Friday, July 13, 2012

Strange Economic Assumptions

A constant complaint from the left is that income inequality has grown and the government has to fix it. Sometimes the income inequality is referred to as an income redistribution.

So, what's the fix? The first part is easy. They want to raise taxes on the rich. President Obama wants a return to the tax rates of the Clinton Administration. Others want a return to the pre-Reagan days when the highest marginal tax rate was 70%.

But what then? How will taking money from the rich build a strong middle class? What would they do with this money once they have seized it? The left is pretty quiet about this. They will sometimes speak in generalities about rebuilding the infrastructure or giving everyone free medical care or free college. There is a common thread here. Big beneficiaries will be heavily unionized labor and other groups in a close relationship with the left. The assumption is that the money will spread out from there to the rest of the middle class.

Democrats like to criticize Republicans for "trickle down economics" but this is just a variation. The main difference is an assumption that government spending is better than private spending. This is known as the multiplier effect. The idea is that the money the government spends goes to people who spend it again resulting in up to $1.60 in economic activity for each $1.00 spent.

A big flaw in this reasoning is that the multiplier effect is highly debated among economists. It may be closer to $0.60 than $1.60 meaning that it depresses economic activity. That is because the government has no money of its own. It can only spend other people's money, either by taking it (taxes) or by borrowing it. For every dollar that the government spends, it has stopped a dollar of activity somewhere else.

So, when evaluating the economic benefit of a repaired bridge we also have to figure in where that money might have gone. Did the government take money that would have been invested in the next Google? Which really helps the middle class?


Another complaint from the left is that we need the government to tame business. Left on their own, corporations are ruthless and cannot be trusted. So, the solution is for the government to keep a tight leash on them. The government will pick winners, allow them to grow, and regulate them.

Libertarians recoil in horror at this arrangement because it is so open to abuse. The bail-outs of four years ago are an example. Companies were judged too big to fail so the government saved them from bad investments. This lead other companies to demand their own bail-outs. Since them, these companies have continued to grow.

With fewer large companies and a cozy relationship between the businesses and the regulators, abuses are inevitable. Take the Libor (London InterBank Offered Rate) rates. Barclay's bank manipulated these rates and make vast sums. Regulators knew that this was going on but did little or nothing to stop it. Again, this is a sign that the regulators are too close to the organizations that they are regulating.

One solution to the too-big-to-fail problem is to let someone fail. The more executives are protected from the consequences of bad decisions the less responsible they will be. Granted, the government may still have to step in to soften the blow to the general economy but when a too-big-to-fail organization needs a bailout it should not emerge unchanged.

The financial regulation package that the Democrats passed in the wake of the 2008 crash does nothing to address this. Instead it codifies too-big-to-fail.


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