The Ecosocialist Critique of Capitalism vs. Real World Socialism

It has been twenty years now since first glasnost and then the collapse of the USSR lifted the curtain on the appalling environmental record of Soviet socialism. Over that same 20 years, the burgeoning economy of socialist China has overtaken the United States as the world's largest emitter of greenhouse gasses. Still, it remains common to hear capitalism singled out as the greatest environmental threat to our planet, and socialism as its salvation.

A forceful statement of the environmentalist case against capitalism can be found in the Belem Ecosocialist Declaration, the product of a conference held in Paris in 2007. That document sets out a simple chain of cause and effect: Capitalism requires profit, profit requires growth, and growth means environmental destruction. Here are some excerpts:

Humanity today faces a stark choice: ecosocialism or barbarism. . . .We need no more proof of the barbarity of capitalism, the parasitical system that exploits humanity and nature alike. Its sole motor is the imperative toward profit and thus the need for constant growth. . . . Capitalism’s need for growth exists on every level, from the individual enterprise to the system as a whole. The insatiable hunger of corporations is facilitated by imperialist expansion in search of ever greater access to natural resources . . . . The capitalist economic system cannot tolerate limits on growth; its constant need to expand will subvert any limits that might be imposed . . . because to do so would require setting limits upon accumulation – an unacceptable option for a system predicated upon the rule: Grow or Die!

To be right up front about it, the critique is not all wrong. There is a “Drill, Baby, Drill!” version of capitalism with a throughput mentality and a contempt for environmental values that provide fodder for the ecosocialist critique. Clearly, neither neither capitalism nor socialism has a monopoly either on environmental sin or environmental virtue. Reaching a considered judgement about their relative economic impacts requires asking two questions:

• Which has been more environmentally destructive in practice, capitalism or socialism?
• Which system, capitalism or socialism, is more receptive to the changes that need to be made to achieve long-run environmental sustainability?

It had long been evident, to anyone who cared to look, that the world’s preeminent experiment in socialism, the Soviet Union, had serious environmental problems. As early as 1972, many of them were detailed by Marshall Goldman in Spoils of Progress.  Peresroika in the 1990s and, finally, the collapse of the Soviet Union, made access to information easier for authors like Murray Feshbach and Alfred Friendly, Jr., who provided a thorough survey in Ecocide in the USSR.  Here are some of the most prominent problems featured in these and other sources:

• Pollution of Lake Baikal, the world’s oldest, deepest, and once cleanest body of fresh water, caused by paper mills and other industries that dumped untreated waste into the lake.
• The near-disappearance of the once-vast Aral Sea, which dried up due to diversion of water for irrigation, leaving behind salt deserts poisoned by agricultural chemicals.
• The 1986 Chernobyl nuclear disaster, the world’s worst, caused not just by operating errors but by a reckless design that provided no containment vessel in case of accident. The nuclear accident that had been considered the world’s worst up to that time also occurred in the Soviet Union, the 1957 explosion of a waste storage pond at the Mayak nuclear weapons complex.
• Disastrous peat fires in the Moscow region, a legacy of ill-conceived Soviet projects for draining the local wetlands.
• Enormous emissions of greenhouse gasses, due to heavy reliance on coal and far lower energy efficiency than capitalist economies.
• High levels of air pollution in major cities, caused by factories sited close to populated areas and operating with minimal if any pollution controls.
• Destructive farm and forestry practices, leading to widespread erosion and habitat loss.

China, the world’s other big socialist economy, also has its long list of environmental sins. Due in large part to intensive use of coal, it has recently taken the world lead in greenhouse gas emissions, despite an economy half the absolute size the United States. In air quality, it is home to 16 of the world’s 20 most polluted cities. Water pollution is a pervasive national disaster. Its leadership in production of rare earth metals was achieved largely due to illegal pirate mining that caused intense heavy metal pollution and local health disasters. An increasing percentage of pollutants, from mercury to soot, that are deposited in the western United States are being traced all the way to China.

To their credit, ecosocialist documents like the Belem Declaration direct at least token criticism at what they call “productivist" socialism. The ecosocialists are on to something, although not perhaps quite what they think, when they introduce this concept.

