Book Reviews

486 THE FREEMAN • DECEMBER 1992 BOOKS WELFARE ECONOMICS AND EXTERNALmES IN AN OPEN-ENDED UNIVERSE: A MODERN AUSTRIAN PERSPECTIVE by Roy E. Cordato Kluwer Academic Publishers,• 160 pages • availablefrom LaissezFaire Books, 800-326-0996,$24.95plus shipping Reviewedby WilliamH. Peterson I f every drama has a villain, perfectcompeti tion-general equilibrium (PCGE) is Roy Cordato's royal knave. PCGE is the welfare economist's paradigm of political correctness, complete with a recommended list of allegedly remedial public policies. Armed with this PCGE paradigm and fortified with advanced mathematics (as a glance at any professional economics journal will reveal), the mainstream welfare economist assumes a world of perfect competition and perfect knowledge. He blithely imaginesan ideal economic system in gen eral equilibrium in which there is a broad balance of forces facilitating the simultaneous fulfillment of plans by sellers and buyers. He holds that mar kets are efficient only when market price and marginal cost are equal; he says that in the absence of such equality markets "fail"; he claims that "market failures" further proliferate when market "side" or "spillover" effects lead to "negative externalities'" with less than optimal results in terms of prices, production" and pollution.

Not to worry. Father Washington knows best. Market failures are corrected, proclaims the modern exponent of welfare economics, by taxes, subsidies, import quotas, antitrust laws, pollution controls, public utility regulations, and other government weapons, all of which magical ly do away with the problems that arise in the mainstream welfare economist's imaginary model. But these problems and solutions are present ed to policy makers, says economist Roy Cordato of the Washington-based Institute for Research on the Economics of Taxation (IRET) "without any recognition of the fact that they were developed within a context that bears very little resem blance to the real world." Why so little resemblance? Dr. Cordato argues persuasively in this scholarly work that the main stream welfare economist should rethink his PCGE position and see market activity as a dynamic and open-ended process creating demand and supply disequilibrium situations that veer toward but never quite reach equilibrium. He should also see that private property rights are sacrosanct, that value and utility are strictly subjec tive and therefore unobservable and unmeasur able, that knowledge of market phenomena such as demand curves and unit costs is always imper fect to both market participants and policy makers, that market competition is an entrepreneurially driven information discovery process upsetting some previously coordinated plans as fresh information comes to the fore and the price system adjusts to ever new situations.

It follows that the main answer to dealing with pollution damage is stricter stipulation and enforcement of private property rights so as to allow affronted property holders to claim tort lia bility and seek redress in the judicial system. In light of this analysis, it is little wonder that government interventions on behalf of environ mental concerns backfire. The concepts of general equilibrium and perfect competition are inherent lyfalse guides, saysthe author, inasmuch as market participants are not robots but real men and wom en who must ever cope with scarce time, with their own individual responsibilities and resources, with their particularly unique private property rights-i.e., with the world as it actually exists. In introducing this book, economist Dominic Armentano of the University of Hartford and author of Antitrustand Monopoly:Anatomy of a PolicyFailure,hails the Cordato logic for filling a gap in Austrian economics and for obviating, among other things, such dubious antitrust tools as market share, concentration, and entry barriers.

He writes: "Roy Cordato's new book is both timely and important. Questions of liability and efficiency with respect to negative spillovers are current, cut ting-edge public policy issues. In the area of indus trial pollution especially, significant private and taxpayer resources have been committed to schemes to redress the 'social costs' of alleged environmental degradation. In addition, govern ment agencies and the courts are increasingly regulating private behavior in this area. Thus it is important to re-examine the economic rationale for regulating externalities and whether existent public policy is appropriate." Dr. Cordato has made an important contribution to our understanding of welfare economics. D Dr. Peterson, adjunct scholar at the Heritage Founda tion and Mises Institute, holds the Lundy Chair ofBusi ness Philosophy at Campbell University, Buies Creek, North Carolina.

THE SEVEN FAT YEARS-AND HOW TO DOlT AGAIN by Robert L. Bartley The Free Press, 866 Third Avenue, New York, NY 10022 347 pages· $22.95 Reviewedby RobertBatemarco R obert Bartle.. y has written a history of U.S. economic policy during the 1970s and 1980s from a supply-side perspective. Given his position as editor and vice president of TheWallStreetJournal,he draws heavily from that publication for source material. Thus, it should not surprise us that his book reflects both the Jour nal's disdain for most economic policies of the Nixon and Carter years and its stance as a cheer leader for Reaganomics. The Seven Fat Years was written with two pur poses in mind. The first was to counter the view of so much of the intelligentsia that the 1980swas a period of veritable economic disaster for all but the "rich". Bartley does so by reminding us that the '80s was a decade of flourishing entrepreneuri al activity and consequent economic wellbeing (31 percent growth in real GNP from 1982to 1990, and the simultaneous massive reduction in the rates of inflation, unemployment, and interest), both in absolute terms and by comparison with the seventies and (so far) the nineties.

