Why sound economics loses out to politics

A quote in a recent article in TheEconomist magazine caught my eye: "politics has a habit of underminingeconomics".   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".   Butit 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 attemptingto achieve that goal would be a vote winner for politicians.   In countrieswithout democracy, or seriously flawed versions of democracy, one might havesome understanding about why policies might not be designed to benefit themajority.   But why do political decisions in democracies, like our own, sooften fly in the face of orthodox economics?  

Although New Zealand has many naturalcharms it also faces a number of natural hurdles that limit our economicpotential.   We have a small, widely distributed population, we aregeographically isolated, and our major competitive advantage is in agriculture,an industry that tends to be heavily protected in other countries.   We havelittle control over these given "environmental" factors.   Even if we doubledour population we would remain a small nation that depends on internationaltrade to enhance our welfare – a population of 10 million would still notsupport a viable car industry.   But the one thing we can control is the qualityof our public institutions and policies.   So why do we, and other nations forthat matter, fail to take full advantage of this opportunity?  

There is always the legitimate issue ofconflicting goals of policy.   For example, protecting the environment frompollutants and effluents will potentially limit productive capacity and materialwellbeing.   Very few would argue that policy does not have a legitimate role inaddressing the undesirable side-effects of industrial production.   Indeed mostof us feel that our welfare is boosted by the achievement of these other goals.  

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

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

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

The alternative approach is forgovernment to decree what activities are permissible.   Such regulations andrules offer a mirage of control to policy makers, but they presume and rely onpeople responding in a way that is consistent with the regulations’ aims.   Ourgeneral experience is that responses to regulations tend to disappointregulators’ expectations and/or result in unintended side effects.   Theregulator’s natural response is to introduce further corrective regulations, thenet result usually being that life gets increasingly complicated, withincreasing overhead costs, and the creation of an associated industry assistingcompliance for the regulated and administering the regulations for the government.  

Despite their very poor track record, itis very difficult to break the faith in regulation.   Regulation appeals to the desirefor power of regulators.   The failure of regulations also generates its ownmomentum and strong vested interests to maintain the regulatory institutions.  Unfortunately this tends to mean public policy is death by a thousand cuts.   Theburden of regulation does not suddenly appear – it creeps up on a society.   Theprocess starts with a poor solution to a real issue that spawns an increasinglycomplex and pervasive regulatory beast.   Ultimately there are size limits andintermittent self-corrections when the burden imposed exceeds any possiblebenefit.   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 radicaleconomic reforms after the 1984 election in New Zealand.   Although suchfailures tend to generate the will power to put in place sensible policies, revolutionarychanges are neither efficient nor comfortable ways of achieving such goals.  

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