Browsing the blog archives for August, 2018.

Why is the economy growing?

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The US economy is heating up. Trump supporters credit the President for the growth, while many on the left struggle to accept, understand, and explain a turnaround they claimed we’d never see. In fact, many Trump detractors predicted a stock market crash and a deep global recession shortly after the election. President Trump deserves some credit, but the situation is a bit more complicated. There are three things to keep in mind going forward.

  1. Don’t get confused about trade restrictions. From an economic perspective, tariffs always impede growth by increasing prices. Some protectionists are actually claiming that current economic growth is evidence that “tariffs are working.” The direct impact of tariffs is—and always is—negative but is currently of modest consequence given policy improvements in tax, regulation, and other arenas. Tariffs and threats of tariffs might be effective negotiating tools with China, but they don’t promote economic growth. Reducing and eliminating tariffs across the board should be the end game and will drive long-term prosperity.
  2. Cronyism is alive and well. I’m all for “draining the swamp,” but there’s a long way to go and a right way to do it. Consider Tesla. Elon Musk’s ongoing extraction of billions in taxpayer subsidies requires support from our politicians. The recent tax reform passed by Congress made some incremental improvements, but the current tax code remains a redistribution haven for those seeking to circumvent market discipline. There is still a shortage of courage and political will in Washington.
  3. President Trump had an easy act to follow. President Obama abandoned the idea of economic growth early on and was intent on demonizing business and expanding wealth redistribution for eight years. President Trump and Republican majorities in the House and Senate have delivered a renewed outlook and a number of better policies. The change has been welcome, but I’m convinced the economy would have improved even if the Republicans had done nothing. Put another way, the current growth is less about Republicans in power and more about Democrats out of power.

I’ll repeat: The President deserves some credit, but let’s no go overboard. The real test is ahead of us. Economic growth increases the tax coffers and creates political opportunities to fix long-term fiscal problems. Downsizing the welfare state isn’t so threatening when 401k accounts are growing and jobs are plentiful, but doing so still requires courage. We’re not there yet.

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Incentives matter

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Much of what we see in the business and political worlds can be explained by incentives. When companies, politicians, and governments create the wrong incentives, bad things happen. Consider the following example at Uber as reported in Tuesday’s Wall Street Journal:

Unlike taxis, ride-hauling services like Uber charge fixed fares to passengers based primarily on the projected distance they will travel, not the actual distance they ride. Uber encourages drivers to take the most direct route, but they are compensated based on actual mileage, incentivizing them to take longer routes at company expense. Out-of-town passengers usually have no incentive to pay attention. The practice, known as longhauling, is clearly unethical. Nonetheless, company policy encourages it, creating what economists call a “perverse incentive.” We should not be surprised when this happens.

Of course, there is a logical reason for compensating drivers based on actual mileage. They know the conditions on the ground and should be free to select the best routes for their customers even if it means deviating from the route recommended by navigation. But this post is not about Uber’s policy; it’s about the role of incentives.

This type of incentive problem is not unique to Uber. When a company reimburses travel expenses without tight controls, employees are more likely to stay at expensive hotels and eat well while on the road. When a government employs a voluntary income tax, individuals are more likely to fudge on the numbers. When EMPTALA guarantees emergency room treatment regardless of one’s ability to pay, some Americans will not pass on health insurance, take their chances, and just ignore the bills if they get sick. The list of examples in business and government is endless. Empirical evidence helps us understand the scope of these problems after the fact, but many of them could have been minimized or avoided altogether by considering the incentives in advance.

Many of these incentive problems occur because policymakers assume that people will overlook a perverse incentive and “do the right thing.” I’m not a cynical person, but this is usually folly. Consider the 2008 financial crisis. Politicians blamed lenders for issuing questionable loans—which some did—but they were simply gaming the system government created.

When it comes to economic policy, bad incentives usually come from government intervention. Free markets promote their own incentives, usually healthy ones, with limited or no government oversight. Companies that deliver better products at lower prices are more likely to succeed, while those that do not serve their customers well will eventually fail. Well-intentioned government schemes designed to aid the poor, clean up the environment, or promote other social objectives usually limit customer choice and favor large companies that can afford the compliance costs.

Incentives matter.

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