Over the page, the draft preface for my book-in-progress, Economics in Two Lessons

I got some great comments first time round, but I can see it would be easier if I presented my drafts in a more orderly fashion, though not necessarily sequential. So, I’ll begin at the beginning. Comments, both critical and favorable, much appreciated.

As the name implies, this book is a response to Henry Hazlitt’s Economics in One Lesson, a defence of free-market economics first published in 1946. But why respond to a 70-year old book when new books on economics are published every day? And why two lessons instead of one?

The first question was one that naturally occurred to me when Seth Ditchik, my publisher at Princeton University Press suggested this project. It turns out that Economics in One Lesson has been in print continuously since its first publication and has now sold more than a million copies.

Both where he was right, and where he was wrong, Hazlitt’s arguments remain relevant today, and have not been substantially improved on by today’s advocates of the free market. Indeed, precisely because he was writing at a time when support for free markets was at a particularly low ebb, Hazlitt gave a simpler and sharper presentation of the case then many of his successors.

Hazlitt, as he makes clear, was simply reworking the classic defence of free markets by the French writer Frédéric Bastiat, whose 1850 pamphlets ‘The Law’ and ‘What is Seen and What is Unseen’ form the basis of much of Economics in One Lesson. However, Hazlitt extends Bastiat by including a critique of the Keynesian economic model developed in response to the Great Depression of the 1930s.

Hazlitt presented the core of the free-market case in simple terms that have not been improved upon by any subsequent writer. And despite impressive advances in mathematical sophistication and the advent of powerful computer models, the basic questions in economics have not changed much since Hazlitt wrote, nor have the key debates been resolved. So, he may be read just if he was writing today.

Some of the key questions addressed by Hazlitt are:

  • Will Keynesian fiscal policies secure full employment?
  • Should the government invest more in infrastructure ?
  • Do minimum wages benefit workers?
  • Can price controls stop inflation ?

Hazlitt answers ’No’ to all these questions. His One Lesson is:

The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.

As Hazlitt develops the argument, his meaning becomes clear. The direct benefits of more jobs and public works, higher wages and lower prices are obvious. But these benefits do not come without costs, often borne by groups far removed from the beneficiaries. The true measure of cost is not a money value, but the alternative use to which resources could have been put. In Hazlitt’s words:

Everything … is produced at the expense of foregoing something else.

Economists call this foregone value ‘opportunity cost’. The decision to provide some particular good or service makes us better off if, and only if, its value to us is greater than the opportunity cost involved in its production.

But how does Hazlitt get from the idea of opportunity cost, accepted by nearly all economists, to the conclusion that government intervention in the economy is hardly ever justified? The answer is simple.

Hazlitt assumes that the opportunity cost of any good or service is its market price. So, he infers, any government interference with markets , such as the provision of ‘free’ services, must involve hidden costs that outweigh the immediate benefits.

So we can restate Hazlitt’s Lesson as:

Assuming that market prices are equal to opportunity costs, government interventions that change the market allocation must have opportunity costs that exceed their benefits.

The simplicity of Hazlitt’s argument is his great strength. By tying many complex issues to a single principle, Hazlitt is able to ignore secondary details and go straight to the heart of the free market case against government action. His answer in every case flows from his ‘One Lesson’.

But Hazlitt’s strength is also his weakness. He never spells out the relationship between prices and opportunity costs. As a result, he implicitly assumes that there is a unique market allocation, in which prices equal opportunity costs, and that the two can only differ as a result of government interference. Although he does not say so explicitly, he implies that the existing distribution of income (or rather, the one that would emerge after the policies he dislikes are scrapped) is the only one that is consistent with his One Lesson.

While markets are exceptionally powerful social institutions, they cannot work unless governments establish the necessary framework in which they can operate. The core of the economic framework in a market economy, and a central role of government, is the allocation and legal enforcement of property rights.

The market outcome depends on the system of property rights from which it is derived. In fact (as we will see later) when markets work in the way Hazlitt assumes, any distribution of goods and resources where prices equal opportunity costs can be derived from some system of property rights. So Hazlitt’s Lesson tells us nothing useful about the distribution of income or about government policies that may change that distribution.

An equally important problem is that, despite the then-recent experience of the Great Depression, Hazlitt implicitly assumed that the economy is always at full employment, or would be if not for government and trade union interference. Experience shows that the economy frequently remains in a depression or recession state for years on end. In such a situation, markets don’t properly match supply and demand. This means that prices, and particularly wages, do not, in general, determine opportunity costs.

Finally, there is what economists call ‘market failure’. Even within a market system, and disregarding equity, a variety of possible problems that mean either that markets fail to emerge or that market prices do not reflect all the relevant opportunity costs for society as a whole.

To understand the central issues in economic policy debates, we need not one lesson, but two. The first lesson, implicit in Hazlitt’s One Lesson is:

Lesson 1: Market prices reflect and determine opportunity costs faced by consumers and producers.

The second lesson is the product of more than two centuries of study of the way markets work, and the reasons that they often fail to work as they should:

Lesson 2: Market prices don’t reflect all the opportunity costs we face as a society.

Two lessons are harder than one. And thinking in terms of two lessons comes at a cost: we can sustain neither the dogmatic certainty of Hazlitt’s free-market policies nor the reflexive assumption that any economic problem can be solved by government action. In many cases, the right answer will remain elusive, involving a complex mixture of market forces and government policy.

The problem of how markets work and why they fail is at the core of most of the economic policy issues that drive political and social debate. I hope this book, and the two lessons it contains will help to clarify these issues.

Advertisements