A streetwise analyst does not expect the typical politician to profess a consistent economic theory. The summits reached by Vladimir Putin in this area would be a matter of analytical wonder if they did not also remind us of the lower peaks where our own political rulers stand–as well as of the poor level of general economic literacy. The readers of yesterday’s Financial Times got two good examples in a single story (“Vladimir Putin Threatens to Cut Oil Output After G7 Price Cap,” December 9, 2022). Putin is quoted as saying: If someone agrees at some point that the consumer determines the price, then the whole industry will collapse, because the consumer will always insist on a lower price. Since the consumer always wants to pay the lowest possible price (“insists on a lower price”), one wonders why all industries don’t collapse. Another pearl reported in the Financial Times story (paraphrasing and then quoting Putin): If buyers do manage to get lower prices for oil, “prices will go down, investment will be reduced to zero, and in the end prices will go through the roof.” This is what, in a previous EconLog post, I called the yo-yo economic model. A simple confusion between supply and quantity supplied, and between demand and quantity demanded, leads to this sort of reasoning: if demand decreases, prices will go down; if prices go down, demand will increase; if demand increases, prices with go up (“go through the roof”); and the cycle will repeat. “What goes up must go down.” The confusion is between a move along the demand or supply curve and a shift in the whole curve. (Incidentally, one advantage of a mathematical representation of supply and demand is that one sees that immediately.) In defense of Mr. Putin in both cases, if we can call this a defense, he may have been speaking of the consumer or producer as a nation or country, for he cannot imagine anything else, even as an ideal, than a collective consumer and a collective producer. Run-of-the-mill protectionists fall in the same collectivist trap. (1 COMMENTS)

In 2021, venture capital investment will reach a record US$15.7 billion in Latin America, more than the amount attracted by startups in the region over the past ten years, according to the Latin American Private Equity Investment Association (LAVCA). In the local environment, Colombia today has 1,100 startups and its entrepreneurial ecosystem is one of the four most competitive in the region, together with Brazil, Mexico, and Argentina. According to KPMG’s Colombia Tech Report 2021, the country’s startups raised more than US$800 million last year. Sadly, the promising future for these companies is about to change forever. On August 8, 2022, a bill was filed before the Congress of the Republic to adopt a new tax reform in Colombia, which aims to raise 25.9 billion annually. The tax reform bill presented contains rules that directly impact both tech-based ventures whose development is based on growth and exit strategy (highly scalable startups backed by venture capital) and those whose nature or objective is not the medium-term sale of the company but rather profit through dividends (more “traditional” ventures). The startup business works very differently from traditional companies, so these valuations often do not reflect the company’s actual value. For example, a company valued at US$500 million does not have that kind of money in equity. Venture capitalists consider “intangible assets” and not the company’s money.   How will this affect the industry? Although the equity tax already existed (for those who owned as of January 1 of each year, a net worth equal to or greater than 5 billion Colombian pesos), with the new reform, both the taxable base and how the shares owned in a company are valued are modified. Previously the nominal value (acquisition value) was taken – and now the intrinsic value (net worth divided by the number of shares outstanding) is proposed. This new form of valuation seeks to reflect the equity reality of the shareholders of those consolidated companies, i.e., the source of income and considerable profits that take into account the contributive capacity, an objective that was not achieved with the previous rule. The tax reform aims to increase the occasional profit tax, which is currently at a rate of 10% to 15%. Does the government want to discourage money, a product of several years of hard work in entrepreneurship, brought back to Colombia to continue generating development by investing in new startups or donating it to social causes? Elimination of the 50% discount on the Industry and Commerce Tax – ICA. Article 115 of the ETN contemplates the possibility, at the entrepreneur’s choice, of: i) taking 50% of the industry and commerce tax (ICA) as a tax discount or ii) a 100% deduction of the ICA in the income tax. The reform bill eliminates this benefit and leaves only the possibility of taking it as a 100% income tax deduction. The difference is that the discount is applied directly to the tax already paid, while the deduction is part of the subtracted items to determine the tax. The impact will depend on each case, but as a general rule, a 50% discount is more beneficial than a 100% deduction of the ICA tax. This modification would imply a higher tax burden for ventures that are in the commercial, industrial, or service businesses, meaning that e-commerce entrepreneurs will now have to pay more income tax because of this change.   