CHAPTER 12 Fiddling With Prices While the Market Burns ON PRICE FLOORS, PRICE CEILINGS, AND OTHER INTERFERENCES WITH MARKET PRICE S

GOVERNMENTS HAVE FREQUENTLY felt the need to interfere with market prices. Such interference can take a number of forms. Price floors set a legal minimum on the price of some good or service. Price ceilings set a legal maximum on the price. Price targets try to keep a price with a narrow range: examples include foreign currency exchange rates “pegged” within a band, and the Federal Reserve targets for interest rates. And fixed prices, such as the price of taxi service in many cities, allow no price flexibility at all.

We’ll examine a few, particularly popular cases of interference with market prices.

A PRICE FLOOR

ACOUPLE OF years ago, I went to my friend Dick to show him a proposal I was working on. Dick happens to be a die-hard interventionist. Since it forwarded a new plan for the government to help the underprivileged, I was sure he would approve. My proposal ran as follows:

Today, many corporations in our strong economy have been left behind by the general prosperity. They may be old-industry stalwarts who have not been able to gain the skills necessary for a smooth transition to the electronic economy. Or, perhaps, they are new companies, just getting going in industry, whose penny stocks are undervalued by investors. Perhaps, through no fault of their own, those companies have had a run of hard luck: the CEO died, a major customer went belly-up, or a new product from a competitor rendered what they produce obsolete.

Many employees, suppliers, investors, and customers are relying on those very companies. Meanwhile, those businesses are suffering from a simple lack of capital. If they had sufficient funding, they could invest in new plants or modern technology and could then aid other players in the economy by buying more of their goods, supplying them with better products, or employing them at higher wages. Not only is it compassionate to help out those companies, but it will help the economy as a whole by boosting purchasing power.

Therefore, I forward a proposal. I recommend that the government set a national floor for stock prices. A reasonable first estimate of where it should be set might be $10 per share. Once my law is passed, it would be illegal to buy or sell the stock of any company for less than the chosen amount. (Naturally, it would be $10 per share for the full number of currently outstanding shares—we can’t have ruthless exploiters trying to skirt the law by forcing a company to do a reverse stock split or buy back its own shares.)

The effects of the law would be entirely beneficial. No capitalization would be taken from any other company to boost the capital of the most-needy corporations. Those corporations, now able to float shares at least at the minimum price, would quickly become more prosperous. The flow of funds to those enterprises would ripple throughout the economy, spreading wealth all around.

“But wait a second, Gene,” Dick said. “You’re not serious about this, are you?”

“Yes, quite serious,” I reply. “Why wouldn’t it be a good idea?”

“Well, first of all, your point about ‘boosting purchasing power’ is ridiculous. If anyone is buying those stocks at the new price floor, they now have less money than they would have had at the old, lower price. In fact, they’ll have as much less as the company in question now has more. So there is no increased purchasing power at all.”

“Hmm, you may have a point there. I’ll have to try and work around that. But do you see any other problems with my plan?”

“Of course! You heard me say, ‘If anyone is buying the stocks at the new mandated price’. . . . But why would they? If yesterday, I was only willing to pay $5 for a share of Dotty Dotcom, why in the world would I suddenly be willing to pay $10, just because some new law is passed? I’ll still only pay what I think an item is worth! Aren’t you the one always going on about that theory of subjective value?”

“Well, I guess I am. But what do you think would happen to the shares of Dotty?”

“Well, they would simply stop trading. Dotty, far from being able to raise more capital, would no longer be able to raise any money at all.”

“You have some good points there, Dick. But the funny thing is, I showed my plan to a few CEOs, and they all loved it.”

“Were these the CEOs of companies whose stocks were trading below $10 per share?”

“Well, no, in fact, everyone of them has a stock trading above $10 per share.”

“Then of course they’d love it! They’re trying to eliminate competition. Since their shares are currently above $10, their stock will continue to trade. In fact, without the competition of the lower-priced stocks, demand for their stock will go up. They’re simply trying to enrich themselves at the expense of the less fortunate. They’re a bunch of scoundrels.”

“You know, Dick, you’ve convinced me. My plan is kind of dopey. Thanks! But you’ve left me with one question.”

