We’re told again and again that government must take action to correct “market failures”. Economists are largely responsible for this widespread view. Our standard textbook treatments of external costs and benefits are constructed to demonstrate departures from the ideal of perfectly competitive market equilibria. This posits an absurdly unrealistic standard and diminishes the power and dramatic success of real-world markets in processing highly dispersed information, allocating resources based on voluntary behavior, and raising human living standards. It also takes for granted the underlying institutional foundations that lead to well-functioning markets and presumes that government possesses the knowledge and ability to rectify various departures from an ideal. Finally, “corrective” interventions are usually exposited in economics classes as if they are costless!

Failed Disgnoses

This brings into focus the worst presumption of all: that government solutions to social and economic problems never fail to achieve their intended aims. Of course that’s nonsense. If defined on an equivalent basis, government failure is vastly more endemic and destructive than market failure.

Related to this point, Don Boudreaux quotes from Peter Boettke’s Living Economics:

“According to ancient legend, a Roman emperor was asked to judge a singing contest between two participants. After hearing the first contestant, the emperor gave the prize to the second on the assumption that the second could be no worse than the first. Of course, this assumption could have been wrong; the second singer might have been worse. The theory of market failure committed the same mistake as the emperor. Demonstrating that the market economy failed to live up to the ideals of general competitive equilibrium was one thing, but to gleefully assert that public action could costlessly correct the failure was quite another matter. Unfortunately, much analytical work proceeded in such a manner. Many scholars burst the bubble of this romantic vision of the political sector during the 1960s. But it was [James] Buchanan and Gordon Tullock who deserve the credit for shifting scholarly focus.”

John Cochrane sums up the whole case succinctly in the “punchline” of a recent post:

“The case for free markets never was their perfection. The case for free markets always was centuries of experience with the failures of the only alternative, state control. Free markets are, as the saying goes, the worst system; except for all the others.”

Tracing Failures

We can view the relation between market failure and government failure in two ways. First, we can try to identify market failures and root causes. For example, external costs like pollution cause harm to innocent third parties. This failure might be solely attributable to transactions between private parties, but there are cases in which government engages as one of those parties, such as defense contracting. In other cases government effectively subsidizes toxic waste, like the eventual disposal of solar panels. Another kind of market failure occurs when firms wield monopoly power, but that is often abetted by costly regulations that deliver fatal blows to small competitors.

The second way to analyze the nexus between government and market failures is to first examine the taxonomy of government failure and identify the various damages inflicted upon the operation of private markets. That’s the course I’ll follow below, though by no means is the discussion here exhaustive.

Failures In and Out of Scope

An extensive treatment of government failure was offered eight years ago by William R. Keech and Michael Munger. To start, they point out what everyone knows: governments occasionally perpetrate monstrous acts like genocide and the instigation of war. That helps illustrate a basic dichotomy in government failures:

“… government may fail to do things it should do, or government may do things it should not do.’

Both parts of that statement have numerous dimensions. Failures at what government should do run the gamut from poor service at the DMV, to failure to enforce rights, to corrupt bureaucrats and politicians skimming off the public purse in the execution of their duties. These failures of government are all too common.

What government should and should not do, however, is usually a matter of political opinion. Thomas Jefferson’s axioms appear in a single sentence at the beginning of the Declaration of Independence; they are a tremendous guide to the first principles of a benevolent state. However, those axioms don’t go far in determining the range of specific legal protections and services that should and shouldn’t be provided by government.

Pareto Superiority

Keech and Munger engage in an analytical exercise in which the “should and shouldn’t” question is determined under the standard of Pareto superiority. A state of the world is Pareto superior if at least one person prefers it to the current state (and no one else is averse to it). Coincidentally, voluntary trades in private markets always exploit Pareto superior opportunities, absent legitimate external costs and benefits.

The set of Pareto superior states available to government can be expanded by allowing for side payments or compensation to those who would have preferred the current state. Still, those side payments are limited by the magnitude of the gains flowing to those who prefer the alternative (and if those gains can be redistributed monetarily).

Keech and Munger define government failure as the unexploited existence of Pareto superior states. Of course, by this definition, only a benevolent, omniscient, and omnipotent dictator could hope to avoid government failure. But this is no more unrealistic than the assumptions underlying perfectly competitive market equilibrium from which departure are deemed “market failures” that government should correct. Thus, Keech and Munger say:

“The concept of government failure has been trapped in the cocoon of the theory of perfect markets. … Government failure in the contemporary context means failing to resolve a classic market failure.”

But markets must operate within a setting defined by culture and institutions. The establishment of a social order under which individuals have enforceable rights must come prior to well-functioning markets, and that requires a certain level of state capacity. Keech and Munger are correct that market failure is often a manifestation of government failure in setting and/or enforcing these “rules of the game”.

