The Myth of the Myth of the Market

Matt Yglesias argues that there is no such thing as a “market distribution” of wealth, because most wealth would not exist without the state. He lists “a few minor exceptions” to the maxim that market solutions are efficient:

— The air pollution impacts of modern electrical power generation, industrial activity, and transportation can’t be efficiently bargained away because the transaction costs are way too high.

— So-called “public goods” like basic scientific research or musical recordings will be underproduced absent some combination of state subsidy and state-created intellectual property monopolies.

— Basic infrastructure (roads, electrical lines, sewers) won’t be provided properly without some eminent domain and they won’t be priced correctly due to the monopolistic nature of the market.

— Absent deposit insurance and regulation, banks will be subject to runs and economically destructive panics.

— Without a central bank minding the store properly, the entire macroeconomy will fall into periodic recessions lasting months or years.

Since these five factors color all market activity, Matt says, there is no such thing as pure market activity, and therefore no distribution of wealth that would result if there were no government provision of pollution abatement, public goods, and so on.

In my view, Matt’s argument is not compelling. Take first his list of “minor exceptions” to the general rule that markets work best. Do we need state intervention to keep air pollution down to acceptable levels? There has never been a completely laissez-faire society that has had dirty air, so it is difficult to say. What we do know from the work of Elinor Ostrom is that we don’t need state intervention in all cases to solve problems associated with water usage or overfishing, which are structurally similar to that of air pollution (i.e., they have high transaction costs). It turns out that the threat of state-sanctioned violence is not the only solution to repeated prisoner’s dilemmas, even when transaction costs are high, either in theory or in practice.

What about other public goods? It is strange to me that Matt chose copyright protections for musical recordings as an example, because I might favor eliminating such protections even as a matter of marginal policy reform. If musicians could no longer make money from selling recordings, they would still produce recordings as advertisements for their live performances. Musicians would tour more, and the live music scene might become more vibrant. It’s not at all clear to me that it would be worse than the status quo. I don’t favor eliminating government funding for basic research, and indeed, at the margin, I would favor more such funding. But similarly, without government subsidies, research would still occur, philanthropists would still donate to universities, and so on. While the result may be some modest “underproduction” of basic research, it still seems unlikely that but for government funding of basic research, we would be living in caves.

I’ve never understood the argument about roads, since as best I can tell, roads have always existed, even in cases in which governments did not have transportation policy. The common law, which itself originated without the state, seems to have made adequate allowance for solving the anticommons problem via various kinds of easements and property rules. Matt also argues that private infrastructure would be monopolistically priced, but I think he fails to consider the possibility of customer-owned mutuals as an alternative to both government and for-profit firms.

Without deposit insurance, would banks face constant runs and panics? This is at best controversial among monetary historians. Modern economists tend to blame bank failures during the Great Depression more on restrictions on interstate banking and the concomitant lack of geographic diversification than on the lack of deposit insurance. New Zealand does not today have deposit insurance; it is not a financial hellscape. If deposit insurance were eliminated, banks would become more sober, prudent institutions than they are today, which may not be such a bad outcome. I favor the elimination of federal deposit insurance, and I don’t think I am very alone. Certainly, it is not one of my most out-of-the-mainstream policy views.

I confess to chortling a little at Matt’s line about central banks. Months or years of recession?! Unimaginable. With central banks in charge, the US is experiencing a years-long slump, Japan is experiencing a decades-long stagnation, and Europe is…fucked. Central banks were also at the helm during the Great Depression. My monetary policy views are conventional, but the central banking track record is not something I would try to draw attention to were I taking Matt’s side of this argument.

None of this is to say that we would all be immensely wealthy in a world without government intervention. The way Matt structures his argument, I don’t have to make that claim. All I need to show is that but for government intervention, we would not be dramatically worse off than we are now, which I think I have done. It seems worth mentioning, in addition, that government sometimes makes us worse off as well as better off. For example, government regulation of pollutants can and often does exceed anything resembling the welfare-maximizing amount. Governments produce public bads as well as goods, such as war, genocide, the new Jim Crow (to say nothing of the original), and immigration restrictions. Transport policy is often counterproductive, and infrastructure resources such as spectrum and airspace are often misallocated or otherwise mismanaged, relative to a common law approach. Financial regulation seems to do more to enrich Wall Street than protect the public. And as I said above, government policy caused the Great Depression and the Euro crisis, as well as innumerable other financial disasters. These costs are significant. Immigration restrictions alone cut global output in half. On top of all this is the deadweight loss of taxation, which is substantial.

What is most unfortunate about Matt’s list is how widely accepted it is. He says you can find it in “a really banal mainstream neoclassical economics textbook,” and he is right. Textbook economics presents a simple model of the world and draws conclusions from that model that are frequently at odds with reality. Most textbooks try to convince the reader of the benefits of economic analysis, not to educate the reader about the limits of the models they present. Real world institutional analysis is much more complicated, messy, and context-dependent than Matt’s textbook allows. We can and should use the tools in the textbook to illuminate our work, but applying them as Matt does to create a universal theory of the (non)existence of a market distribution of wealth seems misguided.

10 replies to “The Myth of the Myth of the Market

  1. joskog

    Hello Eli,

    I’ll just address two points, since the whole thing would take too much time (especially addressing the disastrous effect the deficit-fixated Republicans in the House have had on the economy, separate from any effect the Fed has had at undoing their harm). First – in the case of deposit insurance the classic paper is the Diamond-Dybvig paper showing how bank runs need not occur unless something goes wrong. Thus bank stability without deposit insurance is a case of unstable equilibrium. Per your example, sure New Zealand is doing fine now, but what happens at the first sign of trouble? I don’t think anyone makes the argument that deposit insurance is necessary in good times. The issue is that the lack of deposit insurance increases the destabilizing effects in bad times.

