Centralized vs. Decentralized Social Welfare Maximizers

Faith in a select group of public servants to maximize social welfare is no better founded than the belief in the supernatural gifts of kings or noblemen. Just as misguided is the idea that good things, as decided by a majority, should be mandated. It should be remembered that our current prosperity and freedom have resulted from unwanted gradual changes in mores related to property rights, which when firmly established sparked the Industrial Revolution. Nobody planned that. Property rights were not created to win wars or eliminate poverty, though they did that as well as many other good things.

In a surprise to every intellectual, a modern economy is based on a system that encourages self-interested agents to do what they think is best, and produces results we do not foresee let alone intend. It is the ultimate decentralized system. In contrast, a system based on state regulations and monopolies (eg, public schools, utilities) is centralized. The push for more centralization dominates the state, academics, and media because these are the people who are good at articulating high-minded policies and are pissed-off that they have to sell them, as in most cases consumers don't want their solutions. 

Looking at blockchain technology, often a developer is asked: how does this help the poor? Indeed, some entrepreneurs emphasize how their new coin helps the poor, as when huckster Roger Ver emphasized how Bitcoin Cash saves babies. Everyone knows that if you help the most vulnerable you help society while helping the rich is suspect in that many see the rich as merely taking from the poor (many see the economy as a zero-sum game, so helping the poor increases total utility, helping the rich does not). The implication is that these technological innovations have to obviously help the most vulnerable in society or they are morally suspect, and laws should discourage if not ban wasteful activity if it siphons resources away from what is most important. That violates property rights.

In the Odyssey Odysseus is offended at being asked if he is a merchant, replying: 'that is a black remark!' In contrast, when asked if he was a pirate, he merely said 'no,' as if that would have been no big deal. Indeed, pirates have courage, and courage is a universal virtue, a key to a flourishing society, while traders have no obvious virtue and merely move things around. Similarly, for several millennia interest on loans was seen as parasitic, as money does not do anything, so someone making money on money seems anti-social.

We now understand that banking and trade do help society, and at their essence, letting people lend and trade arises endogenously when we simply letting individuals decide how to use their property, the essence of true ownership. Individuals find it in their mutual benefit to lend and borrow, to sell and buy from traders. The essence of markets—price, profits, entry and exit, free choice, competition—arise naturally as a consequence of private property. There are always markets, such as those in WW2 POW camps, because anything that can be owned, such as cigarettes and personal items, can be exchanged and make both people better off. While thoughtful regulations are useful and some vital, it's like the police: you only need a little.

Rationalists like Sam Harris think we can create a world where truths are discovered bottom up, from axioms to theorems confirmed by empirical data. This is very much like the vision outlined in Paul Samuelson's Foundations of Economic Analysis (1947), where he advocated mathematical economic models built on maximizing agents and equilibrium, much like physics. Alas, in economics this approach is useful only in parochial applications, micro, while most macro results can be obtained via the right assumptions, and researchers rarely have qualms with using the assumptions that generate their preferred policies. We can prove what we want, so the key is knowing what result to want, but that does not come from rational inquiry but rather before: we ask our right-brain what makes us feel good about ourselves.

In the 18th century, proto-economists had a theory called mercantilism that emphasized the ability of trade as a means to acquire gold and silver, which was synonymous with national prosperity. There was also physiocracy that saw the wealth of nations derived solely from the value of land agriculture. In those worldviews, many businesses would seem at best orthogonal to social welfare, the way many today view advertising or bitcoin. Yet, that was the past, and via a combination of naivete and pride, progressives think we have it all figured out now [funny how pride was emphasize by the Ancient Greeks and the Bible as perhaps our greatest sin, now rarely].

The phrase `production for use, not for profit', has been noted by such men as Aristotle, Bertrand Russell, and Albert Einstein, and underlies the ever-present notion that economic decisions would be better served by someone maximizing social welfare instead of their own self-interest. It all seems so simple and minor, just requiring individuals make sure they use their property in a way that advances society’s interest. The problem with this is not what, but who. Who decides what is in society's best interest? What are the incentives for those in charge of top-down direction?

