‘Is Market Failure a Sufficient Condition for Government Intervention?’

Economists Art Carden and Steve Horwitz have a great piece over at Econlog making the much-needed case that market failures — things like negative externalities, public goods, asymmetric information, and market power – are necessary but not sufficient conditions for government intervention. Their paper, Is Market Failure a Sufficient Condition for Government Intervention?,also provide a good introduction to public-choice economics. Public-choice economics reminds us that, even when the market provides less than ideal outcomes, government actors will put in place place policies that won’t necessarily produce a better market outcome, but will may reflect their own priorities. They write:

Understanding “market failure” and the omnipresence of negative externalities can lead us to make the comparison that does matter. Implicit in negative-externality arguments for intervention is the claim that the political process will actually do what economists say it should do. That is, politicians will impose the blackboard solution. However, the public choice revolution that began in the 1960s has challenged that assumption by showing how governments also fail. Politicians’ self-interest, combined with the limits to their knowledge, mean that they likely will not and cannot produce the ideal outcome. We are left to ponder which of two imperfect systems will serve us better: the “failed” market or the “failed” political process. We have many reasons to think that markets will outperform government in this regard, even in less-than-perfect conditions. One approach sees every “market failure” as an opportunity for entrepreneurs to solve a problem and discover, through profit and loss, how well they have done. Political processes do not have the requisite incentives and knowledge-conveying processes to do as well.

One of my favorite examples of a failed political solution to a supposed market failure is the loan-guarantee program of the Small Business AdministrationSBA loan-guarantee programs stem from the premise that, in a free-market system, there’s some market failure that means creditworthy small businesses can’t get loans. The reason typically cited for lenders’ turning down the opportunity to make money by extending loans to creditworthy businesses is a lack of proper information about the actual repayment abilities of the business — they supposedly look riskier than they are.

The SBA and its supporters argue that, by guaranteeing a portion of a small-business loan, thereby reducing the risk involved, the government gives lenders an incentive to offer loans to businesses that they would otherwise deem too risky. In this model, the SBA’s loan guarantees offer a way to correct financial-market inefficiencies, reducing the deadweight losses associated with not funding all worthy projects.

However, evidence indicates that such asymmetry problems have often been addressed without government intervention. In fact, financial markets have developed effective private solutions to such information problems — by, say, maintaining financial relationships or using credit-score systems. In addition, there is plenty of evidence that, in normal times, worthy small businesses simply don’t have a hard time getting capital, but that doesn’t stop the government from continuing its guarantee programs. But even if there were an information-asymmetry problem, the government’s guarantees are not distributed based on some special knowledge the SBA alone acquires, or on a tool the SBA provides that would make the lender better able to assess the risk. Rather, the standard for the loans is simply that a business can’t get credit, meaning the SBA’s underlying assumption is that every small-business owner should have access to cheap credit, regardless of their merits. The standard used by the SBA is called “no credit elsewhere,” not “no credit elsewhere because the lender cannot see that in fact the borrower isn’t as risky as the lender thinks and actually can pay back its loan.” 

The bad news is that, since the SBA’s standard is the inability to get credit at affordable cost, the agency lends money to higher-risk borrowers, who then cost taxpayers a lot of money when they default (the SBA likes to suggest that their default rate is low, but if you look closely, it’s much higher than they claim). These costs come despite the fact that the SBA is a pretty small player in the lending market – according to the Government Accountability Office, the SBA’s flagship loan program accounts for just over 1 percent of total small-business loans outstanding. But even though they’re a very small part of the market, the SBA is giving those firms a substantial advantage over their unsubsidized small competitors.

Unfortunately, this is one of many examples of how the government addresses market failures (real or imaginary), which is why the piece by Carden and Horwitz is so important. You can read it here.

Veronique de Rugy — Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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