Given all the debates and comments, I thought some basic economics ought to be covered, specifically:

  • The Theory of the Second Best
  • Free markets and free information
  • Capture (it occurs)
  • Capture (it really occurs)

The Theory of the Second Best

–or why economic rules don’t mean that you can count on economics to be right.

If  you know what perfection is (e.g. no monopolies) and you know where you are (e.g. a situation with two monopolies), the second best situation is not necessarily the one in a straight line between where you are and perfection (e.g. if you can only get rid of one monopoly you might be better off to have two — think of a coal mining town with one employer and with one union — getting rid of just one might make things worse for everyone).

The result is that it makes the application of economic principals much more complicated.

Free markets are not free

To have a market system requires that there be a free flow of accurate and trustworthy information.  Every historical market system failure has involved information shortages or inaccuracies.  The sub-prime mortgage meltdown? Toxic assets — bad (and fraudulent) information at the core.

The reason for regulations and regulatory systems is to ensure accurate and evenly distributed information (the opposite of insider trading).  Without that, you don’t have free markets, you have free for all theft.

Capture occurs

Capture is when a regulatory entity is taken over by the groups it regulates.  Because regulated groups have the most interest, contact and sustained focus, they tend to capture regulators over time.

There are partial solutions.  (a) When possible, align interests.  The insurance guarantee funds are aligned with the long term interests of the industry.  With a guarantee fund, every pressure to do the wrong thing to benefit part of the industry in the short run gets push back from other parts who take the longer view.  (b) Build in contrary oversight.  Public members, anti-industry groups, etc. all fit into this section.  (c) Conduct reviews and challenges to the agency by those whose interests are counter to the industry.  (d) Make rule making and other activities public, open and of record.  (e) Be very aware of the principal of capture.

Capture really occurs

That is, legislatures get captured by special interests all the time.  A charity that wants a tax break will always have more focused pressure than the general desire of the public to oppose the break.  Most capture looks good in isolation.  It is only as part of a giant ball of messy goo that it looks bad. But the essence of all legislation is capture.  Sometimes good, sometimes bad, sometimes a mix. Invariably it leads to exploitation.

Cures include sunset provisions (if all tax breaks automatically expire after five years, then the buggy whip tax break at some point gets attention).  Zero sum (if you allow “x” amount of breaks, then every time one group gets a break, another has to lose it).  Pro ratas (e.g. if each program gets not $x.xx but instead gets %.xx of the budget).  Balanced budget amendments.

However, in a world of second best situations, imperfect information and constant capture, the economics are not a simple as often assumed.  Too often we act as if the second best was obvious, information was free and trustworthy and total, and no capture would ever occur.

Bonus:  The subtexts in political debates.

“Social security will become broken by the year …” The year is 2011, regardless of what anyone says.  2011 the deficit for social security (where payout exceeds pay-in) will be 158 billion dollars.  Since there is no trust fund (the money was not saved, it was just spent as free revenue for politicians), as of 2011 Social Security started to eat the rest of the budget alive from the inside.

“Medicare …” There is a flood, a deluge, of health expenses that are building, all circling around non-compliant diabetics and their health issues.  If there were no expenditures on non-compliant diabetics and all seniors walked at least two miles a day and did weight bearing exercises, medicare would be less than half of what it currently is.  Instead, it is rapidly headed towards 110% of the total federal budget.

“Energy, the magic bullet missed.” In the late 1960s nuclear fusion was seen as the magic bullet.  Sea water goes in, industrial chemicals, energy, fresh water and helium come out.  By the early 70s (and I read thousands of pages of congressional reports on the topic) the debate was over how long it would take.  Would we have fusion by 1990?  By 2000?  Would we have to wait until 2010?  Well, it is 2011 and we still do not have it, and it does not seem likely to be coming on line soon.

Had we gotten plentiful, free energy (and water) in 2000, the economic boost would have been transformative, and it would have gutted the economic threat of our enemies.  Too many people in politics spent, planned and acted as if that was going to happen, some time, eventually, pretty soon.  If it had, the world would be a much different place (imagine gasoline at 50 cents a gallon — basically transport and tax costs).

“Tax the rich …” Well, you can only tax the rich for about 25% of their income before they start to avoid you and you lose the tax revenue.  The good news is that from the historical levels of 20 to 25% we are currently down to 17%.  The bad news is that just taxing the rich is not (and has never been) enough to solve the tax problems.

“Governmental borrowing is almost always a matter of spending the future” — usually it means a net long term economic loss.  It does allow the current politicians to have all the benefits and passes all the burdens on to someone else.  Consider, we went from pretty much in balance  under Bill Clinton to looking at 14 trillion dollars in debt (that we have to pay off).  It was fun for someone.

… and the most insidious truthful sub-text …

Good government is what makes markets and wealth as we know it possible. You can trust your currency to be currency (barter creates incredible amounts of economic drag and loss).  You can trust your debit card to work.  You can buy stock and sell it.  You can buy milk or gas and trust it to be safe and as labeled.

There are places where a driver has a gasoline testing kit to use when they buy gasoline.  Milk used to be a major cause of infant and child mortality.  In the anarchist paradises of Somalia and Albania looking across the straits at the kleptomancies of Zimbabwe and … there are not reliable banks or currencies.  Without those, there is no real wealth (consider those who destroyed the banking system by seizing all the farms that were the collateral for the banks loans in Zimbabwe — they are now net importers of food.  That land has no real value now that they’ve stolen it and can’t effectively farm it or resell it).

Bad government destroys wealth, but good government is a tremendous competitive advantage that creates wealth — if you don’t let kelptocracies capture it all.  Without government you can be a pretty successful subsistence farmer.  But trade, competitive advantage, and all the benefits of a large and robust economic and educational system?  Those come from good government.

Anyway, that is an initial economic primer on the economics relevant to political discussions.