The adjective productivist, as applied to an economy, appears to mean one that concentrates on maximizing output without paying sufficient attention to the costs of inputs. By “costs of inputs,” of course, I mean what economists call opportunity costs, that is, costs as measured in terms of the value of alternative uses for the same resources. The opportunity costs of industrial production include both the costs of depletion of nonrenewable resources (lost opportunities to use the same resources for some other purpose in the future) and external costs (for example, the lost opportunities to use or enjoy property damaged by pollution).

If we understand the term in this way, then it can identify not only a productivist variant of socialism, but also a productivist variant of  capitalism. The “affordable energy” lobby in the United States is an example of productivist capitalism in action. Affordable energy is a favorite slogan of the American Petroleum Institute, as used, for example, in this comment by API President Jack Gerard: “A ban on offshore drilling will hurt growth “by undercutting our nation's access to affordable, reliable, domestic sources of oil and natural gas.”

The affordable energy lobby worries about attempts to force oil companies to raise the price at the pump by enough to cover external costs of petroleum production and use. In the case at hand, Gerard was concerned about regulations aimed at ensuring that oil companies bore the cost of oil spills and of the precautions needed to avoid them. At other times, the same affordable energy argument has been directed at regulations intended to control air pollution, both on a local level and in the form of global climate change.

The fact is, businesses seek profit, and they tend to go after any and all profit opportunities. We cheer when entrepreneurs increase profits by improving products or reducing production costs. However, profits can also be boosted by lobbying the government to restrict the activities of competitors, and, equally, by lobbying for laws that allow a company to shift part of its costs of production to unwilling third parties. OK, so you don’t want to call those profits? I agree. Economists call them “rents,” but that term is too wonky for many people. Ayn Rand had a better term: Loot. Polluters are looters.

Let’s come back now to the ecosocialist critique. What it really comes down to is less a critique of capitalism than of productivism. The question we have to ask is, which system, capitalism or socialism, is more susceptible to productivist tendencies? I think the answer is socialism, although capitalism is by no means immune.

The first reason that socialism is more likely to develop environmentally damaging productivist tendencies is that economic incentives do not work very well under socialism. In a capitalist society, the number one objective of environmental policy is to ensure that externalities are fully recognized in market prices. If the price of gasoline at the pump fully reflects the opportunity costs of pollution and resource depletion, drivers, regardless of their personal environmental sensitivities, will be forced to think about driving less or buying a more efficient vehicle. The same principle applies to users of industrial energy, whether they be plastics makers, farmers, or power plants. I don’t mean to underestimate the difficulty of getting the legislature of a democratic capitalist country to pass laws that protect property rights to the needed degree. But when the price system is used to fight pollution, it seems to work. For example, in the United States of the 1990s and early 2000s, a system of tradable permits was used with great success to bring down sulfur dioxide emissions from coal-burning power plants, with the result that the intensity of acid rain in the eastern part of the country was cut by half.

Under socialism, economic incentives to fight pollution do not work well. Yes, I know, there is such a theoretical construct as “market socialism.” Under that hypothetical system, advocated by 20th century writers like Oskar Lange and Abba Lerner, managers of collectively owned firms guide their production activities in accordance not with true market prices set by supply and demand, but instead by following “shadow prices” that are set by government planners at a level supposedly equal to opportunity costs. In theory, there would be no reason why the shadow prices could not include appropriate adjustments for environmental impacts. I don’t want to reargue the whole market socialism debate here. The concept has been widely judged to be impractical, and as far as I know, it has no living proponents. I think Ludwig von Mises said it all when he suggested that a real market is to market socialism as a real railroad is to a boy playing with toy trains. So we can drop market socialism, and look at socialism in the real world.

In the Soviet Union, as Goldman pointed out, both law and ideology provided for a degree of environmental protection. To at least a small degree, these protections were backed up by economic sanctions against polluters. The problem, however, was that industrial managers were not just insensitive economic incentives for protection of the environment, but to any kind of economic incentive at all. The Soviet system did not just encourage environmental waste, it was wasteful in every conceivable way. It wasted labor, capital, energy, natural resources, cement, steel, coal, tractors, fertilizer, wood, water—it wasted everything. Why? Because there was no profit motive.
Today, some people worry that big banks like Goldman Sachs do not operate efficiently because they know the government will bail them out if they make a loss. We call this "privatizing the gains, socializing the losses.” Well, the Soviet economy was a system in which every enterprise was a Goldman Sachs. No wonder it collapsed.

