Because governments have chosen to intervene, hundreds of millions of lives are also better protected against ill health and devastating financial risks. In the United States and other rich democracies, the majority of government spending goes to social programs related to health care (Medicare and Medicaid) and retirement (Social Security). These programs are overwhelmingly popular even though they are also, as a rule, highly coercive. We now are in a better position to understand why this is not a paradox.
Whenever new health laws are proposed, critics decry “a government takeover of health care,” as if the only thing that stands between us and a well-functioning health care market is government meddling. But the health care market isn’t a well-functioning one. What critics call a “takeover” is mostly a response to that reality.
If there were no government “takeover” to encourage or require health coverage, few people would get insurance, because of asymmetric information. If there were no government “takeover” to push back against sellers, health prices would (and do) rise to unaffordable levels as consumers agreed to whatever procedures their providers recommended, while having little capacity to negotiate for a better deal. It’s no accident that the world’s highest-performing health systems all rely on government more than ours does. But even the US system is shot through with government and only works tolerably, if comparatively poorly, because it is.
As with health care, so, too, with retirement. Programs such as Social Security are often seen as redistributive. To some degree they are, providing a critical barrier against acute poverty in old age. But Social Security is more like an intergenerational piggy bank. It takes income from individuals during their working years (when they are inclined to overconsume) and provides income during their retired years. This social insurance has guaranteed a modest but secure retirement for tens of millions and has been wildly popular. In recent years, we have given workers more choice by shifting more of the onus onto them to prepare for their own retirement, but we have also expanded the potential impact of myopic behavior. As a result, we now face a looming crisis in which the majority of Americans will reach retirement age unprepared.41 Here and elsewhere, governments can and do supplement or modify markets in ways that make almost everyone better off, boosting investment in goods that people value but where they are prone to myopia.
The moral case for ensuring that all members of an affluent society have a basic level of material well-being is strong. But we shouldn’t gloss over the critical ways in which social programs that supplement markets also drive prosperity. Many programs, for example, support child development, increasing not just the life chances of individuals but also the growth of long-term productivity. Social protections can also encourage valuable risk taking. Just as the limited liability of the corporate legal structure encourages investors and entrepreneurs to take big chances that may pay off for them and our society, welfare states provide a safety net that makes individuals more willing to invest and take risks. The cushioning effect of social programs is also a major source of modern capitalism’s legitimacy. By diminishing the extent to which the system’s inevitable volatility inflicts hardship, welfare capitalism has created a durable non-socialist alternative to the harsh laissez-faire that citizens throughout the affluent world have consistently rejected.
Social programs—and government management of the economy more broadly— make another major contribution to prosperity. Market economies are prone to cycles of boom and bust, exuberance and overreaction. Mixed economies have developed a set of critical public policies that in combination can diminish the frequency and intensity of these painful and costly swings. The absence of such policies, as we’ll see in the next chapter, was a major cause of the recurrent panics and depressions that plagued the United States before the mixed economy’s emergence.
Social programs create an important “automatic stabilizer” that offsets that tendency. Income support programs prop up consumer spending when it is most needed, reducing the risk of a downward economic freefall. When unemployment is high and demand for goods and services low, public spending can prevent a spiral of declining private consumption as people tighten their belts simultaneously. The welfare state’s automatic stabilizing effect is just one component of government’s larger tool kit of monetary and fiscal policies that reduce the risks of boom and bust. As with all important government undertakings, the specifics of these policies are certainly controversial. But few economists question the critical part that central banks and government budgets have played in diminishing the chronic instability that long characterized capitalism. One such economist, writing in 1948, proposed “A Monetary and Fiscal Framework for Economic Stability” that would automatically run deficits and expand the money supply during downturns to restore economic growth. His name was Milton Friedman.42
Active fiscal and monetary policy is not the only way that American government protects against downturns. Restrictions on the financial sector are another—and another coercive policy that is overwhelmingly popular (at least away from Wall Street). Because the financial industry is highly prone to booms and busts, the federal government regulates it heavily. Or, rather, it regulated it heavily during the stable financial era between the mid-1930s and the early 1980s. Then a wave of deregulation pushed by financial lobbyists and free-market enthusiasts unleashed a much bigger, more powerful, more complex—and more unstable—Wall Street.
If anyone needed reminding that markets can fail, the spectacular implosion of our financial system certainly provided it. As the conservative jurist Richard Posner acknowledged in a 2008 speech, “The crisis is primarily, perhaps almost entirely, the consequence of decisions taken by private firms in an environment of minimal regulation . . . We have seen a largely deregulated financial sector breaking and seemingly carrying much of the economy with it.”43 The economic costs of this catastrophe, which spread across the globe and continues to produce widespread suffering almost a decade later, are likely in the tens of trillions of dollars.
