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Beating the Iron Law of Public Choice – a reply to Peter Boettke

Studying Public Choice theory can be very depressing for would-be reformers as they learn about what we could call the Iron Law of Public Choice.

The students of Public Choice theory will learn from Bill Niskanen that bureaucrats has an informational advantage that they will use to maximizes budgets. They will learn that interest groups will lobby to increase government subsidies and special favours. Gordon Tulluck teaches us that groups will engage in wasteful rent-seeking. Mancur Olson will tell us that well-organized groups will highjack the political process. Voters will be rationally ignorant or even as Bryan Caplan claims rationally irrational.

Put all that together and you get the Iron Law of Public Choice – no matter how much would-be reformers try they will be up against a wall of resistance. Reforms are doomed to end in tears and reformers are doomed to end depressed and disappointed.

Peter Boettke’s defense of defeatism

In a recent blog post Peter Boettke complains about “the inability of people to incorporate into their thinking with respect to public policy some elementary principles of public choice.”

The problem according to Pete is that we (the reformers) assume that policy makers are benevolent dictators that without resistance will just implement reform proposals. Said in another way Pete argues that to evaluate reform proposals we need to analysis whether it is realistic the vote maximizing politicians, the ignorant voters and the budget maximizing bureaucrats will go along with reform proposals.

Pete uses Market Monetarists and particularly Scott Sumner’s proposal for “A Market-Driven Nominal GDP Targeting Regime” as an example. He basically accuses Scott of being involved in some kind of social engineering as Scott in his recent NGDP Targeting paper argues:

“No previous monetary regime, no matter how “foolproof,” has lasted forever. Voters and policymakers always have the last word. However, before beginning to address public choice concerns, it is necessary to think about what sort of monetary regime is capable of producing the best results, at least in principle. Only then will it be possible to work on the much more difficult question of how to make the proposal politically feasible.”

So Scott is suggesting – for the sake of the argument – to ignore the Iron Law of Public Choice, while Pete is arguing that you should never ignore Public Choice theory.

Beating the Iron Law with ideas

I must say that I think Pete’s criticism of Scott (and the rest of Market Monetarist crowd) misses the point in what Market Monetarists are indeed saying.

First of all, the suggestion for a rule-based monetary policy in the form of NGDP targeting exactly takes Public Choice considerations into account as being in stark contrast to a discretionary monetary policy. In that sense NGDP Targeting should be seen as essentially being a Monetary Constitution in exactly same way as for example a gold standard.

In fact I find it somewhat odd that Peter Boettke is always so eager to argue that NGDP targeting will fail because it as a rule will be manipulated – or in my wording would be crushed by the Iron Law of Public Choice. However, I have never heard Pete argue in the same forceful fashion against the gold standard. That is not to say that Pete has argued that the gold standard cannot be manipulated. Pete has certainly made that point, but why is it he is so eager to exactly to show that a “market driven” NGDP targeting regime would fail?

When it comes to comparing NGDP targeting with other regimes of central banking (and even free banking) what are the arguments that NGDP targeting should be more likely to fail because of the Iron Law of Public Choice than other regimes? After all should we criticize Larry White and George Selgin for ignoring Public Choice theory when they have advocated Free Banking? After all even the arguably most successful Free Banking regime the Scottish Free Banking experience before 1844 in the end “failed” – as central banking in the became the name of the game across Britain – including Scotland. Public Choice theory could certainly add to understanding why Free Banking died in Scotland, but that mean that Larry and George are wrong arguing in favour Free Banking? I don’t think so.

So yes, Scott is choosing to ignore the Iron Law of Public Choice, but so is Austrians (some of them) when they are arguing for a gold standard and so is George Selgin when he is advocate Free Banking. As Scott rightly says no monetary regime is “foolproof”. They can all be “attacked” by policy makers and bureaucrats. Any regime can be high-jacked and messed up.

Furthermore, Pete seems to fail to realize that Scott’s proposal is to let the market determine monetary conditions based on an NGDP futures set-up. Gone would be the discretion of policy makers. This is exactly taking into account Public Choice lessons for monetary policy rather than the opposite.

