No Sweat Economics

Many people whom I respect think politicians are completely ignorant of basic economics.  Often I’m tempted to agree.  But there’s one concept they understand quite well.  It’s called the inelastic demand curve.  That’s a complicated name for a simple idea:  I want or need something so badly, I’ll pay pretty much whatever I have to in order to get it.

If you took an intro economics course, you might remember a notebook full of Ls with sloped lines known as demand curves.  A normal, downward sloping demand curve refers to the situation where rising prices lead to lower demand for an item.  Falling prices spur greater demand.  If your local pizzeria raises its price for a large pepperoni by $2, they’ll probably sell fewer pies.  Some customers will shrug their shoulders and pay the increase.  Others will buy their pizza elsewhere.  And a third group will eat less pizza.  Pretty straightforward.

Sometimes your personal demand curve for an item may be inelastic temporarily due to special circumstances.  If you had a splitting headache, you probably wouldn’t even glance at the price of the only pain medication in the mini-mart.  You have a very inelastic demand curve and will pay whatever it costs for some relief.  But if you feel fine and still have some pills at home, you’d no doubt wait until you make it to Walmart or your local pharmacy to buy the big bottle of Excedrin.

Unless you’re paranoid, you probably don’t believe politicians are coming after your personal demand curves.  They’re heaping extra taxes on the curves that are inelastic for large numbers of people.  These are the items many of us want or need so badly-and can’t replace easily-that we won’t cut back no matter how much they cost…up to a point.  Some examples include cigarettes, alcohol, and gasoline.

Politicians know that an extra nickel or dime tax on cigarettes, alcohol, or gasoline won’t cause anyone to use less of these products.  They often claim they’re raising the taxes to pay for healthcare or new roads, but the truth is they’re raising those taxes because they can. They’ll spend on healthcare and roads anyway.  But in recent years, governments at all levels got greedy.

A prime example of this is cigarettes.  Federal, state, and local taxes have risen so dramatically that millions of people either quit smoking or substantially reduced their intake.  In spite of the sharply higher tax rate, revenue from cigarette taxes has fallen.  Some states issued bonds backed by the revenue they expected to receive from the 1999 settlement with tobacco companies.  But with fewer smokers, they have experienced a shortfall.  You can certainly argue that having fewer smokers is socially desirable, but politicians are frantic.  They’ve already spent the settlement money.

So what have we learned?  Politicians understand inelastic demand curves and exploit them to ensure the tax money they want keeps flowing.  But if they see a big money machine, they get greedy, raise taxes too high, and kill the golden goose.  Maybe they are stupid after all.

Just fill out these six forms and leave your deposit.  We’ll contact you in 10-12 weeks when your car is ready.  Yes, we’ve noted your request for a full size with red exterior and leather interior.  Unfortunately, we can’t make any promises.  If the US government gets its way, this conversation could play out a few years from now at your local Cadillac or Chevy dealership.

Under the plan (technically released by GM…but under SEVERE pressure), the USG would own 50% of the company’s shares, with a healthcare trust operated by the United Auto Workers getting another 39%. At that point, General Motors would essentially be part of the United States government.

The implications for our country are bad enough:  does a capitalist society want the government controlling major corporations?  But the prospects for GM aren’t rosy either.  Companies thrive because of creativity and innovation.  Does anyone believe a government-controlled entity is capable of these qualities?  GM won’t be designing cars its customers want; it will be following the orders of politicians.  You can expect a flood of new hybrids to clog the lots when gasoline is $1.50 a gallon.

I don’t mean to excuse GM:  after all, it was their former executives who signed the absurd union contracts that have brought them to the brink.  And of course they took the taxpayer bailout money.  But socialism isn’t the answer.  GM must be allowed to sink or swim on its own.  Absent USG interference the company, unions, and bondholders might very well have come to an agreement that all could live with.  We’ll never know.  We can only hope that other companies see this as a warning of the Trojan Horse that is government “assistance.”