As we will see in a later chapter, a variety of perverse incentives led Wall Street firms to take on way too much risk before the crisis. A crucial component was what regulators call “systemic risk”: that is, risk borne by all of us, not just parties to the trade. Of course, bankers worry about whether their investments will go bad. They have no incentive, however, to worry about the risk that those bad investments might affect other people negatively—that an implosion of their company if things go terribly wrong might drag other businesses with them into the abyss. This “systemic” risk is someone else’s problem, an externality, and in 2008 it nearly shattered the American economy.
The financial collapse was also a reminder of another unpleasant feature of democratic capitalism: Market actors do not just have strong incentives to exploit our cognitive biases or offload costs onto society. They also have strong incentives to convert their profits into power and thus to increase their profits still further.
Since the rise of modern capitalism, the power of large corporations has been a central challenge. As Adam Smith was keen to point out, the greatest threat to functioning markets is often those functioning in markets. Capitalists are not natural supporters of competition; indeed, they tend to see it as an inconvenience. As Smith observed, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public or in some contrivance to raise prices.”44 Smith urged political leaders to look on the economic advice of merchants with great suspicion, especially when those merchants were making inordinate amounts of money. Large, sustained profits were not a sign of capitalism’s vitality, he argued; they were a warning that the forces of competition were being impeded.45 Smith probably would have nodded knowingly at the private comments of James Randall, president of agribusiness giant Archer Daniels Midland (revealed in a price-fixing case in the mid-1990s): “We have a saying here . . . that penetrates the whole company. It’s a saying that our competitors are our friends. Our customers are the enemy.”46
As we will discuss in the next chapter, concerns about the power of private businesses to conspire against consumers were one of the main instigators of the push toward a mixed economy in the United States. As industrial capitalism expanded to a national scale, huge corporations came to dominate the landscape, bringing with them the inclination and the capacity to constrain competition. Smith, like other market enthusiasts to follow, argued that the solution to most private conspiracies is increased competition, which requires government policing but not necessarily extensive government regulation. With the rise of modern capitalism, however, this solution was not always available. Consider the railroads, the industry that stitched America together into a truly continental economic power. It made no sense to lay multiple sets of track along the same route. But if one company controlled the tracks, it would use that monopoly to extract excess profits, which, in fact, is exactly what happened in the United States until government helped rein in these “trusts.”
Railroads turn out not to be an isolated case. Features of modern technologies often create huge economies of scale (where the larger a firm becomes, the more cheaply it can produce) or involve network effects (where consumers receive greater benefits if lots of others are using the same product) that can trigger rapid consolidation around one or a handful of firms. Many industries, including transportation, electricity, and water, have such characteristics. Tendencies toward monopoly are also evident in central sectors of the modern economy, from telecommunications (phones, cable, and the internet) to the crucial industries of the computer age. Start-up investments are often huge, while the marginal cost of producing an additional unit is essentially zero. Network effects are massive: The benefits of using Facebook—indeed, of using all social media, almost by definition—depend on how many others are in the network.
The history of modern capitalism has seen continuous technological revolution. Yesterday’s monopoly may be today’s competitive industry. But yesterday’s competitive industry may become today’s monopoly. Market enthusiasts should be the first to recognize that the lure of profits will attract astute investors to these possibilities. One need look no further than the iconic Warren Buffett, whose investment strategy has favored firms that benefit from substantial barriers to competition. Today business schools teach strategies to construct “moats” around one’s business to limit the inconvenience of competition.
Here again, we need government. Sometimes the solution has been to create public utilities, sometimes it has been the establishment of regulatory commissions, and sometimes it has been reliance on antitrust rules and judicial oversight. In all cases, the vital goal is to prevent one or a handful of companies from limiting competition and profiting at the public’s expense.
The specter of monopolies does not exhaust the risks posed by corporate influence. The broader problem is that concentrations of wealth inevitably spill over into politics. When businesses can use their economic power to influence government, they can extract policies that guarantee them returns above and beyond those they would obtain in a competitive marketplace. Such rent seeking is not a “market failure” in the traditional sense, but a failure to maintain political authority that is capable of checking the power of vested private interests.
In contemporary political debate, this dynamic is often described as “crony capitalism.” Economists, as we’ve noted, use their own terminology: They call these extra returns rents and the process of procuring them rent seeking. Where political officials promote the extraction of rents, economists say they have been “captured.” When the economists Acemoglu and Robinson (whose work we discussed in the last chapter) speak of “extractive economies,” they are talking about political systems where rent seeking permeates politics and government is captured by narrow private interests.
