Critics Corner with Prof. Donald Boudreaux

On this episode of Critics Corner, Oren is joined by one of our most active critics and open-letter writers, Donald Boudreaux of George Mason University. They discuss a wide swath of disagreements, including public choice and the knowledge problem, whether the SEC or public schools should exist, and what role industrial policy played in the development of Japan and China. Plus, Professor Boudreaux gives some insight into his personal investment strategies.

• Notable & Quotable: An Idea for Oren Cass by Prof. Donald Boudreaux in The Wall Street Journal
• Another Open Letter to Oren Cass by Prof. Donald Boudreaux in Cafe Hayek

Transcript

Oren Cass: I am delighted to be joined today by Professor Don Boudreaux of George Mason University. I can say with no sarcasm whatsoever, he is perhaps our favorite critic at American Compass. He tells it like it is. He makes it clear who he’s criticizing and why. And he has a lot of very important points, even if we disagree with most of them. So, Don, thank you so much for joining us.

Don Boudreaux: I’m happy to be here.

Oren Cass: I think we could start any number of places, but one that certainly there’s been a lot of discussion of late, I think, surrounds financial markets and the question of how well they’re working, whether there are places where they’re not working at all, and what, if anything, public policy might do about it. And of course, at American Compass, we focused a lot on areas like private equity and hedge funds that we have argued seem not to be delivering especially good returns and not to be creating much value. You obviously have a very different point of view on them. So I will hand it over to you for a moment to give your perspective.

Don Boudreaux: So let’s start with an area where we might agree, because it’s an area where I do think there are imperfections in the financial markets. I think the role that the Federal Reserve plays, especially since the 2008 recession, is unjustified. I think the flooding of the market with accessible liquidity does cause a lot of problems. Now, unlike you probably, I don’t believe this is a fault of the market. I think this is a fault of the unwise intervention of the Federal Reserve into financial markets. But when you flood markets with liquidity, it does prompt private investors to do things that are bad for the economy. Where we certainly disagree, and I know you’re referring to the report that you guys did a few months ago. Look, no one argues that financial markets work perfectly in a tight, efficient market.

I am not a hyper-efficient markets kind of guy. I’m more of an Austrian economics guy who understands that there are imperfections, but I believe these imperfections are best discovered and dealt with by entrepreneurial processes. And so if it’s the case that private market of financial instruments is underperforming, no one has a better incentive to discover that and to adjust to that than do the investors who are thereby leaving money on the table by not adjusting to these problems, to the extent that an investor makes bad investment decisions for himself or herself. Yeah, in some sense that harms the economy because that means that financial assets are not being allocated as well as possible. But no one has an incentive to get these investments right more so than do the private investors who have their money on the table.

And so I don’t see any reason to believe that there are these sustained, substantial losses being made in private financial markets by private investors. It may be that you and I, and I don’t know much, in terms of my own finances, about financial markets, but it may be that you and I don’t understand why financial market product X, Y, and Z seem to earn returns less than these hypothetical returns earned elsewhere, but people keep buying them. But if people keep buying them, that to me deserves a strong presumption in favor of the fact that for those investors, those are the best returns.

Oren Cass: So I think that’s certainly a compelling case when you’re talking about the actual private investors, so the person making decisions with his own money, at least much of the time. Does that apply to the same extent though, for instance, if you take public pension funds, which are arguably the biggest players in areas like private equity, hedge funds, where you have, ultimately, it is public employees money, although it is backstopped by taxpayers regardless, that is then overseen by a group of political appointees within the pension system who then perhaps hire managers who then hire consultants. At what point do principal agent or even public choice concerns start to come in on the investor side?

Don Boudreaux: You’re exactly right to identify this as a principal agent problem. And there’s no question that backstopping any investments with taxpayer money does, of course, lead to moral hazard, does, of course, reduce the incentive to those people directing the financial assets, reduces their incentive to get matters right because they’re protected from downside losses, but they get all the upside gains. To the extent that that exists, then by all means, let’s get rid of that. To the extent that that exists, of course, that can cause problems. And so I’m all in favor of discovering that, rooting it out, stopping that backstopping.

