Why does insurance exist? Insurance exists because risk is inherent in
living life. Think about the various forms insurance takes: automobile
insurance, property insurance, life insurance, health insurance,
disability income insurance, flood insurance, etc. You cannot predict
when another driver will hit your car, when your home will catch fire,
when you’ll get a serious illness or injury or when you’ll die, but
insurance companies can look at the statistics of those who possess
similar characteristics as yours and figure out when you’re likely to
die, which diseases you’re likely to get and when, the likelihood of
getting into an accident in your community or city, or the likelihood of
flooding in your neighborhood. Being able to shift the burden of risk
to a big company is the reason insurance is attractive to consumers –
shifting the burden from those with less knowledge to those with more.
This is the purpose of insurance: to efficiently manage and distribute
risk, from those least able to handle the costs to those most able to do
so.
The competitive pressures of a free marketplace will cause
premiums to be just high enough to earn profits and attract investment
for efficiently managed companies and just low enough to be attractive
to consumers.
In effective markets, the beneficial results of
insurance are two-fold. First, insurance premiums create an incentive to
minimize risky behavior. Second, insurance premiums create an incentive
to maximize ‘good’ (as in, economically efficient) decision-making.
This is why your health insurance premiums will be higher if you smoke,
your life insurance premiums will be higher if you skydive or disarm
bombs for a living, your property insurance will be higher if you live
in a floodplain, and your automobile insurance will be higher if you
live in a big city versus a rural community.
What happens when
economic principles controlling insurance conflict with political
principles controlling government? Inefficiency happens, and sometimes
it is disastrous. For example, let’s take a look at FEMA, the Federal
Emergency Management Agency. Federal disaster relief is sometimes called
insurance, but it is not. The reason is simple to see and simple to
understand. Insurance, as noted above, creates incentives to minimize
risky behavior and maximize efficient behavior. Federal disaster relief
subsidizes inefficient decision-making and risky behavior. The results
are drastic and highly regrettable.
Would Hurricane Katrina have
been as dramatically destructive without FEMA? No. Why not? Because if
you wanted your property protected and you chose to own that property
where hurricanes were able to destroy it, regularly, you would have to
pay for taking that risk in the form of high insurance premiums, if,
indeed, any insurance companies were willing to insure the property at
all. The only ones who could have afforded those premiums, or taken the
risk entirely upon their own shoulders, are wealthy people. If property
losses will be covered by government-directed funds, this mitigates the
costs of locating in risky areas. Suddenly, it is not as unattractive
for poorer people to live in flood plains and coastal areas hit
regularly by hurricanes. Property developers build because the demand is
there and the demand is there because the risk has been shifted from
the property owners to the taxpayers in general. Without federal
disaster relief, it is likely that New Orleans would not have suffered
so much structural damage because the development of the city would have
taken an entirely different form. Note, for instance, the condition of
the old city after the hurricane hit versus the most recently
constructed portions.
The same is true up and down the
Mississippi River. The river floods regularly. Every time the river does
flood, we see images of people stranded on their roofs, many stubbornly
maintaining they’ll never move. Of course they’ll never move. The
government funds the reconstruction, only to have to reconstruct yet
again the next time the river floods, as it will inevitably do.
It
is all needlessly destructive, needlessly wasteful, perfectly
ridiculous economically and perfectly understandable politically. No
politician is going to sit idly by and watch suffering constituents
without ‘taking action.’
If more truly understood basic economic
principles, perhaps the situation would be such that ‘taking action’
wasn’t politically necessary, because the constituents interacted within
a functioning insurance market, understanding the risks and the costs
associated with those risks.
Unintentionally Consequential
Wednesday, October 2, 2013
Why Government-Provided Medical Care is Always Doomed to Fail
There is a fundamental confusion, it seems, of cost with price. The two
are not synonyms. Price must cover cost. If a service is provided or a
good manufactured and the price charged does not cover the cost of the
good's manufacture or of the service's provision, that good or service
will not be provided long. Losses will, sooner or later, drive the
provider out of business. This is assuming, of course, that the provider
needs to profit in order to remain. In the world of consumers and
producers, i.e. the marketplace, this is the rule. It is not, however,
the rule in the world of government. Government has no competitor and
government doesn't go out of business.
