Why Government Fails So Often: And How It Can Do Better (32 page)

†
The Federal Reserve’s innovative course since the financial meltdown of 2007–8 may be the exception that proves the rule. After all, as noted in
chapter 3
, the Fed is the most independent of all agencies.

*
An example is the Oakland Project, detailed in
chapter 8
, in which officials acted hastily lest the appropriated funds revert to Congress.

*
In a similar vein, it has been estimated that subsidizing private taxi service for the disabled would have been far less costly than requiring cities to retrofit their public transportation systems (as distinguished from making new facilities accessible). Some disability advocates argued, with apparent success, that although this approach could save money, it would violate the equality principle, turning the disabled into second-class citizens. This debate is reviewed in Robert A. Katzmann,
Institutional Disability: The Saga of Transportation Policy for the Disabled
(1986).

*
Unfortunately, according to the GAO, the government’s implementation of such changes—discussed in
chapter 8
—has often been egregious, particularly with new information systems.

*
The credibility problem can also be seen as a problem of government incentives. Specifically, changed social or political conditions may cause its ex ante and ex post incentives to diverge, a prospect that entities dealing with government or making decisions in light of its policies will anticipate and take into account.

†
Economist Frank Knight usefully distinguished uncertainty from risk. With risk, probabilities of alternative states of the world can in principle be determined in advance of an outcome. With uncertainty, such probabilities cannot even be reliably estimated. See Frank Knight,
Risk, Uncertainty, and Profit
(1921).

*
Some agencies such as the National Institutes of Health and the Centers for Disease Control and Prevention have achieved wide credibility, probably because they possess scientific expertise and do not exercise regulatory authority, thus avoiding the politicization that such authority inevitably entails.

*
Weak incentives to control incompetence presumably magnify its incidence. See, e.g., Devlin Barrett, “Marshals Lose Track of Encrypted Radios,”
Wall Street Journal
, July 22, 2013.

CHAPTER 7

Markets

O
n September 15, 2013, the
New York Times
ran a front-page story with a two-page spread inside headlined “Wall St. Exploits Ethanol Credits, and Prices Spike.” The
Times
reported that government regulators were shocked—shocked!—that banks and other financial speculators were buying up ethanol credits created by the Environmental Protection Agency in order to reduce air pollution by mandating the increased use of ethanol in gasoline, which had the effect of driving the price of these credits up twentyfold in just six months and increasing gas prices accordingly.
¹
Chapter 8
discusses the ethanol program in some detail; I mention this here because it perfectly exemplifies the power of markets to undermine policies and even to render them perverse. The ethanol program is hardly an isolated example of this tendency, as we shall see.

Markets—the array of transactions in which people and firms voluntarily buy and sell goods and services from each other—are probably more powerful in the United States than in any other developed country. By “powerful” I mean several things. First, they are ubiquitous, society-shaping, and inescapable, influencing everything that government does, how it does it, and what it decides
not
to do. Paul Volcker, former chairman of the Federal Reserve Board, noted this fact when economist James Tobin asked Volcker why he didn’t just lower the interest rate at a certain point, a potent weapon in the Fed’s arsenal of formal economy-stabilizing powers. Volcker replied
that he didn’t set interest rates; the market did
²
—a point that Tobin, a Nobel Prize laureate, surely understood.

Volcker’s observation about markets’ potency relative to that of government is not limited to macroeconomic policy. For example, government has always tried to shape energy markets,
³
but those markets are so powerful that they tend to resist, distort, override, and marginalize such policies. Oil and gas prices are largely determined by global market conditions. These prices—driven in part by private investment in hydraulic fracking of oil shale, deep-water drilling, and other technologies—in turn affect energy consumers’ consumption and efficiency far more than, say, mandatory fuel economy standards for automobiles (see
chapter 8
).
⁴

Markets are also powerful in another sense, which is discussed in
chapter 4
under the rubric of privatism. They are given freer scope to operate over more domains of legalized activity than in other countries because they enjoy greater public legitimacy here. Markets’ individualistic premises dovetail with many other aspects of American culture, and the public strongly identifies these premises with American prosperity and the “American Dream.” (Thus, it is unsurprising that a public furor arose, especially among business people, over president Barack Obama’s statement [which his critics took somewhat out of context], “If you’ve got a business, you didn’t build that. Somebody else made that happen.”)
⁵

Markets’ cultural legitimacy in turn supports a political presumption—one that is rebuttable and often overridden—against government regulation. In a society as ideologically libertarian and diverse as ours, this presumption is unsurprising. Because the diversity of people’s preferences is precisely what makes market transactions possible and mutually beneficial, the more diversity there is, the more beneficial exchanges can occur. Markets affect diversity in other complex and interesting ways—and vice versa.
⁶
The pursuit of comparative advantage and scale economies among producers leads to specialization of functions that engenders further diversification of skills, products, interests, and preferences. This specialization of functions,
like the market itself, underscores the importance of the interdependencies among market participants, the self-interested value of cooperating with others, and the benefits attending to their interests as well as one’s own. Paradoxically, markets are, as Adam Smith famously maintained, a civilizing, socializing, and pacifying process—even as they wreak “creative destruction” (as Joseph Schumpeter put it) with remorseless efficiency. In this way, markets make the toleration of differences an economic virtue not just a civic one, and they give their greatest rewards to those who know how to anticipate and promote differences for which people are willing to pay.

