Tag Archives: United States

Do We Need a Strategic Cherry Reserve?

What do national public interest and cherries have in common? If you follow national politics on a regular basis, the answer probably will not surprise you. It is federal regulation. This week, the USDA issued an interim rule that revised the deadlines for cherry growers submitting their plans to comply with or applications to divert from the centrally planned production of tart cherries. The plan is approved each year by the Cherry Industry Administrative Board, which is elected by cherry growers. The USDA has the power to sanction any grower that deviates from the plan. Yes, the United States has a federally imposed cartel for cherries (among many other agricultural products; you can check here if your favorite fruit made the list). Take that, Canada.

The Agricultural Marketing Agreement Act, which gave the USDA power to regulate the volume of cherries produced in the country, originally passed in 1937. It is doubtful that it had much economic rationale back then (other than granting privilege to favored interest groups). It certainly makes little sense today. Granted that as a key ingredient in cherry pies tart cherries are dear to many Americans, but counting them as “agricultural commodities with a national public interest,” as the federal government does under the Act, is at best an overstatement. In the end, the best way to protect the national public interest is to for the federal government to stop telling farmers when and how to grow their crops.

Why do almost all economists oppose U.S. farm policy?

There are many policies about which economists disagree. To read the news you might think that economists disagree about everything. In reality, there are plenty of areas in which the economics profession has reached a consensus. One is farm policy. Economists from Greg Mankiw to Paul Krugman oppose the “insane” (Mankiw’s word) and “grotesque” (Krugman’s) handouts to farmers that constitute U.S. farm policy. More broadly, Robert Whaples has found that more than 85 percent of surveyed economists oppose agricultural subsidies. (I’m willing to bet that many of the remaining 15 percent also oppose agriculture subsidies but are uncomfortable ending them cold-turkey).

Why is there so much agreement on this issue? Here are a few thoughts.

Subsidies and Price Supports Create Dead Weight Losses

U.S. farm policy is a grab bag of over 80 separate programs with confusing names like the “shallow loss program” and the “dairy indemnity program.” But for all the arcane language, the programs match pretty neatly to the simple microeconomic models that we teach undergraduate economics majors. They are price supports, they are subsidies, or they are barriers to trade. And whatever they are, they are inefficient.

Consider the Dairy Product Price Support Program. According to the CRS, it “specifies minimum purchase prices of: block cheese, $1.13/lb.; barrel cheese, $1.10/lb.; butter, $1.05/lb.; and nonfat dry milk, $0.80/lb.”

With the mandated price set above the market price, consumers gain less from exchange than they otherwise would and producers gain more than they otherwise would. Importantly, though, the simple economic model of a price floor (see below) tells us that consumers lose more than producers gain. Economists call this “dead-weight loss.”

Minimum PriceOr consider the Direct Payments program. According to the CRS, it pays growers of “wheat, corn, grain sorghum, barley, oats, upland cotton, rice, soybeans, and other oilseeds” a fixed subsidy that does not vary according to the market price. This effectively lowers the marginal cost of production, lowering the price and increasing the quantity sold. In this case, producers and consumers gain, but taxpayers lose. Moreover, the simple producer subsidy model tells us that taxpayers lose more than consumers and producers gain. Thus, this program too creates a dead-weight loss.

SubsidyNo Coherent Story of Market Failure or Imperfection

These interventions might be rationalized by some sort of story about market imperfection (externality, monopoly, asymmetric information, etc.). But as a commodity industry with so many producers and so many consumers, agriculture is much closer to the textbook ideal of a perfectly competitive industry than one plagued by market failure.

Safety Nets for People Not for Firms

“Well yes,” a champion of farm policy might reply, “but poor American farmers deserve a safety net.” Lots of economists (even Milton Friedman and F.A. Hayek) have conceded that publicly-funded social safety nets might be worthwhile. But these nets should catch people when they fall, not the firms that these people work for. The farm safety net makes even less sense when you dig into the numbers. As Vincent Smith has shown in his recent Mercatus paper, average household farm income is substantial greater than overall average income. Moreover, about 80 percent of direct payments go to the largest 15-20 percent of farms and a majority goes to the top 10 percent “whose owners, for the most part full-time farm operators, typically earn many times the national average household income.”

