There’s been a bit of a debate about Greg Mankiw’s recent [newspaper: New York Times] column, with Kevin Drum giving it a rather nice smackdown. Mankiw comes back today with some responses. I didn’t get past the first one:
> If no one is proposing eliminating taxes, why compare the Obama policy to a world without taxes? Economists understand that, absent externalities, the undistorted situation reflects an optimal allocation of resources. […]
My first thought was that that’s a very narrow description of “optimal allocation of resources.” If you don’t pay taxes, the government doesn’t build roads, doesn’t fund a Defense Department to keep the borders safe, doesn’t keep your food safe via the FDA, doesn’t regulate airlines via the FAA, etc. How exactly will the corn (the “resource” in this example) arrive at your grocery store (that is, be “allocated”) without a system of roads to get it there? And how will those roads be built without taxes? This is the economists’ magical definition of “optimal allocation of resources”.
That’s when I realized: all the things I mentioned are hidden within Mankiw’s “absent externalities”. Those are two bizarrely overloaded words in this context.
As Justin Fox makes clear in his terrific [book: Myth of the Rational Market], there’s been a long divide in economics between the institutionalists and the rest. (I think the rest have a name, but I’ve forgotten it.) The institutionalists emphasize that when Mankiw talks about “optimal allocation of resources,” he’s brushing aside most of what makes the world interesting.
Take contracts, for instance, which are the most basic weapon within the economist’s arsenal. Economists assume that transactions can be “completely contracted,” meaning that every detail of the transaction can be spelled out and its violation quickly detected. But a contract, so described, is an abstraction hiding a lot underneath it. What happens if I violate a contract that you and I signed? You take it to a court, presumably. The court rules against me and orders me to pay up. What happens if I don’t? The full weight of the state comes down on me to make me pay you. So even talking about “complete contracting” — which is an essential element leading to Mankiw’s “optimal allocation of resources” — requires you to talk about some sort of enforcement mechanism. That enforcement mechanism could be a government, or it could be a mafia that’s willing to break my legs, but in any case there’s an *institutional structure* underneath the contract. Getting the institutions to ensure complete contracts costs money: either the government has to be willing to bring cops with guns to my house to make me pay up, or the mafia has to employ dudes with baseball bats, but someone somewhere needs to be standing ready to enforce that contract.
Now then. I hope we agree that we need to give up something — be it taxes or Vinny’s valuable free time — in order to allow contracts to be signed and enforced. I hope we agree that signing contracts is vital to the optimal allocation of resources. Therefore, I hope we agree that we need to give up something to attain the optimal allocation of resources. So how does it even begin to make sense for Mankiw to say that a tax-free world is relevant in any discussion at all? I contend that it’s only relevant if you ignore institutions — which is exactly what Mankiw is doing.
(Note also that the most basic contract of them all — the labor contract — cannot be completely contracted, as has been known since 1951.)