The Price of Inequality: How Today's Divided Society Endangers Our Future (28 page)

The bankers and their allies unleashed tirades against the homeowners who were losing their homes. They were labeled as having been reckless. A small percentage had bought multiple houses, and, in an attempt to tarnish all of those losing their homes, they were labeled “speculators.” Of course, what else might one call the gambling of so many of the banks? Their reckless speculation lay at the heart of the crisis.

But the greatest irony was the claim that helping some poor homeowners and not helping others would be “unfair.” Yet these inequities pale in comparison with those that arose from the hundreds of billions of dollars thrown at the financial sector. Inequities related to the bank bailouts were never mentioned, and if a critic raised them, they were dismissed as the unfortunate but necessary price to resuscitate the economy. There was no mention of the idea that stopping the flood of foreclosures might be a good thing for resuscitating the economy—and helping ordinary citizens.

There were ways of helping homeowners that would not have cost taxpayers a dime and that would have left homeowners who had managed their debts prudently far better-off than those who hadn’t; but the bankers resisted any and all such proposals.
52

We saw in chapter 1 part of the consequence of the combination of the bank bailout without constraints and the absence of help for homeowners: the increase in the inequality of wealth, including the dramatic reduction in the wealth of those in the bottom half of the population.
53

T
HE
B
ATTLE OVER THE
B
IG
I
DEAS:
G
OVERNMENT VERSUS
M
ARKET
F
AILURE

I have illustrated the fight over perceptions in the context of quite specific battles, but the battles rage most intensely in the field of big ideas. One such battle involves on one side those who believe that markets
mostly
work well on their own and that most market failures are in fact government failures. On the other side are those who are less sanguine about markets and who argue for an important role for government. These two camps define the major ideological battle of our time. It is an
ideological
battle, because economic science—both theory and history—provides a quite nuanced set of answers.

This battle plays out in every realm of public policy. It affects the role that government takes in ensuing macrostability, in regulating markets, in investing in public goods, in protecting consumers, investors, and the environment, and in providing social protection. Our focus here, though, is more narrow: this is the big battle the outcome of which will have much to say about the evolution of inequality in the United States, whether it continues to increase, as it has been, or starts to diminish.

A central thesis of chapters 2 and 3 is that market failures—and the failure of government to circumscribe them—play a key role in explaining inequality in America. At the top there are rents (such as monopoly rents); at the bottom there is underinvestment in human capital. Hidden subsidies that distort the market and rules of the game that give an upper hand to those at the top have compounded the problems.

As we noted in chapter 3, economic theory has shown that markets don’t exist in the abstract. At the very least, there is a need for government to enforce contracts and to provide the basic legal structure. But how governments do this makes a difference, both for efficiency and for distribution. The Right wants the “right” rules of the game—those that advantage the wealthy at the expense of the rest. They’ve tried to shape the debate, to suggest that there is a
single
set of rules that would be best for all. But, throughout the book, we’ve seen how that’s just not true.

Economic theory has shown that markets work well when private and social returns are well aligned, and don’t when they are not. Market failures are pervasive. Externalities, for instance, are not limited to the environment. Our banks polluted the global economy with toxic mortgages, and their failures brought the global economy to the brink of ruin, imposing huge costs on workers and citizens throughout the world. Some of these market failures are easy, in principle, to correct: a firm that is polluting can be charged for the pollution it creates. But the distortions caused by imperfect and asymmetric information are present everywhere, and are not so easily corrected. Managers do not always act in the interests of “stakeholders” (including shareholders), and there’s little that they can do about it. As we saw in chapter 4, incentive pay that was supposed to align their interests didn’t do so; the managers benefited, at the expense of everyone else.
54

But if you listened only to arguments from the Right, you would have thought that markets
always
worked and government always failed. They worked hard to create this perception within the public, most simply by ignoring private market failures and government successes. And they’ve tried to ignore—and to get others to ignore—the distributive consequences of these market failures, who gains and who loses when private rewards and social returns are not well aligned. The crisis provided an instance where it was easy to see the winners and losers; but in almost every case, whether it’s environmental pollution or predatory lending or abuses of corporate governance, it is those at the top who are the winners, and the rest who are the losers.

Of course, not every government effort is successful, or as successful as its advocates would have liked. Indeed, when the government undertakes research (or supports new private-sector ventures), there
should
be some failures. A lack of failures means you are not taking enough risks. Success occurs when the returns from those projects that succeed are more than enough to offset the losses on those that fail. And the evidence in the case of government research ventures is unambiguously and overwhelmingly that the returns from government investments in technology
on average
have been very, very high—just think about the Internet, the Human Genome Project, jet airplanes, the browser, the telegraph, the increases in productivity in agriculture in the nineteenth century, that provided the basis for the United States’ moving from farming to manufacturing. When I was chairman of the Council of Economic Advisers, we assessed the average social returns on government R&D, and it turned out to be well in excess of 50 percent, far higher in other areas of investment (including private sector R&D).
55

Governments are human institutions, and all people, and the institutions they create, are fallible. There are government failures just as there are market failures. Recent economic theory has explained when each of these is more likely to fail, and how governments and markets (and other civil institutions, including those that serve as watchdogs on both corporations and government) can complement each other and provide a system of checks and balances. We have seen myriad instances of this kind of complementarity: a government initiative created the Internet, but private-sector firms like Google built many of products and applications that have placed it at the center of people’s lives and our economy. Government may have created the first web browser, but the private sector and open-source movement have refined it.

