwards’s new book, American Default: The Untold Story of FDR, the Supreme Court, and the Battle over Gold, challenges this assertion. Edwards argues that the United States defaulted on federal debt during the 1930s when it withdrew

GARY R ICH AR DSON is professor of economics at the

University of California, Irvine and a research associate of the National Bureau of Economic Research.

monetary gold from circulation and abrogated the gold clause in both public and private contracts.

Overview / Before I delve into the details of Edwards’s insightful study, I want to give you an overall assessment of the book: It is fascinating, well-written, and thoroughly researched. It provides new perspective on an important era of American history. It discusses the ideas, personalities, politics, economics, and finance underlying the principal policies by which the Franklin D. Roosevelt administration resuscitated the U.S. economy after the catastrophic contraction of 1929–1933. An academic press published the book, but the clarity of its prose and vividness of its narrative make it

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accessible to a general audience. The book should and will be read widely. It’s worth pondering and debating, and I will debate some aspects of it later in this review.

Edwards’s book asks provocative questions about fundamental features of the U.S. and international financial systems.

The author lists these questions at two points in the book: the end of the introduction and the beginning of the conclusion. The lists contain 15 total queries, which I condense into five: Did the United States default on federal government debt in 1934 when it abrogated the gold clause for government bonds (particularly the fourth Liberty Bond)?

■■ Why did the federal government abrogate the gold clause? Was this action necessary?

■■ Who made the key decisions during this episode and how did they justify their actions?

■■ What were the consequences for investors and the economy as a whole, both in the United States and abroad?

■■ Could this happen again?

■■

Edwards answers these questions over the course of 17 chapters plus an introduction, an appendix, a timeline, and a list describing the people around whom the story revolves. The introduction lays out the issues of interest. Chapters 1 through 15 narrate the story. The narrative revolves around such policymakers as Roosevelt, Sen. Carter Glass, and members of the Supreme Court, as well as the people who advised them. Among those advisers were Roosevelt’s Brain Trust, whose initial members included Raymond Moley, a law professor from Columbia University, Rexford Tugwell, an economics professor at Columbia, and Adolf Berle, another law professor from Columbia. The narrative describes the decisions that these men made (or had to make), their rationales for those decisions, and the state of knowledge and state of the world at the times those decisions were made.

Fearing devaluation / The narrative starts in

March 1932, during the economic down- the newly inaugurated President Roosevelt turn now known as the Great Depression. declared a national banking holiday. This A few pages describe the poverty and des- segment of the story ends by describing the peration imposed upon people from all policies that the Roosevelt administration walks of life. Nearly a quarter implemented as it resusciof the labor force experienced tated the financial system and unemployment. Commodity sparked economic recovery. prices declined by more than This review will not go half. These declines proved into detail about the policy particularly hard on people decisions and the logic underrunning small businesses, lying them. For that inforsuch as family farmers who mation, you should read the made up a quarter of the U.S. book, which presents the population. Declining farm materials cogently and clearly. prices accentuated farmOther recent readable treaters’ debt burden because ments on the topic include the nominal value of debts Jonathan Alter’s The Defining remained fixed, forcing farm- American Default: Moment, Anthony Badger’s The Untold Story of ers who wanted to pay their FDR, the Supreme FDR: The First Hundred Days, mortgages and crop loans to Court, and the Battle Adam Cohen’s Nothing to Fear, double production (which over Gold and David Kennedy’s Freedom was often impossible) or cut By Sebastián Edwards from Fear. All of these cover consumption (particularly 288 pp.: Princeton similar material and reach of durable goods like cars, University Press, 2018 similar conclusions. I also radios, and clothing). Some recommend the memoirs of farmers (and eventually Herbert Hoover and Roosalmost all farmers) stopped paying their evelt’s principal advisers; see Edwards’s debts, defaulted on their loans, and faced bibliography for a list. To it, I recommend bankruptcy, which often resulted in the adding Fifty Billion Dollars: My Thirteen Years loss of lands and livelihoods. with the RFC, the memoir of Jesse Jones, Chapters 1 through 4 cover Roosevelt’s who headed the Reconstruction Finance campaign platform and policies and the Corporation. economic turmoil from November 1932 through February 1933. During those last Monetary expansion / Chapters 5 through five months of the Herbert Hoover admin- 10 describe the Roosevelt administration’s istration, a nationwide panic drained funds efforts from the spring of 1933 through from the banking system and gold from the winter of 1934 to help the economy the vaults of the Federal Reserve. The pub- recover. The administration believed a key lic feared for the safety of deposits and cause of the contraction was the devaluarushed to convert their claims against tion of the dollar and decline in prices— banks into coins and cash. The public particularly of farm commodities—that (particularly foreign investors) also feared occurred during the 1920s and early for the value of the dollar because they 1930s. Prices of wholesale goods fell an anticipated that the Roosevelt adminis- average of 25% between 1926 and 1933. tration would lower the gold content of Consumer prices fell by the same amount.

U.S. currency or leave the gold standard The average price of farm crops fell more altogether, as had Britain and numerous than 66%.

Declining prices made it difficult for other nations.

In March, gold outflows forced the Fed- farmers and other producers to earn suferal Reserve Bank of New York below its ficient profits to pay their debts, which gold reserve requirement. To prevent the were fixed in nominal terms. As a result, New York Fed from shutting its doors, families and firms cut consumption and

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investment in order to avoid bankruptcy, or else defaulted on their debts, which was often worse for them and put banks out of business. That, in turn, restricted the availability of credit, triggered banking panics, and resulted in further economic contraction. The Roosevelt administration sought to alleviate this cycle of debt-deflation by convincing (or forcing) individuals and firms to redeposit funds in banks, encouraging banks to lend, and refilling the Federal Reserve’s vaults with gold. All of these actions would expand the money supply and eventually raise prices.

The administration also sought to speed the process along by directly influencing commodity prices, particularly those traded on international markets.

Those commodities had fallen substantially because of foreign governments’ decisions to devalue their own currencies, usually by abandoning the gold standard and allowing the price of their currencies to be determined by market forces. The quickest way to raise commodity prices and alter the exchange rate was to change the dollar price of gold. The federal government had lowered and raised gold’s dollar price in the past; the Constitution provided Congress with the power to do so. Congress authorized the president to raise the dollar price of gold by up to 100% (or synonymously cut the gold content of dollar coins by as much as 50%) in the Thomas Amendment to the Agricultural Adjustment Act in May 1933. The Roosevelt administration used these powers to the utmost, periodically and persistently raising gold’s dollar price from the spring of 1933 through the winter of 1934. Roosevelt’s gold program concluded in January 1934 with the passage of the Gold Reserve Act, which set gold’s official price at $35 per troy ounce.

Gold clauses in contracts impeded this policy. An example was printed on Liberty Bonds: “The principal and interest hereof are payable in United States gold coin of the present standard of value.” Clauses like this were common in public and private contracts. Their intent was to protect creditors from declines in the value of currency

or inflation, which is the same phenomenon but stated as an increase in the average price of goods. Gold clauses ensured lenders that they would be repaid with currency or gold coins with the same real value (in terms of the goods and services that they could purchase) as the funds that they had lent.

Gold clauses had a pernicious effect, however, when deflations and devaluation decisions of foreign governments reduced prices and economic activity. Then, gold clauses prevented governments from quickly and effectively remedying the situation by altering the money supply, interest rates, exchange rates, and prices to push the economy back toward equilibrium.

In Chapter 16, Edwards admits monetary expansion was the optimal policy to pursue. He “strongly” believes it was the “main force behind the recovery.” He indicates, correctly, that this is the consensus of scholars who have studied the issue (and he offers no alternative explanation). The Roosevelt administration understood this problem and on May 29, 1933 convinced Congress to void gold clauses in all contracts retroactively and in the future.

Chapters 5 through 10 do a good job of conveying this material and describing the thought process of the Roosevelt administration as it struggled to make difficult decisions in real time with limited information. The chapters reflect the conventional wisdom found in canonical accounts of this period, including Milton Friedman and Anna Schwartz’s Monetary History of the United States, Peter Temin’s Lessons from the Great Depression, and Barry Eichengreen’s Golden Fetters. The chapters also do a good job of describing concerns and criticisms of Roosevelt’s recovery plans. Perhaps as a narrative device, the chapters do not tell you who was right. That material appears 100 pages later, in Chapter 16.

Breach and default? / Chapters 11 to 15 contain the novel part of the narrative.

They describe investors’ reactions to Roosevelt’s gold policies and the abrogation of the gold clause. Investors quickly sued in state and federal courts, demanding that

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borrowers repay debts with gold coin as required by gold clauses, rather than currency as determined by Congress. Courts consistently ruled against the plaintiffs, usually indicating that the Constitution gave Congress the power “to coin money and regulate the value thereof ” and to determine what was legal tender for the discharge of public and private debts.

Plaintiffs appealed these decisions and the cases quickly reached the Supreme Court.

American Default’s coverage of these court cases is seminal and stimulating. I know the literature on this topic well. As the official historian of the Federal Reserve System, I co-wrote essays on “Roosevelt’s Gold Program” and the “Gold Reserve Act of 1934” for the Federal Reserve’s Federal Reserve History website (www.federalreservehistory.org). I have read much of what scholars have published on this topic. I know of no comparable source for information on these court cases, the arguments presented by the plaintiffs and defendants, and the rationale underlying the Supreme Court’s confusing decision that Congress’s abrogation of the gold clause in private contracts was constitutional while Congress’s abrogation of the gold clause for government bonds—particularly the Liberty Bonds—was constitutional in some ways but unconstitutional in others, did not harm the plaintiffs, and therefore would not be overturned by the courts.

