The Marginal Economics of the Welfare State

The recent news that Fed Chairman Ben Bernanke is launching a second Operation Twist, yet another round of monetary stimulus, raises two related questions: Why do they keep trying this even though it doesn't work, and why doesn't it work?

I am not the first to note that we are living in an era of "permanent stimulus," and it's not just monetary. In fact, you can look at the whole welfare state as a permanent, standing "stimulus" program, since it borrows trillions of dollars that are continually pumped into the economy by increasing the consumption spending of those who otherwise could not afford it. The Supreme Court just removed a major obstacle to a new expansion of that permanent stimulus state-which makes the question of why stimulus fails all the more urgent.

A big clue to the answer is that stimulus fails because it always becomes permanent. The original Keynesian theory of stimulus was that the government would borrow and spend during an economic downturn in order to stimulate economic growth, and then once that growth took off, government would stop stimulating, cut its expenses, and pay down its loans. At least, that is how the idea is generally sold. The stimulators tell us that a recession is the wrong time to cut back spending, as if they ever thought that there might be a good time.

But they never do, and there is an inexorable logic to this. If economic growth is based on government stimulus, if that is what gets the economy going, then we would never dare to remove the stimulus, for fear of stopping the government's engine of growth. Keynes himself agonized that cutting back on the World War II defense buildup, which supposedly ended the Great Depression, would plunge the economy back into a decline. It did the opposite, of course, but our great economists never learned the lesson. And so we see the pattern of the current Stimulus Depression. Every time one round of stimulus begins to wear off, as is happening now, the Fed injects another.

It reminds me of an interview I saw once with a former methamphetamines addict who described how, as always happens, his body became accustomed to the drug. It became the "new normal," and he needed larger doses to have the same effect. By the end, the drug he once took to experience a high of superabundant energy he now took just to be able to get out of bed in the morning. That pretty much describes the function of Operation Twist, Part Two. The economy is hooked on stimulus, and it keeps needing just one more fix, not to thrive, but to keep from crashing.

Addicts are known for having their "lost decades," years that they spend searching for short-term highs instead of dealing with their deeper problems. So it should be no surprise that our addicted economy is halfway through a lost decade of its own.

And it's not just that stimulus is permanent. It also becomes all-encompassing. Consider the pattern of the growth of the welfare state-again, this is a permanent, standing form of stimulus spending-to encompass every economic need experience by everyone. James DeLong has a good summary of this process.

"[T]he concept of 'welfare' has become an open, bottomless vessel into which every desire can be poured: Government takeover of the entire health and retirement systems; detailed regulation of employment; manipulation of money; subsidies for housing, education, energy, food; or anything else that strikes the fancy of some segment of the public.

"The 'some segment' part is crucial, because today's welfare has ceased to be limited to that of the public generally, or to the welfare of any group that has a serious claim to special deserts. Instead, it is the welfare of some special interest that is able to capture the policy process."

Hence the political resistance of public employees' unions against any attempt to make their own portion of the modern welfare state a little less comfortable.

Or consider the life of Julia, the fictional woman featured by President Obama's re-election campaign as a beneficiary of all the welfare-state goodies championed by our magnanimous leader. Yet she is described, not as poor and unemployed, but as a web designer and small business owner, which is to say as a member of the middle class.

Or consider the story of President Obama's mother, whose plight fighting cancer supposedly inspired Obama to push for an expansion of the welfare state. Yet it was recently revealed that at the time of her fatal illness, Anne Dunham was not only fully covered by health insurance but was making $85,000 a year. Adjusting for inflation, that's about $120,000 in today's money, enough to put her solidly in the prosperous middle class.

The welfare state is no longer just about benefits for the poor, or even for narrow interest groups with political clout. It's about benefits for everybody, and particularly for the vast American middle class. So our retirement is to be provided for by Social Security, our health care by Medicare and now Obamacare, our kids' educations from pre-K to graduate school, and on and on. And don't forget getting bailed out of your mortgage debt. A bailout for homeowners is, in a way, the ultimate middle-class welfare program, since homeownership is the hallmark of the middle class.

So we've gone from stimulus as the exception to stimulus as the rule, from government assistance as the exception to government assistance as the rule. And of course the whole concept of "universal health care," the impetus behind Obamacare, openly states that the goal is to move from government-subsidized health-care only for the poor and elderly to government-subsidized health care for everyone.