Now for the second reason why socialism tends to be more productivist than capitalism, which has to do with social attitudes that arise when there are no property rights. Where there are property rights, there is always an owner to resist trespass, whether by people on foot or noxious chemicals wafting through the air. True, the legal system doesn’t work perfectly. Sometimes owners can’t adequately protect their rights, but the rights are there. Furthermore, where there is widespread ownership of at least small scraps of property, respect for the property rights of others also becomes widespread, although, alas, not universal.

But wait, the ecosocialist might say, under socialism there are collective property rights and respect for the property of society as a whole. Really? Let me tell a story.

At the business school my wife and I used to run in Moscow, the students put on an annual May picnic. After some advance scouting by the class president, the entire student body and faculty would jump on the electric commuter train. A few stops outside the city, we would jump off and head into the woods for a nice picnic. Whose woods? Some ministry’s or institute’s or collective farm’s, no one ever seemed to know exactly. A picnic needed a campfire, of course, so someone would bring an ax and cut down the nearest sapling to make a fire. When cleanup time came, the students followed their standard practice, which was to toss all the beer cans and vodka bottles into the remnants of the campfire, where they would become broken, charred, and harder to pick up in the (unlikely) event that someone were to try doing so later. When we suggested bringing our own fuel or packing out our garbage, we were met by looks that suggested that such things had never been thought of before.

I started asking friends and colleagues about all this. Why didn’t the socialist property owner care who picnicked there? Why didn’t kids learn to respect socialist property, and clean up after themselves? The answer was that people didn’t think of those woods as socialist property, even though nominally, they were. Instead, they were seen as nich’ia sobstvennost—“no one’s property.” As such, no one took responsibility for them, and no one felt bad about abusing them. Extend the same attitude to Lake Baikal, the Aral Sea, and the Chernobyl nuclear station, and what you get is Ecocide in the USSR.

The third reason that socialism tends to be more productivist than capitalism stems from political economy. Private property provides political power bases to multiple interest groups. Sometimes that can work against the environment, as when Appalachian coal unions and mine owners join to lobby against restrictions on sulfur dioxide emissions. At the same time, though, producers of low-sulfur coal from Western states can lobby on the other side, achieving some kind of balance. Furthermore, not-for-profit groups like the Nature Conservancy can use the mechanisms of private property to protect critical habitat, and private ownership sustains an independent voice for media that can publicize environmental causes. Even ecosocialists enjoy the protection of private property for their web sites and conferences.

In a socialist system, producers have a stronger grip on the levers of political power. After all, as state enterprises, they are not mere lobbyists—they are themselves a part of the government structure. For example, Goldman noted that there were protests in the Soviet Union when paper mills first started dumping waste into Lake Baikal. However, the protesters themselves were always one government institution, say, the Limnological Institute of the Academy of Sciences, working against another, in that case the Ministry of Timber, Paper, and Woodworking. Sometimes the protesters were able to exploit personal rivalries within the government in order to plant articles in government newspapers, but in the end, they always lost. The whole incentive system of the Soviet economy, from the Politburo down to the local plant manager, was focused on just one thing: meeting the impossibly demanding production targets of the Five Year Plan. The environment always lost.

Once again, let me emphasize that private property and a market economy may be necessary conditions for protection of the environment, but they are not sufficient conditions. The sad story of environmental protection in post-Soviet Russia is a case in point. Socialism no longer reigns in Russia, but the variant of capitalism that has replaced it is no less productivist. Civil society is weak. Green protesters still struggle to get publicity for their causes in a largely state-controlled press. It is no longer casual picnickers who chop down the saplings in Moscow’s green belt, but instead, billionaire oligarchs who fence off whole swathes of protected habitat for their sprawling dachas. Oil is king, and a blind eye is turned to spills on land or at sea. BP, chased from the Gulf of Mexico with its tail between its legs, is getting ready to drill for oil among the drifting icebergs off  Russia’s northern coast. The last wild Siberian tiger may soon fall to a shot from the helicopter of an oligarch or government minister out for a weekend’s “sport.”

