The real world is providing students of economic theory a rare treat with the capital market's discipline of New York City's present legal system. Economists have learned a good deal about how the capital market disciplines firms which have been poorly managed: the Wall Street Journal regularly contains advertisements from investment groups attempting to purchase controlling interest in a company. Successful takeover bids are a well-known method by which the capital market fires the firm's decisionmakers. But the idea of the capital market breaking an entire legal system is not at all routine.
A very real temptation to those discussing public issues is to cast the discussion in terms of heroes and villains. It is certainly easier to point to a small number of choices made by prominent individuals that produced pleasant or unpleasant consequences than it is to trace the process through which collective choices result from public opinion. It is not terribly difficult to see that the newspaper accounts of the problems facing New York are insufficient. That is, it is difficult to believe that the city's expenditures on public assistance, education, or the salaries of city employees are in any simple way directly related to the current difficulties. New York has been making large expenditures for such things for a considerable period of time; yet the heavy discounting of the city's bonds by the capital market is something which has occurred rather recently. Obviously, there is some relation between expenditures and the city's difficulties, but not, I think, a very simple one. Rather, the forces which produce the expenditures on various services are at bottom the same forces which are bringing about the collapse of New York City.
THE ECONOMICS OF NYC'S PLIGHT
Two pieces of economic terminology are required for the argument. The first is that of a legal system. A legal system assigns the right to perform an action or the right to block the performance of an action. (See Ronald Coase, "The Problem of Social Cost," Journal of Law and Economics, 1960, pp. 1-44.) It is not important whether the right is de jure or simply de facto. I am using "assignment of right" as a shorthand notation to analyze the result of the existing legal system. Those who work within a natural right framework argue that people have a set of rights that must be respected in society and that the role of government is, or ought to be, to protect these rights. In my terminology, the existing legal assignment of the right to block a transaction may very well take away the possibility of enforcing an individual's natural right. For example, if there is a rent control law which sets a minimum price below the competitive price, you and I would have lost the enforceable right to effect a mutually beneficial trade at the latter price. Anyone who observes such an illegal transaction has the legal right to block it by notifying the police.
The second term required for the argument is "transaction cost." This is simply the minimum cost of obtaining the legal right to effect a transaction. (Thus, a brokerage fee is not a transaction cost, for it should be insensitive to the legal system.) Let me give an example. If I wish to operate a bookstore, there will characteristically be a cost to obtaining the right to do this: procuring a business license, filling out the state tax forms, etc. Mind you, I have not sold any books, but I have obtained the right to do so. If I wished to sell pornography, I would have to do all that I would to operate a reputable bookstore, and additionally put a lawyer on retainer to fend off the police and reduce the number of days I spend in jail.
LEGAL RIGHTS AND THE MARKET
There is an important aspect of different legal systems which has not been sufficiently studied; that is, what is the impact of different legal systems on what the market produces? (A change in the legal system will make no difference only if there are no transaction costs—see Coase.) It is, I think, New York City's legal system, as it has evolved, which is responsible for the city's present condition and which blocks any easy way out of the difficulty. The relation between a legal system and what firms will produce, however, is sufficiently indirect that an example might be useful.
It must have struck everyone interested in political and social controversy that the range of opinions presented on television is far more constricted than what one can find at even a mediocre newsstand. This difference is due largely to differences in the assignment of rights in the two industries. Magazine publishers have been given the right by the 1st and 14th Amendments to publish almost anything they please, allowance being made for certain statutory exceptions: classified government documents, libel, and pornography. They have been given, therefore, the right to annoy anyone. If an individual is in fact annoyed, he can cancel his subscription and write an angry letter, but not much else: there is no existing legal recourse. He could, if he wished, try to form a group to buy out the magazine or conduct a political campaign to change the law, but this line of action is usually too expensive to be pursued. People are not that annoyed. Thus, although many magazines annoy many people, the annoyed have no real sanction other than not subscribing.
