MASTHEAD-2Ottawa’s Superclusters Initiative has generated debate on the state’s role in the economy, writes Sean Speer. But we need a clear-eyed understanding on the limits of state action and the possibility of “government failure.”

By Sean Speer, June 19, 2017

As I’ve written elsewhere, there are signs of renewed confidence in the state’s capacity to play an active role in the economy. Ottawa’s recently-announced Innovation Superclusters Initiative is merely the latest example. But this high-profile announcement has generated considerable debate about the rightful role of the state in the economy and its capacity to cultivate new technology clusters across the country.

It’s not always conveyed this way but the underlying arguments on each side of this issue, and other similar state-directed initiatives, reflect competing views on market failure versus government failure – or in other words, the efficacy of the market versus that of government.

Those of us who are sceptical about government’s role in the economy don’t always do a good job of explaining our underlying assumptions. The result can sometimes be to appear averse to government in general or accusatory of the government’s motives or those who support greater intervention. Not only can it be impolite, it can damage or undermine what are otherwise sound arguments.

I’ve been reminded of this tendency in digging into Ontario’s hydro woes. There isn’t space here to describe the province’s hydro challenges and their origins but the growing divergence between supply and demand (and the resulting impact on business and household costs) can be attributed more to the state’s inability to make market judgements than malevolence or cronyism. This is another clear example of government failure.

It shouldn’t be a surprise. The government not only has no particular expertise or prescience when it comes to the complexities and nuances of the energy market. It also has non-market factors – such as getting re-elected (think for instance the Ontario power plant scandal) – that invariably affect its decision-making.

The solution ought to be a more clear-eyed view about the limits of state action. Yet the signals from Ottawa and Queen’s Park continue to be overconfidence in government and under confidence in the market. This presumption fails to learn valuable lessons from Public Choice theory.

Most economic analysis starts with a basic premise: the market is comprised of rational actors pursuing their own self-interest. Yet economists didn’t always apply these assumptions about human behaviour to the political sphere. The underlying presumption was that politicians and bureaucrats were beyond self-interest and instead capable of allocating government resources based on optimum efficiency.

The solution ought to be a more clear-eyed view about the limits of state action. Yet the signals from Ottawa and Queen’s Park continue to be overconfidence in government and under confidence in the market.

This changed with the advent of Public Choice economics. Its intellectual catalyst Nobel Prize-winning economist James Buchanan once described it as "politics without romance" because it caused people to more closely examine government motives in its decision-making.

In more technical terms, Public Choice economics uses modern economic understandings to analyze politics and public policy decisions. It starts from the premise that politicians, public servants, and voters are self-interested agents who will seek to maximize their own benefits just like individuals do in the marketplace. In practice, it means that politicians offer voters popular measures to stay elected, public servants conceive of new programs and initiatives to obtain more funding and greater resources for them and their departments, and voters and special interest groups – including, of course, corporations –  lobby government to obtain new benefits such as tariffs to protect their businesses or funding to advance their own commercial interests.

This hardly seems like a revolutionary idea now. Public Choice theory has become a well-respected school of economic thought with a number of prolific exponents (Buchanan himself won the Nobel Prize in 1986). But at its infancy, it was seen as a radical proposition that brought into question the capacity of government to make collective decisions in the public interest without succumbing to political self-interest.

How did it start? The landmark study behind Public Choice theory is the 1962 book The Calculus of Consent by Buchanan and Gord Tullock. In subsequent works, Buchanan explained his rationale for taking an interest in government decision-making and writing the study with his colleague:

As they emerged from World War II, governments, even in Western democracies, were allocating between one- third and one-half of their total product through collective-political institutions rather than through markets. Economists, however, were devoting their efforts almost exclusively to explanations-understandings of the market sector. No attention was being paid to political-collective decision making. Practitioners in political science were no better. They had developed no explanatory basis, no theory as it were, from which operationally falsifiable hypotheses might be derived.

So what did Buchanan and Tullock find? Governments aren't perfect. Just as markets operate on a basis of self-interest, so can governments. And just as markets can fail, so can government. A tendency of politicized decision-making is exacerbated by imperfect information, an inability to quickly respond to market signals, lack of bureaucratic expertise, and of course the electoral cycle.

