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Wednesday, August 20, 2008

Obama's Views on Economics

This article by David Leonhardt describes Barack Obama's view of economic policy, and it is very similar to my own. Most of the time, it is best to leave markets alone, to let them work without intervention, and that should be our starting point. But markets fail, and part of the disagreement with those holding more conservative views is over how often markets fail, whether they can easily self-correct when there are problems, and how effective the government is at fixing problems when they exist.

On the last point, I am a proponent of market-based regulation when it is possible to use it. For example, if you want to regulate the profit of a public utility, one way  to do it is through rate of return regulation. Under this approach, prices are set so as to guarantee investors a particular "fair" rate of return. The problem with this is that there is no incentive for the firm to control its costs, the rate of return to investors will be the same whether it is efficient or inefficient. 

An alternative to this approach is to set a price cap and then tell the firm that it can keep some fraction of any profit over a certain amount, with the rest to be returned to its customers through rebates or lower prices. For example, regulators could set a base return of 5%, and anything over that amount is shared equally with taxpayers (you occasionally see these rebates on your phone bill). Thus, if the firm makes 8%, it would keep 6.5%, and 1.5% would be returned to customers. Under this form of regulation, there's an incentive to cut costs - every dollar saved is another dollar in profit - and there's also an incentive to innovate (unlike with rate of return regulation). The price cap, which can be adjusted to target the 5% base rate, prevents the firm from exploiting monopoly power through its pricing behavior. There are important considerations involving commitment by regulators (e.g. they won't change the split when gets gets larger), but the important thing here is that profit is regulated, yet market incentives are preserved.

I bring this up because as I read Obama's economic philosophy I find myself very much in agreement (with some caveats, see below), but the actual policies that are implemented do not always seem to be faithful to the grander vision he expresses in the article. The windfall profits tax is one example that comes to mind (though in other areas, e.g. health care reform, there is at least an attempt to follow market-based regulation principles, though I'd question whether the market failure in the provision of health care can be solved with this particular approach - not every market failure can be overcome through market-based regulation - and universal coverage may require mandates). I also think there has been too much emphasis on behavioral economics due to the presence of economic advisors invested in this approach when it is just one part Obama's belief in market-based regulatory principles rather than command and control.

One place I do disagree is with Obama's belief in the value of some aspects of Reaganomics. I think both Obama and the article give Reaganism too much credit. The article says that, under Reagan:

The government has deregulated industries, opened the economy more to market forces and, above all, cut income taxes. Much good has come of this — the end of 1970s stagflation, infrequent and relatively mild recessions, faster growth than that of the more regulated economies of Europe.

There were some areas in need of deregulation, but to attribute the fall in inflation, the enhanced stability of output, and faster growth to these factors is inconsistent with research pointing to things such as technology and monetary policy as key factors behind the lower inflation rates and enhanced stability we experienced.

Obama echoes this theme:

In Obama’s second book, “The Audacity of Hope,” he goes further: “Reagan’s central insight — that the liberal welfare state had grown complacent and overly bureaucratic, with Democratic policy makers more obsessed with slicing the economic pie than with growing that pie — contained a good deal of truth.”

The article says:

he also says he believes that there are significant parts of Reaganism worth preserving. So his policies often involve setting up a government program to address a market failure but then trying to harness the power of the market within that program.

As I said above, if that's all he means, I have no problem with this idea, in fact my criticism is that he seems to depart from this when he actually implements policy (however, I do understand he needs to get elected, and that a stronger populist appeal may be needed). But he seems to go beyond this in his embrace of Reaganomics.

Finally, I should also say that I was impressed by what I heard from Obama in terms of his knowledge of economics. He has taken the time to learn about the topic and he has intelligent things to say about it. Better yet, I agree with most of what he says. The contrast to McCain, who doesn't seem the least bit interested in learning about economics and prefers instead to rely on the Phil Gramms in his party to tell him what his positions ought to be, was very clear. [Link to article]

    Posted by on Wednesday, August 20, 2008 at 12:24 PM in Economics, Politics | Permalink  TrackBack (0)  Comments (39)


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