How I Look at the World

With all the turmoil in the financial markets and increasing unemployment, an increasing number of politicians, including President Obama, have stated that the American economy needs to be be drastically retooled. According to these politicians, our economy has been going down an unsustainable path for years. In order to compete in the 21st century, we need to end our dependence on fossil fuels, develop renewable energy, and fundamentally restructure how capital is injected into technological research. For example, New York Times columnist and author of The World is Flat, Thomas Friedman wrote an op-ed in the Times entitled The Inflection is Here? where he argues among other things that the U.S. economy can no longer be dependent on carbon based fossil fuels and function effectively. Renewable resources are a necessity for continued growth.

Now these may or may not be good ideas. I don't know. No one really knows for sure. The future is unpredictable and advances in technology are impossible to foresee in advance. So how does Barack Obama know what is good for the future of our economy? Well, he doesn't. Let me give you an example of what happens when the government steps in an decides what technology is the key to the future.

When gas prices were high of the past couple of summers, legislation passed mandating the use of ethanol based fuels, mostly for use in diesel engines. Ethanol, which is made from corn, was heralded as a renewable energy source that could be a possible substitute for oil based fuels. However, although the sponsors of the bill were sincere in their attempt to create an new, renewable energy source, political realities and a lack of insight led to several unintended consequences. First, making ethanol from corn is a process that takes a large amount of energy itself, much more than the process of making gasoline from crude oil. These high costs contributed to ethanol's high price relative to oil based fuels, making it less desirable to consumers. Second, because corn is such a high demand commodity, mandating that a certain amount of corn be used for ethanol lowered the supply of corn available for other uses, in turn raising the price of corn. This has had a large impact on a variety of industries that use corn, especially for feed for cattle. Higher corn prices have made it more expensive to raise cattle, a cost which the ranchers have passed on to consumers in the form of higher prices for meat and dairy products. Lastly, these factors have caused ethanol to be much more expensive than fossil fuels, leading to lower demand and an excess of supply. However, the government mandates require a certain amount of ethanol to be produced, regardless of demand, so these artificially high costs for fuel are being imposed on the public, regardless of whether or not there is a true market for ethanol.

In the end, the ethanol mandate has done little to curb the demand for crude oil based fuels, raised the price of corn, and subsidized larger corn farmers with tax money from all across the nation. Now not every governmental interference in the economy will turn out this bad. This instance is illustrative of how politicians, who are often more concerned with political consequences rather than reality, are not well equipped to predict what areas are the most ripe for innovation, or what that innovation will look like.

Well, how then should we react to evolve are economy for global competition throughout the next century. Like I said above, I don't believe that any one person can effectively determine what areas will grow, what will flounder, and how innovation will develop. In order to determine what areas will grow and drive down costs many, many, many different factors from all aspects of the supply chain must be taken into account. There is one mechanism that takes all of these factors into consideration, and it is the most reliable determinate of efficiency: prices.

In a free market system, goods are voluntarily exchanged and transactions are made only if both parties see a benefit. This was one of the most fundamental revelations of Adam Smith's Wealth of Nations. How do they determine if the transaction is beneficial? They rely on prices. The price mechanism serves three major functions in our economy: transmission of information, providing incentives, and distributing income. The first task, transmitting information, is the process by which prices tell the consumer how much effort went into producing a product or service and the value the producer believes these efforts are worth. Next, since inefficient products and processes are more costly than more efficient services, prices provide an incentive to produce products at the lowest cost. Additionally, prices provide producers an incentive to alter their output based on demand. Statically, a producer will ideally operate at the margin: i.e. he will produce as many units possible until the production of the next unit will cause him to not make a profit. Lastly, although not as relevant in this discussion, prices will distribute income to producers who goods and services are most valued by the public.

Why all the talk about prices? It is because the price mechanism is the most efficient and effective way of distributing goods and services to those who value it most. Additionally, prices provide entrepreneurs a way of determining what areas are most promising for new investment. For example, in the energy industry, thanks in large part to the global downturn crude oil prices have dropped dramatically. Currently, crude oil based energy sources are extremely affordable and there is little incentive to innovate with prices so low. So isn't that why we need the government to step in and provide that incentive? Absolutely not. The reason that these innovations have not occurred yet is because they are not necessary. All the rhetoric is that our dependence on fossil fuels will bankrupt our country at the whims of Arab sheiks. No, as the supply of oil continues to decrease, the price of oil will rise. Eventually, the price will rise to a level that will provide enough incentives to entrepreneurs to innovate in the industry and create new, perhaps renewable, sources of energy to drive the economy. This change will not happen until it is economically feasible. In short, capital will be allocated to the energy source that is most affordable at that time. While oil is cheaper, we will use oil. When renewables become cheaper, we will use renewables. If we allow the market to function and private actors, not government officials, choose how to invest in innovate technologies, then the economy will operate in the most efficient way.

I am not against investment in renewable energy sources. I believe that the sources of the investment should come from private entrepreneurs and investors, who themselves will bear the risk of failure, not the entire U.S. public. In a free market, the U.S. government is the only one that doesn't have to play by the rules and deal with the unintended consequences of bad investments.