That there are successes and failures in both the public and the private sector is clear. And yet many on the right seem to think only the government can fail. Part of the reason for these disparate perceptions about markets and governments has to do with the theory of equilibrium fictions described earlier. Those who believe in markets discount information about market failure while assigning high saliency to examples of government failure. They can easily recall examples of failed government programs, but the massive failures of our financial system in the run-up to the Great Recession are quickly forgotten, described as an anomaly, or blamed on the government.

The fact of the matter is that there has been no successful large economy in which the government has not played an important role, and in the countries with the most rapid growth (such as China) and in those with the highest standards of living (such as those in Scandinavia),
56
the government plays a very important role. Yet the prevailing ideology on the right is so strong that there continues to be a push for a small government, for contracting out government services and privatization and even a resistance to regulation.

This Right fails to note not only the successes of government but the failures of markets. In the aftermath of the crisis of 2008, however, it is hard to ignore the
repeated
financial crises that have marked capitalism since its origins.
57
Repeated bank bailouts have imposed high costs on taxpayers. If we add up the losses from the financial sector’s misallocation of capital before the crisis and the shortfall between the economy’s potential output and actual output after the bubble burst, we get a number in the trillions of dollars.

After the Great Depression, government succeeded in regulating the financial sector, producing almost four decades of financial stability and rapid growth, with banks focusing on lending, providing the money needed for the rapid expansion of our enterprises. Government helped make markets act the way markets are
supposed
to function, by reducing the scope for fraud and consumer deception and enhancing competition. But beginning with President Reagan and continuing through President Clinton, government stepped back. The deregulation led to instability; with less oversight, there was more fraud and less competition.

Nor is this the only example. Private health insurance companies are much less efficient than the government-run Medicare program.
58
Private life insurance companies are much less efficient than the government’s Social Security program.
59

To take another example: a recent study showed that, on average, contractors “charged the federal government more than twice the amount it pays federal workers” for performing comparable services.
60
As much as one out of four dollars spent on contracting in Iraq and Afghanistan was wasted or misspent, according to the Commission on Wartime Contracting in Iraq and Afghanistan.
61
In an earlier study, Linda Bilmes and I showed how the government could have saved billions by having the armed forces provide these services.
62
But this—and other experiences—suggests that it was not just ideology that drove the contracting/privatization agenda: it was rent seeking.

Liberalization and privatization

The irony is that advocates of privatization (turning over previously publicly run enterprises to the private sector) and liberalization (stripping away regulations) have long claimed that these policies are necessary to restrain rent seeking. They note corruption in the public sector but seldom acknowledge that on the other side of every public-sector employee who takes a bribe is a briber, and that briber is typically a private party. The private sector is fully involved in the corruption. Worse still, in a fundamental sense, the agenda of privatization and liberalization has itself been corrupt: it has garnered high rents for those who used their political influence to push it.
63

Around the world, the examples of failed privatizations are legion—from roads in Mexico to railroads in the UK.

The major privatization in the United States of recent years—of the company that makes enriched uranium, used for nuclear power plants and making atomic bombs (USEC, the U.S. Enrichment Corporation)—has been plagued with criticisms of dishonest dealing. While the former government officials who engineered the privatization and the investment bank that facilitated it made millions, the company was never able to turn a profit. For more than a decade and a half after privatization, government subsidies were at the center of their business model. The results have been so troubling that there have been proposals to renationalize USEC.
64

But had President George W. Bush had his way, there would have been a much, much bigger privatization—the (partial) privatization of Social Security, at the center of his State of the Union address of 2005. Americans are, of course, now thankful that his efforts failed. For if they had succeeded, America’s elderly would have been in an even worse position than they are today: those who had put their money in the stock market would have seen much of their retirement wealth gone; those who put their money in safe T-bills would be struggling to survive, as the Fed pushes interest rates down to near-zero levels. But even before the crisis, it should have been obvious that privatization was a bad deal for most Americans. We noted before that Social Security is more efficient than private providers of annuities. Private insurance companies have much higher transactions costs. In fact, that was the whole point of privatization: for the elderly, transactions costs are a bad thing; but for the financial sector, they are a good thing. That’s their income. That’s what they live off of. Their hope was to get a slice of the hundreds of billions of dollars
65
that people put every year into their Social Security accounts.
66

Liberalization/deregulation initiatives have had as mixed a record as those of privatization—with the most notorious being financial sector deregulation and capital market liberalization. For those devoted to the ideology of the Right, these failures are a mystery. To those more apprised of the limitations of the market, they are predictable—and often predicted. This also applies to liberalization initiatives, including the disastrous liberalization of electric power in California. Enron, one of the big advocates of the liberalization and an outspoken advocate of the wonders of the market (before it went down in 2001, the largest corporate bankruptcy ever recorded up to that point), manipulated the California electricity market to make millions and millions for itself, a transfer of money from ordinary citizens of that state to Ken Lay, its CEO, and the others who ran the company. Bush officials blamed the shortages that Enron had managed to create on excessive environmental regulation that discouraged new construction. The reality was otherwise: as soon as Enron’s market manipulations to inflate prices were exposed and regulations were restored, the shortages disappeared.