Markets

And regulation, incentives and trade.

Photo by Tim Mossholder on Unsplash

Market economies with relatively little regulation or direct government control have proven themselves time and again to be the most effective and efficient way to unleash the productive potential of people for the economic benefit of all.  This is enabled by a simple technology: markets and prices.  Prices are a universal language to communicate value, and a market is the means by which prices are determined in order to enable the mutually beneficial exchange of goods.  This mechanism efficiently balances supply and demand, by incentivizing producers to fill unmet needs by making more of something, or buyers to purchase less in a shortage. This ensures the availability of scarce resources for those who really need or want them (evidenced by their willingness to pay a high price).  It’s no wonder that successful authoritarian regimes achieve their stability by allowing market economies to lift their countries out of poverty, albeit within circumscribed limits.  Centrally planned economies have consistently failed because they rely on the competence and integrity of government bureaucrats to manage an incredibly complex system of countless inputs and variables, and whose power provides them with personal incentives to bend the system to the advantage of elites like them rather than the broader society. 

That said, some government regulation of markets is important.  Unchecked, free markets can lead to excesses and imbalances that may also benefit certain participants but do harm to society as whole.  One example is monopoly power.  In a market with many producers of competing goods, each producer is fighting for the same customers.  This gives them the incentive to lower prices or improve the quality of their products, and the net effect is good for the consumer.  But companies that become dominant in a market – often legitimately through an innovation in cost reduction or product improvements – have an incentive to exploit this dominance to prevent new entrants from competing effectively with them.  They can do this in a number of ways, not all of which are immediately bad for the customer, but eventually it has the effect of reducing innovation and producing worse goods for higher prices than had they faced healthy competition. 

This is one area where governments can step in on behalf of the consumer – by preventing mergers or breaking up companies once they begin to acquire this anti-competitive power.  Another is in regulating externalities.  Externalities are costs or side effects of a productive activity which are ultimately not borne by those doing that activity.  It is effectively a negative consequence for which they do not incur any costs and is therefore virtually “free” to them but not to others.  The classic example of this is pollution – an industrial plant that dumps waste into a river does not experience those costs directly, but they still exist – to the wildlife that live in or off of that river, the downstream farms and towns that rely on it for water, or the tourism industry that benefits from its beauty.  The plant is essentially exploiting a shared resource in a way that harms others.   

Without a government restricting this form of waste disposal, or a government-sanctioned means for these harmed parties to seek redress (e.g. through the courts), this polluter has no incentive to improve their behavior or account for those costs.  This means they can price their products lower than better-behaving competitors or unfairly increase their profits.  Government regulation to protect such shared resources is critical to prevent exploitation and environmental destruction which harm many for the benefit of a few.   

Governments have other ways to address externalities.  Carbon taxes are an example I mentioned in a previous post which leverage the efficiency of markets to reduce carbon emissions.  Coal power is often much cheaper to produce than nuclear or even solar power, but this competitive advantage does not account for their disproportionate cost to the world in the form of greenhouse emissions.  Gas producers may find it cheaper to leak or flare unused natural gas than to shut down wells or seek and fix leaky valves, but this is because those emissions are often free.  Carbon taxes are an attempt to put a price on these side effects by creating an incentive, just like any other cost of doing business, for companies to behave in a more responsible way. Targeted regulations could achieve the same thing, but their effectiveness depends on careful design by bureaucrats to avoid loopholes, unintended consequences (like benefiting specific technologies that may not ultimately be best), etc.  This difference in approach is similar to the difference between planned economies like that of the Soviet Union, and the free or partially-free markets that left it in the dust. 

That’s not to say targeted regulations have no value or are going to lead us to economic ruin.  But they are rarely the most cost-effective or efficient approach to much of anything.  As such, I agree with liberals that governments have a responsibility to regulate the economy against the worst excesses of a free market, but I agree with conservatives and libertarians in their skepticism of governments ability to do this well.  As such, I believe governments should favor simple mechanisms that leverage their core competency - the collection and distribution of taxes - to produce market incentives for behaviors that benefit society as whole. 

An innovation enabled by markets is capitalism. Capitalism is a system which creates wealth through the pooling of resources to produce value efficiently and effectively, generally through legal structures such as corporations.  It leverages the profit motive to organize people and capital to productive ends.  And it has led to the incredible innovation and increases in living standards we have seen all over the world - particularly in capitalist western societies.  But capitalism has a cronyism problem, especially when governments get too involved in the design of regulations.  As I mentioned, I do believe governments have a responsibility to impose costs on externalities and prevent monopolies from exploiting consumers, but once their mechanisms become too complex or carefully architected, they become vulnerable to something called regulatory capture. 