In terms of principal agent problems, the markets never completely succeed in aligning the agent’s interests with 100% accuracy with those of the principals. Of course, there’s some slippage there. But again, I think that’s for agents and principals to discover. In a competitive market, would be principals have incentives to compete with each other, to try to come up with different contractual terms, different institutional arrangements that can ensure it… Excuse me, agents that can ensure principals that they will be better agents for those principals. Principals, of course, have an incentive to find those agents who are more likely to be true to their, the principal’s, interest. It doesn’t happen perfectly.

I’m not probably as troubled as you are by the many different levels of management between the actual worker who earns the income and then has it invested in the pension fund and then the people who do the investments. As long as it’s freedom of entry, and there may be a problem here, but as long as there’s freedom of entry into financial markets, potential agents and actual agents have an incentive to exploit any existing inefficiencies in order to better serve principals. And so if some investment company, if some investment institution is too large, has too many layers, it’s going to lose business, or it ought to lose business to ones that are better at serving principals.

I confess to not knowing all the institutional details about CalPERS and these other major institutional investors. Most of my investment is with TIAA-CREF. It’s done me pretty well. I am not an active investor because I personally don’t know much about investment. I put it basically in index mutual funds, and I’ll trust people at TIAA-CREF to invest for me. And they’ve done, at least from my perspective, a good job. Of course, I don’t know. Maybe if TIAA-CREF were better operated, my 401k would be worth even more than it currently is.

Let me end this thought this way. To the extent that there are problems with the market, as opposed to with interventions into the market, I am skeptical that turning the problem over to government officials will solve the problem. I don’t see the government officials have the information to solve the problem. These are politicians. They specialize in winning elections. They don’t specialize in managing investment funds. Of course, they have an incentive to say they’ll help solve the problem. Talk about a principal-agent problem. The huge principal-agent problem is the principals who are the citizens and the agents, the politicians, who supposedly represent those principals.

But there are huge slips, this gets to the public choice topic that you mentioned a moment ago, there are huge slips between the interests of the principals as citizens voters and the interests of the agents as government officials slash politicians slash administrative officials. So to the extent that there are problems, I doubt that they will be solved or even made better, even improved by turning the matter over to the political process. I would much rather keep it in the private market process and let private entrepreneurs discover how to deal with them.

Oren Cass: Yeah, so the public choice topic is a great one, and we should turn to that in a second. I just wanted to ask you one more follow-up question, because I was struck in your comment about TIAA-CREF. On the one hand, you can say you’re an unsophisticated or not active investor. On the other hand, of course, you’re quite literally an economics professor. And so in the continuum of sophisticated to unsophisticated understanders of markets and managers of their money, one would think you are in the very highest fraction of a percentile. And so assuming that the vast majority of other actors out there are far less sophisticated than yourself, at what point do you start to worry that this is a market in which most of our participants simply are not going to have the right information or a very good understanding of what’s going on and therefore is particularly susceptible to certain bad actors, but also just very large inefficiencies.

Don Boudreaux: I actually don’t worry about it that much, Oren. And ironically, I’ve said this many, many times over my career, one of the few practical things economics has taught me is indeed a matter involving finances. And what it has taught me is that I can’t outguess the market. It has taught me how puny my knowledge is of the market. I’m not being falsely modest when I say I don’t know much about finances. So what economics has taught me to do practically is simply not to mess with my investments. Literally, I got my TIA account back in the 1980s. The first time I ever personally went in and changed anything in the course of that more than three decades was when I became a little bit frightened of inflation a few months ago and so I changed my distribution to help protect me from inflation that I think is coming.

But I don’t know anything about finances and so I trust the competitive market process to find agents for me who will perform for me as well as is possible, not perfectly of course, but as well as possible. And so I don’t worry about the bureaucracy so much, I do worry about the government intervention, I do worry about the manipulation of the money supply by the Federal Reserve and the moral hazard created in the banking system by the Federal Reserve. But I don’t worry about the matters that you worry about so much, again, to the extent that there is free entry into the financial markets to serve as suppliers, to serve as investors, offer different investment instruments. The best I can do is to trust that the competitive process will stumble upon and discover those products that best serve as well as possible people with money to invest.

