Boiling America's economy

WASHINGTON, DC — It is said that if you put a frog in boiling water, it immediately jumps out; but if you put it in cold water and gradually turn up the heat, it does not react, and is eventually boiled to death. Something similar can happen to economies.

If inflation accelerates, the public demands that leaders rein in prices with tighter macroeconomic policies. But if the authorities start interfering in individual industries with ad hoc tariffs, price controls, subsidies, taxes and regulations, there is no such popular reaction, so the interventions are allowed to continue creating inefficiencies and undermining growth.

Both inflation and the ad hoc interventions, sometimes referred to as industrial policy, distort the economy and result in lower economic growth. But inflation triggers a quick response. An economy-wide phenomenon, it gains momentum as one group after another seeks to restore or increase its real returns. But at a certain point, people begin to object. From then on, as the rate of inflation rises, pressure on policymakers to reduce it intensifies. Once inflation is subdued, growth can resume.

By contrast, the impact of targeted tariffs and industry-specific measures at any point in time, or in any one sector of the economy, is usually relatively small. Though they contribute inflationary pressure, reduce the economy’s flexibility, and weaken growth, they tend to be less noticed than a surge in inflation, so the public is unlikely to reject them. Moreover, the prospect of lowering a tariff or removing a subsidy is typically met with strong resistance by the affected industry. So, whereas curbing inflation is a political imperative, reversing distortionary ad hoc measures is politically difficult.

The United States today illustrates this dynamic. US President Joe Biden’s administration has bemoaned inflationary pressures and supported the US Federal Reserve in its efforts to rein in price increases. But it has also sharply increased government expenditure through the Inflation Reduction Act (IRA), and introduced or upheld widespread industry-specific regulations, most of which are inflationary.

Inflation may have peaked in the US, but ad hoc interventions still have plenty of momentum. Donald Trump’s tariffs on steel and aluminum imports, which Biden did not remove, have resulted in the world’s highest steel costs. This means that production costs are rising in any industry that relies on large amounts of steel, say, automobile manufacturers. Meanwhile, American producers of electric vehicles are receiving subsidies and tax breaks.

The Biden administration is also imposing tariffs on solar-panel imports, despite its concern for the environment. It has created large subsidies and other incentives for investment in semiconductors and batteries. It has capped the price of some prescription drugs, such as insulin, for elderly Medicare patients, with price ceilings set to be imposed on additional drugs each year, and has introduced a requirement for the government to negotiate prices of some drugs — measures that could lead to shortages and impede the development of cheaper generic drugs.

Biden has also increased the domestic content threshold for government purchases and required that government procurement maximizes the use of US inputs and supports greater domestic production. In doing so, he has restricted the scope of a decades-old agreement among World Trade Organisation (WTO) members obliging them not to discriminate in government procurement against goods from participating countries.

The WTO agreement led to falling costs for all signatories, saving taxpayers money. The US paid less for items it purchased while exporting goods to other governments for which American costs were lower. Biden’s intervention is now raising the cost of American government purchases (including materials for investment under the IRA) and making it more likely that other countries will retaliate, resulting in reduced purchases from America.

In most advanced economies, agriculture is regulated in ways that buttress farm prices. Price supports and restrictions on planting have raised food prices and reduced the sector’s efficiency. The US also regulates the quantity of sugar imports, despite there being few sugar producers left in the country, so Americans pay almost double the global average for sugar. This puts US producers of cakes and candy at a competitive disadvantage.

A final example of ad hoc interventions in the economy, it would be impossible to enumerate them all — relates to infant formula. During the COVID-19 pandemic, there was a major shortage of this crucial good after a single key factory was forced to close. Foreign producers, such as in Canada, meet the same standards as their US-based counterparts, but restrictions on the quantity imported, and high tariffs on the goods that do enter the US, keep their formula out of American parents’ hands.

It did not help that the federal government’s nutrition program for women, infants, and children, known as WIC, has historically limited each state to one manufacturer of approved formula. Since WIC accounts for about half of all purchases of infant formula in the US, this requirement has helped a few brands gain market dominance.

Direct intervention in particular economic activities or sectors carries high costs, distorting economic activity, raising prices and reducing growth. Some interventions, such as subsidies, can be dangerous, not least because they can suggest favouritism and even outright corruption.

Moreover, with technology changing rapidly, we need new market entrants, for whom regulations are costly. Compounding the problem, for government regulators to do their job well, they must understand the activity they are regulating. But the government compensates its employees less than the private sector does, and industry experts can work on either side.

The US has reached global pre-eminence partly because of its commitment to ensuring a level playing field for the private sector. The industrial policy it engaged in, such as investments in education, infrastructure, and research, aligned with that commitment. But as interventions proliferate and deepen, so, too, do the risks to America’s global economic primacy.

Anne O. Krueger, a former World Bank chief economist and former first deputy managing director of the International Monetary Fund, is senior research professor of International Economics at the Johns Hopkins University School of Advanced International Studies and senior fellow at the Centre for International Development at Stanford University. Copyright: Project Syndicate, 2023. www.project-syndicate.org