In the marketplace, a doctor enters his field of chosen practice possessing costs previously acquired that must now be paid. These include the costs of undergraduate and medical school as well as the required residency and certification requirements (differing in specifics, of course, from state to state), and the cost of malpractice insurance (differing from state to state and depending upon the specific area of practice). These costs must be covered sufficiently enough by the wage earned to encourage the doctor to continue practicing medicine where he is and, also, to encourage future young adults to enter the field.
The wealth created by the doctor is the service provided and the wage paid the doctor derives from the monies earned as wages by the patients in their individual wealth-creating endeavors. In the marketplace, if a consumer is displeased with a producer, that consumer can take his money to a different producer that does not displease him. This provides an incentive for the producer to do his best to please his customers, so as not to lose any future business that may be provided by said customer as well as any future business that may be provided by those who learn how satisfied or dissatisfied that customer is.
The patient also has an incentive to make certain he is 'getting his money's worth.' It's a remarkable fact that when a person spends his own money, he is much more careful about the expenditures than when he is spending other people's money. It tends to entice the individual to prioritize. This is, of course, why we all pay our rent/mortgage payment, bills, debts, etc. before splurging on that new fancy piece of electronic equipment or some other novel trinket we've been wanting. Irresponsibility has a pretty severe price and no one wants to explain to his friends that he got evicted because he kept buying PS3 games with what should have been his rent money.
When patients procure a doctor's services they may choose to render payment in a number of ways: immediate cash payment, a series of payments stretched out over a predetermined number of months, on credit, with borrowed funds, with gifted funds, or the payment may be made in part or in whole by a health insurance company.
All insurance companies were originally created with one goal: to manage risk more effectively than individuals can by pooling as many individuals as possible so as to make use of sophisticated statistics. We cannot eliminate risk. We can, through insurance, shift the burden off the shoulders of those who are less able to handle the costs of these risks onto the shoulders of those who are more able to handle these costs. I can't predict when I'll die, when or if I'll get into a car accident, when or if I'll get cancer or some other catastrophic disease, or when or if my home will catch fire. Insurance companies can predict the odds of all these things by looking at my lifestyle and choices (smoker? drinker? skydiver?), where I live (high crime or low crime neighborhood?), what I drive (bigger, safer car?), and all the previous experiences of those most like me that they have insured in the past. Insurance companies use this information to determine the likelihood of any of these things happening to me. This information is then used to determine the premium I will pay. The premiums charged to all policy holders and the returns earned on investments made with said premiums must cover all of the present and future claims or the company will not be selling policies very long.
We live in a culture that expects medical insurance to pay for even the most rudimentary procedures. This isn’t what insurance is for. If you know you will receive a physical examination every year, you are able to plan for and budget the expense of that exam. If you know you will have children in the future, you are able to plan for and budget the expense of those births. Of course, everyone would rather someone else pay. And, why are premiums so high? If I’m paying such a large sum per month shouldn’t the insurance company pay for my doctor’s visit? Allow me to introduce you to the government.
The government erects the framework of rules and standards within which all market activity occurs. The government also enforces these rules and standards. If the government requires by law that insurance companies pay for services they otherwise would not pay for, premiums must rise to cover this new cost. Why wouldn’t the insurance companies cover these costs anyway, without government intervention? Because we aren’t willing to pay the higher premiums and would buy lower-priced policies (albeit, policies with fewer benefits) from competing firms. But, if government requires all insurance companies to cover these costs, then competition is taken out of the picture and we have no choice but to pay higher premiums, if we want to have health insurance.
And so, costs rise.
Combine this fact with the rising malpractice insurance premiums due to numerous judgments awarding large punitive damages based upon junk science (for example, John Edward’s claim to fame: birth defects resulting from doctors not choosing to perform a C-Section soon enough – leading to preventive C-Sections being performed when they otherwise wouldn’t have been as a just-in-case measure, which raises the costs of birthing those children), the fact that insurance companies are forbidden to compete across state lines, and the fact that state medical boards control the number of students permitted into medical schools each year and we have an inherently rising cost of medical provision. To cover these higher costs, we, the patients, must pay higher medical prices.