“Sure, anything I can do to help.” Dick was feeling quite confident, having thoroughly debunked my proposal.

“Since you can see how bad my plan is, why do you support raising the minimum wage? In fact, why do you support having a minimum wage at all?

“Aren’t low-wage workers analogous to the low-priced stocks I was describing? Aren’t employers equivalent to the investors in my scenario, in that they will only pay wages that seem worth parting with? And aren’t the labor unions, the main supporters of minimum wage legislation, the same as the CEOs of the higher-priced companies that I described to you, enriching themselves at the expense of the less fortunate?”

It took me a while to revive Dick, but when he finally came to, he claimed that he couldn’t remember a word of our conversation.

Minimum wage laws, at least temporarily, will help those who already make more than the level at which the wage is set. But those who would only be hired at a wage below the minimum wage will simply be shut out of the employment market. (Recall that employers will hire workers only up to the point where they expect the revenue from the marginal [last] worker hired will just exceed his wage.) “Well,” some will say, “no one could support themselves on such a wage anyway. Rather than allow businesses to exploit them by paying below-subsistence wages, it’s better they’re on relief so they can go to school or care for their kids.”

No doubt some people have been able to make themselves productive while they were on relief. (J.K. Rowling, who started the Harry Potter series while on relief, is a prominent example.) But for most people, it is a trap. For those at the bottom of the economic ladder, generally the best thing to do is to start working, at whatever wage they can.

I spent eight years playing in reggae bands. Over time, we were able to find steady work in local clubs. But that was only because, when we started out, we were willing to work for whatever a club would pay—sometimes for nothing! By gradually demonstrating that we could attract and satisfy a crowd, our wage steadily rose. If the minimum wage law had been strictly enforced at all of those clubs, we never would have gotten going at all.

That is the situation of the least-experienced workers. The most important thing to their economic future is that they learn that a job is not a right, but an exchange of valued goods—their labor for the employer’s money. Signs of having gotten the notion include showing up on time, being polite to customers, completing assigned tasks, and so on. Once they have demonstrated that they understand that central idea then their wages will rise. I don’t know of any employers who consider receiving government assistance, no matter for how many years, as a plus on a resume.

A PRICE CEILING

THE WINTER OF 2000–2001 was much snowier than the previous four that we had spent in our current house. Given the mildness of those previous winters and the lack of snowfall, we hadn’t bothered to look for a plowing service.

But in the winter of 2000–2001, four different storms each dumped over a foot of snow in our yard. Now, I sure as heck wasn’t going to go out there and shovel away that mess—hey, I’ve been busy writing this book! (I’d send my wife out to do it, but our driveway is visible from the neighbors’ houses, so that’s out of the question as well.) So clearly, we needed someone to plow.

After the first storm, I spotted two men plowing my neighbor’s driveway, and asked them if they would do ours after they had finished hers. They named a price—one that seemed fairly high for a small driveway like mine. It was clear to me that, since these fellows were already going to be across the street from my house every time it snowed, and it would take them less than five minutes to clear out my driveway, that they were each making well over $100 an hour for their work.

I readily agreed. Why? First of all, their price was still lower than what it would have cost me to clear the driveway myself, given the value of my time to me—my opportunity cost. That condition is, of course, the basis for any exchange—a person considers what they are giving up less valuable than what they receive. Further, I understood that all of the plow-truck operators would be quite busy, and that I would spend time searching for another operator who might be cheaper. In fact, I might not find anyone else who would want to take on such a small driveway at all. I could take their price or leave it.

A common reaction to such situations, in both the popular press and among politicians with an election coming up, is to charge that the consumer is being “gouged” by a businessman making “windfall profits,” taking unfair advantage of the consumer’s predicament. The businessman didn’t do anything to earn the high profits—instead, he is taking advantage of an accident of nature that is entirely beyond his or the consumer’s control in order to line his own pocket.

But we should apply Bastiat’s dictum, and contemplate what is not seen as well as what is seen. In the midst of a snowy winter, it was true that the plow operators are making a very high wage right then. But what about the previous four winters, when they had gotten very little business? During those winters, the potential supply of plowing had exceeded the demand for it. Many plow trucks sat idle. Why didn’t the majority of those truck owners abandon plowing? It is precisely the possibility of “cleaning up” in a bad winter that persuades people to maintain their plows and trucks during mild winters.

