It’s not possible to resolve political debates such as “Should we raise taxes to revitalize our aging transportation infrastructure?” without first achieving consensus on the role of government. The role debate, at least in my mind, is far less divisive than “how.” So, as we enter elections to determine the next US President and Congress, I thought it would be a good time to share an economist’s perspective on the role of government.
There would be no role for government in our economy if – in our roles as citizens, business owners, shareholders, employees, and consumers – we acted in the best interests of society as a whole. Rather, we act out of real or perceived self-interest.
There is nevertheless a huge advantage to individuals acting in their self-interest. It creates an invisible hand enabling a market-based economy. Adam Smith argued (correctly) that markets lead to better outcomes than a communist system’s centralized resource allocation. If you are old enough to remember, communism versus capitalism was a contemporary debate until the Berlin Wall fell and we all saw a real life experiment of how alternative economic systems worked. Even the communist Chinese have adopted a quasi-market system.
For markets to maximize total well-being, several critical conditions about markets’ operation would have to be met, including:
- Prices would incorporate true costs. We know this is not always true in today’s world. The price of manufacturing goods from China does not reflect the cost of environmental problems, which China’s residents are largely bearing. When there are externalities such as these (impacts on non-buyers), be they positive or negative, a free market creates too little or too much.
- Having multiple buyers and sellers on both sides of the market. Monopolies and their cousin oligopolies—situations with few sellers and many buyers—do not produce the most efficient outcomes as the seller can extract excess payments from buyers (called “rents” by economists). The only hospital and physician practice in town usually charge premium rates.
- Buyers would have reliable information. Enron succeeded until the true “facts” finally emerged.
Because these assumptions are rarely if ever met, we turn to government to correct the largest failures for the benefit of society at large.
First, governments create a legal system to make sure markets work efficiently and freely, including regulating monopolies. The impact of a well-functioning legal system on economic welfare is well documented. For example, it’s a key driver of differences in different African economies. In the U.S., security markets operate well (for the most part) because of government enforced accounting standards.
Second, government provides public goods. The invisible hand of self-interest leads markets to short-change vital areas such as national defense, transportation systems, clean water, federal R&D, and fire protection. So government invests in these public goods. We can and should debate the how: Do we use vouchers or publicly owned schools, for example, to educate our children?
Third, the government regulates and creates tax incentives. EPA regulations in the USA keep our air a lot cleaner than China’s. Again, we can have engaging debates about how we design regulations and whether economic disincentives offset benefits. But unregulated markets are fraught with problems far larger than disincentives. Tax incentives increase things like business investment in R&D, which creates a stronger economy, benefiting many.
I believe the role of government is becoming more imperative in four areas.
The US Department of Defense, which recognizes the human impact on climate, is on the record citing climate change as one of the top five risks to our nation’s national security. A basic principle of economics states: when irreparable harm might arise, act to reduce risk. Our debate should focus therefore on how we can reduce the risks posed by climate change. Taxing carbon, with proceeds used for infrastructure or for lowering payroll or income taxes, is the preference of most economists. Already many companies are incorporating carbon prices into their investment decisions and insurers are stepping away from climate change related risks.
Another role is campaign finance reform. The argument for reform is that when moneyed interests (be it unions, wealthy individuals, or corporations) influence politicians’ votes and proposals, elected officials no longer act in the interests of the whole but in the payers’ interests. A healthy market system requires strong government (note I did not say large), not a bought government. We call the former Main Street capitalism, the other Crony Capitalism or, at its extreme, an Oligarchy.
A third role is the social safety net: what it consists of and how to provide it in an age of economic disruption, freelance workers, and high underemployment. A final related role rests in addressing growing inequality of income, which data shows hurts economic vitality. Ford got it right: workers need to be able to afford cars for car producers to thrive. How do we best address a level of inequality worse than the roaring 1920s in our nation?
With my economist’s hat on, I’m hope we get Presidential candidates with the skill set and personality to be informed and insightful on these and other vital policy debates.