Market failures If markets "work perfectly well", governments should just play their minimal role, which is to: (a) protect property rights, and (b) enforce contracts. But usually markets fail. This happens when: (a) price rigidities (b) market power (c) public goods/bads and externalities (d) asymmetric information. 1
Price rigidities mean that markets do not clear; monopolistic power means that firms and households are not price-takers and there are price markups; public goods/externalities means that some goods are not marketable and it cannot be specified who uses what and by how much; asymmetric information means that agents are not equally informed so there are adverse selection and moral hazard problems. All of them lead to misallocation of social resources and a socially sub-optimal outcome. 2
If there are such market failures, there are arguments for a more extended role for the government that includes: (a) the provision of public goods, (b) provision of social security and protection, (c) stabilization the macro-economy, (d) regulation (e.g. ensuring competition), (e) redistribution of wealth and income, etc. Thus, the government plays three roles: allocative, stabilizing and redistributive. The government is an institution that has special powers (e.g. the power to tax and regulate). Details about aims, choices and constraints later. 3
Policy failures Policy intervention introduces its own failures. Although the exact effects vary depending on the type of policy, here are some general problems. (a) Policy instruments are distorting. That is, they distort private agents' incentives to work, save, etc. For instance, (i) We need tax revenues to finance public goods. But tax revenues require income taxes that discourage work, saving, etc. See the so-called Laffer curve. (ii) Policy intervention can fix one thing, but can worsen something else. Examples: policymakers may decrease unemployment, but at the cost of higher inflation. Or they may spend on public goods, but crowd out private investment or exports. Or they may reduce nominal interest rates but fuel inflation. 4
Thus, in general, economic policy can be ineffective in terms of the real economy or even destabilizing (check the size and sign of policy multipliers). (a) Policy instruments may work with time lags, so that stabilization policy can eventually become destabilizing. (b) Optimal policies can be time inconsistent. That is, what is optimal for policymakers today, it may not be optimal tomorrow. For instance, they may promise low inflation, but go for inflation surprises once nominal wage contracts have been signed. Or, they may promise low tax rates to encourage investment but, after investment has taken place, they tax more than promised initially. Note that this problem presupposes some conflict of interests, although this can be hidden. It does not presuppose that policymakers are not well-meaning. 5
All the above places citizens/voters above the state. In addition, however, the state can be above the citizen/voter in the sense that government officials and bureaucrats may have the discretionary power to pursue their one interest at the citizens expense. In other words, government officials and bureaucrats may not be benevolent (i.e. they have their own objectives). For instance, government officials may want to stay in power as along as possible and hence use public policy for private use (see electoral and partisan business cycles, rent seeking, bribes, corruption, etc). 6
Therefore, There is a tradeoff: economic policy can correct market failures, but it introduces its own distortions. Check out, not only the direct positive effects, but also the indirect, general equilibrium effects that usually work the opposite way. Thus, think general equilibrium! The effects of government intervention, and hence the socially optimum government size, are not monotonic depending on the mix between the associated cost and efficiency. 7
Aims, instruments/choices and constraints of government The government is like any other economic agent in the sense that it has aims or objectives (benevolent or not), controls (the policy instruments) and constraints (the decentralized economy). 8
Aims or goals of government Protection of property rights so as markets can function (minimal role of the state). Internalization of externalities via taxes/subsidies, and provision of public goods. This has to do with the so-called allocative efficiency. Note that this is not sufficient to justify the creation of the state; however, the state is probably the lowest transaction costs institution for providing public goods and eliminating externalities. Stabilization of the economy. Governments attempt to stabilize the economy from shocks. Shocks are not bad per se: they are bad only when there are market failures that do not allow the economy to cope with these shocks in an efficient way. Fairness. Redistribution of income and wealth via taxes/transfers. 9
All the above reflects voters preferences. Thus, it refers to the activities of a benevolent government. But policy is also (mis)used for other reasons which have to do with non-benevolent aims. Examples include: Electoral and partisan motives. Rent seeking, corruption, etc, on the part of government officials and politicians. Bureaucratic behavior can be explained by budget maximization, which translates into higher salaries and more power. This is the analogue of firm theories that managers want to maximize the corporation s size. In general, there is a tradeoff between market and policy failures and this tradeoff determines the optimal size of the public sector. 10
Policy instruments To play its role and achieve its objectives (see above), the government needs policy instruments (fiscal policy instruments, monetary policy instruments, regulation and industrial policy). Monetary policy instruments: Interest rates, exchange rates, monetary aggregates, etc. Fiscal policy instruments: Government spending, tax rates, public debt and seigniorage. Other policy instruments (regulation, etc). 11