Markets and cognitive failure

I have long noticed that folk comfortable with market economics tend to have much more sophisticated discussions of the proper boundary between public and private action than do more progressivist folk. Among the latter, typically, anything that goes wrong in markets shows that government should do more. The proper answer is always that governments should do more. There is, apparently, no such thing as systematic government failure: no limits to its competence or efficacy, no perverse dynamics, information failures, etc. And no amount of government failure is damning, just as no amount of market success is justificatory. Underneath the “sophisticated” language, one is often dealing with a very simple moral and analytical universe. Which, of course, makes it an excellent structure for opinions as markers of status: nice, simple markers of status.

Though something deeper is going on. The problem is that government and political action is viewed as inherently more legitimate than private or market action. And how to you put any limits on the legitimate over the illegitimate?

Conversely, those comfortable with market economics tend to have much more complex and empirical debates about the proper boundaries of government and private action. There are those who argue that government should always do less (that is, treat private action and markets as inherently more legitimate—or at least more effective—than government and political action) but—given that there are not a lot of anarcho-capitalists around—even they must eventually confront the question of where the boundaries lie. Hence Greenspan, McCain, folk from the AEI, et al arguing that Fannie Mae and Freddie Mac needed more effective prudential regulation (which they clearly did). In the words of a May 13 2005 AEI publication:

If Congress can bring itself to overcome the furious political opposition of the GSEs and their supporters, it will direct the new GSE regulator to reduce the size of Fannie's and Freddie's portfolios and endorse a workable standard by which to measure the proper size of the smaller portfolios that result. This will solve, finally, the problem of two entities using their implicit government backing to control the residential mortgage market, which creates massive risks for the taxpayers and the economy in general.
If Congress cannot take this essential step, however, no amount of additional authority--given to a purported "world class regulator"--will significantly change the course of events. Fannie and Freddie will continue to grow, and one day--as Alan Greenspan has predicted--there will be a massive default with huge losses to the taxpayers and systemic effects on the economy.

AEI is very much a pro-market think tank, but could see the need for firm prudential regulation. Indeed, had been issuing public warnings at least as far back as 1999.

Conversely, those who thought government should always do more did not consider the implications of (1) various states and cities rationing the supply of land for housing, creating one-way bets in their housing markets and (2) using government power to foster cheap housing credit, particularly to low income folk. It was all good-intentioned, government action: what could be wrong with that?

And when it all goes pear-shaped, what is the problem? “Greed” and “de-regulation”. And what is the solution? Much more government regulation, even much more government ownership (as if we do not have vast experience with the dysfunctions of the latter in particular). Yes, a very simple moral and analytical universe indeed. It must be such a comfort, to live in a world where the answers are all so obvious.
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Back in more complex reality, there were wider (and more serious) regulatory failures than those pertaining to Fannie Mae and Freddie Mac. The lack of sufficient prudential regulation (both in rules and in their application) extended way beyond Fannie Mae and Freddie Mac. See the comments of former Fed Chairman Paul Volcker, who was a tad concerned back in May 2005. Which means that the Republicans are well and truly implicated as they had control of Congress 1994-2006 and the Presidency 2000-09. They are also implicated in the pumping of liquidity into the American economy which fuelled the amazing surge in stock prices away from long-term trends and in a misconceived response when the crisis broke.

But these all point to a perennial problem: regulators are not insulated folk, they will tend to go along with prevailing opinion. So if there is too much discretionary power given to regulators, they are likely to go (with some lag) in whichever direction prevailing sentiment encourages. In the 1920s and the lead-up to the current credit crisis, that was clearly too lax on American financial markets. (But, in our time, also too restrictive on land markets.) The interventions in response to the 1929 crash were too restrictive and either greatly exacerbated the economic collapse or retarded recovery: most obviously in the Smoot-Hawley tariff but also in many of the Roosevelt Administrations actions—massive policy unpredictability was and is not good for investment. (Scott Sumner has a striking take on the 1930s and the present crisis that give Smoot-Hawley in particular less significance than it often is.)

What is typically missing is a strong, robust sense of where the proper boundaries between public and private action lie. What regulators should and should not be doing, in particular. (That regulatory discretion should be minimised is fairly clear.)

But it is hard to have the debate to develop such a sense of where the boundaries should lie if large slabs of the intelligentsia are not concerned with being serious about the question at all. If, on the contrary, they engage in what is, ultimately, fairly simple-minded barracking and posturing.

Such barracking and posturing goes on in both directions but by far more broadly-based and virulent is the “government should do more!” noise. A sort of vulgar Marxism, based on the idea that private property, individual action, commerce and corporations really have no ultimate justification beyond a certain temporary pragmatism. Which leaves its adherents with nowhere to go but a form of magical thinking where one has to ultimately prefer public ownership and government control—despite the patent information and incentive problems thereof—in order to be a moral person. Such views have been less persuasive in recent decades simply because their claims were not backed up by the evidence. Indeed, were increasingly clearly contradicted by the evidence. They provided little or no practical solutions to the problems policy makers were actually facing. Nor do they now: such attitudes have little or nothing to contribute to the debate about proper boundaries, as there is no proper boundary to be found between the ultimately illegitimate and the inherently legitimate.

Lacking a genuinely robust debate on the proper boundaries between public and private action—particularly the role of regulation—has meant that ideas that accorded with various interests (rationing land, over-spruiking low-income mortgages, being far too lax in prudential regulation, pumping liquidity into the economy or, if Scott Sumner is correct, also engaging in inappropriate dramatic monetary tightening) interacted in ad hoc, and ultimately highly pernicious, ways.

What we really need is some clear, well-grounded thinking on the role of regulation and what intervention can and cannot, and should and should not, do. But most of those who are paid to be our cognitive elite will continue to be worse than useless for what is most needed.