    On roads, I would prefer if you would cite some examples. The classic historical case is the Romans, to whom roads were most definitely a state-sponsored project and an advantage. But absent other evidence I don’t want to put words in your mouth. Are there examples of civilizations without state-sponsored road policy which prospered relatively more than those with state-sponsored road policy? I tend to doubt it, but I’m always happy to be proven wrong.

    – Jeremy Skog

  2. joskog

    I would add one more point – is there any evidence that bank runs would be less likely to occur at institutions making “sober, more prudent” loans than at others? The defining feature of panic is that reason breaks down and fear takes over. This is not a state where rational observations matter much. Witness the issues that Bear Stearns and Lehman got into in the Repo market even though they were making short-term collateralized loans. in William Cohan’s book “House of Cards” he compares a rejected repo as being “your buddy not being willing to loan you $20 the day before payday.” But that is exactly what happened and caused the failure of these large banks. Is the average person in the street going to be able to hear “Bank Y is closing” and think “Well Bank X made good loans and was prudent so they’re safe.” Most of the research I’ve done on financial literacy would lead me to believe this is unsupported utopianism.

  3. Eli Dourado Post author

    Jeremy, unregulated and uninsured banks have historically used an “option clause” to prevent runs. For example, in Scotland in the early 1800s, banks had the option, per their agreements with their depositors, to suspend deposit repayment for a fixed period, during which they had to pay a penalty interest rate. Combined with unlimited liability, this seems to have aligned incentives and worked relatively well.

    On roads: Matt’s point is not exactly about road construction but about the eminent domain he thinks is necessary to accumulate land for the roads. That’s why I brought up easements in the common law. But if you want to talk road construction, there were roads that were built in Britain as early as 4000 BC, so at a minimum, the modern administrative state is not necessary for the building of roads. In all likelihood, such roads were built by neighbors collectively solving a problem of muddy paths for their wagons. Again, the point is not that such voluntary, cooperative roadbuilding leads to better roads than state-sponsored road policy, just that the it doesn’t make sense to assign credit to the state for any good that is ever transported on a road, which is literally Matt’s argument.

  4. Daniel Kuehn

    re:“What we do know from the work of Elinor Ostrom is that we don’t need state intervention in all cases to solve problems associated with water usage or overfishing, which are structurally similar to that of air pollution (i.e., they have high transaction costs).”

    Ostrom is an odd one to cite here because she’s entirely concerned with non-market distribution mechanisms! Although it’s not the state in her case, I’d think this would militate in favor of Yglesias’s point.

    I think Yglesias raises some good points, but I agree I wouldn’t put it as baldly as he does. I would simply say that we shouldn’t think just of “market distribution” because markets are only one part of a whole lot of institutions that determine distributional outcomes.

  5. Eli Dourado Post author

    Daniel, I agree that Ostrom is about non-market decisions, but I still think this cuts against Yglesias’s point, which that “You have policy choices all the way down.”

  6. Daniel Kuehn

    I guess I don’t understand. I see how you could disagree with him on whether policy is the only way to address the issues, but I don’t know if he said it’s the only way (i.e. – presumably he thinks non-market, non-state action could be relevant too, right? I can’t imagine he doesn’t think that).

    If Ostrom is all about non-market allocation I can’t see how that doesn’t demonstrate Yglesias’s point that a lot of distribution is done outside the market. I feel like I must be missing something stupid here – I don’t get it.

  7. Eli Dourado Post author

    It’s clear in my head, so let me see if I can unmuddle it.

    I take Matt’s point to be about a simple dichotomy: “politics” versus “the market.” Market purists talk as if there is such a thing as baseline distribution of income that government “redistributes.” Matt says that because government intervention is necessary at some level to produce all of that output, there is nothing analytically privileged about people’s earnings before taxes and “redistribution.” It is meaningless to talk about “redistribution”—the wealth distribution that results as a matter of government policy is every bit as “baseline” as any other.

    My most basic point is that government intervention is not nearly as crucial to the production of output as Matt imagines. Because Matt used the simple politics/market dichotomy, so did I. You are right that the Bloomington school does not fit neatly into the “market” category, but neither does it fit into the “politics” category. This is because the terms Matt and I use do not cover the entire space of possibilities: there are non-coercive non-market institutions as well.

    I read Matt’s point as mostly being about coercive distribution of wealth, not about non-market distribution of wealth. He’s not trying to justify “redistribution” of wealth by informal institutions; he’s trying to justify it by the state. Consequently, putting aside any sloppy language on my part, Lin Ostrom’s work counts as evidence for my side of the argument, not Matt’s.

    As an aside, I don’t think that Matt would argue that informal institutions never produce anything. I think he would argue that even if they do produce value sometimes, we still need government intervention at some level or else we’d all be digging grubs out of the ground to eat. Which I think is false. But that’s me putting words in Matt’s mouth, so take with a heap of salt.

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  9. Arthur

    I think you missed Matt’s point.

    He said: “it takes an awful lot of politics to get an advanced capitalist economy up and running and generating wealth”

    It does not matter if the politics is to take the state in or out of the economy. The thing is, we put a lot of effort into making a society where we provide more products and services people want. We do this because we want people to have more products and services. If the majority of people are not getting these products and services, we are not achieving our aim.

  10. Wonks Anonymous

    I’m no expert, but I thought the current historical consensus was that the common law developed in a more top-down coercive manner than Hayek thought. It’s been a good number of years since I read “The Enterprise of Law” and I haven’t read any of Hayek’s (or Bruno Leoni’s) books though.

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