In fact, the plow operators might just as well complain that I had taken advantage of them during the previous four winters! After all, the lack of snow was neither their fault nor the result of any efforts of mine. Wasn’t it “unfair” that their business should suffer while I was able to save the money that, in a normal winter, I would have spent on plowing? From the point of view of the plowing services, it might be quite acceptable for the state to legally limit the price they could charge in bad winters, if it would also mandate that everyone with a driveway have it plowed several times every winter, even if it hadn’t snowed. This would even out the income flow of the plowing services and make their business more predictable. (Of course, their support for such a law would depend crucially on how high the legal price was set.)

Whether we like it or not, the vagaries of the natural world often have a significant impact on our lives. No form of social organization can dodge that fact. The market does have a means of dealing with it, however: the activities of speculators in stockpiling reserves, from which they hope to profit should an emergency occur. In a market system, stockpiles of food, oil, clothing, snow shovels, rock salt, plywood, and many other items needed during severe conditions exist because of the possibility of large profits should they be needed. Politicians often complain that oil companies are making “excess” profits during a shortage, from oil that they held off the market in good times. But ask yourself, where we would be if they hadn’t been holding a reserve? Clearly, the shortage would only be worse! Measures to restrict prices to some “normal” amount during a crisis only serve to discourage stockpiling—producers are also subject to time preference and, all other things being equal, would prefer to sell their products immediately rather than holding them in reserve for an emergency.

Not only are alternate forms of social organization unable to remove the influence of the natural world on our lives, they cannot eliminate the speculative nature of stockpiling goods for unusual circumstances. We do not know what nature has in store for us next month or next year. Speculation is action in the face of the uncertain future: entrepreneurship. The question is who should be doing the speculating: businessmen who specialize in the relevant market, and who have their own money riding on getting supplies correct, or government bureaucrats, whose skills are mostly political and who are betting the taxpayers’ money that they are right?

RATIONING AS A RESPONSE TO INTERFERENCE WITH MARKET PRICES¹

WHEN THE PRICE of a good is decreed by government mandate, instead of emerging from the voluntary interactions of free market buyers and sellers, consumers will often face a shortage of that item. Of course, every economic good, meaning a good traded in a market, is in scarce supply. People will not pay for something, no matter how pleasant or important it is to have around, if they find it present in such abundance that economizing its use is unnecessary. Air is certainly a good—all people need it for their very survival—but no one feels the need to breath less in order to avoid wasting it, and it does not fetch any price on the market.

A shortage of a good, in the economic sense, does not mean merely that it is scarce, but also that at its current price, people attempt to buy more of it than is available. Shortages usually come about when a legally mandated price ceiling is below what the market price would have been. In response to shortages, governments frequently resort to rationing the good in question. The outcome of one government intervention in the market, in this case the shortage that arises from a price ceiling, is used to justify a further intervention, here rationing as a response to the shortage. It is the typical pattern of the interventionist dynamic that we examined in Chapter 11.

Let’s look at a recent case of government-imposed rationing. New York City experienced a prolonged drought, beginning in 2000 and stretching into 2002. The possibility arose of a severe water shortage. However, the government had a plan, in fact, it had a three-phase Drought Management Plan. According to the City of New York’s Department of Environmental Protection:

As conditions dictate the declaration of the successive phases of the City’s drought response plan, certain actions are to be implemented. For a Drought Watch, the DEP responses are primarily operational, while activities that involve the consumer community are primarily informative and voluntary. For a Drought Warning, voluntary use restrictions are heightened and other City agencies are required to modify their operations. When a Drought Emergency is declared, rules and sanctions for failure to comply with them are imposed.

Quite often, when the government perceives a problem—in this case, people attempting to use more water than is actually available—it simply declares various activities, to which it has correctly or incorrectly assigned the blame for the troubles, to be illegal. It employs fines and prison sentences to prompt compliance with its decrees.

