Monday, August 17, 2009

Twenty years ago, as young and impressionable undergraduates, we enrolled in Harvard University Professor Lawrence H. Summers’ public-sector economics course. Mr. Summers had a legendary reputation as a remarkable intellect unwilling to tolerate sloppy reasoning and mundane questions, so we approached his class with awe and fear.

We worked hard, enjoyed the intellectual challenge, and learned a great deal.

We now consider the policies championed by our former mentor from his new post as President Obama’s chief economic adviser. We wonder: What would Professor Summers think of Economic Adviser Summers? A few key lessons from his course would seem to conflict with the policies he now promotes.

Lesson No. 1: Policies that broaden the tax base and lower marginal rates enhance economic efficiency. Professor Summers taught us that the dead weight loss (or economic inefficiency) from taxation increases with the square of the tax rate. Therefore, government should strive to broaden the tax base and lower marginal rates. The current administration — apparently with the blessings of Economic Adviser Summers — seeks to use the tax code to engage in social engineering, often resulting in proposals that narrow the tax base and raise marginal rates. Such policies may redistribute income, but will surely harm economic efficiency.

Lesson No. 2: Federal deficits ultimately drive up real interest rates and crowd out private investment.

Severe economic downturns, particularly liquidity traps, may justify increased federal spending. However, unprecedented government deficits come at a cost. As a professor, Mr. Summers taught us supply and demand - massive government borrowing demands will cause interest rates to rise. The administration promises to rein in these deficits in the years ahead, but experience tells us “temporary” government spending programs prove remarkably permanent. Higher interest rates and the crowding out of private investment ultimately will imperil long-term economic growth.

Lesson No. 3: Markets depend on stable and consistent laws and regulations. Professor Summers taught us that markets function best when government establishes a sound legal system and protects property rights. Put simply, government must create and enforce the rules of the game in a consistent manner. The recent treatment of bond holders at Chrysler LLC and General Motors Corp. appears to undermine the rule of law. While Economic Adviser Summers trumpets the jobs “saved” by the auto bailout, Professor Summers surely would have realized that trouncing on bondholders’ legal rights will increase the cost of capital for all U.S. corporations and ultimately lead to fewer American jobs.

Lesson No. 4: Government has the potential, but not necessarily the ability, to correct for market failures. Markets are not perfect, and market failures harm economic efficiency. However, the costs of government failure often exceed the costs of market failure. The likelihood of government blunders surely rises when presidents, Treasury secretaries and economic advisers who have rarely worked in the private sector begin nationalizing complex industries like banking, health care and automobiles.

Lesson No. 5: Tax policy drives up the cost of health care. Current tax policy taxes wages, but not health care benefits. That discrepancy distorts people’s behavior by making certain forms of compensation (benefits) more attractive than others (wages). This incentive leads employees to select policies with low deductibles and co-pays, which means they bear minimal cost when deciding to seek medical care. Therefore, tax policy pushes up demand, and thereby prices, for both health insurance and medical care.

The current proposals for health care reform make bold promises of cost reductions, yet they do little to address the basic incentives that drive up health care spending. Professor Summers taught us there is no free lunch.

We believe the American people can benefit from the wisdom and insight of Professor Summers. We worry though that political ideologies and agendas may be leading to policies today that would have been subject to a withering critique in that Harvard classroom 20 years ago.

Michael A. Roberto is the trustee professor of management at Bryant University in Rhode Island, and author of “Know What You Don’t Know” (Wharton School Publishing, 2009). Brian L. Gaspardo is managing partner of O’Neill and Gaspardo LLC in Oak Brook Terrace, Ill.

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