Are things better in China, where private industry has made huge inroads into the still nominally socialist economy? Now and then there are a few hopeful signs. This year has seen a belated campaign to shut down some of the worst pirate rare-earth mines in favor of better-run government ventures. China has become a leader in alternative energy, although its efforts may reflect an opportunistic effort to corner the world market for windmills and solar panels more than a genuine concern for the planet. Meanwhile, urban air pollution remains so bad that the Olympics could be staged in Beijing only by shutting down most local industry for the duration. I sit here in my house in Washington State wondering how much Chinese mercury is coming down from the rainclouds that drift in across the Pacific. But at least I won’t have to get the approval of a socialist censor to post this essay to my blog.

This post is an excerpt from the forthcoming 40th anniversary edition of my 1971 book, TANSTAAFL: The Economic Strategy for Environmental Crisis." Watch for it later later this year.

What Can We Learn about the Ryan Medicare Plan from German Experience?

Last week Republicans in the US House of Representatives, following the lead of Representative Paul Ryan, endorsed a far-reaching plan to reform Medicare, the nation's health care system for the elderly. Since it began in 1965, Medicare has been a government-run, single-payer system that reimburses private doctors and hospitals for the health care services they provide. Under the Ryan plan, it would be transformed into a system in which seniors would choose from a list of  competing private insurance plans, with the premiums paid partly by government and partly by the beneficiaries themselves.

Supporters of the Ryan plan see several benefits. An open letter, posted on the web site of the American Enterprise Institute and signed by a list of prominent physicians and economists, puts it this way:

Having more control over their health care spending would encourage consumers and patients to make better health care choices. It would stimulate more innovative and accountable competition by health care providers and give them incentives to better coordinate the care of their patients. Enhanced competition could offer seniors relief from rising Medicare premiums. Just as important, this reform could begin to ease the crushing tax burden imposed by the current program on our children and grandchildren.

Critics fear that in its zeal to ease the burden on taxpayers, the Ryan plan would make Medicare-equivalent health care unaffordable for many, if not most seniors. Under the plan, the value of government payments would be capped at the rate of growth of the Consumer Price Index. If medical costs continued to grow faster than the CPI, as they have in the past, more and more of the financial burden of health care would be shifted over time to beneficiaries. A study from the Center for Economic and Policy Research, using assumptions from the Congressional Budget Office, claims that by 2022, a senior citizen at the median income would have to pay 35 percent of that income to obtain coverage equivalent to Medicare, with the figure rising to 68 percent by 2050.

The idea of competing private health insurance plans, with premiums split between beneficiaries and the government, is far from new. It has been used for many years in Germany, among other places. What insights regarding the likely effects of the Ryan plan can we get by looking at the German experience?


Under the German system, seniors choose insurance coverage from among a list of approved, nongovernmental "sickness funds" (Krankenkassen). As in the United States, those insurers, in turn, pay for health care provided by private physicians and hospitals. Beneficiaries and the government each pay a share of health care premiums. In these respects, the German system is closer to the Ryan plan than to the current version of Medicare.

Does the German system work? Broadly, the answer is yes. A variety of international comparisons rank the performance of the German health care system above that of the United States. That good performance is achieved at a cost of 10.5 percent of GDP, compared with 16 percent here. In dollar terms, Germany spends less than half as much per capita on health care. (See the slideshow attached to this post for details.)

So far, so good. Germany has competing private health insurers with premiums paid in part by the government and in part by beneficiaries. It achieves better health care outcomes at a lower cost than the United States. But before we jump to the conclusion that the German experience supports the claims of the Ryan plan, we need to look more closely not just at the results the German system achieves, but at how it achieves them.

In contrast to the rhetoric of Ryan-plan supporters, the German system does not achieve its results primarily by unleashing the forces of competition. In fact, both the German system and the Ryan plan explicitly prohibit one of the main forms of competition among insurance companies, namely, the use of experience rating, that is, the practice of differentiating premiums according to demographics, health status, past health care use, and similar factors. Experience rating in health insurance leads to "cherry picking," in which insurers compete to lower their premiums by excluding all but the healthiest customers. Under such a system, the very elderly and those with chronic illnesses are likely to find that insurance is unaffordable or completely unavailable.

