The idea of “old” and “young” in economics means very little. As Alfred Marshall taught, economics has a different kind of clock. An eighty-five-year-old firm may fail because it adopts new techniques without proper testing. Is it an old firm or a new firm?
What do we mean by “old” and “new” institutionalists? Clear definitions and distinctions are impossible. Generally, institutionalists look away from the usual economic categories: rents, profits, income, capital, labor costs, and such. Instead they focus on society’s laws, ethos, and institutions for insight. The old institutionalists, who emerged in the early 1900s, criticized Marshall’s eager students for sitting in their offices, drawing the blinds closed, and manipulating irrelevant mathematical curves rather than examining the real world, as their master had implored. In the hands of his proselytes, Marshall’s abstract theory ignored too much, the old institutionalists charged. While the Marshallians naively and gleefully slid along their curves, institutions were evolving and economic theory was growing obsolete.
The new institutionalists are startlingly different from the old school. Like the old institutionalists, they look at society’s institutions—but they use the very tools of Marshall that the old institutionalists assailed.
Let’s first look at the old school by examining its preeminent member, Thorstein Veblen. Except for Karl Marx, the economists we have discussed so far were rather mild-mannered. They probably would have made good neighbors, and one can imagine Adam Smith and Alfred Marshall as jovial Boy Scout leaders. Veblen is a refreshing, devilish exception. Along with his puckish persona, Veblen contributes a scalding critique to the history of economic thought.
Veblen’s institutional approach bashes two pillars of neoclassical economics: (1) Marshall’s law of demand, which says that people buy more of a good when the price falls; and (2) the assumption that laborers work only because they are paid and do not “work for work’s sake.”
Veblen also attacks the marginalists for assuming a smooth, gradual path to a point of equilibrium. Equilibria do not exist; the economy always changes, the old institutionalists charge. Equilibrium is a daydream of economists who do not live in the real world.
Veblen was probably a better critic than constructive theorist. He was not sure how to reconstruct economics, but he was sure that Marshall and his followers made a mess. Veblen thought that economists should be less turf conscious and more willing to meet with sociologists, anthropologists, and psychologists if they wanted to develop better theories.1
Who was Thorstein Veblen, this penetrating critic of neoclassical economics? He was born on a Wisconsin farm in 1857, the son of Norwegian immigrants. When he was eight, the family moved to Minnesota, where the cheese was less good but the crops more plentiful.
Like other American immigrants, the Veblen family was poor. But the children didn’t know it. They had enough to eat, and their neighbors lived a similarly rustic, humble life.
Commentators almost always link Veblen’s critical attitude to his family’s impoverished, immigrant status. Throwing Veblen on the psychoanalyst’s couch, they portray him as a pariah in the United States. In the close-knit immigrant communities of Wisconsin and Minnesota, English was a second language. The pariah theory argues that Veblen’s outsider status gave him a unique and unbiased view of American economic life. He could see the cracks in the foundation of capitalism because his eyes pierced through the facade. Veblen himself employed a similar hypothesis in his essay “The Intellectual Pre-eminence of Jews in Modern Europe.”
No doubt there is something to this, but such environmental explanations may reach too far. After all, his eleven brothers and sisters, equally Norwegian, never showed spectacular insight. In fact, Veblen was always a bit of a kook, albeit a shrewd one. He might have been just as kooky and incisive had he grown up in Norway. A precocious child, Veblen manipulated his parents so that his chores involved reading books in the attic, while his duller siblings toiled in the fields. At seventeen, Veblen attended nearby Carleton College Academy. Because Carleton was not a Lutheran institution, which would have catered to Veblen’s Scandinavian culture, Veblen’s rough social skills presented problems. He showed up for formal affairs in a coonskin cap, and during one class exercise Veblen delivered a sober speech calling for drunkenness. It didn’t go down well with the denominational college. Nor did his serious speech calling for cannibalism. No surprise that the college pushed this heathen to finish his degree ahead of everyone else.
But Veblen graduated with high honors.
Veblen did not convert the college to alcoholism or to cannibalism. During his stay, though, John Bates Clark (later recognized as an eminent American marginalist) persuaded him to read economics. Veblen found it intriguing but decided instead to pursue an academic career in philosophy at Yale. He should have started with the myth of Sisyphus. After completing his doctoral thesis, he would spend a number of frustrating years wandering, loafing around the family farm while his siblings toiled, applying for jobs and waiting for rejections.
Eventually, Veblen’s Ph.D. from Yale landed him a job at Cornell—teaching economics. His future mentor, J. Laurence Laughlin, had been “sitting in Ithaca when an anemic-looking person, wearing a coonskin cap and corduroy trousers, entered and in the mildest possible tone announced: ‘I am Thorstein Veblen.’”2 After two years, Laughlin moved to the University of Chicago, along with his protégé.
Now in his mid-thirties and married for a few years to the niece of the president of Carleton College, Veblen worked on his writing and teaching, as well as his philandering. Two of three came easy.
Let us start with the writing. This involved numerous reviews and articles on odd subjects such as “The Economic Theory of Women’s Dress” and “The Barbarian Status of Women.” His teaching involved mumbling, teasing, taunting, and daring his students to quit. He was happy that most did. This apparently sadistic, irreverent man would start the semester by smearing the blackboard with book titles and then announcing that next week’s exam would cover all the books. He almost always gave Cs—to discourage the Phi Beta Kappa aspirants. As for philandering, the juicy details of his sexual escapades remain a secret.
Regardless of Veblen’s manner and extracurricular activities, one thing is certain: his first book, The Theory of the Leisure Class (1899), demonstrated that the man who spoke in mumbles wrote pristine prose. Subtitled An Economic Study of Institutions, Veblen’s book thrashed the neoclassical model of demand. According to Veblen, the neoclassicalists assumed that each consumer independently weighed the costs and benefits of purchasing an item. In an earlier article, Veblen put it in more sensational, mixed-metaphoric language: “The hedonistic conception of man is that of a lightning calculator of pleasures and pains, who oscillates like a homogeneous globule of desire of happiness under the impulse of stimuli that shift him about the area, but leave him intact.”3
What is glaringly wrong with this model? An individual is not an independent globule. Each globule looks at other globules before deciding where to go. Except for a few trendsetters and sociopaths, most people want to either keep up with the Joneses or at least look over the fence to see what the Joneses are doing. An individual’s valuation of utility depends partly on what her neighbors will think of a purchase. The ritziest host serves caviar at a party. The most insecure guest proclaims the splendor of the salty fish eggs. But how many guests really like caviar better than ice cream or chocolate-chip cookies?
Veblen’s biting observations also apply to fashions. Pity the man who strolls down Wall Street in a polyester leisure suit. “How many polyesters were killed for that?” a wag may tease. But leisure suits were once stylish. Did the leisure suit change? No. Fashions changed.
Veblen conducts a lengthy anthropological study in The Theory of the Leisure Class alluding to the Ainu of Yezo, the Todas of Nilgiri Hills, and the bushmen of Australia. Relying partly on the research of Lewis Morgan and Franz Boas (Margaret Mead’s mentor), Veblen discovers an “emulatory instinct.” Sure enough, he says, the grass is always greener on the other side of the bush, and Todas do try to keep up with other Todas.
Self-preservation is, of course, the primal instinct. But soon after the process of evolution separated the chimps from the boys, the boys began judging their social status by property ownership. He who plundered amassed social esteem as well as wealth.