Unlike the command approach used by the state, the market guides scarce resources toward their most important uses through the voluntary rationing of the price system. No threats or fines are needed to dampen the appetites of consumers. Anyone can have as much of a good as he wants, so long as he is willing to pay the market price. An item that is in short supply at its current price will become more expensive once that situation is understood, as illustrated by Hayek’s tin example, discussed in Chapter Ten. The new, higher price of the good motivates people to use less of it.

A common response to such observations is that the “necessities” of life—such as electricity, natural gas, and above all, drinking water—are far too important to leave to the unpredictable whims of the unplanned free market. Surely people’s welfare, their very survival, should be placed above the desire of a greedy entrepreneur to earn profits!

But that argument simply assumes that government employees can provide services more reliably than profit-seeking businessmen. Don’t most of our experiences with government services indicate that the very opposite is true?

For example, during the hot summer months, when public utilities impose rolling blackouts and mandatory water restrictions, we never find Budweiser selling beer only on even-numbered days, or Oscar Mayer banning the consumption of more than two wieners per person at all cookouts. Consumers take it for granted that the privately supplied products they desire generally will be available.

The difference between private and government provision of goods is not due to scarcity. After all, diamonds are quite scarce, yet we never hear of a diamond shortage. During a drought, when the government is proclaiming that there is a “water shortage,” consumers can always find bottled water, supplied by private firms, on store shelves.

Of course the market isn’t perfect: no human institution is. During the Fourth of July rush, for example, some stores may run out of paper plates. But it is highly unlikely that an entire city will run out of them. In contrast to monopolized public utilities, markets diffuse the responsibility for supplying a good among many vendors. Even if some of them do a bad job at forecasting demand, other entrepreneurs, eager to lure away the customers those vendors have left unsatisfied, will leap into the breach. It is ironic that it is often the most important goods and services that are reserved for shoddy government provision.

Those cynical about bureaucracy may attribute water shortages and harsh regulations to the lust for power of the would-be tyrants and incessant busybodies who haunt most government agencies. But public utilities face a more fundamental problem than that. Even if all government employees were completely selfless public servants, they would still be incapable of rationally managing the water supply in the absence of free competition and market prices.

A public utility manager might possess detailed statistics concerning resource supplies, precise technological formulas, and extensive surveys of the consumers desires. But he will still be unable to select the most efficient uses for any given resource at his disposal. His decision to produce more of one good and less of another is merely guesswork.

Consider, for instance, the plan the New York City government devised in response to the area’s drought. It took into account the capacity of reservoirs, the normal usage of residents and businesses, and the latest weather forecasts. But the actions it ordered in response to those conditions were largely arbitrary. Under its “Drought Emergency Rules,” citizens couldn’t wash their vehicles with a hose, but they could water their lawns between seven and nine AM and seven and nine PM. However, if they lived in a house with an odd street number, they could only do so when the day of the month was odd as well. People living in even-numbered houses were limited to watering on even-numbered days. (Imagine your frustration if you happened to live in an odd-numbered house and had a job that required you to work on odd-numbered days.)

Plant nurseries could use water, but only at 95 percent of their pre-drought levels. (Why 95 percent, rather than 85 or 98 percent?) Restaurants could only give patrons a glass of water if they specifically requested one. All showerheads had to have a maximum performance of three gallons per minute at 60 pounds per square inch water pressure. Finally, a “SAVE WATER” sign, the dimensions and appearance of which were mandated in the plan—had to be placed in all dwellings housing more than four families.

That hodge-podge of citywide regulations could not help but ignore the vast differences among the millions of New York residents in both their circumstances and their personal preferences. It is highly unlikely that even a single person has the exact same demand for water in the exact same uses as anyone else. In a city of eight million people, the variations in individuals’ water needs must be immense.

During a drought, bureaucratic rules regarding water use will prompt some people, especially those who are willing to flout the law, to consume water that is more urgently needed by others. The market distinguishes between more and less urgent demands based on willingness to pay. The government, lacking the guidance of market prices, cannot perform the same task. It is obviously economically inefficient, not to mention tragic, if someone dies of thirst while his next door neighbor is watering his lawn. But it might also be wasteful for a golf course to turn brown while a nearby car wash remains open—or vice-versa! When choosing between such uses, government officials are condemned to operate in the dark.

