The Truth About "Free Markets" and "Market Failure"

[I]t is possible to conceive of better worlds that the one in which we live. But the problem is to devise practical arrangements which correct defects in one part of the system without causing more serious harm in other parts.

—Ronald Coase, "The Problem of Social Cost"

These days everyone has an opinion as to what's wrong with "free markets" and what government should go about it.

On one end of the spectrum are those who remain persuaded that government intervention in the economy inevitably distorts private incentives, and thus that "free markets" function best when they are left alone. In other words, "If it ain't broke, don't fix it."

On the other end are these who believe that government must act assertively to curb market excesses and rein in corporate power. In other words, "It is broke. Fix it now."

A technocratic middle reconciles these two extreme viewpoints by invoking the concept of "market failure." The logic is presumably simple: a role for government exists if, and only if, a market failure exists. The burden to policy lies in establishing the nature of the market failure, and then specifying the mechanisms by which it can be corrected.

Unfortunately, none of these three rules of thumb is of much use as a guide to policy making in a world where markets are as temperamental as a tent-full of toddlers and market failures are as abundant as a bankrupt banker's bonus bag.

This is a problem. To illustrate with an analogy, let's say that the issue under consideration were treating cancer, instead of fixing markets. Suppose scientists understood what cancer is, and how to treat it. What if, instead of working with a definition based on science, every doctor decided to make up her own definition of cancer. For one doctor, it would be any illness that makes people suddenly lose weight. For another, it would be any illness resulting in death. Using the first definition, healthy people would be treated with chemotherapy. Using the second, treatment would only be offered to patients when already dead. Not good.

Similarly economists know what market failure means. However, at least some legislators in charge of its treatment exhibit a persistent disregard for the term's correct definition. As a consequence, where some may see potential government programs everywhere they turn, others only see them when conducting economic post-mortems--of which we have witnessed more than the usual number in the two years.

In its usage by economists, market failure is a concept that is defined in terms of "perfect competition." Contrary to caricature, perfection in this context here means a state of the world that is fundamentally unattainable, not one that is ultimately desirable. The conditions defining perfect competition are numerous: everyone is small relative to the market (no monopoly); all information is public (no secrets); there is no uncertainty or inter-dependency (no surprises); and transactions costs costs are zero (no lawyers). In another words, a fantasy land.

The entire point of creating such an idealized, fundamentally unrealistic model of markets was to provide a stable point of reference for the study of the real world, in all of its astounding diversity and complexity. Indeed, after the early 1970s, economists more or less stopped studying perfect competition. There was nothing left to study. Attention turned almost entirely to another topic: market failure. And what is market failure? Quite simply every situation that isn't perfect competition.

The first takeaway, then, is that the "market failure" test for government intervention is a misleading one. Market failures so permeate economic reality that "correcting" every one of them to arrive at a frictionless, riskless, perfectly efficient alternate reality is a dangerous fantasy.

The second takeway is those who seek naively to equate "free markets" with economic efficiency are engaged in horse-and-buggy reasoning that has no place in any serious, 21st century discussion of economic challenges and their solution. From the standpoint of economic theory backed up by decades of empirical analysis, there is absolutely no reason to presume that "free markets"--markets in which, for example, business opportunities exist and companies pursue them--are "efficient." This is because, under conditions of rigorously defined "perfect competition," business opportunities simply do not exist; there are no proverbial $20 bills lying on the sidewalk. Consequently, even in the total absence of any government intervention, substantial inefficiencies in market outcomes are to be expected whenever participants in markets don't share the same information, the practices of firms differ, and the environment is characterized by significant uncertainties.

To paraphrase the Nobel laureate Ronald Coase, well-designed policy must begin with a situation approximating that which actually exists. The situation that exists in any real-world market is one rife with "market failures." From such a starting point, a change in the market environment created by government may move the market either towards, or away from, efficiency (to say nothing of equity!). It certainly is possible to conceive of worlds in which market failures were less dominant. But the problem is to devise practical arrangements which correct defects in one part of the system without causing more serious harm in other parts.

Unsure? Ask your doctor.

(More to follow on the closely related topic of why "business-friendly" and "entrepreneur-friendly" environments are not the same.)

The Smartest People in the Room

I'm a person of simple pleasures. For instance, I count any day a success when I have the opportunity to use the word "eviscerate." Take Thursday. That was the day when I wrote this blog post about Presidential Study Directive 7 (PSD-7). In additional to employing the word "eviscerate," the post expresses considerable enthusiasm for the direction of the global development rethink currently going on at the White House.

Yesterday NYU development luminary Bill Easterly had the kindness to not only take notice of the post but also to point out to me that I managed to misrepresent a blog post by Aid Watch staffer Laura Freschi as one by the Maestro himself. (Arrghh. Guilty! Though, in my defense, how was I to know that anyone under the age of 50 could so persuasively convey the jaded air of a veteran development insider? Easterly trains his people well!)

It turns out that Easterly is considerably less sanguine than I am about the potentially transformative potential of PSD-7:

Professor Auerswald (sorry for my teasing you in this post), you do seem to have a theory of social change in which promises about government intentions to someday change priorities are a major force. My experience of many years of observing such statements is that they are more like New Year’s resolutions that are repeated every year.

