Allocation of Limited Resources - Part 8 (Government Limitations of Ignorance and Vested Interest)

I began this series with the analogy that presented various modes of allocating limited resources. It concluded that auction … markets … is the most efficient and just system we have. In the following post, I explained that we deal with two types of community: Face-to-face and commercial society. Face-to-face communities can often efficiently and justly allocate resources based on non-market criteria. Because people know each other and their circumstances well enough, they can make informed decisions. That is not possible for commercial society. Markets are, therefore, the most efficient and just in coordinating mass society. We then looked at Paul Heynes' analogy of an urban traffic system to illustrate that a "market economy" is not anarchy or an air traffic control system. It is a complex dynamic system where people act on decisions about their own contexts but interact with the larger community according to agreed-upon rules and mores.

With that foundation, I explained that markets have limitations. They need intervention in various ways. We examined the problem of negative externalities where some escape the costs of their actions, and others must absorb them. We explored positive externalities, cases where the broad application of a good or service benefits the common good, but some or all of society will not avail themselves of those goods and services unless the costs are minimized by spreading them across many people. We saw that government regulation is sometimes necessary to facilitate transparency and the flow of information. We saw that government is needed in the case of natural monopolies. We looked at the role of government in stabilizing the economy through monetary and fiscal policies. We noted that some believe there are cases where it may be necessary for government to intervene in businesses or industries for the sake of the public … for instance, by responding to tariffs placed on imports by other countries. We noted the role that non-profit firms play in addressing many societal needs.

Finally, we looked at the issue of redistribution. In our market economy, instead of trying to manage the economy so everyone gets a "fair" outcome … however "fair" is defined … we have generally opted to let the market do its work and then address inequities through progressive taxation and a variety of aid programs. Of course, the big question is how much of which kind of aid? But there is an underlying belief by most that society, through government, has some responsibility to the poor.

So, two things need to be said here about markets. First, markets are the most efficient and just means of allocating limited resources across millions of people that humanity has yet to devise. The benefits of the market system are nothing short of astonishing by historical standards. Combined with the division of labor and technological innovation over the past two centuries, I can think of no other development that has led to such widespread (and rapidly spreading) physical health and material well-being for so many people.

Second, markets do not constitute a quasi-deity, mystically guiding everything to its highest use. They simply do a far better job of guiding things to their highest use than anything else we know. I've identified several ways markets, left to their own devices, would not create the most efficient and just outcome. Markets need intervention.

So maybe we can let markets do their magic while using government to resolve issues like externalities, stabilizing the economies, dealing with natural monopolies, and providing an appropriate social safety net. Will this lead to a more just and efficient society? Not necessarily. There are two very significant constraints on government.

The first limitation is ignorance. While markets require intervention, there is frequently insufficient information to know how to intervene. In Runaway World, sociologist Anthony Giddens looked at the Mad Cow scare in England a few years ago. Government officials were slow to sound a warning. It is believed the delay caused greater harm. Outcries arose about incompetence and conspiracy. And yet, if government overreacts, sounding the alarm too quickly or forcefully, the same cries of incompetence and conspiracy arise if evidence of their warnings is not forthcoming. Ironically, sounding the appropriate level of warning that generates just the right amount of response to confront a problem can reflect negatively on officials because many citizens will view the failure of a disaster to materialize as evidence of alarmism rather than successful aversion. Giddens' primary point is that what we are confronting in so many of these situations is risk management, not certain choices between right and wrong.

Product recalls and epidemic warnings are tricky enough, but when we move to issues like climate change the calculations become enormously complex. We saw earlier that two ways to combat the problem are to tax carbon or implement a cap and trade scheme. But how much tax? How much CO2 should be allowed by cap and trade? The problem is more akin to handicapping horse races than precise economic calculation.