Regulatory capture is the abuse of corporate power to influence regulations in order to unfairly disadvantage society or competitors to benefit a narrow group of stakeholders.  This is not a problem unique to capitalism, as similar forms of corruption exist in other systems as well.  But it is arguably capitalism’s greatest weakness as it undermines the benefits of a free market by leveraging government not to restrict externalities or promote competition, but to do the opposite.  And it’s only possible when politicians and bureaucrats hold the power to craft regulations with enough specificity and opaqueness as to provide these unfair advantages to well-connected cronies in the private sector, who reciprocate through generous campaign contributions and other forms of reward.  In democracies, this ultimately speaks to the importance of demanding better from our politicians by voting out those found to be guilty of such corruption.  But it also argues for policies which provide less scope for such abuses, by limiting the level of government involvement in the economy which makes regulatory capture possible. 

I’ve used the term incentive several times already because it is fundamental to how economists think about human behavior and the best ways to produce positive outcomes for society.  If you can create incentives which lead individuals and institutions to choose positive behaviors voluntarily, this is generally more politically and practically successful than imposing strict mandates.  Carbon taxes are in my opinion an example of a good government-imposed incentive.  Debt forgiveness is a bad one. 

The high cost of college and health care are significant problems in the United States.  Some claim they are examples of the free market allowing powerful institutions to rake in profits without public recourse.  But health care and education providers are not free markets, nor are they obvious examples of monopolies or regulatory capture, though those exist.  Students have plenty of choices when it comes to colleges, and while a specific location may not have many choices of hospital, there are nevertheless multiple companies in this market, not to mention many smaller providers of primary care.  These markets have not been completely immune to disruption from competitors – urgent care facilities and tele-health have improved access and lowered costs of some health services, and online courses have expanded the availability of high-quality education (albeit often without providing the all-important graduation certificate from a respected institution).  But the fact that both tuition costs and healthcare costs (especially for those with private insurance) have consistently risen faster than the rate of inflation suggests that something about these markets is unique and not functioning as we’d expect them to if they were truly free. 

It’s not difficult to understand what makes these markets uniquely immune to the forces of competition that normally help to keep prices in check.  Both are examples of services that are considered to be essential for health and prosperity.  Both are products that policymakers want to encourage and expand access to (for good reasons).  And as a result, both have significant government involvement in their market, which is well-intentioned but distorts the natural market mechanisms that in other contexts tends to result in lowered prices (or improved quality) over time. 

Let’s first look at healthcare.  Unlike most other categories of goods and services, healthcare is often unpredictable and non-discretionary.  The costs associated with a cancer diagnosis or injuries from a car accident are often extraordinarily high, unpredictable, and essential to survival.  Like the threat of a house fire or theft, this is a category where insurance serves an important role in spreading the risk of somewhat rare but individually financially ruinous events across a large group of individuals who pay into a pool of funds that they can draw from in the event of such a situation.  But unlike property damage or theft, the costs of these services are often opaque.  The value of your home and other possessions is relatively easy to estimate because in most cases there is publicly available price information for comparable equivalents.  And a significant reason for this is that the markets for these goods are dominated by buyers who are using their own money to pay for them and are thus highly price sensitive.  That’s not the case in the health care industry.  In the U.S., thanks in part to government mandates that employers provide health insurance to full-time employees, the vast majority of health care is paid for using insurance – especially private.  And this does not only apply to catastrophic bills, like for chemotherapy or major surgery, but also to minor and preventive care.  This is unique.  My car insurance doesn’t pay for my oil changes, fuel or even more significant costs like a new transmission.  It only pays for repairs that go beyond the expected costs of owning a car, such as damage from an accident or hail.  And even these repairs, or indeed the cost of replacing the car, have costs which are determined by a normally functioning market.

When an entire industry is dominated by buyers who are not price sensitive because in many cases they do not pay or even see the total cost of the service, this provides the service providers a much higher degree of freedom to raise prices without a corresponding drop in demand for their services.  Now, the insurance companies are still paying and have an incentive to not pay more than necessary, but they are still obligated to pay someone for that service.  They can control their networks to some extent and provide incentives to their customers to choose lower-cost providers and products (and live healthy lives to avoid expensive interventions later), but ultimately the health providers hold tremendous leverage by the mere fact that their customers are obligated to buy their services, and there are relatively few of them in a given area.

