Why Government Fails So Often: And How It Can Do Better (33 page)

A special form of crowding out occurs with government provision for the poor, which reduces private charity. Philanthropy expert Arthur Brooks estimates that a dollar in public social welfare spending displaces at least twentyfive cents in private giving and also reduces private volunteering.
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Knowing that the government will provide food, foster care, or other social services, charities have less reason to use their own scarce resources to do so. This may even destroy their very raison d’être. This substitution may or may not be desirable, depending on how one views the role of government. One may think that recipients, as members of a political community, should enjoy these products as a matter of right rather than as private discretionary “handouts.” Others may want civil society to cultivate the charitable impulse, already powerful in American life,
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believing (along with Immanuel Kant) that benevolence has greater moral value if it proceeds from
voluntary, autonomous goodwill rather than coerced taxation. One may also have different views about how public provision and private charity affect recipients. On one account, charities use diverse approaches to serve the needy, including some that emphasize, far more than government programs can, individual character development, higher behavioral expectations, and the value of reciprocal obligations. On another account, public programs can exemplify bureaucratic ideals: equal treatment, formal process, and legal entitlement.
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Finally, government competition for participants may
displace
the market—another form of crowding out—as private providers, unlike the government, cannot provide a service for free. If this discourages private providers from entering the market in the first place, as in the long-term care insurance example, it will increase costs and reduce competition, to the public’s detriment.

COMPETITION FOR ADMINISTRATIVE TALENT

The effectiveness of government policies depends significantly on the quality of its personnel. Their intelligence, administrative skills, diligence, policy sophistication, problem-solving ability, and other relevant attributes depend on government’s ability to compete for talent with potential employers in the private sector. The terms of trade between public and private employment are somewhat complicated. First, the two may not be functionally interchangeable. (How can one compare a U.S. Air Force pilot with a Delta Airlines pilot?) Second, federal employees enjoy more job security than their private-sector counterparts, fewer work hours, and often richer fringe benefits as well. (Public school teachers are local, not federal, employees, but a recent study finds that holding these factors constant, they are significantly overpaid relative to what their human capital would command in the private sector or indeed relative to comparable private school teachers.
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) In
chapter 10
, I explore the federal bureaucracy’s talent, morale, attractiveness, and status. The essential point for now is that private firms can outcompete government for the best workers.

COMPETITION FOR PERFORMANCE

The relative performance of government and private markets can often be readily assessed in situations in which they do essentially the same thing. The key phrase here is “essentially the same”; we must not carelessly compare government apples to market oranges. For example, government often serves low-income or high-risk populations—in public housing and public hospitals, for example—that private markets tend to eschew. But even though the contexts in which they act are not identical in every respect, comparisons may nonetheless be useful in illuminating some of the endemic sources of government’s strengths and weaknesses. An important reason for examining such comparisons is that ordinary citizens often observe the differences and make comparative judgments, which presumably affect citizens’ more general assessment of government and markets.

When one compares government and market provision of essentially the same service, the inescapable conclusion is that the market almost always performs more cost-effectively. One example, mail delivery, was discussed in
chapter 6
. Another is hospital care. Medicare Advantage encourages seniors to enroll in private health insurance plans rather than traditional, government-run Medicare; these private plans are run by managed care organizations emphasizing capitation payments rather than fee-for-service reimbursement. Medicare Advantage has grown steadily in popularity at the expense of traditional Medicare and now serves more than 25 percent of Medicare beneficiaries despite strong political opposition from traditional Medicare proponents. (The comparison is imperfect because Medicare has made a higher payment to the private plans, a disparity that the Affordable Care Act will largely eliminate, and the private plans may have attracted healthier patients.) Private-sector competition has also driven down costs in the prescription drug program added to Medicare in 2003.
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And despite Medicare’s claim to have less bureaucracy (defined as a lower ratio of administrative costs to health delivery costs) than private insurers, the reverse may be true—once one
considers that Medicare covers older and sicker patients and that many of its most significant costs (e.g., tax and premium collection, and some overhead) are borne by other federal agencies and do not appear on Medicare’s budget, while the program also enjoys other fiscal advantages (e.g., exemption from taxes paid on premiums and less monitoring for fraud or improper billing, even though stricter prepayment review would pay for itself twenty times over).
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Market providers can also make government providers of the same service more efficient in two ways—by forcing government to compete in cost and other service variables, and by providing examples of greater effectiveness that government can incorporate into its own programs. A study of public and private prisons in states that operate both, for example, found that the mere presence of private prisons reduced cost increases in the public ones.
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This suggests that a public service need not be completely privatized in order for the competitive dynamic to improve the government providers’ performance. Indeed, policy makers sometimes use privatization for reasons other than merely providing the same services more cheaply.
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COMPETITION TO CREATE REPUTATION

Law professor Jon Macey argues that the recent spate of misconduct by regulated financial institutions is partly a perverse consequence of expanded regulatory interventions that falsely assure the public that regulated firms are honest, reliable, and competent, thus reducing the institutions’ incentives to invest in building their reputations for these qualities.
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When the Federal Deposit Insurance Corporation (FDIC) insures a bank, for example, it signals to depositors that the bank is safe, so the bank need not invest in safety beyond what will qualify it for the FDIC’s seal of approval. If statutory rating agencies have assessed the risks of default, debt issuers have less reason to invest more to win lenders’ trust. In this way, agency assurances displace firms’ credibility earned through market processes.