As Smith points out, many in the farm lobby claim that farmers need the safety net because they are in a particularly risky line of business. But, he says, this claim doesn’t stand up to scrutiny:

Farms fail at an annual rate of 0.5 percent: only one in every 200 farms goes out of business because of financial problems.24 By comparison, the annual business-failure rate is over 7 percent, 14 times greater. Among small nonfarm businesses, the companies most comparable to farms in terms of sales, the failure rate is about 14 percent, almost 30 times greater than among farms.

The farm safety net makes even less sense when you think about justice on a global scale. Daniel Sumner explains it well in his Agricultural Subsidy Program entry in the Concise Encyclopedia of Economics:

Some of the poorest countries in West Africa have traditionally been cotton exporters. In 2001 and 2002, they faced a world price of cotton ranging from thirty-five cents to forty-five cents per pound. Meanwhile, cotton growers in the United States, the world’s largest exporter, received seventy cents or more per pound from the subsidies plus the market price. Economists have estimated that U.S. exports of cotton would have been substantially lower, and the world price of cotton 10 to 15 percent higher, if U.S. cotton subsidies had been unavailable during this period. Reducing farm subsidies in the United States and other rich countries would help poor cotton growers and other farmers in poor countries, and, moreover, would begin a process of relying more on trade rather than aid for economic growth.

Given the near-consensus among economists, why does the U.S. continue this grotesque and insane experiment? I’ll explore this question in subsequent posts.

Delaying the Rearview Camera Rule is Good for the Poor

A few weeks ago, the Department of Transportation (DOT) announced it would delay implementation of a regulation requiring that rearview cameras be installed in new automobiles. The rule was designed to prevent backover accidents by increasing drivers’ fields of vision to include the area behind and underneath vehicles. The DOT said more research was needed before finalizing the regulation, but there is another, perhaps more important reason for delaying the rule. The costs of this rule, and many others like it, weigh most heavily on those with low incomes, while the benefits cater to the preferences of those who are better-off financially.

The rearview camera regulation was expected to increase the cost of an automobile by approximately $200. This may not seem like much money, but it means a person buying a new car will have less money on hand to spend on other items that improve quality of life. These items might include things like healthcare or healthier food. Those who already have access to quality healthcare services, or who shop regularly at high end supermarkets like Whole Foods, may prefer to have the risk of a backup accident reduced over the additional $200 spent on a new car. Alternatively, those who don’t have easy access to healthcare or healthy food, may well prefer the $200.

A lot of regulation is really about reducing risks. Some risks pose large dangers, like the risk of radiation exposure (or death) if you are within range of a nuclear blast. Some risks pose small dangers, like a mosquito bite. Some risks are very likely, like the risk of stubbing your toe at some point in your lifetime, while other risks are very remote, like the chance that the Earth will be hit by a gigantic asteroid next week.

Risks are everywhere and can never be eliminated entirely from life. If we tried to eliminate every risk we face, we’d all live like John Travolta in the movie The Boy in the Plastic Bubble (and of course, he could also be hit by an asteroid!). The question we need to ask ourselves is: how do we manage risks in a way that makes the most sense given limited resources in society? In addition to this important question, we may also want to ask ourselves to what degree distributional effects are important as we consider which risks to mitigate?

There are two main ways that society can manage risks. First, we can manage risks we face privately, say by choosing to eat vegetables often or to go to the gym. In this way, a person can reduce the risk of cardiovascular disease, a leading cause of death in the United States, as well as other health problems. We can also choose to manage risks publicly, say through regulation or other government action. For example, the government passes laws requiring everyone to get vaccinated against certain illnesses, and this reduces the risk of getting sick from those around us.

Not surprisingly, low income families spend less on private risk mitigation than high income families do. Similarly, those who live in lower income areas tend to face higher mortality risks from a whole host of factors (e.g. accidents, homicide, cancer), when compared to those who live in wealthier neighborhoods. People with higher incomes tend to demand more risk reduction, just as they demand more of other goods or services. Therefore, spending money to reduce very low probability risks, like the risk of being backed over by a car in reverse, is more in line with preferences of the wealthy, since the wealthy will demand more risk reduction of this sort than the poor will.

Such a rule may also result in unintended consequences.  Just as using seat belts has been shown to lead to people driving faster, relying on a rearview camera when driving in reverse may lead to people being less careful about backing up.  For example, someone could be running outside of the camera’s view, and only come into view just as he or she is hit by the car.  Relying on cameras entirely may increase the risk of some people getting hit.