The problems with centralized social welfare helpers include the following:

1. No one maximizes social welfare.

It would be pathological to treat strangers as well as your children or friends, and fortunately, no one does it. Those who say they do are like those who say they have no biases, or base all their decisions on the facts: they are naïve about themselves or scheming hypocrites. If one thinks a social welfare maximizer who at least has to think about 'society' is better than a selfish individual, remember that unlike private selfish agents, these less selfish agents have a lot more power, the force of the state. Eventually, their cause becomes less about the pretext and more about simply protecting vested interests.

The iron law of oligarchy claims that rule by an elite is inevitable within any democratic organization. All organizations eventually come to be run by a leadership class, who often function as paid administrators, executives, spokespersons or political strategists for the organization. Far from being public servants, this leadership class will inevitably grow to dominate the organization's power structures, and they tend to favor their friends and family. By controlling who has access to information, those in power centralize their power with little accountability, due to the apathy, indifference and non-participation most rank-and-file members have in relation to their organization's decision-making processes. The official goal of representative democracy of eliminating elite rule is impossible; representative democracy is a façade legitimizing the rule of a particular elite, the Deep State, the inevitable oligarchy.

In any bureaucratic organization there will be two kinds of people: those who work to further the actual goals of the organization, and those who work for the organization itself. Examples in education would be teachers who work and sacrifice to teach children, vs. union representatives who work to protect any teacher including the most incompetent. Eventually the second type of person will always gain control of the organization and will always write the rules under which the organization functions.

2. Social welfare is hard to measure, so any group officially charged with improving it will never have to prove itself.

In the 1950s China thought the key to a good society was having a strong steel production, so they melted down everyone’s silverware and constructed inefficient steel plants everywhere. In Cambodia Pol Pot took all the useless people, such as intellectuals and financiers, and either just shot them or let them work themselves to death in the countryside. In the Soviet Union and Zimbabwe, the wealthy farmers were seen as parasites and expropriated, leading to famine. At no point in these disastrous plans, ones that violated individual liberty and wrecked the economy, did those in charge notice the disaster and stop the way a money-losing business stops doing what it’s doing when it runs out of cash.

Truth is not discovered via a single mind, but rather, via the competition of ideas. Newton, Nietzsche, Tesla, were geniuses, but like everyone else they had lots of bad ideas too. Your average politician has many fewer good ideas. Unfortunately, when the state creates a new policy or agency, it doesn't compete to survive, it just grows like a cancer. Sometimes they redefine their mandate when the initial one becomes less popular (eg, NASA is focused now on climate change and blockchain technology). Other times they redefine success metrics so that they always appear to work (Obamacare was about improving health, but when mortality rates rose supporters simply pointed to higher insurance coverage). The Department of Education's mandate is so vague it is difficult to measure their output, and with defense agencies like the NSA or CIA their productivity is necessarily secret; they do very little outside the occasional grandstanding about some new report, and people are happy if they don't bother them. Lastly, agencies like the TSA who handle airport security are necessary and have a monopoly, so their incentive to improve service is completely absent.

The technique that most explains the efficiency of the private over public sector is that in the private sector businesses eventually stop doing things that lose money. Either the company owners get tired of losing money, the bank forecloses, or they run out of whatever cash they have. A bad regulation (eg, 10% of all gas in my state must be ethanol) just continues because it costs the lawmakers nothing; a pointless agency can point to anecdotes because there literally is no bottom line. Most government 'production' is measured by how much is spent on them, as if spending money on health care is equivalent to generating that amount of value, and debates center on whether the next budget will increase by 2 or 4% as opposed to junking the existing enterprise and starting over from scratch. Only a decentralized system of individuals permits failure, and without failure, capital and labor stagnates.

3. Information is decentralized, incentives must be too.

Economies use information that no single agent can know, in that there are multiple supply chains interacting at every node. No individual can know all the cost and demand curves for various products and specific times and places, and this lack of knowledge matters when production is centrally planned. This is Hayek’s point about the use of knowledge in society, in that only a market economy both incents people with parochial, important knowledge to transmit this information, say by substituting a cheaper input for a traditional one, and has a mechanism to transmit this information via a change in prices. A top-down decision maker has no access to this data. If prices are not produced via equilibrating supply and demand at various stages of production then the prices are arbitrary, leading to suboptimal decisions in the rare case that a social planner actually tries to maximize social welfare. And lots of queueing.

