The Third Lesson of Economics

Henry Hazlitt's insights were far more sophisticated than one modern critic thinks.


Economics in Two Lessons: Why Markets Work So Well, and Why They Can Fail So Badly, by John Quiggin, Princeton University Press, 408 pages, $29.95

On the radio and in his writings for The Nation, Newsweek, The Wall Street Journal, and The New York Times, Henry Hazlitt was the voice for free market economics during the Great Depression and immediately afterward. He brought the ideas of such thinkers as Ludwig von Mises, Lionel Robbins, and F.A. Hayek to the public, using their work to explain the problems with central planning, the benefits of international trade, and the ways sound money and fiscal responsibility can counter economic volatility. 

Hazlitt's most famous book is Economics in One Lesson. John Quiggin, an economist at the University of Queensland in Australia, has now written Economics in Two Lessons. The second lesson, Quiggin tells us, is that markets suffer from external effects, monopoly power, underprovision of public goods, macroeconomic volatility, and inequality.

Quiggin's book is engaging and well-written, and it sums up as well as any work the economic arguments for activist government. But it would be more convincing if the author were a bit more up-to-date on what has happened in the discipline since 1980. Quiggin acknowledges the contributions of the Austrian, Chicago, and new institutional schools of economics. But he argues, mistakenly, that these have since been theoretically and empirically refuted.

The history of the government-vs.-the-market debate can be divided into three stages. The first imagines perfect markets and perfect government, then favors markets for solving economic problems. The second imagines imperfect markets and perfect government, then favors government intervention. The third imagines imperfect markets and imperfect government; it admits market failures are real but argues that we should nonetheless look to markets to fix them. Quiggin misidentifies Hazlitt with Stage 1, but he in fact offered an early version of Stage 3.

Quiggin's own presentation is pure Stage 2. Much of the book is spent showing that markets are not perfect and noting that many economists have made this point already. It frustrates him that Stage 1 must continually be refuted—in another book, he dubs its persistence "zombie economics." But to economists who have been through this debate and operate at Stage 3, Economics in Two Lessons is its own form of zombie economics.

Economics in One Lesson focused on the idea that sound economics considers not just a public policy's immediate, intended consequences but also its indirect, unintended consequences. Quiggin summarizes Hazlitt's message a little differently, as an argument that market prices fully reflect opportunity costs—that is, that the value of goods produced equals the value of the next best alternative use of the resources that went into them, resulting in perfect efficiency in exchange and production. Put simply, this would mean that the best of all possible worlds would be achieved through the market mechanism.

But Hazlitt understood that a market is never perfect, nor is it in equilibrium. The price system guides individuals to discover mutual gains from trade, prodding them to find the most valuable uses for scarce resources and thus moving the whole system into more efficient resource allocation. By ignoring those subtleties, Quiggin ends up collapsing Hazlitt's lesson to "markets work well when they work perfectly"—and when they don't work perfectly, Quiggin says, we need government to fix the problems.

A particularly critical issue, which Quiggin thinks the market is impotent to address, is climate change. Since no one owns the climate, prices cannot communicate important information about how much of an effect an economic endeavor is having. Without prices, economic actors cannot coordinate their plans in a way that incorporates information on climate change and then adapt and adjust accordingly. But as we'll see, Quiggin is arguing with a strawman.

Economics in Two Lessons mentions but doesn't really engage with public choice (which applies the theories and methods of economics to politics); law and economics (which applies economics to the analysis of law); property rights economics (the study of property as an underlying economic institution); and market-process economics (which sees the market order as being fundamentally about exchange and the institutions within which exchange takes place). These fields just aren't part of Quiggin's intellectual DNA, so instead he returns again and again to the high theory of 1950–1980.

The basic ideas behind these fields were part of the common knowledge of classical political economy. But the consensus that Hazlitt opposed, embodied in the work of the late Massachusetts Institute of Technology economist Paul Samuelson, ignored these traditions. After 1950, scholars such as Armen Alchian and Harold Demsetz had to rediscover property rights analysis, just as Ronald Coase had to press economists to understand how alternative legal arrangements impact economic performance and James Buchanan and Gordon Tullock had to explain how the political process within modern democracies operated. And while Joseph Schumpeter had long talked about the role of the entrepreneur as a necessary component of any explanation of the market process, the Samuelson-era model of perfect competition eliminated the analytical need for the entrepreneur. The market process's constant adaptation and adjustment to changing circumstances was therefore little more than an analytical pest to the economic theorist. Once these ideas are taken into account, the sort of market failure theory that Quiggin claims as the second lesson of economics becomes more complicated than he acknowledges to his readers.

This hobbles his discussion of several issues, including the aforementioned matter of climate change. Here he paints his opponents as practitioners of Stage 1 economics, then maintains that when those arguments fail they retreat to denial of the claims about climate science. But this is not the position taken by such economists as Thomas Schelling and William Nordhaus. They instead have looked at the adjustments and adaptations that occur as a consequence of climate change, both in terms of relative price changes that direct economic activity toward more efficient utilization of scarce resources and in terms of technological innovations that are both less costly and more ecologically friendly. They've also explored the dysfunctions that can follow when government decision making isn't checked by the discipline of the market—for example, the environmental degradation that afflicts many publicly managed common-pool resources.

Quiggin's failure to engage the lessons of Stage 3 economics also hobbles his analysis of antitrust. In his view, the law is guilty of tilting the economy toward monopoly rather than competition. But Stage 3 economists have shown that the paradigm that dominated antitrust and regulatory economics from about 1950 to 1980 was a poor guide to policy.

According to that approach, economic analysts could measure industry concentration and from that infer whether a company's pricing conduct would approximate that of a competitive firm or a firm with monopoly power. They could then make another inference about whether the industry's performance was optimal or suboptimal. If judged suboptimal, then government would step in as a corrective. 

But in The Antitrust Paradox (1978), Robert Bork famously argued that any effort to force-fit the economy into the textbook image of a perfectly competitive economy would have the same effect on industrial output as a few strategically placed nuclear bombs. Other Stage 3ers showed how businesses used antitrust to protect themselves from the rigors of competition, as opposed to ensuring a competitive environment. They also showed that entrepreneurial discovery and creativity are the main drivers of economic progress, forces overlooked in the old paradigm's static conception of the market.

In each topic they tackled, Stage 3 scholars have recognized that human beings are imperfect and that we interact with each other in an imperfect world mediated by imperfect institutions. We must deal with bumbling bureaucrats as well as erring entrepreneurs. That requires institutions that provide feedback and stimulation—that direct and redirect our efforts, so we can act less erroneously than previously. The second lesson of economics, understood correctly, isn't really that markets fail; it's that institutions matter.

Institutions matter because they structure the incentives that economic decision makers face, and institutions transmit the information that actors must process to negotiate the environments they find themselves interacting within. It is institutions that determine how we pursue productive specialization and whether we will be able to realize peaceful social cooperation through mutually beneficial exchange. The second lesson thus leads naturally to the third lesson of economics—that it requires a comparative institutional analysis of market and nonmarket decision making.

For the economists who informed Hazlitt and who have worked in his tradition since then, markets are never perfect. They are always in a process of becoming, and that process is where we see the constant adaptation and adjustments that coordinate economic activities over time. Hayek called this complex coordination through the market a marvel. Quiggin's book misses the marvel, and he sees solutions only through the concerted effort of governmental authority. It is he, not those who follow in the footsteps of Henry Hazlitt, who cut the lesson off too early.