Introductory economics textbooks devote considerable attention to market failure: monopoly power, externalities, public goods and asymmetric information. However, government failure deserves the same scrutiny.
Markets are made up of imperfect human beings and so are governments. Legislators, regulators, and civil servants possess limited knowledge, imperfect foresight and incentives of their own. Evidence of market failure is not evidence that government intervention will improve the outcome. The relevant comparison is between feasible alternatives.
The financial crisis of 2008 illustrates the problem. Banks, mortgage originators and investors made serious mistakes. But government was not merely a spectator that arrived afterward to rescue the financial system. Regulators supervised major financial institutions, established important rules governing them, and possessed powers unavailable to ordinary market participants.
A Government Accountability Office investigation found that regulators had identified numerous weaknesses in risk-management systems at major financial institutions before the crisis. Yet regulators did not always take forceful action. In some cases they relied heavily on management assurances and did not fully appreciate the magnitude of the risks until institutions were already under severe stress.
This was not necessarily corruption or incompetence. It illustrates a more fundamental economic problem: public officials respond to incentives just as private actors do. But the consequences they face can be very different.
When a private firm repeatedly makes disastrous decisions, it can lose customers, investors, employees and eventually its existence. Markets certainly do not impose perfect discipline—executives can be rewarded before losses become apparent, and bailouts can protect failing institutions—but firms can disappear. Regulatory agencies ordinarily do not.
Officials who make mistaken judgments generally do not personally bear losses comparable to shareholders whose capital disappears. Agencies can instead receive new rules, responsibilities and resources following a crisis. That creates government moral hazard: substantial authority over other people’s economic decisions combined with limited personal exposure to the consequences of regulatory error.
I recognize that this extends the conventional definition of moral hazard. But the underlying incentive problem is similar: decision-makers exercise authority while being partially insulated from the consequences when their decisions prove wrong. This does not imply that regulators are lazy, malicious or unnecessary. The problem is institutional, not personal.
Economics should therefore evaluate government intervention using the same analytical discipline it applies to markets. Whenever intervention is proposed to correct a market failure, four questions should follow: Who has better information? Who bears the consequences when the decision is wrong? How quickly can mistakes be corrected? Can an institution that repeatedly fails be replaced?
The mistake is comparing an imperfect market with an imaginary government possessing perfect information, perfect incentives, and perfect foresight. The proper comparison is between real and imperfect alternatives.
Economics teaches that incentives matter. It should apply that lesson as rigorously to the people who regulate markets as it does to the people who participate in them.