Eventually, how one acquired property became important. If a person gathered property by toil and sweat, he was not admired. According to Veblen, the family that gained property passively, without a drop of perspiration, earned admiration and incited emulation in the community. The leisure class was born. Veblen pictured rich people lounging around their swimming pools, hoping others would catch them with little umbrellas in their drinks. He thought the walking stick was a great advertisement, because a man carrying a stick rather than a wrench must have time on his hands.
In the 1980s, Veblen was memorialized by an antiperspirant company that advertised the following golden rule of social climbing: “Never let them see you sweat.” The sweaty man betrays his commonness. Effortless grace is the goal. The aristocrat shudders at sweat the way a soufflé chef shivers at a slamming door.
Veblen provides two dramatic examples of the leisure class working hard to maintain their nonworking status. First, “we are told of certain Polynesian chiefs, who, under the stress of good form, preferred to starve than carry their food to their mouths with their own hands.” Second, a “better illustration, or at least a more unmistakable one, is afforded by a certain king of France, who is said to have lost his life through an excess of moral stamina in the observance of good form. In the absence of a functionary whose office it was to shift his master’s seat, the king sat uncomplaining before the fire and suffered his royal person to be toasted beyond recovery.”4
Along with “conspicuous leisure,” Veblen also sneers at “conspicuous consumption.” Our modern culture overflows with examples. Clothing used to have labels on the inside, hidden from view. Today, designer labels blaze from shirts, ties, blouses, and the seats of pants. Of course, it’s free advertising for the designer. More important, it’s paid advertising by the consumer. Ralph Lauren’s name tells the world that the wearer can afford expensive clothing. (One wonders how the designer’s original name, Ralph Lifschitz, would look on an expensive sweater.) In the movie Back to the Future, the 1950s schoolgirl assumes that the name of her friend from the future is Calvin, because he wears jeans bearing that name.
Automobiles obviously provide more than mere transportation. According to comedian Jackie Mason, the Cadillac is considered one of the finest cars throughout the United States—except in Beverly Hills and Cedarhurst, Long Island. In those two hamlets, all respectable citizens own a Mercedes-Benz. A Cadillac is repugnant. No one will accept blame for a Cadillac in his driveway: “Oh, it’s not mine. . . . I don’t know whose it is—maybe my tacky neighbor’s? . . . Someone must have left it there last night. . . . I’ll call the garbagemen now to remove it.” Why do they like Mercedes? “The engineering,” they insist. But these engineering aficionados probably don’t even know how a toaster works, much less a $70,000 car.
According to Washington legend, Senator Everett Dirksen was the first man in D.C. with a telephone in his car and enjoyed calling up his rivals to remind them. One rival, Senator Lyndon Johnson, exploded in rage. He installed an even better system. Immediately after its arrival, Johnson called Dirksen. They spoke for a minute. Then Johnson barked: “Sorry, Everett, I’ll have to put you on hold. I’ve got a call on my other line!”
At first, Veblen’s piercing observations found their way more easily into sociology than economics. In 1950, though, Professor Harvey Leibenstein published an article titled “Bandwagon, Snob, and Veblen Effects in the Theory of Consumer Demand”5 that applied Veblen’s theory to economics. Usually, he said, Marshall’s law of demand reigns, a lower price leads to more demand. But for some goods, “Veblen goods,” a consumer’s demand is determined by the use of the good and the price that the consumer thinks other people will think she paid, the expected conspicuous price. Not long ago, Ursinus College in Pennsylvania jacked up its tuition by almost 18 percent. Why? It wanted to boost its prestige. Surprisingly, it also boosted the number of applications by 35 percent. “It’s bizarre and embarrassing,” said the college president.6 If the market price of Gucci handbags falls so that they become available in any department store, we may soon see fewer Gucci bags sold. They will have lost their Veblenesque appeal. You cannot be taken seriously at the country club with Kmart clothing. You might as well drive up to a valet parking attendant in Beverly Hills with a Cadillac.
Producers know that envy and peer pressure force consumers to act. According to Veblen and his disciples, businessmen spend more time enhancing a product’s expected conspicuous price than improving its usefulness. This, the institutionalists argue, is a shame and a waste of time and talent, resulting in slicker advertisements for shoddier products.
It is also a perversion of a natural drive. Like Marx, Veblen believed in the creative urge, the instinct of workmanship. Unfortunately, as conspicuous leisure and conspicuous consumption infect society, the creative desire suffers.
Veblen avoids Marx’s class-struggle analysis.7 To Veblen, the enemies are not capitalists, and the heroes are not laborers. He portrays a different cast of characters: The bad guys are businessmen (whether or not they own the companies), and the good guys are engineers. In the modern world, only the engineers accept the urge to create, improve, and produce. Businessmen, who boss them around, strangle creativity. Businessmen thrill at conspicuous consumption. They produce for one reason only: to make money. If they could make money without making a single product, they would be happier. Compare the dreams of engineers and businessmen. The engineer goes to bed each night with pens in pocket and CAD/CAM apps on his cellphone. He dreams of inventing the perfect, absolutely efficient motor. The businessman goes to bed in pin-striped pajamas. He dreams that the public suddenly finds his old product fashionable. That way he makes millions of dollars without investing one cent in new technology or innovative thought.
The history of IBM is filled with bitter battles, almost insane arguments, between founder Thomas Watson Sr. and his son Thomas Jr. In the 1950s, Watson Sr. wanted the company to stick to selling punch-card machines. His son, who hired newly minted engineers, urged the company to develop electronic computers. The old man worried that computers would make IBM’s lucrative punch cards obsolete. The son, as president, bet nearly all the company’s assets on computing. IBM survived the radical transformation, but their personal relationship almost did not.8 The lesson: It is better to make yourself obsolete than to wait for your competitors to do it for you.
Veblen thought that the rise of scientific engineers in the twentieth century would bring the downfall of the philosophical bases of capitalism. Veblen expected machines to discipline modern minds and arouse suspicion in capitalist superstition and catechism. Because engineers and even lowly machine operators see scientific relationships, Veblen thought they would rebel against symbolism, ceremony, and abstract collective beliefs in God, country, and private property:
What the discipline of the machine industry inculcates, therefore, in the habits of life and of thought of the workman, is regularity of sequence and mechanical precision; and the intellectual outcome is an habitual resort to terms of measurable cause and effect, together with a relative neglect and disparagement of such exercise of the intellectual faculties as does not run on these lines.9
Veblen predicted that the conflict between engineers and managers would ravage more than just philosophical underpinnings. The economy would also waste and wear down. Captains of industry strive to achieve high profits. Two lanes lead to this goal. The first involves restricting output in a monopolistic manner. The second involves lowering production costs. Since businessmen know little about mechanics, they neglect efficiency. Veblen blasted a conscientious withdrawal of efficiency. After the manager invests in old techniques, he prefers to hold back production and to hold back advances. In contrast, the engineer yearns to move ahead. The manager prefers cheap, cosmetic distinctions. The engineer wants to satisfy needs. The engineer wants to build a better mousetrap; the manager wants to trap the consumer. By stressing short-term financial gain, businessmen and financiers sabotage long-term economic growth.
