SOCIETIES CAN be rich or poor, and they can have big governments or small governments. That leaves four hypothetical combinations: rich/big, rich/small, poor/big, and poor/small. Yet as we saw in the last chapter, in the real world, one of these combinations is missing: There are no rich countries with small governments—governments that spend and regulate little, governments that eschew public investment and keep the public sector’s reach to a minimum. (Okay, there are a few that are sitting on huge pools of oil.) A big government isn’t a guarantee of prosperity, but where we find prosperity, we find big government, too.
We have just seen how the mixed economy propelled wealthy democracies across the Great Divide. But the story of how this happened doesn’t tell us why it happened. Why does it take a lot of government to get and keep prosperity?
Here’s why: Government is special. Democratic government is extra special. In the journey from poverty to prosperity, it doesn’t just come along for the ride or get foisted on already prosperous societies. Effective government makes prosperity possible. It can do so because government has unique capacities—to enforce compliance, to constrain or encourage action, to protect citizens from private predation—that allow it to overcome problems that markets can’t solve on their own. These problems are both economic and political; they concern areas in which markets tend to fall short and areas where market actors tend to distort democratic processes in pursuit of private advantage. Economists use the term “market failure” to describe many of these problems, and we’ll use it too. But it’s crucial to recognize that some of the biggest problems stem not from the operation of markets alone but from the inevitable interaction between markets and politics.
The siren song of “free” markets is simple and catchy. The anthem of market failure is not so hummable, made up of a series of rich but complicated themes. But by countering the siren song, these themes can lead us past many shoals. In this chapter, we consider these themes one by one, showing that in modern economies, trouble with markets is everywhere. That doesn’t mean markets should be avoided. It doesn’t even mean government should always be brought in (since there are government failures, too). It does mean, though, that if you’re trying to foster a flourishing society, you need to consider the best mix with a healthy understanding of what markets alone can’t handle. And once you do, you’ll find that in virtually any prominent economic activity, you’ll want a substantial role for government.
Even the conservative icons of economics such as Milton Friedman and Friedrich Hayek acknowledged that under a wide range of circumstances, markets operating on their own will fail to produce good outcomes. Yet discussions of market failure often seem like mere footnotes to the received story of market triumph. They are not. They are an essential part of the story itself.
Many important goods in a society are “public goods”: They must be provided to everyone or no one.1 The classic example is a lighthouse. Its light is available to all ships navigating a coastline. There is no cost-effective way to limit the lighthouse’s benefits to paying customers. So nobody has reason to pay. And if no one pays, markets won’t motivate anyone to provide the good.
Public goods of this kind are prevalent in modern life. The biggest, most obvious example is national security, which consumes one-fifth of federal spending. As a practical matter, protection from foreign attack is a service that must be provided to everyone within a country. A private firm could not sell that protection to paying customers because a customer’s neighbors would be able to “free ride.” No one will contribute unless required to, which is why in all modern states, national security is a central function of government. Recall Madison: Government is “an institution to make a man do his duty.”
Lighthouses are old-fashioned examples of a broad class of public goods: infrastructure. Sometimes there are ways to limit consumption of these goods to paying customers, but these “toll booths” are often sufficiently costly to construct and maintain that it is more efficient to provide roads, bridges, and other elements of infrastructure as a public service available to all. Like national security, the production of infrastructure (either directly or through subsidy) has long been recognized as a core function of government. As we saw in the last chapter, moreover, it’s also a key contributor to growth.
Another public good that often escapes recognition but is essential to the development of prosperity is knowledge. Without employing the language of modern economists, Thomas Jefferson recognized this critical quality of new knowledge: “He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me.”2
Ironically, this marvelous feature of knowledge—that it can be provided to everyone without being diminished—is a huge problem for markets. Private actors may find it difficult to capture the full benefits from investments in knowledge. This is especially true for basic research, precisely because its benefits are applicable to so many things. Even if private actors could expropriate the benefits of basic research (through patent protection, for example), it could be damaging to the overall pace of innovation to let them do so. Left alone, in other words, markets will fail to produce socially desirable levels of investment in new knowledge—the cornerstone, we have seen, of gains in productivity and prosperity.
