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Sunday, September 13, 2009

Market-Based Reality and Economic Theory 101

Everybody likes to tout the "free market" as the solution to every problem from health care reform to protecting the environment. Let's be clear, there is a lot that a market-based economy gets right. But not everything. Yet, it would be foolish to throw the baby out with the bath water.

So, I'm all for market-based solutions to our problems, but I'm against the unexamined, knee jerk reaction of some on the right that the markets are all wise, all rational, and all accurate. Far from it. And Elaine from Roanoke explains, in what should be Economics 101, exactly what the free market is, including some of its very real limitations.
principles of free market capitalism are competition and the supply-demand curve. Ideally, competition will keep the markets efficient. The supply-demand curve, in a perfect world, will regulate price. Unfortunately, there is no such thing as an ideal world...

Examples of how business can get around having competition include: the concentration of the market by the most successful groups who destroy their competition (i.e., the auto industry in the 20th century), thus creating a few market actors who divide up the market (oligopolies) and avoid the hassles of competing (plus, avoid that efficiency); or the creation of monopolies that ideally should be regulated by government (i.e., cable TV companies).

The creation of such oligopolies is what has happened in the health insurance market. Most areas of the country are dominated by one or two insurance industry actors who collude on prices; they don't compete. That's why there has to be some alternative to them, like a non-profit public option, if we are to control these people and their demands on our pocketbooks.
Elaine goes on to explain the law of supply and demand and the difference between elastic demand - the kind where people stop buying discretionary goods, like cosmetics, fashion, and new iPods, when prices go up beyond what they can afford - and inelastic demand.

The inelastic demand, the demand for basics of survival such as food, housing, and health care, are the goods we will continue to pay for regardless of price increases because we need them to survive.

That difference is important. It's why a monopoly, like the insurance industry, can raise premiums, deny claims even to those who have paid their premiums for years, and throw people out of plans when they get sick. They can do those things with impunity because there is little regulation to stop them and no competition. People can't vote with their pocketbooks.

As I said above, I don't favor throwing out the baby with the bath water. So, the alternative isn't ditching the market-based economy altogether. That's because the economic alternative, socialism, really is not more efficient. Critics of socialism have a point that too much government intervention and central planning stifle the incentive to be productive and to innovate. Without a monetary reward, entrepreneurs won't experiment or take risks to produce new products and services. Government sponsored socialism does not create wealth.

But the current cowboy capitalism of the past couple of decades has not served us well either. Perhaps the situation is not quite the all or nothing - either/or - situation that ideologues on both sides pretend that it is.

Overall, a market-based economy with less regulation works well. But what many on the right seem to want is no regulation at all. Indeed, they come close to being economic anarchists.

But just as every sensible person realizes that you need laws and regulations in other areas of life, so you need them in the marketplace too. First, let's take an example from something other than economics.

We all want the maximum freedom to come and go as we please, to make decisions about where to shop, what we can say, what movies we can watch, what we can read. We want these basic freedoms. But nobody wants to walk out on to a lawless street where muggers are free to hit us over the head and grab our money - or worse. We understand that to preserve freedom for everybody we have to curtail illegitimate freedoms. Criminals don't have the right to grab what is not theirs from us. So, although most of us do not want to lose our liberty, we support law and order, police, and jails. But we want the right balance.

The same should be true in the economic order. We should want the most freedom and least regulation to encourage entrepreneurs and venture capitalists to produce goods, provide services, invest in promising enterprises, and make a profit that rewards them for their risks and their work.

But markets don't work perfectly. That's because we don't live in a perfect world. That's why we have government - a government democratically elected by the citizens - us!

We need sensible regulations in food production to ensure that we don't get sick from food borne illnesses, a real problem as more and more people have evidence-based concerns about our food supply. We have seen first hand over the past few years what inadequate oversight has done in this vital area, as people have gotten sick from lettuce, spinach, peppers, and peanut butter.

It's just not realistic to expect consumers to equip their homes with laboratories to conduct their own food safety experiments before making a peanut butter sandwich for their children. The same is true for making sure toys are safe, drinking water is clean, etc. Ensuring safe, wholesome food and other goods is a real and legitimate function of government oversight, just as much as protecting our streets and keeping them safe.

Then we get to proper oversight to ensure transparency in our financial system. The current economic meltdown was caused by huge financial companies that were too big to fail, but did fail. Without the government's timely intervention last year's financial meltdown, we would be in far more dire straights than we currently find ourselves in.

Large oligopolies, like AIG, created and sold exotic mortgage backed derivatives that nobody in their industry even understood. To this day, nobody really knows how many toxic assets still exist on the major banks' books. Left largely unregulated, these companies created a domino effect that rippled through our economy, taking down businesses as far away as Europe and Asia. They are largely responsible for the severe drop in revenue in states as disparate as New York, California, and Virginia. Virginia is one of the better managed states. But even here, the rise in foreclosures and the drop in consumer spending dried up two of the state's most reliable revenue streams, property and sales taxes. Because of that were plunged into a frantic attempt to stave off a deficit. States, unlike the federal government, are not allowed to run deficits, so our commonwealth has been frantically cutting costs, often cutting not just fat but muscle and bone to do so.

Additionally, many of us have witnessed our 401Ks plummet in value. For many of us, that is our nest egg, our retirement funds, our college funds for our children. Without proper oversight, small investors get hurt and hurt badly - but the huge bonuses for Wall Street moguls just roll on, business as usual.

Large corporation left unchecked, have also watched profits, in the good times, gobbled up by greedy CEOs and top executives, while small investors had little return on those investments. Just as bad, while CEO salaries have soared, their employees' wages have stagnated for years, even before the economic downturn. Heck, I began writing about this in 2005, when our economy was roaring great guns, profits were soaring, and wages were languishing.

So what is to be done?

Markets are good, but they need rules. They need regulation. And they need oversight. Consumers need protection so they are ensured that the goods they buy are safe and wholesome. Investors need transparency so their investment choices can be rational and evidenced-based. And workers need protections that provide for safe working environments and fair wages. And businesses need oversight to make sure they provide these things.

There will always be a debate about how much is too much oversight or how large is too large for the government. It's a fair and necessary debate. But the notion that markets run best with no rules is not a free market, it's an anarchy. The notion that there is no legitimate role for government and that any regulation is an illegitimate encroachment is a recipe for more disaster.

We need to find the right mix between regulation and freedom. Both freedom and fairness do not need to be mutually exclusive concepts. Heck, even a game like Monopoly has rules that all the players abide by. And nobody plays football or baseball without rules and referees.

The economy, though, is more important than a game. It's our livelihood and the key to our future. It is the very heart and soul of the American Dream. And that can't be left to economic anarchists and cowboy capitalists with no sense of fair play.

So, don't throw the baby out with the dirty bath water. But dry the baby, wrap it in a blanket, and watch over it so it can grow and thrive.

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