Veblen offered only faint hope that government would rein in the robber-baron businessmen. In fact, it was too late, for businessmen had already lassoed and corralled public officials: “Representative government means, chiefly, representation of business interests.”10 Despite his critique of neoclassical economics, Veblen sometimes echoed Adam Smith, especially on trade restrictions:
Where the national government is charged with the general care of the country’s business interests, as is invariably the case among civilized nations, it follows from the nature of the case that the nation’s lawgivers and administration will have some share in administering that necessary modicum of sabotage that must always go into the day’s work of carrying on industry by business methods and for business purposes. The government is in a position to penalize excess . . . traffic.11
Veblen viewed labor unions and their bosses with the same contempt he kept ready for government. Like businesses, he said, unions also block efficiency and sabotage the economy. Rather than aiding common workers, unions raise wages by stepping on the backs of the nonunion employees:
The rank and file . . . stand on the defensive in maintaining a vested interest in the prerogatives and perquisites of their organization. They are apparently moved by a feeling that so long as the established arrangements are maintained they will come in for a little something over and above what goes to the common man.12
In Engineers and the Price System, Veblen speculated that engineers might grow so disgusted with waste and wanton sabotage that they would overthrow their bosses and take charge of the factory floor and the boardroom. After all, the administrators needed them more than they needed the administrators. Technical specialists representing 1 percent of the population, and without one college credit of political science, might emerge as the “philosopher kings” of Veblen’s republic: “It will no longer be practicable to leave . . . control in the hands of businessmen working at cross purposes for private gain, or to entrust its continued administration to others than suitably trained technological experts, production engineers without a commercial interest.”13
Like Marx, Veblen had little idea what the new rulers would do. But he was sure they would not do worse.
Veblen writes as if engineers and businessmen represented two entirely different species, but this seems more farfetched as the years go by. According to a Fortune magazine survey, a very high percentage of corporate chief executive officers started in engineering labs,14 and engineers make up a large percentage of today’s MBA students. The CEOs of Amazon, Netflix, and Google earned engineering or computer science degrees. The founders of Microsoft and Facebook were college dropouts, but I will assume that Bill Gates and Mark Zuckerberg would have been clever enough to pass their courses at Harvard. When the coronavirus struck in 2020 and American hospitals were desperate for ventilators, Elon Musk, who holds an undergraduate degree in economics and in physics, directed his engineers at Tesla to build ventilators from car parts that were on the shelf. Within a week, they had repurposed hoses, valves, and sensors to build prototypes, powered by the car’s infotainment system. A video screen that might otherwise display rap music selections was showing oxygen levels and heartbeats. It was a stunning sharing of business, science, and engineering acumen.
Veblen also assumes that engineers who take power will not surrender to self-interest. But why won’t they act as nastily as the oligopolists they replace? Are engineers really more beneficent and permanently committed to the creative urge? In 2019, Boeing fired its CEO after software deficiencies triggered crashes of the 737 Max jet. Boeing had rushed and bungled the rollout of the new jet and the training of pilots. The CEO had been an aerospace engineer at Boeing since his early days as a college intern.
Veblen did not assemble a detailed model of the economy. He did not think he or anyone else could. So he spent much of his time tearing down the neat theories of his predecessors. While Alfred Marshall placed nonmonetary factors in a “pound” called ceteris paribus, Veblen displayed the courage to enter the pound and vet the forces that Marshall assumed would remain steady, such as tastes. Veblen snickered at economists who ignored the unpredictable, human side of economics. Henry Ford recalled seeing John D. Rockefeller only once: “But when I saw the face, I knew what made Standard Oil.” One cannot quantify a face or predict how a grimace from the boss can change productivity on the shop floor.
Veblen is still fun to read and read about. His most distinguished student depicted Veblen writing with “one eye on the scientific merits of his analysis, and his other eye fixed on the squirming reader.” Learning from Veblen was like doing a vivisection without an anesthetic. Not everyone could take it,15 but no one could forget it. Veblen still haunts us. Every time some big-shot executive conspicuously whisks off in a tinted-windowed stretch limousine while we poor slobs wait in the rain for a bus, Thorstein Veblen unleashes a sinister laugh.
Veblen inspired many outstanding disciples, including Wesley Mitchell, John R. Commons, and the sociologist C. Wright Mills. But the follower most famous to the public for keeping alive Veblenite jokes and jibes was John Kenneth Galbraith. In his long career Galbraith took many controversial economic positions. His colleagues acknowledge two areas in which he indisputably reigned supreme: height and humor. Born in rural Canada, Galbraith drolly identified with Veblen’s bucolic background. He wrote that a good farmer needs a strong back and a weak mind. In his memoir, Galbraith recalls the kind of summer day that inspires an adolescent’s hormones. While strolling through an orchard with the fair lass who filled his pubescent dreams, Galbraith pointed to the lush field where the family cows were grazing. As they winsomely gazed, they noticed a white bull “serving” a heifer that was in season. As the lass looked on with interest, Galbraith summoned the courage to say: “I think it would be fun to do that.”
The lass did not blink at the subtle suggestion. She replied: “Well, it’s your cow.”16
Galbraith, who died in 2006 at age ninety-seven, spent most of his long career in the United States, serving as Harvard professor, presidential adviser, novelist, and social commentator. He wore many of these hats simultaneously. For this, many economists deride his works for superficial, dilettantish economics. To wear many hats, you need both a big head and a lot of brains. Only that genius Keynes could get away with it, they insinuate.
Not that Galbraith boasted of superhuman talents. When President Truman telephoned Galbraith to request his help in regulating wages and prices, a young Galbraith reportedly recoiled, “Surely there are at least ten other economists far more qualified, Mr. President.”
“Damn right there are! But none of them will take the job!”
Galbraith took the job and developed a political and economic philosophy favorable to big government. In three major works, The Affluent Society (1958), The New Industrial State (1967), and Economics and the Public Purpose (1973), Galbraith savaged modern capitalism and its chief apologists, neoclassical economists. Galbraith’s writings mocked the same objects that Veblen mocked. How could anyone believe in Smithian competition in the face of enormous, rapacious corporations? For him, the theory of Marshallian competition ranks high on the same fantastic list as Tinkerbell, Santa Claus, and Snow White. Only intellectual dwarfs who couldn’t see above their windowsills would deny the awesome power of General Motors, Galbraith insisted.
How could anyone still believe the myth called “consumer sovereignty,” that consumers determine what subservient firms will produce? Galbraith argues that causation works in the reverse direction: that firms mold consumers to serve their sales needs.
Imagine the following scenario. You walk into a supermarket to buy Cocoa Puffs cereal. You are “cuckoo for Cocoa Puffs,” as the advertisement screams. Ken Galbraith strides in to buy generic, healthful, sugarless, tasteless Bran Dust cereal to keep him going. You turn to Galbraith in the cashier line and say: “I’ve got to have Cocoa Puffs in the morning. I really like them.”
Galbraith objects loudly. He distinguishes “needs” and “wants.” You cannot need Cocoa Puffs. All needs emanate from within. There is no natural drive to consume Cocoa Puffs. You merely want the cereal, and wants are less important than needs. Then, Galbraith denies that you determined your desire for Cocoa Puffs. Madison Avenue advertisers persuaded you to want Cocoa Puffs. Advertising and salesmanship “cannot be reconciled with the notion of independently determined desires, for their central function is to create desire—to bring into being wants that previously did not exist.”17
Galbraith thinks he has exploded Marshall’s “marginal utility of demand.” For the market does not read the consumer’s true demand for goods, formed in his heart of hearts; it reads the artificial desires implanted by manipulative advertisers. Galbraith calls this the dependence effect.