Elimination of the orange economy benefit Before this reform, entrepreneurs from creative industries who won the orange economy benefit were allowed to pay 0% income tax for 5 years. But now, this would not be possible. According to the principle of non-retroactivity of taxation provided in article 363 of the Colombian Constitution, those ventures that benefited from the exempt income programs of the orange economy program provided in article 235-2 of the ETN continue to maintain 100% of the exempt income for the years granted. However, unfortunately, the benefit would be lost for entrepreneurs who would like to access it in the future.   35% income tax rate for large and small businesses alike. Although the reform would not modify the income tax rate for legal entities and maintains it at 35%, it does not provide special treatment or rates for startups. While it is true that during the early years, startups do not yield profits, precisely because all their income and capital are destined for the growth of the company, it can happen, and taxing a startup with an income tax at a rate of 35% is to leave the entrepreneur without any incentive. The reform aims to increase the payment rate for dividend distributions, which are currently subject to 10% and could reach up to 39%. For non-residents (individuals and corporations), a withholding tax of 20% will be applied.   What do companies think about it? Faced with this “reform,” Endeavor entrepreneurs launched a counter proposal before the tax reform project in Colombia. They propose an exception so that the value of the shares revolves around the fiscal cost, not the intrinsic value. Daniel Botero Acevedo, co-founder, and CEO of Lizit, said that the tax reform would virtually wipe out the ecosystem of startups or fast-growing digital ventures in Colombia. In conclusion, the National Government must understand the entrepreneurial ecosystem and establish differentiated and progressive tax rules and combined tariffs that allow them to be competitive with their peers in other countries.   Michelle Bernier is an attorney specializing in international law and commercial law. She is currently studying Master of Laws and International Business with a double degree from the Universidad Internacional Iberoamericana in Mexico and the Universidad Europea del Atlántico. She is also a part of Students for Liberty’s inaugural cohort of Fellowship for Freedom in India.   (0 COMMENTS)

Good plan, Pat. Theranos’s victims, Judge Davila said, include venture-capital firms Lucas Venture Group and Peer Venture Partners, and individual investors including Pat Mendenhall of U.S. Capital Advisors LLC; Richard Kovacevich, the ex-CEO of Wells Fargo & Co.; and Rupert Murdoch. Mr. Murdoch, who invested $125 million in Theranos, is the executive chairman of News Corp, which owns the Journal. “We all screwed up,” said Mr. Mendenhall, an early Theranos investor who testified against Mr. Balwani. “I will never, ever invest in any company again without audited financials.” This is from Heather Somerville and Christopher Weaver, “Balwani Gets 13-Year Sentence,” Wall Street Journal, December 8, 2022 (print edition.) Balwani, in case you haven’t followed, was the president of Theranos, the firm that claimed to have a revolutionary blood test machine that . . . wasn’t. I’ve been following this since reading Bad Blood: Secrets and Lies in a Silicon Valley Startup, John Carreyrou’s excellent book on Theranos. (0 COMMENTS)

This is what happens when a country refuses to give in to bullying: In November 2020, accompanying its import bans, China produced a list of 14 grievances and demanded that Australia “correct” its behaviour. Mr Morrison ignored the demand, and took China to the WTO over its barley and wine bans. Yet now China has relented. This was consistent with Mr Xi’s broader charm offensive in Bali. And no doubt the advent of Mr Albanese, a less abrasive prime minister, provided cover for the climbdown. At bottom, though, Australia’s refusal to bend meant the Chinese approach was just not working. It is a lesson, says Malcolm Turnbull, Australia’s prime minister from 2015 to 2018, universally applicable to victims of bullying: “Stand your ground.” If all countries responded in this way, the world would see less bullying.  Unfortunately, not all countries are willing to stand their ground. The US government recently gave in to bullying from Russia, which essentially kidnapped a US basketball player and held her hostage as a bargaining chip in negotiations to free a convicted arms dealer.  It is tempting to view this prisoner sway as a “humanitarian” gesture, but just the opposite is true.  The fact that Russia’s tactics were successful insures that more people will be used this way in the future.  In the long run, there will be more hostages taken as a result of the US government decision to give in to the Russian demands. This is a perfect example of what economists call the “time inconsistency problem”.  Actions that seem beneficial in the short run may end up being very costly in the long run. (1 COMMENTS)

