Lexington, KY - We are presently in the midst of a major ramping up in the size of government. U.S. government spending is slated to rise by about 30 percent this year, with a quadrupling of the deficit. We have seen essentially a federal takeover of two auto companies and selected banks, with the subsequent direction of merger activity, executive compensation, and product lines to offer. There are prospects of a much larger federal role in health care and energy markets. There are proposals afoot to regulate carbon emissions, establish more rules for the financial sector, and to pursue a more aggressive antitrust policy.
Thus, as promised by the current administration and Congress, we have seen significant change in federal policy. Maybe I'm swimming upstream with my perspective, but I have a negative view of this occurrence. The change should be in the other direction, toward a smaller, more appropriately focused government and more reliance on the private sector.
No one disputes that change is well overdue with our long-festering problems in health care, public retirement programs (Social Security and Medicare), public education, and, as we have found out, in our housing and mortgage markets that have infected the financial sector. These are not a set of institutions ruled by "free markets" by any stretch of the imagination, so it's a bit disingenuous to argue that the problems in these areas are due to a failure of the market. Nevertheless, there are those who argue we need more government to fix them. I have argued for less - and today, I'll elaborate on the reasoning behind that.
Markets rely on voluntary buying and selling of goods and services. This works to hold someone immediately responsible for mistakes and provides rewards to those who do well. If a company invests in a project that provides something to customers that the latter value, the firm is rewarded with a lot of profit. Investors are happy and more line up to put their funds into the enterprise. The converse happens when a company invests unwisely in something that consumers do not wish to purchase. Sales are minimal and losses mount. Stockholders and bondholders are dissatisfied, pressure mounts on management to change course, and managers are at risk to lose their jobs. Present investors may move on to other opportunities and new investors are not forthcoming unless the firm finds something customers really want.
In short, voluntary exchange in free markets is a great incentive system to get things done that ordinary people really want done. Power to the people, baby!
Competition adds to this incentive system, so it's important that individuals and firms have the right to compete in markets as sellers and/or buyers. With competition, not only must companies provide a product customers want and provide a satisfactory return to investors, they must do it better (or at least as well) as their competitors.
And here's another attractive aspect of voluntary trade: It's voluntary. No one is coerced into buying or selling something against their wishes.
Unfortunately, the profit motive inherent in incentives can be co-opted by government to reward and induce unwanted outcomes. A leading example is the government-induced profitability for financial institutions to write high-risk mortgages.
Absent such distortions, free and competitive markets, though not perfect, work quite well. But they normally depend on important forms of government support. Voluntary trade relies on well-defined property rights and rules of exchange, and so clear and strong property and contract law are crucial underpinnings of a market economy. Protection of individuals and their property from violence and theft also are important, indicating the key function of criminal law. Government can also have a role in the provision of certain types of infrastructure and goods that are collectively consumed (as needed by the populace) such as fire protection, road repair, streetlights, sewage and water services, and pollution abatement.
However, it's clear that the role of the above functions is not to plan or decide what gets done, but to enable and support individual decisions by people that determine what is accomplished. Sometimes this sounds simple, but it isn't. It enables people to solve complicated problems. There's nothing simple in the manner that the private sector produces and sells aluminum, electricity, aircraft, audio equipment, artwork, and a multitude of other products.
When governments get outside the above proscription and become involved in planning or regulating specific economic outcomes, things rapidly go awry. There are clear reasons why this happens. One reason is that the incentive system of competitive markets no longer applies. So, for example, government-planned and -backed auto makers, banks, mail delivery services, energy companies, or health-care providers do not have to make a profit to survive since they have tax money to rely on. Thus, customers need not be satisfied and managers are not pressured and penalized for poor performance. Government managers are rewarded with promotions and power by engaging in highly visible, "feel-good" projects that do not necessarily create anything of value to the public.
"Investors" are taxpayers whose dollars are put into government enterprises and who cannot withdraw their funds or withhold investment from unwise government projects. Taxpayers do have recourse regarding poorly performing public organizations via lobbying and the ballot box, but this is a much more difficult and cumbersome process than simply taking your money and business elsewhere. Similar comments apply to government regulatory bodies that issue unwise or counterproductive regulations.
Additionally, the incentives in the private sector are such that it behooves firms to hire and retain managers and employees who are experts at what they do. Absent such incentives in government organizations, there simply is not the urgency to find the people with the right expertise to manage the organization. To illustrate this, witness that the head of the administration's team to reorganize the U.S. auto industry is a former hedge fund manager. Perhaps more telling in this regard is that, effectively, the board of directors of Chrysler and GM is the U.S. Congress. While I'm sure there are a multitude of talents among members of Congress, there is not much information or knowledge embedded in this group on how to successfully manufacture cars.
While some functions of government are essential to support a market-based economy, this is a far cry from reliance on increased government planning and spending on specific economic activities. Governments simply do not have the incentives nor the information and expertise to do so effectively. Our economy and economic recovery depend on a greater reliance on the private sector and less on government planning.
John Garen is department chair and Gatton Endowed Professor of Economics at the University of Kentucky.