In a free market, you determine how much of a good you will consume. You are only constrained by what you can offer to others in exchange for their meeting your needs. You can enjoy long showers if you are willing to pay the cost of the water you use. The market price of a good indicates to you the value of its marginal unit to “the community,” because that price is what others are paying for it. If we had a free market in water, then during a drought its price would rise, discouraging frivolous uses and encouraging imports from nearby areas with wetter conditions. We would not have water shortages, just as today we never have beer shortages or hot dog shortages.

SPILLED MILK²

LET’S CONSIDER AN economy in which the price of farm products is declining. Farmers may begin pleading for the government to stop the price drop. “Wealth is being wiped out of the economy,” they will complain, “and the value of our farms has fallen 50 percent in the last year. That will make everyone poorer, since we can’t spend as much on goods produced by others.” Their reasoning makes their pleas seem to be for the good of the whole nation, instead of just a matter of self-interest.

Surely, most economists would debunk such wrong-headed thinking. The conclusion that wealth has disappeared from the economy is unjustified. The same farms, the same fields, the same tractors are here today as were here last year. If some farms have shut down, it is only because consumers valued some alternative uses of the resources necessary to run the farm more than their use in farming. They chose the products requiring that alternative use over the products of the farm. Therefore, they will be less wealthy, in their own eyes, should the government intervene to keep the farm running.

We can sympathize with those farmers who have had a hard time. But propping up their business is wasting scarce resources. The law of comparative advantage tells us that there is some other role for them in the economy, to which they are better suited in the eyes of the consumers.

All that we definitively can say has occurred is that there has been a change in relative prices. A bushel of wheat buys fewer dollars, but the flip side of the coin is that a dollar buys more wheat. Those holding wheat are hurt, but those holding dollars (or any other good that did not decline along with wheat) are helped. This constant adjustment of prices by market participants, so as to bring supply and demand into balance, is the essence of the market process. There is little further we can say about whether “everyone” is better off with the new price configuration than they were with the old one. Certainly, though, we can point out that it will not help most people to try to maintain the old prices by government manipulation in the face of the new data of supply and demand.

Or consider the continuous, twenty-year decline in the price of personal computers. Economists have (quite correctly!) heralded it as a sign of the wondrous powers of the market. Certainly, computer manufacturers would like to have seen a thirty-year rise in the price of PCs. I haven’t heard any economists worrying about the wealth that was disappearing as the value of my old NeXT Workstation headed to zero. That price decline occurred because better opportunities appeared on the market. In other words, we were becoming wealthier during the price decline, not poorer.

So why do so many economists have such difficulties when the fall in prices occurs in the stock market, instead of in the market for agricultural commodities or personal computers? When stock indices fall, we hear repeated worries that “wealth is being wiped out.” On the surface, that seems too obvious to argue. When, during the year 2000, the NASDAQ plunged from 5,100 to 2,400, the total capitalization of the index shrank by over $3 trillion. It looked as though that wealth had simply vanished into thin air.

However, as we have seen above, that view is the result of confusion between the money prices of goods and the amount of wealth in the economy. The NASDAQ decline did not level any buildings or render any machines inoperable. America was just as full of farms, warehouses, railroads, and oil wells as it had been when the NASDAQ was at its peak. The dot-com wipeout did not suck the knowledge of Java programming out of anyone’s head. Certainly, some companies shut down. But those were the companies that it no longer seemed worthwhile to operate, in light of new market data.

A stock market decline represents a shifting of wealth. Those who were holding cash, bonds, or gold are now wealthier, as their assets can buy a greater share of various corporations. Those who were short shares of companies they judged to be overpriced are wealthier. The largest group made better off by the decline is the non-asset-holding consumer. Before the stock market decline, the stock-rich had been bidding up the price of various goods—homes, carpenters, plumbers, massage therapists, domestic help, private schools, and so on. After the decline, they are no longer able to bid as much, making such items more affordable for others.

Cries for the government to stop a stock market decline are no less special-interest-group pleading than are attempts by farmers to boost wheat prices. Those holding stocks have come to expect that they have the right to see the prices of their assets continually rising, and call for the government to intervene when that expectation is disappointed.