American Enterprise Institute economist Michael Strain has a new paper looking at the relationship between wages and worker productivity and concludes that, contrary to common belief, the link between wages and productivity is strong. I say “contrary to common belief” because the prevailing view is that the once-tight link connecting wages to productivity has been severed (illustrated by a nice chart). In other words, somehow wages for the last few decades have not kept up with productivity growth and, as a result, there is today a real productivity-pay gap. The gap has been used to make the case, on both the left and the right, for allegedly corrective interventions, such as higher minimum wages and wage subsidies. As Strain shows in his paper, however, the alleged gap is an artifact of methodological choices made regarding how to calculate the relationship between productivity and earnings. A more careful and comprehensive analysis of real worker pay and productivity data shows that worker compensation does indeed remain closely linked to worker productivity. Strain starts his paper with a nice discussion about how we should think about wages. He presents the simple economic model and then notes that “In reality, the labor market for an industry or a geographic area—to say nothing of the U.S. labor market as a whole—likely never reaches equilibrium.” In part that’s because nominal wages are sticky, but also playing roles are minimum wages, international-trade patterns, and technological changes. In addition, employers do have more power at setting wages than the simple model states. Strain then goes into which workers should be included in the calculation of the productivity-pay gap. He thinks that most workers should be included, but he is also open to arguments made on the left that managers should be excluded when studying the relationship. He nevertheless concludes that: In addition to the typical worker’s wages, it is also of interest to study the relationship between productivity and the average wage of all workers in the economy. The logic here is straightforward: If you are using economy-wide productivity to study the relationship between productivity and wages, then you should use economy-wide wages as well. While it is true that wages have been growing relatively faster for high wage workers over the past several decades, it may also be true that the productivity of those workers has been growing relatively faster. Excluding them from the analysis may leave a key piece of the puzzle missing. In addition, if the underlying reason for interest in the relationship between productivity and wages is not to see how workers’ standards of living have evolved with productivity, but instead to study how firms compensate workers in their role as a key input to production, then it’s desirable to study the average wage of all workers, not just of production and non-supervisory workers. Next, Strain looks at “which measure of inflation should be used to convert nominal wages into real wages.” He concludes, as have many others, that, …when investigating the relationship between wages and productivity, a strong case can be made that wages should be deflated using a measure of the change in the prices of goods and services produced by businesses, not those consumed by workers. Economic theory predicts that workers are paid according to the marginal product of what they produce, not what they consume. Thus, an output price deflator is most appropriate. He also correctly makes the case that to capture the relationship between worker pay and productivity correctly, investigators should use total compensation rather than just wages. This point is particularly important since about one third of employee compensation today is paid in the form of benefits. Benefits, of course, are compensation paid to workers no less than are money wages. Here’s what I wrote a while back for Reason magazine: According to the Federal Reserve Bank of St. Louis, inflation-adjusted wages have grown by just 2.7 percent in the last 40 years. But inflation-adjusted total compensation—wages plus fringe benefits, such as health insurance, disability insurance, and paid vacation, along with employer-paid Social Security and Medicare taxes—increased by more than 60 percent in the same period. Wages still make up a significant share of your total compensation: 68.3 percent, according to 2017 data from the Bureau of Labor Statistics, vs. 31.7 percent that goes to benefits. But that latter piece has grown significantly, in no small part due to the rising cost of health insurance. And that trend is only going to get worse. Strain’s final argument is that a better way to measure productivity is to use net output rather than gross output. The main reason is that “gross output includes capital depreciation, while net output does not. Since depreciation is not a source of income, net output is the better measure to use when investigating the link between worker compensation and productivity.” He puts it all together and concludes: When properly measured, with variable definitions based on the most appropriate understanding of the relevant underlying economic concepts, trends in compensation and productivity have been very similar over the past several decades. Of course, it is also the case that two variables can evolve similarly over time without necessarily being related. But this chart, combined with the statistical evidence in the Stansbury and Summers paper and economic theory, provides compelling evidence that productivity and compensation are strongly related. Here is the Anna Stansbury and Larry Summers paper. I couldn’t copy the chart he has in the paper, so I am adding this chart I made a few years ago making roughly the same case. Here it is:   The Strain paper is here and well worth reading.   Veronique de Rugy is a Senior research fellow at the Mercatus Center and syndicated columnist at Creators. (0 COMMENTS)