Concerns about rent seeking long predate economists’ coinage of the term. They are prominent in Smith’s The Wealth of Nations. They motivated the agenda of the so-called Progressive Era more than a century ago, prompting, among other reforms, calls for the direct election of senators. At the time, members were still appointed by state governments and typically well insulated from voters. The result, in the words of prominent journalist William Allen White, was a “millionaires’ club,” where a member “represented something more than a state, more even than a region. He represents principalities and powers in businesses. One Senator . . . represents the Union Pacific Railway System; another the New York Central; still another the insurance interests of New York and New Jersey.”47
Conservative economists also worry about rent seeking. Revealingly, however, they have regarded rent seeking as yet another reason for rolling back government, arguing that government regulations typically help privileged companies dig moats around their markets. Historically, certain forms of regulation—such as the midcentury rules that restricted competition in the airline and trucking industries—did fit this stereotype. But in light of what we have already seen about car safety and the Clean Air Act, it seems an odd generalization about government rule making. In fact, looking at corporate influence today, the main vehicle of rent delivery isn’t overregulation that limits competition. Instead, it’s indirect gifts to companies or economic sectors that seem on the surface to be operating as “free” markets. Most blatantly, huge public resources in land, mineral, and grazing rights (and, in modern times, bandwidth) have been transferred at prices way below market value. Other subsidies come through dubious budgetary handouts to industries (from agribusiness to oil), and, less visibly, through preferential tax treatment, favorable rules on intellectual property, and implicit governmental backing that yields market advantages such as the interest rate edge that “too big to fail” banks get as a result of their unstated but assumed bailout protection from the government.
Indeed, most rent seeking in modern economies takes a form opposite of that stressed by conservatives. Nobel laureate Joseph Stiglitz has noted recently that rent seeking by powerful private groups causes many government corrections to market failures to be much too weak.48 Two Harvard political economists, Daniel Carpenter and David Moss, call this “corrosive capture.”49 Its prevalence reflects the growth of externalities and other market failures that warrant regulation in our complex and interdependent modern economies. Examples are endless. The food industry resists efforts to address obesity; oil, auto, and chemical companies fight the removal of lead from gasoline; financial firms mobilize to limit government interventions that would make it more difficult to dupe consumers or to take risks that jeopardize the entire economy. This corrosive form of rent seeking, by far the most common, has been a challenge for all democratic societies. And as we will see later in this book, it is a central feature of the predicament facing the United States today.
Nowhere has this tendency been more clear than when it comes to coal. Coal-burning power plants remain the leading source of US electricity. Yet the production and burning of coal leave behind a trail of devastation: blown-up mountaintops, 150 million tons of coal ash a year, and a variety of poisons spewed into our air and water.50 Coal is the nation’s largest source of both carbon emissions and water pollution.51 Three economists have recently tried to figure out the overall costs and benefits. Focusing only on air pollution, and with a cautious estimate of the costs of global warming, they still conclude that electricity generation from coal is one of a handful of industries that produce negative economic value at current prices.52 It is not just that the absence of appropriate constraints means that private markets overstate coal’s true value. Each additional ton of coal we burn makes us poorer.
The industry and its political allies have decried a “war on coal.” A more accurate assessment is that the coal industry has been engaged in a war on the rest of us. How can a huge industry get away with producing negative social value? It can do so because it is politically powerful, and it uses that power to weaken efforts to use political authority to bring the industry’s production and prices in line with what is good for society as a whole. This exertion of private political power is a form of rent seeking. The industry is not just extracting coal from the ground; it is extracting prosperity from the rest of us.
Coal is an extreme case, but private efforts to extract profits by weakening public authority have long been an obstacle to building an effective mixed economy. The early efforts of the Progressive Era focused on political reforms to increase transparency, counteract or expose corruption, and bolster government’s capacity to exercise independent judgment backed by expertise. Later efforts have also stressed the need to empower groups representing broad interests, groups that can push back against concentrated economic lobbies—what John Galbraith famously called “countervailing power.”53 From labor unions during the New Deal to consumer and environmental organizations in the 1960s and 1970s, these countervailing forces have proven essential in the ongoing effort to limit the danger that private power will capture public authority.
If you want to read a thoughtful and engaging conservative defense of market capitalism, we recommend Luigi Zingales’s A Capitalism for the People.54 Zingales, a professor of finance at the University of Chicago, draws a sharp distinction between defending capitalism and defending business. He eloquently decries tendencies toward crony capitalism, expressing concerns that the United States is becoming more and more like his birthplace of Italy, with its tendencies toward patronage and corruption.