Galbraith does not stop at a mere assertion. He also infers a powerful conclusion: since firms invent and instill wants, and wants are not urgent, the government should limit private consumption and use resources to improve public facilities. Galbraith denounces the fancy limousine that roars through decrepit parks and slums, and asserts that private America flourishes in disgusting, selfish affluence, while public America starves. Americans do not really want this imbalance. Corporations mesmerize them.
Galbraith foresees an even more despicable future unless the government adopts principles of democratic socialism and planning. He predicts more unemployment as technology displaces workers, more pollution, and more houses filled with “new, improved” useless gadgets. Who really needs the motion-activated toothpaste dispenser, anyway? Was the squeeze tube too complex?
Galbraith’s salvo strikes the nerve center of neoclassical economics. If he exposes marginal utility analysis to be as impotent as the Wizard of Oz, Marshall turns out to be a brainless Scarecrow.
But who flies in from the East to play the Good Witch and pour water all over Galbraith’s theory? Friedrich von Hayek.
In “The Non Sequitur of the ‘Dependence Effect,’” Hayek repels Galbraith’s charge that all important wants come from within.18 He contends that only a few needs truly emerge naturally. Does Galbraith mean that only food and sex are important in life, and that all other concerns are trivial desires? Hayek asks why environmental influences should negate the importance of desires.
If Galbraith’s logic is right, culture is trivial. Nobody in the eighteenth century ever woke up and said, “Boy, I wish there were a Mozart symphony.” Mozart composed and then aroused in others a desire for his music. Is his music a mere toy of the rich? Or is it a significant, enhancing contribution to mankind?
For years the Public Broadcasting System promoted Julia Child, “the French Chef,” later memorialized in a Meryl Streep movie. Prior to her show, did any viewers wake up in the middle of the night craving a tall, goofy woman with a funny voice to teach them to cook? Of course not (nightmares notwithstanding).
What we call civilization is largely a reflection of external factors vying for the brain’s attention and affections.
Galbraith pleads for more public schools. Presumably, the schools would spend much time teaching “unimportant,” “externally contrived” things like literature and music.
No doubt, modern homes bulge with silly toys, appliances, and conversation pieces. But what possible remedy can Galbraith provide without appearing either tyrannical or contradictory?
A simple ban on consumer goods is tyrannical. Instead, Galbraith could urge a ban on the advertising of consumer goods. During the 2020 presidential race, Senator Bernie Sanders suggested taxing targeted advertisements on Facebook and other media.19 Taking Galbraith’s advice, leaders could implore the public to spend their money more wisely and less conspicuously. Leaders could persuade people to contribute private wealth for public goods. But this advice contradicts Galbraith’s own principle! By promoting more prudent consumption and more public goods, the leaders would instill new “externally contrived,” “non-urgent” wants. Advertising, whether by politicians or salesmen, is still advertising.
This critique of Galbraith does not imply that politicians should not advocate for public schools. But Galbraith should not push politicians toward this without conceding the flaw in his “dependence effect” theory.
Galbraith probably exaggerates the power of advertising, which is a complex issue. No doubt an advertising battle among virtually identical products that features only musical jingles and jiggling models is a waste of resources. However, many advertisements deliver some useful information amid much flashiness. Does the flashiness simply get the audience’s attention while the information actually sells the product?
A famous study of advertising and eyeglasses showed that in states that permitted opticians to advertise, eyeglasses sold at prices about 25 to 30 percent lower than in states that prohibited advertising.20
Do people fall for mere sparkle? American marketing history is filled with failures named Edsel, Ishtar, and Heinz EZ Squirt rainbow-colored ketchup. Corporate marketing departments struggle to keep up with the fancies of the American public, much less lead them. The Wall Street Journal reported that sneaker manufacturers test-market their goods in inner cities, because urban youth often ignite cultural fads. In 1986, a sneaker called British Knights, or BK’s, leaped into prominence. Sales soared until, for no apparent reason, local street gangs dubbed them “Brother Killers,” at which point sales plummeted.21
Even if a splashy commercial convinces a consumer to buy, for example, a particular brand of shampoo, will the consumer buy it a second time if she finds the shampoo makes her hair brittle? Most print and online advertisements display products that survive on repeat buyers, customer loyalty, and so on. The goods are not one-shot profit-makers. The producers cannot afford to sell just one time and leave their customers bald or otherwise unsatisfied. On the other hand, ads for “big ticket” goods such as automobiles scream out for the consumer to test-drive the product. Only the dimmest wit in the world buys a Buick from what they see on the television screen.
These points do not defend dishonest advertising or deny its existence. But most advertisers are not fly-by-night outfits eager to cheat for a fast buck. Galbraith himself has written that firms concentrate more on market share than on quick profits. Lousy products lose market share fast.
Many people are, like Galbraith, uncomfortable with the choices modern capitalism gives modern consumers. Many are psychologically uneasy that they have such a wide range of choice. With choice comes responsibility for the selection one makes, and existential angst. Do we choose Crest, Aquafresh, Close-Up, Ultra Brite, or Colgate? We can try to blame the advertisers for our ultimate choice. Of course, toothpaste is trivial. Let’s consider the more important principle involved. If Galbraith is right, can people take credit for momentous issues, for choosing Churchill over Goebbels, or the NAACP over the KKK? The Galbraith critique superficially concerns advertising. More important, it concerns what man really is. Are we any more free than Pavlov’s dogs? If we are not, Galbraith is right, and neoclassical economics fails.
Galbraith happily aligns himself with Thorstein Veblen. He shares many traits, including a sardonic view of modern culture and capitalism. But he shares another trait, vagueness. Neither develops a paradigm or method that economists can carefully test or even emulate. The institutionalists seem content to criticize and to observe. Their work is carried on today in the American Journal of Economics and Sociology and Journal of Post Keynesian Economics. Contributors to the latter are also greatly influenced by the Italian economist Piero Sraffa, the Polish Marxist Michał Kalecki, and the late Cambridge economist Joan Robinson.