Moral hazard?  Surely that’s some arcane term for hardcore economics geeks.  Actually, no.  It’s a simple concept that is crucial to the policy debate about the current financial crisis.  A moral hazard exists when a person believes he is protected from the consequences of his actions.  Sounds pretty good, eh?  Not really.

The fear of failure and loss helps govern our actions by stopping us from engaging in dumb or overly risky behaviors.  But if we believe someone is protecting us from failure, what’s to stop us from being irresponsible?

Why would someone build a home in an area likely to flood?  Surely no insurance company would sell her a policy.  Ah, but the federal government comes to the rescue with a taxpayer-subsidized insurance policy that makes the project viable.  So the government protects Suzy Homebuilder from the consequences of her decision, and she is free to do something that otherwise would be stupid or overly risky.  She has merely transferred the risk from herself to taxpayers.  We pick up the tab for a house that should never have been built.

Read the new core article “Inviting Moral Hazards: the Danger of Risk Free Living” for other moral hazards and their impact.  I’d love to hear your examples in the Comments section.

The era of bubbles is over!  Can the federal government ensure we never have a tech stock bubble or housing bust?  POLITICO says the Obama administration intends to do just that.  “According to Austan Goolsbee, a key Obama economic adviser, the president plans to focus on stopping bubbles along with preventing busts. And in an interview with POLITICO, Goolsbee said the administration will be on the lookout for new bubbles, like the tech stocks or housing prices.”  They plan to intervene to make sure no sector gets “out of balance.”

Here’s the rub:  what defines a bubble?  It’s only obvious when it reaches the silly stage, and of course in hindsight.  New technologies in particular need loads of investment capital to survive and thrive.  When a technology first emerges, few people can appreciate its impact.  The money-losing companies sponsoring these new ideas always seem absurdly expensive by traditional measures.  If government acts to choke off investment to industries it considers “bubbles,” it might postpone or prevent major advances.  Do you really trust the government to walk that fine line?

Investment bubbles have been around for many years.  For a fascinating account of some 17^th and 18^th century bubbles see Charles MacKay’s 1841 classic “Extraordinary Popular Delusions and the Madness of Crowds.”  Sometimes mass hysteria replaces rational decision-making.  The result is a bubble.  But the occasional bubble-and the inevitable pop-is a cost of doing business in free markets.  Government control over the direction of investment dollars could cripple a system responsible for an unprecedented improvement of living conditions for billions of people.

I’m not pro bubble.  I merely recognize that markets can do a much better job of figuring things out than politicians and bureaucrats.  This is another example of people with absolutely no business experience telling everyone else how it’s done.

Imagine April 15 was just another spring day.  The only things on your mind are the warming weather and the fact that the Pittsburgh Pirates are still in the pennant race.  Fantasy?  Perhaps.  But before the 1913 ratification of the 16^th amendment, Congress’ ability to levy an income tax was limited.  It sold the concept to the states and people by claiming only the wealthiest citizens would pay.  That didn’t last long.

The next important step in America’s income tax experiment came during WWII.  To speed up tax receipts to finance the war effort, the government began requiring employers to withhold money for income tax from each paycheck.  Without withholding it’s unlikely the current tax system could exist.  Can you imagine middle class taxpayers cranking out checks for $5,000, $10,000, or $25,000 each April?  There would be a revolt.

To illustrate how important withholding is, think about the conversations most people have around tax time.  How much did you pay in taxes last year?  Nothing-I got back $1200!  This poor sap is ecstatic he gave the government an interest free loan for $1200.  If banks could find enough customers like this maybe we could knock a few hundred billion off the bailout package.

According to the Tax Foundation, in 2005 U.S. individuals and businesses spent about $265 billion complying with the federal income tax.  This equals 22% of the amount the IRS actually collected.  And it’s pure waste…unless of course your name is H&R Block.