When the government intervenes and reduces risks for us, it is making a choice for us about which risks are most important, and forcing everyone in society to pay to address these risks. But not all risks are the same. In the case of the rearview camera rule, everyone must pay the extra money for the new device in the car (unless they forgo buying a new car which also carries risks), yet the risk of accident in a backup crash is small relative to other risks. Simply moving out of a low income neighborhood can reduce a whole host of risks that low income families face. By forcing the poor to pay to reduce the likelihood of tiny probability events, DOT is essentially saying poor people shouldn’t have the option of reducing larger risks they face. Instead, the poor should share the burden of reducing risks that are more in line with the preferences of the wealthy, who have likely already paid to reduce the types of risks that low income families still face.

Politicians and regulators like to claim that they are saving lives with regulation and just leave it at that. But the reality is often much more complicated with unintended consequences and regressive effects. Regulations have costs and those costs often fall disproportionately on those with the least ability to pay. Regulations also involve tradeoffs that leave some groups better off, while making other groups worse off. When one of the groups made worse off is the poor, we should think very carefully before proceeding with a policy, no matter how well intentioned policymakers may be.

The DOT is delaying the rearview camera rule so it can conduct more research on the issue. This is a sensible decision. Everyone wants to reduce the prevalence of backover accidents, but we should be looking for ways to achieve this goal that don’t disadvantage the least well off in society.

The Economic Consequences of Misreading Statutes

When Congress adopted the Dodd-Frank financial reform law, it included a number of provisions that had nothing to do with financial markets.  One of these was a requirement that oil companies and other natural resources companies to report annually to the Securities and Exchange Commission payments they make to foreign governments in connection with extracting those countries’ natural resources.  Human rights advocates viewed the SEC’s disclosure system as a convenient tool for influencing how countries use their natural resource revenues.  The statute sets a bad precedent for using the SEC to accomplish goals unrelated to its mission.  To make matters worse, the SEC’s ruleinterpreted the statute in a way that would frustrate the SEC’s mission of protecting investors, fostering fair and well-functioning markets, and facilitating capital formation.   The rule was thrown out by a federal court today.

The SEC’s rule mandated that company’s disclosures—which were required to be very granular—be publicly available.  Because the requirement applied only to companies that file with the Securities and Exchange Commission, it would—in the SEC’s words—“impose a burden on competition.”  The SEC explained that affected companies “could be put at a competitive disadvantage with respect to private companies and foreign companies that are not subject to the reporting requirements of the United States federal securities laws and therefore do not have such an obligation.”  Rules like these are costly to companies and consequently serve as a disincentive for companies to list in the United States.  Moreover, because some countries prohibit public disclosure of the sort the rule required, the SEC acknowledged that companies “may have to choose between ceasing operations in certain countries or breaching local law, or the country’s laws may have the effect of preventing them from participating in future projects.”  Not a great choice.

The SEC was sued for, among other things, interpreting the rule in a manner that was a lot more damaging to companies than Congress intended.  The court agreed and threw the rule out.  The court faulted the SEC for reading the statute to require that company’s filings be made available to the public, when it plainly did not contain such a requirement.  Moreover, the SEC “abdicated its statutory responsibility to investors” by failing to even consider whether an exemption from the rule would be appropriate for payments in countries that prohibit disclosure.

The SEC’s unwillingness to exercise discretion afforded to it by Congress is just one example of how a regulatory agency’s actions can have real effects on the competitiveness of American companies and the returns to investors in those companies.

Where Are The Benefits From Recent Energy Efficiency Regulations?

On Tuesday, President Obama gave a speech announcing his new agenda to combat climate change. As part of his efforts to curb greenhouse gas emissions, the President and his administration plan on releasing a series of energy efficiency regulations, supposedly with the intention of reducing carbon dioxide emissions. The problem is, the vast majority of the benefits from many energy efficiency rules have nothing to do with reducing carbon dioxide emissions, and this is according to the government’s own estimates. Instead, agencies like the Department of Energy (DOE) are eliminating options for consumers, and then counting the loss to consumers as a benefit of regulating.

