Government failure

Introduction

Governments can fail when they intervene in an economy. In economics, government ‘failure’ refers to an intervention that results in an inefficient use of scarce resources, often as a result of attempting to correct a market failure.

As with ‘market failure’ government failure can be considered ‘partial’ if intervention improves efficiency in one area, but at the cost of inefficiency in another area. In theory, it can also be ‘complete’, when the intervention only leads to inefficiency, with no compensating efficiency gains.

For example, a partial government failure could arise as a result of providing a subsidy to a failing or underperforming industry. While the subsidy might result in a failure because it may inhibit industry from attempting to find its own efficiency gains to improve its position, it could help protects jobs, hence saving the economy from paying unemployment benefits. The actual effect will depend on how the subsidy is actually used – if it is used to acquire new technology, and train workers, then productivity can improve, with efficiency gains.

A complete government failure is highly unlikely, given that additional spending in an economy is likely to generate some level of efficiency improvement at some point in the circular flow of income.

Perhaps the clearest example of complete government failure would be when tax payer's money went wholly towards funding a ‘failed’ project, or where, for example, international aid is used exclusively to support a corrupt regime.

How the level of failure is assessed is, of course, itself subject to failure given that inefficiencies may be difficult to identify, and to qualify in the short run, but especially in the long run.

Types of government failure

Lack of information

Effective intervention in an economy requires accurate and comprehensive knowledge of macro-level data, including current levels of inflation, unemployment, trade flows, growth rates, and so on. Official data on such variables cannot be expected to provide a ‘complete’ picture.

Indeed, much activity may be hidden from measurement as it takes place in the ‘hidden economy’. The hidden economy is composed of three elements:

  1. The ‘shadow’ economy, which includes firms and individuals who are pursuing legal production or work activities, but who may hide some or all of their income;
  2. The ‘underground’ economy, which involves illegal activities, such as burglary, and;
  3. The ‘informal’ economy, which includes small scale enterprise which remain unregistered.

There are, of course, ways to estimate the size of the shadow economy, which include:

  1. Surveys of companies and households.
  2. Assessing discrepancies between official data on difference aspects of an economy.
  3. Changes in monetary variables not tallying with measurements in the real economy.
  4. Changes in the demand for currencies.
  5. Electricity consumption as an indicator of economic activity.

Several influential economists, including Milton Friedman, have argued that governments can never know enough about an economy to adoptive active and interventionist policies, and as a consequence advocated highly conservative approaches to policy.

For example, control of the money supply to achieve a desirable inflation rate would be more preferable to active monetary policy (by increasing the money supply) because its effects were uncertain. While knowledge is likely to improve over time it is inevitable that government intervention will be subject to some information failure.

Time lags

Similarly, information flowing to policy makers may be out of date as soon as it is published. Even the most ‘up-to-date’ information will be painting a picture of what was happening several months, or possible years ago. This means that the timing of policy interventions may not be optimal - with some policy decisions taken too late and some possibly too early.

Steering an economy has been likened to steering a huge ship - decisions to turn one way or another, or to slow down or speed up must be made well in advance of the point or destination where the ship is headed. To continue the analogy, an economy has a huge ‘turning circle’!

This can be illustrated by considering the complex transmission mechanism between interest rates and the inflation rate. According to the Bank of England,

‘the empirical evidence is that on average it takes up to about one year in this and other industrial economies for the response to a monetary policy change to have its peak effect on demand and production, and that it takes up to a further year for these activity changes to have their fullest impact on the inflation rate.’

(source: Bank of England)

Unintended consequences

Decisions taken by policy-makers may result in outcomes in the real economy that were not anticipated.

There are numerous examples of possible unintended consequences, ranging from increases in tax rates designed to raise revenue that might actually cause revenue to fall because of increased tax evasion; and traffic calming measures that might encourage drivers to increase their speed before and after they drive through the speed control zones.

Moral hazard

Moral hazard may also increase as a result of intervention. Moral hazard occurs when individuals or firms act recklessly because they believe that they are protected from the adverse effect of their behaviour. The term comes from the insurance industry, when it was noted that providing insurance against the negative impact of a hazard could lead the insured to deliberately seek out the hazard, and collect an insurance pay-out.

