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What Would Hayek Say? Obamacare, Financial Services Regulation, and the Road to Serfdom

by Peter Wallison
April 26, 2011

In what is probably his most famous work, The Road to Serfdom, Friedrich Hayek was principally concerned about the strong interest in economic planning among British intellectuals in the 1940s. Because planning would inevitably require reducing competition and eliminating the pricing system, he saw it as a major step along the path to socialism—the “serfdom” in his title. At the time Hayek wrote, those interested in planning were mainly intellectuals who regarded themselves as socialists, saw socialism as compatible with democracy, and viewed planning as a way to achieve efficient use of society’s resources for the common good. Today, economic planning has been recognized, even by the Left, as less effective than the market in allocating resources. Instead, regulation has become the preferred way to introduce political controls into a market economy. Regulation, however, can have the same effect on competition and pricing as economic planning. Accordingly, it is likely that Hayek—were he alive today—would have the same views as U.S. conservatives about Obamacare and the Dodd-Frank Act, the signature achievements of the Obama administration and the Democratic 111th Congress.

Hayek, as an Austrian economist, had closely observed the rise of National Socialism (Nazism) in neighboring Germany in the late 1920s and early 1930s. In The Road to Serfdom, he made the central point that economic planning would eventually lead to the kind of totalitarianism, then seen in both the Soviet Union and Nazi Germany, that most socialists professed to despise. Among his arguments were the ideas—then very new in political thought—that resources could not be efficiently allocated without a pricing system, and that fascism, Nazism, and communism were not different systems, but the inevitable outcome of the same collectivist thinking with which socialists in England and elsewhere were hoping to remake the postwar world.

What is the contemporary significance of The Road to Serfdom? The fact that Hayek was warning against the possible onset of socialism in England suggests an immediate parallel with the warnings about Obamacare and other Obama initiatives—that these are socialist policies, or at least the result of Obama’s socialist inclinations. In a strict sense, this claim seems wildly off the mark. Socialism is almost always defined as government ownership of the means of production, but nothing in the Obama program involves government ownership. In fact, Obama has provoked heated opposition from the Left because he would not press for a public option in Obamacare, which—because it would have made the government the single payer for medical services—would have had significant elements of government ownership and socialism.

However, Hayek’s critique of planning—describing it as the road to serfdom—was not a critique of an existing socialist system but of an idea that he thought would eventually lead to socialism and from there to totalitarianism. Economic planning, in his view, would ultimately mean control over the means of production, not necessarily its ownership; but control would have the same practical effect as ownership on the lives of individuals: “It is only because the control of the means of production is divided among many people acting independently that nobody has complete power over us, that we as individuals can decide what to do with ourselves. If all the means of production were vested in a single hand, whether it be nominally that of ‘society’ as a whole or that of a dictator, whoever exercises this control has complete power over us.”


Planning and Regulation

Hayek’s particular target was something short of socialism; it was the idea that rational economic planning—what he called “central direction and organization of all our activities according to some consciously constructed ‘blueprint’”—is the most effective and efficient way to produce and deliver society’s resources. He saw economic planning as a necessary element of socialism—perhaps even a precursor— and by focusing his attack on planning as a process he sought to expose the errors at the core of socialism as a system.

This way of interpreting Hayek seems archaic at first because today economic planning is no longer considered a rational or viable approach to controlling the nation’s resources. Experience over the last century has persuaded even the U.S. Left that markets work better than government planning in allocating resources. Regulation has now become the preferred method to attain the elite political control that seems to be the Left’s governing principle. In terms of their potential effects, however, planning and certain kinds of regulation are not much different; both can be destructive of market competition, the one political condition that Hayek sees as fully compatible with and essential to individual freedom. Hayek’s argument against planning is also, then, an argument against some kinds of regulation, although he makes it clear that there is a place for regulation in all free economic systems. It is worthwhile to quote him at length on this point. “Competition,” he writes,