Joan Robinson was one Mao collar away from winning the Nobel Prize in economics in the 1970s. Born in 1903 to an elite family in Surrey, she had briefly studied with the elderly Alfred Marshall but probed for flaws in his model. She married an economist named Austin Robinson, but quickly sped ahead of him academically, and later romantically. In 1933, simultaneously with Harvard’s Edward Chamberlin, she published important findings on “imperfect competition,” identifying cases in which just a few companies might exercise extraordinary power in the marketplace (oligopolies), or where products that fell into the same category might have slight differences that made them less competitive against each other. Gertrude Stein said that “a rose is a rose is a rose,” but today Robinson might say that “coffee is coffee, but if Starbucks can charge five times more than Folgers, they’re not selling the same thing.” She and her Harvard competitor Chamberlin referred to such cases as “monopolistic competition,” and pointed to the power of advertising in distinguishing brands. Robinson’s most famous term, monopsony, recently cropped up in a U.S. Supreme Court case, Apple v. Pepper. In the decision, Justice Brett Kavanaugh said that Apple, which takes a 30 percent cut of an app’s revenues, may have undue power because it is the only buyer of Apple-compatible apps and could be sued as a monopsony. Whereas a monopoly is a single dominant seller, Robinson called a single dominant buyer a monopsony. She came up with the Greek-infused word while having tea with a professor of classics. She was still in her twenties when she wrote The Economics of Imperfect Competition, and quickly became part of John Maynard Keynes’s inner circle, while her ideas began to enter standard textbooks. The Keynes circle was marked by bon mots and nontraditional explorations of economics and other matters. To bring these characteristics together, we might retell Keynes’s story of walking into a study and surprising the married Robinson and his protégé Richard Kahn, as they rolled over each other on the floor. With a wink, Keynes assured his wife that “the conversation was only on The Pure Theory of Monopoly.”22
So why did Robinson, who lived to age eighty, helped remake microeconomics, and was quoted by a sitting Supreme Court justice, miss out on a Nobel Prize? Milton Friedman and Paul Samuelson, arch intellectual rivals, both would have applauded such an honor. A few reasons come to mind. First, she resisted the path of economics hurtling toward “mathematization,” stating, “I never learned mathematics, so I had to think.” As a scholar in the 1960s, Nobel laureate Joseph Stiglitz studied under Robinson, but their relationship grew “tumultuous,” and he soon decamped to a mathematically driven mentor. Second, she seemed to recant support for her earlier work on imperfect competition. Third, her post–World War II politics seemed to infect her economics. Although other respected economists wrote on Marxian economics, Robinson flew to Moscow, Beijing, and even to North Korea, not only to investigate economic policies but to praise their repressive results. She wrote sympathetically about Mao’s Cultural Revolution and called North Korea’s Kim Il-sung “a messiah rather than a dictator,” lauding “the Korean miracle.” In 1964, after a visit to North Korea, she predicted that “as the North continues to develop and the South to degenerate, sooner or later the curtain of lies must surely begin to tear.”23 In fact, since the 1960s, South Koreans have grown about twenty times wealthier than their cousins to the North and stand one to three inches taller. With such role models as Mao and Kim, it is no surprise that Nobel Prize–winning development economist and philosopher Amartya Sen described Robinson as “brilliant but vigorously intolerant.” Perhaps the final straw in Robinson’s application to the Nobel Committee came when she began dressing up as a Maoist peasant to deliver her lectures. The committee might have been willing to finally grant a prize to a woman, but not a blue-eyed one from Surrey lecturing from under a coolie hat.
In his lifetime, John Kenneth Galbraith saw the height of the old institutionalists and the rise of the new institutionalists. He surely liked the old folks better. They criticized free market economics for ignoring institutions and blasted free market economists for leaning blindly on Marshallian assumptions about human behavior.
The renegade new institutionalists reverse nearly everything that Veblen and Galbraith set out to do. They don’t announce that institutions belie Marshallian economics. Instead, they wield Marshallian scalpels and scissors with which to dissect institutions. They are not a carefully delineated group. Most are economists, some are lawyers with economic training. They are united by curiosity about social institutions and confidence in neoclassical economics.
The new institutional economists start with a basic question: What structures need to be in place for an economy to begin developing? In the 1960s, Douglass North, a former merchant marine who admitted to being a middling undergraduate at the University of California, Berkeley, directed economists to a new focus of study, namely, history. He and his colleagues called the specialty cliometrics (after Clio, the Greek muse of history) and uncovered old data, from bills of lading on eighteenth-century ships to receipts for bales of cotton and flasks of whiskey. During the 1960s and 1970s, the University of Chicago’s Robert Fogel, who would later share the Nobel Prize with North, produced controversial, counterintuitive statistical studies questioning the importance of railroads and the economics of slavery. To explain economic development, North himself targeted property rights and the ability of citizens to freely choose their vocations. He theorized, for example, that England and the Netherlands led the Industrial Revolution because the guild system was weaker in those countries, which allowed workers to move more easily among jobs.
If we think about institutions from the very beginning of economic history, I would argue that progress comes when people engage in trading transactions where both sides gain. These are nonzero-sum transactions. In a zero-sum situation, one person’s gain is another’s loss; for example, I just stole your chariot. Even before the golden age of Greece, Thucydides, the historian of the Peloponnesian War, pointed out that without commerce, nomadic groups kept to themselves, never planted beyond their shifting parcels of land, and never improved their standard of living. What makes nonzero-sum deals possible? In a book called Rush, I point to four factors: First, a legal construct with enforceable contracts, whether enforced by a tribal leader, a court system, or social stigma. Second, a willingness to wait for results—that is, patience. Third, an interest rate structure that allows people to gauge the value of waiting for rewards. Fourth, and perhaps more important, repeat transactions, or expecting to deal with someone again. This is what I call the Rule of Repeats. When someone expects to do business with you again, they are far less likely to cheat you. Repeat customers at restaurants are bigger tippers than transient ones. The Rule of Repeats turns strangers into partners and counterparties. Trade prods people to treat strangers better and to expand communities, which largely explains why trading societies are less violent than premodern peasant societies and why contemporary homicide rates in Europe are perhaps one-tenth the rate they were in the year A.D. 1300, and life expectancy is almost three times greater.24
Joseph Schumpeter, a man with a flashy style, a bizarre sense of propriety, and a penetrating mind, taught that modern economic growth relied on the entrepreneur. Schumpeter, who came from the same Austrian school as Hayek before settling at Harvard in the 1930s, shared few views with Veblen but must have shared some of the DNA markers for heresy. He once challenged a librarian to a duel over the right of his students to get better access to books, and bragged that he had three great ambitions in life: “I wanted to be the greatest economist in the world, the greatest horseman in Austria, and the best lover in Vienna. Well, in one of those goals I have failed.” Schumpeter strolled into faculty meetings wearing riding boots, and with his capes, spats, and silk shirts, he could have stepped out of an old Hollywood movie as Errol Flynn’s aristocratic sidekick. But Schumpeter was not just a dandy. He was also the most learned economist of the twentieth century. Even John Maynard Keynes, whose accomplishments drove Schumpeter to jealous depressions, could not compete with Schumpeter’s erudition, which included a command of the economics literature in German, French, English, Italian, Latin, and ancient Greek.
Before immigrating to the United States in 1932, Schumpeter held and was ousted from two notable jobs: Austrian finance minister and chairman of the Biedermann Bank. It is not hard to figure out why he was ousted. As chairman of the bank, he rented a castle, lavished a big salary on himself, and, when told to tone down his manner, rented an open-air carriage and rode along the main boulevard of Vienna at noon with a pretty blond prostitute on one knee and a brunette on the other.25 Schumpeter’s economic growth model did not depend on castles and big banks. Instead, he crowned the entrepreneur as the driver of economic waves that crash against the status quo, bringing new ideas amid gales of “creative destruction.” (His ideal entrepreneur closely resembled his grandfather and great-grandfather, who owned textile mills.) Schumpeter thought Veblen was wrongheaded about businesspeople and accused Veblen of belonging to the “depredation theory of entrepreneurial gain,” which sees these key players as pointless parasites.26 Unlike Galbraith, he wasn’t worried about big businesses, because he figured that sooner or later they would be vanquished by upstart entrepreneurs. In the meantime, large firms that dominate could afford to plow their excessive profits into innovation. Schumpeter would not be surprised that 90 percent of the firms that were in the Fortune 500 in 1955 would be moribund themselves in 2020, either merged, bankrupted, or too shrunken to show up on a list.
Although Schumpeter encouraged pure economic theory and helped found the Econometric Society, he knew too much about human society to hide behind arid mathematical symbols. Indeed, his depiction of the entrepreneur in The Theory of Economic Development appears to stem more from Max Weber and Friedrich Nietzsche than from Adam Smith and David Ricardo: “First of all, there is the dream and the will to found a private kingdom,” he wrote. “Then there is the will to conquer: the impulse to fight, to prove oneself superior to others. . . . Finally, there is the joy of creating.”27 Despite his respect for Weber, who posited that the Protestant work ethic (especially Calvinism) spurred capitalist growth, Schumpeter publicly quarreled with his elder. In one altercation in a coffeehouse, Weber denounced the Russian Revolution while Schumpeter praised it as a “fine laboratory” experiment. Finally, Weber stormed out, screaming, “I can’t take any more of this!” and leaving Schumpeter calmly asking for another drink with a bemused expression on his face.
