Does Market Failure Justify Government Intervention? (with Michael Munger) – Econlib

Michael Munger: Yeah, let me say something about how we came to this. As you said, Bill Keech was a mutual friend of ours. We actually, the three of us, got together once, I think, at the Southern meetings and had some very nice scotch during the conference. I’m very sad that I did not get a picture of you and Bill together. It wouldn’t quite be Friedman and Stigler, but it would be close. Bill was six foot eight–just shockingly tall. In fact, Bill and I used to carpool to Duke. And, surprisingly, the car that Bill had was a Mini Cooper. Now, the reason he had a Mini Cooper was that the front seat would go all the way back on top of the backseat, and that meant that–uniquely, that car meant his enormous six-foot-eight legs would fit in.

So, one day Bill and I pulled into a parking space, and a woman was walking just in front of us, heading towards the office. And, just by accident, Bill and I both abruptly got out at the same time. I’m not a small man, and Bill is six foot eight. She actually stopped and looked and said, ‘Are there more?’ She thought it was a clown car because a Mini Cooper is very small.

Well, so Bill, I wanted to give the idea of–Bill had a manner of speaking that was something like Eeyore, where, ‘[low Eeyore-like voice] Everything is bad’; but if you talk to him, he actually had a great sense of humor. He did die recently.

And, part of the reason that I had brought this up that we might talk about it, Russ, was that 10 years ago, this very day, Bill and I were in a coffee shop at the beach in North Carolina working on this paper. And, what we were struggling with was the idea of how to express the problem of government failure in a way that was on par with what you talked about when you said market failure.

So, market failure has a long history in economics. In some ways, the idea of market failure was prompted by the events of the late 1920s and the 1930s we now call the Depression. But, the question is: why are there such large fluctuations in aggregate economic activity?

And so, the classical explanation doesn’t explain those cycles very well–the classical economic model. But, the claim was you have to let prices work themselves out.

And then, the question in the early 1930s became: is there ways that government could intervene that would either shorten the time period in which prices will work things out or reduce the amplitude of the decline in the first place? So, can we make recessions shorter and shallower? And, the classical response was, ‘No, no. If you do that, you’ll distort prices; you’ll make things even worse.’

So, this laissez-faire, this kind of hands-off approach, was difficult for politicians and for citizens to accept.

And so, people were casting about for ways: How can we explain these enormous fluctuations in aggregate economic activity? And: Do we have a way of thinking about them that will let us find points of intervention for the government?

So, the Austrian response to that–as you know–and Ludwig von Mises, as early as 1920, had written this book on Socialism, saying that the government didn’t have enough information. Without prices, there’s a variety of reasons why the government would not be able effectively to intervene. The Public Choice response in the late 1950s and early 1960s took the Austrian objection as being correct, but added an incentive problem.

So, I have written recently that in order to understand an economic system, you have to look with two eyes: Incentives and information. And, the question is: Can you generate by looking with two eyes–incentives and information–a better outcome than you would get from markets?

Because, markets create a set of information, and markets generate information from prices. Can you do better than that?

So, the Public-Choice response usually would claim that government doesn’t know enough and government bureaucrats will have the wrong incentives. And so, we probably can’t do better.

Now, there was a response that I think Public-Choice people don’t take seriously enough, and that was from the Cambridge Welfare School. And, let me take just a second and explain the Cambridge Welfare School.

So, Oskar Lange famously said, ‘Socialists certainly have good reasons to be grateful to Professor Mises, the great devil’s advocate for their cause. It was his powerful challenge that forced socialists to recognize the importance of an adequate system of economic information. So, as a memento of the prime importance of sound economic accounting, a statue of Professor Mises ought to occupy an honorable place in the Great Hall of the Ministry of Socialization of the socialist state.’

And so, his claim–what Lange claimed–was Mises is right. We may not have enough information. We need to work harder on information than we thought.

Well, what information do we need? Well, when you look back, there’s another school of market failure, and that is the equilibrium people. So, the Cambridge School was welfare economics: Can we have better outcomes? And, the equilibrium school had to do with: Will markets produce coherent outcomes or will they just be chaotic?

And so, Leon Walras in the late 1890s said, ‘What must we do in order to prove that the theoretical solution of the problem of the determination of equilibrium prices is identically the solution worked out by the market?’ That is, we can come up with an ideal. Will the market approximate that? ‘Our task is very simple. We need only show the upward and downward movement of prices solve the system of equations of offer and demand by a process of groping.’

Now, in French, groping is par tâtonnement. So, tatonnement is the process by which markets are going to discover the correct prices.

What’s interesting is that Oskar Lange took exactly that par tatonnement–that groping–and said, ‘That’s what government should do: experimentation. So, what we need to do is experiment with different policies.’

That is literally exactly where President Roosevelt, when he made his speech about experimentation, and where people who favor government control, government intervention in the market, they are advocating for experimentation.

So, the Austrian critique that government doesn’t have enough information is possibly true. But, the–Public Choice in the 1950s, looking back, said, ‘Well, government can’t have enough information. And, they also don’t have the right incentives.’ Because, when you look at Ronald Coase or Gordon Tullock, they say, ‘Well, government officials–people who advocate for government–don’t recognize the political problem.

What I have found is that the Cambridge economists, and A.C. Pigou in particular, very much recognized the political problem, both the incentive and the information problem.

And, I’ve actually found in a number of places where A.C. Pigou in the 1920s, in the 1920s, should be recognized as the first Public Choice theorist. And, I can read the quotes if you want, but I’ve written several things about this.

What’s interesting is that the Cambridge economists–the Welfare School people–recognize the information problem to an extent that I think many later people didn’t give them credit for. But their answer is groping. They want government to have enough power to do constant experimentation.

And, here’s the important thing: It has to be insulated from political incentives. So, it has to be completely outside of any democratic pressures.

This is why, during the 1930s, the Roosevelt Administration–many theorists in the Roosevelt Administration–and people in the United Kingdom were such fans of Mussolini: not because they wanted to be Fascists but because they recognized that the incentive problems of politics were so severe.

So, just one more thing and I’ll be done with my introduction–because I think this intellectual history is interesting for people who have grown up in the Public Choice tradition.

In the Public Choice tradition, we are catechized to learn people who favor government intervention don’t understand the information problem, and they don’t understand the incentive problem. And, once you put politics in, then the scales will fall from their eyes.

That’s not true. They actually recognized those problems before; they just have a different solution.

But so, there’s a paper in 1938 by Abram Bergson that isn’t often read anymore but should be. So, in 1938, Bergson said, ‘If the production functions and individual indifference functions are known, they provide sufficient information concerning the economic welfare function for the determination of the maximum position, if it exists.’ All the details–all of them–are just matters of implementation. So, all we need–