For example, an accepted consequence of financial support to the banking sector in the early stages of the financial crash in 2008-9 was that some US banks thought they were ‘too big to fail’ and would be bailed out, and hence continued to make risky loans to the sub-prime housing market.

Moral hazard has been widely studied in economics, and has the potential to occur as a result of many types of intervention. This includes individuals continuing to smoke cigarettes because healthcare services will provide treatments for lung conditions, and people choosing not to work because welfare benefits provide an insurance against a zero income.

Failings of overseas aid

Similarly, one unintended consequence of providing aid to developing countries is that they may fail to develop their own economies effectively, or that aid may not trickle down through the economy to reach the poorest, who then remain at a subsistence level. In this situation, savings cannot be generated and the economy continues to rely on international aid.

A given level of saving is required to provide a flow of funds to the financial sector, but the poorest will have a marginal rate of saving of zero or even a negative one. Hence most developing economies still have a ‘savings gap’ which aid may not help close, or make even worse.

Failures in farm support

Throughout the global economy governments have wanted to protect farmers from uncontrolled market forces. Supply-side shocks in the form of bad weather and disease have caused considerable instability in agricultural markets, through the so-called Cobweb effect, leading to dynamic price instability. This has led governments to introduce schemes to reduce instability.

However, intervention schemes can cause unintended consequences.

For example, establishing a guaranteed price system may led to over-production, where farmers are incentivised to increase output beyond the natural market equilibrium.

Guaranteed prices and market failure

While farmers increase output (via an expansion along the supply curve, a to b), consumers respond to higher prices by contracting demand (a to c), with the net result that there is a surplus of unconsumed output. In the case of many agricultural goods, storage is difficult, excessively costly, and not possible for perishable goods. The result may be that excess stocks are destroyed. Which, clearly, is not an outcome that anyone would have deliberately wished for.

Farmers (and other producers) may be supported with direct subsidies. As with guaranteed prices they will encourage farmers (and producers) to increase output. However, the subsidy may be greater than is required with the result that economic welfare is lost, rather than gained.

This means that the intervention reduced welfare below the level of that which existed as a result of the market failure.

Regulatory capture

The possibility that regulators slowly ‘switch sides’ by defending the interests of those firms or industries that are charged with regulating was first identified in the 1950s, and was studied extensively by Chicago economist George Stigler in the 1980s [1].

Regulatory capture has been the subject of much research detailing industries where such capture appears to exist.

While outright corruption may be at work in some instances, it is most likely that regulatory capture is a by-product of the need of regulators to understand the fine detail of how an industry works.

In attempting to understand exactly how an industry is composed, and how it operates, it is possible for regulators to understand the range of problems faced in the industry, and to be more sympathetic to practices which, ultimately, are against the interests of the public.

Examples of regulatory capture:

  • Quality and safety regulators giving notice of inspection visits,
  • Frequent staff interchange between regulator and industry,
  • The reluctance of either party to be strongly critical of the other, and:
  • Regulators engaging in increasingly 'closed' and not transparent consultation processes.

The existence of regulatory capture casts doubt on the rigor and effectiveness of regulation.

Welfare loss from controlling demerit goods

Governments are likely to control demerit goods in some way, including through taxation. However, intervention may reduce consumption and production below the socially optimal level.

While campaigners may argue that some demerit goods should be completely banned, the commonest strategy is to impose indirect ‘sin’ taxes and accept that the socially efficient level may not mean zero production or consumption. In most countries some alcohol is tolerated given that output and jobs are created as a result of production and consumption. It is possible that an excessively high tax could push consumption below the socially efficient level, and create a welfare loss. This is shown below:

Welfare loss from government failure

The welfare loss from imposing an 'excessive' tax can be seen as the grey triangle (kam). The most efficient tax would be the one that achieves the socially efficient level of consumption and production.

