Although there is a strong case to be made for the importance of the community, Rajan does not make it nearly as well as he could have. The Third Pillar contains many insights and important facts, but his argument for inclusive localism is half-hearted. He concedes far too much to the current large state apparatus and, in doing so, implicitly accepts that communities will be weak. Again and again in the book, when contemplating how to make local communities more powerful relative to federal governments, he fails to call for a massive reduction in state power. At times he accepts the state apparatus because he believes, often unjustifiably, in its goodness and effectiveness, and at times he accepts it because he seems to have a status quo bias.
Moreover, although Rajan has better than the median economist’s understanding of the free market, he misses opportunities to point out how the market would straightforwardly solve some of the dilemmas he presents. He also gets some important history wrong. And he makes too weak a case for free trade and favors ending child labor even in third-world countries where children and their families desperately need them to work.
The state replaces the market / In explaining the growth of national governments’ power over the economy in the late 19th century and early 20th century, Rajan focuses on Germany and Britain. In the 1880s, he notes, German chancellor Otto Von Bismarck introduced government-financed insurance for sickness, industrial accidents, and disability and old age. Between 1906 and 1911, the British Liberal government implemented old-age pensions, set minimum wages, and introduced government-financed unemployment and health insurance. Rajan grants that these German and British measures “did diminish the role of the community,” but nowhere in a book touting the importance of the community does he call for repeal of any of those measures. In discussing the U.S. Social Security program, for example, he advocates sensible reforms such as increasing the age of eligibility and reducing cost-of-living adjustments for Social Security, but he makes clear that those measures are intended to deal with the exploding federal debt and to keep Social Security afloat.
In a chapter titled “Responsible Sovereignty,” he struggles with a dilemma that a fairly unobtrusive regulation would solve. He points out that U.S. chicken farmers crowd chickens together, whereas chicken farms in the European Union are subject to minimum space and ventilation standards. As a result, U.S. farmers disinfect chickens with chlorine to clean them, whereas EU farmers need use only water. The European Union, he notes, bans chickens washed with chlorine even though there is no evidence that the chickens threaten consumers’ health. He then poses the following dilemma: On the one hand, the restriction can be seen as protectionist; on the other, “it may reflect the genuine preferences of Europeans or the concerns of their food administrators.” What to do? Rajan leaves the dilemma unsolved, even though a straightforward solution is to simply require disclosure and let consumers decide. The EU could require that chickens washed in chlorine carry a label saying so. That way those Europeans with “genuine preferences” for chickens not washed in chlorine could know to avoid U.S. chickens while other Europeans, probably disproportionately poorer ones, could buy lower-price U.S. chickens.
One of the biggest disappointments is his view on immigration. An immigrant from India himself, he makes good economic arguments for more immigration. He notes, for example, that Japan, China, and, to a lesser extent, the United States will need more young immigrants in the future as their populations age. But he is vague about how much more immigration should be allowed or even what the rules should be. Rajan takes as given that immigration is a federal government responsibility even though the U.S. Constitution gives the feds no such power and even though, for many decades after America’s founding, state governments had control over immigration. But he does not advocate reducing federal government power. Interestingly, he notes a tension between an extensive welfare state and more immigration. He argues correctly that the more heterogeneous the population is (which would happen with more immigration), the less support there would be for a welfare state. He seems to see this as a negative, but for people who favor relatively open borders and no welfare state it is a strong positive.
One area on which Rajan is quite insightful is housing. He points out that zoning in New York, San Francisco, and San Jose has prevented residential areas from becoming denser, driving up housing prices and pricing out many families. This, combined with government schools that take students based on residence, means that many families fail to get a quality education for their children. In one of his final chapters, he argues for freeing up housing supply. That is not all he proposes, though; he also calls for price controls — which he euphemistically calls “affordable housing” — on 15% of the housing stock in a given community. A better solution would be to simply allow much more residential construction. Readers under age 60 may not know this, but 50 years ago many middle-class and even lower-income families could afford housing in San Francisco, Los Angeles, and New York without any price controls. Relatively loose restrictions on building did wonders for housing prices.
Unfortunately, he undercuts his own case for allowing more housing. In arguing against government restrictions on building, he writes, “When we have to choose between competition and property rights, we should invariably choose competition.” But on the issue of housing, we do not need to choose between the two. Allowing landowners to build means respecting their property rights, and that leads to a more competitive housing sector.
Sometimes muddled thinking / Rajan takes on Milton Friedman’s view that the only purpose of a corporation should be to maximize profits. Rajan argues that corporations should maximize “value” instead. What is the difference? He illustrates with an example of employee training. Imagine that workers join a firm that is known to maximize profits. Then, he writes, if the firm must choose between profits and investing in employees, it will choose the former. But employees, knowing this, will therefore require more pay than they would if the corporation provided training. Therefore, he writes, the firm that maximizes profits “saves nothing in wages over time.” But because it has not invested in training, it will forgo additional net revenue and be worse off than if it had invested in training.
Are you confused? Rajan is. Notice that the firm that sets out to do what he thinks it should do — namely value-maximize — finds that it also maximizes profits. His posited tension between profit maximizing and value maximizing is nonexistent. And it is Rajan himself who shows that it is nonexistent. Interestingly, though, the issue does not seem to matter for his preferred economic policy. Although he sticks with value-maximizing as the desired objective, he proposes no legislation to force corporations to do so.
