Triumph of Pigou

The idea that government can “perfect” an imperfect market (an artifact of economists’ “perfect competition” theory) has again become an item of faith among intellectuals. In a recent FT column, Samuel Brittan, a former market advocate, discusses three fallacies of U.S. style capitalism or what he not so endearingly calls “market fundamentalism”:

• He rejects the “efficient market” hypothesis. Based on the axioms of theorists such as A. C. Pigou, he characterizes this theory of the market as one of static equilibrium where if one sees a hundred dollar bill on the street, one wouldn’t pick it up because somebody already has. Why Brittan believes this constitutes a criticism of the dynamic entrepreneurial views of economic liberals is unclear.

• He then critiques the view that “Government is not the answer, it is the problem.” And Brittan is certainly correct that this view is central to many market advocates. Brittan, however, presents a choice: either accept the entire welfare, regulatory state or anarchy. He seemingly rejects as politically impossible the constitutionally constrained state. Hayek and most classical liberals were well aware that culture and a rule of law (limited government focused on preventing force and fraud and maintaining a stable legal environment) was essential but they did not wish society to walk the Road to Serfdom.

• And finally he rejects Samuel Johnson’s statement: “There are few ways in which a man can be more innocently employed than in getting money.” Brittan sees self-interest as problematic because of the role of “private” parties in the current fiscal bubble. That such private error was encouraged by the moral hazards created by excessive government intervention is a point he neglects to discuss.

Brittan’s arguments are shallow. He attacks a straw man caricature of capitalism. His objections should be focused on the current “mixed economy” in which crony capitalists benefit from various Pigouvian interventionist rationales (wealth redistribution, correcting externalities, ensuring adequate production of “public goods” and so forth). As Larry Summers noted in his essay in the recent compilation, Creative Capitalism, he’s really criticizing market socialism, not capitalism. Fannie and Freddie are examples of the risks of the GSE-centric mixed economy. That – not “market fundamentalism” – should have been Brittan’s target.

Classical liberals and even some Chicago school economists such as Ronald Coase exposed the foolishness of equating a “market” to the “perfect competitive market” needed to “solve” mathematical equations. Stripping away the critical features of the market to allow this may have some pedagological value but is akin to relating the fall of a feather in a vacuum as having much to say about the same event in the real world. Brittan does, to his credit, recognize that intellectuals emphasize “market failures,” while giving little attention to the far more pervasive “government failures.”

He mentions but one- the tendency of political institutions to reward concentrated interests at the expense of the less well organized citizenry. Yet there are many others- for example, the tendency for government to “avoid risk” by slowing innovation (refusing to allow the creative destruction that another early free market economist, Joseph Schumpeter, saw as the keystone of capitalism). That the risks of stagnation are generally much greater than the risks of innovation is a massive government failure. (This issue, of course, does not arise in Pigou’s static economy – no possibility of innovation means no gains from innovation.) Brittan does caution us that the failure of “private” actors to be responsible owes much to the unholy alliance between regulators and market participants (the regulatory capture problem) but here he seems to echo Pigou, who was confident that “in the English speaking world, a new man was emerging trained in economics and imbued with civic responsibility that would avoid this trap”.

Yet, some 80 years later the U.S. still faces rampant rent-seeking and corruption under the guise of necessary bailouts, protectionism, and trust-busting. Ironically – and a credit to the FT editorial page oversight – the same page carries an article by David Rothkopf, a visiting scholar at the Carnegie Endowment and head of his eponymous international investment firm. Rothkopf repeats the concerns of Schumpeter and Robert Higgs (Crisis and Leviathan). Schumpeter’s famous phrase: “Rational as distinguished from vindictive regulation by public authority turns out to be an extremely delicate problem which not every government agency, particularly when in full cry against big business, can be trusted to solve.” This warning is particularly relevant when politicians face populist outcries about Wall Street and more recently BP over the oil spill.

Higgs noted that market crises become an impetus for governments to further their grip over industry, blurring the distinction between capitalism and crony capitalism. History has proved Pigou very wrong. His view of politics as a virtuous occupation somehow immune from the self-interest problems that are disciplined in a true capitalist system by competition and the profit and loss realities is the dominant intellectual religion. (Note today, Pigou’s chief acolyte seems to be Greg Mankiw.)