Usually, the request for intervention takes the form of the cry, “Lower interest rates!” But such a change in a key market price does not add a single new good to the economy. It simply shifts wealth from those who are intending to lend money to those who are intending to borrow money.

The price of securities must ultimately rest on their prospective future yield. While American productivity has been increasing, and we would therefore expect higher future yields on stocks, this explains only a small portion of the 85-percent rise in the NASDAQ in 1999 and the further 20-percent increase at the beginning of 2000.

A good deal of the NASDAQ run-up was due to the Fed flooding the market with liquidity in preparation for Y2K. That liquidity entered the capital market first, creating a classic market bubble. The bubble was concentrated, as bubbles tend to be, in the fad of the era: hi-tech stocks, in the ‘90s.

In addition, as Professor Roger Garrison of Auburn University has pointed out, the Fed has attempted to create a “firewall” to protect the “real” economy from the securities markets. But firewalls work both ways. We might reasonably suspect that holders of securities have begun to feel that they would be protected from changes in the rest of the economy. The government would step in to bail them out, as during the Mexican and Long-Term Capital Management crises.

Freely established market prices are not arbitrary: they serve an important social function. At any particular time, the market price of a share of stock reflects the best estimates of experts—where “experts” are those who have demonstrated the greatest foresight in the past—of the future price of the share (adjusted for interest). The critic of a price movement is implicitly asserting that he knows better than those actually risking their own money in the market.

In any discussion of share prices, we must also keep in mind the social function of the stock market itself. The price of a stock is closely connected with the present value of the expected future revenues of the company. Thus, unlike stamp collectors, those buying stocks are not merely guessing what everyone else thinks the future price of the good purchased will be. (In this respect, Keynes’s analogy of a beauty contest in which each judge tries to guess which contestant the other judges will rate highly—rather than which contestant is actually most beautiful—is dangerously misleading.) A surprisingly poor performance will invariably reduce a company’s share price. That is vitally necessary, in order for the market to accurately price the company itself.

If a company’s market price is less than the sum of its assets, to some market actor, the company becomes vulnerable to the much-maligned “corporate raider.” The corporate raider—epitomized by Danny DeVito’s character in the movie Other People’s Money—may then execute a leveraged buyout, liberating the underutilized assets (including labor) and transferring them to the highest bidders (i.e., those expecting to use the assets in a manner that better fits consumer preferences). While small alterations in the structure of capital can often be made within a firm, large alterations usually take place by capital moving between firms. It is the stock market that enables those adjustments to occur.

Before condemning a fall in a stock index, we must first ask, “Why has the stock market plummeted?” The answer to that question demonstrates why any interference with the process is harmful. Many people seem to think the market drop in 2000 and 2001 was simply a case of an “irrational,” self-fulfilling prophecy. But to the extent that was true, the real wealth of the economy (as argued above) had not changed.

But what if the stock market plunge was due to something more fundamental than prophecies? In that case, the euphemism “correction” would be accurate. If people realized with dismay that they had been overly optimistic about future corporate earnings, that must necessarily reduce share prices. However, the decline in prices is merely a symptom of the previous errors, not their cause. If Americans change their minds about the justice of the Union cause in the Civil War, the value placed on the Lincoln Monument will fall considerably. That loss of a patriotic symbol would not be offset by anyone’s gain, but it certainly would not justify any attempts to interfere with the adjustment. We need prices to reflect what we value today, not to be an image of what we valued yesterday. People might regret their previous value judgments, but there is no use crying over spilled milk.

Of course, none of the above should be taken to mean that the government should deliberately try to lower security prices, either! Rather, the market should be allowed to price securities in accordance with supply and demand. As Mises said in Human Action:

It is easy to understand why those whose short-run interests are hurt by a change in prices resent such changes, emphasize that the previous prices were not only fairer but also more normal, and maintain that price stability is in conformity with the laws of nature and of morality. But every change in prices furthers the short-run interests of other people. Those favored will certainly not be prompted by the urge to stress the fairness and normalcy of price rigidity.

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¹This section was co-authored with Dr. Robert Murphy of Hillsdale College, and is based on his original article “Blame It on the Rain,” available at http://www.mises.org/fullarticle.asp?control=894&id=65.

²This section was also authored with Dr. Robert Murphy.