How do they do this? It all has to do with a relatively new field of social science known as behavioral economics. You can think of behavioral economics as the intersection of psychology and economics. Behavioral economists believe that people exhibit many biases that cause them to systematically act in ways that are out of line with their true preferences. In a lab situation, there are many examples of such biases that have been demonstrated. For example, a person buying a home may bid one price, but if she is selling the same house, she may require a higher price, implying she values the same object differently depending on whether the object belongs to her or not. Or, people may value objects differently depending on time. For instance, a person might choose to receive $100 today over $110 tomorrow, yet at the same time pass on $100 a year from now in exchange for $110 in a year and one day, implying the person is more impatient today than he sees himself being in the future.

As the chart below demonstrates, the Department of Energy recently finalized a regulation related to microwave ovens, and nearly 80% of the benefits of the rule stemmed, not from protecting the environment or public health, but from saving consumers money by preventing them from buying the products they would choose otherwise. DOE does not seem to understand why consumers might choose to pay a relatively low price today for a product that is not very energy efficient, when this person could buy a more expensive energy efficient product that will save money over the life of the product through lower electricity bills. From an economics perspective, DOE does not believe this behavior is rational, hence it is like one of the behavioral biases described above, and in many cases DOE has decided to ban the products it doesn’t like in order to protect consumers from themselves.

Energy Efficiency Benefits from DOE Microwave Ovens Regulation*

Capture4

Federal agencies are ignoring the fact that consumers may value other attributes of products aside from energy and fuel efficiency. With automobiles, consumers may prefer larger and safer cars, to smaller more fuel efficient vehicles. Restaurants may prefer light bulbs that raise electric bills slightly every month, but whose warm glow creates an ambiance that customers enjoy. And in the case of microwaves and laundry machines, it may be that machines that use more energy simply work better at their stated purpose. And it’s not just microwave ovens. DOE, and other agencies like the Department of Transportation and the Environmental Protection Agency, make this same type of assumption with other regulations, like rules impacting commercial clothes washers, light bulbs, and fuel efficiency standards for vehicles. Agencies even assume businesses are behaving in this manner. Does anyone honestly believe that trucking companies aren’t taking fuel efficiency into account when buying new fleets? Or that laundromat owners don’t consider electricity costs when purchasing new equipment? It seems highly implausible, but agencies are assuming just that.

For decades, agencies have been required to identify a market failure or other systemic problem that exists before intervening in the marketplace with a regulation. Market failures include things like a lack of competition, a lack of consumer information, or costs that spill over onto the public as the result of a private transaction. Now, agencies like DOE have begun to expand the definition of market failure to include what they deem to be personal failures on the part of consumers.

So why are agencies doing this? One reason may be because the environmental benefits alone aren’t enough to justify the costs of some regulations. Claiming additional benefits helps agencies justify an inefficient policy, and keeps government programs continuing to employ regulators. Agencies have other ways to make the benefits of rules appear greater too. In the case of the microwave rule, of the small portion of benefits related to carbon dioxide reductions, most will be captured by citizens of foreign countries, with only a small fraction going to US citizens. Counting benefits to foreigners makes the benefits of rules appear greater, even though agencies are asked to only consider benefits to the United States in most cases.

Another reason we may be getting these types of rules is the rules may really be intended to benefit special interest groups more than consumers. A manufacturer that is already producing an energy efficient product may capture market share by getting the products of its competitors banned. Or manufacturers may simply want to force consumers to buy a more expensive product, or replace old products with new ones, while eliminating the possibility of a competitor undercutting them by selling a cheaper product in the marketplace.

Reducing Carbon Dioxide emissions in order to combat climate change may be a noble goal, but recent energy efficiency regulations are unlikely to get us there. Rather than overriding consumer choice, and counting this loss to consumers as a benefit, DOE and other agencies should give the American people a more honest assessment of the benefits of their rules.

* Source: Department of Energy, “Technical Support Document: Energy Efficiency Program for Consumer Products and Commercial and Industrial Equipment: Residential Microwave Ovens – Stand-By-Power,” (Table 1.2.1.), May 2013. Calculated using a 3 percent discount rate. Assumes 15 percent of reductions in CO2 emissions are attributed to the United States. This is the midpoint between 7 percent and 23 percent, the range estimated by the Interagency Working Group on Social Cost of Carbon, “Technical Support Document, Social Cost of Carbon for Regulatory Impact Analysis under Executive Order 12866,” February 2010.

