Markets fail. That's why we need markets

Or so says Arnold Kling and Nick Schulz in the Christian Science Monitor:

This view can be summarized as “Markets fail. That’s why we need markets.”

This seemingly paradoxical view is based on several overlapping strands of research in economics as it pertains to development, history, technology, business expansion, and new-firm formation. According to this view, entrepreneurs at work in the economy – in finance, high tech, manufacturing, services, and beyond – are constantly experimenting, creating new business models, techniques, and technologies that upend the established order of things.

Some new technologies and innovations are genuine improvements and are long-lasting welfare enhancers. But others are the basketball equivalent of pump fakes – they look like the real deal and prompt market actors to leap hastily into action, only to realize later that their bets were wrong.

Given this dynamic, markets are unpredictable, prone to booms and busts, characterized by bouts of exuberance that are rational or irrational only in hindsight.

But markets are also the only reliable mechanism for sorting out this messy process quickly. In spite of the booms and busts, markets drive genuine long-run innovation and wealth creation.

When governments attempt to impose order on this chaotic and inherently risky process, they immediately run up against two serious dangers.

The first is that they strangle new innovations before they can emerge. Thus proposals for a Consumer Financial Protection Agency, a systemic risk regulator, a public health insurance plan, a green jobs policy, or any attempt at top-down planning may do more harm than good.

The second danger has to do with the nature of political economy. Politics creates its own kind of innovators who can be as destabilizing to markets as market actors themselves – but in far more pernicious ways.

Economists call these political entrepreneurs “rent-seekers.” Rent-seekers gain wealth, not by creating it, but by channeling it through political favors. Examples include government-sponsored monopolies, “targeted” tax breaks for special industries, and legislative loopholes inserted by lobbyists.

The boom in housing and mortgage securities that ended so badly was fueled by government policies that were encouraged by rent-seekers in the real estate, home building, and mortgage finance industries.

Rent-seekers aren’t partisan. They used President Bush’s push for an ownership society to promote sketchy mortgage products. Before that, they used President Clinton’s push for a fairer economy to compel banks to make loans to poorer neighborhoods. In both cases, rent-seekers turned political slogans into profit, but at a steep cost to society when the boom ended.

The response to the current economic crisis has perpetuated and even intensified this process, as hundreds of billions of dollars of taxpayer funds have been used to prop up the very firms that took such reckless risks. The bigger the bad bet, the bigger the bailout.

This gets to the key difference between markets and governments. When innovation-driven excesses and imbalances are recognized in the marketplace, the system can correct itself quickly. This is less the case when government policy failure occurs.

Because political failure is less publicly tolerable than market failure, the temptation becomes for policymakers to avoid acknowledging their role in creating or perpetuating problems. Or they double down on bad bets. So rather than recognize the government’s central role in the housing boom and bust and quickly changing its ways, we see the federal policy apparatus continuing to throw good money after bad in the mortgage market and on Wall Street.

Markets fail; but they learn from their failures. That’s why we need markets. Government can promise to guarantee our prosperity; but only markets can really deliver.