A report due out at end of July on agricultural policies in countries that belong to the Organization for Economic Cooperation and development (OECD) quantifies the extensive government subsidies farmers receive in these countries. These subsidies amount overall to about 29% of their farm revenues. This per cent varies considerably: from highs of 68% in Switzerland, 64% in Norway, and 56 % in Japan, to "only" 16% in the US, and a relatively low 5% in Australia. The beautiful views of cows and sheep on the very green Swiss mountains are courtesy of the Swiss government that pays farmers generously to keep these animals grazing on the mountains.
Developing nations object to the farm subsidies by rich countries because they make it difficult for farmers in their own countries to compete in the world markets for agricultural goods. The European Union has high tariffs against farm imports from countries outside the Union, while the US gives significant export subsidies to its agricultural products. Most rich nations have direct payments to farmers when agricultural production increases, and they also help subsidize the cost of water, seed, machinery, and other farm inputs.
Farm subsidies are the main complaint lodged by developing nations against the trade policies of developed nations in the ongoing Doha talks on more open international trade. Richer nations in turn complain about the many barriers to imports of Western and Japanese goods erected by poorer nations. Both sides are right, but the US and other rich nations should greatly liberalize their farm policies irrespective of whether developing nations lower their trade barriers. The reason is not mainly to help poorer nations, although it would do that in a way that adds to world economic efficiency and trade. Freeing agriculture would also help consumers and even many farmers in rich nations.
Whether subsidies to agriculture raise or lower prices to domestic consumers depends on the form the subsidies take. Restrictions on imports of farm goods clearly raise domestic farm prices by cutting back access to farm products from more efficient producers in poorer nations. Subsidies to farm exports also raise domestic prices by artificially diverting production from the domestic to the export market. Subsidies to farm inputs like water encourage excessive use of water compared to other inputs. This is partly through inducing farmers to shift production toward crops that use a lot of water, such as rice, and away from crops that use little water. The result is lower prices for water-intensive crops, and higher prices for water-sparing crops. The OECD report estimates that more than half of the farm subsidies in member nations are through policies that raise domestic prices of agricultural goods.
The argument is sometimes made that farm subsidies are desirable to encourage small farms, and the way of life on these farms. Yet this claim is contradicted by the evidence available for many decades, and confirmed again in the OECD report, that the vast majority of subsidies go to the largest farms. In many cases they are given to people who own but do not farm their land.
Another argument in defense of farm subsidies is that they contribute to a better environment. Some of the subsidies may do this by reducing population density and pollution, but many others add to environmental damage. For example, subsidies to irrigation and other water use by farmers is one of the major ways that fresh water is wasted. Environmental and geopolitical arguments are used to justify the large subsidies to ethanol production from corn in the US. Ethanol helps reduce the West's dependence on oil because ethanol is a substitute for gasoline. GM and other companies are beginning to promote E85, which means 85% ethanol and 15% gasoline. Automobile fuel tanks can easily be modified to take this combination, but the US still has only a small number of gas stations that have the expensive equipment to dispense highly ethanol-intensive fuel.
Ethanol not only reduces dependence on oil imports, but also ethanol based fuel cause less pollution than gasoline does. Ethanol probably also uses less energy, although that is debated since both the plants that produce ethanol, and the fertilizers that help to grow corn, use considerable quantities of natural gas. The US has subsidized ethanol production from corn primarily to help corn growers rather than to reduce energy use since it is combined with a steep tariff on imports of ethanol from elsewhere. These imports would come mainly from Brazil that produces ethanol from sugar cane at a much lower cost than the US production from corn. Instead of subsidizing domestic production of ethanol, a much wiser policy for the US would be to eliminate these tariffs and import ethanol from democratic and friendly countries like Brazil that can produce ethanol more cheaply.
The economic case for eliminating farm subsidies by rich countries is a compelling one since these subsidies are inefficient, generally raise food prices to consumers in these countries, and anger developing countries that see their natural markets blocked. Yet while economists have been rather united in their criticisms of agricultural policies, the farm lobby has been powerful, especially in Japan and many European nations. This is despite the fact that farmers in most rich countries constitute no more than a tiny percentage of the labor force.