The first decades of Irish independence would have been an economic disappointment to those who birthed the nation in 1922. Then, Irish per capita GDP was 56% that of the United Kingdom: by 1988 it had risen to just 64% and The Economist carried an article on Ireland titled ‘The poorest of the rich’. Figure 1: Irish GDP per capita as % of United Kingdom’s Source: Maddison Project   In 1997 Irish per capita GDP exceeded that of the United Kingdom for the first time (Figure 1) and The Economist now hailed the ‘Celtic Tiger’. Why did Ireland, so poor, suddenly become so rich?   The poorest of the rich Ireland’s economy was badly mismanaged in the 1970s. Governments ran ever larger deficits and as a share of GDP Irish government debt rose from 40% in 1971 to 95% in 1991. This brought no economic benefit: unemployment rose from 6.6% in 1971 to 17.6% in 1987. The economist Dermot McAleese wrote that “high taxes, low confidence, high labour costs, excessive regulation and anti-competitive practices” plagued the Irish economy in the 1980s. Ireland’s accession to the European Economic Community in 1973 brought no respite from these economic woes.   The Celtic Tiger By the end of the 1980s it was obvious that this was unsustainable. The government — with wide support — slashed spending and made credible commitments not to run deficits or inflate the currency. It deregulated and lowered tax rates. The 2002 Index of Economic Freedom ranked Ireland the world’s 4th freest economy. Ireland’s corporate tax rate – 12.5% – is famously low, but there was more to Celtic Tiger fiscal policy than that. As economist Sean Dorgan argues, since 1987: …personal tax rates have been reduced progressively from a base rate of 35 percent to 20 percent and from a top rate of 58 percent to 42 percent. Tax bands (brackets) have also been broadened so that the higher rate now applies to higher income levels than before. The power of low rates was also shown when the 40 percent capital gains tax rate was halved in 1999 to 20 percent and revenue increased by 50 percent in one year and by 270 percent over three years. McAleese argues that controlling government spending was crucial: The espousal of fiscal rectitude and new consensus economic policies was not in fact new. What was new was the decision to attack the debt by controlling public spending, rather than by increasing taxes. For a small, open economy, curbing public spending proved a far more productive way forward. It created room for tax cuts while simultaneously lowering the debt ratio. Another ploy was the introduction of a tax amnesty. Following on the high tax policy of the 1980s and the reorientation in fiscal policy, it proved hugely successful in terms of revenue generation. Domestic interest rates fell steeply as investor confidence grew, thus starting off that rare occurrence in modern economics, an expansionary fiscal contraction. Fears that strong fiscal contraction would prove deflationary were confounded, though precisely why this was so remains the subject of controversy. The results were striking. Ireland’s economy grew at an average annual rate of 9.4 percent between 1995 and 2000. Real GDP growth outpaced that in the United Kingdom in every year from 1989 to 2003 and of the United States in every year after 1993. While Ireland’s GDP grew by 229 percent between 1987 and 2007, the figure was 161% for the United States and 152% for the United Kingdom. Government debt fell from 95% of GDP in 1991 to 25% in 2007 and unemployment fell from 17.6% in 1987 to 3.4% in 2001.   The bust In 2008 this came to a shuddering halt. Growth collapsed and government debt and unemployment rocketed. Some blamed Ireland’s low tax and light regulation policies. The reality was rather different, as economist Patrick Honohan explained: Until about 2000, the growth had been on a secure export-led basis, underpinned by wage restraint. However, from about 2000 the character of the growth changed: a property price and construction bubble took hold…Among the triggers for the property bubble was the sharp fall in interest rates following euro membership.  In short, there had been a good Celtic Tiger, based on sound money, low taxes, and light regulation, which had been replaced by a bad Celtic Tiger based on cheap credit following Ireland’s entry into the euro. True, there was much to condemn in the excesses of the boom’s later stages, but the fiscal and regulatory policies which had spurred a decade of solid growth were not among them.   The primacy of domestic policy (again) In the century since ‘Irexit’ from the United Kingdom, Ireland’s economy has fared badly and fared well. Whether it has fared badly or well has not primarily, or even largely, been determined by its membership of the United Kingdom or even the European Union. It has been determined primarily, instead, by domestic policy decisions. So it will be with other more recent ‘exits’.   John Phelan is an Economist at Center of the American Experiment. (0 COMMENTS)

