Market Failure and Government Failure

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

Two fundamental institutions that undergird our economy are markets and government.  And both are in trouble.

We’re still climbing out of the last great market failure: the downturn born of the housing bubble.  The bubble itself was inflated by a related market distortion: the underpricing of risk.

One of the most fundamental building blocks of capitalism is its ability to convey important and correct signals through pricing, where “correct” means at least roughly accurate valuations of opportunity costs and risks.  No one would buy a Snickers bar that sold for $10 as there would be a lot more “utility” (happiness) spending the $10 on other stuff.  But people would, and did, borrow into unaffordable mortgages because credit was underpriced in ways they either didn’t understand or chose to ignore.  In many cases, the only way they could service the debt was if their home values kept going up â€" i.e., if the bubble kept inflating.

To the extent that lenders knew what was going on, they not only didn’t care, in part because they could unload the risk down the line (IBGYBG), they were also compelled by the profit motive to keep dancing “as long as the music is playing,” as Citigroup’s chief executive said at the time.

In other words, the oversight, or regulatory function that should have prevented all this failed … there’s that word again.  The myriad agencies, from the Federal Reserve to the alphabet soup of (too many) others supposedly focused on some aspect of financial markets, were either asleep at the switch, gutted by lobbying efforts to defund and defang them, or, in the case of the Greenspan Fed, ideologically convinced that markets would “self-regulate.”

We begin to see the toxic combination of market and government failure.

And there’s an interesting back story.  As I describe in a paper due out next week, there’s an additional market failure lurking in the background: the vast increase in inequality and the middle-class income stagnation that occurs in its wake.  Given their historically weak wage growth, the only way many families could get ahead was to borrow into the bubble.  The accumulation of so much wealth at the top meant lots of cheap capital to lend, and lots of lobbying dollars to ensure that the oversight mechanisms were shut off.

All of this, of course, led to the Great Recession from which we’re still recovering, and this introduces the next chapter in market/government failure.  The initial government response, both in terms of stimulus and credit market interventions, was actually strong and effective, though I well know and appreciate all the arguments about their shortcomings.  But though Keynesian stimulus was the most important antidote to the vast demand contraction in terms of helping innocent victims, government, by accepting the austerity doctrine, failed to keep it going long enough.  As I recently documented, the change in the ratio of the federal budget deficit to gross domestic product from 2009 (10.1 percent) to 2013 (4.1 percent) was the largest such decline in over 60 years.

To be clear, all else equal, there’s nothing wrong, and a lot right, with a declining budget deficit.  But the empirically bereft theory of austerity â€" that cutting the deficit in periods of weak demand will revive that demand â€" has policy makers in advanced economies across the globe consolidating public debt far too soon.

So to recap, market failure born of government failure (inadequate oversight), was initially and quickly addressed by good policy, which â€" more government failure â€" ended too soon.

Since then, we’ve experienced as deep an extent of government failure as many of us have seen in our lifetimes.  I’m of course talking about the inability to carry out lasting fiscal policy (careening from one budget patch to the next), mindless across-the-board budget cuts (sequestration), a government shutdown, and a serious threat to default on our sovereign debt.  For good, bipartisan measure, let me throw in the failure thus far to provide workable access to the Obamacare exchanges, a problem made worse by the need of many people to deal with policy cancellations that they did not expect.

O.K., climb back in off that ledge.  It’s bad, but it’s not fatal.

First, one has to be very impressed with the resiliency of the United States economy.  This isn’t a McCain “fundamentals are strong” observation.  Clearly, the growth that’s occurred has been both too slow and not reached most households â€" profits up, incomes stagnant â€" but the fact that we’re expanding and adding jobs given the headwinds of fiscal drag and deep federal government failure is a testament to our fluid capital markets and strong consumer base.

Second, note the word “federal” in that last sentence.  Mayors and governors worth their salt recognized some time ago that if they want something good to happen in their local economies, they’re going to have to do it themselves (in fact, sequestration cuts federal aid to states).  I was particularly impressed and heartened by an announcement from the port of Cleveland to start an oceangoing freight service (and yes, according the map on the wall of my office here, that’s possible).  The Brookings Metropolitan Policy Program has a great list of similar initiatives at the metropolitan level.

Third, recent polls reveal that more people are waking up to the problem of government failure.  A constraint to electoral change in this space has always been the fact that people tended to blame “the Congress” for dysfunction, but held their own representative in high esteem.  But a new NBC/Wall Street Journal poll found that 63 percent of voters want to replace their own member of Congress, the highest percentage on the question since it was first asked in 1992.

To be clear, everybody fares badly in this new poll â€" the president’s 42 percent approval rating is an all-time low.

But that’s also a sign that this government failure is not going unnoticed.  What it ultimately amounts to â€" how voters channel it â€" is to be seen.  Clearly, such discontent can all too easily be channeled in negative directions leading to more divisiveness, nativism and even deeper dysfunction.

On the other hand, it can be an opening for a strong, new leader (or movement) to come forth and explain all of the above in ways people can digest.  She (and I promise I’m just using the generic pronoun here) must explain how and why the market has failed to provide enough jobs, opportunities, income and mobility for so many for so long.  How the notion that the government and market are in opposition, as opposed to complementary, is precisely the recipe for increased failures.  How sending people to Washington who campaign against government will only ensure that it remains a failed institution.  How dangerous that is in a world where the challenges of globalization, climate change, retirement security, market failures (!) are growing stronger every year.

And ultimately, how we’re in this together, and we’d better figure out how to make it all work a whole lot better than it has been lately.  The depth of the failure of these two large, essential institutions leaves us at a crossroads.  What’s more, powerful, deep-pocketed forces are pointing toward the wrong road.  It will take a great deal of energy, will and vision to cordon them off a go the other way.