Does Washington, D.C. create value?

In recent remarks on the Senate floor, Senator Mike Lee (R-UT) contended:

There is a reason that six of the 10 wealthiest counties in the United States are suburbs of Washington, D.C.–a city that produces almost nothing of actual economic value.

This assertion prompted a fact check from the Washington Post’s Glenn Kessler. Kessler grants that Lee is correct in that “six of the 10 wealthiest counties are suburbs of Washington, D.C.” But he goes on to contend:

There’s not really an economic concept that equates to “tangible economic value,” at least as Lee seems to be suggesting. Thus it is hard to disaggregate activity ultimately benefiting from the federal government.

I think most economists would disagree. There is, indeed, an economic concept that distinguishes between “tangible economic value” and the lack thereof. The idea is called rent-seeking.

First, consider how people profit from voluntary exchange. If two parties voluntarily exchange, both expect to gain from the interaction. The consumer expects to gain some value from the product that is in excess of what he pays (otherwise he wouldn’t part with his money). And the producer expects to receive some price in excess of her costs, including the opportunity cost of doing something else with the product (otherwise, she wouldn’t part with the product). The sum of this consumer and producer surplus is called “economic surplus” and it is at the heart of economics. Indeed, it is at the heart of human progress.

Sometimes, however, the producer is the exclusive producer of the particular product. Her exclusivity could be natural (only Michael Jordan could do what he could do), or it could be contrived (by law, only the USPS is allowed to deliver non-urgent mail). Whether natural or contrived, exclusivity permits a producer to capture a larger share of economic surplus than she otherwise would. This above-normal producer surplus is a payment in excess of what would be necessary to bring the good to market. Economists call it an economic rent (and it has nothing to do with apartments).

Significant problems arise when exclusivity is contrived. One problem is that people will invest valuable resources–time, money, effort–into convincing those with political power to grant them an exclusivity. People will lobby. They will donate to campaigns. They will make products that politicians like instead of products that consumers like. All of this is potentially wasteful and it is called rent seeking.

It isn’t easy to measure the losses from rent seeking (though a few have tried). But I suspect this is exactly what Senator Lee had in mind. After all, Washington, D.C. Is the place people go to seek rent. Want to force people to buy your product? Go to Washington and seek an individual mandate. Want to make your competitors’ product more expensive than your own? Go to Washington and seek tariffs of up to 250 percent on foreign producers. Want to raise the production costs of your competitors? Go to Washington and seek a production standard that plays to your competitive advantage.

Rent seeking is hardly a fringe concept. Professors Roger Congleton, Arye Hillman and Kai Konrad have just released a two-volume anthology of rent seeking research called 40 Years of Research on Rent Seeking (I know; not cheap). They report that the EconLit database has over 401 academic journals and books with “rent seeking” in the title and that a Google Scholar search produces 1,500 papers include the term.

Mr. Kessler is right that much of what happens in D.C. is not rent seeking. But his assertion that only 40 percent of the region’s gross product came from government spending is hardly convincing. That isn’t just a “big chunk.” It’s a mammoth chunk. Moreover, it misses the fact that a lot of “private” economic activity in the region is still related to rent-seeking. See, for example, the K-Street corridor.

These critiques aside, the fact check missed a nice opportunity to educate the public on an important concept at the core of modern economics.

Economic Freedom and Economic Privilege

Heritage indexLast week, the Wall Street Journal and the Heritage Foundation released their annual Index of Economic Freedom by Terry Miller, Kim Holmes, and Edwin Feulner. I was delighted to contribute a chapter on government-granted privilege. I began by noting that despite the manifest evidence of a strong empirical link between economic freedom and economic prosperity, large numbers of people still lack basic economic freedoms.

In the latest edition of the Index, for example, 92 countries—home to nearly 70 percent of all of humanity—were listed as “mostly unfree” or “repressed.” Even among the freer nations such as the United States, economic freedom in recent years has been declining.

Why? I suggest two answers. The first is that ideas matter and we are currently losing the battle of ideas.

The second answer is more difficult:

Put simply, some entrenched interests benefit from the current lack of economic freedom and are prepared to go to great lengths to maintain the unfree status quo.