The second purpose Bartley had in mind in writ ing this book was to advocate the continuation and extension of the policies to which he credits these successes. He saw the 1980s as the apotheosis of supply-side economics and his book is a paean to the set of theories bearing that designation. While those theories are by no means without merit, they suffer from several blind spots which provide this reviewer reason to take issue with several of the book's major points. BOOKS 487 The author starts with the 1970s (he takes the liberty of defining his decades by policy regime rather than strict chronology, so that his '70s last until the end of 1982) to remind us just what we were up against as the '80s dawned. To quote him: "Still, the fat years were a striking contrast with the nine years between 1973and 1982,when the econ omy grew at a rate of only 1.6 percent a year. That miserable period saw four years with actual declines in real GNP; productivity stagnated and poverty grew. By the way, inflation raged, with the consumer price index leaping by more than 10per cent in each of four years-1974, 1979, 1980 and 1981."

Bartley assignsvarious degrees of blame for this state of affairs to Nixon's New Economic Policy (wage-price controls and dollar devaluation), the Impoundment Act of 1974 (which reduced presi dential power to limit government spending), excessivemoney creation, and rising taxes (mostly as a result of inflation pushing people into higher tax brackets as well as generating fictitious, but taxable, capital gains). Two other contributing fac tors, the increase of federal regulations (particu larly the EPA and OSHA) and the burgeoning expenditures for the Great Society entitlement programs, were omitted but seem to belong here as well. Against the backdrop of these events, Bartley introduces his readers to the policy discussions of the "inner circle" of the supply-side movement Arthur Laffer, Robert Mundell, Jude Wanniski, and himself-at the New York eatery Michael 1. The author came away from these deliberations with three major policy prescriptions. To stop the price inflation caused by easy money, the consen sus favored tying monetary policy to the price of some commodity, preferably, but not necessarily, gold. Since this price rule would apply to the inter national economy as well, it would restore fixed exchange rates and, thus prevent the erosion of the international division of labor. To help revive the economic growth (which had slowed to a crawl), they called for steep reduction of tax rates, not only directly but also by indexing both tax brackets and, more importantly, the basis for computing capital gains. Finally,there was agreement that the .

growth of government spending must be restrained and despair of its being done in the absence of institutional constraints such as a line item veto or balanced budget rule.

488 THE FREEMAN • DECEMBER 1992 He proceeds to catalogue the implementation of these policies: the 1978Steiger capital gains tax cut, the 1982 Reagan income tax cuts (which he characterizes as both smaller and more slowly implemented than desirable), and Volcker's tight money policy, which targeted the money supply through 1982and price level thereafter. This done, he asserts their efficacy,stating, "As 1982 drew to a merciful close, both sides of the Michael 1 pre scription were finally coming into place. The Seven Fat Years started in November." The supply-side fiscal policies that Bartley advocates, namely lower tax rates and reduced government spending, are admirable. However, his enthusiasm for the policies actually enacted may be misplaced, given that he is settling for no more than half a loaf. As he himself recognizes, because of the much lamented quest for "revenue neutrality" the justly acclaimed rate reductions of 1981 and 1986were offset, to a large extent, by the elimination of many personal deductions and increases in business taxes in those very same bills, not to mention the increases in Social Security tax es and the tax increases of 1982and 1984.And gov ernment spending fell only in relative terms, never in absolute terms.

On the controversial Laffer Curve, Bartley's effort to rescue it from the caricature which would have it implythat anytax rate cut willincrease gov ernment revenue is successful on its own terms, although his assertion that the prohibitive range starts at 35 percent seems unrealistically low. The real problem with the Laffer Curve is that it appearsto accept the premise that the raising of tax revenue is the most important justification for reducing tax rates. Philosophical arguments, such as the presumption that taxpayers have first claim to what they have earned in the absence of com pelling evidence to the contrary, have never been the supply-siders' strong suit. Perhaps the most serious weakness of supply side economics is its treatment of monetary policy and the business cycle. That weakness manifests itself in this book in the notion that recessions are really independent of the booms that preceded them. To quote once more, "... we are not helpless before some inexorable 'cycle.' Without such arti ficial impediments as wage-price controls or Reg[ulation] Q, expansions can in theory go on indefinitely.... " This view rejects the lesson of Austrian business cycle theory that the seeds of recession are already planted by the credit expan sion which generates the boom. Bartley makes this quite explicit by criticizingR A. Hayek's view that "you cannot stop inflation without causing a depression." Indeed, he goes so far as to argue in the face of contrary evidence that "Somehow the abrupt end to inflation did not cause a depression.

