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Three Economists Had the Answer to the President's Questions

Last night at the State of the Union, the President asked three questions regarding domestic policy (I’ll leave the foreign policy question to others). They were:

First, how do we give everyone a fair shot at opportunity and security in this new economy?

Second, how do we make technology work for us, and not against us – especially when it comes to solving urgent challenges like climate change?

And finally, how can we make our politics reflect what’s best in us, and not what’s worst?

These three questions are best answered by three great economists, Joseph Schumpeter, Ronald Coase, and Friedrich Hayek.

First, how do we give everyone a fair shot at opportunity and security? Schumpeter’s answer would be that we must allow creative destruction. As anyone who invested in Borders Books will tell you, if someone like Amazon comes along with a better idea, then an old industry will fall and a new one, providing more opportunity than the one before, will replace it. That is the process of creative destruction. But all too often we don’t allow the process to take place. Innovators and entrepreneurs are often denied opportunity by special interests that have worked with authorities to create rules that are barriers to creative destruction.

Getting rid of these rules, or refusing to create new ones in the case of wholly unforeseen technology like Uber, is key to allowing the process of creative destruction to take place. Creative destruction always creates new opportunities.

What about security? Creative destruction actually makes society wealthier as a whole. Jobs lost in old industries are generally replaced by jobs in newer, better quality industries providing yet more opportunity (see the tables in the article linked above for examples).

There will of course be some people who lose out in creative destruction – people just below retirement age, for example. The answer to increasing their security is to allow creative destruction to take place in the provision of welfare. The book After the Welfare State, edited by Tom Palmer, has a host of ideas of how we can apply creative destruction to current institutions to make people more secure.

Second, how do we make technology work for us? Ronald Coase has the answer there, which is allow technology to reduce transaction costs. This is what has happened in the case of Uber, which is an excellent example of how technology benefits people by reducing transaction costs. Transaction costs, which Coase originally called marketing costs, are (to put it very simply) the costs (time, money, uncertainty, etc.) involved in selling or obtaining a service. If someone wanted to have someone take them from point A to point B quickly it used to be that they would have to stand on a street corner and attempt to hail someone, perhaps taking 15-20 minutes, ending up with a stranger pulling up about whom they knew nothing other than that a local authority had granted them a license, or call a company and wait an uncertain length of time for a stranger to show up at your door, again with no validation other than the bureaucrat’s stamp of approval. Today, technology has significantly reduced those costs. In many cities you can get a car minutes after pulling out your phone, with a specified arrival time, and a rating by other customers like you of the level of service provided. The technology is working for us so well that there are early indicators that drunk driving is decreasing in cities with ridesharing services, saving lives, and that car ownership is also falling, significantly reducing the cost of underused capital. Meanwhile, ridesharing drivers are seeing a return on their own previously underused capital.

Ronald Coase also had the solution to environmental concerns as well. He identified pollution and other forms of environmental degradation as arising when property rights were not properly identified and the transaction costs of bargaining to allow win-win solutions were too high.

Finally, how do we make politics reflect what is best in us? Friedrich Hayek would have regarded this question as exemplifying the “knowledge problem.” How do we know what is best for us collectively? Only by the revealed preferences of people acting freely in markets. No mastermind can devise a moral plan for us all. Indeed, this insight goes back to Adam Smith, whose companion work to The Wealth of Nations, The Theory of Moral Sentiments, pointed out that reciprocity, the better part of our nature—the propensity to gift things of value or favors—is fundamental to our behavior. Combined with the “invisible hand” of the market, the totality of human behavior can be both self-interested and concerned for others at the same time.

Indeed, as Nobel laureate Vernon Smith put it,

As humans, we are born social exchangers, much as we are born to learn naturally, without being taught, any language we hear spoken around us, which language becomes the communication basis of social exchange. In this sense, the property rights that support these spontaneous exchange systems are natural, and it is natural for formalized societies to embody such rights in legal codes that mirror the vast human experience captured in exchange practices.

In other words, for our politics (in the broad sense of our political institutions) to reflect what is best in us, we should allow the market (again, in its broadest sense, including the market of ideas) to operate. Any attempt to dictate morality by tinkering with institutions and rights will almost certainly backfire, as no-one has the knowledge to be certain of a better outcome.

In other words, Mr. President, the answers to your three questions can be found in the work of free market economists.