Preserving the American Dream: Free markets vs Government intervention and everything else in between…

Posted on April 6, 2010 by


By Orphe P. Divounguy

On April 5th 2010 5:30pm, I attended a lecture by prominent economist Irwin M Stelzer, co-founder and former president of National Economic Research Associates, senior director and fellow of the Hudson Institute, former resident scholar and director of regulatory policy studies at the American Enterprise Institute.  Irwin M Stelzer is a well known conservative who has edited many news articles and wrote a book on neo-conservatism.

Neo-conservatives unlike traditional conservatives are generally comfortable with the welfare state, and while rhetorically supportive of the free markets, they are willing to allow some interference for overriding social purposes.  This is well documented in the Cato Institute’s Michael Tanner’s book Leviathan on the right, how big government conservatism brought down the republican revolution.

Dr. Irwin Stelzer described what he believes to be the role of government in a free, capitalistic society. He made the following comments:

  1. Government has to enforce and maintain competition.  Capitalism is the system that we’re trying to protect and so any alternative to competition is a return to control by one entity and that is often the state.  Government should enact policies that ease new entrants access to the markets.  Society must be open and mobile.
  2. Where there exist natural monopolies and competition is not possible, Government can and should step in.
  3. Social costs of consumption (externalities) must be internalized.  Taxation is less intrusive or responsive to government failure (corruption, loopholes etc…) than is regulation.  Mr. Irwin Stelzer prefers a tax to regulation. 
  4. Government intervention is sometimes necessary to offset market failure.  Sometimes there are problematic incentives systems and government should put in place incentives to deal with these market imperfections (moral hazard, corporate governance etc…) For example:
    1. In the case of the latest financial crisis, bankers had the incentive to maximize short term profits so they were willing to take on risky positions and to make outrageous bets.  Banking encourages excessive risk.
    2. Politicians had every incentive to make finances available for homeownership even to people who couldn’t afford these homes (political cycles, re-election etc…)
  5. Government has an obligation to ensure that capitalism prevails and produces “fair” results.

Although I disagree with most of what was said at this lecture, I am not a politician, I am an economist.  As an economist, I have a responsibility to myself and to the hundreds and thousands of people who read my research papers, my blog articles, a responsibility to those who choose to engage with me in searching for economic solutions to the problems we face in our world today (unemployment, poverty, crime etc…).  I owe it to the academic community and to my readers to report the content of Mr. Irwin Stelzer’s lecture and to leave it to discussion.        

To what extent do I agree with Dr Stelzer? We do not live in a First Best setting.  Markets are not completely free.  In fact Dr Stelzer’s lecture reminded me of the Theory of the Second Best.  The Theory of the Second Best concerns what happens when one or more optimality conditions cannot be satisfied in an economic model. Canadian economist Richard Lipsey and Australian-American economist Kelvin Lancaster showed in a 1956 paper that if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the ones that are usually assumed to be optimal.  Economists and policymakers must be very careful. This means that in an economy with some unavoidable market failure in one sector, there can actually be a decrease in efficiency (in my case my concern is household welfare) due to a move toward greater market perfection in another sector. In theory, at least, it may be better to let two market imperfections cancel each other out rather than making an effort to fix either one.  This is where Dr Stelzer and I began to disagree: Dr Stelzer proceeded to make recommendations such as increased taxation as a trade-off for regulation in order to promote a slow return to the First Best setting.  I suggest that we should encourage neither.  Increased taxation reduces the household ability to save or invest, causing a direct affront to the american dream of entrepreneurship, ownership and the capitalistic system that Dr Stelzer is trying to preserve.  The First Best setting is the free market, the point where optimality conditions are met. 

My policy recommendation: It is better to do nothing and to let market imperfections cancel each other out rather than allowing government to intervene.

An excellent example to support my claim, often used when teaching about the Theory of the Second Best:

Consider a mining monopoly that’s also a polluter: mining leads to tailings being dumped in the river and deadly dust in the workers’ lungs. Suppose in addition that there is nothing at all that we can do about the pollution. But the government is able to break up the monopoly.  Allowing for more competition in most cases increases production, reduces prices and increases quality of service. The problem here is that increasing competition in this market is likely to increase production (since competitors have such a hard time restricting production compared to a monopoly). Because pollution is highly associated with production, pollution will most likely increase. This may actually make the world worse off than before.

R.G. Lipsey & Kelvin Lancaster, The General Theory of Second Best, The Review of Economic Studies, Vol. 24, No. 1. (1956 – 1957), pp. 11–32.