I'd write more about this, but I can't improve on Hayek's piece, and it's a non-technical and short read. Those interested in more mathematical expositions should look at the First and Second Welfare theorems, as well as Sandy Grossman's work in the 1970's on information in prices (book here).

4. Concentrated benefits and diffuse costs favors business over consumers.

Industry representatives have excessive clout in decisions about how their structure best helps social welfare. This is why regulators, charged with choosing what is best for the country tend to become captured by industry, lobbying for the industry more than consumers. Sugar producers employ only 60k people, and the $2B it costs the US in sugar price supports creates a huge incentive for the producers to maintain their little fiefdom, and little incentive for the 330 million consumers to fight it.

James Buchanan

The net result is that industry regulation is mainly a cartelization device, as it was from its very beginning in the US with industry supporting Teddy Roosevelt's anti-trust initiatives. For example, Roosevelt's first trust-busting regulation focused on banning railroad rebates, as if one of the greatest specters facing consumers was predatory pricing, which supposedly caused smaller firms to go bankrupt, and then allowed the remaining firm to raise prices. Banning price discounts to prevent monopoly power is something so stupid only an intellectual can believe it, as falling real prices is the essence of productivity increases, and prices do not fall in concert, but piecemeal, by the more efficient firms. By outlawing price discounts, the more efficient firms and processes will not grow to take over the way they would in a free market. In this way insiders can build a mote around their inefficient but profitable businesses and share their largess with government officials via the revolving door among their executive suites, and mutually supporting each other in less obvious ways (eg, when banks supported non-profits that supported politicians that supported bank regulations that supported the non-profits that made it more costly to enter the industry).

5. State Policy suppresses discovery

An inefficient business can be annoying, but is not oppressive, as usually one has many alternatives. Progressives realize their biggest problem is that adverse selection, in that a policy designed to help some group only works if most of the current population acts as if the policy were not there. Yet the non-targeted group invariably subsidizes the targeted beneficiaries, and so they opt out in various ways. To prevent this, the policy must be universal, and so the benefits of competition, of watching certain companies or industries thrive (industries also compete with other industries, offering different means to an end), is absent.

Thus top-down solutions must prevent individuals from exercising their liberty. In some cases, choice is simply made costly, as when parents move to get their students out of bad school districts, and the predictable response of school administrators is rarely to actually reform its methods, but rather, to vilify 'school choice' as a pernicious mechanism that hurts everyone. Obamacare makes those who do not buy insurance pay a fee. The licensing and registration also explicitly forbids alternatives: it is illegal to get legal counsel from someone who is not a licensed lawyer, health care from an unlicensed physician, or a manicure from an unlicensed cosmetologist.

Coercion implies you are not making someone better off according to the person you are coercing. While there are exceptional cases where coercion is warranted—children, criminals, psychopaths—in general it should be obvious that if coercion is necessary for your policy, it is a symptom your policy is not making individuals better off.

6. Creative destruction is seen as destruction.

Productivity has more costs than benefits from a utilitarian point of view if one models it as we see it occur. Most economic models of growth simply put in a term for productivity growth that makes it look both passive and benign, as the canonical models are the reification of an economy into a representative firm's optimal growth problem. Everyone is in favor of such productivity because there are no losers, just one happy representative agent. In contrast, if Joe invented a hair-cutting machine that enabled him to cut the hair of 5 men at a time, his invention would deprive 4 of his colleagues a job. If then Joe cuts his price from the market rate of $15 to $12, the cost to society for cutting hair went from $75 to $60, but Joe now rakes in $60 while his 4 colleagues lost $15 each. As most people's budget for haircuts is immaterial and given utility increases at a decreasing rate, that lowers social welfare, QED. Further, a muck-raking journalist could note this would increase the load on social services, and family disruption, etc. Thus one could prove Joe's hair-cutting machine is not merely inefficient, but a vampire squid monstrosity.