So, why can’t government step into the picture and pay for it all? Government certainly can. And, now, government will. But, you say, government isn’t paying for everything! Private insurers still exist! We still have choices! Yes, for now – but, not for long. First, I will explain why private insurance will be crowded out of existence by government payments and then I will explain why we aren’t better off for it.
Insurance companies, like every other company in the market, exist to make money. When a company cannot make enough money it folds, in a normally functioning market. Government may certainly ‘bail out’ the failing company so it does not die a normal death. This choice is highly problematic, however. The money used by government to bail out failing firms is money that, by necessity, is taxed from the wealth creators. Government cannot, on net, create wealth. Every penny spent by government is a penny gained by taxes. Every penny earned by a business is a penny earned by creating a good or service desired by consumers and every penny paid by consumers is a penny they earned in their various jobs by providing productive value to the firms employing them.
If government builds a library in a small town, we can see the construction crews working with stone and wood to build the building. We can see the books placed on the shelves and we can see the librarians who now have jobs at the new library. What we cannot see are all the myriad things that would have been purchased by the taxpayers with those tax dollars of theirs that funded the library’s construction and maintenance. Perhaps one would have purchased new shoes earning a commission for a salesman at the local mall department store, as well as a sum for the company that manufactured the shoes and the employees that actually pieced them together. Not to mention the sum earned by the providers of the leather, thread, and rubber used in the shoes’ construction and the employees that harvested that rubber, cured that leather and spun that thread. Or the sum earned by the rancher whose cattle provided the leather, the farmer whose cotton provided the thread, or the landowner whose trees provided the sap that helped create the rubber. We can’t see all of these effects because they didn’t happen. Multiply these ‘might haves’ by the number of tax payers and we get into some pretty serious numbers.
The problem isn’t whether or not government can create or save a job. Government certainly can. The problem lies in whether that is a net gain, whether government will spend tax dollars as carefully as we spend our own, and whether individuals are better off buying what they want with their own money or having their money taxed away to purchase things thought better for them by those with political power.
Since government will never go out of business, the government-provided medical plans do not have to charge cost-covering premiums. Private firms do. How may a firm that must remain profitable to continue in existence compete with a government that does not have to earn a profit to do likewise? The private-sector insurance companies will be undercut. The only way they will survive is if they eventually become wards of the state. We may have choices now, but as the number of those who purchase the government plan grow, inevitably, the private insurance companies will be pushed aside or absorbed, one by one.
Another side effect of the growth in the number of those being added to the government medical plan, is a necessary rise in the costs of that government medical plan. To pay for these costs the government must cut spending in other areas, raise tax rates in hopes of earning higher tax revenues or establish a system of price controls mandating what doctors and hospitals may charge for each service and even what a doctor may legally earn as wages. As compensation for doctors and hospitals declines simultaneously with the inevitable increase in demand for medical services due to the free or artificially low price, the only way costs may be lowered is by cutting corners so the quality of care received will worsen.
The easiest corner to cut is time. If price is not permitted to ration medical care, then time will. You’ll wait. We’ll all wait. Maybe you’ll be one of the lucky ones that gets necessary surgery in a timely fashion provided by a well-trained doctor for a low, low price. Maybe you won’t. Maybe you’ll die on a waiting list.
When the wage earned by doctors drops due to government cost-saving initiatives, what will happen to the number of people who decide to enter medical school? The number will drop. They’ll find other fields that permit a higher return on the investment of their time, energy and skill. Who will take their place? Cheaper doctors will take their place – most likely from Third World countries and other nations whose medical schools have lower entry requirements and lower overall performance standards. We can already see this playing out in Britain’s National Health Service and in Canada’s system as well.
None of this will matter to rich people. Money always provides the possessor with options. The middle-class and poorer people will be the ones to suffer. We can also see this play out in Europe and Canada. Witness the recent trip made by the premier of Nova Scotia, a province in Canada, to Florida to get surgery.
Our quality of life will not improve. Our bills will not decline.
At the end of the day, my friend, you will always have to pay the Piper.
In the marketplace, a doctor enters his field of chosen practice possessing costs previously acquired that must now be paid. These include the costs of undergraduate and medical school as well as the required residency and certification requirements (differing in specifics, of course, from state to state), and the cost of malpractice insurance (differing from state to state and depending upon the specific area of practice). These costs must be covered sufficiently enough by the wage earned to encourage the doctor to continue practicing medicine where he is and, also, to encourage future young adults to enter the field.
