November/December 1988

Using the Market for Social Development

By Milton Friedman

An episode during an earlier visit to China impressed me strongly with the wide gulf of understanding that separates people immersed in different economic institutions. That gulf makes it extremely important to stress over and over basic principles and idea that all of us simply take for granted with respect to the system to which we are accustomed. The episode in question occurred when my and I had lunch with a deputy minister of one of the government departments who was shortly going to the United States to observe the American economy. Our host wanted help from us on whom to see.

His first question is that connection was, "Who in the United States is in charge of materials distribution?" That question took my wife and me aback.; I doubt that any resident of the United States, however unsophisticated about economics, would even think of asking such a question. Yet it was entirely natural for a citizen of a common economy to ask such a question. He is accustomed to a situation in which somebody decides who gets what from whom, whether that be who gets what materials from whom or who gets what wages from whom.

My initial answer was to suggest he visit the floor of the Chicago Mercantile Exchange, where commodities such as wheat, cotton, silver, and gold are traded. This answer understandably baffled our host, so I went on to elaborate on the fact that there was no single person — or even a committee of persons — "in charge of materials distribution." There are a Department of Commerce and a Department of the Interior that are concerned with materials of production and distribution in a wholly different way. But they do not determine who gets how much of what. In consequence, I was forced to answer in terms that my host found extremely difficult to comprehend. Needless to say, that is not a criticism of him. Given his background, it is almost inconceivable that he could have understood how the market can distribute a variety of materials among millions of different people for thousands of uses untouched as an ad might say, by political hands.

The miracle of the market I s precisely that out of the chaos of people screaming at one another, making arcane signals with their hands and fighting on the floor of the Chicago Mercantile Exchange, somehow or other the corner store always seems to have enough bread, the bakery always seem to have enough flour, the miller always seem to have enough wheat, and so on. That is the miracle of the way the market coordinate the activities of millions of people, and does so in a wholly impersonal way through pricing that, if left completely free, does not involved any corruption, bribes, special influence, or need for political mechanisms.

Let me now turn more directly to the topic. In some ways, referring to "the market" puts the discussion on the wrong basis. The market is not a cow to be milked; neither is it a sure-fire cure for all ills. In literal terms, the market is simply a meeting at a specified place and time for the purpose of making deals. Needless to say, "meeting" and "place" are often euphemisms; they do not involved physical getting together. As of the moment, there is a market in foreign exchange that encompasses the world. People get together through satellites, telephones, and so on. Moreover, the deals made in or through a market are not restricted to those involving money, purchases, or sales. Scientists who cooperate with one another in advancing their discipline, whether it be physics, chemistry, economics or astronomy, are effectively making deals with one another. Their market is a set of interrelated journals, conferences, and so on.

The market is a mechanism that may be mobilized for any number of purposes. Depending on the way it is used, it may contribute to social and economic development or inhibit such development. Using or not using the market is not the crucial distinction. Every society, whether communist, socialist, social democratic, purely capitalist, or what you will, uses the market. Rather, the crucial distinction is private property or no private property. Who are the participants in the market and on whose behalf are they operation? Are the participants government bureaucrats who are operating on behalf of something called the state? O rare they individual operating directly or indirectly on their own behalf? That is why, in an earlier paper delivered in China, I advocated the widest possible use of not the market but "free, private markets." These words "Free" and "private" are even more important than the word "market."

Many specific problems arise when a society tires to replace a command economy with the invisible hand of the market, of which I shall discuss only a few. Those problems are not restricted to societies that have tried to command as their basic economic mechanism, such as China and Russia; they also arise in Western economies such as the United States, Great Britain, and Germany, in which command elements have become more extensive over time and in which there are attempts to reverse that process. Eliminating government-owned enterprises in the West, such as the postal service in the United States and railroads and utilities in other countries raises problems that are identical with those that arise in replacing command and public ownership by voluntary cooperation and private ownership in China, Russia and so on.

Partial versus Total Decontrol

Introducing a greater role for private market mechanism in one sector of an economy may be partially or completely frustrated by the limited scope of the change. Consider what has been regarded as a major move toward wider use of the market, namely creation the European common market and the attempt to achieve free trade among the common market countries. It has now been nearly 40 years since the Schuman plan for a coal and steel community was adopted, yet no observer will disrupt that free trade with the common market is still an ideal rather than a reality. The latest bit of evidence is the recent agreement to really eliminate all barriers by 1992. Had the initial common market agreement been successful, that would have been achieve many years ago.