Though few college students have seen Schumpeter’s Theory of Economic Development, thousands continue to study his Capitalism, Socialism, and Democracy, which we will discuss in the final chapter. In that book Schumpeter poses his most famous query: “Can capitalism survive?”
Starting in the post–World War II era, a new institutional approach invaded the world of law. Although antitrust law always involved economics, economists forced lawyers and judges to examine nearly all legal decisions through the eyes of Alfred Marshall and his followers. No area of law can hide from economic analysis, and no law professor today can teach competently without some economic training. Law journals and court judgments bulge with discussions of marginal benefits and marginal costs. The discussions are not just academic. Several prominent experts in law and economics sit on federal courts, influencing the lives of millions of people. No one can hide from economists. Even jailbirds must worry that some graduate student will perform an economic analysis of jail cells, perhaps proving that a particular diet of bread and water optimizes rehabilitation rates.
In 1916 Louis Brandeis wrote that a “lawyer who has not studied economics . . . is very apt to become a public enemy.”28 Unfortunately, the United States produces thousands of public enemies each year.
Let us explore four very important areas in which economists have dramatically transformed traditional legal analysis of negligence, property, crime, and corporate finance.
Most accidents fall under the category of negligence law, also known as tort law. Every time someone slips on a banana peel left on the supermarket floor, a lawyer hopes for a lawsuit on the grounds of negligence. “The supermarket shouldn’t have left the peel on the floor,” a tweedy litigator will argue. He will probably win.
Should a person or business be held liable for every accident on its premises? Try another example. A storm shipwrecks Gilligan, the skipper, and the passengers of the S.S. Minnow on a palmy isle. Only two people live on the island. But they share the island with two hundred monkeys. The 202 inhabitants produce banana liqueur for export. The monkeys peel and squeeze the bananas. In the process, they hurl the peels across the island. Suppose Gilligan wanders around the island and slips on a banana peel. Is the banana business negligent? Most courts would say no.
What are the key differences between the supermarket and the deserted island? First, the probability of a human walking down the fruit aisle of the market is high, whereas the chance of a shipwrecked person wandering around the island is small. Second, the cost of supervising the supermarket is low, whereas the cost of monitoring monkeys on an island is high.
Using these concepts, Judge Learned Hand established a brilliant economic analysis of negligence law in a 1947 case.29 Hand identified three key factors: the probability of injury (P), the extent of injury or loss (L), and the cost of preventing the accident (C). According to Hand, a person is negligent if the probable injury to the victim exceeds the cost of avoiding the accident. Thus in algebraic terms, a defendant is negligent if P × L > C.
In the supermarket, the probability of someone slipping on a banana peel left on the floor is high; let’s say 20 percent. The injury is severe; let’s say $20,000 in medical bills, lost wages, and inconvenience. Thus P × L = $4,000. If the supermarket could have prevented the accident for less than $4,000, it was negligent. A $3 broom in the hands of a stock boy would have done the trick.
On the balmy and palmy isle, the probability of a shipwrecked wanderer slipping on the banana peel is very low, perhaps 1 percent. Even if the injury causes $20,000 damage, the probable loss or expected loss is only $200 (.01 × 20,000 = 200). The liqueur producers would be negligent only if they could have prevented the accident for less than $200. Of course, they could have prevented the accident by placing fences, signs, and security cameras all around the island. But this would be expensive. Further, the monkeys might have injured themselves on the fences. According to Hand, producers should not waste money protecting against an accident highly unlikely to occur. If a judge declared them negligent, he would encourage them to waste valuable resources.
To maximize social welfare, courts should encourage people to spend money on safety only as long as the marginal benefit surpasses the marginal cost. Thus Hand’s formula brings Marshallian logic to the law.
We could try to avoid all accidents. We could wrap ourselves in foam rubber and never leave our homes or turn on an oven. But most of us agree to take some risks. Hand helps us to know when the risks are foolishly high or trivially small. In the fifty years following Hand’s opinion, lawyers and economists have improved his original formula. Nonetheless, the original formula still correctly conveys the flavor of modern negligence law.
Over the past few decades, law and economics scholars have forced judges to recognize the effects of their legal decisions on real property. Judges who ignore economics sometimes command people to take actions that result in precisely the opposite of the judges’ intentions. Let’s look at two examples in which scholars have compelled lawyers, judges, and legislators to rethink their analyses: Coase’s Theorem and rent control.
In 1960, Professor Ronald Coase of the University of Chicago presented a powerful tool for economic analysis.30 In short, Coase showed that the initial assignment of a property right may not determine how the property is ultimately used. Let’s apply Coase’s Theorem to nuisance law. Assume that Frank Sinatra owns a nightclub. Sleepy Simon lives next door. Whenever Sinatra belts out a high note, it rattles Simon’s teeth and jars him from his bed. Simon brings Sinatra to court, claiming that he has a right to snooze soundly. Sinatra claims a right to hit the high notes. The judge sides with Simon and closes down Sinatra’s saloon. According to Coase, the story is not over. Coase’s Theorem predicts that Sinatra will sing again if he values his saloon more than Simon values sleep. If Sinatra values his saloon at $1 million and Simon values his sleep at $100,000, Sinatra may bribe Simon into withdrawing his complaint. If Sinatra offers more than $100,000, Simon would accept. With $100,000, Simon could install soundproof walls or buy fancy earplugs. Coase’s Theorem states that once a property right is clearly defined, the property will be put to its most valued use. Once the judge clearly assigns to Simon the right to sound sleep, Sinatra can buy that right or bribe Simon into giving up his sleep or moving elsewhere. Even if the judge gives Simon the right to silence Sinatra, Sinatra may sing again if he treasures the right to hit high notes.
So, Sinatra and Simon will settle at a price between $100,000 and $1 million. (If Simon insists on receiving more than $1 million, Sinatra will not pay and will not sing. If Sinatra offers less than $100,000, Simon will turn it down.)
What if the judge had ruled for Sinatra and decided that he had a right to hit the high notes, regardless of his neighbor’s sleep? Is it possible that Sinatra would not sing even though he had won the case? Yes. If Simon valued his sleep more than Sinatra valued his singing, Simon might buy Sinatra’s silence. According to Coase, then, the judge’s initial assignment does not determine what ultimately takes place. It determines only who might buy and who might sell. While adoring fans may pay Sinatra to sing, his neighbors may pay him not to.
Coase applies this same analysis to polluters. After all, a soaring human voice may be considered by some as just another form of pollution. A factory that releases smoke may irritate its neighbors. But if the factory values its right to pollute more than its neighbors value the right to clean air, or if the factory is willing to pay the neighbors to move to another location, the factory may continue to pollute. The upshot: judges act foolishly if they assume that by assigning a right, they determine what will finally take place.
Sometimes it is impossible to know in advance whether a neighbor’s behavior will be a positive or negative “externality.” With great fanfare, in 2003 Los Angeles unveiled the swooping, stainless-steel Walt Disney Concert Hall, designed by the renowned Frank Gehry. At first, neighboring residents assumed that this $274 million marvel would boost their property values. Then the sun came out, and Gehry’s stainless steel reflected laserlike rays into apartments, propelling interior temperatures, baking sidewalks to 140 degrees Fahrenheit, and burning the skin of pedestrians like ants under a magnifying glass. Employees observed trash bins combusting and traffic cones melting. Concert hall officials sandblasted the gleaming exterior, trying to turn their negative externality into a positive again.
