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December 2002

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Economic Literacy Leads to Better Grasp of Public Policy Issues

Gary H. Stern
President
Federal Reserve Bank of Minneapolis

Editor's note: The following speech was given at the annual meeting of the Virginia Council on Economic Education, Richmond, Va., in late October.

Good evening. I am delighted to join you here in Richmond to participate in the Virginia Council on Economic Education's annual meeting. I have been involved in economic education for a long time now, both in Minnesota and at the national level, and I think the effort has, if anything, become increasingly urgent. In this vein, I am pleased that the Federal Reserve Bank of Richmond is hosting this event and that Kemper Baker of the Richmond Fed is the chairman-elect of your organization, and I am equally pleased to be able to publicly thank Buford Scott for his many significant contributions to economic education. As you may know, Buford and I serve together on the Board of the National Council on Economic Education.

This is the fourth opportunity I've had in the past year to address an annual meeting of a state council on economic education. While I genuinely welcome these opportunities, they present a challenge in that I do not want to take these occasions to simply repeat “the same old song.” But that means I am obligated to reflect upon and to refine the content and the message I plan to deliver.

For this evening, I thought I would argue for the value of economic education by demonstrating that economics can provide insight into several interesting and somewhat controversial public policy issues. In particular, I will provide examples of economic analysis as it pertains to four such issues: transportation and congestion, affordable housing, the minimum wage and deposit insurance. In at least some cases, the rigor of economic analysis is missing from much of the public discussion of these issues, and hence the quality of the debate has suffered. At the same time, I readily acknowledge that considerations other than those of economics are relevant to the policy choices that might be made. Further, let me emphasize that the points made are not original; rather, they are part of the ongoing economic commentary on these topics. And let me also remind you that I am speaking only for myself, and not the Federal Reserve, on these issues.

The launching pad for these thoughts is a comment by Bob Solow, a Nobel Prize winner in economics and a professor emeritus at the Massachusetts Institute of Technology, in an interview in the [September] issue of our Region magazine. Paraphrasing, Solow said that conveying economic ideas clearly is a very difficult thing to do, and yet it is essential that we succeed because too much of what passes for debate on policies is nearly incoherent. Certainly, citizens better steeped in the principles of economics would be able both to understand and to contribute to discussion about policy at a higher level, and consequently we should expect better policies over time as a result.

As indicated, I am going to discuss several issues for illustrative purposes, and since there is no one obvious place to begin, let me arbitrarily start with transportation. An issue in many large cities today is congestion—specifically, a level of automobile traffic that has lengthened commuting times and heightened inconvenience for many. One response to this problem, implemented in numerous locations, has been special lanes for high occupancy vehicles (HOV), that is, cars with two or more travelers. Unfortunately, such lanes are generally underutilized and have done little to relieve congestion.

Observing this, economists have proposed opening HOV lanes to anyone willing to pay for them, presumably drivers who want to save time and have the financial resources to permit them to do so. By the way, the lanes could remain free to cars with at least two travelers. This proposal, to permit cars with only one occupant to use HOV lanes for a fee, has been opposed because allegedly it favors those with high income and therefore is unfair. In light of this opposition, few politicians have been willing to take up the cause.

The problem with this argument is that it overlooks the fact that almost everyone would be made better off by charging for HOV lanes and opening them to more vehicles. By definition, those who pay to use the lanes are better off because they have voluntarily decided to do so. And those who continue to travel the regular lanes are also better off because congestion will have decreased, since some travelers have transferred to the HOV lanes.

Taking these considerations one step further, those with training in economics might see in pricing a potentially effective way to address congestion more broadly. Suppose rush hour in city X is from 7:30 to 9 in the morning and from 4:30 to 6 in the evening. Why not charge one price for use of highways during those hours and a lower or no fee during off-hours? Since we, the economically literate, know that incentives matter, we can say with confidence that such a fee schedule, known as congestion pricing in the trade, will alter traffic patterns and will reduce congestion.

Let me move to a second issue where an economic perspective helps to elucidate policy options. We hear a lot today about affordable housing and, specifically, about an affordable housing crisis. Yet, the nature of this crisis is hard to pin down since, as far as we can tell from available evidence, housing markets work well in most locations, and only a small part of the population lives in substandard housing. It turns out that the affordable housing crisis is best described as a situation where low-income families have to spend a disproportionately high share of their income on housing, leaving limited resources for food, clothing, medical care and so forth.