I found this article by Alex J. Pollock and Paul H. Kupiec, “Profligacy in Lockstep,” at our sister site “Law and Liberty,” interesting. It’s about the financial position of many of the world’s central banks. A large part of the Pollock/Kupiek discussion is about marking assets to market. I sent the link to monetary economist Jeff Hummel for his comments. Here’s what he wrote: As I’ve pointed out several times before, including here (https://www.econlib.org/is-the-fed-likely-to-go-bankrupt/), marking the Fed’s balance sheet to market tells you little, because nowadays the Fed rarely sells assets before maturity. Even when tapering, the Fed usually just fails to replace maturing assets with new purchases. I don’t know to what extent this applies to other central banks. Back when central banks purchased assets solely by creating money, as did the Fed before the financial crisis, any losses were far less likely, less severe, and temporary, even if they marked their balance sheets to market. Minor losses might result from bad loans to private banks or operating expenses that were unusually high. But only a government default could result in major losses. What has changed that situation is central banks now paying interest on reserves and borrowing in other ways (as with Fed reverse repos) to finance their purchases of interest-earning assets. On the asset side, the Fed is in much better shape than the European Central Bank (ECB.) Although the Fed temporarily acquired fully private assets during the financial and Covid crises, it eventually unloaded most of them with few if any losses. It has not even made any significant discount loans to private banks for a long time. As a result, its interest-paying assets consist almost entirely of Treasuries and government-guaranteed mortgage-backed securities (MBS.) Thus only a Treasury default could really threaten the Fed’s solvency. The ECB, on the other hand, faced restrictions on buying sovereign debt when it was first created and held mainly private assets. Since the European debt crisis, it has been freer to acquire sovereign debt, but it still holds a lot of private assets. Moreover, not all European sovereign debt is equally sound. This makes the ECB’s solvency much more vulnerable to market factors. Pollock and Kupiec are correct that the ECB is not very transparent and considerably less so than the Fed. My own efforts to find out what precise assets are on the ECB’s balance sheet has not been very successful. The Pollock/Kupiek article states: “This idea would not help the Federal Reserve, because it owns no gold.” That’s technically correct because the Fed holds only gold certificates. But those are demand claims against the Treasury’s gold. So their statement is misleading. I (DRH) checked the Federal Reserve’s holding of gold certificates, which, in the Fed’s balance sheet, it calls “Gold stock.” It is valued at $11.041 billion. But a footnote explains that the value is based on a gold price of $42.22 per fine troy ounce. In reality gold currently sells for about $1,778.00. So the real value of the good holdings by the Federal Reserve is not $11 billion but, rather, $465 billion. (0 COMMENTS)

Tyler Cowen broke the sad news that Walter Grinder passed away. Tyler was one of the many intellectual protégées of Walter- certainly the most prominent and successful, the one with whom Walter felt the stronger bond, as he met Tyler when the latter was a teenager. But Walter, as the engine behind the Institute of Humane Studies, played a similar role to many, whom he gently and wisely steered in several new avenues of research. Never underestimate the role of the person who puts a good book in your hands. Particularly if he imagines you could expand your views thanks to it and perhaps use it to see the world from perspectives you did not imagine before. Walter did precisely that to perhaps countless people, some of whom honoured his sagacity by building on his insights, becoming thoughtful academics or serious think tankers. In the last few years, when he was already seriously debilitated by illness, Walter did that predominantly by e-mail, engaging with a younger generation of libertarian scholars and authors that he perhaps never met in person. I was privileged to be in his e-mail list. Walter was not sending around comments or reviews to show his erudition off: he was writing about works he considered important and eye-opening, to carefully assembled mailing lists of people that he thought could benefit of those. I have myself met him only once, in early 2020 (before Covid). I know he corresponded, and rather intensely, with colleagues whose faces he never knew. This is an effort too easily dismissed as the pastime of an old man. Walter was again playing, as the circumstances allowed him, the role of the intellectual impresario that so suited him. He belonged to the generation of libertarian scholars who envisioned and built the modern libertarian movement. A few of those, most