But ignorance bedevils us in other arenas as well. It has long been believed that homeownership makes for better citizens. It was viewed as a positive spillover which government should subsidize. While hardly the only contributing factor, the rising pressure from both Democrat and Republican administrations to take more financial risks in the mortgage lending market contributed to the market's recent collapse. We can point back to the 1960s when government concentrated the poor in high-rise housing projects to centralize services to the poor more effectively. The concentration was one of the worst disasters of aid to the poor in U.S. history. Predicting how people will respond to various incentives interjected into the market is often quite difficult. There is no great oracle who knows all the facts and can give us the policy direction we need.

The second big issue is vested interests. In democratic societies, politicians must get re-elected. That means every decision has a combination of considerations. I'm not as cynical as some in that I believe that many politicians do have noble public service as a part of their vision. But every politician also must weigh the impact of their decisions with the support of campaign donors and voters. Virtually no political decision is the optimal decision that would be made in a perfect world, and some are downright destructive. Most are somewhere in between.

Right now, it is popular to decry the influence of large corporations in the political process. It is believed that large corporations resist regulation. This is true sometimes, but large corporations in many industries embrace regulation. Regulation creates what business analysts call a barrier to entry. Large established corporations are usually more adept at managing regulation than smaller firms. Potential new companies in a regulated industry must go through a learning curve in handling regulatory requirements. The more daunting the regulation is, the more of a deterrent it is to the would-be new competitors. A partnership develops between corporations and politicians. Supportive politicians get sizeable support in their campaigns. Corporations get the ear of politicians in tailoring regulations that benefit the perpetuation of their firms while discouraging competition. Populist efforts to control large corporations frequently have the unintended effect of consolidating corporate power and stifling small business innovation.

Churchill remarked that democracy is the worst form of government except for all the others. We can also say that market economies are the worst economic systems except for all the others. And the two of them together will not yield us the optimal world as seen through the eye of an all-knowing deity … but neither will any other system!

We seem to have a strong need to perceive that someone is in charge … that our world is predictable and safe. When something unpredictable or threatening emerges, that means our "someone" wasn't doing his job; otherwise, these things would not have happened. In our case, that "someone" is usually perceived to be the national government because it is the centralized entity that is "running" the country."

But let's return to traffic analogies. If you let millions of people drive around in their cars at speeds up to 70 mph, there will be accidents. Some people are going to get killed. Many others will be injured. Still, others will suffer financial setbacks from car repairs. In any given accident, we can study events and determine what roles driver error, mechanical failure, or other factors played. We can learn from such studies to minimize contributing variables, but we can't eliminate all collisions if we allow this kind of mobility. We could universally reduce the speed limit to 5 mph, likely dramatically reducing the accident statistics. It would also make the transportation system useless from any practical standpoint, and a load of other miseries would befall us (Think of increased death due to heart attacks from people unable to get to the hospital in a timely way or firefighters getting to fires, much less the way it would end trade.) To paraphrase a popular bumper sticker, "Stuff Happens!" If there is going to be a meaningful transportation system, people are going to get hurt.

Similarly, people are going to get hurt in a market economy. People make seemingly wise investment decisions and lose money. Unscrupulous people do unethical things with their businesses, and others get hurt. Industry dynamics means some businesses rise while others fall. The volatile evolutionary nature of the market means there are times of retraction and loss for the overall economy. And just as with auto accidents, each case can be studied to understand the variables that led to the negative outcome, and we can learn from those variables. But if we are going to have economic freedom, people will get hurt! Stuff happens! There categorically is not a "great mind" or a system somewhere that can make our lives wholly predictable and safe.

Where does that leave us? Markets are a remarkable system for the just and effective distribution of limited resources. Government intervention is critical to both markets' functioning and addressing several limitations markets possess. The deification of the markets as the master of providence and the deification of the state as an all-knowing, benevolent mind guiding the economy with enlightened reason are fantasies. Some combination of the two will not free us from harm, and acting as though changing the system in some direction would free us is a delusion.

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