Tuesday, October 25, 2011

The Second Most Important Economic Rule of Thumb

Rule #1 is, "Price controls cause shortages." But for some reason Rule #2 has only recently crystallized for me:
Economic Rule #2: Whenever the government subsidizes something, its price goes up.
Let's look at some examples from recent history:
  • Companies were subsidized through tax policy to provide health insurance; medical costs went up.
  • Healthcare was further subsidized by Medicare and Meidcaid; medical costs went up a lot.
  • Student loans were subsidized through Federal loan guarantees; the cost of higher education skyrocketed.
  • Ethanol production was subsidized; the price of corn, and all of its dependent foodstuffs, went up.

  • Home ownership was subsidized through federal loan guarantees and cheap bundling of mortgages through Fannie and Freddie; we had a housing bubble.
I'm sure I could add another fifteen or twenty examples of this if I wanted to do some research, but you get the idea. Why is this true? The answer is simple: Free money. It may come out of our tax dollars, but the ability to get not only your own tax dollars but a hunk of everybody else's is at worst a good deal and at best the basis for a lucrative business model.

So: Suppose I'm a doctor, and I charge my patients $10 a visit (hah!), because I know that it's what they can afford if they're going to buy my service on a regular basis. Then I read in the paper that Medicaid will pay for $10 an office visit, and I know that 25% of my patients are on Medicaid. To me, I now know that my patients have, on average, an extra $2.50 that they'll happily give me without changing their buying habits at all. So I raise my price to $12.50 and office visit.

The reason for the price increase is obvious, but there's a deeper, more corrosive dynamic at work under the surface. In the example above, there are winners and losers. For the 25% of patients on Medicaid, they now have an extra $7.50 that they wouldn't otherwise have had. But for the 75% of patients not on Medicaid, they've each lost $2.50 in spending power. The doctor's doing great, the Medicaid patients are doing better, but the other 75% of the doctor's patients are getting screwed. We've destroyed real purchasing power by picking a few winners (the Medicaid patients and the doctors) and disadvantaging a vastly larger number of losers (the other 75%). And in the end, because we've favored the few at the expense of the many, more people need Medicaid, which drives prices even higher, which further impoverishes the many, and the beat goes on.

But it's even worse than that: The doctor increased his prices because he knew how much money was out there to be had. So the net result is that the economic value of the subsidy is completely destroyed by the price increase.

So, what does this tell us about a philosophy of government? Are subsidies ever justified? We clearly want to have some form of social safety net. That implies that we subsidize the poor, but we have to understand that we need to be extremely careful about how we allow the subsidies to flow back into the economy, or they simply become worthless.

But lots of subsidies are instituted for policy reasons, to encourage some sort of behavior that the government finds desirable. These are effectively worthless, because the price increases will always wipe out the value of the subsidy, causing the economic activity that was being encouraged to decrease back to its equilibrium level. In short, policy subsidies are worthless in the long run.

There are still lots of collective action problems that only government spending can address. But behavior modification is never going to be the government's strong suit.

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