is superior not only because it is in most circumstances the most efficient method known [for guiding individual efforts] but even more because it is the only method by which our activities can be adjusted to each other without coercive or arbitrary intervention of authority. … Any attempt to control prices or quantities of particular commodities deprives competition of its power of bringing about an effective coordination of individual efforts, because price changes then cease to register all relevant changes in circumstances and no longer provide a reliable guide for the individual’s actions. … This is not necessarily true, however, of measures merely restricting the allowed methods of production, so long as these restrictions affect all potential producers equally and are not used as an indirect way of controlling prices and quantities. … To prohibit the use of certain poisonous substances or to require special precautions in their use, to limit working hours or require certain sanitary arrangements, is fully compatible with the preservation of competition.

Accordingly, to the extent that Hayek’s view of the tension between competition and regulation can be encapsulated, he believed that competition should be preferred as the most likely method to preserve individual freedom, but regulation can be compatible with competition as long as it does not impair the price system that competition creates. The link between competition and the price system is vital in Hayek’s thought because he sees the world as constantly changing in unfathomably complex ways: new resources become available, others decline, consumer tastes evolve, life expectancies lengthen, birth-rates rise or fall, and working and leisure habits change. All these changes, among many others, are mediated by constant price changes.

Without this mediation, individuals receive no useful signals. If we assume, for example, that a blight reduces the U.S. apple crop, apples should become marginally more expensive. As a result, some buyers will switch to oranges, others will switch to pears, and still others will pay higher prices for the apples that are available. But without a competitive pricing system, the price of apples does not change when the supply declines. Consumers get no signals and go on buying apples at the old price until there are none in the stores. Those who would have paid more for apples do not get a chance to do so. Nor do the producers of oranges and pears get signals to supply more of those commodities. Without competition, there cannot be a price system, and the only way that apples can be distributed other than on a first-come-first- serve basis is through government-run rationing. That is exactly what Hayek is talking about when he refers to “coercive or arbitrary intervention of authority.”


Obamacare

According to many estimates, health care represents about one-sixth of the U.S. economy. The Patient Protection and Affordable Care Act—colloquially known as Obamacare, even though the president never submitted his own plan—imposes substantial new regulation on the insurance companies operating in this sector. Although the rules that will implement the law have not yet been promulgated, and many of them will not go into effect until 2014 or thereafter, they will substantially impede competition.

While the individual mandate—the Obamacare provision that requires every person eligible for insurance to purchase it—has thus far been the most controversial part of the new law, the law contains many elements that would appear to impede competition and thus run afoul of Hayek’s view that competition should be free of regulation that impairs an effective pricing system. Among other provisions, Obamacare requires health insurers to 1) offer only four coverage tiers and a catastrophic plan for young adults; 2) accept all applicants regardless of preexisting conditions; 3) limit premium variance only by coverage tier, number of dependents, geographic region, age, and tobacco use; 4) spend at least 85 percent of premiums on “activities that improve health care quality” (the Medical Loss Ratio, or MLR) for large-group insurance; and 5) justify “unreasonable” rate increases. All these provisions will in one way or another require the government to make arbitrary rules for what insurance companies pay for health services.

With the MLR, for example, the government’s rules on what goes into the numerator and denominator of this ratio will determine the profitability of individual companies and whether they will be able to participate at all in a competitive system. Speaking generally, the numerator of the MLR will be only what the government considers as “activities that improve health care quality.” Immediately we see that price competition is impaired because consumers have no choice on this issue; the services they want may not be available simply because the government has determined that they do not “improve health care quality.”

In addition, companies will have to price their services to ensure that they meet the minimum MLR in any year or be forced to rebate premiums. This immediately distorts the pricing system by introducing an element that has nothing to do with what consumers are willing to pay for insurance services.

Finally, many companies that offer specialized services that do not fall into this category may have to abandon the services entirely, thus restricting not only competition for those services specifically, but also—if those firms sell out to competitors or otherwise leave the business—the competition that comes from the number of competitors in a market.