If this is not immediately obvious, it may be because the advocates of economic freedom often fail to emphasize it. Too often, those of us who argue for freedom highlight the fact that taxes are crushing, that regulations are burdensome, and that government involvement in the economy is an impediment to progress. While this is typically true, it is also true that tax dollars line the pockets of some well-connected companies, that regulations often allow some firms to profit at the expense of customers and competitors, and that almost every intervention in the market creates both losers and winners.

The chapter, adapted from The Pathology of Privilege, can be found here.

There are other interesting contributions from Robert Barro on “Democracy, Law and Order, and Economic Growth”; James Roberts and John Robinson on how “Property Rights Can Solve the Resource Curse”; and by Myron Brilliant on how “Good Business Demands Good Governance.”

Also, don’t miss Miller’s OpEd from the Wall Street Journal. It offers a nice overview of the latest data and a summary of the chapters. Lastly, be sure to spend some time exploring the data and the website. They’ve done a brilliant job of bringing all of this information together and presenting it in a user-friendly way.

My thanks to Heritage and especially to Terry Miller for the opportunity.

The Study of American Capitalism

(Note to readers: Three talks in three states over the last week have made me a terrible blogger. Thankfully, Eileen and Emily have stepped up where I have stepped down.)

Mercatus has now organized its work around government-granted privilege and crony capitalism under a new project called the Study of American Capitalism. We are thrilled that Celia Sandel has joined the Mercatus team to manage the project. If you are a scholar working or thinking about working in this field, please reach out to Celia. We’d love to hear from you.

Speaking of which, we’ve already released a number of excellent papers on the topic. And now, in no particular order:

In Crony Capitalism: By-Product of Big Government, Professor Randal Holcombe of Florida State University explores the links between government power and cronyism, writing:

The more government is involved in an economy, the more the profitability of business will depend on government policy. Even those entrepreneurs who would prefer to avoid cronyism are pushed into it, because they must become politically active to maintain their profitability. When the government looms large in economic affairs, businesses push for government policies that can help them, and try to avoid suffering harm as a result of government policies that can work against them. If one’s competitors are engaging in cronyism, avoiding cronyism means that one’s competitors will gain government-bestowed advantages.

In Government Cronyism and the Erosion of Public Trust, Professor John Garen of the University of Kentucky examines the relationship between cronyism and eroding trust in government. He writes:

Survey data show a large decline in trust in government, much of which has occurred while government grew rapidly. Evidence indicates that government growth has been associated with rent-seeking and cronyism, leading to a withdrawal of trust. Thus, cronyism—bad government— can undermine even the appropriate functions of government.

Professors Daniel Smith and Daniel Sutter of Troy University gauge public perceptions of the problem in Gauging the Perception of Cronyism in the US:

Cronyism can have real and significant costs, yet it is challenging to measure objectively. In fact, just the perception of cronyism can inhibit business formation, distort the allocation of entrepreneurial talent, and undermine support for free market capitalism. Refined measures of perceptions of cronyism among both business leaders and the public could help advance our understanding of cronyism and its effects on our economic system.

Last, but by no means least, my graduate-school colleague Professor Jeremy Horpedahl of Buena Vista University has teamed up with my current student, Brandon Pizzola, to explore the privileges that lurk in our tax code in A Trillion Little Subsidies:

Total tax expenditures in the United States are currently around $1 trillion, with over 80 percent accruing to individuals and the remainder to corporations. We review each of the ten largest tax expenditures for individuals and corporations, focusing on the following distortions of economic activity: spending on goods and services, capital allocation, the distribution of income, and lobbying and rent-seeking. The benefits of tax expenditures accrue disproportionately to higher-income earners, since they are more likely to itemize deductions and can afford to hire accountants to minimize their tax burden. Eliminating tax expenditures would increase economic growth and allow for lower tax rates, further increasing growth.

(Many) more to come!

If You Are Successful, Did You Do It On Your Own?

A lot of people are upset with the President’s remarks from last weekend. Here is what the President said:

[L]ook, if you’ve been successful, you didn’t get there on your own. You didn’t get there on your own. I’m always struck by people who think, well, it must be because I was just so smart. There are a lot of smart people out there. It must be because I worked harder than everybody else. Let me tell you something — there are a whole bunch of hardworking people out there. (Applause.)

