ObamaCare and the Dodd-Frank Act
What Would Hayek Say?

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March 2011


In what is probably his most famous work, The Road to Serfdom,[1] 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 US conservatives about ObamaCare and the Dodd-Frank Act, the signature achievements of the Obama administration and the Democratic 111th Congress.

Key points in this Outlook:

  • Friedrich Hayek, the famous free-market critic of central planning, would oppose many modern-day regulations because--from the perspective of their effect on competition--they are as destructive as central planning.
  • Hayek would oppose ObamaCare because it impedes competition in health care through regulations that distort the price system.
  • Hayek would also oppose the Dodd-Frank Act because it interferes with competition by applying different regulations and rules to financial institutions that are deemed "systemically important."

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.

One of the most interesting aspects of the book's publication--aside from the fact that it was rejected repeatedly by the most respected publishing houses in the United States before it was picked up by the University of Chicago Press--was its differing reception in England and the United States. At the time, Hayek was a professor at the London School of Economics and wrote the book principally for political economists in England. The book received what might be called a polite reception among the English intellectual and political elite; the initial printing was 2,000 copies, followed by another 2,500. But the reception in the United States was quite different. The Road to Serfdom became an enormous bestseller, but its reception among the intellectual elite of the Left was furious and hostile. The difficulty in finding a US publisher is typified by the response from Macmillan: "Frankly, we are doubtful of the sale which we could secure for it, and I personally cannot but feel that Professor Hayek is a little outside the stream of much present-day thought, both here and in England."[2]

In his introduction, Hayek described his surprise at the strong reaction his views provoked in the United States: "Contrary to my experience in England, in America the kind of people to whom this book was mainly addressed seem to have rejected it out of hand as a malicious and disingenuous attack on their finest ideals; they appear never to have paused to examine the argument. The language used and the emotion shown in some of the more adverse criticism the book received were indeed rather extraordinary."[3] This has the ring of truth for anyone who has published similar analyses from the conservative or free-market point of view, even in contemporary America.

Controls of exactly the kind imposed by ObamaCare were what Hayek thought would eventually lead to more government controls, to collectivism, and finally to totalitarianism.

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."[4]

Thus, in a simple hierarchy of Hayek's values, individual freedom would be at the top. Competition would be important insofar as it contributes to or safeguards individual freedom. Socialism and other forms of collectivism would be disfavored because they deny individual freedom. Hayek would also say that both planning and socialism will not work as a practical matter, because they eliminate competition and thus a pricing system. That, however, is outside the scope of this Outlook. Of course, putting individual freedom at the top of the value hierarchy has important consequences; if equality in the distribution of goods and services were at the top, a very different system would result. As Hayek notes, the advocates of socialism support the idea because it will "secure a more just and equitable distribution of wealth. This is, indeed, the only argument for planning which can be seriously pressed. It is indisputable that if we want to secure a distribution of wealth which conforms to some predetermined standard, if we want consciously to decide who is to have what, we must plan the whole of the economic system. But the question remains whether the price we should have to pay for the realization of somebody's ideal of justice is not bound to be more discontent and more oppression than was ever caused by the much-abused free play of economic forces."[5] It's because he puts individual freedom at the top of his value hierarchy that Hayek's views are so compatible with those of US conservatism.

Planning and Regulation

As noted above, 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'"[6]--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. Accordingly, in interpreting Hayek for today's politics, I will primarily consider his arguments against planning rather than his arguments against socialism or collectivism in various forms.

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 US 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.[7]

Accordingly, to the extent that Hayek's view of the tension between competition and regulation can be encapsulated, he believes 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.

Regulation has now become the preferred method to attain the elite political control that seems to be the Left's governing principle.

Without this mediation, individuals receive no useful signals. If we assume, for example, that a blight reduces the US 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 can-not 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--say, three per customer per week. That is exactly what Hayek is talking about when he refers to "coercive or arbitrary intervention of authority."

In a famous essay, "Competition as a Discovery Procedure," Hayek went further. He pointed out that only through actual competition is it possible to determine what a product or service might actually cost.[8] This is because the most important facts--such as the price at which consumers will buy and the marginal cost of the last input and output--are not known and cannot be known in advance of actual competition. Because the cost of inputs keeps changing, as does the willingness of the last consumer to pay the marginal price for a product or service, none of these things can be predicted accurately in advance, and thus they cannot be set by the government. This is another factor that bears on the question of whether regulation is helpful or harmful to competition.

It is difficult to draw the line between regulation that leaves competition unaffected and regulation that does not, but Hayek supplied some useful guidance. If regulation interferes with competition so much that competition no longer produces useful prices, it reduces individual freedom because it will eventually require the government to make a coercive and arbitrary rule, one that permits the orderly distribution of a good or service that would otherwise be determined by its price.

This Outlook, then, will apply Hayek's analysis to regulation, the modern substitute for planning, focusing on the two major initiatives of the Obama administration--the universal health care plan known as ObamaCare and the financial regulations embodied in the Dodd-Frank Act. The question we will explore is whether the regulation under these two legislative initiatives would have provoked the same kind of concern from Hayek as the interest in economic planning he saw as the road to serfdom.

Regulation under ObamaCare

According to many estimates, health care represents about one-sixth of the US 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,[9] 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.[10] All these provisions will in one way or another require the government to make arbitraryrules 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 prepared for AEI, Scott Harrington of the Wharton School lists thirteen 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.[11]

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.[12]

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 reviewing the Dodd-Frank Act (DFA), I am considering a different aspect of the impairment of competition. In an effort to ensure stability in the financial system in the wake of the financial crisis, the DFA makes major changes in the competitive environment in the financial sector, which represents another one-sixth of the US economy. The most far-reaching of these changes was 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 US 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 US 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.[13]

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 US 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 pay-ment obligations.

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.

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.[14]

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.

Peter J. Wallison ([email protected]) is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.

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Notes

1. Friedrich Hayek, The Road to Serfdom (Chicago, IL: University of Chicago Press, 2007).

2. Bruce Caldwell, introduction to The Road to Serfdom, by Friedrich Hayek, 15.

3. Friedrich Hayek, The Road to Serfdom, 41.

4. Ibid., 136.

5. Ibid., 131-32.

6. Ibid., 85.

7. Ibid., 86.

8. Friedrich Hayek, "Competition as a Discovery Procedure," in New Studies in Philosophy, Politics, Economics and the History of Ideas (London: Routledge & Kegan Paul, 1982), 179-90.

9. The most controversial element of the legislation is the so-called individual mandate, which requires everyone eligible for coverage under the law to purchase insurance or pay a fine. This can be viewed either as a direct assault on liberty--an extraconstitutional burden on individuals--or as a necessary requirement to achieve universal coverage and avoid free riding under the provisions of the law that prohibit insurers from denying coverage for pre- existing conditions. It is not necessary for this analysis to consider the individual mandate. Although it can certainly be considered a restriction on individual freedom, and for that reason Hayek would probably have opposed it, it is not the kind of restriction on competition that reflects the similarity between planning and regulation.

10. Scott E. Harrington, “Regime Change for Health Insurance Regulation: Rethinking Rate Review, Medical Loss Ratios, and Informed Competition," in Beyond Repeal and Replace: Ideas for Real Health Reform (Washington, DC: AEI, December 2010), 1, www.aei.org/paper/100163.

11. Ibid., 15-16.

12. Friedrich Hayek, The Road to Serfdom, 128.

13. Ibid., 154.

14. Ibid., 89.

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