Oren Cass: All right. So let’s talk about public choice then, and as you’ve just described it, obviously public choice itself is a very deep field of research, but I think you gave sort of a good pithy summary of it a moment ago when you sort of described the assumption that even when there may be problems, it is unlikely that political actors are going to solve them and more likely that they’re going to make them worse. Is that sort of a fair two-bit summary?

Don Boudreaux: So in my circles, not quite, but it’s certainly forgivable. So in my circles, we talk about the public choice problem and the knowledge problem. The Buchanan problem named after the 1986 George Mason University Nobel Prize winner, James Buchanan, a founder of public choice, and the knowledge problem, which comes from Frederick Hayek, who won the 1974 Nobel Prize in economics. So what you describe is sort of a combination of both. So the public choice problem isn’t so much a knowledge problem. So a public choice economist would say, look, even if we assume that government officials have all the requisite knowledge to intervene in the economy in ways that if that knowledge is used, would indeed improve the economy in ways that the typical voter/citizen would applaud, even if the politicians and government officials had that knowledge, they don’t have adequate incentives to do it.

Their incentives are not aligned very well with citizens and voters. The classic case, although it’s not the only one of this misalignment is the special interest group effect. So you have roughly 4,400 sugar farmers in the US, you have roughly 330 million sugar consumers in the United States, and so the political process is much more attuned to the concentrated interest groups of sugar farmers and it doesn’t pay much attention to the dispersed interest of sugar consumers. And so sugar farmers, because they are of such relatively small number, they have disproportionate political say relative to their numbers and that comes at the expense of the larger populous because politicians have an incentive to cater to the special interest group while ignoring the general public. So that is the public choice.

The knowledge problem would be the opposite in a way. So, look, even if politicians had all the right incentives, even if they were motivated, had the great motives of God, of a benevolent deity, they don’t have that deity’s knowledge. They don’t have adequate knowledge to know how to intervene in ways that will in fact bring about the results that they intend to bring about. But the public choice problem is the first, it’s the incentive problem.

Oren Cass: Yeah. So it’s a good distinction. And as you said, I sort of grouped them together to the punchline that therefore politicians tend to be very ineffective. And so I guess, I am in entire agreement with the general point that politicians are often very ineffective. What I am struck by and maybe where we differ is the extent to which we can assume that that is always going to be the case, or so often the case that we should sort of have a presumption that public policy responses won’t be helpful. And I guess the reason for that is just the empirical observation that obviously policymakers have done a great deal, say over the last 200 years in the United States. And that while none of it is perfect and some of it is bad, there’s a great deal that seems like we’re glad we have it.

And I don’t just mean like having a police force, but I mean the fact that we have a securities exchange commission, the fact that we have antitrust enforcement, the fact that we have a safety net, the fact that we do public education and so on and so forth. And so it strikes me that all of these things, if I were to go ex-ante prior to their creation, one could, in theory, raise the public choice concern that we should not do this, it will go badly. And yet in hindsight, I think we can say that would have been the wrong conclusion. Or in your mind, would that have been the right conclusion?

Don Boudreaux: Well, it would have been the right conclusion actually. So the first serious research I did was in antitrust. And so you look at the history of antitrust and the standard story is that antitrust arose in the US in order to prevent monopolies such as J.D. Rockefeller and James Buchanan Duke from harming consumers with high prices. When you look at the actual history of antitrust, and that’s exactly the opposite, what was happening in the 1880s, it was a period of enormous economic growth. Prices were falling and the main complaints against these big firms were not that they were raising prices. The main complaint is that they were lowering prices. You look at the actual debates in Congress, they would complain mostly about lowering prices. Senator John Sherman, after whom of course the iconic Sherman Antitrust Act is named, the first national antitrust act, Senator John Sherman was a huge supporter of tariffs.

And tariffs at the time, I think correctly, were believed to be sources of monopoly power for firms that got the tariffs. And so it was, in my view, almost a public relations move on John Sherman’s part to put his name on this antitrust act because then he was able to say, “Oh, people accused me because of my interest in tariffs, people accused me of being pro-monopoly. Now, look, I have my name on this antitrust statute.” Robert Bork wrote a famous book in 1978 called The Antitrust Paradox, and he supported antitrust. But the interesting thing about that book, the paradox is that, I’m summarizing, of course, wow, we got this antitrust statute in 1890, but amazingly for the first almost 90 years of its existence, it has been used to suppress competition rather than to promote competition.