Say, for example, that an insurer offers a doctor-referral service, and that service is not included among the items that the government considers an activity “that improves health care quality.” The insurer, then, would likely abandon that service because its cost would then have to be paid out of its 15 percent of premium revenue that is available for both administration and profits. Abandoning that service would reduce competition among insurers for the most effective referral services.

In a paper for the American Enterprise Institute, Scott Harrington of the Wharton School lists 13 ways in which insurers’ costs—not includable in the numerator of the MLR fraction— could vary simply by chance, or because of differences in accounting practices or the populations or geographical areas covered, requiring insurers to raise their premiums (the denominator of the MLR) just to cover these possibilities.

It is clear that Hayek would see Obamacare not only as a regulatory impairment of the competitive pricing system but also as exactly the same kind of arbitrary government control that comes with planning: “If we remember why planning is advocated by most people,” Hayek writes,

can there be much doubt that this power would be used for the ends of which the authority approves and to prevent the pursuit of ends [of] which it disapproves? … In a directed economy, where the authority watches over the ends pursued, it is certain that it would use its powers to assist some ends and to prevent the realization of others. Not our view, but somebody else’s, of what we ought to like or dislike would determine what we should get. And since the authority would have the power to thwart any efforts to elude its guidance, it would control what we consume almost as effectively as if it directly told us how to spend our income.

Thus, controls of exactly the kind imposed by Obamacare—in this case through regulation rather than planning—were what Hayek thought would eventually lead to more government controls, to collectivism, and finally to totalitarianism.


The Dodd-Frank Act

In an effort to ensure stability in the financial system in the wake of the financial crisis, the Dodd-Frank Act (DFA) makes major changes in the competitive environment in the financial sector, which represents another one-sixth of the U.S. economy. The most far-reaching of these changes is to empower the Financial Stability Oversight Council— an organization of all the federal financial regulators, chaired by the secretary of the Treasury—to designate certain companies as “systemically important” because their failure or financial distress could cause “instability” in the U.S. financial system. Once that designation is made, these companies—which could include large or otherwise important banks, bank holding companies, securities firms, insurers, insurance holding companies, finance companies, hedge funds, and any other financial institution deemed to be systemically important—all become subject to stringent regulation and supervision by the Federal Reserve. The Fed’s powers under the act are also extraordinarily broad; it can determine the appropriate levels of capital, leverage, and liquidity for these firms, and restrict their activities, all to ensure that their failure or financial distress does not cause instability in the U.S. financial system.

The DFA changes the competitive environment for financial services in the United States by providing for different regulation of large firms than small ones. In effect, the firms that are designated as systemically important have been declared too big to fail. While the act also provides that these firms cannot be bailed out in the event of their failure or financial distress, it gives the Federal Deposit Insurance Corporation enough authority and discretion to save most if not all of their creditors from losses in the event of their failure. This, together with the fact that these firms will be specially regulated by the Fed, will create moral hazard; the creditors of these companies will believe that they face lower risks of loss than the creditors of other companies. For this reason, the companies designated as systemically important will likely have a lower cost of funds than their smaller competitors and thus an unfair competitive advantage that will suppress competition from smaller firms.

In addition, the Fed’s ability to control the capital, leverage, liquidity, and activities of these firms will give it the power to suppress competition between them. For example, the Fed will be able to decide whether an insurance holding company can enter a financial sector where it will be competing with a securities firm or hedge fund. If the Fed deems this new field too risky for the insurance holding company, it can prevent the entry, thus protecting the securities firm from new competition. The Fed could also require the insurance holding company to hold more capital if it enters a new field of activity, again suppressing cross-industry competition.

This way of suppressing competition— through government favoritism toward particular well-established enterprises—was also recognized by Hayek as part of the process of the government gathering the power to control society and the individuals within it. As noted above, Hayek believed that regulation is not harmful to competition in general if it applies equally to all (“so long as these restrictions affect all potential producers equally and are not used as an indirect way of controlling prices and quantities”). But when regulation singles out some competitors for different treatment than others—exactly what has been prescribed in the DFA—it is a matter of concern: “There has never been a worse and more cruel exploitation of one class by another than that of weaker or less fortunate members of a group of producers by the well-established which has been made possible by the ‘regulation’ of competition.”

