The Fallacy of the Free Market

Democrats’ vision that our broken economy simply needs to correct for market failures has its limits.

Quick quiz: Who said, “Government is not the solution to our problem; government is the problem”?

That’s an easy one—President Ronald Reagan, in his first inaugural address in 1981. But who said, “The era of big government is over”?

That was President Bill Clinton, in his 1996 State of the Union address.

The central narrative of American politics in the second half of the twentieth century was a transformation in how people saw government: from the positive force that had kept society intact during the Great Depression and defeated Nazism in World War II, to a bureaucratic, inefficient burden that dampened innovation and the entrepreneurial spirit. In their conception of society, the conservative ideologues at the center of that story replaced government with the “free market.” The bedrock faith of the conservative revolution was, and is, the idea that there is such a thing as a free market, and that it is diametrically opposed to government, which inherently makes markets less free.

Political scientist Steven Vogel offers a useful corrective to that view in his book Marketcraft: How Governments Make Markets Work. But the book also has lessons for those of us who criticize free market ideology—and for today’s Democratic Party, which is still the party of Clinton and his intellectual heir, Barack Obama.

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Marketcraft: How Governments Make Markets Work
by Steve Vogel
Oxford University Press, 200 pp.

Building on decades of comparative research into advanced industrial societies, Vogel lays out in impressive detail the myriad ways in which governments, private sector institutions, social practices, and cultural norms construct and shape markets. It makes little sense to ask whether a market is free or regulated. The important questions are who governs a market, how, and for what ends; and the key public policy question is how the government (which is, at least theoretically, an instrument of the people) should act to modify the resulting market in pursuit of the public interest.

These truisms, Vogel argues, are well understood among people who study the developing world and post-communist transitions. In those contexts, it’s clear that the establishment of a market economy depends on the active construction of supporting institutions. It’s only in the advanced industrialized world that people speak of “restoring” a “free market” through “deregulation.” But, as Vogel shows through in-depth portraits of the United States and Japan, the idea that simply removing government from the equation could be the correct prescription for a complex economy is preposterous.

This is particularly apparent when it comes to competition policy and intellectual property. In the absence of antitrust law, it is well known that monopolies can have harmful effects on consumers, using their dominant market share to raise prices while under-investing in quality, innovation, and customer service. True market competition requires government policies to prevent excessive consolidation. Even more to the point, intellectual property, which makes up an increasing proportion of our economy, simply doesn’t exist without government action to create and enforce intellectual property rights to begin with. In both domains, functioning markets require more government involvement, not less.

Vogel extends this analytical framework across the entire economy, demonstrating the complexity of any attempt to shape a market. In Japan, for example, reformers have long seen a rigid labor market as a barrier to growth. Laws giving employers additional flexibility, however, have had limited effect against the prevailing norm of lifetime employment for (mostly male) regular employees. “If the Japanese government really wanted to give employers more freedom to lay off workers,” Vogel argues, “it would have to do more, not less—that is, the restrictions on dismissals reflect corporate practices and social norms, which are in turn reflected in case law.” This example illustrates one of his larger themes: markets exist in a complex equilibrium between incumbents and challengers, firms and individuals, regulations and norms; and the job of government is to craft a desired equilibrium by influencing these factors. There is no neutral, “free” position.

Marketcraft covers an impressive amount of material, showing Vogel’s deep command over policy details, in relatively few pages. But most of the book is easy to agree with—yet another smart rebuttal of libertarian economic ideas. The most provocative section is the final chapter, which discusses the rhetoric of the market. “The elegant juxtaposition of the words free and market evokes many of the presumptions challenged in this book,” he objects: “that markets are natural; that markets arise spontaneously; that markets inherently constitute an arena of freedom; and that government action necessarily constrains this freedom.”

Vogel is obviously aiming at conservative ideologues who reflexively laud the market and vilify the government. But this dichotomy also permeates policy discourse in the center and on the left. The conceptual opposition between market and government is, at its root, a product of the way students learn basic economics—for better or worse, the predominant explanatory discipline of our time. Undergraduates learn early in their first semester that competitive markets maximize social welfare, and therefore government regulations that inhibit voluntary transactions make everyone worse off. Even when properly understood, this fundamental model “implies that imperfect markets are the puzzle to be solved and perfect markets the natural order.” The corollary is that government “intervention” in these imagined markets should be limited to setting the ground rules and, in later chapters, correcting for specific market failures. But this “market failure frame,” Vogel argues, is the wrong way to think about policy: “It suggests that it is possible for the market not to fail, and therefore that government action is a second-best solution, rather than a prerequisite for modern markets to function in the first place. And it evokes an image of a one-by-one matching of government response to market failure, rather than a more holistic process of market design.”