So Bork then ends the book with proposals to how to improve the matter. But for the first 90 years by Robert Bork’s own ignition, antitrust was used in an anti-competitive and not a pro-competitive way. And his explanation for that was, well, the courts were just economically illiterate. I think there’s something to that. My explanation for that is, no, the antitrust actually was meant as a device to suppress competition and not as a device to promote competition. On all the other issues you mentioned each one of them, the SEC, public schooling, at least on those two issues, I would prefer to do without those actually.

Oren Cass: So literally just not have an SEC or government regulation of financial markets or the banking system.

Don Boudreaux: I would prefer, that’s right, not to have bureaucratic regulation of those. Of course, you’d have legal causes of action against fraud and deceit and contract breach.

Oren Cass: Okay. Yeah, so essentially a common law approach almost.

Don Boudreaux: A common law approach, yes.

Oren Cass: And on antitrust, it’s interesting, there’s, of course, the breaking up of companies. There’s also the regulatory side, and I guess one could argue whether this is antitrust, but for instance, utility regulation or railroad regulation where you have a natural monopoly. Does that fall under the same rubric with railroads in particular on a similar timeline, you would say, actually, we would have been better off if we’d never regulated the railroads?

Don Boudreaux: So we got federal regulation of the railroads, as you know, in 1886 with the Interstate Commerce Act and the creation of the Interstate Commerce Commission. George Hilton, the late George Hilton, an economist at UCLA, did a very famous study of the Interstate Commerce Act and Commission back more than 50 years ago and what he discovered is that the Interstate Commerce Act actually wound up helping railroads earn monopoly profits that they otherwise couldn’t earn. The railroads actually were highly competitive with each other. Because of their cost structure, a lot of their competition, they were scared of them because they had all these fixed costs and their rates would be driven down to rates so low that it was very difficult for them to cover their fixed costs. And so that was one of the reasons for the regulation, to help stabilize rates in order to enable the railroads to cover their fixed costs.

Oren Cass: Mm-hmm (affirmative).

Don Boudreaux: We got Munn on the common law regulation, Munn versus Illinois in 1877. That was long before antitrust. And so I would prefer to have these kinds of matters settled in the courts rather than by agencies.

Oren Cass: And so I guess maybe the better way to ask the question is in reverse. As I said, from my perspective, I’ll certainly acknowledge all sorts of things that public policymakers do very poorly. Is there any area that you see that you’d say actually policymakers got it right or that it was good and appropriate that policymakers have stepped in the field, again, going beyond basic public safety into fields like economic regulation?

Don Boudreaux: I’m a pretty small government guy. No, not much. I would rather leave most regulation to the market and to the criminal and the common law.

Oren Cass: And do you think that applies, I guess, and this is one other topic I wanted to make sure that we’d hit was on industrial policy, and so I’m curious if you think this applies? Is this a unique situation in the United States at all or would you say that it applies globally and thinking, particularly in the context of, for instance, East Asian economies that seem to have at least benefited some degree from some state-led development? Does that seem at all like a counterpoint or for some reason not?

Don Boudreaux: If the evidence were clear that East Asian countries did benefit from industrial policy, then that would be a counterpoint. But I think the evidence is not clear on that. In fact, the evidence as I read it is that they didn’t really benefit. I can’t remember the guy’s name offhand, but some guy at Carnegie just within the past year, Jim Schroff maybe, he did an analysis of Japan and could find no evidence that the vaunted Japanese industrial policy of the 1960s and ’70s and ’80s was any benefit to that economy. Nicholas Lardy, looking at China more recently, and also the late Nobel Prize winner, Ronald Coase and Ning Wang in their book, they find that China developed to the extent that China became open to genuine competitive market processes and that particularly since President Xi rose to power almost a decade ago, the growth in China is slowing down because it’s moving away from market-oriented policies.

