Friday, 4 April 2014

When states don't perform

One of the essential roles of the modern state is to solve market failures, i.e. provide goods on the market for which the demand is high, but the supply is inadequate. Or in other words provide goods and services when the markets for such goods don't exist (at least not enough to satisfy the demand), when the selection is adverse (e.g. health insurance market), when there is a lack information (e.g. used car market), or when there is a lack of competition (e.g. monopolies - even though we are aware that monopolies can only exist with the consent of the government). In some of these cases we can indeed find market solutions (reputation in case of asymmetric information - "fool me once, shame on you, fool me twice, shame on me", or venture capital funds to solve the adverse selection problem on the financial markets in loans to small businesses), however in certain cases we do need the government to at least provide the basic infrastructure.

In the past governments built roads, railways, telecommunication lines or pipelines, so one would expect all of these to be a public good. However, it's a completely different story when governments give a single company monopoly rights to use the infrastructure it has provided. That is an example of failed government intervention. The proper solution would be to enable many companies (even though it's usually a few) to use these goods and compete on the market for customers by doing so. The privatization of the British railways is one good example, the telecommunications industry worldwide is an even better one. Why should a single company bear the right to extract all the profits from what is essentially a public good? Particularly since such monopoly companies are overrun with inefficiency and rigidity. 

Government failure

But the real question is do the states always perform their role efficiently and fairly? Even when they do provide us with public goods or services, they often do it very costly and inefficiently. The reason for lack of efficiency and high costs is due to the lack of the profit motive that characterizes the private sector. On the other hand the lack of profit motive is precisely the reason why markets for certain goods don't exist. The free rider problem disables any entrepreneur from offering a certain good to the public since there would always be individuals who would use a good or service without paying its price - or in other words it is hard to exclude people from consumption of public goods (such as street lights, city roads, anti-missile defense system, etc.). Then there's also the justice system, protection of private property, safety (police, military), and even the use for public administration (to get permits, IDs, drivers licence etc.). However even when such goods and services are provided government intervention can result in failure.

The dichotomy between fairness and efficiency is important in the issue of justifying government intervention, but we so often see cases of governments that are neither fair (high inequality) nor efficient (governments that act extortionary). This is not limited to failed states in Africa, whose ethnic fractionalization and wars keep pushing out new dictators which only further perpetuate the iron law of oligarchy. No this can also be applied to many states of the developed (or developing) world, which carry only a fictional democracy, while in reality they are dominated by state capitalism and cronyism.

Why do states fail? There is a multitude of potential reasons, most of them well explained by Public choice theory. If market participants are modeled as being self-interested, there is no reason not to apply the same logic when it comes to politicians in power and bureaucrats in office. Even more so since the selfish behavior of market participants doesn't hurt anyone, whereas the self-interest of politicians can have huge negative ramifications upon the economy.

Furthermore, reasons for state failure stem from the very definition and assumptions of market failure. It is said that due to a lack of perfect (or full) information, markets fail. However, government bureaucrats and decision-makers arguably possess even less information than the private sector whose incentives they wish to correct. Because of this government intervention is, the least to say, also imperfect. The key is to distinguish between relative efficiency of both the market and the government. If there is a market failure that the government tries to solve but its solution causes a great deal of inefficiencies then it is best not to involve the government at all.  

Rampant and persistent government failures lead to vast differences in the perception the population has towards governments and it can sway public preferences in either direction. A highly efficient government operating in a stable and strong institutional environment (e.g. Scandinavia) has a population which favors and more easily justifies government intervention. On the other hand in countries with highly inefficient governments with a high public perception of corruption of government officials and the society in general, there is very likely to be a very negative perception of the government's role in the society. This depends first and foremost on the historical trails the country went through (social capital diminishes following a transition process), but generally in failed states people perceive the role of the government much differently than those in successful states.

The point is to opt for an efficient government, regardless of its size. The size will depend primarily of the preferences of a particular nation. But efficiency, transparency and accountability can be the end goals every voter desires from its government. 

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