It may seem paradoxical that farmers are typically rather heavily taxed in poor countries, like India and China, where they constitute a large fraction of the population, and are subsidized in rich countries dominated by cities and towns. But the economic analysis of interest group politics demonstrates that small groups are often much more powerful politically than large groups, even in democracies where large groups would seem to command more votes. The explanation is that small groups may be organized more easily-although farmers tend to be spread out geographically- and the per capita tax on others to finance the subsidy to small groups tends to be smaller than the per capita cost of subsidizing large groups.
Whatever the explanation, experience has shown that it is difficult to eliminate, or even greatly cut back, farm subsidies in richer nations. There is more hope for being able to change the subsidies to ways that are less discouraging to agricultural imports from poorer nations, that do not mainly help richer farmers, and that do not raise food prices to consumers. Possibilities include the equivalent of an earned income tax credit to fulltime farmers who make low incomes, lump sum income payments to farmers, and possibly greater support for education in farm areas. While the best politically feasible alternatives to present policies are not so clear, it is obvious that the present system of farm subsidies in rich nations is a lightening rod for conflict in trade talks with third world countries, while they help their own farmers in highly inefficient ways.
A government subsidy of the production of a good is defensible if the good generates external benefits, i.e., benefits not captured by the producer, in which event the good will be underproduced if left entirely to the market. This is not usually true of agricultural production. But Switzerland may be an exception because of its heavy dependence on tourism and the undoubted contribution that Swiss farms make to the beauty of the Swiss countryside. However, before determining how much of a subsidy to provide or indeed whether to provide any subsidy, one would have to determine how much and what kind of agriculture would be produced with no subsidy. Perhaps the reduction in agricultural acreage would be too slight to make significant inroads into tourist revenues. Assuming the effect could be measured, the proper method of financing the subsidy would be by a tax on the tourism industry. As for the form of the subsidy, this should depend on the effect on touristic values. The aim presumably would be to increase the amount of agricultural acreage, and perhaps dairy production because the cows with their bells are, to the tourist, particularly attractive adornments of Swiss farms.
Quite apart from tourism, Swiss people themselves may derive pleasure from their agricultural countryside. That would constitute an additional external benefit that might justify subsidy, but it would be very hard to measure. "Contingent valuation" surveys ask people what they would pay for various environmental amenities if such amenities were priced. But the responses are not reliable. People are being asked to put a price on goods that are not sold in markets, and they have no relevant experience with pricing such goods. The surveys tend also to focus on a single amenity (as in my Swiss example), which produces exaggerated responses because the respondents are not being asked to allocate a limited budget among a range of possible subsidies.
Switzerland may be a special case; it is inconceivable that agricultural subsidies in general are justifiable in terms of positive externalities. A country like France, for example, which receives a quarter of the European Union's generous allocation for such subsidies, has highly productive agriculture and its huge tourist industry is far less dependent on bucolic vistas than Swiss tourism is. Agricultural subsidies generally reflect, as Becker points out, the operation of interest-group politics. A related feature in the European context is job protection--it may be especially difficult for many farmers to find alternative employment outside the agriculture sector.
Our ethanol subsidy is a particulary disgraceful example of the genre, especially given the availability of much cheaper sugar-based Brazilian ethanol blocked by a high tariff from competing with the ethanol produced from our corn. It is possible though unproven that ethanol as a fuel involves a net reduction in carbon dioxide emissions compared to gasoline and so may help to limit global warming. I qualify with "unproven" because while ethanol is not a fossil fuel and so burning it does not emit carbon dioxide, its production requires fossil fuel. Even if ethanol as a fuel has definite advantages from the standpoint of controlling global warming, this is a poor argument for a subsidy of it, as the subsidy can distort the efficient choice of inputs into the manufacture of fuel. Better would be a tax on carbon dioxide emissions; this would give producers and consumers of fuels and of products utilizing fuels, such as cars and electricity, an incentive to search out the cheapest substitutes for fossil fuels, which might or not include ethanol.