Like Learned Hand’s negligence theory, Coase’s Theorem has been attacked and refined. The prime point of attack is the assumption that people can bribe each other without large transaction costs. Especially in pollution cases where large numbers of homes are affected, it’s unlikely that families can organize efficiently to bargain with the polluter. (When an externality affects masses of people, they might lobby the government to tax the behavior—that is, levy a “Pigou tax,” as discussed in the earlier chapter on Malthus.) Despite these complications, though, Coase’s Theorem appears to be a brilliant and innovative insight into the way legal decisions may actually affect individuals. His approach was so novel that his most learned colleagues thought it had to be wrong. George Stigler recalls Coase presenting the argument to twenty-one members of the University of Chicago faculty, all of whom dismissed it as foolish heresy. After a two-hour debate at the home of Milton Friedman’s brother-in-law, Coase had won over each of them. Stigler recalled that it was such an “exhilarating moment” that “he lamented afterward that we had not had the clairvoyance to tape it.”31
Economists have carefully analyzed another real property issue, municipal rent control laws. Legislators who know how to get votes but not how to govern prudently frequently pass economically perverse regulations. In the 1970s, officials possessed by a utopian vision promoted rent control laws aimed at providing affordable housing by restricting the landlord’s ability to raise prices. Some would call this a noble goal but a lousy policy.
Quite simply, rent-control laws nearly always create a shortage of housing. At low prices, people demand housing. But the laws convince landlords to constrict supply. At first, you may think that landlords have no choice once they construct a building. In fact, landlords can reduce supply. They can skimp on maintenance and repair. Or they can convert the rental units into condominiums, cooperatives, Airbnb rentals, or commercial office space. A wrecking ball cares little for history or sunk costs. One econometric study of U.S. cities estimated the long-run price elasticity of supply to be 0.20, which means that if the government forces rents down by 10 percent, landlords will take 2 percent of the rental units off the market.32 In the long run, landlords do alter the number of units in response to price changes.
Stockholm, Sweden, has compiled a waiting list for rent-controlled housing that includes nearly six hundred thousand people—more than half the population! Once you sign up, you will wait between nine and twenty years for a phone call. Spotify, which launched its music-streaming business in Stockholm, wrote an open letter to policymakers threatening to vacate the city if the rules weren’t relaxed and if more housing wasn’t encouraged.33
In 1979, Santa Monica, California, adopted the toughest rent control laws in the United States. The laws prevent landlords from cutting back supply by forcing them to pay for a new rental unit for each one converted or destroyed. As a result, property values acted perversely. Ten years after the laws were passed, an empty lot could sell for $600,000, whereas an apartment building on an equal-size adjoining lot might command $200,000 less.
No surprise that Forbes magazine reported that
abandoned small apartment buildings sit forlornly next to homes costing $500,000 or more. Run-down rental units share streets with chic merchants selling everything from high-fashion clothing to automobiles for the rich and famous.34
Even if landlords do not cut supply, they may furtively raise rents, by demanding bribes or “fixture fees” especially from new tenants. “The apartment costs $400 per month. But the window shades, which you must buy, cost $10,000,” says the landlord.
Does anyone gain from rent control? In the short run, two groups profit. First, politicians, who sound like heroes slaying the evil landlords. Second, tenants who already occupy units at the time rent control is invoked and thus continue to enjoy bargain rents. As a result, these tenants seldom move. This reduces mobility and freezes out new residents of the city. Because of rent control laws enacted in 1980, a high percentage of University of California, Berkeley, students commute to classes from neighboring towns or take long freeway drives from outlying regions. New York City boasts many large apartments occupied by older couples who once shared them with their children. Instead of moving to smaller apartments when the children moved out, they stayed. So a large family moving to the city hasn’t a prayer. Most people know that the way to find an apartment in Manhattan is through the obituary pages, not the real estate pages.
Ultimately, rent controls tend to depreciate the housing stock, as maintenance falls and supply diminishes. Usually, such controls are a poor way of helping the poor—and a good way of destroying a city.
So far we have seen how economists examine tort and property law. But no area of law is untouched by rapacious economists. Economist Gary Becker applied Marshallian economics to family law and to criminal law. The issues are fascinating. Becker’s crime model posits criminals who apparently weigh the costs and benefits of committing offenses. If we have a crime problem, Becker implies, it’s because crime does pay. Economists have tried to calculate what deters criminals. Two variables seem most important: (1) apprehension rates and (2) severity of punishment. The deterrent effect differs for different types of crimes. For some crimes, police should concentrate on catching the criminals. For other crimes, apprehension rates do not scare offenders. Instead they are frightened and deterred by severe punishments.35 The Beckerian analysis has not been unanimously adopted. Many statistics contradict each other. Nonetheless, it ranks higher than Evelyn Waugh’s silly theory that almost “all crime is due to the repressed desire for aesthetic expression.”
Criminals often figure that crime pays because they care little about the future. They are willing to dodge bullets, flee police, and pocket a quick payoff rather than make an investment in the future (school, job training). Criminologists and economists who study crime have not focused enough on time horizons. In an economic model I developed back in the 1980s, I concluded that when time horizons shrink, the value of acting honestly diminishes, leading to economic collapse.36 With due respect to one’s Sunday-school teacher, honesty is not always the best policy if your goal is to get rich with the least amount of effort. Two forces normally dissuade even amoral egotists from cheating or stealing, especially in business. First, the fear of punishment. Second, the fear that a bad reputation will repel others from dealing with you in the future. But what if you do not care about the future? Crime goes up. (The same dynamic explains why tourists passing through tend to tip waitresses less than regular restaurant patrons.) Sometimes society shrinks the time horizon, making crime look more inviting to more people. How? When governments are about to collapse, for example, South Vietnam in 1975, Indonesia in 1998, or Iraq after 2002.
Another way for society to shrink time horizons is to let interest rates rise. Higher interest rates force us to discount the future more. That is, a dollar next year is worth less today if interest rates go up. The “Buchholz Hypothesis” suggests that higher interest rates induce people to commit more crime because they reduce the value of people’s future. During the Great Depression, nominal interest rates dropped, which could solve the mystery of why crime rates actually descended amid economic misery. From the 1960s through the 1970s, interest rates began a steady climb, accompanied by higher crime rates. Violent crime peaked around 1980, as did interest rates, only to climb again in the late 1980s. In the 1990s and 2000s, we enjoyed a rapid drop in interest rates that tracked the plunge in violent crime, with both the crime rate and U.S. Treasury yields plunging and staying near historic lows.
Surely interest rates are not the only factor. Demographics, police work, and punishment rates play a huge role. But when society tells potential felons that tomorrow counts for less, we should not be shocked when they take advantage of today.
Economists who examine the criminal narcotics trade criticize misguided government policies that fail to solve the dreaded problem. During the last thirty years, the federal government has tried to curtail the supply of drugs by destroying crops and sealing U.S. borders. Although the Drug Enforcement Administration seizes tons of narcotics each year, for several reasons this supply-side focus does little good.