“The real question is … how the rules of the game should be structured in terms of incentives, property rights, and constraints.”

The Regulatory State and Market Failures

Government can do too little in defining and enforcing rights, and that’s undoubtedly a cause of failure in markets in even the most advanced economies. At the same time there is an undeniable tendency for mission creep: governments often try to do too much. Overregulation in the U.S. and other developed nations creates a variety of market failures. This includes the waste inherent in compliance costs that far exceed benefits; welfare losses from price controls, licensing, and quotas; diversion of otherwise productive resources into rent seeking activity, anti-competitive effects from “regulatory capture”; Chevron-like distortions endemic to the administrative judicial process; unnecessary interference in almost any aspect of private business; and outright corruption and bribe-taking.

Central Planning and Market Failures

Another category of government attempting to “do too much” is the misallocation of resources that inevitably accompanies efforts to pick “winners and losers”. The massive subsidies flowing to investors in various technologies are often misdirected. Many of these expenditures end up as losses for taxpayers, and this is not the only form in which failed industrial planning takes place. A related evil occurs when steps are taken to penalize and destroy industries in political disfavor with thin economic justification.

Other clear examples of government “planning” failure are protectionist laws. These are a net drain on our wealth as a society, denying consumers of free choice and saddling the country with the necessity to produce restricted products at high cost relative to erstwhile trading partners.

There are, of course, failures lurking within many other large government spending programs in areas such as national defense, transportation, education, and agriculture. Many of these programs can be characterized as centrally planning. Not only are some of these expenditures ineffectual, but massive procurement spending seems to invite waste and graft. After all, it’s somebody else’s money.

Redistribution and Market Failures

One might regard redistribution programs as vehicles for the kinds of side payments described by Keech and Munger. Some might even say these are the side payments necessary to overcome resistance from those unable to thrive in a market economy. That reverses the historical sequence of events, however, since the dominant economic role of markets preceded the advent of massive redistribution schemes. Unfortunately, redistribution programs have been plagued by poor design, such as the actuarial nightmare inherent in Social Security and the destructive work incentives embedded in other parts of the social safety net. These are rightly viewed as government failures, and their distortionary effects spill variously into capital markets, labor markets and ultimately product markets.

Taxation and Market Failures

All these public initiatives under which government failures precipitate assorted market failures must be paid for by taxpayers. Therefore, we must also consider the additional effects of taxation on markets and market failures. The income tax system is rife with economic distortions. Not only does it inflict huge compliance costs, but it alters incentives in ways that inhibit capital formation and labor supply. That hampers the ability of input markets to efficiently meet the needs of producers, inhibiting the economy’s productive capacity. In turn, these effects spill into output market failures, with consequent losses in .social welfare. Distortionary taxes are a form of government failure that leads to broad market failures.

Deficits and Market Failure

More often than not, of course, tax revenue is inadequate to fund the entire government budget. Deficit spending and borrowing can make sense when public outlays truly produce long-term benefits. In fact, the mere existence of “risk-free” assets (Treasury debt) across the maturity spectrum might enhance social welfare if it enables improvements in portfolio diversification that outweigh the cost of the government’s interest obligations. (Treasury securities do bear interest-rate risk and, if unindexed, they bear inflation risk.)

Nevertheless, borrowing can reflect and magnify deleterious government efforts to “do too much”, ultimately leading to market failures. Government borrowing may “crowd out” private capital formation, harming economy-wide productivity. It might also inhibit the ability of households to borrow at affordable rates. Interest costs of the public debt may become explosive as they rise relative to GDP, limiting the ability of the public sector to perform tasks that it should *actually* do, with negative implications for market performance.

Inflation and Market Failure

Deficit spending promotes inflation as well. This is more readily enabled when government debt is monetized, but absent fiscal discipline, the escalation of goods prices is the only remaining force capable of controlling the real value of the debt. This is essentially the inflation tax.

Inflation is a destructive force. It distorts the meaning of prices, causes the market to misallocate resources due to uncertainty, and inflicts costs on those with fixed incomes or whose incomes cannot keep up with inflation. Sadly, the latter are usually in lower socioeconomic strata. These are symptoms of market failure prompted by government failure to control spending and maintain a stable medium of exchange.

Conclusion

Markets may fail, but when they do it’s very often rooted in one form of government failure or another. Sometimes it’s an inadequacy in the establishment or enforcement of property rights. It could be a case of overzealous regulation. Or government may encroach on, impede, or distort decisions regarding the provision of goods or services best left to the market. More broadly, redistribution and taxation, including the inflation tax, distort labor and capital markets. The variety of distortions created when government fails at what it should do, or does what it shouldn’t do, is truly daunting. Yet it’s difficult to find leaders willing to face up to all this. Statism has a powerful allure, and too many elites are in thrall to the technocratic scientism of government solutions to social problems and central planning in the allocation of resources.