Failure & Progress: The Bright Side of Dismal Science

Preface

By any measure of economic success, socialism has been a total failure. The hope of socialism was that it would promote wealth and distribute it fairly by transferring power away from capitalists interested only in profits and giving more control to political representatives concerned with economic growth and social justice. That hope has been dashed. Socialism has succeeded only in providing special privileges to a few by imposing grinding poverty on everyone else.

With socialism a sinking ship, the goal in country after country that has been impoverished by the legacy of Karl Marx is to achieve the wealth-creating power of capitalism. The most dramatic examples of the rejection of socialism and the move to embrace capitalism have come from countries of Eastern Europe and the Soviet Union itself-countries that have experienced the poverty of socialism firsthand. But countries in Africa, South America, and other parts of the world that had been beguiled by the false promises of socialism also are anxious to trade socialism for capitalism.

Although the embrace of the market economy has been widespread, it has also been cautious. Many people want the wealth created by capitalism, but they also perceive the marketplace as being harsh, callous, and unfair. Isn't the market place littered with the victims of those who have suffered the failure of bankruptcy, unemployment, and poverty at the unmerciful hands of market competition? Isn't there some way to accept the wealth that capitalism offers without having to endure the constant failures it imposes? The calls have been for a market economy with a human face or for a third way between the productivity of capitalism and the compassion of socialism. And there is no end to politically inspired proposals to reform the marketplace to protect its innocent victims.

However, contrary to the wishes of persistent critics, capitalism is a bundle of coherent and inextricable attributes. Of course, it would be nice to unbundle the economic package known as capitalism, or the free market, and keep the sweet while rejecting the bitter. It would also be nice if everyone had an above-average income. Unfortunately, the only way to avoid the failures that result from capitalism is to pass up the wealth that results from capitalism. Failures in the marketplace serve an indispensable function in the production of wealth; they provide both information on the most productive use of resources and the motivation for people to respond appropriately to that information. Failures are part of the steering mechanism that directs an economy toward prosperity. Attempting to improve the marketplace by preventing economic failure is equivalent to attempting to improve an automobile by removing the steering wheel. It is no surprise that socialist economies that were applauded initially for eliminating unemployment, bankruptcies, and economic failure of every variety have themselves been colossal economic failures. By allowing economic failures in the small, and converting these failures into useful information, market economies have produced economic success in the large. In economics, overall success depends on a constant supply of small failures.

As economists, we favor the market as the best means for organizing most economic activity. Thus, we believe it is important that the role of economic failure be understood as necessary to the advantages derived from the marketplace. Conveying that message is our overriding objective in this book. There are six important points that are developed and that can be briefly covered here.

First, although economic failure is a positive force in a market economy, it has to be recognized that there is no economy, market or otherwise, that stands apart from the political process. Every economy is a political economy, and for the very reason that economic failure promotes wealth in the marketplace, it also promotes political responses that can undermine the market process. A public understanding of the importance of economic failure is the best way to moderate harmful political responses to that failure. The lack of understanding of the essential role of economic failure stands as the biggest political obstacle to achieving free-market prosperity in formerly socialist countries. The same lack of understanding also prevents the market process from yielding the full measure of its potential wealth in those political economies that are predominantly capitalist.

Second, it is easy to see the failures imposed by the market as isolated occurrences rather than as an integral part of a wealth-creating process. When economic failure is viewed in isolation, it is natural to see it as unnecessarily harsh and unfair and to conclude that government can protect people against such failure' without harming economic productivity. And if government can, at little cost, protect people against failures unfairly imposed upon them by market forces, then surely social justice must require that it do so. But government cannot protect everyone against failure. The best government can do is to protect a privileged few against failure by diminishing the opportunity for success of everyone else. Obviously, such special-interest protection is neither efficient nor fair.

Third, and ironically, for the very reasons that it is both more efficient and fair than alternative economic systems, the market economy appears to be unfair to the superficial observer. The efficiency of the market process derives from the fact that it holds people accountable for the costs of their actions. Those costs are concentrated on market participants in ways that are difficult for them to ignore, and they are commonly imposed through the harshness of bankruptcy, unemployment, and other forms of economic failure. Although this market accountability conveys long-run benefits on all by promoting productivity, each economic interest group prefers to be protected against the accountability of the market while benefiting from the accountability the market is imposing on others. In the marketplace, such free riding on the contribution of others is not allowed, and that is the basis for the fundamental fairness of the market. In the marketplace, all people have to contribute to the general well-being by accepting the failures as well as the successes that come their way. However, because the benefits from market accountability are general, they are easily ignored and taken for granted. Because the costs and failures of market accountability are concentrated, they easily dominate the public's perception of the market and create the impression of unfairness. Indeed, the failures inflicted by the market appear all the more unfair against the backdrop of the economic success made possible by those failures.

