Tag Archives: incentives

Embrace Change

Kaiserin_Maria_Theresia_(HRR)Whenever someone suggested a new innovation or an improvement, Empress Maria Theresa had a favorite response: “Leave everything as it is.” As the sovereign of most of central Europe during the 18th Century, the Habsburg Empress epitomized absolutist rule, claiming that her powers had no limit.

But as her statement demonstrates, she clearly understood that her powers were limited by new and disruptive innovations. Her husband, Holy Roman Emperor Francis I understood this as well. Daron Acemoglu and James Robinson relate that when an English philanthropist suggested some social reforms for the benefit of Austria’s poorest, one of Francis’s assistants replied: “We do not desire at all that the great masses shall become well off and independent….How could we otherwise rule over them?” (A&R, 224).

This is why these Habsburg rulers did everything they could to stand athwart innovation. As Acemoglu and Robinson put it:

In addition to serfdom, which completely blocked the emergence of a labor market and removed the economic incentives or initiative from the mass of the rural population, Habsburg absolutism thrived on monopolies and other restrictions on trade. The urban economy was dominated by guilds, which restricted entry into professions. (A&R, 224).

Francis went so far as to block new technologies. For instance, he banned the adoption of new industrial machinery until 1811. He also refused to permit the building of steam railroads. Acemoglu and Robinson inform us that:

[T]he first railway built in the empire had to use horse-drawn carriages. The line…was built with gradients and corners, which meant that it was impossible subsequently to convert it to steam engines. So it continued with horse power until the 1860s. (A&R, 226).

Unfortunately, history is replete with examples of despots who stood in the way of innovation. In Russia, Nicholas I enacted laws restricting the number of factories and “forbade the opening of any new cotton or woolen spinning mills and iron foundries.” (A&R, 229). And in the Ottoman Empire, sultans banned the use of printing. So stultifying was the effect that “well into the second half of the nineteenth century, book production in the Ottoman Empire was still primarily undertaken by scribes hand-copying existing books.” (A&R, 214).

The centuries and the miles that separate us from these episodes give us some objectivity and allow us to see them for what they are: the naked exercise of government force to obstruct innovation for the benefit of a few entrenched interests. But how different are these episodes, really, from the stories we read in today’s newspapers? Are they all that different from New Jersey’s refusal to allow car companies to sell directly to consumers? Are they any less silly than the anti-Uber laws cooked up by a dozen U.S. cities? We like to think that our own political process is more enlightened but right now, federal, state and city policy makers are working to block the development of promising innovations such as wearable technologies, 3D printing, smart cars, and autonomous vehicles.

book-cover-smallFor a thoughtful and forceful discussion of what might be called the anti-Maria Theresa view, everyone should read Permissionless Innovation by my colleague Adam Thierer. It is a well-researched and well-argued defense of the proposition that our default policy should be “innovation allowed.” You can find Kindle and paperback versions on Amazon. Or you can check out the free PDF version at the Mercatus Center. For a nice overview of his book, see Adam’s post (and video) here. Please read it and send (free) copies to any modern-day Maria Theresas you may know.

What the Affordable Care Act Can Teach Us about Government Failure

Most people probably believe that the recent failures of the Affordable Care Act (ACA) are an anomaly, and that most areas the federal government involves itself in, from education to transportation, operate quite smoothly, or at least adequately well. This belief is misguided, however, and the issues we see from the ACA should not be viewed as anomalies. Problems like unintended consequences of policy, privilege granting to special interests, adverse selection in insurance markets, and other issues, are widespread in countless areas of public policy. It just so happens that we usually fail to associate the pernicious effects of laws with their source: public policy.

First, public policies create many unintended consequences. People will change their behavior in response to altered incentives from policies and when these behavior changes are not anticipated by lawmakers, unintended consequences occur. As an example, the ACA has altered incentives for many employers. Business owners are now likely to cut worker hours and keep their staffs under 50 employees in order to avoid paying penalties imposed by the law. The intention was that people will get insurance through their jobs, while a result is that many people will lose their jobs or work fewer hours.

A similar effect occurred after passage of the Americans with Disabilities Act. This well-intentioned Act of Congress was supposed to level the playing field for disabled workers by requiring that businesses with disabled workers provide accommodations, such as wheelchair access. The Act also sought to prevent discrimination of disabled workers, such as firing someone for having a disability. The reality once the law was in place was very different, however. Economists have found that the law was followed by a steep decline in employment among disabled workers, likely because of increased costs associated with hiring them, exactly the opposite result the law intended. Perhaps the most famous unintended consequence of all is the fact that minimum wage laws actually hurt low skilled workers.