Fixes to this market are not easy to design, especially given the status quo.  Some point to the relatively lower rate of growth in the costs of public insurance schemes compared to private insurance and suggest that having a single payer (the government) would shift the balance of power in favor of the buyer, since health providers would have little pricing power if their only customer were the government.  On the other hand, there is already a relatively limited number of insurance providers and their attempts at wielding their power to control costs have not proven too successful.  Like in the private insurance sector, there’s no guarantee that providers will not still be able to name their prices and expect payers to pass that cost on to the consumer (either through higher insurance premiums to the employer or individual, or taxes if the government is providing the insurance).  Perhaps more significantly, though, is that even if the government refused to pay more than a certain price for a service, that they would know how to determine the lowest price that wouldn’t lead to scarcity.  And this gets to the fundamental issue with government-provided healthcare schemes – by moving to a situation where few producers are serving a single consumer who has little choice in whether to purchase a good, they remove what little market dynamic still exists in this industry and mute its ability to efficiently identify the optimal price for a service.  Over time, this may dampen incentives by health care providers to innovate by cutting costs (at least, not in a way that gets passed on to consumers) or improving value.  Their demand is guaranteed, and as long as government bureaucrats consider the price fair, there’s little incentive for improvements.  And here again, we get into that issue before about highly involved governments leading to cronyism.  If government officials get to decide how much a service costs, how can we expect them to not be susceptible to attempts by industry lobbyists to pay more than is necessary, at the expense of the taxpayer? 

That said, making this a totally free market has downsides too.  The biggest one is the fact that, unlike car repair, health care can be an urgent matter of life or death.  So, I do believe that government has a role in ensuring everyone can afford health care.  But the best answer is not likely to be giving up on market dynamics in this industry.  Rather, a combination of scaling back the role of insurance to only pay for catastrophic care (making it cheaper and reducing the range of services whose costs are not passed on to the consumer) plus some form of government-subsidized health savings plan would turn health care into something closer to other insurance markets.  Catastrophic care may still suffer from opaque pricing since those services would rarely be paid by “normal” market consumers, but it at least scales back the problem.  For all its flaws, the Affordable Care Act’s approach of offering government-subsidized and approved insurance plans may still be a reasonable approach to providing a pseudo-market for catastrophic insurance, while maintaining a role for private insurance and its many employees.  A further advantage of this approach would be decoupling employment from health care benefits, which would lower the costs – especially at the lower end of the income spectrum – of employment.  This would greatly benefit organizations of all sizes to be able to employ more people than they can currently afford (or, in a tight labor market, use the savings to pay more). 

Higher education is a somewhat different situation, as the market distortion here is not insurance or the necessity of the service, but artificially low lending standards.  Normally, lenders must evaluate the likelihood of being repaid when determining whether and how much to lend to someone, and how much interest to charge to offset the risk of default.  While this does unfortunately lead to higher lending costs for those with less collateral or credit history, it also acts as a regulating force on the lending market.  Lenders and borrowers alike must weigh the cost of a loan against the expected benefit, which leads to rational actors in the market. 

Education, however, is seen as a public good and as such, various government and private programs exist to provide loans to many students, often with little consideration of their ability to repay.  These loans have artificially low interest rates, often need not be repaid for years, and sometimes include debt forgiveness in certain circumstances.  While this is hugely beneficial on an individual level and has a positive effect on reducing income inequality, it is economically flawed.  The problem is that because these loans and scholarships come with all these loopholes, many students (and more importantly, universities) realize that they may not need to be repaid, at least not in full.  This reduces the incentive of students to spend those funds wisely (since they’re at least partially “free”) on institutions and degrees that provide a strong return on investment.  Universities have caught on to this, leading to a steady rise in tuition costs and non-essential amenities in order to compete for these customers with inflated budgets. 

Now, I’m not suggesting that we should just get rid of college loans and limit higher education to the already-wealthy.  But I am suggesting that large-scale debt forgiveness programs and other market-influencing interventions in the normal process of lending lead to significant societal costs in the form of ever-increasing education costs that someone must ultimately bear.  If not the individual student, then the broader society of taxpayers, many of whom either did not go to college or did not have their debt forgiven.  This ultimately results in a regressive and self-perpetuating cycle that only benefits the universities who are able to offer a product at artificially elevated rates.  It's not easy to figure out how to balance the desire to expand access to higher education without undue influence on the market and pricing power of universities, but more careful targeting of financial support to those who need it, and an end to indiscriminate, broad-based debt forgiveness would be a good start toward incentivizing schools to compete on price again. 