Unfortunately, prohibiting experience rating also weakens the extent to which competition encourages people to make better health care choices. Lifestyle decisions like smoking, diet, and exercise no longer affect the availability of insurance or its price. Instead market forces must operate indirectly, through competition among insurers to devise packages that offer consumers the best value for money. One way to do so is to assemble provider networks of doctors and hospitals that offer good quality services at reasonable prices. Another is to cover only treatments that are known to be cost effective. Still another is to encourage preventative care, when doing so reduces total health care costs.

Would those forms of competition among insurers be enough to achieve the slowdown in growth of health care costs that supporters of the Ryan plan hope for? Competition based on cost-effectiveness already exists in some sectors of the US health care market, for example, in the provision of employer-paid group health plans and in the Medicare Advantage program. Health care costs have continued to rise faster than the CPI in both of those cases, and many observers are skeptical that the Ryan plan would lead to a different outcome.

Germany, too, encourages sickness funds to compete in providing patient-friendly and cost-effective care. However, it backs up the effects of competition with an array of proactive cost-control regulations, including the following:

• National and regional budgets to cap total quarterly health-care outlays.
• Diagnosis-related groups to reimburse hospitals for care of patients with specific conditions, rather than paying for each test and procedure performed.
• A reference-price system for drugs that provides for similar payments for drugs with equivalent therapeutic effects, favors use of generic drugs, and encourages pharmaceutical companies to concentrate on innovation rather than developing follow-on drugs with little added benefit.
• Disease management programs for chronic conditions like diabetes and heart disease, which use evidence-based guidelines for cost-effective treatment protocols and focus on preventing high-cost complications.
• A national institute that assesses the effectiveness of medical treatments and products; encourages speedy introduction of new treatments that offer added value; permits the use of new treatments that provide similar value to existing ones, but without higher reimbursement; and disallows reimbursement for new treatments that have no demonstrated added value.

Germany's health care system, which dates back to the rule of Otto von Bismarck in the 19th century, did not always have these cost-control features. They were introduced gradually, many of them over just the last 20 years, in an attempt to curtail a tendency for medical costs to grow faster than the rest of the economy. They have not been completely successful, but the excess growth of health care expenditures has been less than in most other developed economies. In the decade from 1999 to 2008, health care costs grew only from 10.3 to 10.5 percent of GDP in Germany, compared with an increase from 10.1 to 11.2 percent in France and from 13.4 to 16 percent in the United States. (In the preceding decade, before many of the cost-control regulations were implemented, German health care expenditures had grown from 8.3 percent to 10.2 percent of GDP.)

There is one more difference between the Ryan plan for Medicare and the German system. The former is what is popularly described as a "voucher" program. It provides beneficiaries with a fixed payment toward the purchase of health insurance that increases only with the general cost of living. Any excess growth of health care costs beyond the CPI is borne by the individual. That formula assures that as the economy grows, the government's share of health care costs decreases as a share of GDP regardless of what happens to total costs. At the same time, the share of a typical senior's retirement income that goes to health care would increase over time unless total health care costs decreased steadily as a share of GDP, something that has never happened in any developed country.

In contrast, the German system uses a premium support approach. Beneficiaries and the government share the cost of health insurance, but the individual's share is capped as a percentage of his or her income. Any excess increase of health care costs relative to the CPI or to GDP is borne by the government. Long-time US backers of the premium support concept, like Henry Aaron of the Brookings Institution, strongly object to applying that term to the Ryan plan. So does Alice Rivlin, who worked with Ryan on an earlier Medicare reform plan, but vehemently rejects the version that appears in the current Republican Plan for Prosperity.

Taking all these similarities and differences into account, then, what do we learn about the Ryan plan from the German experience? I see three lessons.

First, there is nothing inherently unreasonable in the idea of replacing today's single-payer, government-run version of Medicare with a system that offers beneficiaries a choice among competing private plans. The Germans do it, and it works.

