"There is an equivalence between a tariff and a quota as these are drawn on the blackboard...They are not, however, equivalent in practice. A tariff and a quota generally involve different institutional frameworks...With the quota, the distribution of sales across vendors and the specific types of products sold are not determined through ordinary commercial arrangements. Rather, they are determined through a political process where those who hold offices of political power are able to award allotments to the particular vendors that those holders of power choose. A quota necessarily injects venality, inequality, and hierarchy into political practice and changes the character of effective commercial conduct."
--Richard E. Wagner
One of the most important ideas of the late Nobel Laureate Friedrich Hayek was the concept of "spontaneous order." This can be a difficult concept to explain.
When spontaneous order exists, we take it for granted and make little effort to understand it. If your body is healthy, you do not need to think about how your muscles work, how your heart and brain function, or how your metabolic processes operate. You only notice it when order breaks down, and you are sick or in pain.
Similarly, when the economy is functioning properly, we do not notice all the behaviors that are required to make it work. We go to the supermarket and find grapes available, and we do not wonder why or how.
In theory a central grape distributor could be at work. A single entity could try to assemble all of the information that pertains to grape production and grape consumption. In addition, the grape-distribution czar would master all of the details of storage and transportation systems. Using this information, the czar would send instructions to all of the individuals involved in production, storage, and distribution, telling them what to do and where and when to do it.
In practice, there is no grape-distribution czar. Grapes make their way from distant lands to your neighborhood supermarket via a series of local decisions guided by prices and self-interest. No one person has all the information necessary to direct the distribution of grapes properly. But each participant, guided by prices, knows what to do. Their collective interaction results in grapes available at nearly all supermarkets nearly all the time. This is an example of spontaneous order.
Disorder in Gasoline, 1974-1975
One characteristic of the order created by markets is that there are no persistent shortages or surpluses. This in turn means that people do not crowd into lines or fight one another to obtain goods and services.
If you want to see disorder, all you have to do is implement price controls. Price controls create shortages or surpluses, and the result is chaos. The failure of the Soviet economy reflects that disorder.
We saw an example of Soviet-style economics in the United States in the mid-1970's, when we maintained price controls on gasoline. This was in response to the Arab oil embargo.
In Oil Econ 101, I explained that because "oil is oil," it is not really possible to boycott Saudi oil. If we do not use Saudi oil, someone else will. The oil we use will come from country X, and Saudi oil replace the oil of country X somewhere else.
The same logic says that the Saudis cannot boycott us. If they stop selling to the United States, but they continue to supply their oil to the market, then we will get more oil from other countries instead.
If markets had been allowed to operate in 1974 and 1975, the effects of the oil embargo almost surely would have been minor and temporary. Instead, price controls created a massive disorder.
Because gasoline prices could not rise, there was no natural incentive to increase supply or to curtail demand. The result was a shortage.
As people found that gasoline stations were occasionally running out of gas, they reacted by raising their demand for gasoline. Whenever you saw a station that had gas, your impulse was to fill up, because you did not know whether the next station you passed would be out of fuel.
If there were order, your normal reaction to seeing a line at a gas station would be to pass up the station in order to avoid wasting time in the line. But with the disorder of price controls, your reaction was the opposite. Seeing a line meant the station had gasoline, so your impulse was to join the line! At some stations, hundreds of cars lined up, and occasionally tempers flared and fighting erupted.
Those of us who lived through the gasoline crisis of 1974-1975 will never forget the frustration, perverse incentives, and absurdity of the disorder caused by price controls. That is why very few experienced politicians argued for price controls after Hurricane Katrina shut down many oil refineries.
Rent Control and the Minimum Wage
Another example of a disorder created by price controls is the market for rental housing in New York City. The annual construction rate of new apartments in New York is less than 10 percent of what it was in the 1920's. For many renters, the net result is higher cost of renting. However, instead of this rent going to landlords where it would induce supply, it goes to people taking advantage of the system. Brokers earn fees for finding people apartments. People who sublet their rent-controlled apartments earn profits from tenants. This disorder makes for high cost to renters while short-circuiting the process by which higher rents would encourage more apartment construction. Of course, as supply has been held back, the true cost for renters has risen, which only reinforces the demand for controls. For sixty years, New York has been in a vicious cycle of price controls and undersupply.
