It is said that if you put a frog in boiling water, it will come out immediately; But if you put it in cold water and gradually increase the heat, it won’t react – and will end up burning to death. The same thing can happen with economies too.
As inflation accelerates, the public demands that leaders control prices through tougher macroeconomic policies. On the other hand, when authorities begin to intervene in certain sectors through tariffs, price controls, subsidies, taxes and ad hoc regulations, this does not trigger such a public reaction; Interventions can continue to create inefficiencies and undermine growth.
Both inflation and ad hoc interventions – sometimes referred to as industrial policy – create distortions in the economy and result in lower economic growth. But inflation triggers a quick reaction. It is a common phenomenon throughout the economy, increasing as groups after groups try to restore or increase their real returns. However, at a certain point people start to object to it. As the inflation rate rises, the pressure on political decision-makers to reduce it increases. Once inflation is under control, growth can resume.
In contrast, the impact of targeted tariffs and sectoral measures at a given time or in a given sector of the economy is generally relatively small. Although these interventions contribute to inflationary pressures, reduce the economy’s flexibility and weaken growth, they are generally less noticeable than an increase in inflation, so the public is unlikely to oppose them. Furthermore, the prospect of reducing a tariff or eliminating a subsidy is typically met with strong resistance from the affected industry. While tackling inflation is a political imperative, it is politically difficult to reverse ad hoc measures that create distortions.
The United States today exemplifies this dynamic. The government of US President Joe Biden complains about inflationary pressure and supports the US Federal Reserve in its efforts to curb rising prices. However, the Inflation Reduction Act (IRA) also greatly increased government spending and introduced or maintained numerous sectoral regulations, most of which are inflationary.
Inflation may have peaked in the United States, but ad hoc interventions still have a bright future ahead of them. Tariffs on steel and aluminum imports imposed by Donald Trump – which Mr Biden has not lifted – have meant steel costs are now the highest in the world. This means that production costs are rising in all industries that rely on large amounts of steel – for example car manufacturers. Meanwhile, U.S. electric vehicle manufacturers benefit from subsidies and tax breaks.
The Biden administration is also imposing tariffs on imports of solar panels despite its concerns about the environment. Significant subsidies and other incentives have been created for investment in semiconductors and batteries. It capped the price of certain prescription drugs, such as insulin, for seniors on Medicare and placed price caps on other drugs each year, causing shortages and hindering the development of cheaper generics.
Mr. Biden also raised the domestic share threshold for government purchases, requiring that government procurements maximize the use of U.S. inputs and support greater domestic production. This narrowed the scope of a decades-old agreement between members of the World Trade Organization that requires them not to discriminate against participating countries’ products in public procurement.
The WTO agreement resulted in lower costs for all signatory states and saved taxpayers money. The United States paid less for the products it purchased while exporting goods to other governments for which U.S. costs were lower. LMr. Biden’s intervention has the effect of increasing the cost of U.S. government purchases (including materials for IRA investments) and increasing the risk of retaliation from other countries, which will result in a decline in purchases from the United States.
In most advanced economies, agriculture is regulated to support agricultural prices. Price supports and cultivation restrictions have pushed up food prices and reduced the efficiency of the sector. The United States also regulates the amount of sugar it imports, even though there are hardly any sugar producers left in the country and so Americans pay almost twice as much for sugar as the world average. American cake and confectionery manufacturers are therefore at a competitive disadvantage.
A final example of ad hoc interventions in the economy – it would be impossible to list them all – concerns infant formula. During the COVID-19 pandemic, there was a major shortage of this important product after only one key factory had to close. Foreign producers like those in Canada meet the same standards as their American counterparts, but restrictions on import quantities and high tariffs on products entering the United States prevent American parents from having access to their mother’s milk.
It hasn’t helped that the federal government’s nutrition program for women, infants and children, known as WIC, has historically limited each state to just one licensed manufacturer of infant formula. Since WIC accounts for about half of all infant formula purchases in the United States, this requirement has allowed some brands to dominate the market.
Direct intervention in certain economic activities or sectors carries high costs because it distorts economic activity, increases prices and reduces growth. Some interventions, such as subsidies, can be dangerous, not least because they can encourage favoritism or even outright corruption.
Additionally, as technology advances rapidly, we need new entrants for whom regulations are costly. For government regulators to do their jobs well, they must understand the activities they regulate, which only compounds the problem. However, the government pays its employees less than the private sector, and industry professionals can work on either side.
The United States has achieved global preeminence in part because of its commitment to ensuring a level playing field for the private sector. The industrial policies they implemented – such as investments in education, infrastructure and research – were consistent with this commitment. But the more frequent and deeper the interventions become, the greater the risks to US dominance in the global economy.