American political rhetoric often frames the decision in the dramatic terms of myth: Either we leave the market free, or the government controls it. The starkness of the choice thus posed infuses issue after issue with mythic overtones, and excites debates over where we dare and where we must abandon other social concerns in favor of the vigor of the market, or abandon free enterprise to pursue a higher public good. The debates have generally failed to help the public understand the options and the stakes of each issue.
Two truths underlie the grand debate; each side tends to emphasize one to the exclusion of the other. First, government efforts to dictate economic outcomes are inherently inefficient; they stifle innovation and concentrate decision making within imperfectly accountable bureaucracies. Second, unfettered profit seeking inherently neglects both the broader costs and the potential benefits that do not figure in individual tallies of profit and loss. This is true to the extent the rules that define the market fail to induce profit seekers to take such effects into account. Posing the debate in mythic terms, as a moral choice between the security combined with stagnation of bureaucratic control and the vitality combined with rapacity of capitalist enterprise, obscures the more prosaic but central choice, the real choice, of how we make the rules.
The idea of a free market somehow separate from law is a fantasy. The market was not created by God on any of the first six days (at least, not directly), nor is it apparently maintained by divine will. It is a human artifact, the shifting sum of a set of judgments about individual rights and responsibilities. What is mine? What is yours? What is ours? How do we define and deal with actions that threaten these borders—theft, force, fraud, extortion, or carelessness? What should we trade, and what should we not? (Drugs? Sex? Votes? Babies?) How should we enforce these decisions, and what penalties should apply to transgressions? As a culture accumulates answers to these questions, it creates its version of the market.
These answers are not found in logic or analysis alone. Different cultures, at different times, have answered them in different ways. The answers depend on the values a society professes, the weight it places on solidarity, prosperity, tradition, piety, and so on. In modern societies, government is the principle agency by which the culture deliberates, defines, and enforces the norms that structure the market. Judges and legislators, as well as government executives and administrators, endlessly alter and adapt the rules of the games—usually tacitly, often unintentionally, always under the watchful eye and sometimes under the guiding hand of interests with clear stakes in the outcomes of particular decisions.
To the extent that rhetoric frames the issue as one grand choice—between government and market—it befogs our view of the series of smaller choices about the wisest and fairest of an endless set of alternative ways to structure the rules of ownership and exchange. The myth of Rot at the Top, which indicts in turn profit seekers and policy makers, blinds us to the real source of so many economic inefficiencies and outrages—bad choices about rules, flawed procedures for making such choices. Complicated codes of laws and regulations lack the emotional charge of mythic struggle, but they are where the action is.
Economic activities often have consequences for people not immediately party to them. Some of the consequences are unwelcome: private ponds flood neighboring fields, locomotives ignite prairie fires. Some are socially useful: a beekeeper’s swarm pollinates his neighbor’s orchards; knowledge gained in developing a new product proves relevant to a range of other endeavors.1 As the world shrinks and the pace of economic change quickens, many of these side effects loom larger. Industrial pollution, unsafe products, community abandonment, and sudden unemployment all take a toll. Simultaneously, new knowledge, skills, and experience are ever more central determinants of a culture’s prosperity. How to deal with these social effects? The mythic contest between the free market and government intervention forces us either to ignore them, or to rely on countless government directives to pull corporations, and on subsidies to push them, onto paths other than the pursuit of profit. Each of these alternatives invites abuse and inefficiency, as we have observed, which tend to launch the pendulum of righteous fulmination in the opposite direction.
There is a third alternative, however. It is to reorganize the market to bring these broader effects into consideration as private agents decide on transactions. This is not a Utopian proposal. It suggests merely that the government concern itself with designing the right market rules, rather than trying to dictate the right market results. Consider how the most recent swing in the pendulum has obscured government’s role for dealing with the unwanted side effects of corporate action in just this way.