The minimum wage is another example of a government policy that fosters disorder. Harvard economist Greg Mankiw aptly describes the minimum wage as:
- A wage subsidy for unskilled workers, paid for by
- A tax on employers who hire unskilled workers.
What difference does it make whether you address substance abuse with taxes, as we do with alcohol and tobacco, or with prohibition, as we do with cocaine and heroin? There is a sense in which the two approaches lead to similar results--an increase in price and a reduction in available supply. However, the tax maintains order while prohibition produces disorder.
As Richard E. Wagner points out in the essay quoted at the beginning of this article, the spontaneous order of the market can adapt to a tax relatively easily. However, when government tries to control supply, disorder emerges. Profit opportunities are created in crime and corruption. Compare the crime and mayhem in the market for drugs with that in the market for cigarettes. Or compare the disorder that resulted from alcohol Prohibition with the order that prevails today.
The Great Depression
I have argued that the spontaneous order of the market system serves to head off incipient shortages and surpluses. However, during the Great Depression, there was a long period of high unemployment--a surplus of labor. This makes the Depression an important episode in economic history.
Most economists believe that the Depression required a disruption to the financial order as well as a disruption in the wage-setting mechanism. I believe that the most important financial disruption was the run on banks. As I pointed out in my essay on recent financial turmoil, financial intermediation involves the management of risk by the intermediary. If I trust the intermediary, then I lend my money at a low risk premium, and the intermediary can pass this along to the borrower. If I lose trust in the intermediary, then the risk premium goes up. At the onset of the Great Depression, people lost trust in banks, many banks closed, and financial intermediation was curtailed. The most prominent exponent of this theory of the financial causes of the Depression is none other than the current head of the Federal Reserve, Ben Bernanke.
The cause of labor market disorder is somewhat more difficult to pin down. In theory, an excess supply of labor should cause wages to fall, until additional demand and reduced supply have eliminated the surplus. There are some intrinsic reasons that this mechanism works less well in labor markets than in other markets, but I think that President Roosevelt's New Deal policies, which were intended to boost wages and prices through cartel mechanisms, played a role in prolonging the disorder. See Amity Shlaes' The Forgotten Man.
In any case, the disorder of the Great Depression was a traumatic experience. To this day, many people distrust the market system because of the breakdown that occurred in the 1930's.
Today, the most important issue with a potential to create disorder is the desire to reduce emissions of carbon dioxide. The most orderly way to achieve such a reduction would be through taxes. The next most orderly way would be through an auction of tradable permits.
Disorderly ways to reduce carbon emissions include emission controls and "cap-and-trade" systems where the government assigns caps to specific industries. These sorts of approaches insert politics into the process at a narrow, personal level, ensuring widespread and persistent lobbying, cronyism, and corruption.
Oil, Aid, and Populism
In The Bottom Billion, Paul Collier points out that countries with a lot of wealth concentrated in a natural resource, such as oil, tend to function poorly. When people have to work to earn wealth, there is order. When wealth is there for the taking, then people focus on exactly that--taking. The rewards go to those who know how to use violence and power. Ironically, countries that are rich in resources are "cursed," because the disorder caused by the fight over ownership undermines the wealth of the resources themselves.
Foreign aid can have the same impact as a resource. It can foster disorder by creating a climate in which ambitious people, instead of engaging in productive activity, fight for control over the distribution of aid.
Populist economics, as propounded by a John Edwards or practiced by a Hugo Chavez, is a recipe for disorder. It tells people that they do not have to earn wealth. Instead, the government will redistribute wealth to its consiosing policies that would exacerbate disorder.
In the United States, I hope that enough people appreciate the spontaneous order of markets to keep the politicians at bay.