If you were successful, somebody along the line gave you some help. There was a great teacher somewhere in your life. Somebody helped to create this unbelievable American system that we have that allowed you to thrive. Somebody invested in roads and bridges. If you’ve got a business — you didn’t build that. Somebody else made that happen. The Internet didn’t get invented on its own. Government research created the Internet so that all the companies could make money off the Internet.

I agree with those who believe the remarks seem to completely dismiss the role of the entrepreneur. I also agree with those who think the president is exaggerating the role of government. But in two important respects, I think it would be a mistake for free market advocates to dismiss the entire statement. In fact, we should embrace some of it.

First, the president is absolutely right to note that intelligence is not the only determinant of success. In fact, I expressed a very similar sentiment in my SPN piece:

What allows me and my fellow countrymen to command such salaries? I’d like to think work ethic or intelligence has something to do with it. But the truth is that those things can explain only so much. There are plenty in the bottom 99 percent with better work ethics and more intel­ligence than I. Most of the world’s unemployed and underemployed—the ones with nowhere to go and nothing to do—would jump at the opportu­nity to work hard and would excel if given the opportunity to do so.

Second, the president is absolutely correct that a person’s productivity is crucially dependent upon the “system” in which he or she operates. Too many free-market advocates get hung up on the ‘pull yourself up by your bootstraps’ mentality and miss this point. There is a reason more successful businesses are started in the U.S. than in Zimbabwe. It has nothing to do with the inherent business acumen of Americans and everything to do with our “system.”

As I point out in my SPN piece, those who move just a short distance across the border from Mexico into the U.S. increase their salaries more than 415 percent. What could possibly account for such a dramatic improvement?

Physical capital is surely part of it. Once on the American side of the border, the typical worker is more likely to work with machines that enhance her productivity. But an important World Bank study demonstrates that these differences in physical capital only account for a small fraction of the differences in productivity around the world.

Much more important are differences in “intangible assets.” These are factors that cannot be seen but nevertheless help determine our productivity. When a worker produces a good or a service, he uses more than the physical tools in his hand. As I wrote in the piece:

He also uses a legal system, which (ideally) ensures his contracts are honored. He uses a police force, which (hopefully) protects his property. He uses a curren­cy, which either affords him a reliable means of exchange or one that may lose its value at any moment. He depends on the honesty of government officials as they judge his compliance with the laws. Since governments require resources, he relies on the incentives of his country’s tax regime as it encourages or discourages him (and those with whom he does busi­ness) to work, save, invest, and consume. A worker even relies on the culture of his countrymen. Are they disposed to praise him for his hard work and business acumen? Or—like the Romans in their decline—will his countrymen save their plaudits for those who destroy goods in armed conflict rather than sell them in the marketplace?

It turns out that the U.S. has a much larger stock of such intangible capital than Mexico (the World Bank estimates it at $420,000 per capita in the U.S. compared with only about $34,000 per capita in Mexico). And this helps make a Mexican immigrant to the U.S. far more productive than he would be in his home country.

But here is the irony in the President’s statement: the enormous stock of intangible capital in the U.S. is mostly due to the country’s economic freedom, not its active government. Historically speaking, people in the United States have been some of the most-productive on the planet because they have been the most-free. Compared with citizens elsewhere, Americans have enjoyed better protection of their property, lower taxes, fewer and lighter regulations, greater ability to trade with foreigners, and more-sound monetary policy. Historically, business decisions in the U.S. have been more likely to be driven by consumer interests than by political considerations. Our culture has tended to celebrate entrepreneurship and risk-taking and we have been more willing to trust one another. I put all of this in the past tense because there is evidence that many of these things are less true now than they were twelve years ago.

But the basic point is that, historically, the “unbelievable American system” has indeed allowed Americans to thrive.

But the president is mistaken to imply that our “system” is superior because we spend more on roads or bridges, or because we invest more public capital in private R&D, or because we make more grants to start-up businesses like Solyndra. To the extent our system has succeeded, it is because it has allowed Americans more freedom.

It takes a village. A free one.

Puerto Rico Secretary of State on Government Reform

On my last post about government reform in Puerto Rico, a commenter pointed out that some of the trends indicating that the territory’s government is shrinking have reversed in the past year. Indeed, the number of government employees increased from 259,000 in December 2010 to 269,000 in December 2011. Likewise, government revenues ticked up in 2010 and 2011 after decreasing in 2008 and 2009.