Television broadcasters, on the other hand, do not have the right to broadcast. They hold licenses, good only for a few years, with renewal contingent upon their "public service." If a television station were to broadcast material which annoyed enough people to induce a sizable number of hostile letters to the Federal Communications Commission, the station would be in danger of having its license revoked. Loss of a license would be a multimillion-dollar loss if the TV station were in a metropolitan market. If the station wished to broadcast disturbing material, it would have to bribe those who would be annoyed not to write the FCC. Since this would be expensive and there is not much money to be made in truly controversial material, stations cannot afford to broadcast anything seriously offensive to any vocal group in its market.
POLISHING OFF THE BIG APPLE
The important point for analyzing New York's difficulties is that different legal assignments of rights result in important differences in the range of economic activity carried on. Indeed, what would be trivial outside of New York may be prohibitive inside.
What makes New York City's legal system so interesting is its multiplication of the rights of individuals to block transactions. Insufficient attention was paid to the difficulty that McDonald's had in obtaining the right to sell hamburgers in part of the city. The construction of a McDonald's store annoyed a significant number of people, whose complaints had to be taken seriously. The store was built eventually, but at no inconsiderable cost in obtaining the right.
Other examples are not trivial. It seems clear by now that under the existing legal system all sorts of eminently sensible transactions cannot be made. It does not seem to be possible to replace city-run activities with corresponding private activities. For example, private garbage collection is commonplace in many parts of the country. In New York the cost would be less if the city service were replaced, but it cannot be replaced. Nor does it seem to be possible to replace the welfare system with a straightforward cash grant system, even though a vast number of governmental employees (and their salaries) could be dispensed with. Nor does it seem to be possible to arrest the rapid decay of the city's housing stock by repeal of the rent control law. This last problem deserves detailed attention.
The effect of rent control on the state of a city's housing stock is absolutely predictable. If rents are controlled at below-market prices, and there is no low-cost method of evading the law, then landlords will have more potential tenants at the controlled prices than they require. One effective method of allocating apartments is by letting the buildings decay until the number of potential tenants just equals the number required to fill the building. If the building is allowed to decay, the owner saves maintenance expenses and, under rent control, will not lose any revenue. This brings a clear gain to the landlord.
The decay has been going on for a considerable period of time, but the storm hit in response to increases in the price of oil. The cost of operating an apartment building rose dramatically, but the right to raise the rent enough to offset this increase in New York is costly to obtain. So costly, indeed, that owners have simply abandoned their buildings to the mercies of arsonists.
This brings us to the role of the capital market. New York City discovered long ago that a promise of future tax receipts is readily marketable. Buyers in the capital market have been quite willing to trade cash for this promise of future revenue at very favorable rates because, in part, municipal bonds are exempt from Federal income tax, and, in part, because it was believed that these bonds are a first lien on the tax receipts.
Political entrepreneurs discovered long ago that by regularly marketing such promises of future tax receipts they could raise the probability of their election by increasing the standard of living of various groups. This access to the capital markets is important, because if the political entrepreneurs tried to increase the standard of living of these groups at the direct expense of other groups in the city, the victims of this redistribution could simply leave.
The capital market abandoned New York City, however, when the magnitude of the housing decay and the consequent future reduction in property-tax revenue, as well as the magnitude of the debts New York City had contracted, became clear. Not only were there billions in bonds to be eventually paid off, but also unknown billions in pensions contracted to municipal employees. It took a while, but the capital market finally was able to see that the city was operating a Ponzi scheme.
The revenue to pay off the bonds cannot be raised by increasing taxes over the long run, since the victims would move out and lose any liability for New York City's debts. It does not seem as if revenue can be raised by wholesale governmental reform. The right to fire government employees comes at a very considerable cost. It does not appear that revenue can be raised by encouraging new business activity. Indeed, the new securities-transfer tax may end the city's domination of the financial community. It does not appear that the revenue can be raised by encouraging an increase in the housing stock by repeal of rent control. Many New York citizens have become very attached to the right to prohibit a rent increase. So where had the city planned to acquire the revenue to pay off the bonds? Why, by selling more bonds. Paying off the "first in" with the revenue from the "last in" is the defining characteristic of a Ponzi scheme.
