Defining Social Welfare—and Achieving It

Friday, April 30, 2004

Lawyers and economists often tackle the same problem from opposite directions. Lawyers talk about the protection of private property under the rule of law, from which competitive markets emerge. Economists talk about the gains from a competitive economy, from which they derive the need for property rights under the rule of law. Property rights, freedom of contract, and limited government are the touchstones for both approaches. Keep them in the forefront, and it is hard to go wrong. Deviate from them, and it is hard to get back on course.

Unfortunately, because every element of this thesis is contested today, it is critical to see how the parts fit together. If we start at the back end, the simplest proxy for economic performance is the wealth that any society can accumulate. At this point, however, the skeptic chimes in by condemning this crass vision for ignoring a rich array of human values and sentiments. For them, some broader, if ill-defined, measure is needed to establish the correct social measure.

Much can be said for this criticism at an abstract level, but in the end it should not deter us from embracing the simple propositions with which we began. At root, all people wish to combine material wealth with personal health, happiness, and satisfaction. Any test of economic performance that fixates on the former to the expense of the latter does serious violence to our deepest intuitions. To the extent that we are able to measure these diffuse matters, most people attach about equal weight to the non-pecuniary aspects of their lives: good health, families and friends, hobbies, and the like. Indeed, if one wants to get a fair sense of the progress of the last hundred years, it is sufficient to look at overall measures of public health. Life expectancy moved up about 30 years between 1900 and 2000, from about 47 to 77 years, which counts as a greater increase (from a higher base no less) than took place in the previous 2,000 years. And with that improvement came massive advances in general fitness; the average person at 60 today is as healthy a person at 45 only a half-century ago. Infectious diseases such as polio, and the crippled children they left behind, were once commonplace in society; mercifully, now both are rarities. Many chronic conditions such as gout are largely controllable. The benefits are not confined to the United States. Similar advances have taken place across the globe.

No one in his right mind should disparage these enormous achievements. In addition, everyone should remember that the distribution of these personal benefits is more widely dispersed than the traditional forms of income or wealth. One representative English study of infant mortality reported deaths per 1,000 in 1900 that ranged from 247 for the poorest working class groups to 94 for the most fortunate, a ratio of about 2.5 to 1. That ratio has not changed in 100 years, but by 2000 the top to bottom ratio had gone from 8.1 to 3.1 per thousand. Why worry about the persistence of inequality in the face of massive improvement for individuals across the entire income spectrum?

Yet even here there are doubters about the measure of progress. One theory, which I think is more fashionable than sound, stresses the importance of relative preferences. Stated in a nutshell, the proposition is that people care less about their absolute sense of well-being and more about how their personal position compares with that of their peers. Misery is not so bad when there is company. No one here can deny that individuals learn about possibilities for improvement by looking at the behavior of their peers. But it is a far odder thing to say that a person would rather die at age 50, as long as all his friends did, than live to age 70 even if his friends reached 80. At this point, the theory of relative preferences presumes that rational individuals are happy to cut off their noses to spite their faces. To accept this definition of human progress treats equality, not as a test of opportunities to make one’s way in the world, but rather a giant vise that holds each person back until everyone else can participate in his advances. But would anyone really rather have overall infant mortality rates of 94 (the best cohort in 1900) or the current skew of 8.1 to 3.1 that we have today? Do we know anyone today who spurns the known and accepted advances of technology in order to return to the good old days? The defenders of material wealth may overlook much of what matters, but at least they do not make the mistake of sacrificing progress for all on the altar of equality.

The nature of this attack on the standard measures of social welfare is profound. The basic position that I would defend—I would almost call it the “non-envy principle”—holds that if you have two states of the world, such that in state A everybody, or even one person, is better off than in state B, while nobody is worse off in B than in A, then choose A. So don’t quake with each revelation that the rich have increased their share of wealth. Rather ask the question whether this comes at the expense of other individuals, or whether it is part of a rising tide that raises all ships. By this measure, property rights and the rule of law really do matter. Where these are not in place, then the good fortunes of the few frequently come out of the hides of the many. But when they are secure, then accept that those who have acquired wealth have done so through market transactions that have made everyone better off across the board. The key inquiry is not what the distribution looks like. It is what processes bring it about.