Finally, the Fed’s significant regulatory power over the activities of firms that have been designated as systemically important creates the possibility of a partnership between these institutions and the government. In return for the Fed’s protection against failure and competition, the largest financial firms in the U.S. economy will be inclined to follow the government’s directions on how to conduct their business. For example, if a smaller financial firm is failing, the Fed will be able to induce one of the larger firms to acquire it; if a country is having difficulty selling its bonds, the Fed will be able to get some of the firms it is regulating to invest in those securities. These are not fantasies. In the past, when the Fed was regulating only bank holding companies, it induced them—in the interest of stability in financial markets—to lend to countries that were having difficulty meeting their international payment obligations.

Hayek also recognized the possibility that a partnership between government and the largest institutions could be another path to government control through the suppression of competition. He saw it (in his phrase) as a “corporative” structure, in which government supports certain favored companies, which then acquire monopoly power within their industries. In political science, these arrangements are now often called “corporatist” and are characteristic of economies in which only certain large companies or the members of guilds are allowed to provide goods or services. At the time Hayek was writing, he saw the danger of corporatism as the result of economic planning, but the same danger arises through excessive regulatory power that suppresses competition for those favored firms:

[T]hough all the changes we are observing tend in the direction of a comprehensive central direction of economic activity, the universal struggle against competition promises to produce in the first instance something in many respects worse, a state of affairs which can satisfy neither planners nor liberals: a sort of syndicalist or “corporative” organization of industry, in which competition is more or less suppressed but planning is left in the hands of the independent monopolies of the separate industries. … By destroying competition in industry after industry, this policy puts the consumer at the mercy of the joint monopolist action of capitalists and workers in the best organized industries. … Once this stage is reached, the only alternative to a return to competition is the control of the monopolies by the state—a control which, if it is to be made effective, must become increasingly more complete and more detailed. It is this stage that we are rapidly approaching.

Regulation has produced exactly this outcome in the past. Regulation of air travel pricing and services under the Civil Aeronautics Board, abolished in the 1970s, permitted airlines and their unions to charge high prices that restricted most air travel to business purposes. Regulation of commission rates in the securities field, also abolished in the 1970s, reduced competition among securities brokers and limited the amount of public participation in the securities markets. It was not until the AT&T monopoly over long-distance telephony was broken in the 1980s that the Internet could develop and telephone rates could come down to the point where virtually everyone around the world now has access to inexpensive voice and data communications. Beginning in the 1970s, the extent of deregulation in the United States was extraordinary, and it brought enormous benefits to consumers in these areas and others. But today, Obamacare and particularly the DFA represent a significant trend back toward increased political interference in market decision making.


Conclusion

It appears, then, that Hayek would be as concerned about the DFA as about Obamacare, although each affects competition in a different way. Obamacare involves regulation that impairs the operation of the price system, while the DFA impairs competition directly by putting the most important financial firms under the direct control of the government.

In considering the relevance of Hayek’s critique to today’s politics in the United States, we have to keep in mind that the regulations imposed by Congress and the Obama administration were limited to two large industries— health care and finance—and not the economic system as a whole. When Hayek was writing, his concern was with the development of intellectual support for economic planning, which, if it had been instituted in Britain, would have resulted in control over the entire economy. Still, there are enough parallels between the economic planning that Hayek feared and the likely results of regulation under Obamacare and the DFA to raise similar concerns. This does not mean that the policies of the Obama administration are “socialist,” but it does mean that the alarms that Hayek raised about planning—his belief that planning was a step on the road to socialism—are worth our attention. Excessive regulation, Hayek would say, can also put us on the road to serfdom.


Mr. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. A longer version of this article was originally published as a paper by the American Enterprise Institute in March 2011.


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