Of course, governments can create certain visible winners, but the question is not whether or not company X, Y, and Z that got government subsidies or is protected behind tariff walls is able to export and is able to survive. The question is, does that policy raise the living standards of the people in the country? And my reading of the evidence of Japan, of China, is that it doesn’t. It actually makes us countries worse off. David Henderson, an economist at the Hoover Institution, had a famous paper in 1983 and I think it’s still valid. He looked at MITI and he found that, if anything, it hindered Japanese development rather than help Japanese economic development.

Oren Cass: Yeah. The point about can it support a particular industry or company is interesting though, because I suppose, depending on how one looks at a little bit of public choice but especially the knowledge problem, it would even be puzzling how they would succeed in that. So if you see, let’s say Taiwan and South Korea decided they wanted to have really strong world-leading semiconductor industries, and then in fact accomplished that, is that at all a challenge to something like the knowledge problem, or is that consistent with your understanding of the knowledge problem?

Don Boudreaux: I think the details here matter a lot. Again, if you throw enough money at something, you protect it with high enough tariff barriers, you can enable it, you can push enough resources into that particular sector to allow it to survive. Now, I would doubt that, that sector is surviving in a way that is promoting the overall development of the economy as a whole. I feel quite confident that the costs of that policy to the economy as a whole far exceed the benefits to the economy as a whole. I think we would on that be a loser.

Oren Cass: So you think Taiwan would be better off without its semiconductor industry or without its semiconductor industry something else better would have arisen?

Don Boudreaux: Quite possibly, yeah. We don’t know. I mean, you argue that governments should basically help the economy discover its better comparative advantage, and I disagree with that. I believe that the best way to discover a comparative advantage is to let entrepreneurs do what they do, let consumers spend their money as they choose, and then the comparative advantages that are most consistent with the underlying taste preferences and resource allocations or resource endowments of that society will be discovered and put in place. Yes, government policy can in fact alter the current pattern of comparative advantage and then it can appear because, well, Taiwan gets a thriving semiconductor industry and people say, “Oh, industrial policy succeeds because Taiwan has a thriving semiconductor industry.” We don’t know what Taiwan gave up because of that and we don’t know the costs of what it took to do that.

Oren Cass: I guess I would say it a little differently, which is, I think probably our disagreement is that I don’t think comparative advantage is discovered. I think it’s created, that is I don’t think Taiwan had a comparative advantage in semiconductors, obviously, and it decided it wanted one. So it wasn’t discovered, but I suppose, to your point, certainly, it is nonfalsifiable to say it could have come up with something better. Is there a counterexample of a country that did stick to a more free-market model and came up with something better? I mean, to be pedantic, I’d say Madagascar doesn’t seem to be doing so great. But what’s the counterexample that that looks better than a Taiwan or South Korea?

Don Boudreaux: Hong Kong. Hong Kong. Hong Kong had virtually no government intervention at all for much of the 20th century, until just recently, until just five or six, seven years ago. By the early 20-teens, it’s arguable that Hong Kong was the wealthiest place on the planet measured in per capita income, probably wealthier than America. And no industrial policy at all in Hong Kong, certainly no tariffs. I think the United States, for most of the 19th century, the U.S., of course, did use tariffs, not as extensively though always, as a lot of people believe it did, the American government relied chiefly on tariff as a source of revenue. So it could not raise tariffs too darn high for protective purpose because it would lose too much revenue. But there obviously was extensive use of tariffs in the U.S., but largely the United States in the 19th Century and the very early part of the 20th Century, it had nothing like industrial policy, and it became the most entrepreneurial dynamic economy in the world and it became the wealthiest country in the world then, I believe as a result of that. And so, I think there are a number of counterexamples. England in the 18th Century didn’t have anything by way of industrial policy, and yet that’s where the Industrial Revolution began. Thomas Newcomen and George Stevenson, none of these people were supported by government. And England famously is, again, the cradle of the Industrial Age.