What was the problem? Why is there no real United States of Europe? IN my view, the answer is that decontrol was adopted even principle only for goods and services but not for money. The separate countries retained full authority over their national moneys. More important, they refused to adopt a system of freely floating exchange rates- that is, the free exchange of one currency for another at whatever rates of exchange were voluntarily agreed to in free private markets. The refusal to let the private market determine the rates of exchange among currencies was a fatal weakness.

Currently, China is faced with precisely the same problem. But my purpose in discussing it here is not to present again the case for a system of freely floating exchange rates but rather to give a striking illustration of how limiting decontrol or privatization to one area, while not extending it to closely related areas, can largely frustrate the basic objective.

A second example is from the United States. Although nominally private, U.S. airlines were subject to extensive government control with respect to the prices they could charge and the markets they could serve. Deregulation of the airlines in 1978has resulted in very much in enhanced competition, widespread and enhanced competition, widespread and substantial reduction in prices and increase in the range of services, and in, consequence, and major expansion in the volume of air traffic. However, while airlines were deregulated, or, as I would prefer to put it, privatized, airports were not. They remain government-owned and operated. Private enterprise has had no difficulty in producing all the planes the airlines find it profitable to use. The private enterprise airlines have had no difficulty in finding pilots to fly them and attendants to service them. On the other hand, planes filled with passengers are often delayed because facilities or provisions for landing them at government run airports are inadequate. Naturally, the government responds by trying to blame the private airlines: it ahs started requiring them to report delays in meeting their scheduled arrival times and publishing summary reports on the on-time performance of the several airlines. Repeated proposals have been made that, even if government retained the ownership and operation of the airports, at the very least rights to gates, with respect both to number of gates and to the times at which they are to be used, should be auctioned off. Unfortunately, the opposition of airlines that have vested interests in the gates and times assigned to them by government entitles has prevented the adoption of even such incomplete reforms. Of course, a far better solution would be to privatize the airports.

A third example is privatizing some areas of manufacturing while keeping the production or pricing of the raw materials under government control.

Let me cite some obvious examples for China. Introduction of a considerable element of privatization in agricultural has produced a remarkable increase in agricultural output and productivity — the most dramatic manifestation of China's success in widening the use of the private market. Bu tit is clear that the very success has created a real problem. The overwhelming majority of the Chinese population is employed in agriculture. Even a relatively small improvement in agricultural productivity obviously means release from agriculture of labor that it is no longer productive to employ. It is in China's interest to use that labor in more productive areas, such as industry. Yet the bulk of industry remains in the command economy; it has not been privatized, deregulated, or fully subjected to the market process.

There has been a real attempt to change the way government-owned enterprises operate. The people in charge have been told to use market mechanisms, and an attempt has been made to provide incentives of them to do so. However, as long as bureaucrats run government-owned industries, their ability to respond to market pressures effectively will be severely limited. In the case of China, the most serious limitation is on their flexibility, their willingness or ability to be venturesome, to undertake risky projects that have a likelihood of failure but a real, if small, chance of spectacular success. Again, the problem is universal. Every study of the United States or the United Kingdom demonstrates that small enterprises — not the mega corporations that are household names — are responsible for most of the new jobs. In China, the scope for such private enterprises is extremely narrow.

A much wider privatization of economic activity would greatly reduce the difficulty of absorbing the workers release from agriculture. Private enterprises would then spring up all over the place to absorb the workforce.

A second example for China is similar to the problem I described for the common market: the difference between the extent of freedom in the production and distribution of goods and services and in the production and distribution of money. The substantial freeing of many prices, particularly those of agricultural and similar goods, has not been accompanied by the privatization of the banking system. As I understand it, the Chinese government indirectly determines what happens to the money supply through the credits it grants state enterprises. The results include a rapid increase in the quantity of money and, not surprisingly, a rapid upward pressure on prices, so that inflation, both open and repressed, has reared its ugly head.

When should reform be gradual, and when is radical and immediate change appropriate? One alternative is illustrated by the tale of the tortoise and the hare, when the "slow but steady" tortoise reaches the finish line ahead of the much speedier but more erratic hare; the other is illustrated by the maxim, there is no sense in cutting a dog's tail off by inches. This is on eof the most difficult problems encountered in widening the scope of the market. Let me illustrate with foreign trade. Suppose a country that has had high levels of tariffs decides to move to a free trade position. The case for moving gradually is clear. Capital has been invested in ways that twill no longer represent an effective use of private resources under the new conditions. Much of that capital is in the form of machinery, buildings, human skills and the like. Is it not clearly both more equitable and more efficient to reduce the tariffs gradually? That would give the owners of specialized resources the opportunity to withdraw their capital gradually and thus would reduce the costs imposed on them by the change.

