Give Me Liberty or Give Me Competition

As recriminations fill Republican airwaves, one question the party should ask itself is whether it is the party of competitive markets or the party of free markets. When the dust settles from the 2008 elections, one casualty will be the automatic alliance between economic libertarians and advocates of the Invisible Hand.

The Competitive Markets Point of View

The Invisible Hand operates in perfectly competitive markets to guarantee that the pursuit of individual profit will lead to economic efficiency, national growth and the distribution of riches according to each person’s (marginal) contribution to creating those riches. However, as nature abhors a vacuum, business abhors competitive markets because competition is the enemy of profit. That is why both Adam Smith and Milton Friedman advocated strong government intervention to maintain competitive markets and roll back the tendency of free markets to concentrate power, collude, conspire and even corrupt (Enron, WorldCom, big tobacco, Three Mile Island…).

Adam Smith and the “freshwater” economists who evangelize “free market” capitalism are actually advocating “perfect competition.” The “free” in “free market” refers to freedom from concentrated market power and from a government menu of prices and outputs levels. It refers to markets where all workers and all businesses face a full and identical range of choices and where none can influence the choices of its competitors. In particular, perfect competition requires:

• infinitesimally small businesses selling things and services that are perfect substitutes for their competitors’ products
• perfect information about what things and services are worth, now and in the future
• prices that reflect all the downstream impacts of products and services
• some mathematical niceties, like rationality and free disposal

Game theory and behavioral economics have added complexities but have not changed Adam Smith’s proposition that perfect competition requires active and robust government intervention. Even if we set aside do-gooder interventions motivated by distributional, environmental, political or other ethical objectives, we are still left with a competition-based case for government interventions such as:

• product labeling and corporate disclosure requirements
• laws against insider trading of securities
• antitrust, anti-predatory practices laws
• product liability laws
• standards setting
• inspections
• compensatory tariffs
• etc.

The Free Market Point of View

In contrast, the libertarian meaning of “free market” capitalism is that government should leave workers and businesses alone. It is primarily motivated by the ethical belief that private entities have a right to do whatever they choose unless there is a compelling reason for governments to restrict their choices in order to protect other people’s choices.

Under the libertarian approach to free markets, there is no rigorous theoretical connection between libertarian ideals and economic efficiency except through “natural law” arguments that are sometimes more hortatory than theoretical. Even if Mussolini could make the trains run on time, the argument goes, that wouldn't make it right. Libertarians generally observe that when governments meddle, they make things worse. This observation overlaps with the Invisible Hand economists’ desire to get the government out of setting prices and outputs.

The Split

For a long time, examples of inept and ineffectual government interventions, contrasted against steady growth in wealth and income in the private sector, papered over the fundamental incompatibility of the two approaches to free market capitalism and allowed them to coexist in the Republican party.

Two things have changed, recently. One is that the financial crisis has proven once and for all that private entities left to themselves do not reliably make economically optimal or even selfishly smart choices. Unregulated markets are far from perfectly competitive, as market power is highly concentrated, some private entities hide and distort information unless corned like rats, and they daily make decisions with societal impacts far beyond their own bottom lines (“externalities,” in economics-speak).

The second change is that for most of the past decade or so, corporate profits and income among the wealthiest individuals have risen strongly while middle and lower class incomes have fallen in inflation-adjusted dollars. The increasingly stark contrast between the growth in national output and stagnation in worker bee incomes and security has made it harder for the Joe the Plumber argument to stick: that we should help the business class because their success will trickle down, or at least because we are likely to join their ranks one day.

Now, Samuel Joseph Wurzelbacher notwithstanding, the Joe the Plumbers of the Republican party have begun to divide over the choice between the right to be left alone and the right to a fair fight.

Our schoolroom pledge to uphold “liberty and justice for all” takes on new meaning. One persuasive (for some) line of argument is that there is no justice without personal liberty, so we must get government out of our private economic lives. Another persuasive (for others) line of argument is that being stuck at the losing end of an uneven playing field is its own sort of prison, so liberty and justice require government to level that playing field by negating the anticompetitive tendencies of private enterprise.

Both are legitimate Republican points of view, up to now mashed together with faith in the integrity, intelligence and efficiency of private enterprise acting as the glue. But that glue dissolved in the 2008 elections. As free markets appeared to be neither efficient nor benevolent, some of the Republican electorate stuck with free markets as intrinsically just and an end in itself, while others turned to government intervention to restore competitive markets and enable stable and efficient outcomes. The Republican party needs to confront that schism and decide where it stands between free markets and competitive markets.

Is Keynes Dead in the Long Run?

It may turn out that the erstwhile discredited John Maynard Keynes’ key error may have been that, in the long run, he is not dead after all. What both the left and the right identify as today's problems and their solutions stir dusty memories from my generation of economists.

My generation entered the “dismal science” during the twilight years of Keynesian economics, but ripened in graduate school under the full force of the conservative, neoclassical revolution. Now, much of what my professors – including Martin Feldstein, Greg Mankiw and Larry Summers – taught us to cast away is coming back for a reprise. However, like George Carlin’s seven dirty words, the old Keynesian lingo still seems banished. Are these Keynesian terms below rising from the dead, only unspoken and invisible as ghosts?

Liquidity trap. We've relied on monetary policy to manage business cycles since Reagan – in particular, interest rates. Keynes posited a condition where confidence and interest rates might be so low that reducing interest rates further would have no effect on borrowing and economic activity. People would be just too fearful, and interest rates would be too low to matter. He called this condition the “liquidity trap,” and used it as an argument against those who advocated monetary policy instead of government spending (“fiscal policy”). If our current state is not a liquidity trap, then what is? Our recent death spiral began when the Fed slammed its foot down on the interest rate gas pedal but the lending community completely failed to respond.

Fiscal multiplier. Keynes prescribed government deficit spending in economic downturns. He argued that supply-side interventions would fail due to the liquidity trap, plus the slowness of supply-side policies (thus the “in the long run, we are all dead” quote). He predicted that supply-side stimuli wouldn’t work as long as aggregate demand stayed low and nobody had the confidence to buy things. Therefore, he favored direct government spending over tax cuts, because buying roads and bridges and hiring people would “prime the pump” and get production started again. Sound familiar? Both left and right say the next stimulus package has to include direct federal spending. Feldstein declared last spring's fizzled tax rebates a miscalculation on his part and on the part of his fellow neoclassicists.

Automatic stabilizer. Keynesian economists taught that governments should embrace deficits during downturns because a downturn is the worst time to cut spending and raise taxes. It is the time when people need the most safety net spending, such as unemployment benefits. Also, tax revenues naturally decline as the income base falls. The last thing people need during a recession – Keynesians said – is for higher taxes to cut their take-home pay even more. Now, even most Republican fiscal conservatives are willing to use deficit spending as a stabilization tool.

Neoclassical theory predicts that government spending will just “crowd out” private business investment, resulting in zero net growth. True, the size of the economy is the sum of government spending, consumer spending, private investment and net exports, so increasing government spending seems like it should grow the economy. But deficits would drive up interest rates and drive down the private investment part of the equation. Government spending would also drive up inflation, decreasing the consumer spending part of the equation (in inflation adjusted dollars) and exports. Rational expectations could even make these mechanisms cancel the stimulative effects of government spending sooner rather than later.

Are the Keynesians right, after all? We’ll know in four to six years. Are the neoclassicists right, after after all? We’ll know that in two to twenty years, as the pipers come calling. Place your bets.