This new theory had far-reaching implications for our understanding of the market and the role of the state. Previously theorists had assumed that the politicized corrections for market failure would always work perfectly.  Market failure was set against an idealized view of politics that was impermeable to the pressures of self-interest. Scholars like Buchanan and Tullock argued that this interpretation was wrong, and, in so doing, spawned a whole new school of thought that showed that government was just as a prone to “failure” as the market. (Incidentally it informed future Prime Minister Stephen Harper’s own graduate research.)

Governments aren't perfect. Just as markets operate on a basis of self-interest, so can governments. And just as markets can fail, so can government.

The term “government failure” was coined in 1964 by US economist Ronald Coase to describe the state’s propensity for making things worse when it intervenes in the economy or in individual choices.   Scholars and bureaucrats had long used “market failure” as the rationale for government intervention.

Coase was saying in response that “government failure” was also possible and, in many ways, more serious because of government’s coercive power and the fact the state isn’t subjected to competition.

If government was to intervene, Public Choice economics dictated that it should do so cognizant of its limitations. Policymakers need to understand the risks inherent in government action because government failure is usually far more pervasive, damaging, and less self-correcting than market failure. The bias should therefore be to let the market operate even if it’s producing sub-optimal outcomes.

The University of Chicago economist (and another Nobel-Prize winner) George Stigler famously addressed this question of what constitutes market failure and what warrants government intervention. As he said:

For some, market failures serve as a rationale for public intervention. However, the fact that self-interested market behavior does not always produce felicitous social consequences is not sufficient reason to draw this conclusion. It is necessary to assess public performance under comparable conditions, and hence to analyze self-interested political behavior in the institutional structures of the public sector.  We may tell the society to jump out of the market frying pan, but we have no basis for predicting whether it will land in the fire or a luxurious bed.

It’s not to say that markets don’t fail or that there’s never any role for government intervention. But judgement about when and how the state should intervene ought to be based on a clear-eyed understanding of its limits and prospective failures.

Superclusters-type programs, for instance, don’t tend to fail because politicians or public servants are corrupt or inherently bad. It’s that the government cannot possibly replicate the multitude of decisions inherent in market pricing, including the matching of good ideas with capital, workers and customers. And when one adds the propensity for politics to infuse these types of decisions (think for instance the geographical distribution of funding) we frequently end up with sub-optimal outcomes such as the misallocation of resources. Canadian-based research on the underperformance of state-financed firms relative to those backed by private venture capital is notable in this regard.

How should policymakers respond to the insights of Public Choice theory?

Some believe the solution is enact more rules to regulate the interactions between lobbyists and public officials and to bring greater transparency to government decision-making. This has no doubt helped but it certainly has its limits. It’s difficult to regulate for human nature after all.

Another solution is to ensure the government is comprised of individuals unsusceptible to the pressures of modern lobbying or other politicized calculations. This view suggests we need more enlightened technocrats who can withstand special interests and deploy public resources in a dispassionate and analytical manner.

Public choice economists would argue that this view is naïve. They take a realist view of government and instead argue the only solution is to limit the government's role to core areas and functions.

This doesn't mean we should have no government. Of course, there’s a significant role for government in our economy and society. Lakehead University economist Livio Di Matteo has shown that certain levels and types of public spending contribute to positive economic and social outcomes.

But we should be under no illusion that the market is prone to failure and government decision-making is somehow infallible. With this clear understanding, we can then decide whether an economic or social problem is sufficiently vexing and important to introduce government despite its limitations. This is Public Choice theory's main contribution to the public policy debate.

We should be under no illusion that the market is prone to failure and government decision-making is somehow infallible.

Which brings us back to where we started with superclusters and Ontario hydro’s problems. It’s logical to ask that if the Ontario government could so fundamentally misread supply and demand in the province, how we can expect Ottawa to anticipate new technological trends and “invest” in forward-looking clusters? There’s good reason to be skeptical. The risk, of course, is public funds are misallocated or, put more bluntly, wasted.

And the irony is that those with a more activist predisposition do themselves and the government a disservice by asking the state to take on these tasks for which it’s ill-equipped. The result is invariably diminished trust and confidence in government that should concern us all.

Our debates about the proper role of government in our economy and society ought to respectful and fair-minded. But we should be clear-eyed about the limits of the market and of government.

Sean Speer is a Munk senior fellow at the Macdonald-Laurier Institute.