Fourth, for the very reasons that the political process is typically less efficient and fair than the market process, it appears to be fair to the superficial observer. A major source of the inefficiency resulting from the political process derives from the fact that it provides opportunities for people to acquire benefits without being held accountable for the full costs. Political action commonly con· centrates benefits on a well-organized few while spreading the costs thinly over the general public. As opposed to the fairness of the market process, the political process encourages some to free ride on the contributions of others. Because political benefits are concentrated, however, they are easily noticed, greatly appreciated, and readily associated with particular policies and politicians. Because the costs are spread over so many, they are easily ignored. The impression conveyed is that the political process prompts generosity and mitigates the unfairness of the marketplace. And the larger the number of people receiving political benefits and the poorer the market operates because of the increasing burden of government, the more fairness seems to demand extending political benefits to yet additional recipients.

Fifth, the impression that failure in the marketplace is unfair and government action to moderate that failure is fair is accentuated by special-interest politics. No matter how well a group is organized politically, it is not likely to be successful in obtaining special-interest subsidies, protections, and other exemptions from the discipline of market competition if it tries to argue that its members want to benefit at the expense of the general public. A far more effective argument for a special interest is that both it and the public interest are being threatened with bankruptcy, job losses, and dislocations by unfair market forces. Whether it is farmers facing foreclo-sure, steelworkers facing indefinite layoffs, or Chrysler Corporation facing bankruptcy, the group's chances of appealing to public compassion and obtaining political protections against market pressures are increased with a persuasive argument that those pressures are unfair.

Sixth, with public compassion being exploited by interest groups using economic failure as a pretense for capturing special privileges, the result is unlikely to be very compassionate. There are certainly people who, for reasons beyond their control, are left behind in the marketplace and who deserve sympathy and help. Unfortunately, those who need help the most are the ones whom political action in the name of compassion helps the least. Pointing to the problem of poverty has long been the most effective way of disparaging the market economy and persuading the public that, in the absence of government programs, the marketplace would be littered with the poor and the desperate. What has been almost completely ignored is the government's impotence in helping the poor. Indeed, various studies suggest strongly that, by reducing the productivity of the marketplace, government transfer programs have reduced the income of the poor. By concentrating attention on the economic failures in the marketplace to justify expanding political control over economic decisions, the influence of special-interest demands has been increased and the scope of economic failure has been enlarged.

This book was written with the conviction that unless economic failure is understood as integral to the successful performance of market economies, it will be seized upon by active political interests as justification for expanding government action that stifles general economic productivity for the short-run advantage of the politically influential few. As long as the economic failures that impose the guiding discipline in market economies are widely perceived as unnecessary and unfair, a threat remains to the prosperity of existing capitalist economies, and a roadblock stands in the path of economic progress in those economies that are trying to escape the blight of socialism.

Although our book is short, the list of people and institutions that assisted us in the writing of it is long. Our colleagues George Selgin, Richard Timberlake, and Larry White have read parts of the manuscript at various stages and have made useful comments. The Liberty Fund sponsored a conference around a long paper that served as the nucleus of the book. The written comments of Paul Heyne, William Mitchell, and Kenneth MacKenzie presented at the conference, as well as the general discussion, were responsible for numerous improvements in both the content and exposition of the final product. Thanks are also due to the Center for the Study of American Business at Washington University, where both authors were John M. Olin visiting scholars for a year (McKenzie during the 1985-86 academic year and Lee during the 1988-89 academic year) and where significant portions of the early writing on this book were done. Murray Weidenbaum and Kenneth Chilton provided many useful comments and editorial suggestions during this period. Kristin Johnson deserves special appreciation for her patience and skill in typing and retyping the manuscript, and for her insightful responses from the perspective of a noneconomist.

Dwight Lee would like to thank the Philip M. McKenna Foundation for the general financial assistance it has provided his work over the last few years. Richard McKenzie must thank the John M. Olin Foundation and the Lynde and Harry Bradley Foundation for supporting his work at times during the period this book was developed. Special thanks must go to the Earhart Foundation, which provided us with a joint summer research grant to put our earlier writing and thoughts into book form.

