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Preferring Market Failure

Lately, the beltway seems to be drunk off the wine of market failure – framing every hiccup as proof of the markets’ inability to produce socially justifiable results. Whether various individual examples are the genuine article or exceptions doesn’t seem to matter as everything becomes the reason for the government to do everything. In Virginia, the implications of DC’s flurry of spending & programming stretch long beyond the obvious effects of being part of the Union. If we hold the market failure premise as true, as it’s normally bandied about today, the precedents being set on Capitol Hill today will reverberate in Richmond tomorrow. Bearing this in mind, I think it’s important to describe market failure’s less detectable but potentially more injurious analogue on the public-sector side.

It is customary to hear in the media and in the halls of power about issues of market failure and the gaps that are exposed by that failure. In general, whether through crisis or a gradual realization of undesirable outcomes, this conversation turns to the means by which these perceived failures can be addressed. And the most common theme has typically implied that the cleavages borne from perceived market failure is the province of government to alleviate. While this is certainly true to some extent – there are certain public goods that quite simply cannot be replicated by the markets effectively – there are also those cases where this understandable inclination may be incorrect. For example, certain cases, while unfortunate, could be a relative rarity and are only exceptional, anecdotal examples being amplified by the media or interest groups. Highlighting such an outlier may create impetus for nonmarket intervention that may be ill-conceived and could serve to distort market mechanisms that may be, for the most part, working.

At the same time, market failures are a reality. The provision of services and goods by the market is motivated primarily through the fixation with the profit margin and the bottom line. This is not an inherently problematic issue, but as noted earlier, there are certain public goods that cannot be proffered by this mechanism alone. In such cases, such as national defense and security, market products can only at best supplement nonmarket products. On the other hand, public-sector performance is generally motivated by intangibles such as the needs of constituencies, operational concerns, and political issues. For the same reason that market mechanisms cannot satisfy public goods efficiently – output and “success” being tethered to generally unquantifiable variables – the public sector is often hampered by its inability to measure how its inputs generate desirable outcomes. In many cases, this results in a slate of externalities all its own that are generally unobservable well past policy windows and political time horizons. A good illustration of this phenomenon is the fact that output in public programs is often measured by its inputs – x percentage increase in this, x many more officers on the streets, and the like.

All this is further complicated by what the RAND Institute’s Charles Wolf, Jr. calls “internalities,” or the internal processes of an organization that may or may not be well suited to producing the desired outcome. These internalities are primarily a public-sector issue as they are often disconnected from the output, having been emplaced earlier or with different types of outcomes in mind. In the private sector, this is less of an issue as internalities are always strongly coupled to the desired outcome for profit. Being disconnected from output, internalities have a way of distorting or even preventing the output from being anywhere near the desired goals; more ominously, by its very nature the full results of these distortions may not be detected for a much longer time or ever fully understood. Essentially, the danger of nonmarket action can be found in every phase of its production: the inputs cannot be accurately tethered to the outcome and are often made along political lines; internalities are disconnected from the desired final product and may actually undermine what is being attempted; and the outputs are difficult to measure and may produce a host of derivative externalities all its own.

While the risks of utilizing market mechanisms are real and generally well-known, the idea that whichever missions the markets cannot fully satisfy are the province of government is simply a fallacy. Of course, in public policy discourse today, market failure is such a broad and subjective term that can be manipulated to serve the interest of any politician (President Obama’s tonsil stories, for example) or interest group (such as blatant rent seeking from corporations) as a means to advance their agenda through political channels. But the truer danger may be not in identifying market failures, but in being so embracing of nonmarket alternatives that, although possibly politically expedient, will probably not solve the problem and may even compound it.

The lessons for Virginia are clear. As we enter the final months the gubernatorial race, those vying for spots need to understand the implications of their programs and ideas and actions that introduce more government. Virginia earned the top spot in CNBC’s 2009 list of Top States for Business largely because of the Commonwealth’s ongoing commitment to preserving an environment where free enterprise can thrive. But as national politics becomes ever more enmeshed in the idea that government is the better alternative, our representatives and elected officials need to understand that their good intentions (if even that) may be doing more harm than good.

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