Although the percentage of farm revenues generated by subsidy is less than half in the United States what it is in the EU countries (16 percent versus 34 percent, according to the OECD study discussed by Becker), the efficient rate is probably zero. The fact that it is positive may reflect not just the operation of interest-group politics but the skewed representation of states in the U.S. Senate. Because each state has two Senators regardless of population, thinly populated agricultural states have disproportionate influence which they can use by means of logrolling to attract support for generous subsidies having no public-interest justification whatsoever.
I will briefly respond to some of the interesting comments.
Many politicians oppose privatizations because of the opposition from employees of the enterprises that might be privatized. Employees have opposed every single privatization that I am familiar with. The reason is clear: public companies have too many employees from an efficiency perspective, and the employees know this. Also they have to work harder for lower pay when their enterprise becomes private.
Windows has a large share of the market, but Apple, Linus, and other systems limit the power of Microsoft's Windows. Microsoft's power is in my judgment rapidly declining in the overall computer-internet market. This is one of the best examples of the difference between static and dynamic competition.
The USPO illustrates the worst of public monopolies. It has lagged virtually all the important mail delivery innovations in recent decades. It is grossly overmanned, and its employees are often surly and unpleasant. The need to subsidize mail sent to remote places is no justification for a public monopoly. Such mail can be subsidized-if that is desirable- without having a public monopoly. Simply subsidize Fed Ex or any one else for their deliveries to such places. Take away the protection of the law and subsidies, and the USPO would collapse within a short time.
Many public institutions in higher education offer very fine products, but that is because they face stiff competition from each other and from private universities. Eliminate that competition-as in Germany, France, or Italy- and one sees how ineffectual public universities become.
Phone service has become much cheaper, not more expensive, since the telephone market was opened up. It is far cheaper to make long distance calls, including international ones, than it was before. Imagine what the phone system would be like if ATT still had a monopoly: where would wireless, cable, and Internet telephony be? ATT would have used its political power to resist and handicap every one of these and other innovations.
There were a number of interesting comments; I limit myself to respomding to three. One is that the lessee overpaid; this is possible if the lessee is ambitious to acquire other U.S. highway systems and wants, and is willing to pay for, "first mover" advantages; other states will be more inclined to deal with a pivate highway operator who has a track record.
The second comment is that the private lessee of the Indiana Toll Road will have an incentive to skimp on maintenance in order to reduce costs and thus maximize profits. Notice the tension with the first point: if the lessee is ambitious to acquire additional highway systems, it will want to create a good reputation for honoring its maintenance obligations under the lease of the Indiana Toll Road. In Europe, which has a number of private operators of highway systems, maintenance has not been a problem, maybe because poor maintenance is quickly detected.
Third is the question of checks on abuses of monopoly power. Some commenters fear the monopoly power of the lessee of the Indiana Toll Road, others argue that the state could offset it by building a parallel road. Speaking from personal experience as a frequent user of the Indiana Toll Road, it has ample capacity even at existing toll rates, which means that the construction of a competing toll road is unlikely, since it would create excess capacity, and competition under conditions of excess capacity is likely to result in prices that do not cover total costs. One comment indicates that one term of the lease is a promise by the State of Indiana not to improve certain roads that run parallel to the Indiana Toll Road, and that promise would tend to secure the lesee's monopoly and thus increase the price of the lease. As I said in my post, while monopoly pricing has misallocative effects, so do taxes, for which the revenue from the lease may be a substitute.
The State of Indiana has just leased the Indiana Toll Road--a 157-mile-long highway in northern Indiana that connects Illinois to Ohio--to a Spanish-Australian consortium for 75 years for $3.8 billion, to be paid in a lump sum. (The deal has been challenged in the Indiana state courts.) The lease is complex, imposing many duties on the lessee (such as to install electronic toll collection, in which Indiana has lagged). A key provision is that the consortium will not be able to raise toll rates until 2016 (for passenger cars--2010 for trucks) and then only by the greatest of 2 percent a year, the consumer inflation rate (CPI), or the annual increase in GDP. (On the eve of the lease, Indiana raised toll rates--which hadn't changed since 1985--significantly.) Two years ago Chicago made a similar lease of the Chicago Skyway, an 8-mile stretch that connects Chicago to the Indiana Toll Road, for $1.8 billion. There is considerable interest in other states as well in leasing toll roads to private entities.