Now we get to one point on which I disagree with the author. Edwards clearly believes the U.S. federal government defaulted on its debts. The Supreme Court equivocated but generally seemed to think that the United States did not default. I agree with the Supreme Court. Here’s why: The Merriam-Webster Dictionary defines a default as either (1) a failure to do something required by duty or law, or (2) a failure to pay financial debts. The U.S. Supreme Court decision in the gold cases indicated that the federal government defaulted in the first sense by not fulfilling a promise printed on the bonds, which was to literally repay bond holders with U.S. gold coins at the standard of value that

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prevailed when the bonds were issued in 1918. At that time, the basic gold coin was the Eagle. It was worth $10 and contained 0.48375 troy ounces of gold and 0.05375 troy ounces of copper. So, a Liberty Bond with a face value of $100 promised upon maturity payment of 10 gold Eagles containing a total of 4.8375 troy ounces of gold and 0.5375 troy ounces of copper.

When the Liberty Bonds matured in 1938, however, the government gave bondholders neither the Eagles nor the metals that they contained.

However, the Supreme Court ruled that the federal government did not default in the second sense: it fully paid its financial debts. The latter conclusion requires explanation, particularly because the book emphasizes the “American Default” aspect of the Court’s decision. The Court justified this conclusion using two arguments originally advanced by the federal government.

The first began with the fact that in 1933, the federal government had withdrawn all monetary gold from circulation and paid in return paper currency at the standard of value that had prevailed since 1900.

This meant that an individual holding 10 Eagle coins had to give them to the government and accept $100 in paper currency in return. The government argued that Liberty bond holders could and should be treated the same way as everyone else in the United States. In a hypothetical scenario, when the bonds matured, the government would pay bondholders the gold coins as promised, but then would immediately confiscate the coins and compensate the former bondholders with currency at the same rate that everyone else had been compensated a few years before. This hypothetical sequence of transactions was legal. The U.S. Constitution enumerated Congress’s power to determine the standards of coinage and legal tender. These enumerated powers enabled Congress to convert gold coins to paper currency and/or redefine the standards of value and objects accepted as payment for public and private debts. If the government executed this hypothetical sequence of transactions when the bonds matured in 1938, an individual who had

purchased a $100 Liberty Bond in 1918 would in the end receive $100 in currency.

The Supreme Court ruled that it was acceptable for the government to give that currency directly to the bondholders upon maturity, rather than go to the hassle of giving them gold coins, taking them back, and then paying the currency for them.

To understand the second argument that abrogating the gold clause did not involve a financial default, it may help to step back from the legal technicalities and think of the repayment in an economic sense. The purpose of the gold clause was to protect bond holders from a fall in the value of American currency, a phenomenon known as inflation. The clause promised that individuals who invested in the United States would be repaid with dollars whose real value in terms of goods and services was equivalent to the real value of the dollars with which the individuals purchased the bonds. Did the U.S. government do this? The answer is yes. The purchasing power of the dollar rose 4% between 1918, when the fourth Liberty Bond was issued, and 1938, when the fourth Liberty Bond matured. So, an American citizen who in 1918 purchased a $100 Liberty Bond received in 1938 funds sufficient to purchase goods and services that would have cost $104 in 1918. The government also paid 4.5% interest each year along the way. So the government did honor its pledge to maintain the purchasing power of the funds entrusted to it by purchasers of Liberty Bonds and return that to the purchasers plus interest.

What about foreigners? They owned many U.S. bonds. The largest group of foreign investors were English. Their position is worth considering. In October 1918, when the Liberty Bonds were issued, the dollar–pound exchange rate was 4.77.

An English investor could exchange £1 for $4.77 and purchase a $100 Liberty Bond for £20.96. In October 1938, when the Liberty Bonds matured, the dollar– pound exchange rate was 4.77. An English investor who redeemed his bond for $100 in U.S. currency could convert that into £20.96, exactly what he had paid for it.

And with those funds he could buy goods that would have been valued at £46.69 in 1918 because the purchasing power of the pound had risen substantially since that time. So English investors, like many others overseas, made large profits from investing in Liberty Bonds.

Plaintiffs in the gold clause cases before the Supreme Court hoped that their suit would allow them to reap even higher returns. They argued that the government should be required to pay them with old gold coins, like the Eagle, at the 1918 standard of value, and then they should be able to convert the Eagles to dollars at the price established by the Gold Reserve Act of 1934 ($35 per troy ounce of gold). The government countered that this was infeasible: there was not enough gold in the United States to pay all the Liberty Bond holders. The plan was also illegal; the law no longer allowed the public to own, save, or spend monetary gold. In that case, the plaintiffs argued, they should receive the amount that would result from a hypothetical sequence of transactions where the government gave them gold coins at the 1918 standard of value (as stated on the bonds) and then immediately converted that gold to currency at the 1934 standard of value. This sequence would pay $166.67 on a $100 Liberty Bond upon maturity in 1938, a sum sufficient to purchase goods and services that would have cost $174.19 in 1918. The majority of the Supreme Court rejected this claim and referred to it as unjust enrichment.

No evidence of distress /

Chapter 16 discusses the consequences of the abrogation of the gold clause. At the time, opponents of the policy contended that its effects could be catastrophic. Contracts would not be trusted. Creditors would no longer want to extend loans. Interest rates would rise. Investment would fall. The economy would stagnate.

Edwards looks for evidence of these ailments in data on investment, borrowing, bonds, stocks, prices, interest rates, and output. He finds none. After abrogation, the government actually found it easier

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to borrow, rather than harder. Edwards concludes that there is no evidence of distress or dislocation in the period immediately following the abrogation, or the Court ruling. … It is possible that if the gold clause had not been abrogated, output and investment would have recovered faster than they did, and that the costs of borrowing would have declined even more. Those outcomes are possible, but in my view, highly unlikely.

The reason abrogation had no detectable effect, Edwards concludes, was that it was an excusable default. Excusable defaults occur under circumstances “when the market understands that a debt restructuring is, indeed, warranted, and beneficial for (almost) everyone involved in the marketplace” when the restructuring is done according to existing legal rules, and when the default is largely a domestic matter with few foreigners involved. Excusable defaults do not stigmatize sovereigns because they do not change borrowers’ expectations of sovereigns’ probability of repaying future debts.

I agree with Edwards that the abrogation of the gold clause fits these circumstances and I argued, in the preceding paragraphs, that the abrogation fit another classic characteristic of an excusable default: bondholders received payment equal to (or better than) what they expected when the debt was issued. Since past holders of Liberty Bonds received the repayments that they expected when they purchased the bonds on origination in 1918, despite the tremendous shocks to the United States and world economies between then and maturity in 1938, future bondholders had no reason to doubt that their expectations would not be met.

A future default? / Could it happen again?

The author asks that question at the beginning and end of the book (and in the title to Chapter 17) because, he says, “among all questions, [it was] the one that kept coming back again and again.” In emerging economies, Edwards indicates, “situations

that mirror what happened in the United States during 1933–1935 have occurred recently in a number of … countries, and it is almost certain that they will continue to arise in the future.” Examples from the recent past include Argentina, Mexico, Turkey, Russia, Indonesia, and Chile.

Advanced economies are not immune from these economic forces. In 2008, Iceland faced “a gigantic external crisis with a massive devaluation and a complete collapse of the banking sector. It took almost ten years for Iceland to recover.”

Greece continues to struggle with a similar situation, as do other European nations such as Portugal, Italy, and Spain. These nations may be tempted to leave the eurozone, reintroduce independent currencies, and devalue their exchange rate in order to speed economic recovery. But any nation that tries (or is forced) to do this will struggle with contracts, all of which are written requiring payment in euros. If these are rewritten to permit repayment in new currencies of lesser value, the issue is sure to end up in domestic and foreign courts as well as the World Bank’s tribunal for international investment disputes.

While the rest of the world may be in danger of experiencing events similar to the U.S. abrogation crisis of the 1930s, Edwards argues that “it is almost impossible that something similar will happen again in the United States.” The main reasons are the change in the monetary system and the exchange rate regime. The United States’ exchange rates are now determined by market forces. Gold no longer underlies the monetary system. Most contracts are denominated in lawful currency, not gold, commodities, or foreign currency.

Even if a repeat is extremely unlikely, the chance of the United States restructuring its debt, Edwards argues, is not zero. The federal debt outstanding is now nearly equal to gross domestic product. A tenth of the debt is fixed in real terms because, upon maturity, bondholders receive a premium payment linked to increases in the Consumer Price Index. The implicit debt for future entitlements—particularly Medicare, Medicaid, and Society Security—exceeds 400%

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of GDP. There is little agreement on how to pay for these promises, Edwards notes, and at some point in the not too distant future the U.S. government may be forced to restructure its payments. This potential crisis, he argues, differs from the crisis of the 1930s because that crisis stemmed from deflation, exchange rates, and the structure of the monetary system. The modern problem arises from promises made in the present for the future delivery of services.

On all of these points, I agree with Edwards. I am, however, less hopeful for the future. The unsustainable federal debt is not an accident. I believe it was consciously created by Republican politicians to justify reducing (or eliminating) future federal entitlements. With Republicans in control of all three branches of the federal government, taxes cut, deficits up, and a recession on the horizon, the day of reckoning may soon be upon us. I anticipate a massive abrogation of federal medical and retirement entitlements within the next decade—sooner if Republicans retain control of Congress and the White House in the next two election cycles.

The roots of the past and current crises may have more in common than Edwards indicates. Most payments for federal entitlement programs are indexed for inflation. Federal entitlement obligations are, in other words, guaranteed in real terms, just like payments for Liberty Bonds 100 years ago. They cannot be adjusted on aggregate by monetary policies that generate inflation; they can only be adjusted through the legislature and the courts. On this point, Edwards’s American Default ends on a high note.

The ability of the United States to deal with the crisis of the 1930s and the abrogation of the gold clause demonstrate the strength of our legislative and judicial institutions. Given these, it is likely that our nation will be able to overcome future federal financial restructurings. Memories of those events will fade and be forgotten just like the events that Edwards masterfully recounts in his book, and America’s federal debt will remain the risk-free standard for the rest of the world.

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Tyranny by Facebook or

by Leviathan? ✒ REVIEW BY PIERRE LEMIEUX

D

espite being authored by a professor of politics at the grand old Cambridge University, How Democracy Ends sometimes feels light. Its catchy formulas and cheesy pronouncements get annoying. A biological analogy is over-exploited: “Western democracy is going through a mid-life crisis”; “American democracy is in miserable middle age. Donald Trump is his motorbike.”