notably Murray N. Rothbard, were constantly writing and producing page after page as ammunition for this new small movement. Others were quieter, like Walter and his friend Leonard Liggio, but weaving the web of connections and institutions which allowed the following generation of libertarian scholars to benefit from opportunities unknown to them. Walter edited a new edition of Albert J. Nock’s Our Enemy, the State and Capital, Expectations, and the Market Process by Ludwig Lachmann, an author he helped many to appreciate better. He wrote many articles, always insightful, some of which can be found online. In the last few years, he was working, with John Hagel III, on a paper entitled “Evolving Liberalism to Thrive”, which I hope will still see the light. He was planning, if I’m right, for his books to be donated to the Institute of Liberal Studies in Canada. I hope this happened and that we may all go visit a “Walter Grinder Library” soon. In different moments in history, classical liberalism shows different nuances. It is largely because of the circumstances, but also because of the personality of some highly influential authors. Vilfredo Pareto, for example, was very upset with some of the late 19th century liberals. He thought they were overemphasizing reasons for optimism, inebriated as they were by economic growth, and they forgot a key lesson by one of their very heroes, Frédéric Bastiat. That is, that government is basically plunder, and that exploitation mechanisms lie behind any kind of government. This was an insight never lost on Walter. It may have been for generational reasons, because they lived through WWII and then the Korean war and, of course, because of Vietnam, or because of the influence of the so-called “old right,” or because they were scoffed by the “cold warriors,” but I think the great libertarians of Walter’s generation tended to have clearer in their mind the indissoluble link between government and violence. Perhaps Walter’s way of thinking is still best expressed in “Toward a Theory of State Capitalism: Ultimate Decision-Making and Class Structure”, written with John Hagel in the 1970s. He was certainly distressed by the reemergence of militarism, as he was by the lack of historical curiosity by some of the contemporary libertarian economists and pundits. He was a very good man, intellectually as honest as he was pugnacious. May we do a fraction of the good he did, for this movement. (0 COMMENTS)

In recent months, the US government has tried to make it more difficult for China to access cutting edge chip technology from American firms, as well as from our allies.  Back in March, Ben Thompson discussed one consequence of delinking from China: This point applies to semiconductors broadly: as long as China needs U.S. technology or TSMC manufacturing, it is heavily incentivized to not take action against Taiwan; when and if China develops its own technology, whether now or many years from now, that deterrence is no longer a factor. In October, Thompson expanded upon that warning: China meanwhile, has had good reason to keep TSMC around, even as it built up its own trailing edge fabs: the country needs cutting edge chips, and TSMC makes them. However, if those chips are cut off, then what use is TSMC to China? . . . the more that China builds up its chip capabilities — even if that is only at trailing nodes — the more motivation there is to make TSMC a target, not only to deny the U.S. its advanced capabilities, but also the basic chips that are more integral to everyday life than we ever realized. Bloomberg points out that the US is heavily reliant on Taiwan’s chips, and that even the new TSMC factory being built in Phoenix will not change that reality: TSMC’s Arizona fabs will produce 600,000 wafers annually. That sounds impressive, but it’s really not. The Taiwanese company topped 14.2 million last year and is on track to churn out 15.4 million 12-inch wafers loaded with chips this year. If it keeps the same average capacity growth of 8.1% it achieved over the past five years, Arizona will account for just 2.85% of its 21 million annual global output in 2026. That’s a drop in the bucket, not a game changer. In my view, this exercise in industrial policy merely papers over the fundamental problem, which is a lack of talent: TSMC founder Morris Chang has poured cold water on the US ability to compete. “There’s a lack of manufacturing talents to begin with,” Chang told The Brookings Institution earlier this year. “We did it at the urging of the US government, and we felt that we should do it.” If the government were serious about competing with China they’d be changing our immigration laws to attract more engineering talent, not building white elephants in the Arizona desert: Research, development, planning and operations will all remain in Taiwan. Should Beijing decide to attack, those functions will cease at least temporarily, if not permanently. This would mean cutting TSMC Arizona off from all the crucial know-how it needs to run the minuscule capacity it has on US soil. (0 COMMENTS)