Somehow, indeed, vigorous growth emerged in 1983." To claim that the 10.8 percent unemploy ment rate of 1982was not a depression is to make far too much of the distinction between a recession and a depression. By callingfor price level stabilization as a proper goal of monetary policy,Bartley frees himselffrom the errors of the seventies only to embrace the errors of the twenties. As much as a monetary pol icy which stabilized prices is to be preferred to the more obviously inflationary policy currently in effect, it would nonetheless generate malinvest ments and the boom-bust cycle. It did so in the 1920s, even though many prominent economists were fooled into declaring that period a "New Era" in which we had rid ourselves of the cycle. The view that price stabilization is an appropri ate monetary policy ultimately rests on the belief that money is neutral. By taking money to be neu tral, supply-side economics is oblivious to the extent to which the "seven fat years" were also seven years of fat, much of which would have to be shed in a subsequent recession. The recession which started in 1990would have occurred even in the absence of the tax hike, S & L problems, and other factors to which Bartley attributes blame.

None of this, however, should be taken as a failure to recognize that there were many healthy devel opments during this period. There were, indeed, and Bartley describes them, albeit incompletely. Conspicuous by their absence in his account were any mention of the deregulation movement (as halfhearted as it was) and the firing of the PATeO strikers, which set the stage for other events which weakened unions' ability to keep wages above their equilibrium level. To return, however, to the causes Bartley did choose to emphasize, I found his defense of the financial innovations which allocated capital to some of the most productive people in the country, particularly "junk" bonds and leveraged buy-outs, to be well done. He insightfullyplaces those devel opments in a broader historical context. Indeed, it is interesting to learn here that the bonds of only 800 of the 23,000 largest U.S. companies would not be classified as "junk."

The parts of this work which I found to be of greatest value were his critiques of two perennial bogeymen: the trade deficit and income inequality. Both have been used with no little success to pro vide cover for any number of perverse policies-protectionism, currency devaluations, and tax increases, to name only the most obvious. In each case, he shows the basic flaws in the con cepts themselves and the substantive harm in enacting the policies they are used to advance. Here he points out the striking fact that a mere $53,711 placed a household in the highest 20 per cent of the income distribution in 1989, and $91,751placed it in the top 5 percent. Widespread knowledge of these figures combined with the realization that many of these incomes are pro duced by two earners should, I would hope, cool some of the zeal for taxing the "rich" which is currently at a fever pitch. All in all, this book is a better source of informa tion on the supply-sideparadigm than it is of under standing this particular business cycle episode. It reveals the supply-side mind-set to be one which favors piecemeal, even inconsistent, application of free market ideas. The message conveyed through out this book is that supply-side economists have no inclination to take even the first steps toward dismantling the welfare state. They merely intend to make it more efficient. Anyone looking for a ringing affirmation of laissez faire in these pages willbe as disappointed as he was by the policies of the Reagan years described therein. 0 Robert Batemarco teaches economics at Marymount College, Tarrytown, New York, and at Dominican College,Orangeburg,New York.

MONEYOFTHE~ND-BORRO~NG AND LENDING IN AMERICA FROM mE CML WAR TO MICHAEL ~LKEN by James Grant Farrar Straus Giroux, 19 Union Square West, New York, NY 10003. 513 pages· $27.50 Reviewedby James Picerno O f all the distortions government creates when it intervenes in the free market process, few, if any, are more deleterious BOOKS 489 to the economy than when it socializes credit risk. That hasn't stopped the federal government from continuing such policies, though, as documented in James Grant's recent book, Money ofthe Mind: Borrowingand Lending in Americafrom the Civil War to Michael Milken. Over a period of decades, the federal govern ment has taken it upon itself to "regulate" credit markets, ostensibly to improve safety,stability,and fairness. The results have been less than impres sive, however. For example, a decade ago when the Texas real estate market was crumbling, the regional banks began feeling the fallout, Grant writes. Eventually, every key Texas bank went bankrupt during this time or was merged or required assistance from the federal government. Ironically, big Dallas banks managed to survive the Great Depression 50 years earlier with relatively little, if any, federal help.