The idea of privatizing toll roads is an attractive one from an economic standpoint. Private companies are more efficient than public ones, at least in the limited sense of economizing on costs. I call this sense of efficiency "limited" because there are other dimensions of efficiency, for example the allocative; a monopolist might be very effective in limiting his costs, but by charging a monopoly price he would distort the allocation of resources. Some of his customers would be induced by the high price to switch to substitutes that cost more to make than the monopolist‚Äôs product but that, being priced at the competitive rather than the monopoly price, seemed cheaper to consumers. (This is the standard economic objection to monopoly.) The reason for the superior ability of private companies to control costs is that they have both a strong financial incentive and also competitive pressure to do so--factors that operate weakly or not all in the case of public agencies--and that their pricing and purchasing decisions, including decisions regarding wages and labor relations, are not distorted by political pressures and corruption. There is a long history of price-fixing in highway construction and maintenance, attributable in part to bidding rules that, in endeavoring to prevent corruption, facilitate bid rigging. For example, if to prevent corruption contracts are always awarded to the low bidder, a bid-rigging conspiracy will always know whether one of its members is cheating, if the low bidder, who gets the contract, was not the bidder that the conspiracy assigned to make the low bid. If cheating on a conspiracy is readily detectable, cheating is less likely and therefore the conspiracy more effective.
The problem of allocative efficiency looms when, for example, there are exernalities; but the solution to the problem rarely requires public ownership. One significant externality associated with vehicular transportation is the congestion externality: no driver is likely to consider the effect of his driving on the convenience of other drivers, because there is no way in which he can exact compensation from drivers for not driving or driving less and therefore improving their driving time. That externality is internalized by a toll road, because congestion reduces the quality of the driving experience and so the amount each driver is willing to pay in tolls; the owner of the toll road will trade that willingess to pay off against the reduction in the number of drivers as a result of a higher toll.
Another externality, however, will not be internalized by the toll-road operators. That is the contribution that driving makes to pollution and global warming. But public ownership is not necessary in order to internalize this externality. The government can force its internalizing by imposing a tax on driving.
There is, however, in the toll-road setting another source of allocative inefficiency, and that is monopoly, which I have mentioned already. Drivers who do not have good alternatives to using the Indiana Toll Road can be made to pay tolls that exceed wear and tear, congestion effects, social costs of pollution, and other costs of the road, engendering inefficient substitutions by drivers unwilling to pay those tolls. To an extent, the toll-road operator may be able to discourage substitution by price discrimination, but this is unlikely to be fully effective and indeed can actually increase the allocative inefficiency of the monopoly.
The monopoly issue raises the question: what exactly was Indiana selling when it leased the toll road for $3.8 billion? The higher the tolls and the greater the lessee's freedom to raise the tolls in the future, the higher the price that the state can command for the lease. If the lease placed no limitations on tolls, the state would be selling an unregulated monopoly. If the lease could constrain the lessee to charge tolls just equal to the cost of operating the toll road (including maintenance, repairs, snow removal, lighting, and the collection of the tolls), the market price of the lease would be significantly lower. To the extent that the state wants to maximize its take from the lease, it will be creating allocative inefficiency by conferring monopoly power on the lessee.
It is difficult to determine whether the $3.8 billion price tag for the Indiana Toll Road is closer to the competitive or the monopoly price level. On the one hand, the lessee cannot raise tolls until 2010 or 2016 (depending on the type of vehicle), and increases after that are capped. On the other hand, the tolls were raised significantly just before the lease, and allowing the operator in 2010 to begin raising toll rates annually by the increase in GDP may confer windfall gains, since the cost of operating the toll road may not increase at so great a rate. One would have to know a great deal more about the economics of operating a highway than I do to figure out whether the terms of the lease confer monopoly power on the lessee.