Moral hazard is an important and badly named idea in the economics toolkit. Important, because it identifies how certain arrangements can encourage inefficient or wasteful behavior. Badly named, because anyone hearing it for the first time would have no idea what it means. Luckily, it’s easy to understand. Imagine you’re out to dinner with nine friends, so there are ten of you in total at dinner. Let’s say it’s been agreed that there will be one bill, and everyone will share the bill equally regardless of his or her individual orders. If you’re like me at all, you probably involuntarily winced a bit just reading that. You likely recognized that this situation creates moral hazard, even if you didn’t know the term. Here’s the moral hazard problem. Imagine it comes time to order dessert. One member of the party is nearly full and knows he probably wouldn’t be able to finish a dessert order. Desserts are priced at $10, but given how full he is, he wouldn’t be willing to pay more than $5. In normal circumstances, since the price of the dessert is $10 but it’s valued at only $5, he wouldn’t place the order. But wait! Since the bill is being split evenly with the whole party, his marginal cost for ordering dessert is only $1 – the other $9 is paid for by the rest of the party. Suddenly, ordering dessert looks like a good deal – for him, anyway. Since most of the costs are paid by other people, a cost sharing system creates an incentive for someone to impose $9 in costs on the group to acquire something they only value at $5, at a cost of only $1 to themselves. Of course, dear reader, you would never do such a thing at that kind of dinner party. Neither would I. Doing that would be behaving like (to use a technical term) a total jerk. If you’re with a small group of friends, in a face-to-face situation, you’re unlikely to act like a jerk in that way – you’d feel bad. So, in small groups, moral hazard can be offset by social norms and good manners. But in large groups, where the “others” who would bear the costs are faceless and anonymous to you, moral hazard rears its ugly head much more strongly, and people don’t feel like jerks anymore for engaging in what is fundamentally the same behavior. Moral hazard is particularly strong in the health insurance market. Economist Amy Finkelstein has done some good work examining how it manifests. She looks at two different forms of moral hazard created by health insurance – ex-ante moral hazard, and ex-post moral hazard. Ex-ante moral hazard would occur if someone says, “Well, now that I have health insurance, I don’t need to put as much effort into taking care of myself.” According to her research, this is theoretically possible, but it doesn’t seem to be a big issue in practice. Ex-post moral hazard, by contrast, is the tendency to overconsume healthcare once insurance is acquired, because most of the costs are being paid for by someone else. Here, the evidence for moral hazard is much stronger – and the overuse of healthcare created by this incentive structure is one important factor driving up health care costs for everyone. But there’s another kind of moral hazard as well – what Jonathan Gruber calls provider-side moral hazard. Here’s how he describes it: “This issue is best summarized in the saying that having a doctor tell you how much medical care to get is kind of like having a butcher tell you how much red meat to eat. What we face in the United States is a broken fee-for-service health care system where physicians and providers are paid based on how much care they deliver, not on how healthy they make you.” (What created this fee-for-service system with all its terrible incentives that Gruber rightly laments? Government regulation, with a hefty dose of lobbying and regulatory capture.) All this came to mind recently when I received an email from my health care organization. This email encouraged me to check with my insurance company to see if I had reached my maximum out-of-pocket costs for health care this year. And if I had, according to this email, I should make sure to book as many medical appointments as I possibly can between now and the end of the year – after all, I won’t be paying anything additional for it! But it would create a lot of opportunities for the doctors to bill the insurance company. A more perfect example of both ex-post and provider-side moral hazard could hardly be asked for, or more shamelessly flaunted. As it happens, I have in fact reached my out-of-pocket maximum for the year. And there are probably several things I could think of for which to see a doctor. But nothing I’d have gone to the doctor for if I had to pay even a trivial out of pocket expense. So I’m not planning on booking any appointments in response to this email. Unlike the hypothetical dinner party above, the additional costs would be paid by others who are faceless and anonymous to me, but still, the behavior is the same. The study of economics, and of classical liberal and libertarian philosophy, causes me to view my behavior with a more comprehensive mode of sympathy that I’ve written about before. Being comfortable with offloading the costs of my behavior onto faceless “others” doesn’t fit with the kind of person I want to be. They may not be my friends at a dinner party, but they should be respected all the same.   Kevin Corcoran is a Marine Corps veteran and a consultant in healthcare economics and analytics and holds a Bachelor of Science in Economics from George Mason University.  (0 COMMENTS)