A lot of these effects, while unintentional, are actually quite predictable and any good economist should be able to identify potential unintended consequences before a law is even implemented. So why do these policies get adopted? A big reason is because special interests have enormous influence in shaping policy. The Affordable Care Act literally has provisions allowing handouts to insurance companies to make up for losses they face in the new government health insurance exchanges. Unfortunately, cronyism like this shapes policy at all levels. For example, a recent USDA regulation will require additional food safety inspection of imported catfish. This may sound like a sensible idea, until one finds out there is no evidence of a significant problem from tainted catfish. The new program was actually lobbied for by domestic catfish producers who wanted to hurt their foreign competitors by driving up the price of imports, all at the expense of American consumers.

A final problem created by the Affordable Care Act relates to adverse selection in insurance markets. Adverse selection occurs because of information problems between buyers and sellers of insurance. Healthy people may have trouble signaling that they are a low risk to insurers, and so the healthy drop out of insurance markets when insurers don’t offer them a low priced product that serves their needs. This can lead to mostly sick people signing up for insurance coverage, while the healthy decide to go without coverage. Over time this leads to higher prices, causing more healthy people to decline coverage and the pool of insured to become ever sicker.

The ACA creates this problem through community rating requirements and other regulations, like guaranteed issue, that don’t allow insurance companies to price policies based on the riskiness of the applicant. As insurance premiums rise (because of regulations and because insurance companies must cover many new services), more and more healthy people will find these policies unattractive. The insurance pool will become ever sicker over time. To avoid this problem, the ACA includes a mandate that everyone purchase insurance. However, it is far from clear whether the current mandate is strong enough to prevent adverse selection problems from taking place.

This problem is hardly new. New York State passed extremely strict community rating regulations several decades ago. This led to higher premiums and lots of young, healthy people dropping out of the insurance pool. I should know, I lived in New York and went without insurance for most of my 20s. The prices of policies were simply too high for me to justify paying.

The list of government failures likely to result from the Affordable Care Act is too long for one blog post. The ACA also has regressive effects that tend to favor the wealthy at the expensive of the middle class, and the law will add to moral hazard problems in our healthcare system (i.e. people over-utilizing medical services or not taking adequate care of themselves because the costs of their behavior are passed on to others).

The ACA may have serious problems, but it works great as a teaching device. Nearly every day we see another example of government failure in action.  Maybe once Americans see the effects of the ACA, they will look more closely at the effects of other policies as well.

It’s Time to Change the Incentives of Regulators

One of the primary reasons that regulation slows down economic growth is that regulation inhibits innovation.  Another example of that is playing out in real-time.  Julian Hattem at The Hill recently blogged about online educators trying to stop the US Department of Education from preventing the expansion of educational opportunities with regulations.  From Hattem’s post:

Funders and educators trying to spur innovations in online education are complaining that federal regulators are making their jobs more difficult.

John Ebersole, president of the online Excelsior College, said on Monday that Congress and President Obama both were making a point of exploring how the Internet can expand educational opportunities, but that regulators at the Department of Education were making it harder.

“I’m afraid that those folks over at the Departnent of Education see their role as being that of police officers,” he said. “They’re all about creating more and more regulations. No matter how few institutions are involved in particular inappropriate behavior, and there have been some, the solution is to impose regulations on everybody.”

Ebersole has it right – the incentive for people at the Department of Education, and at regulatory agencies in general, is to create more regulations.  Economists sometimes model the government as if it were a machine that benevolently chooses to intervene in markets only when it makes sense. But those models ignore that there are real people inside the machine of government, and people respond to incentives.  Regulations are the product that regulatory agencies create, and employees of those agencies are rewarded with things like plaques (I’ve got three sitting on a shelf in my office, from my days as a regulatory economist at the Department of Transportation), bonuses, and promotions for being on teams that successfully create more regulations.  This is unfortunate, because it inevitably creates pressure to regulate regardless of consequences on things like innovation and economic growth.

A system that rewards people for producing large quantities of some product, regardless of that product’s real value or potential long-term consequences, is a recipe for disaster.  In fact, it sounds reminiscent of the situation of home loan originators in the years leading up to the financial crisis of 2008.  Mortgage origination is the act of making a loan to someone for the purposes of buying a home.  Fannie Mae and Freddie Mac, as well as large commercial and investment banks, would buy mortgages (and the interest that they promised) from home loan originators, the most notorious of which was probably Countrywide Financial (now part of Bank of America).  The originators knew they had a ready buyer for mortgages, including subprime mortgages – that is, mortgages that were relatively riskier and potentially worthless if interest rates rose.  The knowledge that they could quickly turn a profit by originating more loans and selling them to Fannie, Freddie, and some Wall Street firms led many mortgage originators to turn a blind eye to the possibility that many of the loans they made would not be paid back.  That is, the incentives of individuals working in mortgage origination companies led them to produce large quantities of their product, regardless of the product’s real value or potential long-term consequences.  Sound familiar?