This should not distract us from the thesis of the book and the questions it raises. David Runciman argues that democracy is threatened by new sorts of predicaments. Military coups d’état are passé. Even Trump (or, I would add, his successor) doesn’t represent the main danger; the new threats are subtler. Even people who subvert democracy, like populists do, believe or pretend that they are defending it. An environmental or nuclear catastrophe could end democracy, but a technological takeover is more likely.

Democratic failure /

Runciman goes from a “minimal definition” of democracy as that which chooses its political leaders via regular elections, “which remain the bedrock of democratic politics,” to a more general and fuzzy one that includes such features as “democratic legislatures, independent law courts and a free press.” What about other individual liberties? Perhaps democracy also includes those, or perhaps not. The word “liberty” is absent from the book, although the less committal “freedom” occurs once every 15 pages or so.

Runciman believes that democracy is undermined by the decline of representative democracy and the rise of populism, which revolves around the idea that “democracy has been stolen from the people by the elites.” If democracy worked well,

PIER R E LEMIEUX’S latest book is What’s Wrong with Protectionism? Answering Common Objections to Free Trade (Rowman & Littlefield, 2018).

he believes, there would be no populist backlash. Working well implies providing a “collective experience.” This so-called collective experience is more difficult to pull off in the absence of war—or, at least, of a traditional war, not waged by drones— and when great social reforms have already been accomplished, decades ago. In the Progressive Era, democracy was able to tame populism because of social reforms and World War I. In Runciman’s view, war also has the benefit of reducing wealth inequality (because wealth is destroyed) and thus keeping populism at bay.

Runciman argues that referenda provide only the appearance of democracy, while elected representatives can manage the inconsistent, unrealistic, or inefficient demands of the electorate. Pure democracy is “reckless” and “terrifying.” But he also admits that representative democracy implies more power for the politicians and the experts.

At any rate, he writes: “The threat to democracy is not manipulation. It is mindlessness.” Both pure democracy and technology are fueling mindlessness.

One reason why modern democracy tends to destroy itself, argues Runciman, is a tension between individual dignity and “collective benefits.” Individual dignity is better satisfied by pure or direct democracy, but such democracy’s inconsistent or irrational policies compromise the “collective benefits” of efficiency and economic growth. The resulting mess is easily exploited by populist leaders who sell “identity politics” as a booster to individ-

ual dignity. (In return, the populist leader gets more power for himself.)

Voters are not interested in big issues.

Large risks like environmental catastrophe and nuclear war become difficult to control rationally. (It’s unclear why those dangers wouldn’t give us some good “collective experience.”) People grow more frustrated: Modern democracy is riddled with holes.

Many people do feel neglected. Their views seem to count for little and their representatives often appear uninterested in hearing them out. Contemporary populism feeds off this sense of disconnect.

How Runciman would reconnect people is unclear. How would representative democracy reconnect what it has disconnected?

And how can populism and the mob do it?

How Democracy Ends neglects other promising explanations for people’s growing frustration under the all-powerful democratic state. Standard public choice theory explains how organized interests game the system. Anthony de Jasay presents a different but astute theory. In his 1985 book The State, he argues that the more the state responds to sectional demands, the more it frustrates other parts of the public, and the more it must intervene to respond to the latter complaints, and so forth in a cascade of ever-frustrating interventions.

Everybody is both helped and hindered by the state, which fuels growing discontent.

In de Jasay’s perspective, authoritarian democracy is unstable because it is essentially unlimited—that is, responsible for everything and everyone. For Runciman, democracy seems to be a value by itself— perhaps the ultimate value—and only its subversion is dangerous. Democracy has failed; long live democracy!

Zuckerberg and Leviathan / A strong thread runs through How Democracy Ends that questions the new technologies represented by computers and robots. “Politics,” writes Runciman, “needs to regain a measure of control over these machines and over the people who currently control them.”

In his view, “the network” undermines democracy. This network is made of the

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computers that connect people with oth- American democracy than Donald Trump.” ers, people with machines, and machines Really? He views Leviathan as a potentially with machines. This interconnectedness good machine that can regain control of the becomes essential to people’s lives. Social private and corporate machine: “Leviathan networks provide “a sense of belonging” still has life left in it.” Franklin D. Roosevelt that substitutes for the state and enhances was the face of “Leviathan in action,” he tribalism. Leviathan itself— writes approvingly. We need the all-powerful state—is a an activist democracy again: machine, as Thomas Hobbes If American democracy imagined. There is often somefound the strength to face thing guru-like and vaporous down corporate titans like in Runciman’s descriptions.

Standard Oil at the start of Yet the Cambridge profesthe twentieth century, why sor recognizes that digital shouldn’t it take on Google technology has reinforced and Facebook today?

Leviathan more than it has Instead of criticizing corfulfilled its original promporations, online advertisises of liberating individuals ing, and “the consumerist from the powers that be. It madness” à la John Kenneth also intensifies voters’ cog- How Democracy Ends Galbraith, Runciman should nitive biases through “fake By David Runciman focus on the danger of Levianews” and the isolation of 256 pp.; Basic Books, than. Information and surindividuals in partisan silos, 2018 veillance are dangerous when as any regular user of social they can be used by the state networks can observe.

Participation in social media may for coercive control. Of course, the state resemble ancient direct democracy, but can be captured by private interests, but without its built-in controls: “Twitter is the problem is the state, not the private sometimes described as being like the Wild interests. The power of advertising is nothWest. But really it is the closest thing we ing compared to the state’s prisons. have to democracy of the ancient world: Libertarianism to the rescue / Runciman fickle, violent, overpowering.”

Reading Runciman on technology, I was idealizes democracy as a system of governreminded of Jacques Attali, a French econo- ment. He thinks that “collective decisionmist who was an adviser to socialist presi- making works better than any individual’s dent François Mitterand in the 1980s. In a choices if our biases are allowed to cancel 1978 book titled The New French Economy, each other out.” That’s a big “if.” He genAttali argued that “self-surveillance capital- erally ignores voters’ rational ignorance— ism” was replacing the free market ideal, the fact that an individual votes blind and that only socialism could prevent this because the process of gathering and ananew totalitarianism. He warned that pocket lyzing information is not worth the cost calculators were the prelude to surveillance when he has only one vote. “Every vote by electronic devices. In my first book, From counts,” Runciman echoes. A single vote Liberalism to Anarcho-Capitalism, published in may count to boost individual dignity, Paris in 1983, I mocked Attali’s dramatiza- but not to change election results. The tion of the pocket calculator, but perhaps author of How Democracy Ends does not seem to see how voting and mindlessness he was on to something.

Runciman sees the danger of mass fit together.

He ignores the problem of aggregatsurveillance but, just like Attali, he does not realize that the state is the problem. ing preferences among different individuThe author of How Democracy Ends thinks als. He throws around the word “we” like that Mark Zuckerberg is “a bigger threat to bread at the Multiplication of the Loaves

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and Fishes, ignoring the demonstration (notably by Kenneth Arrow in his 1951 seminal book Social Choice and Individual Values) that, at least in most cases, collective values are either meaningless or totalitarian. He also ignores public choice analysis.

Ideally, Runciman seems to believe, democratic politics should control everything. But he does not explain how that would not be the dictatorship of the mindless. Representative democracy does not solve the problem for the simple reason that the representatives are elected.

Sometimes the reader will be puzzled

by Runciman’s economics. For example, he does not seem to know what “public goods” are, since he wants them to be “equitably distributed.” By definition, a public good can be consumed by everybody once it is provided to anybody. Perhaps he is not using the expression in its technical sense.

Or perhaps he is thinking of “public goods” that are only such for part of the public, but this opens a Pandora’s box and an explanation would have been welcome. Then again, he may just be speaking in catchy formulas.

He blames economics for supplanting “the messiness of political life” by “the clean lines of perfect competition and efficient markets.” With due respect, his own argument would have been less messy with some cleaner modeling.

I am puzzled by a remark he makes when contrasting his ideal of slow-moving, thoughtful representative democracy with the addiction and superficiality of social networks. He claims that “buyer’s remorse is relatively uncommon in the world of online commerce because there isn’t time for it.” This looks hopelessly Galbraithian, again. According to the National Retail Federation, 15–20% of items bought online are returned, which actually fuels a whole industry that purchases returns for reselling (at Dollar stores, for example) or recycling. One would like to be so easily reimbursed when not satisfied with public services. Many would like to be able to change countries as easily as they switch from Amazon to Walmart.

After briefly discussing Robert Nozick’s anarchist utopia, Runciman dismisses it,

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perhaps because he does not find it practical. But there are more practical versions of this ideal. In his 1969 In Praise of the Consumer Society, the late French philosopher Raymond Ruyer wrote that “real anarchism, feasible and realized, as opposed to mere emotional statements, is simply the [classical] liberal economy.”

If he studied libertarianism more carefully, Runciman might realize that democracy is just an imperfect means of managing public goods, changing the political guard when necessary, and restraining the state. Democracy should not be imagined as a way to choose coercive moral values.

In Law, Legislation and Liberty, Friedrich Hayek wrote that “democracy is basically a negative value which serves as protection against despotism and tyranny.”

Contra Runciman, politics is not a panacea, “political emptiness” is not a terminal disease, and it is not true that “only politics can rescue politics.” Private and voluntary activities would beneficially replace a large part of politics. If the rule of the mob, the rule of the experts, and the rule of the politicos are all fraught with great dangers, which Runciman might concede, the problem must be the rule itself or its scope, not who happens to rule. The solution is to severely constrain state power.

What about tyranny? / Philosophers or political scientists usually imagine that democracy ends with some form of tyranny. Jean-François Revel, author of the 1983 book How Democracies End, saw communist totalitarianism as the danger. For de Jasay, democracy ends in state capitalism, where the democratic state monopolizes both political and economic power. This state will ultimately terminate electoral competition because it is inconsistent with economic management: the workers cannot decide their own salaries at the ballot box.