The huge expenditures and market interven tions by Washington in the more recent Texas set back had little remedial effects. In fact, such inter ventions are said to have exacerbated the problems because they redistributed corrective pain and thereby mitigated the healing effects of the market. "It was the received wisdom of the 1970s and early 1980s," Grant writes, "that mod ern banks do not fail (thanks to federal deposit insurance) and that inflation is a permanent American condition (as a result of the Employ ment Act of 1946). However, the impossible pro ceeded to happen." Despite policy failures over the decades, Wash ington has been slowlyadding layers of bureaucra cy to do more of the same. Statist manipulation of credit markets has since become overt, counter productive, and sometimes dangerous, as Grant points out regarding interventions into the bank ing market throughout the nation in recent decades: "The doctrine that some banks were too big to fail subverted the most basic banking fran chise of all, safety; promising to protect its deposi tors' money at all hazards, a small, safe bank could make no competitive headway against a large, risky bank. The Treasury Department was the ulti mate big-bank stockholder."

Grant might have added that Congress' record in recent years on distorting banking policies is equally troubling. Consider that institution's deci sion to raise the savings and loan deposit-insur490 THE FREEMAN • DECEMBER 1992 ance ceiling to $100,000from $40,000as the 1980s opened. This action attracted more money from depositors, who were comforted-some say lured-by the artificially higher levels of govern ment guarantees. Yet that money-indirectly solicited by government guarantees-was fun neled into speculative, though illfated real estate ventures. A good deal of the country's monetary and cred it illscan be traced back to the creation of the Fed eral Reserve System just before World War I, Grant suggests.Few can argue with this notion, as this system has contributed greatly to the politiciza tion of monetary policy,partly by removing formal institutional constraints on monetary excesses, as in the jettisoning of the gold reserve ratio.

Over the years, Fed power became increasingly centralizeda predictable development, given the nature of the beast-giving it more authority to act unilaterally and, consequently, beyond market rationality. The Banking Act of 1935,for example, removed individual banks' influence in open market mone tary operations, ceding that ability to the Fed. Sub sequently, all key monetary decisions were to come within its domain. Unfortunately, the situa tion has degenerated so that monetary policy choices are often derived from a politic~l calculus. Such power shifts opened the door for Congress to sanction irresponsible fiscal policies, as in 1946 when it promoted monetary excesses by directing the Fed to promote high employment under the Full Employment Act. By the early 1970s,the arrival of the Penn Cen tral affair should not have come as a surprise to anyone monitoring the trends of previous decades.

Grant recounts that the tribulations of this compa ny became the most prominent example of market manipulations, partly induced, if not sanctioned, by government policies. In fact, some of the nation's most conservative bankers, and ardent critics of state intervention as well, had experi enced a philosophical change of mind as they suc cumbed to modern monetary mismanagement as promoted by Washington. As a result, the previ ously independent-minded Walter Wriston, chair man of the First National City Bank, petitioned the Federal Reserve Bank of New York in the early '70s for a $200 million loan guarantee as assis tance in dealing with the increasingly risk-laden Penn Central, to which City Bank and other insti tutions had made loans. Regardless of government intervention, howev er, Penn was headed for failure. And rightly so, as the company had made egregious errors in busi ness judgment. Yet even after Penn had fallen, it was clear that the Fed system wasn't about to mend its ways nor acknowledge market logic.

Indeed, the Federal Reserve Bank of New York assessed Penn's failure as unrelated to rational market pressures, but instead the result of techni cal difficulties.In essence, the bank refused to face reality, explaining that Penn crashed and burned because holders of the firm's commercial paper "became apprehensive about the low level of cor porate liquidity as well as about the ability of bor rowers to refinance existing debt, given the tight position of the banking system. The difficulties encountered by a number of brokerage firms, including some of the oldest and largest houses, and the fact that stock prices continued to fluctuate erratically added to the widespread uneasiness. Moreover, the Penn Central default came at a time when the amount of maturing paper was seasonal ly high because of the midyear statement date." Overall, Money a/the Mind provides an engag ing look at how government monetary policies have infiltrated and corrupted the market process.

To be sure, decisions made in the private sector must share in the blame for excesses, and yes, sometimes scandals. Such is the reflection of human nature rather than market failings,though. Beyond that, such private market stumbles typ ically are corrected by assessing penalties to the offending parties. In contrast, government induced improprieties in monetary affairs are rarely corrected. Instead, such statist errors are allowed to multiply,primarily because responsibil ity is diluted and pawned off onto millions of unwilling taxpayers who have no culpability, and no avenue for redress of grievances against the autonomous Fed. D James Picerno is associate editor ofStanger's Investment Advisor, based in Shrewsbury, New Jersey. He is also a contributor to Barron's, Financial Freedom Report, and Business Facilities.