Let’s put aside the philosophical debates for now.  We’ll accept that government is entitled to every dollar it gets (as much as it pains me).  Isn’t there a more efficient way to collect this money?

Fortunately, a group of business leaders financed a study on precisely that question.  Their conclusion led to the national phenomenon (including two best selling books) known as the FairTax.

The FairTax is based on consumption, not income.  It’s like a sales tax.  But unlike an ordinary sales tax, which is regressive (more painful for the poor), there is a “prebate” that completely removes poor people from the tax rolls.  Since it doesn’t tax income, the FairTax would encourage businesses to make decisions for purely rational reasons, as they no longer would factor in tax liabilities.

There are no loopholes under the FairTax.  It is revenue neutral, meaning it takes in as much money as the current system.  And best of all, it gets rid of the IRS.  There are many more benefits of switching to the FairTax.  I encourage everyone to read about it on the FairTax.org web site.

Campaigning to end the income tax may seem like tilting at windmills.  And maybe it is.  But if incumbents start losing elections to FairTax supporters, the landscape would change in a hurry.  After all, there’s nothing more important to politicians than keeping their own seats.

According to Sunday night’s NY Times story, the US Treasury Dept. is instructing General Motors to lay the groundwork for a June 1 bankruptcy filing, in spite of the firm’s claims it could restructure outside of court.  The federal “automotive task force” has been engaged in discussions with GM over the past week.

It is clear that GM must either come to agreements with its unions and debt holders, or file for Chapter 11.  The company is not viable with its current debt load and labor obligations.  But the federal government should not be directing the negotiations.  In recent history, government ownership over business has usually been limited to cities seizing firms to satisfy tax delinquencies.  I recall a case several years ago where New York City owned a strip club.  The government would not exercise any control over the firm’s operations.  But now big government is feeling its oats.

GM should have known better.  By inviting bailout funds from the taxpayer, the company gave away control of its own future.  It should have negotiated with debt holders and unions, with a potential bankruptcy filing being the motivation for the sides to come to an agreement.  Now the government is calling the shots.  I doubt the UAW will make major concessions at this point, as it likely expects favors from an administration unions helped elect.  This is an extremely dangerous precedent for a capitalist economy.

What will the future of GM be like if the government retains an ownership stake?  When politicians are involved, decisions are based on politics.  Almost certainly, GM will be making more “green” cars whether consumers want them or not.  Control over executive salaries is also a slam-dunk.  GM could turn into another Amtrak, losing money forever and basing strategy on political expediency.

How can we get out of this mess?  No taxpayer bailouts of private business would be a good start.  How about legislation prohibiting the US government from owning equity stakes, or at least voting shares of stock?  Let me hear your ideas.  We must tell Washington we don’t want to go down this slippery slope.

The U.S. Commerce Dept. reported that the Trade Deficit fell for the seventh straight month in February.  Is it unusual that this number continues to “improve” while the country suffers through a brutal recession?  Read “When Bad News is Good: Exploring the Trade Deficit Myth” and discover it’s no coincidence.

If the choice is between a wide trade deficit or a steep recession, bring back the deficit!

Lobbying groups in the U.S. celebrated when they won a hike in the hourly minimum wage from $5.15 to $5.85 to $6.55 to $7.25.  But who can raise a family on that kind of money?  Why not $50,000 a year?  How about $100,000?  If you recognize that overly high wages could cause companies to lose money (or fire workers so they don’t lose money), then you understand that the minimum wage is not a cost-free policy.

It’s fine to figure out how much money you need to live your desired lifestyle.  But nobody pays you based on your desires.  They pay you for the value you provide them.  A rational employer will pay you an amount less than or equal to the value he thinks you will provide him.  If you cost him more than you’re worth, he loses money on you.  If your employer hires too many people that cost more than they’re worth, he goes out of business.  And in some places, raising the minimum wage turns workers from money makers to money losers.