I wanted to learn more about the reversal of the shrinking central government, so I spoke with Puerto Rico Secretary of State Kenneth McClintock about these trends. He explained, as the commenter pointed out, that the increase in government revenue is in large part due to an excise tax on foreign corporations that went into effect in 2011. This temporary tax is being used to finance broad-based tax reform and is gradually being phased out over the next five years when it will expire in 2016. McClintock explained that a six year plan for tax reform was one of the administration’s top priorities upon Governor Luis Fortuño taking office in 2008.

Reform measures have included cutting corporate tax rates from 39 percent to 30 percent and individual tax rates by 50 percent over the six year period. McClintock said, “Beginning in year one, everybody had more money in their pockets.” These reforms include a unique trigger. If Puerto Rico doesn’t achieve a balanced budget by the end of the six-year reform period, the final tax cuts will not go through. “We wanted to show people that good things happen with fiscal discipline,” McClintock continued.

Regarding the increase in government employees, McClintock said that part of the increase was due to stimulus funds from the American Recovery and Reinvestment Act and hiring by local governments. Additionally,  a negligible number of the initial cutbacks were deemed to be unsustainable and required refilling some positions that were eliminated in the initial round of cuts. Attrition policies are still in place, so longterm cuts should still be expected.

Initially, government job cuts raised Puerto Rico’s already high unemployment rate by about 1.2 percentage points. McClintock said that while hard data is not available on the individuals laid off from government jobs, anecdotally about half of them are now employed in the private sector. The layoffs included a $1 billion severance package which provided $5,000 for each laid off employee that they could use either to go to school or as seed money for a new business.

Of course, not everyone is as optimistic about the success of the territory’s reform efforts. As a blog produced by Center for the New Economy, a Puerto Rican think tank, reports, the tax reform program is not uncontroversial:

The control and reduction of government spending has stabilized the Commonwealth’s financial position.  Unfortunately, this stabilization is not cost free.  The implementation of this contractionary fiscal policy in the middle of a four year recession may have deepened and prolonged the economic recession in Puerto Rico.  Furthermore, the government’s pro-cyclical fiscal policy has been implemented at the same time that commercial banks in the island are undergoing a de-leveraging process that has significantly reduced the availability of credit.

As the article explains, some aspects of the tax reform plan may not point toward long run stability. The territory’s budget is increasingly reliant on federal funds with $1 of every $4 spent by the central government coming from federal transfer payments. Furthermore, debt service payments are increasing as a percent of Puerto Rico’s GDP.

While siginificant economic growth has yet to be seen coming out of the recession, economic indicators are looking better than when Governor Fortuño took office, despite about 12,500 government layoffs by the central government. Unemployment has fallen from 18 percent to under 16 percent and the Economic Activity Index reached positive territory in 2011 for the first time since early 2006. Some recent reforms will have staying power beyond Governor Fortuno’s term in office. The focus has been on improving Puerto Rico’s business climate relative to the states and neighboring countries by expanding trade and lowering taxes.

Reducing bureaucracy has also been a priority. “So far we have approved 11 of 13 reorganization plans to consolidate and eliminate agencies,” McClintock explained. He also said that many of the barriers to the renewable energy industry have been eliminated, leading the territory to become home to the largest wind and solar farms in the United States.

Puerto Rico is also pursuing an institutional change that could reduce long run spending. In August, Puerto Ricans will vote on an amendment to cut the number of legislators from 27 to 17 in the senate and 51 to 39 in the house of representatives. As research from Jowei Chen and Neil Malhotra demonstrates, state spending is likely to decrease with fewer state senators and with a higher ratio of representatives to senators.

Matt Mitchell and Nick Tuszynski covered their research in a literature review, and Matt estimates that these changes could be expected to reduce spending in Puerto Rico by about $77 per person yearly. The change to the legislature would take place ahead of the 2016 elections. McClintock said that this proposal is the result of “courageous legislators who are thinking from the people’s perspective rather than their own. It’s only natural that after cuts in the administration, people would expect cuts in the legislature as well.”

Many of the changes in Puerto Rico could be implemented in states looking to streamline government, particularly their tax reforms and triggers to provide incentives for voters to act as watchdogs to be sure that fiscal discipline is carried through.