Market distortions.

It did not take long for the conflicts to emerge as Republicans struggle to make good on their commitments to reduce federal spending. In the wake of the Republican victory last Tuesday, public comments regarding how to cut the federal deficit followed a familiar line: Across the board cuts in spending, exempting Medicare, Social Security and Defense. Now, just a few short days after John Boehner’s victory lap, this strategy has been kicked to the curb.

The problem is that the math doesn’t work. Since 1980, those sacrosanct programs, Medicare, Social Security and Defense, have grown from 72% of the federal budget to 84%. Based on Congressional Budget Office data, non-defense discretionary spending for 2010 totaled $512 billion, which means that to meet Senator Jim DeMint’s threshold of $300 billion in cuts, one would have to reduce the non-defense discretionary budget by 60%. Despite the urge to point the finger at non-defense discretionary spending as the source of all that ails us, that spending category represented 3.7% of GDP in 2010, down from a quarter century peak of 3.8-3.9% in 2003-05, but up from the low of 3.2% reached in late 1990s.

Senator-elect Rand Paul has challenged the notion of sacrosanct programs, by suggesting instead that a 5% cut should be applied across the board. A 5% cut in the $3.2 trillion federal budget would translate into a $160 billion cut—still well short of DeMint’s threshold—but it puts into play those programs heretofore off limits, though still avoiding specifics of what to cut. Meanwhile, DeMint himself is mired in a battle with Mitch McConnell over the largely symbolic issue of earmarking.

Much has been written about the lack of specific proposals for spending reduction coming from Tea Party candidates during the run-up to the elections, but underlying the movement has been a call for reduced federal regulation and spending, and a return to greater reliance on free markets.

Such a call for the federal government to take its finger off the scale of competition and commerce could be a healthy change for the country, even if a painful one to achieve. Some of the pain would come in the form of economic dislocation, as industries now supported by federal subsidies or favorable tax or other treatment would have to swim in unfamiliar, competitive waters. But the greater pain would be felt by the members of Congress themselves—of every political stripe—who for decades have traded on their ability to tip the scale on behalf of those who support them.

We have all paid a price for the policies and priorities that are now deeply woven into the tapestry that constitutes the federal budget and system of regulation. Consider for a moment the role of federal spending and policies in exacerbating just a few of the problems that we continue to grapple with.

First, federal policy has directly encouraged overleveraging at the corporate and household level.

The 2008 economic collapse followed a period of massive over-leveraging at the corporate and household levels. At the corporate level, debt has been used for the past quarter century as a tool for increasing economic value, by companies, private equity funds and others. This over-leveraging of the corporate sector increases financial risk and vulnerability. Corporate over-leveraging is a specific response to the unequal treatment of debt and equity under the tax code. Simply stated, interest paid on debt is privileged by being deductible, while dividends are paid on an after tax basis. For any company seeking a $1 million investment, this unequal treatment provides a direct inducement to seek debt financing rather than equity investment.

At the household level, the inducements to borrowing are grounded in the tax-deductibility of mortgage payments vs. the payment of rent from after tax dollars, and the stimulation of consumer credit through home equity loans. Home ownership has long been touted as the cornerstone of national social policy, but of late the disadvantages of home ownership have become apparent. As we have built an increasingly dynamic national economy, labor mobility has become an increasing value, both for individuals seeking to optimize their career and educational opportunities, as well as for overall economic growth. Recently, Fed Chairman Bernanke noted the issue of labor immobility as an increasing problem for economic development. This was shorthand for people who cannot move for a job because they cannot sell their home.

Second, federal policy has directly encouraged overspending on medical procedures and pharmaceuticals.

The current structure of health insurance provides direct inducements to overspending on medical care. For example, drug insurance plans—whether private or public—that have the consumer paying a fraction of the price of a drug lead to high consumption based upon the low net price, while leaving the tax or premium paying public absorbing the rest of the cost. The impact of this incentive to overspending can be seen in the rash of commercials for new drugs for every imaginable syndrome from social anxiety disorder to overeating disorder to acne. For a $5 co-pay, there is a market for anything. At the full price of $200 per month, many consumers might choose lifestyle or nutritional solutions instead.

Third, federal policy has encouraged dependency on foreign oil.

Since the creation of CENTCOM by President Jimmy Carter, the United States has affirmed its policy priority of protecting western access to Middle East oil. After decades of failing to enact a federal energy policy, it is high time that we recognize that CENTCOM is our energy policy. If a heavy military presence in the Middle East and in other energy producing regions is part of the price of predictable access to our annual consumption of $400 billion or so of imported crude oil and petroleum products—as reported by the federal Energy Information Agency—then perhaps some share of our $600 billion defense budget should be internalized into the price consumers pay for oil products. Like overspending on drugs for which we only pay a portion of the true cost, our current energy policy has the effect of encouraging spending on oil by having consumers pay only a portion of the true price of delivering gasoline to the pump on a reliable basis.

Banks, pharma and oil are just three industries that have effectively used the federal government to enhance their competitive position and support or protect the markets for their products. And each of the practices that has been implemented to support and protect those industries—deductibility of debt, copayments for drugs and medical treatments, defense protection of oil supply lines—have encouraged patterns of over-consumption by masking the true price from the consumer and contributed directly to bubbles that we often discuss but rarely diagnose or address: Overleveraging, excessive societal spending on medical care and growing reliance on foreign oil.

In each case, addressing the incentive structure and effectively taking the federal finger off the scale could ameliorate these problems of over-consumption for which we have paid and continue to pay a heavy price: Reduce the bias toward debt in corporate finance and reduce financial risk. Increase individual incentives to make good health decisions through lifestyle changes and nutritional choices. Provide a more level playing field for non-oil based energy sources.

“The government is promoting bad behavior,” marked the opening salvo of Rick Santelli’s rant in the opening moments of the Tea Party movement. “How many of you people want to pay for your neighbor’s mortgage…?” Yet while Santelli focused on the bank bailouts, the larger problem stemmed from years of federal programs that promoted low cost mortgages—to support both home ownership and the building trades—that promoted a culture of over-borrowing and over-building.

There is no end to ways that we subsidize bad behavior, only to pick up the back end costs that ensue. To extend Santelli’s point, how many of us want to pay for agricultural subsidies and marketing programs to promote sales of cheese, corn syrup and sugar, and then pay for the skyrocketing health costs that stem from our poor nutrition habits? In Santelli's world of free markets and free choice, would not farmers live or die based on demand for their products—rather than their state's role in presidential primaries—and the customers bear the consequences of their own nutritional choices?

Today, we live in a world where prices have been distorted, often as a direct product of federal policies. And those distortions come with a price. We are now paying a high price for the collapse of an artificially induced housing boom. We pay through taxes, premiums and public debt for that portion of drug prices that are hidden from the consumer. And we pay the hidden cost of delivering oil to the pump through taxes, debt and war.

The question for Republicans as they seek to reduce the federal budget is not just whether they are prepared to cut discretionary military spending and tackle entitlement reform, but whether they are prepared to go farther and confront the complex system of subsidies, protections and regulations now built into the federal budget that distort free markets and lead to adverse outcomes that, as Rick Santelli noted, none of us want to pay for.

The free market aspirations of the Tea Party should not be silenced or dismissed, but instead should engender a much-needed reevaluation of federal fiscal, tax and regulatory policies. The question for Tea Party acolytes will be whether they are prepared to walk the walk and push to cleanse the federal budget of all manner of pork and privilege, or if theirs is a partisan battle that only aims to cut the federal budget on the backs of their political adversaries.