In ordinary life, most people understand the tension between wealth creation and wealth distribution. In ordinary business, managers must always cope with massive income disparities within their workforce. Yet most Microsoft employees do not get terribly upset that Bill Gates is richer than they are. They live happy and rewarding lives even knowing that someone out there is worth north of $80 billion (much of which is devoted to charitable purposes in any event). On the other hand, if the good-for-nothing in the next cubicle earns five dollars more an hour than you do, that could be the source of great indignation, uneasiness, and unhappiness. What’s going on? Are people crazy?

Not at all. Most of the concerns with relative preferences in economic performance do not turn on simple differences in wealth but on the perception of free-loading in cooperative ventures. If two persons get the same salaries for performing like work and one does not deliver, then the other is forced to carry more than his fair share of the load. It is that perception of a forced cross-subsidy in a cooperative setting that is treated as a form of theft, which in fact it is. Setting the right pay differentials and promotion structure enhances the productivity of the firm. Anxiety over relative wages in narrow contexts is a measure of long-run social efficiency. Unfair burdens lead to low morale, the departure of the ablest workers, and fewer widgets.

The job of the Hoover Institution is not to manage individual firms but to figure out the background social conditions that make these firms possible. So we segue back to the rule of law. What exactly does this noble, if time-worn, expression mean? At a minimum it rules out both anarchy and tyranny. Anarchy allows any person to use force against anyone else. Tyranny allows one person to use force against everyone else. What’s left in the middle?

The rule of law is the verbal trope designed to convert a tyrant into a sovereign. All too often it is associated, mistakenly, with democratic institutions. But in fact its natural home is as a counterweight to a monarch’s powers, forcing him to operate under known and observable constraints. That trope was strong enough to lead the emperor Justinian to codify the principles of private property and voluntary contract for the ages. Embracing the rule of law made it harder for monarchs to engage in abusive practices but still left them enough discretion to govern. As our own great Justice Benjamin Cardozo said, the rule of law supported a conception of “ordered liberty,” with equal weight on both words.

To control discretion, the rule of law matters. Today’s alternative is too often a multifactored test that confers enormous discretion on political organizations to dispense favors to their friends and impose burdens on their opponents. In contrast, general rules treat two individuals in like circumstances in the same fashion. The rule of law, however, requires not only coherent legal doctrine but also sound institutions for the impartial adjudication of disputes. Bias in administration can subvert the finest set of substantive rules.

These conditions might sound like simple platitudes, but the breakdown of law and order worldwide offers vivid reminders that the rule of law is extremely difficult to maintain in practice. Daily, we witness arbitrary arrest, torture, special privilege, and retroactive rules. But why worry when these take place in Iraq and North Korea? In March 2003, former Stanford University president Gerhard Casper organized a conference on the rule of law. I asked the group the following—serious—question: Does the city of Palo Alto observe the rule of law? The first response was, how absurd in the absence of any massive immigration from Palo Alto to Rwanda, where housing is a lot cheaper. We are free in Palo Alto from arbitrary arrest by political officials for political dissent. Bodily security and personal liberty are intact.

Even so, serious doubts about the rule of law remain for us in Palo Alto— or Chicago or New York. Special legislation and retroactive laws offend the rule of law; yet both are rampant. The rot starts at the top. The Supreme Court takes pride in its ability to formulate general protection for property rights and celebrates the use of “ad hoc rules” for land-use planning. This relaxed attitude opens the door to Palo Alto’s huge doses of special legislation and Byzantine and interminable procedures. The stifling of new development yields an enormous premium to the rich and famous who settled down before the barriers to entry went up. But we delude ourselves into thinking that Palo Alto’s restrictive decisions are guided by some neutral expertise that allows government panels to “designate” who may build on what land. In today’s overheated world, permits to build can count for upward of 80 percent of the value of any parcel of land. Restrictive building policies stifle economic competition and create a new form of protectionism if the furniture store on the west side of the boulevard can persuade the zoning board to keep out a potential rival on the east side.

Elsewhere, the prohibition against retroactive legislation has frequently broken down, so that legal transactions can be ripped open, creating vast new liabilities when none existed before. Retroactive taxation and regulation are routine business today. The endless political churning results in a diminution of social wealth. The stability of property rights in land and in patents is needed to harness productive private labor, free from endless political machinations. But we will never design stable and sensible property rights consistent with the rule of law until we, collectively, are persuaded that these actually advance human welfare. Seeing the indissoluble connection among property rights, the rule of law, and economic well-being will not solve all our problems. But it is a giant first step in that direction.