I do not regard the monopoly concern as a strong objection to the leasing of the toll road, however. The reason is that most, maybe all, taxes have monopoly-like effects, in the sense of driving a wedge between cost and price. Suppose the lease price would have been only $2 billion had the state imposed more stringent limitations on toll increases. Then the state would have $1.8 billion less in revenue and would presumably make up the difference by increasing tax rates or imposing additional taxes, and these measures would have allocative effects similar to those of higher tolls charged by the lessee of the toll road. If the monopoly issue is therefore considered a wash, the principal effect of the lease will be the positive one of reducing the quality-adjusted cost of operating the toll road and the lease is clearly a good idea.
Toll roads are more attractive candidates for privatization than non-toll roads because it is easy to charge user fees; tolls are user fees. It would be harder to charge for the use of city streets, though no longer impossible, given electronic technology for monitoring drivers. Privatizing certain security services pose special problems as well, as Becker and I discussed in our May 28 posts about security contractors in Iraq. But public services the cost of which is defrayed in whole or significant part by user fees are good candidates for privatization, including Amtrak, the Postal Service, building and restaurant inspections, veterans' hospitals, and federal, state, and local airports. The privatization movement has a long way to go before achieving an optimal mixture of public and private service providers.
Against all this it will be argued--it is an argument emphasized by opponents of leasing the Indiana Toll Road--that privatization, at least when it takes the form of a sale or long-term lease of government property for a lump sum, beggars the future by depriving government of an income-producing asset. The argument, at least in its simplest form, is unsound, because the state is not disposing of an asset but merely changing its form: from a highway to cash. The subtler form of the argument is that, given the truncated horizons of elected officials, the state will not invest the cash wisely for the long term, but will squander it on short-term projects. This is a danger--how great a one I do not know. It would be an interesting study to trace the uses to which privatizing governments here and abroad have put the proceeds of sales of public assets.
There is a well-known conflict in privatizing a government enterprise between the desires to raise revenue from the privatization and to create an efficient enterprise. Government revenue is increased by giving the privatized company a protected position against competition, while allowing other companies to compete vigorously against the privatized company increases efficiency. Greater efficiency typically means lower prices for the privatized product, and hence lower bids for the enterprise to be privatized.
Governments often succumb to the desire to increase their revenue, which has caused the creation of monopolies in privatization programs all over the world. I differ with Posner in believing that the revenue from a monopolized privatization would not be fully raised elsewhere if not raised from the privatization because it is difficult to tap other sources of revenue to substitute for foregone revenues from privatizations. Put differently, governments end up with bigger total spending budgets when they increase their revenue from privatizations by giving privatized companies some monopoly power.
Still, I generally strongly support privatizations, even when privatized companies have monopoly power in setting prices and other conditions of the sale. The reason is that other companies are more likely to find ways to compete against private monopolies than against government ones. A very important part of this argument is that technological progress is faster with private monopolies than with public monopolies. For example, ATT was a private regulated monopoly before the breakup of the Bells in the early 1980‚Äôs into competing entities. The breakup was desirable, but still ATT was much more efficient than were the government run companies that dominated the telephone industry at that time in the rest of the world.
These and the arguments given by Posner strongly imply that highways, along with postal systems, trains, airports, ports, and other infrastructure, including even some security activities, should be privately rather than publicly operated. The main challenge arises when it is more difficult to stimulate competition for the privatized company because of so-called "natural monopoly" conditions in the industry. Due to economies of scale, it may not be efficient, for example, to have another highway built across Indiana to compete against the Indiana toll road. Yet even in that case, it would still be desirable to privatize the toll road, but controls could be imposed on the prices and other conditions that can be levied imposed on consumers by the privatively owned road.
Yet I believe that in the dynamic world we live in, natural monopoly considerations are less common than often supposed because new technologies and processes can bring competition to what appear to be protected markets if the profits are large enough. In this way, the supposed natural monopoly position of traditional telephone companies due to the large fixed costs of a network of telephone wires has been eroded by the development of cable and its alternative wired network, and of course by wireless telephony and the use of the internet for phoning.
