When markets work, finding the right economic policy is easy. Government must merely ensure their smooth functioning. But, as Steven M. Sheffrin shows, trouble starts when markets fail to work. Economic failure is too often compounded by political failure in the guise of clumsy partisan regulations. Applying his analysis to seven critical problems - health care, Social Security and Medicare, the environment, the liability crisis, international trade, monetary and international financial policy, and the deficit - Sheffrin pinpoints the market failures at the root of these problems and the heavy-handed regulatory regimes that have exacerbated them, and shows how innovative solutions, sensitive to both market and political failures, can solve them.
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Steven M. Sheffrin is a professor and director of the Center for State and Local Taxation at the University of California at Davis, and the author of three previous books: Rational Expectations (1983), Macroeconomics: Theory and Policy (1987), and The Making of Economic Policy (1989).Excerpt. © Reprinted by permission. All rights reserved.:
When Markets Fail
Lecturing in Eastern Europe in the autumn of 1989, I was asked in a reproachful way why I did not urge the economics of Professor Friedrich Hayek as the alternative to the economic system there so obviously failing. I replied that this was not a design which, in its rejection of regulatory, welfare, or other ameliorating actions by the state, we in the United States or elsewhere in the nonsocialist world would find tolerable.
John Kenneth Galbraith
The end of the 1980s and the early 1990s marked a victory for democratic society around the world. Dictators in Eastern Europe were overthrown, the Berlin Wall was tom down, and the former Soviet Union began the difficult and dangerous process of fundamental change. As the secrets spilled out from previously closed societies, the truth was even worse than we had imagined: a massive epidemic of AIDS among the poor children of Romania, choking air pollution and retrograde factories in Eastern Europe, and a complete collapse of the economy of the former Soviet Union.
Democracy was a clear winner in this worldwide transformation and became the United States' best export. It also appeared that capitalism would be a big winner. As Marxist professors quickly became unemployed (except in universities in advanced capitalist economies), free marketeers airlifted themselves to Eastern Europe and the newly formed republics in the former Soviet Union. In conferences, speeches, and meetings they preached the virtues of self-interest, the efficiencies of competition, and the productive genius of the market.
But in this euphoria it is easy to forget an important lesson from the experience of modem successful economies. Sometimes markets work, but sometimes they don't.
When markets work well, economic policy is cut and dried: do everything possible to ensure that the private system continues to function freely and without impediments. As an example of successful markets, consider how an Eastern European citizen would view our all-purpose drug and convenience stores. Open all hours and jammed with merchandise, they provide envelopes, toothbrushes, cold remedies, film, greeting cards, and the cornucopia of other items that we just assume will be available. As we learn in beginning economic classes, it is a miracle that this vast variety of items can reach the consumer without any centralized planning or production and with minimal, if any, government oversight.
Markets also operate silently. They allocate goods and services, generate incomes, reward the talented, skilled, and lucky and punish the less talented, less skilled, and unlucky. A myriad of decisions about the allocation of resources and the distribution of resources are quietly made, prompting economists to describe the silent working of markets as part of a grand circular flow. Consumers purchase goods and services from businesses that, in turn, generate incomes -- wages and profits -- that accrue to workers and investors and are then reinvested in goods and services.
But markets can fail to work. And when they do, the silence ends. When markets fail, governments intervene and impose regulations on the economy. Economic decisions are no longer left to the silent workings of markets but become heavily influenced by politics. The grand circular flow is thus transformed into the noisy and chaotic Washington money-go-round.
When Washington politics meets the free market, a host of new actors, new factors, and obsessions come into play. Considerations of political equity emerge from the silence. Experts, scientific or otherwise, are called in to share their wisdom, opinions, and prejudice. Raw political power and other political considerations begin to influence economic outcomes. And solutions to social problems based on reintroducing markets are viewed with skeptical eyes since problems seem to have arisen in the first place because markets were not working.
It is precisely at this interface of economics and politics, where markets seem to fail, that the grand debates of U.S. economic policy should occur. We should be asking how markets can be reformed or regulated in a sensible way to achieve our goals. Instead, in the Washington money-go-round we find thousands of lawyers and lobbyists, special interests, influence peddlers, self-anointed reformers, regulators, bureaucrats, and ambitious politicians. All are out to promote their narrow interests or those of their constituencies. In this environment, there are few honest dialogues on economic policy. Instead, discussions of policy often become just another pretext for promoting self-interest.
Today U.S. economic policies are made by accommodating the lobbyists and pressure groups. Occasionally policy rises above the fray, such as with the passage of the Tax Reform Act of 1986, which swept many loopholes and sweetheart deals from the tax code. But this exception, a remarkable detour from politics as usual, proves the rule. The Washington money-go-round provides the media with tales of intrigue, power, and influence that titillate the public. Sometimes this mad scramble for economic positioning may seem amusing, but it deflects attention from the very serious business of making our economy work in a time of increased global economic competition.
Special interests thrive in an atmosphere in which there is no consensus or even a general framework for thinking about economic policy. Without any basic ground rules, all claims on government seem equally valid and plausible:
A housing problem? Let's have a subsidy or tax credit.
Your industry is losing out to foreign competitors? Try a tariff, quota, or "voluntary export restraint."
Worried about the burden of caring for the elderly? Let's start a program of federally subsidized long-term care.
Health care costs rising? Let's put price controls on hospitals.
Lists like these can and do continue indefinitely. We currently do not have any framework to sort the good claims from the bad. Instead, we rely on the day to day workings of the Washington money-go-round to sort out these claims. Unfortunately, this means that power, influence, and access will often be decisive over common sense and sound public policy.
Some reformers claim that the real culprit in our economic and political system is the corrosive effect of money in politics. They promote campaign finance reform as the answer to our difficulties. Put everyone on an equal playing field, they say, and then we will have sound economic policy.
But this argument fails in two important respects. First, try as we may, we can never equalize the power of economic interests in our economy. Large, sophisticated interests will find ways to wield their influence. The evils of today -- political action committees and soft money -- were the byproducts of our previous reform efforts in the 1970s. The law of unintended consequences has worked with a vengeance in campaign finance. Moreover, in a free society it is extremely difficult to place limits on political actions. The Supreme Court has ruled that billionaires are free to spend as much of their own money as they desire to run for office. Wealthy heirs are permitted to set up tax-free foundations to promote their visions of environmentalism. And it is naive to believe that large corporations would not find similar mechanisms to influence political outcomes.
But there is a more fundamental limitation to campaign finance reform as a solution to our economic problems. Even if we could level the playing field, without a general framework for thinking about policy, we still could not separate the good claims from the bad. The same conundrum remains: there are an infinite number of claimants on public resources. Some basic principles are necessary to decide whic
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Book Description Free Press, 1993. Hardcover. Book Condition: New. New item. May have light shelf wear. Bookseller Inventory # BK0103547
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