A hike in the minimum wage doesn’t have much direct impact in high-cost cities such as New York and San Francisco.  Entry-level wages are usually well above the minimum wage, so employers don’t face higher costs.  But there’s an insidious boomerang effect:  many union contracts set wages at some multiple of the minimum wage.  So when the minimum wage goes up, any covered union members see their rates go up-perhaps three, four, or five times the minimum wage.

Who earns the minimum wage in the U.S.?  A 2006 Heritage Foundation study discovered the majority were young workers aged 16-24.  And the income data suggests the bulk of this group are middle class kids earning extra money.  Of all minimum wage households, fewer than 20% were at or below the poverty level.  When tips are included, just over 1% of the workforce was earning minimum wage.  So the idea that an army of workers is trying to survive on the minimum wage is a myth.

It’s mainly teens and other unskilled workers who earn the lowest wages.  These are precisely the ones who need to develop experience and good job habits to succeed later in life.  Now they have little to offer but enthusiasm and a willingness to work.  If the government prices their labor too high, some will never get the chance to prove themselves.

In developing countries minimum wage hikes are potentially much more damaging.  When many workers are at or near subsistence, wage policies can have a dramatic impact on hiring and firing decisions.  Yesterday Viet Nam’s government announced a 20% increase in the minimum wage.  It warned companies not to take advantage of the move by raising prices to consumers.  There’s no free lunch.  Affected companies will either raise prices, fire workers, or lose money.  And some of the latter group will shut down, cutting all their workers’ wages by 100%.  If you value results more than intentions, this is a very inhumane policy.

Here’s an excellent Neil Cavuto column about NY Governor Paterson laughing off Rush Limbaugh’s promised flight from NY taxes.  Politicians view wealthy people as piggy banks.  If you need more money, just raise taxes on the rich.  Most voters approve, as politicians and the media foment wealth envy.  But the game is changing.

In decades past, many people were tied to certain cities or states by their business interests.  Today an increasing segment of the workforce can live anywhere in the U.S….or even overseas.  If taxpayers believe they’re being exploited, they can just pick up and move.  And in high tax states like New York, California, and Michigan, that’s just what they’re doing.  New York City Mayor Bloomberg has urged the state to refrain from adding a millionaire tax (and $300,000 makes you a millionaire).  He understands how few people actually pay the taxes that run his city…and he can’t afford to lose any more of them.

The cities and states that treat taxpayers as property–instead of customers–will see a continued flight of wealthy and middle class citizens.  Governor Paterson has a real chance to do the right thing.  As the most unpopular governor in state history, the same old politics will not win him another term.  But if he tackles the budget on the spending side he can lead a fiscal turnaround.  In this environment raising taxes on the wealthy will cause an exodus from the state, and likely even lower tax revenues.

Read the case of Barbara Wagner, a cancer patient on Oregon’s government health plan.  When Wagner’s lung cancer returned, the state refused to pay the $4000 monthly cost of her prescribed meds…but did offer to cover the $50 for assisted suicide.

I’m not sure who originated this quote, but a government run healthcare system would treat us with the efficiency of the post office, and the compassion of the IRS.  Is there anything you can think of that government does well and efficiently?  It’s hard enough coming up with anything they do well!  Why people would want to put their health in the hands of faceless bureaucrats accountable to nobody is beyond me.

Government healthcare systems are imploding around the world, with private insurance coming in to pick up the slack.  Government-run systems suffer from shortages of doctors, supplies, and equipment; long waiting lists for treatment; limitations on treatments; and other deficiencies Americans would find intolerable.  Yet we seem ready to dive off the socialized medicine cliff.  Is our system perfect?  Of course not.  But let’s not make the perfect the enemy of the good.

We’ve been suckered into thinking that government medicine is free.  Well, read THERE’S NO FREE LUNCH to debunk the idea that anything is free.    Canadians who can’t wait for treatment have the option of crossing the border into the US and paying for it.  Many do.  But where would Americans go?

Oh, and Barbara Wagner died in October.