Roads and airports are examples of industries that pose greater challenges to create competition among private companies. However, smaller airports in a region, such as the one at Gary Indiana, would be expanded to attract business from higher priced dominant airport in the same region, like O‚ÄôHare, if the dominant airport was charging excessive fees, and if both airports were privately run. Even a second private toll road would be built to compete against at least part of a privatized toll road that was charging excessive fees, especially over the most densely traveled portions of the privatized road.
The theory of the efficient allocation of resources is radically changed when dynamic competition with induced technological progress is the framework of analysis instead of the traditional static theory of competition. Dynamic competition analysis is more comfortable with accepting short -term monopoly power of privatized enterprises that are allowed to set their own prices. The reason is that the monopoly profits from high prices by the privatized enterprise would stimulate other entrepreneurs to find ways to compete against the enterprise, and in this way claim some of the monopoly profits through lower prices and better service. "Natural monopoly" looms large in the theory of static allocation of resources, but is considerably less important in the actual world because of technological progress that is induced by monopoly power and excessive profits.
When dynamic competition is effective, a public enterprise, like a toll road or the postal system, should be sold without any restrictions on future pricing, unlike what happened in the sale of the Indiana toll road. I do not go so far as to claim that dynamic competition always arises in a powerful way to compete against privatized roads or other privatized infrastructure that have no restrictions on pricing. But I do believe it is far more common and effective than in textbook discussions of competition and entry. If that is the case, it would then pay to privatize most of the public infrastructure of roads, communication, mail delivery, electric power generation, and the like, with few controls over the prices that can be charged to consumers. That would create some pockets of persistent monopoly profits, but it would take politics out of rate setting. It would also stimulate the development of different ways to compete against what appears to be an unassailable monopoly enterprise.
I want to note one particularly acute comment--that awarding grants of federal money to localities on the basis of the "quality" of their grant proposals just rewards skillful grant writers. I think that is probably true. This is not like grant applications for money for scientific research, which are evaluated by distinguished scientists. Counterterrorism is not a science, and the "peers" who reviewed the grant applications for the Department of Homeland Security appear to have been a miscellaneous assortment of persons engaged in emergency response and other security-related activities. The room for subjective, political judgments must have been large.
I also agree with the commenter who criticized me for suggesting that DHS had experienced "political pain" by cutting the allocations for New York City and Washington, D.C. DHS received criticism, but since both NYC and Washington are solidly Democratic, the political pain has been more than offset by the gratitude of cities in states that lean Republican or are toss-ups. Now for all I know politics played no role in th allocations, but the lack of transparency in the "peer review" process makes it difficult to dispel suspicion of political motives.
Commenters debated over whether cities or the federal goverrnment have better information about optimal counterterrorist measures for a given city. Thinking further about that issue, I now incline to the view that the only respect in which a city has the comparative advantage is with respect to measures for gathering information about residents who might be terrorist supporters and for patroling local sites and facilities (like the New York subway system). These information-gathering and patrolman-on-the-beat activities, which incidentally are labor-intensive, are ones for which grants to cities make sense. But when it comes to capital expenditures, such as for radiation and pathogen detectors, radiation shields, communications equipment, and decontamination facilities, the federal government probably has the comparative advantage. Apart from being able to extract price concessioms by buying in bulk, the federal government can assure compatibility across cities where needed (for example, in communications equipment), exploit economies of scale, base expenditures on more sophisticated appreciation of threats and technology, and resist granstmanship and local political pressures. Thus, on reflection, I am inclined to change my mind and conclude that DHS has it backwards in emphasizing grants to cities for capital rather than for personnel expenditures.