“Deregulation,” a term that had a heyday in the late 1970s and 1980s, was broadly seen as a manifestation of a decisive swing toward the free market, away from government intervention. In fact, deregulation represented only a shift in the nature of government action, from commanding specific outcomes to creating and maintaining new markets. By 1980, for example, the airline industry was deregulated in the sense that the Civil Aeronautics Board no longer passed judgment on air fares or routes. Carriers could compete on prices and services, to the delight of passengers. This reform did not eliminate the government’s involvement in the air travel business, but rather shifted government responsibilities. Government was now charged with organizing a new market, whose development called for all sorts of decisions: Under what conditions should mergers and acquisitions among airlines be barred because they might stifle competition? How should airport landing slots be apportioned among competing airlines? On what terms should airlines gain access to their competitors’ computerized reservation systems? What kinds of standard, comparative information should airlines provide prospective passengers about their flights and services? How should the airlines handle overbooking, or the sudden cancellation of flights? Beyond these issues lay new concerns about safety. With so many more flights, more passengers, and more airlines competing far more furiously against one another, there was a greater risk of accident. The government now had to expand its safety inspections—and also restructure industry incentives to guarantee the proper degree of care. This prompted some liberal interventionists to talk about “reregulating” the airlines. But that option was irrelevant to the issue at hand. In continuing to view the choice as between government intervention and the free market, the more subtle questions of market design were often obscured.
The control of air pollution offered another example. Since the passage of the Clean Air Act in 1970, the federal government had issued mounds of regulations determining the maximum concentrations of air pollution throughout the nation and how much airborne toxin could be emitted by each of tens of thousands of industrial facilities. Enormous amounts of data had to be accumulated and analyzed, and even then it was possible only to issue uniform and inflexible rules for whole industries and regions. The uniform rules took no account of individual needs or deviations and were altered only slowly or more often not at all as circumstances changed. They were almost impossible to enforce.2
Free marketeers (including not a few trade associations and large businesses) periodically argued that because the costs of enforcing the Clean Air Act far exceeded its benefits, the regulations should be scaled back. Environmentalists (and, if polls are to be believed, a majority of the American public) disagreed. The debate centered on the value of clean air versus the costs and inefficiencies of regulations to achieve it. But posed in this way, the debate left out a far more useful line of inquiry: How could government better organize the market to attain the cleanest possible air at the lowest possible social cost? This way of framing the debate may have invited consideration of numerous options, such as a system of transferable pollution permits. Such permits, issued in numbers equal to the maximum amount of pollution allowed in a particular region, could be bought and sold by polluters. Thus each polluter could decide which was cheaper, in light of its own special circumstances: cutting pollution or buying permits. As a result, the air would be as clean as before, but most of the cost of curbing emissions would fall on firms that could do it most cheaply. In addition, all firms would have an incentive to develop more efficient methods of cleaning up in the future.3
Or consider the question of how tall and wide buildings should be in a crowded city. For years American cities struggled with complex zoning regulations designed to assure adequate sunlight and fresh air for their inhabitants, notwithstanding office construction that was rapidly depleting the air space downtown. As the price of office space increased and developers became cleverer and more demanding, the regulations typically grew more complicated and less effective. But the answer was neither to bar further development, as some argued, nor to abandon all efforts to save some modicum of fresh air and sunlight. It was for government to organize a market in air space, featuring a three-dimensional form of property that could be purchased and sold, like any other. Some of this property would be reserved for the public’s fresh air and sunlight (rather like a three-dimensional park). Thus as developers purchased the air space that their proposed buildings would displace, construction would occur on sites where it was most valuable, and fresh air and sunshine would be retained at least cost.4
A final example concerns product safety. Here again, the most important choice is not between government intervention and the free market. In the absence of regulations governing product safety, consumers injured by a faulty product would not simply take their business elsewhere. They would seek compensation for their injury from the producer or from their insurer. The practical choice, then, was between (1) regulations specifying how safe products should be, (2) lawsuits by injured consumers against the firms that produced the products, and (3) a more comprehensive system of insurance that would fully compensate injured consumers for any lost wages, pain, and suffering they endured. To the extent that government withdrew from the task of regulating product safety directly, it would find itself more involved in the latter two alternatives. Indeed, by the mid-1980s there was some evidence that the Reagan administration’s disinclination to regulate had prompted a rise in product liability lawsuits. The action had simply moved from the regulatory agencies to the courts. The central question, however, remained: Which response, or combination of responses, comprised the most efficient and equitable way of coping with products that caused injury?
