Let’s try a thought experiment:
Let’s say that there is a relatively high priced good for which there is a perceived societal benefit if it is widely purchased by the public. Congress decides that, given this societal benefit, it makes sense to subsidize the purchase of this good so that as many citizens as possible can benefit. Laws are written and passed to bestow a tax benefit on purchasers of this good and for those too poor to purchase it on their own, an additional subsidy is provided. Demand for the good rises dramatically.
Unfortunately, the industry which produces this good cannot increase the supply rapidly due to some constraint. The constraint could be regulatory; for instance, deeming that only goods produced to some standard are allowed to be sold or that only licensed producers can produce the good - and there is a lengthy licensing process. Or the constraint could be imposed by non regulatory outside forces; the resources needed to produce this good may be better used for production of another good. The means of constraint is relatively unimportant; that it is difficult and/or time consuming and/or expensive to expand supply is the important factor.
Given this set of circumstances, is there any doubt about how the price of this good would respond? Well, of course not; simple economics tells us the price will rise until supply and demand is once again balanced. Why do politicians have such a hard time understanding this basic economic story?
Since Congress is voting (or will likely have already voted by the time most people read this) on healthcare reform this weekend, most readers will assume that this thought experiment is about that subject and it is. But it isn’t just about healthcare reform. Politicians routinely enact policies which they claim will solve some (alleged) problem even when past experience or basic economics tells us the proposed policy will fail. Ironically, when the policy inevitably fails, it is more likely to be expanded rather than corrected.
As I write this I have no idea what the outcome of the healthcare reform vote will be but I already know that it will not solve the problem of rising healthcare costs. No permutation of the bills being considered sufficiently addresses the supply of healthcare services. Countless hours have been spent trying to figure out ways to cover the uninsured, but almost none devoted to expanding the supply of healthcare workers (or equipment or facilities for that matter) to service these new customers. The good people of the CBO are near exhaustion after scoring near infinite approaches to funding health care reform and I can tell them without knowing any details that their estimates are wrong. Why? Because there is no way to accurately predict the future cost of a good without knowing something about both supply and demand and while CBO may (and I emphasize may) have a good estimate of future demand for healthcare they know almost nothing about future supply. We do know though that there are barriers to expanding the supply of healthcare services which have not been addressed so if reform as currently envisioned becomes reality the outcome is easy to predict; the rate of healthcare inflation will rise absent explicit government price controls. And if you have explicit government price controls, past experience and basic economic theory tells us that shortages will develop. This will not be the end of the healthcare reform debate by a long shot. If our elected officials are smart, they will spend the time between enactment and implementation trying to figure out ways to expand the supply of healthcare. I am not optimistic that will be the case.
We have just witnessed what happens when demand for a good is subsidized while supply is constrained. Numerous government policies subsidize the demand for housing and starting in the late 90s those subsidies were expanded. Fannie Mae and Freddie Mac subsidized the mortgage market through the implicit government guarantee of their debt. They further subsidized the market starting in the early 00s by purchasing lower quality mortgages. The Federal Reserve subsidized housing by holding interest rates too low for too long and thereby reducing the carrying costs of owning a home. Tax policy subsidized housing by making capital gains on a primary residence tax free. There were other more subtle ways too but the point is that demand for housing was subsidized by government policy.
The supply of housing on the other hand was constrained by other government policies and the fact that building is a time consuming process. Zoning laws, building codes, permitting, inspections and environmental concerns all act to slow the expansion of the supply of housing. And the result was predictable - the price of housing rose as demand outstripped supply. Or at least it did until supply finally caught up with - and eventually surpassed - demand; then the glut pushed prices down. Now government policy is once again trying to artificially support demand in an effort to prevent further price declines. The home buyer’s tax credit and the Fed’s mortgage purchasing program are efforts to artificially increase the demand for housing to mitigate the damage done by the government’s previous successful efforts to artificially increase the demand for housing. And the perceived societal benefit of home ownership? Dubious at best.
It is ironic too that folded into the healthcare reform bills being considered is a provision to eliminate private student loan lenders. If the bill passes, student loans will come directly from the government and be serviced by private companies. It is believed by supporters that this will free up more funds for more loans for more students; in other words it will further expand demand for a service which is already rapidly rising in price. Whether government guaranteed student loans should be provided directly by the government or through private lenders is almost irrelevant. More important is the impact of the expanded higher education subsidy on the price of that education. Higher education is subsidized through Pell Grants (which will be expanded by the Obama administration) and subsidized loans such as Stafford loans. The government provides these subsidies to demand, supply is artificially constrained (through accreditation requirements, tenure systems, etc.) and we wonder why the cost of a college education continues to rise faster than the rate of inflation. Congressional attempts to make a college degree more attainable are admirable but demand subsidies won’t solve the problem without addressing the supply side of the equation.
