Subsidies Are Tricky

I've made this point before, but I want to repeat it. You have to think very carefully about who the benefit of a government subsidy is, and if you design subsidies poorly you can cause tremendous waste and/or unfairness.

Here's what I mean. Let's say a farm is worth about $150,000. The farmer bought it for that much (perhaps taking out a loan for part of the purchase price), and when the farmer is ready to retire he will sell it for roughly the same amount. (Let's ignore inflation.) In the meantime the farmer makes a living by working the land and selling crops.

Now the government puts in place a farm subsidy that makes the farm worth three times as much, $450,000. Whoever happens to own the land at that time can now sell it for three times what he paid for it. Clearly that individual has benefited from the subsidy, which is exactly what you would expect.

But now fast forward a few decades, and assume the original farmer has retired and sold the farm. Whoever owns the farm now paid $450,000 for it. She may have taken out a loan for a large fraction of the purchase price. Is the current farmer benefiting from the subsidy?

Well, sort of. Certainly the farmer is getting money (or crop insurance or whatever) from the government. But the benefit of the subsidy was (at least in large part) baked into the purchase price of the farm. The farmer has approximately $300,000 more debt than would have been the case absent the subsidies, and that debt should (roughly) correspond to the benefits she is getting. (In other words, the extra earnings that the farmer receives due to the subsidy should be worth about $300,000, that's why the farm increased in value by that much when the subsidies were put in place.)

So what happens if Congress decides that the subsidy is excessive and reduces or eliminates it? Well, the farmer still has the $300,000 in debt (or, equivalently, $300,000 less in assets), but now has a farm that is worth less than the $450,000 she paid for it. The value of the subsidy was mostly or entirely captured by the person who owned the farm at the time the subsidy was enacted, and reducing the subsidy now is truly felt by the current farmer as a punitive measure.

I want to emphasize this point: the farmer is not wrong to see the subsidy reduction as something akin to expropriation. Of course it's not expropriation in the classic sense, but it has the same effect on her wealth. (So for instance, if the government simply seized 2/3 of all farmland, it would reduce the value of her farm to $150,000, and that would clearly be expropriation.)

Let's say she borrowed $350,000 to buy the farm and the subsidy is entirely eliminated. Now she owes $350,000 in debt and owns a farm worth $150,000. This is obviously a financial catastrophe for her, and there's really nothing she could have done to avoid it (other than not going into farming or maybe lobbying harder for the subsidies to stay in place—speaking of which, I won't get into it in this post, but a certain amount of the subsidy will probably be pissed away on lobbying, and in extreme cases the lion's share of the value could end up going to lobbyists).

But of course in the meantime maybe the subsidy really is a huge waste of money! It may be necessary, or at least strongly beneficial, to get rid of the subsidy. The problem is that the principal beneficiary of the subsidy is out of the picture. The owner of the farm at the time the subsidy was enacted is not required to give the $300,000 back. He might not even be alive. So the cost of maintaining the subsidy falls on taxpayers who may not receive commensurate benefits, but the costs of eliminating the subsidy fall on people who also never truly enjoyed the benefits.

Now consider Mayor de Blasio's ferry subsidies. When you provide ferry service to an otherwise under-served neighborhood, you increase the value of the real estate in that neighborhood. You might even induce people to build additional housing there, in reliance on cheap, city-subsidized access to Manhattan. And that's great if the ferries are cheap to operate. (Well, not great if the land will be under water in a few decades, but let's ignore that.) If the ferries are expensive, on the other hand, we've got a situation basically identical to the farm subsidies described above. Except it could be even worse: with farms, you basically plant what you plant. But with residential neighborhoods, you build structures that are appropriate for the level of transit. It makes sense to build large apartment buildings that have easy transit access to jobs in the city, but it makes a lot less sense to build large apartment buildings in isolated areas. By providing expensive ferry service, you might induce people to build large buildings in areas where the only connection to jobs is the ferry.

Again, that's not a big deal if the ferry is cheap enough that no one minds subsidizing it indefinitely. But if the ferry is an inefficient form of transit that can't be justified in the long run, you're going to want to increase fares or cut service. And when you do, you will be hurting people who, like the farmer in the example above, didn't really benefit from the subsidies (in the sense that the value of the ferry service was included in the purchase price of the house). Whoever owned the land when the ferry service started has walked away with a windfall, and what is left is a fight between taxpayers and homeowners who need the expensive subsidies just to break even. The homeowners may win the political fight, but in that case you've locked in a permanent expense that burdens the city forever.