MARKETS FRUSTRATE MARKET-PERFECTING POLICIES

Because markets are so powerful and ubiquitous, we should not be surprised that they affect government programs in countless ways. After all, market transactions comprise most of the economy, and they directly or indirectly affect virtually everything else that policy makers seek to influence. For better
and
for worse, markets even shape some of the most intimate spheres of social life—marriage, parenthood, sexuality, religion, and morality
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—as well as other areas that we often hope, perhaps naively, can be isolated from market forces—for example, politics,
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the fine arts,
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the natural environment,
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and amateur sports.
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Government depends on markets in an even more elementary way: they generate the wealth that government must tax in order to support its activities. Although this fact is perfectly obvious, it constitutes one of the most important constraints on policy making—namely, that policies must be carefully designed so as not to kill the goose that lays the golden egg. Macroeconomists often disagree, of course, about which policies will have what particular effects on economic growth and government revenues; these disagreements figure prominently in political and policy debates. (Macroeconomic projections are notoriously inaccurate; their failure to foresee the Great Recession is simply the most recent example. Their predictive failures are themselves predictable.
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) That said, any policy that seriously threatens to reduce economic growth and thus tax revenues will likely fail, both politically and functionally.

The same markets that provide government with its sustenance at the macroeconomic level also undermine its effectiveness at the microeconomic level, even under the most benign conditions. The reasons for these “subversive tendencies” inhere in the very nature of markets, coupled with the government’s ineffectiveness in identifying and correcting market failures. In this section, I shall discuss nine of these endemic policy-frustrating reasons: (1) speed; (2) diversity;
(3) informational demands on regulators; (4) price and substitution effects; (5) transjurisdictional effects; (6) political influence; (7) enforcement obstacles; (8) rational expectations; and (9) lack of good substitutes for market ordering. Two other important market-related reasons for policy failure are discussed in other chapters—moral hazard (
chapter 5
) and black or “informal” markets (
chapter 8
).

Speed
. Markets move at lightning speed and change constantly. This reflects the powerful incentives that market suppliers have to meet the demands of consumers who are constantly being stimulated and sought by similarly motivated competitors. The instantaneous price movements produced by computer-driven electronic trading on stock exchanges constitute only the most iconic example of this dynamic. They have helped to improve financial markets in many ways; Floyd Norris, a
New York Times
reporter, notes that “trading costs, whether for small individual investors or large institutional investors, have declined sharply. The cuts going to middlemen are smaller, and many markets are deeper and more liquid than ever.”
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Yet this enhanced speed risks occasional but very costly (and apparently more frequent) glitches.
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Policy makers seeking to influence or control these markets must aim at a rapidly moving target that assumes protean forms, and their weapons are akin to blunderbusses. The ability of large investors to move their capital anywhere in the world with the click of a mouse means that policies whose success depends on attracting asset-specific investments are harder and more costly to implement, as the opportunity costs for such investments—their sacrifice of asset mobility—rise.

Perhaps the best example of how markets’ speed challenges policy makers is macroeconomic policy, for which the main tools—monetary policy, fiscal policy, and exhortation (“jawboning”)—are inadequate to this extremely complex, opaque task whose parameters constantly change.
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The Federal Reserve Board, despite its history of exceptionally talented leadership, has compiled a mixed record on controlling inflation and unemployment and maintaining economic growth. (In fairness, the “compared to what” rejoinder is appropriate here; there is only one Fed.) Its record in regulating the banking system
and preventing asset bubbles has also been severely criticized, particularly during the post-2008 banking crisis. This mixed record partly reflects the inevitable tension among these goals but also shows that seeking to fine-tune interest rates by manipulating the money supply, whose composition constantly changes, is inherently problematic. Fiscal policy, which is the province of elected politicians, has manifestly failed, as evidenced by more than a decade of growing budget deficits as a share of economic output even in good economic times, deficits that will explode due to impending demographic changes and (relatedly) rising health care costs unless radical policy changes are enacted. In addition, the effects of fiscal policy changes ordinarily take twelve to eighteen months before they can affect the real economy. By that time, the rational expectations and anticipatory adjustments of market actors may have neutralized the new policy, or economic conditions may have changed in other ways that render the policy change inapt or undesirable when it takes effect. Jawboning has occasionally had some bite in the very short run (president John F. Kennedy’s stance on steel price increases, for example), but is notoriously ineffective as a serious policy tool.

Diversity
. Markets are as diverse as the preferences of the consumers whom they seek to attract and satisfy. There is no single market for, say, banking, food supplements, Internet services, consumer credit, or sports clubs; instead, there are a vast number of providers, each with a different business model, seeking to find or create a specialized market niche with a discrete subset of consumers. Government policies seeking to shape or regulate these markets almost always rely on wholesale, centralized techniques that this vast, uncoordinated, volatile, differentiated array of market actors tends to confound. (The reasons why government relies on such crude techniques are explored in
chapter 9
.) Indeed, as I have explained elsewhere, government and law are natural enemies of diversity, especially when they are most eager to create it.
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(Antitrust and anti-discrimination law are possible exceptions to this—only “possible” because although both are diversity-enhancing in principle, particular enforcement policies in both areas can sometimes suppress it.
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)