The wealth created by the doctor is the service provided and the wage paid the doctor derives from the monies earned as wages by the patients in their individual wealth-creating endeavors. In the marketplace, if a consumer is displeased with a producer, that consumer can take his money to a different producer that does not displease him. This provides an incentive for the producer to do his best to please his customers, so as not to lose any future business that may be provided by said customer as well as any future business that may be provided by those who learn how satisfied or dissatisfied that customer is.
The patient also has an incentive to make certain he is 'getting his money's worth.' It's a remarkable fact that when a person spends his own money, he is much more careful about the expenditures than when he is spending other people's money. It tends to entice the individual to prioritize. This is, of course, why we all pay our rent/mortgage payment, bills, debts, etc. before splurging on that new fancy piece of electronic equipment or some other novel trinket we've been wanting. Irresponsibility has a pretty severe price and no one wants to explain to his friends that he got evicted because he kept buying PS3 games with what should have been his rent money.
When patients procure a doctor's services they may choose to render payment in a number of ways: immediate cash payment, a series of payments stretched out over a predetermined number of months, on credit, with borrowed funds, with gifted funds, or the payment may be made in part or in whole by a health insurance company.
All insurance companies were originally created with one goal: to manage risk more effectively than individuals can by pooling as many individuals as possible so as to make use of sophisticated statistics. We cannot eliminate risk. We can, through insurance, shift the burden off the shoulders of those who are less able to handle the costs of these risks onto the shoulders of those who are more able to handle these costs. I can't predict when I'll die, when or if I'll get into a car accident, when or if I'll get cancer or some other catastrophic disease, or when or if my home will catch fire. Insurance companies can predict the odds of all these things by looking at my lifestyle and choices (smoker? drinker? skydiver?), where I live (high crime or low crime neighborhood?), what I drive (bigger, safer car?), and all the previous experiences of those most like me that they have insured in the past. Insurance companies use this information to determine the likelihood of any of these things happening to me. This information is then used to determine the premium I will pay. The premiums charged to all policy holders and the returns earned on investments made with said premiums must cover all of the present and future claims or the company will not be selling policies very long.
We live in a culture that expects medical insurance to pay for even the most rudimentary procedures. This isn’t what insurance is for. If you know you will receive a physical examination every year, you are able to plan for and budget the expense of that exam. If you know you will have children in the future, you are able to plan for and budget the expense of those births. Of course, everyone would rather someone else pay. And, why are premiums so high? If I’m paying such a large sum per month shouldn’t the insurance company pay for my doctor’s visit? Allow me to introduce you to the government.
The government erects the framework of rules and standards within which all market activity occurs. The government also enforces these rules and standards. If the government requires by law that insurance companies pay for services they otherwise would not pay for, premiums must rise to cover this new cost. Why wouldn’t the insurance companies cover these costs anyway, without government intervention? Because we aren’t willing to pay the higher premiums and would buy lower-priced policies (albeit, policies with fewer benefits) from competing firms. But, if government requires all insurance companies to cover these costs, then competition is taken out of the picture and we have no choice but to pay higher premiums, if we want to have health insurance.
And so, costs rise.
Combine this fact with the rising malpractice insurance premiums due to numerous judgments awarding large punitive damages based upon junk science (for example, John Edward’s claim to fame: birth defects resulting from doctors not choosing to perform a C-Section soon enough – leading to preventive C-Sections being performed when they otherwise wouldn’t have been as a just-in-case measure, which raises the costs of birthing those children), the fact that insurance companies are forbidden to compete across state lines, and the fact that state medical boards control the number of students permitted into medical schools each year and we have an inherently rising cost of medical provision. To cover these higher costs, we, the patients, must pay higher medical prices.
So, why can’t government step into the picture and pay for it all? Government certainly can. And, now, government will. But, you say, government isn’t paying for everything! Private insurers still exist! We still have choices! Yes, for now – but, not for long. First, I will explain why private insurance will be crowded out of existence by government payments and then I will explain why we aren’t better off for it.