Tyranny is quiet in Runciman’s book.

The word “tyranny” appears only four times in the body of the text—including once as “corporate tyranny.” To be fair, another occurrence refers to Tocqueville’s “tyranny of the majority.” Runciman admits that “pure democracy is a terrifying thing. It’s all

too easy for the crowd to turn on any individual who displeases it.” Indeed. But perhaps he should name tyranny as the danger.

The book’s conclusion is anticlimactic: at some point in the future, democracy ends or perhaps it does not end; and there is no solution to this non-event. The last two sentences of the book (before a sciencefictional epilogue) read: “This is not, after all, the end of democracy. But this is how democracy ends.”

More to the point, Runciman suggests, democracy will have changed but, in most places, will have remained democracy of a sort. It will reign over a nonviolent and dull society of old people going through the motions of voting occasionally. They will find partial dignity in the network, but many governance problems will be unsolvable. Addicts and suicide deaths will be numerous, as prefigured in many

advanced societies of today.

Let me complement the description.

Individuals—if we can still call them such— will smile and be happy, like in Aldous Huxley’s Brave New World or Patrick McGoohan’s The Prisoner. They won’t have much choice anyway. Why doesn’t Runciman call this tyranny? Not Facebook “tyranny,” but real tyranny from Leviathan, even if it is softer than in George Orwell’s 1984. Runciman brings us close to this, but he stays fixated on Zuckerberg against the good Leviathan.

I would agree that Facebook’s “community” gibberish and standards à la Mrs. Grundy often look like the Brave New World. But Leviathan’s power is the real danger. It’s much easier to disconnect from Facebook than to close one’s account with the state. How Democracy Ends may help ask the right questions, but it does not provide useful answers.

Perspective on the Terrorist Threat ✒ REVIEW BY DAVID R. HENDERSON

I

n 2007, Princeton University economist Alan Krueger published a short book, What Makes a Terrorist, based on three lectures he gave in Britain debunking many of the myths about terrorism.

Now he has published a 10th anniversary edition with a new prologue and updated material. What distinguishes his work from many others on the subject is his empirical approach: he looks carefully at the data.

The three chapters of the book are titled, “Who Becomes a Terrorist? Characteristics of Individual Participants in Terrorism,” “Where Does Terror Emerge? Economic and Political Conditions and Terrorism,” and “What Does Terrorism Accomplish?

Economic, Psychological, and Political Consequences of Terrorism.” In each chapter, he draws on data to answer those questions, DAV ID R . HENDER SON is a research fellow with the Hoover Institution and emeritus professor of economics at the Graduate School of Business and Public Policy at the Naval Postgraduate School in Monterey, CA. He was a senior economist with President Reagan’s Council of Economic Advisers. He is the editor of The Concise Encyclopedia of Economics (Liberty Fund, 2008).

and what he finds is striking: International public opinion surveys find that support for terrorism is higher among those who are more highly educated and have higher family income. One striking statistic comes from a survey of 1,318 Palestinians in the West Bank and Gaza Strip: 86.7% of merchants and professionals, versus “only” 73.9% of the unemployed, supported armed attacks against Israeli targets.

■■ Terrorists “are more likely to be well educated and less likely to come from impoverished backgrounds” than the ■■

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populations from which they come.

International terrorists—Krueger never defines the term but, in context, he means (and he confirmed this by email) those who engage in terrorism against foreign targets, whether in their own or in other countries—tend to come from countries whose governments suppress civil liberties and political freedom.

■■ There is no connection between a country’s income per capita or illiteracy rate, on the one hand, and the number of international terrorists from that country, on the other.

■■ Terrorists’ preferred targets tend to be wealthy countries whose governments respect civil liberties and political freedom rather than poor countries with repressive governments.

■■ Distance matters; that is, international terrorists and foreign insurgents tend to come from countries that are geographically close to the countries they target.

■■ For their acts to have the desired effects, terrorists who use conventional methods of terrorism “need the media to propagate fear.”

■■

Understanding terrorism /

To discuss terrorism, you first need to define it. Krueger characterizes terrorism as “premeditated, politically motivated violence.” He notes that although this characterization doesn’t exclude state-sponsored terrorism, his goal is to consider “substate organizations and individuals with the intent of influencing an audience beyond the immediate victims.”

In context, his winnowing down to non-state actors makes sense because what many people would like to understand is who the substate actors are and what motivates them. I think I understand, for example, the vengeance motive that led the U.S. government, early after its entry into World War II, to send Lt. Col. Jimmy Doolittle and his squad’s airplanes to firebomb the Japanese mainland. But what many people aren’t entirely sure of is what causes various non-state actors to attack

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the targets they choose in, say, the United third countries, rather than occupier or States. Krueger doesn’t answer everything occupied countries. we might like to know, but he does give some answers and is careful not to go far Inflating the risk / How serious a problem is beyond what he can extract from the data. terrorism? Krueger’s table of relative risks On the lack of a connection between shows that the answer is “not very.” An terrorism on the one hand and poverty and American’s lifetime risk of being killed by low education level on the other, Krueger, a terrorist, calculates Krueger, is 1:69,000. besides looking at his assembled data, Compare that to the 1:88 chance of being makes a big-picture empirical point: “If pov- killed in a motor vehicle accident and the erty and inadequate education were causes even more serious 1:7 risk of dying from of terrorism, even minor ones, the world cancer and 1:4 risk of dying from heart would be teeming with terrorists eager to disease. Based on other risks he shows in destroy our way of life.” In fact, he notes, his table, he writes, “In 2005 the average uneducated poor people are particularly American’s chance of being killed by a terrorist was much less than unlikely to participate in any his or her chance of being political processes, terrorist or killed by lightning or in an otherwise. They are too busy airplane crash.” trying to make a living.

People often respond to When we think of terthis by pointing out that, rorism, many of us think of with terrorism, someone is Muslims. University of Chiactively trying to kill othcago political scientist Robert ers, whereas with the other Pape, who gathered data on risks, fatalities “just happen.” every known case of suicide While that certainly should terrorism between 1980 and affect our moral evaluation— 2003, found little conneclightning is amoral, while a tion between it and Islamic terrorist is virtually certain fundamentalism. Krueger What Makes a Terrorcites Pape and reports on ist: Economics and the to be immoral—it should not affect one’s evaluation of his own study, co-authored Roots of Terrorism relative risks. Krueger doesn’t with David Laitin, that found By Alan B. Krueger address this response, probsimilar results for terrorism 195 pp.; Princeton ably because he sees it as the in general. Krueger and Laitin University Press, 2018 red herring that it is. But looked into whether a counhis table of risks implicitly try with a high percentage of Muslims is more likely to be a home answers the argument. He shows that an to terrorists than a country with a high American’s lifetime probability of being percentage of Christians. They found no murdered is 1:240, which is 287.5 times the probability of being killed by a terrorist. In significant difference.

What motivates terrorists? Krueger both cases, the killing is intentional.

Given the small risk of terrorism, found that “countries that occupy other countries are more likely to be targets of Krueger is right to decry government terrorism.” That certainly makes sense. officials’ pronouncements that hype Interestingly, though, he also found that the threat. He reports that in July 2007, countries that are occupied are only Michael Chertoff, then secretary of home“slightly more likely to be perpetrators land security, told the Chicago Tribune of his of terrorism.” Of course, countries can’t “gut feeling” that al-Qaeda might attack perpetrate terrorism. Krueger is clearly the United States that summer. His reareferring to terrorists and identifying soning was that “summertime seems to be them by the country they came from. appealing to them.” But Krueger, using the And many terrorists seem to come from government’s own data, found no summer

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spike in al-Qaeda terrorist attacks between 2004 and 2006. He found 10 attacks in the winter, 13 in the spring, nine in the summer, and seven in the fall.

He notes that in the summer of 2007, someone had brought his evidence to the attention of the Department of Homeland Security. Did DHS then say, “Oops, our bad?” Dream on. Instead, DHS spokesman Russ Knocke responded, “If any doubt lingers in his [Krueger’s] mind about activity in spring and summer months in recent years, he need only ask the families of victims from London, Madrid, and 9/11.” In his book, Krueger has a great comeback: “Evidently Mr. Knocke does not think it important to consider the victims of terrorist attacks that occurred in winter and fall.”

More than a decade before giving these lectures, Krueger was the chief economist in President Bill Clinton’s Department of Labor; after giving these lectures, he went on to become chairman of the Council of Economic Advisers (CEA) under President Barack Obama. His experience in government doesn’t seem to have led him to the same skepticism about government competence that I had in my two early-career stints at the CEA. He does find fault, quite justifiably, with the important statistical errors issued by the State Department under President George W. Bush’s secretary of state, Colin Powell.

For instance, a major report on world terrorism in 2003 was supposed to cover the entire year, but the last terrorist attack it listed in the appendix was on November 11. This made no sense, argues Krueger, because on November 15, there were attacks in Turkey on two synagogues, the British consulate, and a British bank. Krueger’s solution is for the State Department to have its own statistical agency, but he doesn’t express any overall skepticism about the government’s competence in dealing with terrorism.

At one point, he notes that terrorists may be “motivated by some grievance concerning American activity in the Middle East, such as the presence of American troops in the Persian Gulf and American support of autocratic regimes friendly to the United States.” He concludes that we

“have to confront their grievances.” But he adds, “And we may not want to confront their grievances.” His solution instead, which he admits is unlikely to be “an important part of the solution,” is to have the government—presumably he means the U.S. government—control the content of education that people in other countries receive.

He never suggests that government officials be fined or even fired for misreporting facts. But he doesn’t have the same tolerance for private-sector actors. He writes, “Perhaps the FCC could keep track of inaccuracies in reporting on terrorism and fine media outlets if they repeatedly make mistakes.” It is certainly true that the media hype terrorism and that that has

bad effects. But his confidence in proposing that a government agency be given the power to fine those who are exercising their freedom of speech is breathtaking.