As these examples suggest, the absence of government regulation does not necessarily mean an abrogation of government authority nor the abandonment of public goals. It often calls for a different governmental role—organizing and maintaining decentralized markets that can align the publicly desirable with the privately profitable. The debate over the relative merits of government intervention or free enterprise has obscured this more difficult and subtle task. It has distracted the attention of the public and of opinion leaders, who continue to fulminate against either government incompetence or corporate irresponsibility. Because neither free marketeers nor interventionists are accustomed to view the challenge in terms of market design, this potentially more fruitful course has often been left unattended.
Precisely the same lesson applies to corporate activities that have positive social effects, such as creating new knowledge and skills. Here again, the mythic choice between government intervention and an unfettered market has obscured the central issue. Our debates often have degenerated into diatribes about whether government should attempt to steer the direction of the nation’s economy by selecting for favorable treatment certain “industries of the future,” or leave it to the market to decide who comes out the winner. Some liberal interventionists have talked wistfully of tripartite boards comprised of business, labor, and government, which would plot industrial strategies and outcomes. Free marketeers have argued in response that the government is incompetent to pick winners, and that any such attempt would just end up as another trough at which the special interests fed. The debate has been less than edifying.5
The debate should be about how the market can be better organized to stimulate new knowledge and skills. The government has already tipped the scales in certain directions: Countless decisions about taxes, publicly sponsored research and development, the enforceability of commercial contracts, defense procurement, the organization of banks and securities markets, labor, patents and copyrights, antitrust, and international trade (to name only a few pertinent areas) influence how the American economy is evolving. Because each industry6 has a distinct competitive position relative to all others—based upon the costs it bears and the markets it serves—any seemingly evenhanded rule is likely to affect it differently from others. The notion of “neutral” policy is simply fantasy. Even something so apparently neutral as tax depreciation rules for plant and equipment alters the relative prospects of industries whose competitive success hinges on the careful hiring and training of personnel or on the use of sophisticated marketing techniques (the costs of which can be deducted in the year they occurred) vis-à-vis those that depend on factories and machines. Gross disparities in effective rates of corporate income tax among industries7 have been due not so much to tax breaks targeted to particular groups of firms as to differences in the ability of firms to take advantage of superficially neutral deductions and credits. Notwithstanding the determined efforts of tax reformers—which in 1986 did indeed manage to eliminate some of the less rational disparities—no conceivable tax system can raise revenue with no effect on the structure and dynamics of the economy. The same general point applies for every other rule of the game. Most industry lobbyists—and not a few legislators and government officials—well understand that no rule, however neutral in appearance, is neutral in competitive effect.
Disparities in effect are inevitable as new circumstances impel the design of new rules. A sampling: Should copyright protection be extended to cover computer software? This decision would profoundly affect the development of computers and semiconductors. If no copyright protection is granted, then each semiconductor and computer manufacturer will have a strong incentive to copy another’s software rather than invest money in designing its own. This in turn will create winners out of smaller or more backward segments of the industry, including upstarts in South Korea and Taiwan, at the expense of industry leaders like IBM. It could also be expected to reduce the ardor with which inventors devised new software. On the other hand, a decision that software can be copyrighted would make it difficult for smaller firms to produce peripheral equipment or programs compatible with leading computers, whose innards they could no longer copy. This would have the effect of shouldering them out of the market, and boosting the market power of IBM. Either way, the pace and direction of technological change (and work force experience) will be affected.8
Should coal slurry pipelines be authorized to lay their pipes beneath railroad lines?9 An affirmative answer would alter both the energy industry (enhancing the competitiveness of coal, reducing that of oil) and transportation (boosting the pipelines, hurting the railroads, which would then carry less coal to market). Should the government grant fiber-optic cable systems rights of way along interstate highways? An affirmative decision here would spur fiber-optics, but stall the development of communications satellites, which compete with fiber-optic cable for data transmission.
