The ingrained socialism in the US economy

I think there is an interesting disconnect between the impression of free market forces dominating the US economy and the extend of government influence. And I am not basing this observation on the huge government spending programs to bail out financial institutions, their shareholders and bond holders (thanks, tax payers). Nor am I referring to the huge stimulus package that interestingly enough has no clear signature initiative to revive the flailing economy.

Instead let’s look at the automobile industry, the initiative to curb Co2 emissions and the price of fuel. The problem with the fuel price is that it pays for the cost of extracting the oil, processing it into fuel and shipping it right next door to you ready to be filled into your car. However the cost of burning the fuel which has an adverse impact on the environment is not included in that price. The cost of that is burdened on society instead. This is called an External Effect. It leads to a wrong market equilibrium as the price of the good (here fuel) it too cheap, as the external cost of burning the fuel is not included in the price. Therefore this cost is not included in the decision making process on how much to consume, i.e. how to drive (MPG of your car, distance driven etc.).

Economists can agree that a way to improve the market allocation and thereby total welfare is to increase the price of fuel to reflect this external effect – basically tax it. That would lead people to demand less by either buying more fuel efficient cars or driving less.

But instead of using the price of fuel and thereby market mechanism to improve the market equilibrium and in our example reduce CO2 emissions and reliance on oil imports, the US government for years has used Miles-per-Gallon standards that the car industry had to meet by its average fleet. So instead of using price and market mechanisms, the government tries to ‘tell’ the car makers what cars to build and consumers what cars to buy. That does not make any sense. It is not an efficient way to influence behavior, it has huge time lags to be enforced and most importantly it is easy to circumvent – as is the case with all large, cumbersome government regulations. This is why Detroit has lobbied for these kind of regulations – they have in the end little or no effect.

We see a similar notion in todays debate around the banks bailout plan. Lawmakers want to ‘tell’ the banks to start lending. Banks do lend to make a profit, if they can make a profit. In the current market environment they cannot open the siphons and start excessive lending again – there are enough toxic, i.e. non performing loans for a while (wasn’t that the whole problem anyway?). Instead of forcing banks to do something that is not in their profit making interest, the government needs to set the right framework that will allow banks to do business which will inevitable leed to lending (one should not forget that banks still lend – but they are much more careful and have only limited liquidity).

But there are three reasons why government seems to prefer to try to directly influence the behavior of market actors (companies) instead of setting incentives and using market forces:

It seems easy. Instead of understanding the complex framework of incentives that influences corporations and their customers, just draw up a bill that requires people to do stuff – no matter if it makes economic sense. Often it does not, otherwise you would not have to write a law.

– It is a quick fix. We live in fast times. Who remembers last years legislation. Who cares about next generation if re-election is around the corner. Roger Ehrenberg wrote a good post on short-termism that sums it up.

It can be influenced by the industry that is to be regulated. We saw that during the last 20 years with the introduction of MPG standards. Detroit did a good job in making sure they were not adversely effected. Unfortunately they missed the whole point that at some point fuel might become scarce.

To me this kind of behavior legislation is not too far off what could be seen in former socialists countries and you would expect to see in many parts of Europe but not in the US. Influencing behavior by setting the right incentives seems to me far superior than guiding somebodies hand.

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