My rebuttal to this? My counter-attack? None whatsoever. Easterly is right. My last post is probably mostly wishful thinking. What is the likelihood that awareness of the exigencies and opportunities of the moment will be enough displace entrenched bureaucracies and transform decades-old habits of thinking? What is the likelihood that an esoteric administrative exercise like PSD-7 will turn out to have made a difference in the lives of actual human beings? Even people like me who were actually born in Washington DC (yes, some of us exist) recognize the obstacles that stand in the way of such outcomes.

As Easterly is, I believe, aware from any one of my six previous posts calling into question the coherence--indeed the very existence--of his own theory of social change (1, 2, 3, 4, 5, and 6), I do not in fact hold the view that the United States government (USG) is likely to be a "major force" in global development. If anything, I would say that the causality is reversed: the point of my post, and a core point of this blog, is that global development will almost certainly be the major force affecting the United States in the next quarter century, whether the USG plans effectively for this eventuality or not.

So what was it about Freschi's post that motivated me to drop deadlines on that particular day and go on the offensive? It's pretty simple: I find it more than a bit depressing when The Smartest People in the Room refuse to leave the room in which they are the Smartest People. For instance, from Easterly:

I vaguely remember that I was invited to a meeting with a US government big shot on development whose name I’ve forgotten, to take place in Washington. I failed to do my patriotic duty, using the lame excuse that the meeting was two days before Christmas, and I unreasonably treat the days around Christmas as belonging to Family Zone.

After a lifetime working on development, might not Easterly have made it a priority to influence the most sweeping review of priorities in global development undertaken by his country's government in a decade, if not longer? After all, the government of the United States may not be much to Bill Easterly, but it's got more resources at its disposal than he does. No way to find an alternate time? Schedule a call? Write an email? Post a direct Tweet? Undertake a pinkie lift?

No. None of the above. Just not worth the time.

(Note: Bureaucrat appears to have been working two days before Christmas. Not everyone has the benefit, as Easterly and I do, of living by the academic calendar.)

In any process that involves difficult decisions with uncertain outcomes, those seeking solutions should welcome, even celebrate, the views of astute critics (in this case, Easterly). But when critics hold themselves apart from engagement in anything that might resemble positive action, one is sorely tempted to make sausage of their studied detachment.

Step 1: Eviscerate...

What it Means to "Elevate Development"

The White House process aimed at redefining U.S. development policy for the 21st century (known internally as Presidential Study Directive 7, or PSD-7) is coming to a close. Earlier this year some colleagues and I had the opportunity to offer input to Gayle Smith in the National Security Council, who was tasked with leading PSD-7, which we did.

On Monday Foreign Policy blogger Josh Rogin leaked a copy of the document that is coming out of PSD-7. Item one on the proposed new agenda for global development policy, as advanced in this draft, is this:

Moving forward, the United States will foster the next generation of emerging markets by enhancing our focus on broad based-growth and democratic governance.

To begin with, consider here what is not listed first on the nation's development agenda: "Poverty alleviation." "Nation-building." "Global threats." "Counter-terrorism." And other code words allegedly relating to "development" that are based alternately about fear & condescension.

Notice further that in this sentence "broad-based growth" is listed before "democratic governance." What does that mean? It means that the people who wrote this draft get it: expanded economic opportunity precedes democratic change. Both together lead to increased prosperity. That is development. (Elaboration here.)

Now as a counter-point, Bill Easterly [actually, Aid Watch staffer Laura Freschi, see below] offered his comments today. He focused on administrative structure:

The most significant change in the draft is the creation of interagency committee reporting to the President to run US development policy.

He wants to know what it means to “elevate development” as a “key pillar of US foreign policy.”

Here's my attempt at an answer to that question. "Development" today refers to the process by which the majority of the world's population is joining the global economy. It is a process whose momentum is going to overtake and obliterate puny debates about "aid" (pro and con) and eviscerate stale discussions about donor coordination and accountability.

"Elevating development" means taking (at least some!) decision-making away from those alleged development experts who pay no attention to entrepreneurship and global business (the actual drivers of development) and instead continue to devote their energies to making failed approaches less failed. (Yes, I am talking about pretty much every "development economist," Easterly included.)

It means that people who have not been accountable or serious about advancing actual development may potentially lose their authority, and then their jobs, because this is too big an opportunity for this country to be entrusted to people not determined to make the most of it. It is not only too big for one agency. It is also much too big for the entirety of the U.S. federal government--which, incidentally, will have succeeded if manages to remain relevant to global development in the next quarter century, much less dominant.

That is what this process is about. That is what the draft PSD-7 memo from the White House is about.

Now if you don't care about the role of the U.S. government in the world today, don't read this memo. If you do, its message is worth considering carefully. There is not an organization in this country that would not benefit from its own PSD-7 process, and that wouldn't also be moving forward if it similarly found a way to "elevate development" in its strategic planning.

Correction: ... Ummm ... well... as it turns out Bill Easterly didn't quite exactly write the post that I attribute to him in this blog post. As kindly pointed out to me by Bill, the post was actually written by Aid Watch staffer Laura Freschi. Apologies to Bill... and to Laura!