Oren Cass: The America example is one that I guess we probably conflict on most directly. And obviously something that we look a lot at American Compass is questioning sort of what is the American tradition of economic policy? Our argument, anyway, is that from Hamilton, to Clay, to Lincoln, to McKinley and so forth, the American system was explicitly a tradition of industrial policy in terms of both infrastructure, investment, and tariffs, and of course the national financial system. But I guess maybe I’m interested in looking just beyond that into the early 20th Century, well, I guess into the mid 20th Century, and the sort of post-World War II era and the sort of sources of innovation that we have today. And I guess this’ll be the last topic we have time to hit on.

My interpretation is that if you look at the kind of core innovations and developments that drive recent economic progress, they are overwhelmingly the source of at the end of the day government investment, and that with no government investment, it’s hard to see where those would have come from. And so I wonder if, as you think about sort of the innovation process generally, do you see stages at which government plays a vital role and then stages where policymakers need to get out of the way, or is it just policymakers should never get in in the first place?

Don Boudreaux: I mean, this is a vitally important point. And I think an important distinction has to be made, or a definition has to be clarified. What is industrial policy? So when I think of industrial policy, I think of a process in which government officials explicitly tried to choose particular industrial winners, which particular industries will thrive and we’re going to nurture those at the expense of other industries? It is true, of course, you’re right, that there was infrastructure built in the United States in the 19th Century. A lot of it was built privately, but a lot of it was funded through government state, and national, and local. I don’t consider that to be industrial policy. I consider that to be just infrastructure building. Building highways does not determine what particular products will be transported across those highways.

Basically, here’s the infrastructure. We’re going to allow entrepreneurs then to do what they do. We’ll let them compete as they will compete, and consumers to spend their money as they will spend their money. And so you can make an argument that that kind of spending, that kind of government activity is a necessary foundation for the free market to thrive on. I think you can make an argument contrary to that too. You can make an argument that the market’s actually capable of supplying infrastructure. I’m not that intent on arguing against infrastructure spending. Obviously basic law and order provision of dispute resolution in the formal courts. But I don’t consider that to be industrial policy. And so, people talk about the internet, the role that DARPA played in the internet.

But I don’t think of that as industrial policy. I think that the internet, as we know it today, largely developed, it was a free market. Yes, it had this platform that was built in large part because of involvement by government. But that was at a very early stage. And then entrepreneurs got on, like a highway, they got on it, and they transported all kinds of different things and used it in all kinds of different creative ways that no one could have anticipated. Certainly the government back in the 1960s didn’t anticipate the way the internet would develop and be used. And so, I think it’s a different argument about what is the appropriate extent to which infrastructure spending, funding basic R&D should be done, versus what is the appropriate role of industrial policy, where the government actively uses tariffs, subsidies, tax breaks, and things of that sort in order to pick particular winners? I think those are two different kinds of policies, and I think the latter is much more problematic than the former.

Oren Cass: I think that’s a very fair distinction. I would argue in the earlier American Republic, the very act of choosing to industrialize in effect was a hot political topic.

Don Boudreaux: Hamilton versus Jefferson.

Oren Cass: Yeah. And so in that respect, even the choice to do basic infrastructure was in respects a more sort of weighted political choice than merely a creating of basic foundations. But I certainly take your point in the modern era that highway spending is not itself industrial policy. I guess, to bring things back around to where we started then at the end, are those areas, things like infrastructure spending, then places, where it seems like policymakers, are more likely to be able to overcome the knowledge problem or the public choice problem, or are they just areas where as bad as it’s going to be, the cost might be worth it?

Don Boudreaux: I think probably generally those problems don’t loom as large. I mean, so we want to build highways. People know what highways are. And so it doesn’t involve a great deal of prediction about what the future is going to be like. We’re just going to build a highway from New York to Los Angeles, or a network of highways. You have some knowledge problems. Obviously, you have some public choice problems. You got bridge and road construction projects going to friends of the governor. These are fairly minor things in the grand scheme. So I think the knowledge problem and the public choice problem in those sorts of government actions do indeed loom much smaller than they do in industrial policy, proper as I understand that to be.

Oren Cass: All right. Well, we’ll leave it there. Donald Boudreaux, thank you so much for joining us on Critics Corner. And thank you as always for your criticism.

Don Boudreaux: Thank you, Oren. You’ll have more, I’m sure.

Oren Cass: Looking forward to it.