Insurance companies, like every other company in the market, exist to make money. When a company cannot make enough money it folds, in a normally functioning market. Government may certainly ‘bail out’ the failing company so it does not die a normal death. This choice is highly problematic, however. The money used by government to bail out failing firms is money that, by necessity, is taxed from the wealth creators. Government cannot, on net, create wealth. Every penny spent by government is a penny gained by taxes. Every penny earned by a business is a penny earned by creating a good or service desired by consumers and every penny paid by consumers is a penny they earned in their various jobs by providing productive value to the firms employing them.
If government builds a library in a small town, we can see the construction crews working with stone and wood to build the building. We can see the books placed on the shelves and we can see the librarians who now have jobs at the new library. What we cannot see are all the myriad things that would have been purchased by the taxpayers with those tax dollars of theirs that funded the library’s construction and maintenance. Perhaps one would have purchased new shoes earning a commission for a salesman at the local mall department store, as well as a sum for the company that manufactured the shoes and the employees that actually pieced them together. Not to mention the sum earned by the providers of the leather, thread, and rubber used in the shoes’ construction and the employees that harvested that rubber, cured that leather and spun that thread. Or the sum earned by the rancher whose cattle provided the leather, the farmer whose cotton provided the thread, or the landowner whose trees provided the sap that helped create the rubber. We can’t see all of these effects because they didn’t happen. Multiply these ‘might haves’ by the number of tax payers and we get into some pretty serious numbers.
The problem isn’t whether or not government can create or save a job. Government certainly can. The problem lies in whether that is a net gain, whether government will spend tax dollars as carefully as we spend our own, and whether individuals are better off buying what they want with their own money or having their money taxed away to purchase things thought better for them by those with political power.
Since government will never go out of business, the government-provided medical plans do not have to charge cost-covering premiums. Private firms do. How may a firm that must remain profitable to continue in existence compete with a government that does not have to earn a profit to do likewise? The private-sector insurance companies will be undercut. The only way they will survive is if they eventually become wards of the state. We may have choices now, but as the number of those who purchase the government plan grow, inevitably, the private insurance companies will be pushed aside or absorbed, one by one.
Another side effect of the growth in the number of those being added to the government medical plan, is a necessary rise in the costs of that government medical plan. To pay for these costs the government must cut spending in other areas, raise tax rates in hopes of earning higher tax revenues or establish a system of price controls mandating what doctors and hospitals may charge for each service and even what a doctor may legally earn as wages. As compensation for doctors and hospitals declines simultaneously with the inevitable increase in demand for medical services due to the free or artificially low price, the only way costs may be lowered is by cutting corners so the quality of care received will worsen.
The easiest corner to cut is time. If price is not permitted to ration medical care, then time will. You’ll wait. We’ll all wait. Maybe you’ll be one of the lucky ones that gets necessary surgery in a timely fashion provided by a well-trained doctor for a low, low price. Maybe you won’t. Maybe you’ll die on a waiting list.
When the wage earned by doctors drops due to government cost-saving initiatives, what will happen to the number of people who decide to enter medical school? The number will drop. They’ll find other fields that permit a higher return on the investment of their time, energy and skill. Who will take their place? Cheaper doctors will take their place – most likely from Third World countries and other nations whose medical schools have lower entry requirements and lower overall performance standards. We can already see this playing out in Britain’s National Health Service and in Canada’s system as well.
None of this will matter to rich people. Money always provides the possessor with options. The middle-class and poorer people will be the ones to suffer. We can also see this play out in Europe and Canada. Witness the recent trip made by the premier of Nova Scotia, a province in Canada, to Florida to get surgery.
Our quality of life will not improve. Our bills will not decline.
At the end of the day, my friend, you will always have to pay the Piper.
Sunday, February 10, 2013
The Flat Tax
Question -
What are the disadvantages to having a 'flat tax' where the government took a
fixed percentage of money any time it changed hands (no tax write offs for
charitable contributions, no progressive tax brackets, no luxury/sin taxes,
etc.). Congress would have a fixed budget and have a direct incentive to better
their respective economies. People would know exactly how much they would owe
and no one company could get the upper hand by hidden tax breaks tucked away in
obscure bills. - At least this is what the Utopian point of view is. Are there
any good examples of economies that have tried this? How have they dealt with
national emergencies, paid for a military, unplanned expenses, etc.?