While I recommend the book overall, I point out one thing that is missing. In a well-referenced book, nowhere does Krueger mention an article that makes many of the points he does about relative risks and about how the main damage from terrorism comes not from terrorism per se, but from its provoking destructive government policies. The article I’m referring to, published over a year before Krueger’s 2006 lectures, is Ohio State University political scientist John Mueller’s “A False Sense of Insecurity” in these pages (Fall 2004).

A Degree Too Far ✒ REVIEW BY DWIGHT R. LEE

I

n his latest book, George Mason University economist Bryan Caplan has done what educators universally laud and applaud: he has impressively applied critical thinking to an important issue. Yet most educators will be appalled by The Case Against Education because it argues that most of what is spent on education in America is wasted.

Caplan has no illusions that his argument will be widely embraced. Most people have heard all their lives that spending more on education is the best way to improve the futures of our children and the prosperity of our country, and they serve as Baptists in the political process for the well-organized bootleggers who profit from education spending.

Politicians and organized groups, including educational professionals, routinely justify government support for activities benefiting them by claiming they create positive externalities: social benefits that are not captured by those providing them. Thus educational professionals argue that, without government

support, less education will be provided than is socially desirable. Unfortunately, even when there is a positive externality, it is often used to justify government spending that creates a more-than-offsetting negative externality: social costs that are ignored by those benefiting from the spending. Caplan’s case against the existing level of educational spending is that it creates negative externalities by motivating people to increase their education even when the social costs exceed the social benefits. The book makes this case more effectively than it has been made before, by considering the theoretical and empirical implications of applying the concept of signaling to education.

DW IGHT R . LEE is a senior fellow in the William J. O’Neil

Signaling / Signaling occurs when an individual’s actions communicate useful, if only probabilistic, information about himself that is not otherwise apparent.

Center for Global Markets and Freedom, Cox School of Business, Southern Methodist University. He is a coauthor of Common Sense Economics: What Everyone Should Know about Wealth and Prosperity, 3rd edition (St. Martin’s Press, 2016), with James Gwartney, Richard Stroup, Tawni Ferrarini, and Joseph Calhoun.

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For example, how people dress, the con- tive abilities they develop because of their eduspicuousness of their tattoos, and whether cation. The most obvious characteristic stuthey support the arts signal information dents bring to school is their intelligence, about them to others, such as potential which most agree cannot be increased employers. The amount and difficulty much, if at all, by education. Obviously, the of the formal education a person has more intelligent can compile an impressive acquired is obviously such a signal and educational record that sends a useful sigwas mentioned by the Nobel Committee nal to employers on both their intelligence in 2001 when announcing Michael Spen- and what they have learned in school. But ce’s Nobel Prize in economics for his work except for strongly applied studies such as on signaling. accounting, engineering, and pharmacy, Caplan considers whether an indi- employers are more interested in prospecvidual benefits from the sigtive employees’ ability to learn nal a good education sends rather than in what they have to prospective employers, already learned. One might and whether that signal is argue that, this being the case, an accurate measure of the a lot of time and money spent social benefit of that educaon education could be saved tion. He provides plenty of by simply giving prospective evidence that getting a good employees an IQ test. formal education yields the However, Caplan notes, educated person a very attracthere are legal limitations on tive financial return. For readrequiring potential employers interested in how to make ees to take IQ tests. More the best use of educational importantly, intelligence is The Case Against signaling to increase their Education: Why the not the only thing employfinancial payoff, his Chapters Education System Is ers are looking for. They are a Waste of Time and 4 and 5 are worth the price of also interested in a person’s Money the book. willingness to work hard and But Caplan also wants By Bryan Caplan to adhere to prevailing social to know whether this indi- 416 pp.; Princeton norms. Completing a degree vidual benefit also benefits University Press, 2018 also signals information on society. The answer depends these characteristics. A person on how much it contributes may have an IQ of 150, but if to a student’s productive characteristics as he doesn’t go to college, his apparent lack opposed to how much did those character- of diligence and unwillingness to do what istics preexist his education and contribute is expected of highly intelligent people are to his educational achievements. red flags to employers. This explains why Economists and educators have always high-school graduates earn more than recognized that productive characteristics dropouts, even if the latter pass the tests both facilitate and are facilitated by educa- necessary to earn a General Equivalency tion. The widely held view, according to Diploma. As Caplan says of the GED, “Its Caplan, is that the dominant direction of chief function is to signal employers, ‘I educational cause and effect runs from have the brains but not the grit to finish education to productive ability. He refers high school.’” There is a “sheepskin effect” to those who hold this view as “human to education signaling seen in a sharp capital purists.” income increase from staying in school Contrary to the purists, Caplan argues long enough to receive a diploma. Tenacthat empirical research supports the alter- ity and “fitting in” may not be as strongly native view that education is more a signal determined by heredity as intelligence, but of the productive characteristics students by the time a person reaches high school bring to their education than of the produc- it is unlikely these characteristics will be

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improved by forcing unmotivated students to sit through hours of what they consider boring lectures.

Caplan recognizes that education signals useful information to employers on the productivity of potential employees. That information, in turn, will affect those workers’ salaries. He finds, however, that most of the productivity signaled by formal education is not the result of the education itself but of the characteristics students bring to their high school and college experiences.

He illustrates his argument with the analogy of a sculptor and appraiser: The sculptor raises the market value of a piece of stone by shaping it. The appraiser raises the market value of a piece of stone by judging it. Teachers need to ask ourselves, “How much of what we do is sculpting and how much is appraising?” (Caplan’s emphasis.)

Teachers do some sculpting and appraising, but careful and multiple empirical approaches point to what Caplan labels “a reasonable estimate of 80%” as the “share of education’s effect on earning and employment [that] stems from signaling” or appraising. That leaves 20% as education’s sculpting contribution.

Negative externalities / Without using the term, Caplan gives an example of the type of negative externality educational signaling motivates with the following:

The person who gets more education, gets a better job. It works; you see it plainly. Yet it does not follow that if everyone gets more education, everyone gets a better job. In the signaling model, subsidizing everyone’s schooling to improve our jobs is like urging everyone to stand up at a concert to improve our views.

Both are smart for one, dumb for all.

Everyone standing up at a concert is a commonly used example of a prisoner’s dilemma, in which all are worse off when each does what is in his best interest. It is also an example of the negative externalities each creates when trying to increase his benefit by imposing an uncompensated

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cost on everyone else. The result is everyone ends up worse off in futile attempts by each to become better off.

In the case of education, the higher salary from getting one more degree makes it financially attractive for students, even though the social cost of the additional education is greater than the social value it contributes by increasing productivity.

This can motivate wasteful spending on education even if students or their families are paying the full cost. It is a larger problem when government is paying for much of the cost, which motivates more students to get—or attempt to get—a higher degree to signal qualifications greater than justified by their natural abilities and what they learn in school. As more people try to signal their productivity with more education, employers will find the signals becoming less impressive and students will find it less beneficial to send them.

Yet this doesn’t reduce the appeal of additional education, even to weak students. The student who doesn’t try for the extra education is now signaling to employers that he cannot even send a weak signal.

So more weak students try for degrees they don’t complete, which means the signal they send is even weaker. Furthermore, those with the ability to earn an extra degree find that the signal they now want to send requires education beyond that degree. As in Caplan’s prisoner’s dilemma example of standing at the concert, as educational signaling motivates students trying to get the edge on other students by getting relatively more education, it takes more years in school for all students to maintain the value of their signaling.

Yet dropping out of this educational race would be the equivalent of sitting down at the concert while others continue standing; by sitting, a person would no longer be imposing a negative externality on others, but the harm imposed on him by those still standing would be greatly increased.

Caplan recognizes that there is social benefit from signaling information on students’ natural abilities that are otherwise difficult to observe. But he also recognizes that even a large total social benefit from

educational signaling doesn’t indicate much, if anything, about its marginal benefit. If Caplan is correct that “employers’ knowledge of worker quality would be essentially identical if everyone had one less degree,” then he is also correct when saying that “in economic jargon, the marginal social benefit of signaling is roughly zero, even though its total social benefit is substantial” (Caplan’s emphasis). The “roughly zero” is a hedge, but not a troublesome one. Before the marginal social benefit of educational signaling reaches zero, it is sure to be less than its marginal social cost, in which case reducing that signaling by spending less on education is socially beneficial.

The marginal cost of providing this signaling is enormous. Government spending on education in 2010–2011, including federal assistance to individuals (and removing double counting), was over $960 billion, significantly higher

incomplete…. Counting everything that counts, industrial policy for education has clearly gone too far. The United States—and probably the rest of the world—is overeducated.

Conclusion /

He ends the book by reemphasizing what few people have considered, much less accepted: Academic success is a great way to get a good job, but a poor way to learn how to do a good job. If everyone got a college degree, the result would not be great jobs for all, but runaway credential inflation. (Caplan’s emphasis.)

From the very beginning of his book until the end, Caplan makes it clear that he believes the net social benefit from education would be larger and the world would be a wealthier place if we would “cut the subsidies” to education or “slash government subsidies” to education. And government As more people try to signal their subsidies are not the only productivity with more education, way the cost of education employers will find the signals becoming has been reduced for less impressive. students. Although he does not mention grade inflation, it has greatly reduced the study time than the $700 billion in the military required by students to send what used budget. According to Caplan, “If half [of to be an impressive academic signal, but that] is wasteful signaling, we are wast- one that has been significantly reduced in ing [almost] half a trillion dollars a year.” value. In other words, teachers are failing Even with this optimistic assumption on at their most important job: accurately signaling waste, taxpayers end up paying appraising student performance.

Caplan devoted six years to making a $960 billion for $480 billion worth of education. That education does create powerful case for significantly reducing the some positive externalities, which are con- money spent on education, even though this tinuously being used to justify the $960 would threaten the career he loves. Why did billion paid in taxes. But those benefits he do this? Because of a “blend of idealism are not worth anywhere near the $480 and cynicism.” He says he is “duty-bound billion needed to cover the negative exter- to blow the whistle on my industry’s vast, nalities on taxpayers plus those on large ongoing abuse of the taxpayer.” But he is also convinced that “even the most intellecnumbers of students. As he writes: tually compelling arguments won’t convert My own calculations incorporate the typical voter to distasteful conclusions.” multiple positive externalities. What Having written The Myth of the Ratiolow and negatives returns show is that nal Voter in 2007, he sees no threat from standard pro-education arguments are voters. But there could be a threat that

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he has not considered from private markets and rational voters. The Wall Street Journal ran a recent article on the rapid growth of one-year private alternatives to college that focus on vocational training.