The Department of Homeland Security will be distributing some $700 million this coming year to American cities for antiterrorism measures. The amounts allocated to New York and Washington, which are generally regarded as the prime U.S. targets for a terrorist attack, are about 40 percent lower than the current year's allocations, and this has engendered indignation on the part of officials of those cities. Other large cities have seen their allocations cut sharply as well. In part the change in allocations is due to the fact that Congress cut the overall amount of money for this program, but in larger part it is because of a deliberate decision to shift money to smaller cities. Michael Chertoff, the Secretary of Homeland Security, defends the shift on two grounds: that the money should be used to build physical capacity to respond to terrorism rather than to fund recurring expenses such as salaries of emergency-response personnel, and that New York, Washington, and a few other major cities have received the lion's share of the grants since the beginning of the program because they are the prime targets but their urgent needs have been attended to and it is now time to attend to the needs of the lesser targets.
The interesting policy questions are, first, should the federal government be making such grants to cities, and, second, what should be the basis for deciding how large a grant to make to each city? Taking the first question first, there is no doubt that the federal government and not just states and municipalities should spend money to protect the nation from terrorist attacks, since, as we know from the 9/11 attacks, an attack on a city (or on any other major target) has consequences far beyond the state in which the city is located. But should the government finance defensive measures by the cities or should it spend the money itself? The argument usually heard for the grant approach is that the locals know better their vulnerabilities and how best to reduce them. But the argument is weak because while the locals do know a great deal about the competence of their response personnel, they know little about terrorist threats--terrorist plans, methods, preferred targets, and so forth.
Moreover, when a pot of federal money has to be divided up among state or local governments, pork-barrel politics are bound to distort the allocation. Concern with this problem led DHS to employ anonymous committees of local security and emergency-response officials to vet the grants, but partly because of their anonymity and partly because such officials are only quasi-professional, this version of peer review was not highly credible.
Furthermore, the locals may use the federal money simply to replace the expenditures they would otherwise have made on antiterror measures. Suppose a city wants to spend $10 million on such measures and would spend it out of its own funds, but it gets a grant of $10 million from DHS. Then it may simply reallocate the $10 million in its own funds that it would have spent on such measures to some unrelated program. To the extent that such reallocations occur, the $700 million DHS program, with all its entailed paperwork, peer reviews, and political controversy, is not a security measure at all but just a general federal subsidy of local government. Notice, moreover, that the less of its own money the city spends, the less secure it is against terrorist attacks, and it can use the lack of security to argue for an increased federal grant next year!
All this said, probably some sort of grant program makes sense simply because optimal antiterrorism measures require enlisting local facilities and personnel, and cities may underspend on these because the benefits will accrue in part, maybe major part, to other, perhaps far distant, cities; that is the externality point with which I began. I am puzzled why the program should favor communications equipment, computers, emergency vehicles, pathogen detectors, containment shields, and other capital goods over salaries; effective antiterrorism measures tend in fact to be labor-intensive. Becker, however, suggests an explanation in his comment.
Moving to the second question, how should the amount received by each city be determined, one encounters baffling problems of measurement. Ideally, one would like the grant moneys to be allocated in such a way as to maximize the excess of benefits over costs. The costs are relatively straightforward, but the benefits are not. The benefits of an antiterrorism measure, for each potential target, depend on (1) the value of the target (not just in terms of financial loss, of course) to the United States, (2) the likelihood of its being attacked, (3) the likely damage to the target if it is attacked (which requires consideration of the range of possible attacks), and (4) the efficacy of a given measure to prevent the attack or reduce the damage caused by it. (2) and (3) are probably the most difficult to estimate accurately, because to do so would require extensive knowledge of the plans, resources, number, location, and motivations of potential terrorists. But (4) is very difficult too, because the effectiveness of increasing the number of policemen, or of installing surveillance cameras on every block, or of increasing the number of SWAT teams, or of taking other measures of prevention or response, is extremely difficult to assess in advance.