Like many contemporary conservatives, Zingales portrays much of modern governance as thinly veiled rent seeking. “Government agencies,” he states flatly, “tend to be captured and represent the interests of industry.”55 This diagnosis leads to Zingales’s preferred solution: much smaller and simpler government. His logic is straightforward: If government does less and is more open about what it continues to do, it will provide fewer opportunities for rent seeking.
Yet Zingales’s insistence that the way to cope with crony capitalism is to radically scale back government is a mirage. Like all mirages, pursuit of it is a case of dangerous misdirection.
That misdirection, however, is revealing. Setting out to liberate markets from government, Zingales inadvertently makes a powerful case for a mixed economy with an extensive range of governmental activity. Even in Zingales’s market-celebrating account, once you peel away the rhetoric, you see that we need a lot of government. His specialty is finance, and in that area, he sees government’s necessary role as anything but hands off. He acknowledges that citizens are myopic and subject to serious manipulations, which markets alone will not correct. He worries (rightly) that much of modern finance constitutes rent seeking and, too often, outright fraud rather than a contribution to greater prosperity. He proposes many reforms in financial rules, but his envisioned structures would be no less extensive than today—and probably the opposite.
Zingales also recognizes the need for substantial public authority to counter the threat of monopoly. He notes that extensive provision of education has been central to the growth of American productivity, attributing it to our “democratic (indeed populist) tradition” without noting that this means the government. He acknowledges the need for an extensive safety net, and not just as a matter of basic justice. He agrees that such arrangements sustain public support for markets: “A safety net is . . . a mechanism to ensure political consensus for free markets.” He accepts that strong safety nets contribute to efficiency by encouraging risk taking, writing that it is “a way to encourage people to invest in their future. The sure way to fail is not even to try, and without a safety net to protect them from the costs of failure, many people won’t try.”
That’s a lot of government. But, of course, even this list is too short for modern realities. Zingales says little about public goods or positive and negative externalities. Nor does he seem to recognize the extent to which the informational problems he sees in finance extend to many areas of modern economies. The oversight is perhaps most obvious in the case of health care. In one of his recent articles, Zingales notes that Americans pay much more for health care than citizens of other countries, before blaming these inefficiencies on government intervention.56 This argument is odd, since, as noted, all these other countries with much lower costs and better health outcomes rely on government in their health sectors much more than the United States does.
Add it all up, and we are in a position to understand better what conservatives such as Zingales surely find puzzling: Whether you look at the history of individual countries or compare rich and poor countries in the world today, big governments and prosperity go together. The emergence of modern economies capable of generating unprecedented affluence—the crossing of the Great Divide we traversed in the last chapter—has coincided with the emergence of activist government capable of extensive taxation, spending, regulation, and macroeconomic management.
Once you understand why markets are prone to a range of failures, you understand why the rich/big quadrant is full and the rich/small one is empty. All of the largest and fastest-growing sectors of modern economies—health care, education, finance, information technology, energy, telecommunications—are rife with challenges that require government action. All of them require the strong thumb of government to complement and, at times, constrain the nimble fingers of the market.
Because of its powers of coercion and coordination, government can produce public goods and encourage the production of goods with positive externalities. Government can also restrict activities that produce negative externalities. Dumping carbon into the atmosphere has been costless to private actors; put a price on it (with a tax or government auction), and we will all pay more attention to the true costs of our choices. Government can provide nudges of varying strength that combat the dangers associated with our own myopia, and it can work to prevent the predictable efforts of companies to exploit our shortcomings for private profit.
Government does not always work well—indeed, we wrote this book because it is working less and less well. And when well regulated, markets often work very well indeed. But there is no recipe for prosperity that doesn’t involve extensive reliance on effective political authority. The conservative vision of shrinking government to a size that will make it “safe” from cronyism is the economic equivalent of bloodletting. The cure is far worse than the disease. Prosperous societies need a lot of government. Because they do, the incentives for rent seeking will always be present. Making a mixed economy work requires keeping that cronyism, and the other dangers we have recounted, within tolerable limits—and that requires not less government (or necessarily more government) but effective government.
And here is the most encouraging point: This “Goldilocks” balance is possible. In the United States and other rich nations, the mixed economy worked. We crossed the Great Divide. Now, with our eyes opened to the trouble with markets and the promise of public authority, we are in a better position to understand the policies—and the unexpected political coalition—that made America rich.