How Markets Tell the Truth and Politics Tells Lies

Or, how to get more trust in society
by GARY M. GALLES
The Freeman
Feb. 05, 2015

Have you ever tried to work with people you couldn’t depend on to tell you the truth? It isn’t pretty. Without the ability to rely on what you’ve been told (or the assurance that you’ve been told everything relevant), effective cooperation at almost every margin of choice is reduced. That’s because the foundation on which cooperation is built has been undermined.

As John Donne succinctly put it, “No man is an island.” In a modern economy, all of us are dependent on multitudes of strangers not just for our prospering, but for our survival. So the problem of effective cooperation increases exponentially when we expand our horizons to the countless areas in which people — the vast majority of whom don’t even know each other — interact.

People aren’t always truthful because being dishonest can serve one’s interests. Sometimes we perceive a strategic advantage in lying to gain at another’s expense. Our words are also often post-hoc rationalizations, both to ourselves and to others, for why whatever we said or did was a good idea.

But with time, that can make what people say a frail reed to hang upon. And when political power is involved, the incentives for such deception and self-delusion are put on steroids. The payoffs of deception are far greater when it comes to politics, because politics rarely rewards honesty. As the level of dishonesty goes up, the level of trust goes down. And in the absence of trust, information that is vital to cooperation becomes increasingly scarce.

Making matters worse, the amount of information out there is vast. No individual can possibly know the infinite permutations of who, what, when, where, why, and how. As Hayek famously reminds us, knowledge is mostly local, distributed among billions of people. But voluntary market arrangements, based on private property rights, provide a powerful mechanism for overcoming problems associated with our limited knowledge.

The price is right

Most of the time, we don’t really care to know all the details that might have affected our interactions with others. In commercial interaction, we mainly just want to know, “How much?” In that price, we get a glimpse of what trade-offs others are willing to make between goods and services, current versus future consumption, labor versus leisure, and so on. Regardless of the specific determinants from person to person, others’ trade-offs determine what is and isn’t possible for us in any society where people are free to choose.

By revealing more and more accurate information, more and more social coordination is possible. Mutually beneficial arrangements are expanded. Others, including all prospective central planners, don’t know the trade-offs each individual would make; only the individuals involved know for sure. Coordination requires a process that reveals accurate information to those who make choices. Otherwise, the information will be lost, along with any wealth creation that might have followed.

Undistorted market prices provide that information. While what people say may be misleading, people reveal many truths when they engage in market behavior. After all, what you do is often far more truthful than what you say. For example, if you buy a product for $10, you reveal that it is worth at least $10 to you; similarly, if you sell a product for $10, you reveal that what the money might purchase is worth more to you than the product. And those choices reveal valuable information about the real alternatives available to those who might deal with you in the future.

The mendacity of politics

In contrast, because politics is based more on what people say than on what they do, it often short-circuits the mechanisms for discovering the truth: prices, profit, and loss. Politics becomes less about cooperation and more about creating perceptions. In fact, government interference in people’s voluntary relationships substitutes lies for the very truths that might otherwise be revealed. And in a world where relative scarcities are generally what we really want to know the truth about, politics can be very damaging. Consider the following:

1. Price ceilings lie

Price ceilings, such as rent controls, lie about scarcity. In the absence of such controls (truth), market rents tell you the prices at which you can find apartments and reflect the opportunity costs landlords really face. But rent controls impose a price divorced from landlords’ opportunity costs, and a price at which many prospective tenants will be unable to rent an apartment. The price lies to people, telling them that the opportunity costs are cheaper than they really are. In the process, it distorts the terms at which apartments can generally be rented successfully.

2. Price floors lie

Price floors, such as minimum wages, act in a similar manner. In the absence of such controls (truth), market wages tell you the prices at which you can generally find jobs and hire employees. But a minimum wage dictates a price that is divorced from prospective workers’ opportunity costs, and at which many people will be unable to find jobs. Such wages misinform people that unskilled labor’s opportunity costs are higher than they really are. And in the process, minimum wages distort the terms at which jobs can be successfully gotten.

