There’s been a lot of talk lately about market failure, although some of it, perhaps a lot of it has been misleading.
The basic argument goes like this: finance has been relatively unregulated over the past generation, in contrast to the 50 or so years following the Great Depression, when the first round of government oversight befell Wall Street. Lessening the regulatory strings that bound is at the heart of the current ills. The solution: ratchet up government regulation, just like in the old days, a decision that will inoculate the economy from similar bouts of trouble in the future.
Undoubtedly, some reordering of regulatory powers is in order. The fact that the government had to step in and bail out Bear Stearns, Freddie and Fannie and lesser names suggests that something’s amiss. But let’s be clear: rethinking regulation isn’t the same as creating more regulation. And even the most-intelligent regulatory notions will come at a price.
New government regulations, no matter how well meaning or deftly conceived will spawn unintended consequences. History is clear on this point, as it’s been proven time and time again. Market forces are always with us. Governments are inclined to suppress and re-engineer those forces to satisfy political demands. That’s all well and good, and in a republic the crowd’s demands, within reason, must be addressed. Still, the basic inspiration for action on this front is invariably one of manufacturing a free lunch of one sort or another. But there is no free lunch. Of course, that piece of information tends to be overlooked at the dawn of a new age of regulation.
Overlooked or not, re-engineering market forces here and now creates an effect there and then. The risk is that the byproduct of a new piece of regulation creates a new problem elsewhere. That opens the possibility of making matters worse on a macro level by intervening in the marketplace. That doesn’t mean that the unintended consequences are obvious, or even recognized as painful. If the fallout of market intervention is spread out across the economy, over time, the fleeting appearance of a free lunch may arise. If a new tax grabs a few pennies more from everyone’s wallet for a commodity or service, for instance, the apparent pain is minimal, perhaps even unnoticed. Meanwhile, the accumulated cash that’s generated by the new tax can be redeployed for the common good. The result: the emergence of what looks like a free lunch.
Regulation is more subtle than taxes as a tool of market intervention. New rules of operation may impose additional costs of doing business, or they may equate with higher opportunity costs. Meanwhile, the efficacy of new regulations may not be obvious. A new financial structure that’s designed to prevent corporate implosions a la Bear Stearns will, if effective, create the appearance of normality. In other words, regulation often seeks to prevent certain outcomes–bankruptcy, for instance–as opposed to creating events that might not otherwise happen, such as redistributing wealth. As such, regulation may be a covert force, impacting free markets in a way that’s overlooked by the crowd.
The best case scenario is when regulation works quietly and produces a social good that’s generally applauded as progress. But there are unintended consequences to consider, too. The fact that such consequences are “unintended” means that they’re not obvious in advance. All the more so in an economy that’s already regulated every which way. The prospect of identifying cause and effect has gone the way of the dodo as a practical matter in economic analysis.
Perhaps the mother of all unintended consequences is unfolding now, thanks to the grand plan in recent decades at engineering recessions out of existence. For 20 years or so, the so-called Great Moderation has been a success, or so it seemed. But a victory based on suppressing market forces is by definition a temporary victory, as we’ve discussed.
The idea that you can trim or eliminate economic contraction without materially affecting growth, or creating dangerous unintended consequences elsewhere in the economy is a popular myth. That’s not to say that market forces should always and forever have the last word. But if we’re wedded to the idea of some degree of government intervention to tame market forces, we must also recognize that the task will come at a price–eventually.
That leads us to assess the current dilemma, including the cries that unfettered market forces as the source of the financial and economic pain. First, we need to recognize that market forces, by their nature, are a volatile lot and in the short term there will be pain. Joseph Schumpeter, among others, made this clear long ago. In exchange for short term pain, however, is the prospect of long-term gain that, in the aggregate ends, produces a net plus for the economy overall. In the meantime, market forces will naturally and inevitably produce pain in one corner of the economy on an ongoing basis. Growth, after all, requires innovation, and innovation is by nature experimental, and experiments sometime stumble. Is that a sign of market failure? Absolutely not.
Let’s also recognize that the broad efforts at promoting the Great Moderation have probably exacerbated the pain by promoting 20 years of borrowing and risk taking that might not otherwise have occurred if recessions weren’t tamed. By pushing the payback into the future, the accumulated price tag has grown, and is now coming due, with interest.
No, we’re not arguing that our economic policy should return to the 19th century, when booms and busts were dramatically more frequent and severe and government intervention was virtually unknown. The dismal science has learned much over the years and there’s no reason to think that an intelligent management of the economy can yield benefits, or at least minimize the pain. But there’s a limit to the benefits that can be extracted from market cycle management, and we may have reached those limits.
Conceptually, an intelligent economic policy will seek a) to maximize the growth that naturally flows from creative destruction; and b) minimize the pain. There are multiple points of equilibrium in that tradeoff, and deciding which point is preferable is a political decision, and an evolving one at that.
Economically speaking, the tradeoff is likely to yield relatively meager results in the next few years, if not the generation ahead. Why? Because the benefits of the past have been unusually big.
What’s coming will not be evidence of market failure. Rather, it’s the cost of the “free lunch” we’ve all been enjoying over the past 20 years. So, yes, the bill has arrived and we’re being asked to pay. But this time, management is only accepting cash.