And finally, though she had no direct involvement with the writing of this book, we want to thank Betty Tillman of the Center for Study of Public Choice at George Mason University for her wonderful presence in our academic lives. We both spent important years at the Center for Study of Public Choice at Virginia Tech and George Mason. These years were more productive and pleasant because of Betty's competence, cheerfulness, and charm. We dedicate this book to her.

1. In Consideration of Failure

There is an old saying that success has many parents, but failure is always born an orphan. No one wants to experience failure or to be held responsible for it. Individuals go to great lengths to avoid failure, and when they are unsuccessful, as is persistently the case, they are easily convinced that the causes lie beyond their control.

Yet it is also recognized that the economic success of individuals, as well as the success of the general economy, depends upon failure. The person who is successful is typically one who has attempted difficult tasks and who has failed at many-often most-of them. Each failure provides information that the successful person pays attention to and uses in future endeavors. A critical feature of-and major reason fo-the success of decentralized market economies is that such economies send clear signals of failure in the form of depressed profits and prices to those who are making poor use of their resources. People either respond appropriately to these signals or experience personal economic failure in the form of losses that transfer their resources to others who will make more productive use of them.

Although people do recognize the importance of failure, typically they do so grudgingly. Their dominant reaction to failure is quite naturally a negative one. That is as it should be, given that it is people's intense aversion to failure, along with their equally intense desire for success, that motivate appropriate market responses to the information provided by prices and profits. But economic failure can motivate more than market responses. Individuals and organized groups often find advantage in taking political action in attempts to avoid the threat and consequences of economic failure. Their attempts are often facilitated by public opinion that sympathizes with those who have suffered financial hardship and that sees economic failure as a social problem requiring corrective action.

Not only do victims of economic failure see advantage in govern ment efforts to assist them, but large numbers of public employees have an interest in government programs that attempt to address problems of economic failure. Few academic researchers or government commissions study failure, except to lament its consequences and to formulate what they believe to be corrective solutions. The strong tendency is for the political process to concentrate on the negative side of failure and ignore the positive contributions to our economic well-being that flow from failure. This tendency is pernicious because it commonly leads to government activity that increases the general failure in the economy through inept attempts to reduce specific failures in the economy.

Because we, like others, are not fond of failure, we believe it is important to focus on the bright side of failures, especially the economic failures experienced in the marketplace. Our purpose here is not to simply lament the harm caused by failure but to study the conditions under which the failure that is inevitable can generate the most benefit. Economic failure is an understudied and underappreciated side of economic progress. By helping to develop a more informed and tolerant public opinion on failure, we hope to counter the public pressure that causes government to respond to failure with public policies that retard economic progress and promote greater failure. Indeed, our central thesis can be stated succinctly: failure is the nursemaid of progress, and vice versa.

Nevertheless, we fully recognize the emotional reaction to failures and the desire of well-meaning people to do something about them. In this book, we explore the reasons that political leaders so frequently devise agendas to rectify apparent cases of failure. However, we concentrate on the potential harm resulting from collective efforts to mitigate economic failure by blunting corrective responses to that failure. Direct public solutions to failure-those that often seem most obvious-are invariably less effective than advertised, and they commonly aggravate the very problem they are suppose to solve.

Our purpose is to unravel the essential insight that the late Joseph Schumpeter, professor of political economy at Harvard University, summarized as creative destruction. Schumpeter's fundamental insight was to recognize that A system-any system, economic or other-that at every given point of time fully utilizes its possibilities to the best advantage may yet in the long run be inferior to a system that does so at no point of time, because the latter's failure to do so may be a condition for the level or speed of long-run performance.¹ The wisdom contained in this short passage can be appreciated only when there is an understanding of the linkages that exist within the marketplace between failure and success. Those linkages are the focus of much of the following discussion. But first it is useful to have a brief statistical perspective on economic failure and success in the United States.

The Abundance of Success and Failure

The economic history of any country is typically written with considerable attention being given to the successes of its people. Accordingly, the economic history of the United States is generally viewed with much reverence for the growth in the country's well-being, which typically is evaluated in terms of the rise in gross national product (GNP), industrial assets and productivity, consumer purchases, jobs, and personal income.

Figure 1.1 shows four decades of success in national production as