The case for eliminating the tariffs in one fell swoop, that is, for shock treatment, is more subtle, yet at the level of economic efficiency, compelling. Insofar as it is economically efficient to use the specialized resource in the absence of a tariff, they will be used. If any return over marginal cost can be obtained by continuing to use the specialized human and other resource it is better to get that return than to get nothing. The burden would be imposed on the owners of the specialized resources immediately, but technical disinvestment would proceed only as rapidly as the specialized labor and other resources could be employed more productively else where. On the other hand, gradual reduction in the tariff makes it privately profitable to continue using specialized resources at a higher level than is socially efficient, thereby imposing unnecessary costs on the community.

Ending an ongoing inflation raises similar problems. Eliminating inflation at one fell swoop, if not anticipated long in advance, may cause widespread capital losses. Long-term contracts entered into with on e expectation about the likely rates of inflation may now suddenly be rendered inappropriate. The case on equity grounds for a gradual transition is far stronger for moderate degrees of inflation than for tariffs. The effects of both the prior inflation and its unanticipated ending are more pervasive and affect more people who have not only been harmed rather than benefited by the prior inflation but would be harmed again its abrupt end. Reducing inflation gradually eases the transition and reduces the costs of achieving non-inflationary growth.

However, much depends on the height of the inflation. If inflation is extremely high — at annual rates in triple digits — the situation is very different. Almost all participants in the market will have adjusted their arrangements so that nay longstanding commitments are fully indexed. Abrupt disinflation will impose few costs because financial and other institutions have been adapted to radical changes in the rate of inflation — indeed, such adaptations represent a major cost of high and erratic inflation. Gradual elimination is sometimes not even feasible because there is not time enough — the dog will be dead before its extra-long tail can be cut off by inches.

Direct controls over prices — whether general or specific, e.g., on rents or exchange rates — are most always best ended at once. Margaret Thatcher properly ended exchange-rate controls in Britain overnight and completely. Gradual adjustment only prolongs the harm done by controls and provides unjustified benefits to "insiders." The shortages, queue, and other distortions produced by trying to hold prices below their market level would continue though they might be reduced, and additional problems arise because gradualism encourages speculation about reversal and encourages opponents to seek reversal. A similar proposition holds for attempts to maintain prices about market levels — as is so simply demonstrated by the agricultural policies of the United States, Japan and the common market.

Overcoming Political Obstacles

The subject has already inevitably intruded into the preceding section. The general issues here is how to overcome political obstacles to widening the market. The danger is not alone that these obstacles will frustrate the attempt to free the market, but equally that over coming political obstacles may destroy the advantages of freeing the market. The challenge is to find ways to overcome obstacles that do not have those effects. The West's experience with privatization is particularly helpful in this connection. Perhaps the most extensive body of experience and the experience that has been most widely analyzed is the British experience with privatization, and I strongly recommend to our Chinese friends seeking to widen the market that they examine the evidence of privatization in Britain.

A simple case from the United States that illustrates the problem is privatizing the post office. The U.S> Postal Service has a monopoly in first-class mail because of the private express statutes, which make it a crime for individuals to offer common-carrier first class service. Various attempts to do so have only succeeded in prosecution, which has ended the attempts. Privatization has been creeping in at the margin, first in the form of alternate parcel services. The United Parcel Service and other parcel delivery companies have taken over the bulk of the Postal Service's prior business. IN addition, private messenger services have developed, of which, the best known is Federal Express, which has been so successful that numerous competitors have emerged. Developments that technological advanced would have encouraged no matter how postal service was organized have doubtless been speeded up. Examples are electronic mail via computers and telephones and facsimile service, again over telephones. These examples illustrate the ingenuity of private markets in exploiting the opportunities offered by the inefficiency of government enterprises.

Repeated attempts have been made to seek the repeal of the private express statues so that private individuals and enterprises could compete with the Postal Service. However, such attempts always bring violent protests from the postal employee unions, from the executives of the U.S. Postal Service, and from rural communities that feel they would be deprived of postal service. On the other hand, few people have a strong and concentrated interest leading them to favor repealing the state express statues. Entrepreneurs who might in fact enter the business if it were open to private entry do not know in advance that they would do so. Hundreds of thousands of people who would doubtless obtain employment in a privately developed postal system do not have the slightest idea that they would do so.

One way to overcome the opposition to privatization, widely used in Britain is, as described by Robert Pool,

To identify potential opponents and cut them in on the deal, general by means of stock ownership. The specific applications of the principle are (1) employee stock ownership, and (2) popular capitalism...