My second point is the Pete’s view is ignoring the importance of ideas in defeating the Iron Law of Public Choice. Let me illustrate this with a quote from Hayek. This Hayek in an interview with Reason Magazine from February 1975 on the prospects of defeating inflation:

“What I expect is that inflation will drive all the Western countries into a planned economy via price controls. Nobody will dare to stop inflation in an ordinary manner because as things are at present, to discontinue inflation will inevitably cause extensive unemployment. So assuming inflation stops it will quickly be resumed. People will find they can’t live with constantly rising prices and will try to control it by price controls and that of course is the end of the market system and the end of the free political order. So I think it will be via the attempt to regress the effects of a continued inflation that the free market and free institutions will disappear. It may still take ten years, but it doesn’t matter much for me because in ten years I hope I shall be dead.”

Here Hayek is basically making a Public Choice argument – the West is doomed. There will not be the political backing for the necessary measures to defeat inflation and instead will be on a Road to Serfdom. Interestingly enough this is nearly a Marxist argument. Capitalism will be defeated by the Iron Law of Public Choice. There is no way around it.

However, today we know that Hayek was wrong. Inflation was defeated. Price controls are not widespread in Western economies. Instead we have since the end of 1980s seen the collapse of Communism and free market capitalism – in more or less perfect forms – has spread across the globe. And during the Great Moderation we have had an unprecedented period of monetary stability around the world and you have to go to Sudan or Venezuela to find the kind of out of control inflation and price controls that Hayek so feared.

Something happened that beat the Iron Law of Public Choice. The strictest defeatist form of Public Choice theory was hence proven wrong. So why was that?

I will suggest ideas played a key role. In the extreme version ideas always trumps the Iron Law of Public Choice. This is in fact what Ludwig von Mises seemed to argue in Human Action:

“What determines the course of a nation’s economic policies is always the economic ideas held by public opinion. No government whether democratic or dictatorial can free itself from the sway of the generally accepted ideology.”

Hence, according to Mises ideas are more important than anything else. I disagree on that view, but I on the other clearly think that ideas – especially good and sound ideas – can beat the Iron Law of Public Choice. Reforms are possible. Otherwise Hayek would have been proven right, but he was not. Inflation was defeated and we saw widespread market reforms across the globe in 1980s and 1990s.

I believe that NGDP targeting is an idea that can change the way monetary policy is conducted and break the Iron Law of Public Choice and bring us closer to the ideal of a Monetary Constitution that both Peter Boettke and I share.

PS Don Boudreaux also comments on Pete’s blog post.

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Related blog posts:

Boettke and Smith on why we are wasting our time
Boettke’s important Political Economy questions for Market Monetarists
Is Market Monetarism just market socialism?

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Update: Pete has this comment on Scoop.it on my post:

“Very thoughtful reply to my CP post. I too believe in the power of ideas, but I also believe that any time we assume away public choice issues we are in effect being intellectually lazy.  I think a robust approach to institutional design would explore not only the incentive compatibility of the proposal, but an incentive compatible strategy for its implementation.  Absent that, and we aren’t thinking hard enough.  I have been as guilty as anyone else in this regard, so I am not going to point fingers.  But I’d like us to think harder and clearer about these issues.”

I very much apprecaite Pete’s kind words about my post and fundamentally think that we are moving towards common ground.

Update 2: Scott Sumner also comments on Pete’s post. Read also the comment section – George Selgin has some very insightful comments on the relationship between Free Banking and NGDP level targeting.

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“We refuse to let Detroit (and Egypt) go bankrupt”

The big story of the week in the US has undoubtedly been the bankruptcy of the city of Detroit. I should stress that I have next to no insight into Detroit’s fiscal situation. However, the bankruptcy is nonetheless a reminder of the risks moral hazard.

Conservative commentators has been fast to pick up on a comment from President Obama who back in October last year made the following statement:

“We refused to throw in the towel and do nothing. We refused to let Detroit go bankrupt. We bet on American workers and American ingenuity, and three years later, that bet is paying off in a big way”

This quote is of course taken completely out of context. Obama was not talking about the municipality of Detroit, but about the Detroit auto industry. So claiming that Obama in some way had promised to save Detroit from bankruptcy is not really fair. However, the quote nonetheless raises a highly relevant question of local public finances and moral hazard, which is highly relevant for not only US municipalities, but also have wider global implications as I will argue below.