Response -
Your questions possess many subjective qualifications. Obviously, there is no
objective concept of 'disadvantage' or 'advantage.' What appears to be an
advantage to one person may also appear to be a disadvantage to another. For
example, the progressive income tax currently in place is viewed by some as 'good'
and others as 'bad' for precisely the same reason: that those who earn more pay
higher rates than those who earn less. Progressivity is 'advantageous' or
'disadvantageous' depending entirely upon whom one questions - and their views
of what the 'best' outcome is.
One cannot even really ask which tax system is most
efficient, because it depends upon the goal of that tax system and the
structure of the bureaucracy implementing that tax system.
In other words, the starting point matters. So does the
ultimate result desired. Each helps define the road taken from the former to
the latter.
I could write an essay about the different goals of
taxation. Should we care most about overall per capita standard of living?
Maximizing overall tax revenues? Only generating as much tax revenue as is
'needed' (requiring the determination of some formal definition of
'necessary')? Who should possess the power to determine how these monies are
spent - the bureaucrats, or the people? If the people should possess the power,
how should this power be demonstrated and acted upon?
I don't think any of that, however interesting it may be, is
necessary to tackle the various characteristics of a 'flat tax.'
So, let us assume we have a flat tax. All income, regardless
of label (profit, capital gain, dividend, wage, rent, interest, etc.) is taxed
at a fixed rate. There are no loopholes, no tricks, no gimmicks.
Now, this system can exist independent of a balanced budget.
So, I'm not going to address budgetary issues.
The first wrinkle that must be addressed is: how do we
determine income? Which costs are permitted to be counted against revenues to
determine taxable income? We have the same issues, it seems, with a flat tax as
we do with progressive taxation. Someone is going to have to determine what is
permissible and what isn't when we subtract costs from revenues.
So, what would have to happen is the authors of the
legislation to implement a flat tax would have to specify deductions that would
apply to married versus single and parents versus childless.
It is possible that, over time, a tendency will arise for a
gradual increase in complexity within the tax system. Remember, our current
labyrinthine income tax system didn't come about overnight.
The authors would also have to deal with the problem of
'double taxation.' If corporate profits are taxed, and the money left over
generates capital gains - and those are also taxed, then spending will be
incentivized over investment. There would still have to be a lot of caveats
within the legislation to cover as many of these issues as possible in order to
avoid as many unintended consequences as possible.
Of course, it's perfectly reasonable to simultaneously have
both a progressive and a flat tax. The taxpayer could then select how he wished
to calculate his tax liabilities and pay his taxes.
Remember in class, how we talked about the fact that
everyone's income is someone else's spending? The reason I'm bringing this up
to you is because the main antagonists among those seeking to replace
progressive taxation are those advocates for the flat income tax and those
advocates for a national consumption (or sales tax). In either scenario transactions
are still being taxed, it's just the tax is being funded from the buyer's hand
in one situation and the seller's hand in the other. Same money. Different
angle.
It's interesting to think about.
As far as nations using a flat tax are concerned, there are
actually quite a few. Russia, Estonia, Latvia, Lithuania, Ukraine, Serbia,
Romania, Slovakia, Georgia, The Channel Islands (Jersey and Guernsey), and Hong
Kong (Hong Kong actually has a dual tax system - where you can choose either
progressive or flat).
Economic growth in
many of these nations is pretty significant.
Personally, I think simpler is always going to be less
costly than complicated. But, there's an entire industry built around the
complications of the current tax system that will be extremely resistant to any
change (tax accountants and tax attorneys, for example).
Also, remember, income taxation is only one way a government
can raise revenues. Import tariffs and bond sales are others. Unplanned for
(emergency) expenditures shouldn't prove to be a problem.
This is a subject that can get incredibly complicated and we
could probably have an ongoing conversation that could last an entire semester,
but I hope this short 'mini-essay' at the very least points you in the right
direction cognitively and helps you better understand the topic.
Of course, let me know if you need anything else.
Monday, January 21, 2013
Money, Debt and Default
Question - How can the U.S. have trillions of dollars in
debt when the debt (at least to me) appears to be in a currency we control?
Inflation notwithstanding, couldn't we just print extra money periodically to
pay this debt back? It seems an odd concept to me that a country can be in debt
within the currency that it controls.
