Why sound economics loses out to politics
Wed 30 Jan 2008 by David Grimmond.

A quote in a recent article in The Economist magazine caught my eye: "politics has a habit of undermining economics".   It was just a throw-away line in an article about the Bali conference on climate change.   As an economist my initial reaction was "so true".   But it leads you to ask why is this statement so true?   Economics is, at heart, about maximising the welfare of a society.   One would, naively, expect that attempting to achieve that goal would be a vote winner for politicians.   In countries without democracy, or seriously flawed versions of democracy, one might have some understanding about why policies might not be designed to benefit the majority.   But why do political decisions in democracies, like our own, so often fly in the face of orthodox economics?

Although New Zealand has many natural charms it also faces a number of natural hurdles that limit our economic potential.   We have a small, widely distributed population, we are geographically isolated, and our major competitive advantage is in agriculture, an industry that tends to be heavily protected in other countries.   We have little control over these given "environmental" factors.   Even if we doubled our population we would remain a small nation that depends on international trade to enhance our welfare – a population of 10 million would still not support a viable car industry.   But the one thing we can control is the quality of our public institutions and policies.   So why do we, and other nations for that matter, fail to take full advantage of this opportunity?

There is always the legitimate issue of conflicting goals of policy.   For example, protecting the environment from pollutants and effluents will potentially limit productive capacity and material wellbeing.   Very few would argue that policy does not have a legitimate role in addressing the undesirable side-effects of industrial production.   Indeed most of us feel that our welfare is boosted by the achievement of these other goals.  

Where economic criteria come in when designing policies, say to protect the environment, is to ensure that we minimise the material sacrifice required to achieve these other goals or, alternatively, that the gain in terms of other goals is maximised for a given sacrifice in material wellbeing.   In particular, this is about ensuring that the policy does achieve the intended outcomes with the minimum of unintended consequences.

One of the common unintended consequences of public policy is that the establishment of rules creates an artificial business environment that can be exploited by the lucky or the unscrupulous. Rules have the habit of creating an artificial environment that bestows privilege on a minority group in society.   Sometimes this is the explicit intention of the policy – it is redressing an already recognised wrong.   Too often it is an unintended side-effect.   Every time we bestow privilege on certain individuals we impose a burden on the rest of society which erodes both material wellbeing and our ability to achieve other goals.

In general this is the reason that economists prefer pricing mechanisms to regulations.   Taxes on alcohol and petrol are examples of using pricing mechanisms to influence behaviour.   The increase in price has a dissuading influence on excess consumption and the revenue collected is available for addressing the costs caused by the activity.   People remain free to drive, but the amount they pay in tax compensates society for the harm that driving may cause to the health of others or to the environment.

The alternative approach is for government to decree what activities are permissible.   Such regulations and rules offer a mirage of control to policy makers, but they presume and rely on people responding in a way that is consistent with the regulations’ aims.   Our general experience is that responses to regulations tend to disappoint regulators’ expectations and/or result in unintended side effects.   The regulator’s natural response is to introduce further corrective regulations, the net result usually being that life gets increasingly complicated, with increasing overhead costs, and the creation of an associated industry assisting compliance for the regulated and administering the regulations for the government.  

Despite their very poor track record, it is very difficult to break the faith in regulation.   Regulation appeals to the desire for power of regulators.   The failure of regulations also generates its own momentum and strong vested interests to maintain the regulatory institutions.  Unfortunately this tends to mean public policy is death by a thousand cuts.   The burden of regulation does not suddenly appear – it creeps up on a society.   The process starts with a poor solution to a real issue that spawns an increasingly complex and pervasive regulatory beast.   Ultimately there are size limits and intermittent self-corrections when the burden imposed exceeds any possible benefit.   However, this limits the extent of the burden rather than avoids it.  At the extreme, we have system-wide failures, such as what led to the radical economic reforms after the 1984 election in New Zealand.   Although such failures tend to generate the will power to put in place sensible policies, revolutionary changes are neither efficient nor comfortable ways of achieving such goals.

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