But that example specifically-the expansion of government-provided health care from a narrow subsidy for special groups to a universal entitlement for all-brings us to the fundamental economic reason why the welfare-stimulus state fails.

Last year, the economics blogger Megan McArdle named the basic problem in a brilliant aside on the economics of online streaming of movies and television shows. The problem with this business model, she argued, is its confusion of marginal cost with average cost. Netflix is able to offer inexpensive online streaming because the producers of the content only have to cover the very small marginal cost of providing it to a small additional audience. But as online streaming becomes a larger and larger percentage of viewers and eventually becomes the entire audience, the content-producers will have to start charging enough to cover all of their costs, including the big, fixed, up-front costs of hiring stars, building studios, and the like. So the price of online streaming is guaranteed to rise.

Here is where she applies it to our political dilemma.

"You can get a sweet deal if you are the customer who gets marginal cost pricing. Medicare does this-reimburses hospitals at above their marginal cost, but below their average cost, so that private insurers have to pick up most of the hospital overhead. European countries do this with prescription drugs: reimburse above the marginal cost of producing the pills, but below the total cost of developing the pills, so that the US has to pick up most of the tab for drug development.

"The problem is that as voters and as customers, we often get the notion that this can be extrapolated to everyone. So liberal policy wonks want to save money by putting everyone on Medicare, or some equivalent program that uses the government's monopsony pricing power to get lower prices for everyone; thrifty customers think that everyone should drop cable and just pay $14.95 for streaming plus DVDs.

"But everyone cannot be the marginal cost consumer."

This is the specific economic mechanism for a phenomenon I described recently as the Thatcher Line, the point at which a welfare state runs out of other people's money to spend. It helps explain what happens when a welfare state inevitably expands from a small, marginal actor in the economy to being the dominant actor in the economy.

McArdle has already explained the impact on health care. But this basic rule is very wide and applies, with variations, to all aspects of the welfare state.

Student loans and grants, for example, can buy a lot when they have a marginal impact on the higher-education market. But when everyone is getting grants and loans, when this becomes the normal way that the middle class pays for college, then the influx of dollars bids up the price of education, and the benefit of all of this government support is swallowed up by bloated university administrations.

Similarly, to support a small number of the unemployed, or the retired elderly, on government assistance may be a manageable cost. But the more people are dependent on government, the fewer people there are in the productive private economy to support them. That's how you get the infamous death spiral of the Southern European welfare state, where there are so many government workers on the Greek government's payroll that the private economy is sinking under their weight. That's a death spiral we are re-enacting here with Social Security, where the number of workers per recipient is declining from 16 to 1 in 1950 to 3 to 1 or 2 to 1 in the near future.

And something similar applies to fiscal and monetary stimulus. Zero percent interest rates might spur economic activity-as a small, one-time offer which people feel they need to act quickly to take advantage of. But declare that these interest rates are available to everyone for the indefinite future, and demonstrate to the markets that every time one monetary stimulus ends, another one will be launched, and these interest rates become the "new normal." So rather than printing a limited amount of money to finance a one-time burst of economic activity, the Fed is printing trillions of dollars to finance everything. The government goes from bearing a small cost (in expansion of the money supply) to provide a little free money, to bearing enormous costs to create oceans of free money-costs that will be paid in full when it comes time to make the choice between soaking up all those extra dollars or allowing them to create runaway inflation. And it gets diminishing returns. As zero percent interest rates become the expected norm, they are no longer a stimulus. They are what bankers need just to get up in the morning.

There are many elements of the welfare and stimulus state that seem affordable and sustainable so long as they remain small, so long as they are little islands of socialism paid for and supported by a much larger capitalist economy. The basic confidence game of the Western statist is to point to these seeming successes and tell us that they can be expanded to become the majority of the economy-at which point they quickly collapse the system. That, in sum, is the economic history of the welfare state over the past 75 years.

Hence the great political and economic project of our era: to unwind the unsustainable permanent stimulus of the welfare state. If we cannot eliminate the welfare state-because so many people are accustomed to thinking that they need it to survive-we can do the next best thing: we can marginalize it.