Free-market-oriented economists probably live in a state of perpetual despair these days. Politicians and voters on both the left and right are turning on markets. Polls suggest widespread support for interventionist policies that economists long discarded for causing more harm than good.
We can blame ignorance, either of the population or of economists naive to people’s changing needs and challenges. But I suspect what’s behind the support for populism is the same thing that is behind every financial blow-up — the desire to believe we can have both low, or no, risk and upside, too.
The idea is seductive. It’s also the hollow promise unpinning almost every financial scam or ill-considered financial innovation that’s ended in calamity. It never works out, as we learned from the savings and loan crisis in the 1980s, the blowup of Long-Term Capital Management in 1998, the meltdown of mortgage-backed securities and the Bernie Madoff scandal in 2008, and who knows what next (there are many candidates).
The fundamental law of finance is that higher returns only come with the risk of loss. I call the persistent denial of this fact the risk delusion, and even the best minds in finance fall for it time and again.
It should not be a surprise that the same schtick is appealing when it comes to policy, too, particularly at a time when inflation has stretched budgets for some while others fear new technology may leave them unemployable.
A majority of Americans in both parties support price controls on childcare, prescription drugs and credit card interest costs, according to a recent Wall Street Journal survey. Other polls have found that measures to cap rent increases are popular on both sides of the political divide. These ideas violate basic economics and ignore the long history of price control producing shortages and even higher prices once the ceiling is lifted. Yet, they are compelling because the negative consequences aren’t apparent at the outset.
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Inflation, for example, is a big risk to consumers; it leaves people uncertain about how much their income will buy every time they go to the grocery store. Price controls seem to assure stability, which sounds great. Even Paul Samuelson, the Nobel laureate and father of modern economics, thought they were a good idea. The problem is safety means less upside; in this case, a paucity of goods available when you need them. You may know the price at the market, but you don’t know if you will find empty grocery shelves or, with rent controls, a sufficient supply of apartments.
Populism is also at odds with economic reasoning when it comes to taxes. A wealth tax on billionaires is popular among voters and has also garnered support from some economists, who believe it’s possible to outsmart the law of risk and reward. A big part of the appeal is the levy being paired with the promise of more government benefits, such as healthcare in California, or safety in the form of a guaranteed income that someone else pays for.
Most economists, however, hate wealth taxes because wealth is harder to value and easier to move around than income. Any tax on it, therefore, is easy to evade. Wealth taxation also has a greater impact on people’s behavior and, consequently, on economic growth.
Most wealthy people invest their money in their own companies or the market. A tax incentivizes them to move money out of productive investments and into assets that are harder to value and potentially less productive. A 2.5% wealth tax, for example, is the equivalent of a 50% capital gains tax if you assume a 5% return. Reducing the returns to risk-taking generally means less risk is taken, translating into fewer companies and jobs created, and slower growth. Economists prefer progressive consumption or well-designed income taxes instead.
The promise of no risk and a high return also explains why we have run up so much debt to expand benefits, and why politicians keep dangling more, including $5,000 checks to voters, an allowance for stay-at-home mothers or further tax cuts. No one mentions the downside risk of higher interest rates or a painful financial reckoning.
The bipartisan interest in government ownership of private corporations and industrial policy comes from the same playbook. These policies promise growth and innovation that is carefully controlled by the government, which means less job loss, no firms failing or people losing money. The result is often waste and stagnation.
These are dark days for those of us who dedicated our lives to both learning how the economy works and educating people about it. It feels like we all failed. But there is no getting around the hard fact that pursuing safety with the expectation of high return leads, at best, to no growth and, at worst, to a bad result you didn’t prepare for. We always believe this time is different, that we are now smart enough to have a well-designed policy or financial algorithm that can outsmart risk. Alas, it is never true.
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