The opportunity to become shareholders can dramatically change the incentive of unionized civil servants, as illustrated in the case of British Telecom. Union officials denounced the planned privatization of Telecom, telling their members to purchase the shares which were being offered. Yet in the end, sensing the chance to make money, some 96 percent of the work force bought shares.

Poole also uses British Telecom to illustrate the second technique, popular capitalism:

To encourage telephone customers to buy shares, they were offered vouchers granting them a discount on their phone bills if they held their shares for at lest six months. And to prevent institutions and large firms from buying up the lion's share, initial purchase were limited to 800 shares per buyer.

A pitfall to be avoid in adopting such expedients is to sweeten the deal by converting a government monopoly into a private monopoly — which may be an improvement but falls far short of the desirable outcome. The U.S. Postal Service illustrates that pitfall as well as the fallacy that mimicking the form of private enterprise can achieve the substance. It was established as a supposedly independent government corporation that would not be subject to direct political influence and that would operate on market principles. That has hardly been the outcome, and understandably so. It i remained a monopoly and did not develop a strong private interest in efficiency.

My own favorite form of privatization is not to sell shares of stock at all but to give government-owned enterprises to the citizens. Who, I ask opponents, owns the government enterprises? The answer invariably is, "The public." Well, then why not make that into a reality rather than a rhetorical flourish? Set up a private corporation and give each citizen one or one hundred shares in it. Let them be free to buy or sell the shares. The shares would soon come into the hands of entrepreneurs who would either maintain the enterprise, for example, the postal system, as a single entity if it was most profitable to do so or break it up into a number of entities if that seemed most profitable.

A final example illustrates the point in another way. The Russians have permitted small private plots in agriculture. Those private plots are estimated to occupy about 3 percent of the arable land in the Soviet Union, and roughly one-third of all domestic food products in the Soviet Union are sold as coming from those private plots. I have chosen my words carefully. I did not say that one third were "produced on those private plots," because in my opinion that would not be correct. Much of the food sold as coming from the private plots ahs indeed been produced on them, but I strongly suspect that much as also been diverted from collective farms.

For decades, it has been clear to the rulers of the Soviet Union that they could increase the domestic output of agriculture substantially by increasing the size and role of the private plots. Why have they not done so? Surely not because of ignorance. The answer clearly is that privatization would tend to establish independent centers of power that would reduce the political power of the bureaucracy. The rulers regarded the political price they would have to pay as higher than the economic reward. As of the moment, largely I suspect under the influence of such a policy in China, President Gorbachev is talking about a considerable expansion in private plots. It is by no means clear whether he will succeed.

Tyranny of the Status Quo

The problems of overcoming vested interests, of frustrating rent-seeking, apply to almost every attempt to change government policy, whether the change involves privatization, or eliminating military bases, or reducing subsidies, or anything else. The resulting "tyranny of the status quo," as my wife and I entitled a recent book discussing a range of such cases in the United States, is the major reason that political mechanisms are so much less effective than free-market mechanisms in encouraging dynamic change, in producing growth and economic prosperity.

Few simple maxims exist for overcoming the tyranny of the status quo. But there is one that ties in closely with the earlier discussion of gradual versus abrupt change. If a government activity is to be privatized or eliminated, by all means do so completely. DO not compromise by partial privatization or partial reduction. That simply leaves a core of determined opponents who will work diligently and often successfully to reverse the change. The Reagan administration repeatedly attempted, for example, to privatize Amtrak (the railroad passenger service) and to eliminate the Legal Services Corporation. In each case, it settled for a reduction in budget, achieving a fairly transitory victory. On the other hand, the complete abolition of the Civil Aeronautics Board gives far greater hope that airline deregulation is here to stay.

In conclusion, there are better and worse ways to privatize a command economy, but there is no magic formula for shifting painlessly from a command to a voluntary exchange economy. Nonetheless, the potential rewards are so great that, if the shift can be achieved, transitional costs will pale into insignificance. It is a tribute to the current leaders of China that they recognize that the potential gains dwarf the transitional costs and that they are engaged in a serious effort to make the transition. The Chines people would be the main but by no means the only beneficiaries of the success of this effort. All the peoples of the world would benefit. Peace and widely shared prosperity are the ultimate prizes of the worldwide use of voluntary cooperation as the major means of organizing economic activity.

Milton Friedman, recipient of the 1976 Nobel Prize for Economic Science, has been a Senior Research Fellow at the Hoover Institution, Stanford University, since 1977. He is also Paul Snowden Russell Distinguished Service Professor Emeritus of Economics at the University of Chicago, where he taught from 1946 to 1976, and was a member of the research staff of the National Bureau of Economic Research from 1937 to 1981.