Friday, February 24, 2012

The Truth about Consumption, Production, Government "Knows Best" Price Fixing and Free Markets

British philosopher and economist John Stuart Mill said this in 1844 (Notable & Quotable):

"From John Stuart Mill, "Of the Influence of Consumption on Production" (1844):

Among the [economic] mistakes which were most pernicious in their direct consequences . . . was the immense importance attached to consumption. The great end of legislation in matters of national wealth, according to the prevalent opinion, was to create consumers. . . . It is not necessary, in the present state of the science, to contest this doctrine in the most flagrantly absurd of its forms or of its applications. The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained.

Taxes are not now esteemed to be "like the dews of heaven, which return again in prolific showers." It is no longer supposed that you benefit the producer by taking his money, provided you give it to him again in exchange for his goods. There is nothing which impresses a person of reflection with a stronger sense of the shallowness of the political reasonings of the last two centuries, than the general reception so long given to a doctrine which, if it proves anything, proves that the more you take from the pockets of the people to spend on your own pleasures, the richer they grow; that the man who steals money out of a shop, provided he expends it all again at the same shop, is a benefactor to the tradesman whom he robs, and that the same operation, repeated sufficiently often, would make the tradesman's fortune. . . .

What a country wants to make it richer, is never consumption, but production."

In simple terms, Mills demonstrated the idiocy of emphasizing consumption and not production. Why are government initiatives to create additional demand almost always a wrongheaded approach?

Well, for one reason, because we can't consume more than we produce. It's not possible. Or maybe because there is no such thing as a free or beneficial government price fixed approach without causing unseen, unintended and harmful consequences elsewhere.

In any event, Mill's comments caused me to reflect on how this applies so directly to our current financial mess. We've created lots of demand without making any serious effort to pay for it through increased private sector production. It's as if demand creation will pay for itself. If only that were so! But it's not and never has been, as Mill said in 1844.

For a peek into our nation's self-made financial debacle, let's look briefly at the demand-production-pricing problems associated with the four huge government expenditure programs of Medicare, Medicaid, Social Security and public education.

If we bring these four programs under control, our nation will be well on the road to a sustainable state of financial stability. Until then, however, it's all happy talk.

Demand is strong when prices are weak, all other things being equal. And when prices are fixed by government at a free or heavily subsidized level, demand is especially strong. So stimulating demand is not a problem in a non-market based segment of the economy. It's the lack of supply at a free market set competitive price that's the killer. And that's exactly what the government does when it interferes with the free market's price discovery mechanism

You see, new demand needs to be accompanied by a spike in production, productivity, prices, or all three.

1- Medicare and the Affordable Care Act, aka ObamaCare, both fix prices as set by government officials. Demand is generated by "consumers" who don't freely choose what or whether to buy based on pricing set by the suppliers, as is the case with market based pricing and services.

The supplier doctors are represented by the nation's strongest union (American Medical Association) and operate under a fee for services pricing structure. The more services and tests performed, the more the doctors are paid. So doctors are happy to produce more services as demand is created. They in fact often are the originators of that demand for tests and such. All the consumer contributes is his time and body. Government pays the doctors supplying the services.

2- Medicaid is largely about providing elderly nursing home patient care. Medicaid payments are about 50% paid for by the federal government and about 50% paid for by state governments. As with Medicare, prices are fixed by government, and government pays the bill.

3- Social Security pays benefits to recipients according to a formula adopted by government from time to time. Like Medicare and Medicaid, Social Security payments are not dependent on the government having specific funds available to make those payments.

In all three cases (Medicare/ObamaCare, Medicaid and Social Security), the government establishes who contributes what amounts, if anything, and what benefits and payments they and their providers will in turn receive, regardless of whether sufficient funds are available to make the required payments.

4- Public education is financed by local property taxes, individual state grants and federal funds as well. It's a free lunch proposition for those students who attend the public schools.

What's all this mean with respect to the relationship between demand and supply, or consumption and production, or deficits and taxes? Asked another way, what happens when free markets don't set prices and consumers aren't required to make choices about how much of their own money they'll spend in order to receive the services supplied by government? In other words, what happens to demand when pricing and production/supply are controlled by government?

The answer to all three questions is the same; nothing good.

Here are two additional simple questions. (1) Why would there not be heavy demand for free services, even if that demand is not supported by additional production or supply? (2) And if all the emphasis is on stimulating demand, why would we expect there to be much additional supply created unless the pricing mechanism allowed an acceptable profit to the would-be supplier of that additional production?

So creating demand is easy. And not creating supply for that demand is easy as well. So it's paid for either by taxing those who have the ability to pay for the new demand, or by borrowing from those who are willing to lend us the money to pay for that new demand and support our nation's ongoing spendthrift ways.

Where's it end? Well, it ends when we run out of money or new production to pay for the newly created demand. That time is nigh.

Health Care's Coming Price Revolution discusses the importance of a market price mechanism in relation to value received. The article optimistically predicts that market based and not government mandated pricing will be coming to our health care system soon. Let's see what's already happening in parts of the private sector:

"A more encouraging turn is the gradual emergence of a workable market-driven alternative to all this in the private sector, which is happening for a simple reason: There's no money left.