Second, the German experience suggests that it would be unrealistic to rely on unregulated market competition to hold the rate of growth of health care costs to the rate of CPI inflation. That has never happened anywhere, not in any foreign country, and not in any sector of the US health care system where competition has been tried. The point is an important one because Republicans tend to have an ideological aversion to government regulation in all forms. One cost control measure, medical malpractice reform, does pass the Republican litmus test, but, although helpful, it solves only a small part of the problem. If the Ryan plan is to have any hope of achieving its promised results, it will have to embrace a full-court press of cost control regulations.

Third, if the Ryan plan were implemented, and if health care costs did continue to grow faster than the CPI, the burden of health care for seniors would increasingly shift to individuals. If that happened, there is no conceivable way the American political system could resist the resulting political pressure to increase benefits. There are just too many senior voters. Anyone with the slightest sense of realism must realize that a clash between growing health care costs and lagging government benefits would be resolved through annual Congressional approval of benefit increases, just as used to happen with Social Security before benefits were indexed, and just as happens now with the alternative minimum tax.

In short, the Ryan plan, as it stands, does not represent a realistic path forward. Either it will not be enacted, or it will be modified to look more like the German system before it is enacted, or it will be enacted first and modified later. Meanwhile, it will remain more of a political platform than a serious policy initiative.

Follow this link to view or download a brief slideshow with additional information on the German health care system.

Is Tax Reform Really on the Table, or Not?

Last October I wrote a lengthy post explaining why tax reform is the best path to growth-friendly deficit reduction. At that time, six short months ago, hardly anyone in Washington was talking about tax reform. Now both the Republicans, in the Ryan plan, and President Obama, in this week's deficit-reduction speech, are trumpeting tax reform as the centerpiece of their respective proposals. Does that mean tax reform is finally on the table? Should we expect a dramatic, bipartisan breakthrough soon? I'm afraid not.


Economists are in rare agreement about the basic principles of tax reform. The objective of reform should be, first, to lower marginal tax rates, that is, the rates paid on each additional dollar of income or profit, as much as possible. Low marginal tax rates minimize distortions and maximize incentives for growth and job creation. Second, for any given amount of revenue to be raised, the way to get tax rates low is to make the tax base as broad as possible, that is, to eliminate loopholes that allow some income or profit to go untaxed while  the rest bears a disproportionate share of the burden. Unfortunately, agreement on the principles of tax reform is easier to achieve than agreement on the politics of it.

The first barrier to achieving political agreement lies in a difference between Republic and Democratic notions of the purpose of tax reform. Republicans are interested in tax reform only if it is "revenue neutral." Any base-broadening must be fully offset by rate reduction. Democrats, on the other hand, view tax reform as a way to help close the budget gap. They would only partially offset the effects of closing loopholes with reductions in tax rates.

I think Republicans are making a strategic mistake. By insisting on revenue neutrality, they are, in effect, divorcing the discussion of tax reform from the issue of deficit reduction. In doing so, they are missing a historic opportunity to reform the catastrophically complex, perverse, and inefficient US tax system they constantly complain about.

Instead, Republicans should seize on the big bargain chip presented by the Democrats' recent, grudging, admission of the need for deficit reduction. They should be saying to Democrats, "OK, we will meet you part way. We will go along with closing the budget gap partly with increased revenue, provided every penny of that added revenue comes from genuine, growth-friendly, loophole-closing, marginal-rate-reducing tax reform." Several Republican members of the Bowles-Simpson deficit-reduction commission endorsed such a deal, but not those currently serving on Capitol Hill.

By refusing to make this offer, the Republicans in Congress are going to come away empty handed. They are going to get neither deficit reduction nor tax reform. Is the mantle of ideological purity more important to them than making real improvements to public policy? If so, it's just plain sad.

So much for the differences between the Republican and Democratic approaches to tax reform. The second reason tax reform isn't yet truly on the table lies in a fundamental similarity between between them: Both parties endorse tax reform in the abstract, but neither is ready to designate which specific loopholes they want closed.