In the case of public goods, it is difficult to create an effective market. The second big case of failure—and it is really big—involves markets that produce large effects on people who are neither buyers nor sellers. Economists call these external effects, well, “externalities.” In an unregulated market, a factory owner may spew toxins into the air or water with impunity. Neither he nor the buyer of his goods has a reason to take these external effects into account. Where externalities are present, market prices will not reflect the true social costs (or benefits) associated with the private transaction.
Negative externalities such as pollution are the simplest to understand. And they permeate complex, interdependent economies. But positive externalities are at least as crucial and much easier to overlook. Sometimes private transactions can be good for others as well as for the buyer and seller—as when the vaccine I have purchased makes me less likely to develop a contagious disease.
Why should we worry about such positive spillovers? If a deal between two people benefits some unknown third party, isn’t that a good thing? It is a good thing, but it is a big problem for markets all the same. Markets depend on incentives for private gain. As Adam Smith famously put it, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”3 Yet this powerful feature of markets creates no incentive for buyers and sellers to pay any notice to external benefits, which means markets will produce less of such benefits than we would like. The bigger the share of benefits going to people who aren’t parties to the transaction, the more the marketplace will get things wrong—even if the benefits to society are very far-reaching.4
Consider education. During the 2012 presidential campaign, a young man at a Mitt Romney campaign event expressed concerns about whether he would be able to afford college. Romney replied: “It would be popular for me to stand up and say I’m going to give you government money to pay for your college, but I’m not going to promise that. Don’t just go to one that has the highest price. Go to one that has a little lower price, where you can get a good education. And hopefully you’ll find that. And don’t expect the government to forgive the debt that you take on.”5
Shorter Romney: You’re on your own. Best of luck. Shop wisely!
Romney was posturing as a tough teller of unpopular truths, but he knew his Republican crowd would love it. They shouldn’t have. There are huge social benefits that come from having a more educated workforce: enhanced productivity, lower crime, greater technological progress, stronger democracy. Individuals can’t capture these external benefits, and so, left to their own devices, they will systematically underinvest in education.6 Recognizing this doesn’t tell us what the exact mix of policies to promote and improve education should be, but it does tell us that society has an enormous stake in whether young Americans can afford to go to college. The blinkered view expressed by Romney (and shared by many others) helps explain why we’re falling behind other rich nations in the educational race.
Of course, externalities can be negative as well: A profitable exchange may impose huge costs on people outside the transaction. Unregulated markets encourage us to treat the air, water, and soil as inexhaustible goods, which they are not. Absent external constraint, the result is a rapid deterioration of their quality as the capacities of capitalist economies grow. A hundred years ago, individuals and companies were free to dump raw sewage into municipal water supplies; it took government’s coercive powers to stop the lethal practice.
Environmental externalities can be horrific. In rapidly industrializing India, air pollution is estimated to be taking three to five years off average life expectancy.7 That the air in American cities does not look anything like Mumbai’s reflects a series of federal initiatives dating back to the Clean Air Act of 1970. Since then, the size of the economy has tripled, but average levels of six major pollutants have fallen by more than 70 percent.8 Among the biggest of these initiatives was the Clean Air Amendments of 1990. In one of the last bipartisan efforts to nurture our mixed economy, Congress focused on reducing exposure to ambient fine-particle pollution, a major health hazard. Compliance with these regulatory requirements is expensive: The US Environmental Protection Agency (EPA) estimates that the annual costs will reach $65 billion by 2020.9 But that $65 billion turns out to be an amazingly good deal. The EPA projects that in 2020 the Clean Air Act amendments will prevent 230,000 adult deaths from particulate pollution, or seven or eight times the number of traffic fatalities likely to occur that year. The regulations are projected to prevent 5.4 million lost school days and 17 million lost workdays per year. Even from the narrowest economic perspective, the gains will vastly exceed the costs. All told, peer-reviewed scientific evaluation estimates that the benefits that year will be $2 trillion, exceeding those $65 billion costs by a ratio of 30 to 1.