Expanding such opportunities could find students voting for them with their feet, a means of voting that encourages rational consideration of competing alternatives.

This should not worry Caplan, however. Even if his educational recommendations were implemented fully, there would remain academic positions for individuals with his intellectual ability, not to mention his willingness to work hard. The only concern he might have is his inability to accept the prevailing wisdom on an increasing number of topics.

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of income inequality over the past three decades. He does not provide much empirical evidence for this, but the hypothesis looks reasonable: many of the super-rich— who are found not only among CEOs of large companies and high-tech entrepreneurs, but also among entertainers and athletes—would not be skewing the income distribution as much if the government did not protect flimsy intellectual property—and both “intellectual” and “property” deserve to be put in quotes.

Tanzi, who earned his doctorate in economics from Harvard University in the roaring 1960s, is familiar with the economic literature. He also seems to have duly read REVIEW BY PIERRE LEMIEUX ✒ the defenders of what he calls “market fundamentalism”: Milton Friedman, Friedrich ito Tanzi is a former academic and high-level bureaucrat in the Hayek, Robert Nozick, and many others he cites. He believes that “some libertarian International Monetary Fund and the Italian government. He aspirations suffer from lack of realism” and is also a prolific author. His latest book, Termites of the State, that laissez-faire is “naive.” He is not easy to covers 400 pages (excluding the bibliography and index) in 34 short pin down on the usual (and not very useful) chapters. It is easy to read but loosely structured and often repetitive. left–right spectrum but, as we will see, he Summarized in a few sentences, his the- ism. Further, public policy has contributed suffers from his own naiveté. sis is that many new problems have, like to redistributing income from ordinary Contrary to many economists—and a termites, undermined the market and made individuals to the rich and well-connected. vast multitude of non-economists—Tanzi it less free and less equitable—sometimes He has a point. understands and explicitly recognizes the because of state intervention. The state He makes an interesting case against implications of Kenneth Arrow’s Impositself, victim of its own termites, has become intellectual property rights as they are sibility Theorem. (See Arrow’s 1951 book less efficient at solving these problems. Yet now protected by the state. Patents only Social Choice and Individual Values.) Arrow later we must look to the state for solutions. became widespread in the second half of shared a Nobel Prize in economics for his The termites of the state are “various the 19th century, well into work in this area. The theorem elements that enter into the political the Industrial Revolution. fundamentally challenged the system and that corrupt, or distort, the Copyrights developed from concept of “public interest,” legitimate economic role that governments the 17th century on but were except in the rare cases when try to play.” Similarly, the termites of the not fully protected until the it is a common interest. It is market are factors that “distort the legiti- 19th century. For a long time, generally impossible to aggremate functions of markets.” Inequality and the U.S. government did not gate divergent interests withexternalities are two big market termites. protect foreign copyrights; out imposing the preferences Alexander Hamilton was all or values of some individuals Something rotten in the state / Termites of the in favor of stealing induson other individuals. Yet Tanzi State can be read as arguing that the state trial secrets from the Britoften slips into invoking the must mend its ways and that the market ish, for instance. But today, notion of public interest. is desirable to ensure prosperity and pro- trademarks, concerts, sport For example, he calls for “an tect individual freedom. The state, Tanzi games, and even the images Termites of the State: income distribution closer to Why Complexity Leads suggests, has become so complex and so of famous athletes or enter- to Inequality the one that society would concapturable by special interests that it has tainers are protected. sider desirable.” Considering

By Vito Tanzi turned the free market into crony capitalTanzi argues that the something desirable is precisely 454 pp.; Cambridge proliferation of these little University Press, 2017 what society cannot do, as per PIER R E LEMIEUX’S latest book is What’s Wrong with Protecstate-sanctioned monopolies Arrow’s theorem. tionism? Answering Common Objections to Free Trade (Rowman & Littlefield, 2018). has contributed to the rise I think that Tanzi is critical

The Ideal Fox in the Ideal Henhouse

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of economic freedom for two reasons. His main normative value lies in some ideal or preferred income distribution that only the state can establish. And he sees the termites (or failures) of the market as worse than those of the state.

Market termites / The market, Tanzi argues,

is highly imperfect: it “does not work well enough, especially in some sectors.” Consumers are often irrational and, if only because of information asymmetries, badly informed. Nowhere, however, does he explain how the state is more rational and better informed, and why we should expect it to promote some common interests— instead of, say, favoring its cronies. Moreover, the proliferation of laws and regulations, which Tanzi himself criticizes, must generate tremendous asymmetric information—not to speak of political deceits, which are in the interest of politicians.

Tanzi repeats the oft-cited statistics on how income has become more unequally distributed during the past three decades in developed countries. He focuses on relative shares instead of the absolute levels of income, and probably underestimates the growth in middle class incomes. (See “The Unintended Case for More Capitalism,” Fall 2014.) He neglects the many legitimate reasons that have influenced recent trends in the distribution of income, such as rapid technological change or, as research indicates, changes in the marriage market.

Whom people choose to marry (assortative mating has been on the rise: physicians marry physicians instead of nurses) and how many people remain single may explain one-third of the increase in the Gini coefficient, according to recent research.

Another factor in growing income inequality lies in the actions of the state itself, as we have seen in the case of intellectual property. Tanzi also recognizes that cronyism—the state helping large corporations at the detriment of consumers, for example—has fueled income inequality.

But he continues to focus on the need for new government interventions as if the state could be termite-free.

In his view, negative externalities are

another huge class of market termites. Negative externalities, we may recall, are costs that bypass the market and are shifted to people without compensation. Air pollution is a standard example; antibiotic resistance is an even clearer case. Externalities are usually defined to exclude non-physical and (in some sense) non-significant effects.

The mere awareness of what is happening to others is generally not considered an externality, nor is the lighted cross on your property that your atheist neighbor may deem to be photon pollution. Extending the concept of externalities renders it useless, especially because private property is precisely a means of reducing negative externalities in society. Anybody can do what he wants on his own property, except for significant physical spillovers onto somebody else’s private property.

But Tanzi adopts a very wide concept of externalities, which includes “psychological” and “aesthetic” ones: things that

contrary, Hayek argued, it is because, and to the extent that, society is free that it can become complex. Tanzi borrows Mussolini’s quote from Hayek but opines that “we must recognize, though we may not wish to accept” the idea it conveys. In practice he often seems to accept it, which I think is not warranted.

Bleeding hearts / Tanzi frequently repeats that laissez-faire is not a solution. He seems to want both a not-too-intrusive state and a state that corrects everything that “society” thinks is wrong.

Focused on the distribution of income in rich countries, Tanzi plays down a stunning story of the past few decades: thanks to liberalization and trade, many poor countries have started to grow. The proportion of the world population living in extreme poverty has fallen from 42% to 11% between 1981 and 2013, according to World Bank data. The distribution of income has become more equal over the whole The distribution of income has become world. Shouldn’t everymore equal over the whole world. one across the politiShouldn’t everyone across the political cal spectrum be happy spectrum be happy about this? about this? Wasn’t dire poverty a huge negative externality à la Tanzi?

I have other quibbles some people don’t like to see, or negative with Termites of the State. The author claims perceptions even if mistaken (that some that the move of manufacturing to less foods are not safe, for example). He views developed countries “has led to the deinrelative poverty and the envy it generates as dustrialization of advanced countries.” a negative externality: “the spending habits This is an exaggeration. What happened of some of today’s rich and super rich … are is that traditional “dirty” manufacturing likely to create externalities of a psychologi- has moved to poor countries and been cal nature,” he writes. By making differences replaced in developed countries by more in wealth more visible, the new communica- sophisticated, automated, and efficient tion technologies have multiplied this envy manufacturing. Higher productivity has externality. The state must thus intervene reduced manufacturing employment since the early 1950s in America, but it has also against this “market failure.”

If we follow Tanzi’s approach, greater increased manufacturing output. Official social complexity multiplies negative exter- federal figures show that America’s real nalities that call for government interven- manufacturing output has nearly tripled tion. In The Road to Serfdom, Hayek objected since 1972. Value added in manufacturing, to Mussolini’s statement that “the more which measures the sector’s contribution to complicated the forms assumed by civi- GDP, is up 40% in real terms since 1997 (the lization, the more restricted the freedom first year available for this series) despite the of the individual must become.” On the dip caused by the Great Recession.

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Which presumption? / Tanzi’s favored poli-

cies to reduce income inequality include a more redistributive tax system and a basic minimum income, besides the good but underplayed idea of abandoning the state’s activities that fuel inequality. In the last chapter of the book, he invokes “the new wisdom for a new age” that Keynes was calling for in The End of Laissez-Faire (1926). This new wisdom, writes Tanzi, would allow both democracy and the market to continue to operate closer (in reality and not just in theory) to the way they should ideally operate. … Wise experts, from different disciplines, should focus on generating that wisdom.

Tanzi, it now seems, is after an ideal state that will bring about the ideal market: the ideal fox in the ideal henhouse. And we will owe this nirvana to the rule of experts?

This is not consistent with the skepticism toward the state that Tanzi showed at the beginning of the book.

The author of Termites of the State entertains a strong presumption for the state. I would argue the exact opposite: we should defend a strong presumption for individual liberty and only accept state intervention when it is indispensable to protect liberty, to produce other public goods narrowly conceived, and to combat narrowly defined negative externalities. Strictly limiting the state is a condition for liberty.