You may be picking up on a theme here, which is that balance is key, and problems tend to be greatest when we over-emphasize either market efficiency or social stability and equality.  The same is true of trade. 

A key tenet of classical liberalism which has been central to the economic policies of Western democracies for the last century has been the idea that free trade leads to economic prosperity.  Most economists would tend to agree, and the reasons are similar to free markets.  The ability of markets to enable efficient and mutually beneficial exchanges of goods is not limited to local economies. It works on a global scale, too.  It stands to reason that countries blessed with valuable raw materials would be able to sell those profitably to countries who lack them, who in turn may sell services or manufactured goods that their population is uniquely capable of producing.  Lower-income countries benefit from a larger market for their low-cost goods, and wealthy countries benefit by purchasing them.  On a macro level, free trade does lead to greater overall prosperity and has been a critical enabler of the increased standard of living that citizens around the world have enjoyed in recent decades. 

But just as unregulated free markets can lead to distortions and inequality, free trade is not without consequences as well.  Countries with ample low-cost labor will be able to undercut higher-wage countries in their pricing of certain manufactured goods, rendering those industries unviable and those workers unemployed.  Certain products may have strategic significance where a reliance on potentially hostile nations for supply can undermine national security or put critical supply chains at risk.  In order to contain these effects, most countries impose certain barriers to free trade, such as tariffs which are essentially a tax on imported goods, in order to level the playing field enough to preserve certain domestic industries for strategic or political reasons. 

Tariffs, and their harsher cousin sanctions, can also be used as a tool of foreign policy.  Trade agreements between two or more countries can be a tool of stronger nations to extract certain behaviors from trading partners in exchange for favorable tariff treatment.  The Trans Pacific Partnership (TPP), signed by the Obama administration but never ratified and then abandoned under Trump, was a good example of such a multifaceted trade agreement.  It was designed to establish common standards of human rights, intellectual property and environmental protection on the part of its signatories in exchange for reduced barriers to trade.  It also had a less explicit goal of boosting the competitiveness of many nations which competed with China and would likely have served to tilt trade toward countries whose regimes are more aligned with the West’s.  

Of course, trade agreements like the TPP and the earlier North American Free Trade Agreement (NAFTA) must balance geopolitical aims against the more isolated costs to domestic industries which lose competitiveness when trade barriers are reduced.  NAFTA likely benefited its signatories – especially the United States – economically, but certain businesses such as in the agricultural and automotive sectors likely contracted in the US as a result of increased competition from Canada and Mexico.  As a result, trade policies such as the TPP often meet bipartisan resistance - from Bernie Sanders to Donald Trump - because of these impacts.  Even when the broader impact would likely have been favorable and well aligned with other goals. 

And here we get to a key challenge when it comes to market economies and trade.  The systems involved in driving macroeconomic trends such as GDP growth and inflation, and more isolated changes such as competition amongst producers of certain goods and services, are highly complex.  It is incredibly difficult, if not impossible, to eliminate all unwanted side effects of changes to economic policy.  And often, political incentives are unevenly distributed across sectors of the economy and political parties.  For example, the Trump administration’s tariffs on China likely harmed the US economy and jobs far more than it helped, yet the Biden administration has not reversed them for fear of appearing pro-China at a time when both parties (for good reasons) see China as a growing geopolitical adversary.  The TPP might have done more to hurt China while actually benefitting the US economy, but it was harder to sell politically because those effects would have been indirect, while the negative impacts to specific industries would have been easier to identify.

Trade policy is hardly the only area where political incentives are at odds with good policy.  Policies passed in one four-year administration are often not felt until the next, and the tendency of voters to credit or blame Presidents for the economies they oversee incentivizes short-termism.  Tax cuts or stimulus can give an immediate boost to the economy but may have long-term costs such as increasing government debt or boosting inflation. But because these negative effects tend to be delayed, politicians often do what will serve their more immediate interests (re-election).

It is understandable that voters treat the economy as one of the most important factors in deciding who to vote for.  But it’s unfortunate that partisanship and a misunderstanding of what drives economic change, and the delays often involved, leads many of them to draw the wrong conclusions about what helps.  I believe economic literacy, combined with a longer-term perspective, is the best remedy.  And that’s why I spent most of this chapter on economic principles which partisans on both sides tend to ignore in the interest of short-term electoral success.