From this perspective, the issue is more appropriately understood as an income problem rather than a housing problem. Moreover, this is a distinction with a difference, for it suggests that the solution lies not with housing policies per se but with policies which increase family income. In the long run, these may well involve an emphasis on education and training. But in the short run, for low-income families spending a high percentage of income on housing, one could consider a housing voucher program, a voucher program for other necessities thereby making them more affordable or direct income transfers to families who qualify. These are all potentially effective means of relieving pressure on the budgets of low-income families. All of these suggestions will have side effects to be sure, not all of which will be desirable, but none of these proposals involves direct government intervention in housing markets, markets that are already functioning well.

Also on the income front, we have the issue of the minimum wage. Proposals to increase the minimum wage abound, and they are usually “sold” as beneficial to people with low incomes. But economic analysis suggests that this is not the whole story. It is more accurate to say that an increase in the minimum wage is helpful to low-income workers who remain employed; however, an increase in the minimum wage will decrease employment, other things equal, because labor will have become more expensive, and hence employers will use less.
Straightforward supply and demand analysis produces this conclusion.

But the incentive effects of an increase in the minimum wage also ought to raise concern. An increase in the minimum wage may induce some to drop out of high school earlier than otherwise to seek employment, since returns to work have gone up. This outcome may not be desirable. After all, we know that the economic and other returns to education are substantial, and in general education is something we want to encourage. An increase in the minimum wage seemingly does not contribute to this objective.

Finally, in a different arena, let me offer a few thoughts about deposit insurance, a policy successful in several respects but one which carries substantial, albeit subtle, costs as well. As initially conceived back in the 1930s, deposit insurance at banks and similar institutions was designed to protect the assets of small and presumably unsophisticated account holders. With the current insurance limit of $100,000 per account, one might argue that the original intent has been surpassed, but that is not the key point. Any amount of deposit insurance necessarily creates a group of depositors with no incentive to monitor the quality of their bank and worry about the soundness of its practices. This is because such depositors know they will be fully protected by insurance in the event the bank fails.

This absence of incentive to worry about the riskiness of the bank means that market discipline of insured institutions is not all that it could and should be. One might think that this is a relatively minor issue, since large uninsured depositors have ample incentive to monitor banks. In many cases this is true, but it is not accurate for banks deemed “too-big-to-fail,” that is, banks so large and important that policymakers will not permit them to fail. Even uninsured depositors may have little incentive to monitor these banks because they expect to be protected by extraordinary government action if the bank encounters serious difficulty.

As suggested earlier, one significant consequence of deposit insurance and too-big-to-fail is that market discipline of banks is unduly low. As a result, at least some banks will take excessive risks, not because they intentionally make bad loans but because the market is not pricing risk accurately. That is, because of deposit insurance and
too-big-to-fail policies, risk taking is priced too low, and we know from economics that, therefore, too much risk will be taken. Even if no bank fails, mispricing risk and excessive risk taking mean that resource allocation in the economy is suboptimal and living standards are not as high as they could be. Admittedly, we don't know the size of the resource misallocation, although it could be sizable. Costs of implicit too-big-to-fail guarantees clearly have been substantial in several developing economies where turmoil in the financial sector and subsequent disruptions in economic activity reduced living standards appreciably.

To be sure, deposit insurance has conferred significant benefits as well as costs. But the point is to recognize that this policy, like so many others, is a double-edged sword. Moreover, it is especially important to recognize this in light of the current debate about the desirability of increasing deposit insurance coverage in the United States, a step I think ill-advised.

The point of these examples, as suggested earlier, is to demonstrate that economic thinking can contribute meaningfully to significant policy issues. Economic considerations will not necessarily be decisive but, given the “law of unintended consequences,” I would maintain that such considerations deserve considerable weight. After all, it is important that we get public policy right—it can affect the well being of many.

I suspect that emphasizing the value of economic reasoning before a group of economic educators is tantamount to “carrying coal to Newcastle.” That's OK from my perspective. It doesn't hurt to remind ourselves and others that economics has a lot to say about important issues. It's one of the reasons we should and do care about economic education-and it's one reason why I congratulate and sincerely thank the classroom teachers, economic educators, and business and community leaders here tonight who have contributed so meaningfully to the cause of economic education.

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