Colluding with Central Banks, Not Russians ✒ REVIEW BY VERN MCKINLEY

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hree years ago, I reviewed Nomi Prins’ last book, All the Presidents’ Bankers. (See “Finance According to Non-Academics,” Spring 2015.) The book traced a century of connections between U.S. presidents and U.S. banks. As I explained it, the book’s endnotes made clear that Prins relied on “a wide range of contemporary

books, articles, and original documents drawn from the deep bowels of the archives of numerous presidents.”

In her new book Collu$ion, she departs those dusty presidential archives for an around-the-world tour of many of the key global financial centers. According to her Author’s Note: To research this book, I set out on a global expedition. I visited Mexico City, Guadalajara, Monterrey, Rio de Janeiro, Sao Paulo, Brasilia, Porto Alegre, Beijing, Shanghai, Tokyo, London, Berlin and many cities throughout the United States.

V ER N MCK INLEY is a visiting scholar at George Washing-

ton University Law School and coauthor, with James Freeman, of the new book Borrowed Time: Two Centuries of Booms, Busts and Bailouts at Citi (HarperCollins).

As the book’s subtitle makes clear, her focus is the world’s central bankers and their method of creating money out of thin air. Throughout the book, she uses such verbs as “fabricated” and “conjured” to describe the many methods of creating money. No matter which descriptor she chooses or which global city she is talking about, the result is always the same: Since the financial crisis, these illusionists have created money, altered the nature of the financial system, and orchestrated a de facto heist that enables the most powerful banks and central banks to run the world…. Much of the twentieth century belonged to Wall Street. The twenty-first century now belongs to the central banks.

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Prins’ approach /

Her method for laying out the facts is relentless. Her formula is to choose five global economies: Mexico, Brazil, China, Japan, and Europe. She explains how the Fed conjured up money to prop up the banking system in the United States and then how, in rapid-fire succession, central bankers in each of the other economies responded to the Fed. Prins tracks Mexico’s two central bank governors during the crisis and summarizes their balancing act between looking inward to respond to domestic pressures and outward to coordinate interventions with the Fed. She explains how Guillermo Ortiz (late 1990s through the end of 2009) and Agustin Carstens (2010 to 2017) “reacted in different ways to the push from the Fed and the pull from their country.”

Ortiz cooperated with the Fed on issues like a $30 billion foreign currency swap line that supported the Mexican financial system and he even dabbled with quantitative easing. But he was not seen as a team player, as he took the opportunity of the crisis to stress that the G10 economies, especially the United States, failed at regulating and supervising their financial institutions. As Prins puts it, “Ortiz had gone too far” and was replaced by Carstens, who was “likely to be more of a yes man…. With his establishment background, he would be a point person of the Fed and offer a gateway to Washington Beltway economic leaders.” Although Carstens did criticize U.S. monetary policy at times, he was considered much more of a team player.

The leadership of Brazil’s central bank fell to the hawkish Henrique Meirelles during the crisis years through January of 2011. As Prins bluntly states it: Meirelles did not blindly follow the Fed’s money-conjuring policies. Instead he was forced to balance domestic requirements against those of external monetary doves espousing cheap money as a cure-all for economic woes.

Brazil made it through these years with a relatively mild recession in 2009. During 2010, a year Prins labels “The Best of

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Times,” the Brazilian economy clocked a strong 7.5% growth rate in gross domestic product. That same year, voters elected Dilma Rousseff as president, which resulted in a change in central bankers, as Prins explains: Rouseff changed the guard at the [Central Bank of Brazil]. Inflation hawk Henrique Meirelles got the boot. The dove Alexandre Tombini became chairman on January 1, 2011 when Rouseff took office…. Rouseff’s choice signaled that Brazil would follow the United States and Europe and embrace lower interest rates.

By 2013, Brazil “faced a potential currency crisis” and the financial system was “in distress.” Inflation rose and rates rose to double-digit levels and by 2015 a deep recession had taken hold. “Responsibility for [the] decline was connected to multiparty economic elites and political hits and errors,” writes Prins.

In China, Zhou Xiaochuan was the dominant figure in central banking circles since 2002, relinquishing his chairmanship earlier this year. Zhou chose to criticize the United States and leveraged the crisis to raise China’s profile and push the yuan as an alternative to the almighty dollar as part of the International Monetary Fund special drawing rights (SDR) basket of currencies. With the crisis still in full swing, he spoke publicly that the “financial crisis was a by-product of loose regulations and U.S. dollar dominance in the international monetary system.” In early 2008, when many in the United States were hoping the turmoil of 2007 would blow over, Zhou correctly predicted, “The crisis has not yet run its course and it shouldn’t be ignored.”

Notwithstanding his criticisms, Zhou followed the Fed’s lead in reducing interest rates during 2008. But the criticisms continued, as Prins explains how Zhou presented a detailed critique of the monetary policies of major countries such as the United States, United Kingdom, European Union, and Japan.

According to him, they negatively affected

the way emergent countries were supposed to deal with their own monetary policies. He lambasted moneyconjuring policies.

actions many readers who follow central banks are likely already familiar with. Prins dedicates one chapter to the term of ECB President Jean-Claude Trichet (“Monsieur Euro,” 2003–2011) and another to the term of Mario Draghi (“Super Mario,” 2011–present). She addresses their contrasting styles:

By late 2016, the yuan was included in the SDR basket.

U.S. Treasury Secretary Jack Lew’s snarky response: “Being part of the SDR basket at the IMF is quite a ways away The French hawk and the from being a global reserve Collu$ion: How Italian dove controlled money currency.” according to their monikers The leadership of Japan’s Central Bankers Rigged the World and on the basis of their indicentral bank has not been

By Nomi Prins vidual relationships with the dominated by a single fig384 pp.; Nation Books, U.S. elite. And though Trichet ure as in the case of its Asian 2018 was slightly reluctant to neighbor. Masaaki Shirakawa follow the Fed’s easy-money was governor of the Bank of lead at first, Draghi would Japan during the height of adopt the Fed’s policies, hook, line, and the crisis from 2008 to 2013 and Haruhiko manufactured-money sinker.

Kuroda has served in that role since 2013, chosen by Prime Minister Shinzo Abe. Prins Trichet agreed to a swap facility of up to does not hold back in her introduction of the latter governor: “Kuroda took the helm $30 billion with the Fed in March of 2008, on March 2013, and proceeded to conjure which would soon balloon to $240 billion money faster than any other central bank by September. But rather than fall in line leader—including Ben Bernanke—ever had.” with the thinking at the Fed and cut rates, She further gives the Bank of Japan (and Trichet chose to raise rates in July 2008. As Shirakawa) credit for being “the original Prins tells it, “He struck an independent G7 money conjurer, formulating an early path from his Fed brethren.” But by October, “Trichet realized that he would have to version of quantitative easing in 2001.”

Right from the start in 2008, Shirakawa succumb to collusive forces.” was all-in with the Fed’s loose-money, coordinated approach: “He believed that there Prins’ finale / Prins pulls together her work could be no solution to its pressures with- on the collusive central bankers in her out collaborating, or colluding, with other final chapter: central banks.” But Japan faced a problem Policies that conjured artificial money because its rates were already quite low, to deal with the crisis continued far so the first intervention was a cut of the beyond their originally stated purpose. key benchmark interest rate from 0.5% to Measures that were supposed to be 0.3%, combined with “powerful monetary temporary lingered, virtually unchecked, easing.” Enter Kuroda in 2013, along with unquestioned, and unstoppable by an negative interest rates and the concept of external authority. “unlimited easing.” Even after the Fed ended its final round of “quantitative eas- She echoes Milton Friedman’s old line ing” in October of 2014, Japan still had its that central banks “vacillate between takfoot on the monetary accelerator: “Kuroda ing credit for what they deem are positive results in the world economy and remainpicked up where Bernanke left off.”

The last stop on Prins’ world tour is ing silent in the wake of catastrophic failthe European Central Bank (ECB), whose ures that result from their policies.” Her

FALL 2018

final conclusion is not optimistic: “The threat of a collapse larger than the 2008 financial crisis looms because of the plethora of asset bubbles that central banks have created and fueled—setting the scene for a disastrous fall.”

My one substantive quibble with the book is that although Prins emphasizes

her travels in accumulating much of the material for the book, very few interviews are cited in the endnotes. The vast majority of the sources cited are online references to speeches and articles.

Readers of this review might think that a narrative discussing intervention after intervention for 250-plus pages could be a

/ Regulation / 77

dry read. They would be right. All the Presidents’ Bankers was more readable, thanks in part to its manageable chapter lengths of 15–30 pages as compared to 30–50 pages for Collu$ion. But I am hard-pressed to say that there is a different way that the many monetary interventions could have been presented.

Working Papers ✒ BY PETER VAN DOREN A SUMMARY OF RECENT PAPERS THAT MAY BE OF INTEREST TO REGULATION’S READERS.

Drunk Driving “Are Buzzed Drivers Really the Problem? A Quasi-Experimental Multilevel Assessment of the Involvement of Drivers with Low Blood Alcohol Levels in Fatal Crashes,” by Richard J. Stringer. March 2016.

Available at https://docs.wixstatic.com/ugd/6b9875_8e07a3cd7e6c 45cdadaf6a34cf4ba4d2.pdf.

I

n 2013 the National Transportation Safety Board recommended that states lower the legal blood alcohol concentration (BAC) for Driving Under the Influence from 0.08% to 0.05%. A 2007 article in the Journal of Safety Research, “Effects of Legal BAC Limits on Fatal Crash Involvement: Analyses of 28 States from 1976 through 2002,” by A.C. Wagenaar et al., claims that this reduction would save 538 lives, but this paper argues that simple arithmetic indicates that claim is overstated.

In 2012 there were 27,605 fatal accidents. Of those, 17,455 had driver BAC of zero. In contrast, there were only 646 fatal accidents in which the driver had a BAC between 0.05% and 0.08%. Thus, for the policy prescription of 0.05% to save 538 lives, alcohol would have to be responsible for over 80% of all such crashes and the policy change would have to be 100% effective. But according to the official traffic fatality reporting system, alcohol was deemed responsible for the accident in only 14% of those crashes.—P.V.D.