What should they be looking at? Here is a dirty-dozen list of tax expenditures from the Urban Institute and Brookings Tax Policy Center (figures in parentheses show the 2008 value in  billions of dollars):

1. Employer-paid health care (131)
2. Pension contributions and earnings (117)
3. Mortgage interest deduction (89)
4. Accelerated depreciation (56)
5. State and local tax deduction, other than property taxes (49)
6. Charitable contributions (47)
7. Deferral of income from foreign corporations (31)
8. Exclusion of capital gains on sale of homes (30)
9. Property tax deduction on homes (29)
10. Child credit (28)
11. Capital gains rate (24)
12. Capital gains basis step-up at death (22)

 Notice that elimination of any one of the top six, or any two of the second six, would exceed the "historic" $38 billion deficit reduction passed by Congress this week. Some of the twelve are beloved of Republicans, some beloved of Democrats, and none (yet) hated enough by both to be placed on the chopping block.

The bottom line: Tax reform, the idea, may be in the air, but tax reform, the thing itself, is not yet on the table. It will remain off the table until Republicans wake up to the fact that compromise means giving up part of one thing you want (revenue neutrality) in order to get other things you want (tax reform and deficit reduction). How will we know when things have changed? When either party starts listing which of the dirty dozen tax expenditures it would like to eliminate. Until then, it's just hot air.

Follow these links to view or download slideshows from earlier posts on tax reform: Pro-growth fiscal consolidation; the case against the mortgage interest deduction.

Is Financial Reform Working or Will It Make Things Worse?

The 2008 financial crash gave rise to a world-wide call for a review of regulations. In the United States, the EU, and international forums like the Basel Committee on Bank Supervision, the conclusion was reached that regulators had allowed banks and other financial institutions to take risks well in excess of those justified by the public interest. Legislatures were brought into the act where needed to change the regulatory framework. Everyone vowed to fix things.

Now, with some of the key pieces finalized on paper, but not fully implemented, financial reform is running into a backlash. Skeptics, including former Fed Chairman Alan Greenspan, who expressed his misgivings recently in the Financial Times, argue that reform efforts not only will not work, but are making things worse. Others, like U.S. Representative Barney Frank, co-sponsor of the 2010 Dodd-Frank financial reform act, strongly disagree. In a reply to Greenspan, Frank argued that the financial system can be made safer while still leaving it able to perform its essential economic functions. Who is right?

I find it helpful to frame the discussion in terms of a simple risk-return diagram like the one shown here. Financial markets, by their nature, present banks and other institutions with a trade-off between risk and return. Financial managers move up and to the right along the frontier until they reach a preferred point, say point A, beyond which they judge that any additional increase return not is not worth the extra added risk.

Regulators tend to be more cautious. They would prefer to see banks operate at a lower point along the risk-return frontier, say, point B. There are three main reasons why regulators think financial managers, left to their own devices, tend to take risks greater than are justified by the public interest:

• Contagion: Failure of one financial institution can spread to others, harming the broader economy in the process.
• Moral hazard: Banks and their creditors may neglect needed precautions because they believe they will be bailed out when threatened with failure.
• Agency problems: Bank managers are supposed to act in the interests of their shareholders, but bonus schemes, golden parachutes, and other incentives may induce them to take risks that are excessive from the shareholders' point of view.

The fundamental dilemma of financial regulation is that attempts to move the system down along the risk-return frontier from A toward B can have unintended consequences that move it, instead, to a point  inside the frontier, like point C. Such a point is inferior both from everyone's point of view. It has the high risks that the regulators would like to avoid without the high returns that the bankers seek.

This framework helps us refine the question of whether financial reform will make things better or worse. We need to ask which elements of the post-2008 round of reforms are likely to produce the desired effect of moving from A toward B, and which are in danger of producing unintended consequences like a move from A to C.

The kinds of regulations most likely to fail are those that prohibit specific activities. The Dodd-Frank financial reform act includes a number of these, for example, restrictions on proprietary trading and use of derivatives. The problem is that they take out specific items from the mix of activities that bankers formerly judged to offer the most attractive risk-return profile without curbing the underlying appetite for risk.

There is no reason to think that bankers, faced with, say, a prohibition on derivatives, would simply replace them with safe government bonds. Instead, they would turn to activities that they passed over before, either because  they were riskier ways to earn the same returns, or offered less return for the same risk. To put it in terms of our diagram, instead of responding to the prohibitions by moving along the curve from A toward B, they would be motivated to move up and to the left from point A, hoping to end up at a second-best point a little northeast of point C. But if that happened everyone would be worse off.