For decades businesses merely absorbed health-cost increases and effectively took them out of employee compensation. But the erosion of real wage increases that this caused is now too large to ignore. RAND recently estimated that health care consumed 79% of the dollars that otherwise would have gone into paychecks for the average U.S. family during the 2000s. Meanwhile, after the enactment of ObamaCare, premiums in employer-sponsored health plans climbed by 9% in 2011, and they're due to rise another 9.4% by 2014, according to Medicare's actuaries. They further estimate that the increase would be 4.4 percentage points lower without ObamaCare's mandates and rules. . . .

The commercial unit cost trend—the rates insurers pay for services—for 2012 is basically flat, after increasing 5% to 10% over the last decade.

The other important trend in terms of aligning costs and incentives is the growing interest by employers in defined-contribution insurance. Here companies would give their employees a fixed-dollar payment and allow them to choose from a menu of coverage options and make the trade-offs themselves, rather than having their bosses do it for them. . . .

The impulse here is to restore the price signals that will drive U.S. health care to deliver care that is worth the money. But these gains—in transparency and efficient pricing, for instance—will need to be consolidated and expanded to constitute a true revolution. The Affordable Care Act stands in the way.

ObamaCare's core philosophies are standardization and centralization, which in practice will mean higher costs for everyone caused by suffocating price competition. The share of insurance industry revenue that comes from government now stands at 42%, up from 36% just three years ago, and that's before the new entitlement kicks in. And a wave of ObamaCare-promoted provider consolidation is creating hospital monopolies that can demand higher-than-competitive prices.

"Health-care reform" is inevitable. The only question is whether it will run in the direction of prices and choice or more government control."

Governor of Illinois Urges Cuts to Medicaid says this:

"Illinois Gov. Pat Quinn pressed for cuts to Medicaid spending and major pension changes in an annual budget speech that underlined the huge challenges facing one of the country's most indebted states. . . .

"The truth is that over the past 35 years, too many governors and members of the General Assembly have clung to budget fantasies rather than confronting hard realities, especially with respect to pension and Medicaid investments," said Mr. Quinn, who took office three years ago. "Today, our rendezvous with reality has arrived."

Last year, Illinois's Democratic-controlled legislature raised tax rates for individuals and companies. But those levels are scheduled to fall in three years, and lawmakers already have handed tax breaks to some companies to prevent them from moving to lower-cost states.

Mr. Quinn said Illinois must cut spending by $2.7 billion in the coming year on Medicaid, which provides health care for needy and disabled people and has long been favored by Democrats. He said a working group of legislators will have to reconsider all aspects of the program—who is eligible, what services are provided, and how it is paid for—to "save the entire program from collapse."

He assigned another legislative working group to come up with a blueprint for pension reform by April 17, stressing that "everything is on the table." And he said the state will close or consolidate dozens of facilities, including mental-health hospitals and prisons. . . .

Plagued by economic weakness, mismanagement and corruption, Illinois is by some measures the most financially troubled state. It has the largest unfunded pension liability, according to Moody's Investors Service, with accrued liabilities exceeding assets by some $83 billion as of June. . . .

Last month, the state comptroller estimated that the total backlog of unpaid bills owed by state offices—from corporate tax refunds to Medicaid payments—had grown to $8.5 billion."

That leaves Social Security and public education.

The Social Security discussion is easy. It has no funds. All current contributions and more are needed to make payments to current beneficiaries. Yet some people still get upset when Social Security is labeled a Ponzi Scheme. If it's not exactly that, it's close enough for horseshoes.

As for public education funding, it's very much stretched financially. While a portion comes from local property taxes, ~50% comes from state budgets and another 12% comes from the feds, none of the three sources has money to spare.

Of course, local citizens don't want to pay more property taxes, especially when their homes have declined in value. And the federal government and most state governments are teetering financially. Still, we keep spending more on public education and getting less for what we spend. And we pretty much ignore the public sector pension time bomb that's ticking away.

The teachers unions and the doctors' AMA, coupled with government accomplices, are a taxpayer's nightmare when it comes to market based pricing, supply and financial responsibility.

Summing Up

One dollar or unit of production can be used for only one purchase or its equivalent. If we spend that unit of production on Medicare, Medicaid, Social Security, public education or unemployment benefits, it's a done deal.

Unless we produce something to compensate for that demand based expenditure, stimulating yet more demand through government initiatives will only make the hole that much deeper.

Additional government created demand cannot possibly be the answer to any of our financial ills. It will only exacerbate the financial mess we've created for ourselves.

And paying for that new demand with higher taxes would be the wrong thing to do. That's because nothing extra would be produced as a result of raising taxes, and probably less, since we'd be taking money away from a potential investor.

We need more private sector production, as Mill says. How about producing some more oil and gas?

Or how about generating less government spending and waste? Or spending less on post office deliveries? Or reducing the influence of public sector unions and the higher than competitive salaries and benefits they demand and receive?

Or how about letting parents choose the schools their children attend and the prices they pay to do so? Or giving people more choice about medical care, doctor selection, pricing and spending?

Getting more production from cost and quality competitive providers would be very simple. Just give consumers access to useful information about choices, prices and providers, and then allow them to make their own choices.

In other words, take all this demand creation, pricing power and control from the government and give the available money to free individuals participating in a free marketplace.

The lack of supply and high demand for today's "free lunches" would take care of itself in very quick order. And we'd all be better off for having done so.

Thanks. Bob.

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