This is not an argument against all subsidies. Sustainable subsidies that meet a clear public need are fine. Also, you can cushion the blow somewhat by phasing subsidies out slowly (for instance you could raise the fares on ferries by $x per year until they reach a sustainable level). And of course, on some level people don't "deserve" to be protected from loss of government subsidy (but I would emphasize—on a subjective level it is painful all the same).

But to some extent you can avoid these ends by avoiding these beginnings. (This is a paraphrase of a Justice Jackson opinion on an unrelated issue.) In putting a subsidy in place, you must consider who benefits and who will pay the price if you have to reduce or eliminate the subsidy in the future. The subsidy may still be a good idea, but at least you have to consider the downsides.

Better Analogies

In the wake of the 9/11 attacks it was common to compare them to the Japanese attack on Pearl Harbor. But it seems to me that with the benefit of hindsight the better analogy is the assassination of Franz Ferdinand.

There are at least three parallels worth noting. First, both the 9/11 attacks and the assassination were carried out by non-state groups operating under the protection of small, relatively weak states. (The parallel isn't perfect—Black Hand was seemingly much more intertwined with the Serbian state than Al-Qaeda was with any particular country.) Both crimes were asymmetric warfare, carried out against vastly bigger powers using (fairly) unconventional methods. Both of the target countries had arguably over-extended themselves for questionable strategic purposes, provoking the attacks. And in each case the specific target had important symbolic importance. (By contrast, Pearl Harbor was a purely military target, with no particular importance to the American public beyond its inherent importance as a U.S. military base. The attack was motivated by strategic calculations, however misguided, rather than ideology. The fight was essentially symmetric.)

Second, and I think most importantly, the political leadership of each country perceived the attack to be a casus belli, and because each of them desired war, they regarded it as a windfall. Preserving the value of that windfall (not letting the crisis go to waste) became in each case an idée fixe. Any attempt to reason with them was treated as a disreputable attempt to deprive them of their hard-won prize. (I just finished reading July Crisis: The World's Descent Into War, by T.G. Otte, which is a diplomatic history of the events leading to World War I. The book is nuanced and does not attribute blame entirely to any one person or country, but a theme of the book is the implacability of the Austrians, the pointlessness of even trying to reason with them. It seems to me to be only a minor simplification to say that the war happened because the Austrians wanted it, and once they secured German support nothing but abject surrender by the Serbs would have convinced them not to launch it.)

I want to emphasize this point: neither Austria-Hungary in the wake of the assassination nor the United States in the wake of the 9/11 attacks was faking its anguish. The subjective feeling of pain and outrage was genuine enough. But both countries conducted their diplomacy in bad faith. For the sake of appearances (and to keep their allies on board) they went through the motions, but neither was in any meaningful sense open to any alternative but war. (In Austria-Hungary's case there was probably one thing that could have dissuaded it from its march to war: an indication from Germany that it would remain neutral. But in early July Wilhelm wrote his infamous "blank cheque" and from that point forward Germany had little power to exercise restraint. Italy in fact did remain neutral, much to Germany's consternation, but Austria-Hungary didn't care. Likewise Austria-Hungary didn't care about the bellicose rhetoric coming from Russia. Those were Germany's problems, not Austria's.) Similarly the weapons inspectors in Iraq were there for show, and there is nothing they could have said that would have prevented war.

Third, while both Austria-Hungary and the United States were led by people who badly wanted war, in both cases the wars reshaped the world with essentially the opposite of the intended effect. Austria-Hungary disintegrated and the Habsburgs were dethroned while Serbia expanded its territory, and the invasion of Iraq demonstrated the severe limits of U.S. military power, caused a political backlash, forced the U.S. to adopt a more humble posture, elevated Iran's influence in the region, and destabilized the world (not to mention, of course, the terrible humanitarian consequences—but those were not wholly unanticipated).

In all of these ways the 9/11 attacks more closely resemble the assassination of Franz Ferdinand than the bombing of Pearl Harbor. Of course the second and third factors were not apparent at the time, but the danger of them should have been. In particular the second point is worth remembering. The unqualified support of Europe's strongest military power blinded Austria-Hungary's leadership to the dangers of war, and the perception that the U.S. military was all-powerful led Rumsfeld to seek war wherever he could justify it.

No analogy can, by itself, be decisive. The U.S. was looking for a casus belli in 1941 just as it was in 2001, and the main thing distinguishing these situations was the strategic wisdom of pursuing war. But any time Pearl Harbor is trotted out as support for war, it is worth considering how the other world war started, and whether we are again sleepwalking into the abyss.