Update: Paul replies here. I agree with absolutely everything he says, but ultimately I think our views on what constitutes “optimal” action still differ as a result of different value judgments.
You should definitely go read the posts, they are very good posts which cover the idea of government failure, and the limits to market failure through asymmetric information. I completely agree with all the objective parts of his posts. However, I still believe my response to “Now there may be something wrong with the price system, but there is a lot more wrong with the government system”:
That’s really your key value judgment isn’t it. I’m not sure I agree. I am not a fan of “multipliers” – but in the face of a large, sustained, market failure I find it hard to conclude that there is no role for government.
It is still a value judgment
Yes, government failure happens – a lot. Governments, like all other institutions are filled with self-interested individuals, whose actions are not fully related to the goal of the organisation.
However, in reality market failures are also endemic. There are a multitude of situations where the interests of individuals and social interests are not aligned.
Determining that government failures will always be larger than the market failures they are supposed to cover is a value judgment.
Why is your value judgment different
Market failure stems intrinsically from one thing – the failure of prices to represent scarcity. We know that markets can fail in any of the cases where perfect competition fails namely:
- Sellers of a product have market power,
- Buyers and sellers without a voice in the market are adversely/positively influenced by the market,
- Entry and exit from the market are difficult,
- Information is asymmetric,
- Institutional conflict pushes firms/buyers away from rational behaviour.
Now as Paul Walker rightly says, even when we have market failure (which we often do) we also require government action to improve outcomes – which it often doesn’t. In fact, in a number of these cases the market will adjust to improve outcomes.
However, as Paul Walker does, I would like to move away from this relatively static/short term conception of market failure and towards a dynamic view. Look again at what my comment said on the post:
in the face of a large, sustained, market failure I find it hard to conclude that there is no role for government
In Paul Walkers discussion, the price allows us to solve market failures over time. However, this is not always the case when there is interaction between agents. Specifically, there may be “multiple pareto-ranked” equilibrium which are stable and consistent over time – each with their own set of prices and welfare levels. In this case there are multiple ways the economy can go – and we have no assurance that, over time, the market price will converge to the “best” outcome.
Now, in the case of a massive negative shock to output such as the one we MIGHT have now, we are able to make a case for further government intervention to push us towards a pareto superior outcome.
For government to do this, it needs to understand the true “capacity” of the economy to produce and then work to influence “expectations” to get us to a better outcome.
Given the relationship between labour and other inputs, I believe that an unemployment rate in double digits (or even high single figures) indicates that we are at risk of moving to a pareto-inferior equilibrium. In this case, government actions seem justifiable – even if their implementation will be wasteful.
However, of course this is a value judgment on my part. Given that we will never face the counterfactual of our actions we can’t even test these value judgments – so I do not expect to convince anyone of my point of view. Even so, this should make it clear that the idea that government failure always exceeds market failure is a value judgment – it is an opinion based on belief rather than an objective statement of how the world works.
Note: My opinions on a stimulus here seem to support some degree of stimulus in the US. But unemployment in NZ is only 4.2%, even the worst forecast pick it to reach 7%. As a result, there isn’t as large a case for a stimulus package here. Furthermore, I did not cover the “optimal type” of stimulus. Ultimately, multiple equilibrium come from identified structural issues, and specific market failures – a “stimulus” package should target those, instead of arbitrarily throwing around and wasting national resources.