About all that can be said with any confidence is that cities and other targets that are near the nation's borders (including coastlines) are probably more likely to be attacked than cities and other targets that are well inland, that larger cities are more likely to be attacked than smaller ones because the larger the city the easier it is for a terrorist to hide and move about in it without being noticed, that attacks on large cities are likely to kill more people and do more property damage than attacks on small ones, that among coastal cities New York and Washington probably are the prime targets because of their symbolic significance, but that to neglect the defense of the small inland cities would simply make them the prime targets, and that an attack on such a city might sow even greater fear nationwide than another attack on a large coastal city by making people feel that nowhere is safe. But no numbers can be attached to these probabilities. They belong to the realm of uncertainty rather than of risk, to borrow a useful distinction made by statisticians: risk can be quantified, uncertainty cannot be.
This analysis suggests that more antiterrorism resources should indeed be allocated to the large coastal cities than to other potential targets, but that is the pattern even after the recent cuts. What seems indeterminate is the precise amount of money that should go to each city. That makes one wonder why DHS was willing to incur the political pain of drastically altering the existing grant pattern.
Posner discusses many of the thorny issues involved in the
allocation of funds by The Department of Homeland Security
to American cities to combat terrorism. I will concentrate
my comment on how to align the incentives of cities to those
of the country as a whole.
Posner points out that there is a conflict between the
incentives of cities and those of the federal government.
When cities do more to prevent terrorism against their
residents and buildings, they also help the country fight
terrorism against other cities and towns without getting
compensated for that help. He also indicates that if the
federal government simply gives money to cities, the cities
may reduce the amounts they would otherwise spend fighting
terrorism. Both problems arise in many infrastructure and
entitlement programs, such as road-building, Medicare for
the poor, and the fight against contagious diseases.
These sources of the tendency for cities to underspend on
anti-terrorist activities can be at least partially overcome
if Homeland Security did not outright give various amounts
to different cities, but instead relied on the method used
to combat similar issues that arise with other grant
programs. The Department of Homeland Security should offer
to give cities a certain number of dollars for each dollar
they spend on antiterrorist activities. For example, if a
city spent $30 million, they might get an additional $60
million from the federal government. In this example, a city
would get to spend $3 dollars for each dollar they used from
their own funds to fight terrorism.
Federal matching of this type discourages cities from
cutting back on their spending to fight terrorism since they
lose say $3 dollars for each dollar they cut back. Matching
grants also induce cities to give de facto recognition to
the fact that each dollar they spend helps residents of
other cities as well by improving the overall American fight
against terrorism. The ratio of federal spending to city
spending should be a measure of the ratio of the benefits to
other cities compared to the benefits to the city spending
their own money to fight terrorism.
The matching need not be independent of how cities spent
their own monies. Cities are more likely on their own to
spend on salaries than on capital goods that are produced
elsewhere since spending on employees gives jobs to local
residents. The matching grants should then be oriented
toward capital spending rather than labor spending. In fact,
the Homeland Security program is so oriented, and that seems
to me to make some sense.
However, matching grants, particularly if the ratio of
federal to local contributions is large, can create the
opposite problem from that created by outright grants;
namely, cities may spend too much since their spending is
multiplied through the amounts available in matching funds.
This is usually controlled by placing upper limits on the
amounts that could be received in matching funds. Cities
that are especially attractive to terrorist attacks--such as
New York and Washington--would spend more fighting terrorism
even without federal grants. Still, on their own they may
not spend enough, so the upper limits they could receive in
matching grants should exceed that available to say Kansas
One problem is that as coastal cities like Los Angeles, San
Francisco, Boston, New York, and Washington became better
prepared to fight terrorism, terrorists might shift inland,
to places like Detroit, Chicago, Cleveland, Omaha, Topeka,
and elsewhere. As the bombing in Oklahoma City showed, even
attacks in smaller cities cause considerable fear and
consternation. That is why a federal program has to be
national, and target smaller places as well as larger ones.
Matching grants encourage smaller cities also to contribute
to the fight against terrorism, and they will spend more
when they become more vulnerable after the more attractive
terrorist targets became better prepared. So the system is
partly self-correcting through the incentives that cities
have to protect their own citizens.
But matching grants do not solve all the problems of how to
best allocate limited federal funds. So the federal
government will still need some guidelines that determine
which cities should be given more Homeland money, although
in a matched way.