When it comes to regulations that prohibit specific risky activities, then, Greenspan may well be right. It is like parents telling their overweight kids, "Don't eat ice cream, don't eat pizza." Little Jimmy and Jenny just replace their favorite fatty foods with second-favorites, like Twinkies or Big Macs or something even more disgusting that their poor parents didn't even know existed.

The prohibitions in Dodd-Frank are not the only reforms that can produce unintended consequences. For another example, consider the increased capital requirements mandated by the Basel III agreements that were finalized late last year. The thinking behind Basel III is of course correct to the extent that, other things being equal, increasing a bank's capital will tend to move it down and to the left along the risk-return frontier. But will other things remain equal? If they are forced to maintain more capital, what is to keep bankers from clawing their way back toward their preferred risk-return point by acquiring riskier assets, or choosing riskier funding alternatives, or engaging in risky operations that don't show up on their balance sheets at all?

The members of the Basel Committee on Bank Supervision are well aware of that problem. They have tried to deal with it by defining capital more strictly than in the past, by using risk-weighting to require banks that hold low-quality assets to hold more capital, by issuing a separate set of regulations dealing with liquidity risk, and by paying more attention to off-balance sheet risks. Still, Basel III is, at its core, not that much different from a parental ice-cream-and-pizza list. The Basel III list is longer and more comprehensive, but we can be pretty sure that devious financial engineers will figure out new ways to subvert its intention.

Does that mean nothing can or should be done? Not really. Greenspan is far too complacent in assuring us that if bankers continue to operate at their preferred point of high risks and high returns, all will be well "with notably rare exceptions." Those rare exceptions are the tsunamis and meltdowns of the financial world that we should be most worried about. They are exactly what provide the motivation for financial reform in the first place.

It seems to me that the elements of  financial reform that are most likely to work are those that eschew the ice-cream-and-pizza approach in favor of directly attacking the underlying causes of excessive risk taking: contagion, moral hazard, and agency problems. Dodd-Frank, Basel III, and financial reform measures in other countries do include some measures of this kind, although not enough. For example:

• The Financial Stability Oversight Council set up by Dodd-Frank should help control contagion. Its job is to spot systemic risks before they build to the point where failure of one financial institution would trigger the failure of many.
• The counter-cyclical capital buffer set up by Basel III could help overcome the problem that strict enforcement of high capital requirements during a financial downturn acts as a trigger for forced deleveraging, which then spreads financial stress from weaker to healthier institutions.
• Dodd-Frank provides for a new resolution regime intended to allow orderly dissolution of large, complex, insolvent financial institutions. Orderly dissolution would help control contagion of the type that followed the failure of Lehman Brothers. It is also intended to mitigate the too-big-to-fail problem and to ensure that bondholders and other counterparties of failing institutions bear an appropriate share of losses. The new resolution mechanism is untested, but if it can be made to work, and if regulators and politicians have the courage to invoke it when needed, it could materially reduce moral hazard.
• Agency problems could potentially be reduced through reform of compensation practices. Mechanisms like deferred compensation or clawback of previous bonuses could ensure that top managers and mid-level traders suffer personal consequences when their financial strategies produce short-term profits but longer-term losses for shareholders. Dodd-Frank includes only token steps to reform compensation practices, for example, nonbinding "say on pay" votes by shareholders and more transparency in golden parachutes. The UK and France have introduced more aggressive measures.

The bottom line? Financial reforms undertaken since 2008, including Dodd-Frank and Basel III, contain some promising elements and some that are likely to disappoint. How well they will work depends to a large extent on how well they are implemented. And that is where we come to the darkest cloud on the horizon right now, which lies not in the unintended consequences of reform, but in the unintended consequences of the backlash against it.

The worst of all possible worlds would be to enact complex new regulations and then starve regulators of the funds they need to work out key operational details or provide consistent enforcement. Doing so would impose heavy compliance burdens on financial institutions and subject them to great legal uncertainties, while doing little to reduce systemic risk. Unfortunately, the current efforts by some in Congress to starve the Securities and Exchange Commission, the new Consumer Financial Protection Bureau, and other regulators of the funds and leadership they need to do their jobs may lead to just such an outcome.

Follow this link to view or download an updated slideshow discussing Dodd-Frank, Basel III, and other elements of financial reform.