In practice, through a process not fully understood (ie, modeled mathematically), the 4 unemployed barbers will probably find employment doing something else that makes society better off. Consider that most of us were farmers 200 years ago while now it's only 3%. Many of ancestors who left the farm did not do so out of their own choosing, but rather, found themselves squeezed out by the newfangled machines that made them redundant. We are better off, but only with hindsight. If we demanded every job displaced by a new technology had to have a better job available for everyone displaced, we simply would have very little new technology.

Top-Down Helpers Don't Help

The best we can do is to minimize state power is by minimizing the size and scope of the state, which means emphasizing restrictions on the state, not individuals. That does not mean individuals have no limitations, just that their rights imply they have the default presumption of being a true owner, with an ability to do what they want, not what some government agency wants. Individual rights are like the presumption of innocence in a jury trial, they shift the burden of proof to advantage one side.

It is not mere folly, but dangerous, to think there can ever be a group, let alone a person, who can maximize social welfare better than what happens when you leave people alone. No one person can create most of the products we use, from a simple pencil to a smartphone. No one fully understands their current role in the production process because it is constantly changing as new technologies arise. If there was a group of earnest bureaucrats charged with maintaining social welfare who had to approve of all new technology or disposition of existing capital, there would be several billion fewer of us, and most would be farmers.

A better solution simply assumes everyone is maximizing their self-interest and to encourage competition, the greatest social welfare improvement policy ever created. If we make sure that people pay for what they use—including the costs of externalities like pollution—profits imply that they are creating more value than they destroy, and they and others should be encouraged to do it more; if they lose money, they are destroying value, and should be discouraged. Profits allocate resources to their most efficient use (like an invisible hand or something!). Competition requires low barriers to entry, which is much more beneficial than licensing requirements and ADV forms.  For example, the mission of SEC is 'to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation'. Yet spreads came down only in spite of them, via a new technology and businesses (high frequency traders) that arose outside of the self-satisfied government-sanction monopolies (ie, NYSE/AMEX/Nasdaq).

Ownership implies control over one’s property, and so the phrase that ownership is nine-tenths of the law means that one defers to the current owner. This prevents endless litigation, as invariably at sometime someone in the past stole the land that one is using from someone else, if not a European from a Native American, then one Native American tribe from another. Further, giving the current owner the ability to transmute or sell their current property incents them to maintain and improve it or sell it to someone who can. Thus, when Pennsylvania was founded back in 1681, it was given to the William Penn to settle a debt owed by Charles II to Penn’s father. Penn promptly sold plots to American settlers who then developed the land productively. It was arbitrary that Penn was given initial ownership, but as Indians had no records or even a conception of private property, there was no way to specify a rightful owner before. Yet Penn's initial ownership was irrelevant, the key merely that someone had to own it before it could be developed. It is a good example of the Coase Theorem.

Property, whether land, capital, or gold, is used best when it is owned by individuals, which means they do not have to ask the state if what they are doing improves social welfare, and they are not obliged to answer the question 'how will this product help the world?' Airbnb, Uber, or bitcoin would not exist if they asked permission first. Even computers, which most white collar workers consider indispensable, were for a long time a curiosity, as Nobelist Robert Solow—whose specialty was economic growth—famously remarked, 'You can see the computer age everywhere but in the productivity statistics.' Solow was a leading expert on long-term growth and was not so much pooh-poohing computers as much as admitting economics was not very good at modeling these new technologies. Those who demand we fully know how any new service or product serves society prior to letting people develop it would retard growth, and giving a group power to make such decisions is an almost irreversible act.

Faith that markets work, and that profits create wealth when they are produced in a competitive market, is not blind faith, but rather something that cannot be proven yet is highly reasonable to believe. Innovation won't come from any single individual's  creativity or Artificial Intelligence, it will only come from zealous advocates and adversaries driven by all the virtues and vices common to men, and only decided by consumers who prefer their products to whatever else they might wish to buy. To presume a state can do this efficiently and will not instead become a self-interested hypocrite monopolist more powerful than any firm or private industry, ignores history, human nature, politics, and economics.