And so, having failed so miserably at solving purely domestic concerns such as healthcare, housing and education, our politicians now turn their attention to international trade. Based on recent developments in the debate concerning trade between China and the US, I feel confident in predicting that their efforts in the international arena will be every bit as successful as their domestic interventions. The crux of the “problem” is the value of China’s currency, the Yuan. US politicians such as Chuck Schumer and Lindsay Graham, a bipartisan incarnation of Smoot and Hawley (both Republicans), claim the Yuan is undervalued and that by pegging the Yuan to the dollar the Chinese are causing unemployment in the US. They have introduced a bill to impose tariffs on Chinese goods if they don’t raise the value of the Yuan.
This dynamic duo made the same claim a few years back and the Chinese allowed the Yuan to appreciate by roughly 20% against the dollar. And the trade deficit with China….got worse. If they had reviewed our experience with Japan in the 70s and 80s they could have predicted that but history, even of recent vintage, apparently isn’t their strong suit. In the early 70s, the Yen traded at roughly 350 to the dollar and it was slowly appreciating as trade between the two countries expanded. By 1985 it had reached roughly 250 to the dollar but the US trade deficit with Japan had reached a politically unacceptable $46 billion. That year the US negotiated the Plaza Accord which deliberately devalued the dollar against the Yen and Deutschmark in an effort to solve a persistent US current account deficit. The dollar promptly fell 50% against the yen to 120 and the trade deficit…..rose to $56 billion. By 2008, the yen traded in a range of 90-110 and the deficit had reached $74 billion.
Why did this happen? Well, our politicians assumed that Japanese companies would just raise the dollar price of their goods as the Yen rose and that US customers would therefore buy fewer Japanese goods. And with a higher value for the Yen, they assumed the Japanese would buy more US goods and the trade deficit would disappear. It all seems so simple - and so wrong. First of all, as the Yen rose, the cost of raw materials imported to Japan fell so they didn’t have to raise prices much if at all. Second, Japanese businesses got more efficient and further mitigated the price disadvantage of a higher Yen. All the Plaza Accord accomplished was to give Japanese companies an incentive to become more productive.
The Chinese reacted the same way when the Yuan rose against the dollar earlier this decade. They will react the same way again if they allow the Yuan to appreciate as Schumer and Graham wish. Our trade deficit with China will not be solved by manipulating the exchange rate because it isn’t caused by the exchange rate. We run a current account deficit because Americans don’t save enough. If we saved more and consumed less, we would necessarily reduce our consumption of Chinese - and other countries’ - goods. Why don’t we save more? Well, it isn’t the only reason but the Fed holding interest rates at 0% surely doesn’t help. Schumer and Graham could have a greater impact on the trade deficit by concentrating on policies which encourage savings and investment. This is our problem and we shouldn’t be looking to China to solve it for us, especially when they can’t.
And one last thing about the effects of currency manipulation. The Plaza Accord which convinced the Japanese to appreciate the Yen in the mid 80s was an indirect cause of Japan’s twin stock and real estate bubbles. The BOJ kept interest rates low to offset the effects of the higher Yen. Low interest rates and a strong currency diverted capital to speculative purposes. The bursting of Japan’s twin bubbles and a strong, rising Yen has kept Japan near deflation for nearly two decades. In other words, in many ways it is the US that is responsible for Japan’s two lost decades. Do we want to do the same to China? How will that help our economy? Wouldn’t it be better to have a healthy Chinese economy to which we can continue to expand our exports? Is it worth starting a trade war for a policy that will not - cannot - solve a problem of our own making?
I have no answer to the title of this article. For some reason our politicians keep trying the same things over and over despite results that are contrary to their stated goals. In a quote most often attributed to Albert Einstein, it is said that doing the same thing over and over but expecting different results is the definition of insanity. Personally, I think the mere pursuit of political office should be sufficient for commitment to a mental health facility so politicians pursuing irrational policies are not surprising to me. What is surprising is that we keep re-electing them anyway. So, do your part, stop the insanity. Throw the bums out.
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