Yet the market failure frame is in large part the economic policy vision of the modern Democratic Party, desperate to run away from an imagined past characterized by unions, active government intervention in targeted industries, and welfare programs. The conservative strategy was to shout, “The market is rational and the government is dumb.” Democrats, afraid of being tarred as government-loving (and hence dumb) liberals, responded with “me, too.” Only, as well-educated technocrats like to do, we added a few qualifiers: markets are usually rational, and the government is usually dumb, but sometimes markets make mistakes, so in those cases (only) the government should intervene to restore the outcome that the market should have produced.

The market failure frame was tailor-made for a Democratic Party searching for an economic agenda. It enables us to find issues on which we disagree with Republicans. It appeals to our desire to show that we are smarter than they are. And it allows us to advocate for government action while insisting that we believe in markets, not socialism.

Several of contemporary Democrats’ signature economic causes fall squarely within the market failure frame. The classic example is the Obamacare individual mandate, which was designed to correct for the specific market failure called adverse selection: People know more about their health status than insurers do, so only sick people will buy insurance, but insurers anticipate that outcome and raise prices accordingly, so only really sick people buy insurance, and so on until no one can afford insurance. Hence the individual mandate—an example of government coercion that enables the health insurance market to function in the first place.

Another example is regulation of systemically important financial institutions. The financial crisis of 2008 demonstrated that some banks are too big to fail and will be rescued by the federal government no matter what. This implicit guarantee encourages those banks to take on excessive risk; therefore, they need to be subject to additional regulatory oversight.

Antitrust is the latest issue taken up by the Democratic policy elite. Monopoly or oligopoly power is often the first market failure in the textbook. For progressives, advocating for stronger enforcement is attractive because we can position ourselves both as the defender of the common man against the specter of big business and as the true champion of market competition against a Republican Party bought off by oligopolies.

This is all fine as far as the textbook economics goes. And the individual mandate, regulation of megabanks, and more aggressive antitrust enforcement are all good ideas, at least compared to their opposites. But the market failure frame has two major shortcomings. First, it is lousy politics. If the terrain of debate is what constitutes a market failure and how to correct for it, Democrats have already lost. If Donald Trump visits a depressed county in the Midwest and says, “We’re going to invest in infrastructure to make America great again!” and the Democratic response is, “We’re going to invest in infrastructure because infrastructure is a public good that is underproduced by the private sector,” you don’t need a poll to know who is going to win that issue.

Second, economic policies that simply seek to create the optimal conditions for competitive markets will not solve the biggest problems that we need to solve today. Even though Obamacare has cut the uninsured population in half, real health care costs continue to rise, resulting in deductibles and copayments so high that millions of Americans can’t afford to actually use their insurance. Better financial regulation will reduce the risk of another crisis, but will not help millions of people buy homes to replace the ones they lost to foreclosure. At the end of the day, the goal of the market failure frame is to level the playing field of the theoretical competitive market—a market in which people start out with radically different endowments and opportunities and bear the risk of personal and economic shocks over which they have no control.

The market failure frame also rules out policies that could directly address the challenges that ordinary families face. We all agree that all people should have access to the health care they need, regardless of income. Yet many Democrats shy away from the most direct way to achieve that goal—a single-payer system—because it feels like too much government and not enough market. Many families have no defined benefit pension and virtually nothing in their retirement savings accounts. Democratic policy experts love sophisticated “nudges” like automatic enrollment in 401(k) plans or the myRA accounts created by the Obama Treasury. But these technocratic reforms fail to address the roots of the problem: many workers just don’t make enough money in the first place. The direct solution is to increase Social Security benefits and the taxes necessary to pay for them. But, again, expanding the old-fashioned safety net violates the market failure frame.

We know what people want. We want a decent place to live, health care when we need it, a good education for our children, and the ability to retire. And we know why many of us don’t have those things. The problem is inequality. The contemporary Democratic Party, converted to the gospel of markets, has neither a political nor a policy solution to this problem. Saying that “our markets are better than their markets”—that our collection of clever tweaks is better than the magic Republican potion of free enterprise and small government—is true as far as it goes, but scarcely compelling. The only economic policies that today’s Democrats can seem to agree on—infrastructure and job training—may add a few tenths of a percentage point to the growth rate and help a few hundred thousand people get better jobs, but they do not change the basic equation of the American economy: when it comes to housing, health care, education, and retirement, you’re on your own.

Republicans believe that shrinking government will restore the ideal competitive market; many Democrats believe that enlightened government policy will create the ideal competitive market. Steven Vogel reminds us that the ideal competitive market never was and never will be. Before we can craft a market, we have to think about what objectives we want it to achieve. Here are a few: affordable housing for all families; adequate health care for everyone; free public education from pre-K through college; and a minimum retirement income that people can live on. Simply correcting for market failures will not get us there.

James Kwak

James Kwak is a professor at the University of Connecticut School of Law and the author, most recently, of Economism: Bad Economics and the Rise of Inequality.