05 May 2011

Systemic Uncertainty

Thomas Sowell explains why the recovery is delayed:

That is a big part of the problem. It is not politically possible for either the Federal Reserve or the Obama administration to leave the economy alone and let it recover on its own.
Both are under pressure to "do something." If one thing doesn't work, then they have to try something else. And if that doesn't work, they have to come up with yet another gimmick.
All this constant experimentation by the government makes it more risky for investors to invest or employers to employ, when neither of them knows when the government's rules of the game are going to change again. Whatever the merits or demerits of particular government policies, the uncertainty that such ever-changing policies generate can paralyze an economy today, just as it did back in the days of FDR.

There are two ways in which government tinkering promotes systemic uncertainty:  by discouraging investment or by encouraging malinvestment.

The government discourages investment when it increases taxes and/or the cost of regulatory compliance.  The state also discourages investment when it constantly reverses its own policies or is erratic in the enforcement of already existing policies.  A continual state of flux discourages long-term investment because no one is able to feel certain about forecasting.  One of the main reasons why ObamaCare and its counterpart RyanCare is so damaging is imply due to the fact that businesses aren’t able to feel certain about the future.  The vociferousness with which RyanCare was debated helped to fuel systemic uncertainty, to a limited extent, because economic actors weren’t able to tell if any (or all) of the proposal would become law, and were thus unable to also determine what sort of long- and short-term plans would be viable.

But beyond that, the constant flux of change that is government tinkering also has a tendency to encourage malinvestment and market timing.  Virtually every subsidy speaks as evidence for the former; Cash for Clunkers speaks as evidence for the latter.

Subsidies encourage malinvestment because they eliminate what economists refer to as moral hazard.  Moral hazard is simply a fancy way of saying that people are more careful when investing their own money.  When the government, for example, subsidizes corn-based ethanol, farmers have an incentive to grow more corn and venture capitalists have an incentive to invest in companies that will turn corn into ethanol-based fuel.   This is generally unsustainable by market means because corn-based ethanol is energy negative, which simply means that producing ethanol burns more energy than it creates.  Malinvestment can also be encouraged by indirect subsidies, like tax breaks or regulatory exemptions.  This lowers the cost of doing business and increases profits, encouraging companies to pursue certain ventures.

When people think that the government may subsidize them, directly or by tax breaks, they have a tendency to wait until they qualify for the terms of the subsidy. This is true especially of temporary programs, like Cash for Clunkers, as mentioned before, or special tax breaks, like the first-time homeowners tax credit.  These programs were ultimately failures because all the accomplished was pulling demand forward by a couple of months.  They did not jump start the economy or increase long-term demand.  Temporary subsidies, then, contribute to systemic uncertainty because economic actors try to time the market in order to get the most favorable deal.  Businesses hold inventories to take advantage of greater demand later on.   Consumers delay spending money in order to purchase things later on.  Instead of allowing the market to function as it ought and smooth demand over time, government interference causes people to time the market and upset long-term plans.

Incidentally, the reason why temporary government programs generally become permanent is because there are some people who find temporary programs to be personally beneficial. When you have programs that offer lower prices to consumers and larger profit margins to businesses, most of the parties involved want to continue taking advantage of that system.  Because of this, politicians vote to make temporary programs permanent because it is politically popular with their constituents, and because the political costs are widely dispersed and indirect.

Of course, the possibility of a temporary program becoming permanent also encourages systemic uncertainty because economic actors are unsure which specific programs will become permanent and if the terms of those programs will be altered in the process of attaining permanence.

In sum, it is simply best to let the market correct itself.  Tinkering is futile at best and counterproductive at worst.  Therefore, simply letting the market be is the best strategy, even if it is somewhat painful from time to time.

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