SHAPING UP NEW YORK CITY
It is not difficult to write down a set of prescriptions for New York City that, if effected, would bring about the desired restoration of its financial reputation. The decay of the housing stock could be stopped by abolishing rent control. Expenditures for public services could be easily reduced by replacing government management with private provision of city services such as trash disposal and by substituting cash public-assistance payments for payments in the form of the services of social workers. A system of tuition/loan/scholarship assistance could be designed to replace the "free" tuition at the City University. There seems to me absolutely no doubt that the city would do very well to follow David Friedman's advice: sell its activities in small pieces. The next time garbagemen go out on strike, the city could sell its garbage collection facilities to a large number of private firms.
Note well: each of these proposals would abolish rights acquired by individuals through the existing legal system. For example, under current rent control law, the present tenants have a right to occupancy at the controlled rent. If they were to leave their apartments, they would be forced to move to non-price-controlled apartments or to buy from someone the right, de facto, to occupancy at the controlled rent. Say the controlled rent is $125 a month, but the price which other individuals would be willing to pay to rent this apartment is $200 a month. The landlord cannot raise the rent of the existing tenant or replace the existing tenant. The tenant has a right, worth $75 a month, to continue occupancy at $125 a month. If rent control were abolished, this valuable right would be abolished.
Similarly, city employees have acquired a de facto right to continued employment at an above-market wage. Abolition of this right by recontracting for city services would again result in a real loss to individual employees. A positive tuition would, of course, be a tax on middle and upper income students who would not receive offsetting grants.
Hence, it is not at all clear that there exists a feasible path inside the New York City legal system by which it can restore a semblance of financial stability. The obvious, dramatic remedies require that a considerable number of individuals take a financial bath. It is equally obvious that a considerable number of individuals will stoutly resist such a fate. Presumably, the citizens of the city will have to convince themselves that the gain from the restoration of stability will be worth the cost of attaining it.
One of the tempting aspects of a formal default is that the decisions would be made for New York City outside its legal system, probably in the Federal courts under pressure from the city's creditors. A legal battle over who, in law, has first claim on city revenue would promise to restore full employment to the legal profession and to amuse that part of the general public which is neither long on New York City bonds nor long on pensions. But here, the legal rights acquired by individuals might simply be ended by fiat.
A less drastic possibility is compensation: for example, individuals who lose the right to occupancy at the controlled price would be paid off by those who would gain by the abolition of rent control. (If this were easy to accomplish, however, it would have been done already.) The city might pay some of the compensation in the form of discounted city bonds so that the restoration of the city's financial health brings with it financial gain to those individuals who otherwise lose in the process.
The people of New York City may believe, however, that they can continue to bluff the funds out of the other parts of the country. They may believe this, and this belief may lead them to conclude that no action is required on the fundamental flaws in the city's legal system. If the people of New York make this bet, and if they eventually lose, then a great many acquired rights may be abolished overnight in a bankruptcy court.
It is clear that at least one thing has changed in the last few months. No one seriously believes anymore that New York City bond holders will actually have first claim to city revenue in the event of default. The de facto default has solved that problem. This alone may shut the city out of the municipal bond market for a considerable period of time. The days of Ponzi financing are over.
The Federal assistance provided in President Ford's program has given the people of New York City a period of grace in which to negotiate with each other. If the assistance is not forthcoming in the future, then default, and government by fiat, may follow. This consequence may well be grim enough to induce the people of New York City to consider seriously their future.
David Levy is a Ph.D. candidate at the University of Chicago and teaches economics at the University of Kansas. His article "Learning Economics from Walt Disney World" appeared in REASON's October 1975 issue.