I know I'm dismissing the
complexity of international currency here, but perhaps you could expand upon
what it really means when a country is in debt to other nations.
Response - Your question touches on two issues that require
clarification and explanation. First, what is debt? Second, what is money? Once
debt and money are understood, your question becomes relatively simple to
answer.
What is debt? Debt is one of the
two perspectives in the relationship between a borrower and a lender (the other
being credit). Whenever I deposit money into my bank, my bank becomes a debtor
to me in the amount deposited. Whenever a business or a municipal, state or
federal government sells a bond to me, that entity becomes a debtor to me in
the amount contracted. A bond, after all, is simply a contract to pay a fixed
amount of money at some predetermined date in the future. The difference
between the amount I pay, and the amount I receive is the 'rate.' So, if I'm
indifferent between $100 today and $105 one year from today, my effective rate
is 5%. I will not be willing to loan you $100 today unless you promise to pay
me at least $105 in one year. Likewise, I will not be willing to spend $100 to
purchase a bond that pays any less than $105 in one year.
This is, of course, assuming I
believe the borrower will have no problem paying me back. The higher I believe
the risk of default, the higher the rate I'll require. For example, even though
my effective rate is 5%, I may view the borrower as risky and demand 15%. The
10% premium serves as compensation for the risk I am taking that I may never
see my money again. The initial 5% serves as compensation for the inconvenience
of not having the money I'm lending at my immediate disposal. If a potential
lender is not presented adequate compensation for the inconvenience and risk
associated with lending his money to the borrower, then he will have no
incentive to lend. The inconvenience and risk simply must be compensated by the
rate offered by the borrower.
Ah, but how can the federal
government default? Before I can answer this question, I need to explain what
money is and how it functions.
Money often gets confused with
wealth. Money is not wealth. Wealth is, in a nutshell, stuff. Stuff, and the
knowledge and means of making it, inventing it, and innovating with it. As you
can see, wealth is versatile. With wealth, one can create more wealth, or sell
it for cash, or exchange it for other forms of wealth. Money, however, is only
good for one thing: the purchase of wealth.
Money exists because barter is
awkward. Money helps economies run smoothly, particularly as they grow in scope
and complexity. For example, if I owned an apple orchard and decided I wanted
to acquire a new chair for my home office, I might go to a person who makes
chairs and offer an exchange of apples for a chair. But, how many apples is a
chair worth? How many apples does the chair maker even desire? The chair maker
may propose a counteroffer whereby I give him a receipt for 115 pounds of
apples. So, whomever presents this receipt to me may expect me to deliver unto
him 115 pounds of apples. This way, the chair maker receives something he can
use to purchase other things he desires, and I get my office chair without
having to cart around 115 pounds of apples. Nor does the chair maker have to
worry about getting rid of 115 pounds of apples. He only has to worry about
making chairs.
The chair maker may then decide
he wants to purchase some bacon, so he goes to the butcher and offers him my
apple receipt. Now, the butcher is not going to need all 115 pounds of apples
as compensation for 1 pound of bacon. Not only that, but the chair maker won't
want to give up rights to all 115 pounds of apples for 1 pound of bacon. Let us
suppose, that the chair maker writes a receipt to the butcher signing over his
rights to 11 pounds of apples in exchange for 1 pound of bacon.
The receipts for apples have
become money in this economy.
What if I decide to start
exchanging receipts for my apples above and beyond what my orchard can reliably
produce? Well, what are the odds everyone will show up at once and demand their
apples? Here's where the art of finance and banking come in. How much wriggle
room do I have? If I take too many liberties with my receipts, my neighbors may
lose faith in my ability to redeem their claims on my apples. If this happens,
there might be a 'run' on my orchard and I'll be ruined. This threat will also
create an incentive for receipts for other producers' goods and services to be
used as cash as well. There might even arise a sophisticated multi-layered
banking system whereby large banks issue widely accepted notes to serve as
currency while holding deposits of a wide variety of producers' receipts as
claims on actual wealth.