Retaliation

In terms of international trade policy, while the imposition of a tariff by one country is likely to have some predictable effects on consumption, the reaction of foreign governments may be less predictable. Governments may retaliate and increase their own tariffs by a disproportionate amount. Trade wars are a possible consequence of this tit-for-tat approach, where all those involved lose.

Dealing with symptoms not causes

Government intervention can fail because it deals with the symptoms of a problem, not the causes. For example, agricultural 'set aside' programmes in the EU cereal sector, which aimed to stabilise agricultural markets by forcing farmers and growers to take land out of production, and so reduce supply onto the market, are likely to fail because they target market supply – which is a symptom of the problem – rather than the cause – the relatively high prices of cereals.

It has been argued that the focus on set aside caused several market distortions, including that famers could not combined factors of production in the most efficient way (with less land available), and that payment for the scheme led to a rise in distortionary taxes, and that the reduction in supply would raise price which would disproportionately affect the less well off.

Of course, given the circularity of economic activity, it is difficult to separate cause and effect. The debate between monetarists and Keynesians regarding the connection between the money supply and price level highlights this issue. Do increases in the money supply lead to a rise in the price level (as monetarists claim) or do increases in the price level increase the demand for money, which the encourages banks to supply more money to willing borrowers?

The past may not be a predictor of the future

Current policy is usually informed by analysis of past behaviour. If, for example, an increase in taxes on demerit goods, such as alcohol and cigarettes, of 10% in 2005 led to a reduction in their consumption by 15%, in 2006, it might be assumed that a similar effect would occur If the same policy was introduced in 2020. For many reasons, this might not hold. Initially, behaviour adjusted elastically, but 15 years later, behaviour might adjust inelastically, or not at all.

Micro-economic policy interventions may produce several inefficiencies as a result of false expectations derived from the analysis of previous interventions.

At the macro-economic level, there has been widespread debate about macro-economic forecasting, and the extent to which models derived from analysis of previous episodes (or unemployment, or inflation, for example) are applicable to current situations. This idea is captured in the ‘Lucas Critique’.

The essence of this critique is that individuals may adjust their behaviour in response to a repeated policy in a way that weakens the effect of the policy. For example, over time, individuals may learn to ‘side step’ policies which were once effective, and hence reduce the impact of the policy at the macro-economic level. This can be seen in how economists have dealt with the breakdown of the Phillips curve.

This raises important questions about whether individuals are becoming more resistant to government policies in all aspects of economic life. Perhaps this explains the rise of behavioural theories, which emphasise the use of nudges to change behaviour rather than, now blunter, traditional policies.

Whichever policy initiative to control Covid-19 has been introduced in Western economies, there appears resistance by individuals to changing their behaviour. Contrast this with several Asian economies, where individuals appear more responsive to policies to control the virus, such as mask wearing requirements, and as a result there are, currently, fewer Covid cases.

In this respect, some government failure may be as a result of the increasing resistance of individuals to policy initiatives.

Failures and costs of enforcement

Finally, some government failure may arise because of failings in terms of enforcement. Policies need to be implemented by various agents and official bodies, who themselves may be subject to inefficiencies and limitations. Government activity inevitably involves bureaucracy and administrative costs, which can add a layer of inefficiency to intervention.

Conclusion

Most examples of government failure have more than one feature, such as government subsidies which can suffer from information failure, cause unintended consequences such as moral hazard, and suffer from considerable time lags. There are many possible unintended consequences of macro-economic intervention, but better modeling and more accurate data collection will, gradually, reduce these - but it is doubtful that they will ever be eliminated given the fundamental and enduring problem of information failure.

Of course, governments may fail because economic considerations are only one of the factors taken into account. Governments will also be concerned with a range of other considerations, including issues related to 'equity', 'inequality', defense, healthcare and social justice - all of which may conflict with other policies designed to improve efficiency.

[1] Stigler, George J. “The Theory of Economic Regulation.” The Bell Journal of Economics and Management Science, vol. 2, no. 1, 1971, pp. 3–21. JSTOR, www.jstor.org/stable/3003160. Accessed 15 Oct. 2020.


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