The list of such questions can be extended indefinitely. Each decision affects how the economy evolves and the sorts of skills and knowledge that will be generated as a result: What computer language should the Defense Department adopt so that its complex networks of military hardware can “talk” to one another? This choice would alter the relative competitiveness of several high-technology industries and firms, each of which has invested in different computer languages and standards. How long should proprietary drugs maintain their patent protection? A decision here would shift the balance between proprietary and “generic” drugs, and determine both the cost of prescriptions today and the pace of drug research and development. Should large firms be permitted to band together in research joint venture, which might spur the pace of technological advance but cut competition? And so on.
America’s competitiveness is directly at stake in many of these choices. In 1982, for example, a federal judge approved the settlement of a government antitrust suit to break up AT&T, the world’s largest corporation, into seven regional holding companies—“Baby Bells”—and a new, but far smaller, AT&T. This decision boosted competition and reduced prices on long-distance telephone service. It also opened a vast new market to Japanese producers of telecommunications equipment. They could now sell their private-branch-exchanges, fiber cables, cellular phones, digital networks, and other gadgets to the new Baby Bells, who before had got all their equipment from Ma. The decision to dismember AT&T also altered Bell Labs, AT&T’s research arm, which had functioned as a kind of national laboratory for developing new technologies in transistors, semiconductors, and advanced electronics. Before the breakup, Bell Lab’s research had been financed, in effect, by all of us through our telephone bills. But the new, more competitive AT&T could no longer afford such luxuries. Bell Labs shrunk, and much of its work was redirected toward more immediate applications. Thus a national telecommunications policy with major consequences for America’s place in the world economy was set by a solitary unelected judge.
None of these decisions turn on whether the government should “intervene” in the market, but on how competition within the market should be organized. It is impossible for government not to make these sorts of decisions. A decision not to decide simply forces private parties to rely on prior decisions, or else creates uncertainty in areas where the prior decisions offer no clear guidance for what the market rule should be. Because technologies, tastes, and industries are forever changing, new questions are always arising, and prior decisions are often inadequate.
The debate over whether government should embark upon a centralized “industrial policy” has tended broadly to miss the point. Our government and every other is continuously engaged in devising industrial policies through their market-structuring decisions. Indeed, the key to Japan’s successful industrial policy has lain not in any elaborate plans emanating from MITI, but in an industrial structure that has been designed and redesigned for the express purpose of pushing Japanese industry (and Japanese workers) into ever more complex and efficient production, thereby enriching their experience and extending outward the frontier of their production possibilities as quickly as possible. Their rules of the game (taxes, public procurement, the organization of banks and labor, and so on) are tilted in favor of the rapid accumulation of new knowledge and skills.
In the United States, by contrast, the pattern of winners and losers that has resulted from our implicit industrial policy is typically of the “do-it-yourself” variety—spearheaded by the most politically active and sophisticated industries, firms, and labor unions. The pattern bears no particular relation to those economic activities that could be expected to advance as the American work force gained experience and skill in applying new technologies. Our resulting industrial policy has lain fragmented and hidden from view while the larger choices it embodies have never been clearly posed.
The problem is one of focus and interpretation. The deregulation of airlines has benefited consumers, but so has the regulation of toxic chemicals. The point is that many of the most important choices have nothing to do with the grand mythic division between free markets and control. When almost every discussion about the unwanted or the desirable side effects of corporate activity becomes shoehorned into a debate over the relative merits of centralized planning or a decentralized market, we lose the capacity to design the market in accordance with our values. We thus miss opportunities to better match corporate conduct to public goals through the market. Our cycles of righteous fulmination against, in turn, meddling bureaucrats and irresponsible executives have tended to elicit the worst of both worlds—a rigid tangle of rules that fails to enforce effective accountability. This is particularly lamentable, since it is entirely within our organizational and analytic powers to achieve a good deal more of the best of both.