Money will only continue to
operate as it is meant to when the production of wealth (upon which the
currency is founded) keeps pace with the creation of money. When wealth creation
outstrips the creation of money, or when available credit evaporates faster
than any decline in the creation of wealth, the result is deflation - where the
money circulating in the market may purchase more wealth per unit of currency
than before the deflation. When wealth creation is surpassed by the creation of
money, or when any decline in the creation of wealth occurs at a faster rate
than any decline in available credit, the result is inflation - where the money
circulating in the market may purchase less wealth per unit of currency than
before the inflation. Naturally, deflation is most harmful to the debtor
because the cash he is paying back to his creditor is worth more than the cash
he initially borrowed. And, inflation is most harmful to the creditor because
the cash he is receiving from his debtor is worth less than the cash he
initially lent out. This is a main reason why governments that possess monopoly
power over the production of currency would much rather err on the side of
inflation than deflation. Inflation would make it easier to pay off debts while
deflation would make that much more difficult. The reason governments want to
possess a monopoly on coining and printing money is not because the bureaucrats
are worried about producers and consumers seeking to con one another. Con men
and fraud will exist regardless. Governments want to possess a monopoly on the
coining and printing of money because the bureaucrats want power.
Diversification and a credible threat of competition are the opposite of power.
Legitimate power only exists when there are no other present legal alternatives
and no threat of any future legal alternatives.
So, can the federal government
default? Technically, no. You are correct in assuming the printing presses can
simply be kept running until there is enough cash to pay off all of the bills.
However, hyperinflating a currency is catastrophically destructive to a
nation's economy. For a potent example, one may simply look at Germany in between
the two World Wars. The monetary actions of the German government fleeced the
German population of all of their savings and created a massive burden to
present innovation and future growth by creating incentives for investors and
potential investors to seek foreign opportunities in more stable markets. Money
can serve as oil in the gears of the economic machinery. It isn't necessary for
an economic machine to run, but it helps it run smoother. Hyperinflation is
like pouring sand into those same gears while simultaneously removing the oil.
The machine will break down and require extensive repair, if not outright
replacement.
In short, you should hope your
government does not seek to print its way out of debt. If it tries to do so,
very unfortunate things are going to happen.
Saturday, January 5, 2013
Adam Smith on Wine Consumption and Relative Drunkenness
Question - "In the Wealth of Nations on pages 525-526,
Adam Smith states '... the cheapness of wine seems to be a cause, not of
drunkenness, but of sobriety.' Why is
this a common vice in countries/societal classes where liquor is expensive and
not a problem with countries that produce or classes that can easily afford it?
I've read this a few times. Smith seems to give good
examples but not so much as to why it is so."
Response - Adam Smith identifies the justification for his
observation of relative drunkenness when he states on page 525 (1994 Modern
Library Edition), "People are seldom guilty of excess in what is their
daily fare."
He wasn't so much making a statistically supported statement as he was voicing a general observation of human nature.
A similar example could be the way many Americans treat food during the holidays of Thanksgiving and Christmas. Many I personally know (and, I'd wager, many you personally know as well) have even stated vocally that, since it is Thanksgiving (or Christmas) after all, they can be excused for eating more than usual. The fact that many foods are more available during these times than others (egg nog, pumpkin pie, etc.) may also contribute.
Not many (if any) 'overconsume' peanut butter and jelly sandwiches, for example, or other comparably pedestrian meal options that are relatively cheap to create, easy to obtain and possess no significant ties to any kind of holiday emotions.
Wednesday, November 28, 2012
Copyrights
Question -
Should a free market have copyright laws and if so to what extent? What
incentive does this give to produce new products?
Response -
I think copyright laws may be written to serve an efficient purpose. They may,
as you hint at, create strong incentives to be creative by protecting the creator of the work from having his ingenuity 'stolen' from him by copycats. Piracy may certainly lessen the desire to place one's creations into the open market if they are going to be permitted to be copied and distributed without compensation by the pirates. The problem with
copyrights comes when/if they are permitted to transform into perpetuities. If the
author/artist/musician/etc.'s heirs and the heirs of those heirs ad infinitum
are permitted to limit the use of the copyrighted material, then the copyright
becomes an obstacle to creativity.
I do not think it would be unreasonable to limit the
copyright to the life (however long or short it may be) of the original
creator. After that, the work should be permitted to enter the public domain so
it can be used by future creators without penalty.
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