3. Taxes lie

Taxes, which are the price of an artificial input — “government permission to produce and sell” — reflect coercively imposed government burdens rather than opportunity costs of inherently scarce goods and services. Taxes tell buyers that products are scarcer than they really are.

The same is true of import restrictions such as tariffs and quotas, which raise prices above opportunity costs.

The burdens of government regulations and mandates also act like taxes. Government barriers to entry and operation in markets similarly raise prices above what relative scarcity would dictate. All of these interventions result in artificially high prices, underuse, and waste.

4. Subsidies lie

Subsidies act in a parallel manner to taxes, but in the other direction. They communicate to prospective buyers that products are more abundant than they really are, leading to artificially low prices, overuse, and waste.

Not only do voluntary market interactions better reveal the truth about relative scarcities through pricing; they also allow more accurate evaluation of other aspects of trading, such as product and service quality.

Reputation promotes honesty

The key (though often ignored) factor is repeat business. The usual scare stories to justify a “need” for government regulation involve one-time interactions in which others can gain by “cheating” on what they promise. The relevant question, however, is not whether they can cheat, but whether it is in their interest to do so.

We don’t need government protection against acts people will choose not to engage in. And since almost everyone we deal with economically wishes to continue in business, effects on future business act as a performance bond against misbehavior — both directly, as when current customers refuse to deal with such suppliers in the future, and indirectly, through reputation effects on other current and prospective trading partners.

Reputation leads to far better outcomes than scare stories imply. As students of game theory recognize, one-shot games and repeated games generate very different strategies.

Repeat business discourages cheating

Consider an example. Suppose I can cheat you today by providing lower-than-promised quality, and doing so would generate $1 million in increased profits. If it would leave my future business relationships unchanged, I have an incentive to cheat.

But what if I expect the resulting damage to my reputation to cost me $1 million or more in future discounted profits? I can cheat you, but I will not, because I have no incentive to.

The problem in this case is completely solved by markets’ reputation mechanisms. Even if the future losses don’t completely eliminate my incentives to cheat, they sharply reduce them, letting much of the air out of the “we need government regulation” balloon.

Ancient reputation markets

This mechanism, while ignored by ubiquitous state acolytes, is far from new. For instance, the famous 11th-century Maghribi traders of Northern Africa did not rely on government enforcement of international trade arrangements but on reputation-based self-regulation. In fact, a core role of Maghribi trader guilds was to protect themselves against government extortion by threatening them with the loss of future business relationships.

Modern technology has done nothing but improve voluntary reputational institutions. It allows people to detect “cheating” on quality more quickly, reducing the gains to be had from that misbehavior, as with the constantly improving transaction-by-transaction feedback from those on both sides of exchanges on eBay and other websites. Further, it spreads the word to other potential trading partners far faster and more broadly than was once the case, increasing the ability to punish, and thereby deter, such misbehavior.

Government promotes dishonesty

What has been the role of governments in all of this? They have been orders of magnitude behind markets in their creation and utilization of reputational mechanisms. In fact, their efforts have more frequently been turned against efforts to better serve customers, defending the old ways that governments have found to control and extort against potentially superior new options (for example, heavily regulated taxis versus Uber and heavily taxed hotels versus Airbnb) without such parasitic attachments.

This sort of intervention is not new, either. For example, it is striking how taxi regulations targeting Uber and Lyft, to benefit those enriched by government restrictions at the expense of consumers, mirror cities’ earlier strangulation of the jitney (unregulated cab) market, because jitneys were taking too much business from municipality-owned streetcar systems. Further, unlike those who have their own money at stake in preventing or solving abusive behavior in markets, government overseers have far worse incentives to watch as carefully or innovate as much.

Ask yourself if you get more, better, and quicker oversight from Airbnb or the hotel commission.

A great deal of social coordination is only achievable when based on the truth.

Not only does the truth set us free, but freedom in our cooperative endeavors reveals truths we have no other way of knowing.
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Gary M. Galles is a professor of economics at Pepperdine University. His recent books include Faulty Premises, Faulty Policies (2014) and Apostle of Peace (2013).