Misguided Mortgages and the Great Recession “Mortgage-Backed Securities and the Financial Crisis of 2008: A Post Mortem,” by Juan Ospina and Harald Uhlig. April 2018. NBER #24509.

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his September marks the 10th anniversary of the collapse of Lehman Brothers, arguably the watershed event of last decade’s financial crisis sparked by a collapse in residential real estate. The standard explanation for the crisis blames “loose” lending standards by mortgage originators, particularly for lower-income borrowers, combined with the repackaging of PETER VAN DOREN is editor of Regulation and a senior fellow at the Cato Institute.

mortgages into securities sold to investors falsely informed by misguided AAA ratings.

In previous Working Papers columns (Spring 2011, Fall 2012, and Spring 2014) I described papers that challenge the lowerincome-borrowers portion of this narrative. This paper examines the other portion, asking how large were the investment losses on AAA-rated non-governmental mortgage-backed securities.

Ospina and Uhlig examine all non-agency residential mortgage-backed securities (RMBS) issued between 1987 and 2008.

They find that the total cumulative losses through 2013 were only 2.3% of the original principal for AAA-rated securities and only 0.42% for subprime AAA-rated securities. AAA securities provided a return of about 2.44% to 3.31% on average, depending on the assumptions regarding their terminal value. For reference, the yield on 10-year treasuries in 2008 was 3–4%.

The total investment loss on all non-agency RMBS amounted to less than $350 billion, which was quite a bit less than the amount devoted to the 2009 American Recovery and Reinvestment Act. Write the authors, “We suggest that it is an interesting challenge to craft a theory of a world-wide recession, triggered by these losses.”—P.V.D.

Banking “The Impact of the Dodd–Frank Act on Small Business,” by Michael D. Bordo and John V. Duca. April 2018. NBER #24501.

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he consensus among economists is that banking regulation in the United States historically protected small banks whose loan portfolios were geographically and economically undiversified. (See “Banking Approaches the Modern Era,” Summer 2002.) This regulation stemmed from the important role of small banks in congressional electoral coalitions.

Congress recently repealed some Dodd–Frank regulatory restrictions on smaller banks. Ordinarily I would have viewed this as special interest mischief, but this paper demonstrates that Dodd–Frank had adverse effects on smaller banks and the small business loans in which they specialize.

The share of commercial and industrial loans of less than $1 mil-

78 / Regulation / FALL 2018 IN REVIEW

lion at large banks—those with at least $300 million in assets—has fallen by 9 percentage points since 2010. The share of small loans at smaller banks has declined by twice as much. The real volume of small loans declined sharply in 2011, and it has grown only slowly in subsequent years, while the volume of loans of over $1 million has increased by 80% since 2011. This development marks a sharp break from the 1993–2010 period, when the value of small and large loan originations followed roughly similar trends. —P.V.D.

Stock Market Short-Termism “Stock Market Short-Termism’s Impact,” by Mark J. Roe. May 2018.

SSRN #3171090.

“Short-Termism and Capital Flows,” by Jesse M. Fried and Charles C.Y. Wang. May 2018. SSRN #2895161

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merican investors, and thus the companies in which they invest through public stock markets, are allegedly characterized by excessive “short-termism”—that is, their demand for quick returns undercuts long-term investment. This, in turn, supposedly is responsible for decreased research and development, and a subsequent decline in U.S. living standards.

In my Winter 2017–2018 Working Papers column I described a paper by Steven Kaplan that presented data inconsistent with short-termism. These two papers also argue against the idea that changes in investing have reduced R&D and living standards.

Mark Roe notes that stock trading has increased enormously

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and the average time investors hold stock has deceased drastically over time, but R&D has not. Instead R&D has increased from about 1% of gross domestic product in the 1970s to almost 1.8% now.

Many criticize stock buybacks as a sign of lack of corporate investment in the future. Stock buybacks have increased since the 2007– 2008 financial crisis, but long-term borrowing rose in tandem. Low interest rates induced corporate America to substitute low-interest debt for stock. As a result, public firms have more cash, not less.

Capital investment is down in the past decade, but not because of stock market short-termism. First, factory capacity utilization in the United States has failed to fully recover from the 2007–2009 recession. Capacity utilization was still only 75% in January 2017, down from 81% before the recession. When capacity is more fully utilized, investment will rationally follow. Second, if the stockmarket-driven story were correct for the United States, we should see differences between capital spending trends for the United States and for nations in which capital comes from banks rather than equity markets. But the capital expenditure decline since the 2007–2009 economic setback exists in Europe and Japan as well.

The Fried and Wang paper challenges an influential 2014 Harvard Business Review article entitled “Profits Without Prosperity,”

by William Lazonick. According to him: Corporate profitability is not translating into widespread economic prosperity. The allocation of corporate profits to stock buy-backs deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their net income—a total of $2.4 trillion—to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their net income.

That left very little for investments in productive capabilities or higher incomes for employees.

According to Fried and Wang, S&P 500 shareholder payouts provide an incomplete and distorted picture of corporate capital flows and their effect on firms’ investment capacities, for three reasons. First, companies are issuing new stock even when they are buying up existing stock. After taking into account equity issuances, Fried and Wang estimate that net shareholder payouts from S&P 500 firms during the years 2007–2016 were only about $3.7 trillion, or 50% rather than 96% of these firms’ net income over this period. Second, a focus on S&P 500 firms—which generally have fewer growth opportunities than smaller and younger firms—creates a misleading picture of net shareholder payouts among all public firms. S&P 500 firms are net exporters of equity capital, but public firms outside of the S&P 500 are net importers of equity capital. Third, the focus on shareholder payouts as a percentage of net income is highly misleading because R&D spending (equal to about 25–30% of net income) is subtracted from corporate revenue before net income is calculated. In fact, a firm that spends more on R&D will, everything else equal, have a lower net income and a higher shareholder payout ratio. —P.V.D.

Robert Higgs, Founding Editor

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80 / Regulation / FALL 2018

Regulating All That Is Delightful

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ike anyone who reads the news, I come across a lot of calls for government to step in with more regulation of … just about everything. I’ve seen articles demanding more regulation of funeral processions, funeral plans, drones, medical devices, organic food, crypto currency, short-term apartment rentals, surgical smoke (it’s a thing), the nutritional standards of kids’ meals in restaurants, duck boats, and—obviously— social media.

And that’s just this morning. (I’m not making this up.)

There are so many requests for regulation that it’s too tiring to get worried about every single one. You have to pick your battles.

In other words, let them have the duck boats.

It’s the International Traffic in Arms Regulation (ITAR) that should be keeping you up at night, now that it is being used to ban the internet distribution of computer files that contain 3D-printed gun plans.

Predictably, because guns are involved, everybody is freaking out about this. Well, not everyone. President Trump, who is apparently trying to picture dot matrix printers spitting out fully formed assault rifles, has concluded that the technology of 3D-printed guns “doesn’t make sense.” But everyone else is going ballistic—so to speak.

For most people—including a federal judge who has ruled that posting blueprints for 3D-printed guns is illegal because it violates ITAR—the scariest part of all this is the potential for criminals and terrorists to create MAR NI SOUPCOFF is the former executive director of the Canadian Constitution Foundation.

untraceable guns that they can use against innocent people. But that’s not the scariest part for me.

Don’t get me wrong. I’m horrified by the idea of everyone and anyone—even the least stable of the unstable—being able to generate deadly weapons easily whenever they feel like it.

I’m not an especially brave person. I won’t be calmly meeting armed terrorists head-on with my own 3D-printed firearm that I’ve stashed in my purse. I’m someone who gets nervous when teenagers look at me funny in the mall.

So why aren’t armed psychopaths my biggest fear when it comes to banning the online distribution of gun blueprints?

Because such a ban is at best an inconvenience, and more likely completely meaningless, to armed psychopaths.

As writers David French, John Lott, and Mike Masnick have noted, Americans can download and print 3D gun blueprints regardless of whether putting the blueprints online is banned by ITAR. The blueprints were readily available before the ban and—thanks to the never-forgetting internet—still are now.

Far more worrisome is the possibility that the 3D gun case will result in

courts enshrining into law a broadening of the government’s ability to use “prior restraint” to restrict what information Americans can post online, as a federal judge has already done.

It’s the health of the First Amendment that’s at risk here. Any restraints on speech and expression are cause for concern and have always been the exception in U.S. constitutional jurisprudence rather than the rule. There’s particular sensitivity about prior restraint, which doesn’t just deliver a negative consequence for offending speech, but restrains the speech before it can actually be uttered.

The U.S. Supreme Court has characterized prior restraint as “the most serious and least tolerable infringement on First Amendment rights.” It’s like gagging people proactively rather than letting them talk and face the consequences of what they say. The gagging approach leads to less speech, less information, and a lot more retching.

When John Milton argued against authors having to be licensed before they could be published, he pointed out that such censorship would be useless unless one started censoring absolutely everything.

“If we think to regulate printing,” he wrote, “thereby to rectify manners, we must regulate all recreations and pastimes, all that is delightful to Man.” It’s true. And what’s more delightful than the internet? Which is indeed what we’d have to regulate to achieve the ends that are being aimed at with the prohibition on posting gun blueprints.

For Milton, the idea of regulating all the fun and good stuff that makes life worthwhile was so obviously bad and absurd that his argument ended there.

For us in 2018, the more likely response is, “Regulate all that is delightful to Man? OK, let’s get started!”

And they have. That’s why it’s so important to be vigilant about protecting the First Amendment right to post 3D gun blueprints online—of all things—even as we do everything constitutionally possible to minimize the technology’s danger.

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en years after the 2008 financial crisis, we are again facing the possibility of economic turmoil as the Federal Reserve and other central banks exit their

unconventional monetary policies. Although central banks will move gradually, unforeseen circumstances could trigger a flight to safety and a collapse of asset prices. Contributors to Monetary Policy in an Uncertain World draw lessons from this last decade of unconventional monetary policies and offer

proposals for reducing monetary uncertainty, including adopting a rules-based monetary policy both at the domestic and international levels.

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