First, drugs such as cocaine are derived from plants that grow easily in many parts of the world. There are just too many fertile fields to burn or monitor. Second, because the street value of cocaine, for example, exceeds the import price by tenfold, boosting the price at Miami docks would add very little to the price on Chicago streets. Third, even if interdiction or burning fields did raise the street price, regular cocaine users do not care much about cost. In Marshallian terms, addicts have an inelastic demand. And perversely, higher prices might spur addicts to mug and rob even more in order to pay for their drug habits. (New consumers of narcotics may be more sensitive to higher prices.)
To win the drug war, or at least achieve a truce, the federal and state governments must focus on the demand side. That means severely penalizing drug users. They may be insensitive to price; but they may be more sensitive to jail time. Of course, better counseling and treatment should also be available. These measures should be accompanied by harassing and punishing street vendors. Until Americans give up a desire to use drugs, the war against drugs cannot be won in fields south of the border or on docks on the southern border. It can be won only in the streets of American towns and cities.
No one denies that economists have enriched legal scholarship. Critics do ask, however, if lawyers mesmerized by economics have gone too far. After all, the law should aim for justice. Does efficiency equal justice? Should we repeal inefficient laws, even though they are just? What if whipping prisoners were efficient? Defenders retort in two ways. Extremists actually argue that justice equals efficiency, which recalls the pre–nervous breakdown Mill. The early editions of Richard Posner’s treatise Economic Analysis of Law claimed that efficiency is “perhaps the most common” meaning of justice. “We shall see that when people describe as ‘unjust’ convicting a person without a trial, taking property without just compensation . . . they can be interpreted as meaning nothing more pretentious than that the conduct in question wastes resources.” This rather dim observation by a brilliant man was lightened up, however, in the third edition of the treatise, in which Posner admits, “There is more to justice than economics.”37
The more reasonable retort has two parts. First, in many legal decisions, especially involving business law, judges do strive for efficiency. The law and economics school can help them. In past decades, judges tried to act efficiently, but ignorance clouded their sight. Second, in cases where issues of justice arise, a moral judicial system should at least know the likely consequences of its decisions. From a moral point of view, we should distinguish between just actions and just actors. A just man is one who chooses correctly after contemplation. A laboratory rat can choose the right action, but that action is not just unless it has been contemplated. A judge who simply ignores consequences is no more just than a laboratory rat. Even if a judge refuses to enforce an efficient result, he should know that he is ignoring efficiency. Lest we reach clouds too lofty, let us put aside this tangential argument with Posner and Kant and move on to an interesting development in corporate finance.
The law and economics scholars contrast with the old institutionalists because the new people use Marshallian tools to investigate institutions. In one narrow area, however, the old and new sound alike. In 1932, Adolf Berle and Gardiner Means, a law professor and an economist, respectively, at Columbia proclaimed a mortal split between owners and managers of firms.38 Since the owners (including stockholders) no longer run the firm but delegate authority to paid managers, firms no longer act efficiently. Galbraith later insisted that managers would pursue their own goals such as enhancing their own prestige by increasing the size of the firm.
Though denying the dire effects, new institutionalists admit that owners must monitor their managers. To monitor costs money, sometimes called “agency costs.”
To lower agency costs, owners often give managers incentives to raise profits. Most senior corporate officials receive part of their compensation in the form of stock. If they raise profits, the stock will rise, and they will earn more. In addition, executives frequently receive “stock appreciation rights,” where the company pays a cash bonus if the stock price climbs. This trend took off in the 1990s when the share of top executive compensation tied to stock prices zoomed from less than 10 percent to almost 70 percent by 2003. More and more companies are also promising stock incentives to nonexecutive employees. The corporate scandals that took place in the late 1990s at Enron, Tyco, and Fannie Mae did show, however, that shady executives may manipulate stock incentives by backdating options or artificially propping up share prices for short-term gain, with little regard to the firm’s long-term health.39 A few years ago, executives at Wells Fargo were exposed for pressuring their employees to open millions of fake new bank accounts in the names of existing customers without the customers’ consent. The operation tricked the stock market into thinking that the bank had acquired more customers, lifting its share price, as well as the bonuses of executives. There is much room for fine-tuning the incentives that shareholders give management. Stock options, crooked executives, and lazy boards can be a treacherous trio for shareholders to face.
Crookedness is not limited to the executive suite, of course. The General Mills Green Giant brand once had a problem with insect parts showing up in bags of frozen peas. The Green Giant mascot was not so jolly to see the legs and thoraxes, and neither were consumers. The company set up an incentive program to reward employees for detecting bug parts. The incentives must have been too alluring, however, since some employees began sneaking insect parts from home gardens into the factory, planting them among the peas, and “finding” them to collect a bonus.40
In the 1980s, strong incentives to cut agency costs arose with the increasing popularity of the leveraged buyout (LBO). In many leveraged buyouts, the managers borrow money, buy up all the stock, and take over the ownership for themselves. The new debt pressures them into trimming costs and selling off less productive assets. Vice presidents hand in their keys to corporate jets. Thus, the mortal split is mended. Agency costs plummet because the managers have an extremely large stake in the company’s performance. Hertz, Levi Strauss, and Black Entertainment Television took part in the first wave of LBOs. Not long after Black Entertainment Television’s LBO, founder Robert Johnson became the first black billionaire in the United States. In recent years, PetSmart and Dell have “gone private.” Leveraged buyouts do have their critics. Although stockholders who sell their shares to the managers usually receive substantial premiums over the pre-LBO market price, critics question whether the buyout price is determined in a fair manner. Maybe the managers have inside information that they haven’t divulged that should make the price even higher.41 Furthermore, critics point out that the mammoth debt burden can dramatically increase the risk of bankruptcy if the economy falters. While this is true, new creditors of these companies are generally sophisticated insurance companies and institutions that carefully examine risks.
Many plays and films are now financed so that producers pay stars and directors a percentage of the gross proceeds only after costs are paid. Thus, everyone has an incentive to reduce costs. No one has an incentive to squander and splurge on lavish extras. Hollywood financiers call these “contingent deferments.”
In corporate finance, the old institutionalists pointed to a problem. Fifty years later the new institutionalists pointed to solutions.
Almost every institution and social phenomenon has economic implications. According to a 1988 study, the historical treatment of prisoners of war closely correlates with the costs and benefits of killing or sparing a vanquished adversary. The Middle Ages, the authors conclude, were not always horrible for prisoners of war, since captors often treated captives well enough to command high ransom prices.42 The bad news for prisoners of war seized during the Middle Ages: if demand for them or for their labor fell, heads would roll.
Even the existence of time has economic implications. How would people behave if they knew that the world would end tomorrow? How would they behave if a new legal system, a system that would not enforce contracts or punish criminals, was going to be imposed next week?
People act civilly toward one another for many reasons. One reason is that they want reputations for being trustworthy. This is especially important in business. But if time is short and reputations in the coming regime will not be based on present behavior, some people might renege on promises and take advantage of others. A healthy market economy demands a certain level of civility and sanctity of promises. A society that perceives no future would see economic collapse.43
There is clearly more to economics than prices, profits, rents, and costs. Laws, morals, fashions, and philosophies all contribute to an economy. They may support it, or they may tear it down. Veblen and Galbraith expanded the definition of economics and forced colleagues to open their eyes to broader phenomena. Economics is not as easy as Marshall made it look.
The new institutionalists admit that economics isn’t easy. But they show how robust Marshall’s tools are. For they use his methods to understand the complex institutions that help mold the economy.
Brandeis warned that lawyers ignorant of economics menace society. What is the legacy of the old and the new institutionalists? They finally explained that economics is as big as society itself.