Are you confused? Rajan is. Notice that the firm that sets out to do what he thinks it should do — value-maximize — finds that it also maximizes profits.Rajan worries, as do many economists, that occupational licensing unnecessarily impedes many people from climbing the economic ladder. He cites work by Morris Kleiner and the late Alan Krueger showing that the percentage of the labor force subject to government licensing has climbed from under 5% in the 1950s to almost 30% in 2008. He quotes the Kleiner/Krueger finding that the monopoly power due to occupational licensing causes wages in the licensed occupations to be about 18% higher than otherwise. He leaves unsaid, but clearly understands, that the only way licensing can do this is to restrict supply. That means that many people who fail to get into those occupations are worse off than if licensing did not exist. Disappointingly, he does not advocate ending licensing but settles for advocating national licensing and also advocating that local licensing be no more restrictive than his proposed national licensing. But how restrictive should national licensing be? Rajan does not say.
One area, though, in which he does advocate reducing monopoly power is in intellectual property. The extreme form that protection of intellectual property has taken over the last few decades concerns many economists. Rajan argues, correctly in my view, that although the original purpose of patents was to encourage innovation, the ease with which they are granted makes patents on relatively trivial innovations a barrier to innovation. Patents now last 20 years, up from the 17-year length that we had for many decades. He proposes a fairly straightforward reform: allow a patent to expire after the current 20 years or, say, eight years after a product using the patent is sold in the market, whichever occurs first. Why eight years? Because many years pass between when drug companies get a patent on a new drug and when the Food and Drug Administration finally approves the drug’s sale. The eight years would assure that the drug companies get a monopoly for eight years. This would preserve their incentive to spend heavily on research and development. If there is any area where patent protection is particularly important for innovation, it is pharmaceuticals, and the main reason for this is that the FDA takes so long to approve.
Rajan worries that competition in the U.S. economy has fallen and advocates stepped-up enforcement of antitrust laws. He seems to have two main reasons for the decline in competition. The first is based on economic history. He criticizes the “control” that John D. Rockefeller’s Standard Oil had over refined oil. But Standard Oil’s market power came mainly from producing a quality product, taking advantage of extensive economies of scale, and vertically integrating. Rajan’s senior University of Chicago colleague, Lester Telser, in his 1987 book A Theory of Efficient Cooperation and Competition, put it well: “The oil trust did not charge high prices because it had 90 percent of the market. It got 90 percent of the refined oil market by charging low prices.” And were those prices ever low! As economist Thomas J. Dilorenzo has shown, the price of refined petroleum fell from over 30¢ a gallon in 1869 to 10¢ in 1874 and 5.9¢ in 1897. That is why Rockefeller’s major critics were heads of other oil companies and muckraker Ida Tarbell, the daughter of an oilman whom Rockefeller competed out of business.
Rajan’s second reason for favoring increased antitrust enforcement is the increasing concentration of U.S. industries. But he notes that the costs of complying with government regulation hurt small businesses more than big businesses because small businesses have less output over which to spread the cost. In my doctoral dissertation, I called this “economies of scale in compliance.” Regulation, therefore, creates concentration. Deregulation, not more antitrust enforcement, is a better way to get more competition.
In making his case that we can go too far in the direction of markets, Rajan writes, “Reverend Thomas Robert Malthus epitomized the heartless side of [classical] liberalism, when taken to its extreme.” Commenting on Malthus’s claim that disease, war, and famine would be natural checks on population growth, he writes, “No wonder historian Thomas Carlyle termed economics the ‘dismal science.’ ” But that is not why Carlyle coined the term. Instead, in noting that the dominant economists of his day strongly opposed slavery, Carlysle said economics was dismal because they opposed slavery. That is a big difference.
One thing that is well established in economics is that child labor in very poor countries is a boon to children and their families. I made that point in Fortune in 1996 and Nobel economics prizewinner Paul Krugman made it in Slate in 1997. We both pointed out that children who work in “sweat shops” are virtually always better off than in their next best alternative. That next best alternative, if they are lucky, is a lower-paid job in agriculture or, if they are unlucky, picking through garbage or starving. Yet Rajan, who comes from a poor country, writes, “All countries should, of course, respect universal human rights, including refraining from using slave labor or child labor.” He is right on slave labor; he is horribly wrong on child labor. If he got his way, millions of poor children would suffer needlessly.
Rajan, like the vast majority of economists, favors free trade. He writes, “The jobs protected by steel tariffs typically are outweighed by the jobs lost everywhere else.” That is true and it is a good point. But he does not mention the main case economists make for free trade: the gains that protection gives to domestic producers are well below the losses that it inflicts on consumers.
In arguing for strengthening communities, he perplexingly advocates an increase in state power. He writes, “The state can also create bridging vehicles such as national social or military service.” He does not specify whether he means compulsory or voluntary national service. The form it takes matters a lot. Either way, it undercuts his favored third pillar.
One bright spot is Rajan’s refreshing way of expressing insights. For example, he sees a lot of problems with China’s unusual mixed economy and coins a beautiful phrase to describe it: “competitive cronyism.” And here is how he characterizes populism: “Populism, at its core, is a cry for help, sheathed in a demand for respect, and enveloped in the anger of those who feel they have been ignored.”
In short, The Third Pillar is a mixed bag. It has many insights and Rajan knows how to turn a phrase. Unfortunately, he does not make a strong case for community and too readily accepts a high amount of state power over people’s economic lives, even in “the land of the free.”