But the presumption favoring markets is often overcome. Our modern history exhibits periodic spasms of proregulation fervor.
⁷
Such arguments often prevail—most recently in the Sarbanes-Oxley and Dodd-Frank Acts, which extended government controls over the financial industry, and in the Affordable Care Act, which imposes numerous new requirements on the health care and insurance industries.
⁸
The notion that markets have intruded upon public morality to an indecent extent is a familiar trope of moral discourse.
⁹
Even so, the promarket default governs more strongly here than anywhere else.

This chapter neither extols nor criticizes markets—although there is much about them both to extol and to criticize. Rather, my concern here is to analyze the formidable obstacles they pose for policy effectiveness. Upending the common complaint by market enthusiasts that public policies distort markets, I focus here on the reverse: how markets distort government policies.

I organize this chapter around five different ways in which private markets interact with public programs: (1) they compete for participants; (2) they compete for administrative talent; (3) they compete in performance; (4) they compete to build reputation; and (5) markets frustrate market-perfecting policies. I devote most of this chapter to the fifth aspect because one can only understand how markets frustrate such policies by examining how this dynamic plays out in different policy settings. In
chapter 8
, which focuses on implementation, I extend this analysis by exploring many more examples of market-driven policy failure.

COMPETITION FOR PARTICIPANTS

People eligible for a government program providing a good or service can choose whether to participate in it or whether instead to remain in the market that provides the same or a similar good or service, and they will ordinarily make this choice by comparing the advantages and disadvantages of each alternative. This choice, while an individual one, has several far-reaching policy implications.

First, creating a government program or expanding an existing one is likely to have a “crowding out” effect in which people who previously purchased products in the market at some cost or would do so in the future will now opt instead to obtain them from the government program where they are cheaper or even free.
¹⁰
This means that the government is not expanding access nearly as much as it might seem if one simply looks at its participation numbers. Instead, many of the “new” participants in the government program will simply have shifted from their private providers to the cheaper public one. Presumably, this is a net gain for these participants; otherwise they would not have shifted. The flip side of crowding out, of course, is crowding in: just as government provision may draw consumers away from market providers (crowding out), it will draw those consumers in to its program (crowding in), producing more demand (and thus greater staffing need and budgetary cost) than it may have anticipated.

From a public policy perspective, the consequences of these shifts may be highly undesirable, even fiscally catastrophic. Taxpayers will now have to pay for participants who, absent the program (or its expansion), would have continued to receive those products or services in the private market at their own expense. This may increase taxpayers’ political opposition not only to this government program but to others. The resulting crowding in of program participants within a relatively fixed public budget may degrade the quality of the product or service for participants. Scarce taxpayer dollars, which could have been used to provide more coverage for the poor or been spent on other things that the market does not provide to people who need them will have been wasted in this important sense.

Many government programs “crowd out” market or other forms of private provision; the effect of this is difficult to measure precisely and likely varies from program to program. The home loans promoted by Fannie Mae and Freddie Mac are among the largest and most important examples of crowding out—in this case, mortgage-backed securities with a low-cost government guarantee (first only implicit, now actual) replacing private activity in the same market. Dwight Jaffee and John Quigley’s study, discussed in
chapter 5
, finds that “[i]f the government guarantee were eliminated, there is every reason to expect that private market activity would simply replace the activity of the government entity.”
¹¹
In fact, their analysis shows that the market would more than “simply” replace government activity; it would produce different, and sounder, underwriting decisions.

Another example is Social Security retirement benefits, which may crowd out private savings for retirement during the working years. If so, this would somewhat reduce private savings’ net positive effect on seniors’ living standards. Much depends, however, on how rational and future-oriented people are; myopia would tend to reduce preretirement savings and thus the crowding-out effect. There are other complications as well, such as whether retirees plan to use preretirement savings for consumption or for bequests to their survivors.
¹²

An even clearer case of crowding out is Medicaid’s effect on private insurance for long-term care expenditures, which is one of the largest uninsured financial risks facing the elderly today. A National Bureau of Economic Research study finds that

the presence of Medicaid is sufficient to explain why at least two-thirds of all households would prefer not to purchase private long-term care insurance, even if there were no other factors limiting the size of the market…. Medicaid’s large crowd-out effect stems from the fact that—because of its design (specifically, means testing and its status as a secondary payer)—a large portion of the premiums for private insurance for most individuals go to pay for benefits that are redundant given what Medicaid would have paid if the individual had not bought private insurance. [The authors call this an “implicit tax” that Medicaid imposes on private insurance].

Finally, “since Medicaid itself provides far from comprehensive insurance, reliance on public insurance alone leaves most individuals exposed to substantial out-of-pocket expenditure risk.”
¹³

The vast expansion of Medicaid coverage for previously uninsured children and pregnant women with low incomes in the late 1980s to the late 1990s provides another example of crowding out. The study concluded that “for a given level of public expenditure on a coverage expansion, enrollment by those who would otherwise have private coverage reduces the potential number of uninsured people who can be covered.”
¹⁴
Reducing this crowding out is hard for programs, often requiring substantial resources without any guarantee that they will be effective.
¹⁵
Predictably, the Affordable Care Act will cause many small businesses that now provide private health insurance to their employees to drop this coverage, knowing that the employees will be covered under the new program. (In November 2013, the program’s severe database problems forced it to delay small business participation in the exchanges.
¹⁶
)