The moral hazard of local government

While Obama’s comments regarding Detroit was not explicitly about the municipality they nonetheless are a pretty good illustration of the general perception about the US federal government’s willingness to bailout major US cities and US states for that matter.

By saying that he was happy to have bailed out the auto industry Obama most likely also signaled that he would be equally happy bailing out the city of Detroit. Furthermore, the fact that Detroit has been run by Democrats for decades probably also adds to investors’ expectations for some kind of Federal bailout of Detroit.

However, as I said I don’t have a lot of insight to the finances of Detroit and what I really want to discuss is the general problem of moral hazard in local government.

The key problem is that central government – in the case of the US state and federal government – will be tempted to bailout major municipalities that gets into financial distress. In US history this of course has happened numerous times. Just imagine what would happen if the mayor of a major city comes out and says “We are bankrupt so from now on there will be no public services. The police force has been sent home”. If that happened it would put tremendous political pressure on state and federal government to “solve” the problem.

And this is really the problem in terms of local government funding. Investors know that they to some extent can rely on state and federal government to step-in and save the municipality even if it has been grossly financially irresponsible. As a consequence the financial markets will tend to significantly mis-price the risk of a default. This is, however, not market failure, but rather government failure. At the core of the problem is that investors rationally expect local government to be bailed out by either state or federal government. It might or might not happen, but just the fact that there is a certain probability that this will happen will lead to a mis-pricing of the default risk.

This means that the funding costs of local government will be lower than it should be to reflect the true default risk. It is not very hard to see that that will at least indirectly reward irresponsible policies. The local government will likely be politically rewarded for building a new mega stadium (a well-known local finance problem in the US) or increasing teachers salaries etc. However, the cost of bankruptcy will at least party be transferred to states and federal government. This obviously encourage irresponsible policies locally.

Did moral hazard play a role in Detroit’s economic troubles? I am not sure, but I am very sure that moral hazard has had a major negative impact on the state of the US auto industry for decades and that at least indirectly have had a serious impact on the state of city of Detroit’s finances. Anyway I am sure that the bankruptcy of Detroit will inspire aspiring young public choice economists to study the impact of moral hazard of Detroit’s bankruptcy – at least I hope so.

Since it is very hard to avoid the temptation of bailing out failed municipalities it is not surprising that in most developed countries in the world the fiscal independence of local government is restricted by more or less strict rule imposed by central government (for example balance budget rules or rules limiting the ability to raise funds through lending in the financial markets). That is also to some extent the case in the US. These “constitutional” restrictions apparently has not be effective enough to avoid the Detroit’s bankruptcy and if Detroit’s troubles should lead to any policy debate in the US – then it should be how to change the constitutional/institutional set-up for major US cities to provide lawmakers with the right incentives to ensure prudent financial manage of municipal finances. And yes, this is of course is a completely parallel discussion to the discussion of moral hazard in the banking sector.

From Detroit to Egypt

The bankruptcy of Detroit should actually also lead to a debate about US foreign aid. Yes, believe it or not there a strong parallels between the moral hazard problems in US local government finances and US foreign aid.

The recent political unrest and the military coup in Egypt has made me to think about moral hazard problems of particularly US foreign aid.

There is no doubt that US foreign aid to a large extent is driven by what the US government perceives to be US foreign policy interests – particularly security interests and this has been a key motivating factor for US aid to Egypt for decades and no one would deny that the changing Egyptian governments over the years has been reward for keeping peace with Israel – a close ally of the US.

A list of the top-five recipients of US aid clearly reveals to what extent US foreign aid is driven by geo-political concerns rather than anything else: Afghanistan, Israel, Iraq, Pakistan and Egypt. Particularly the fact that Israel – not exactly a developing country and a country  – is notable.

To argue that the key concern of US foreign aid is economic and social development is pretty in fact pretty hard. Rather it is US foreign policy interests that determines what countries, which will receive foreign. And investors of course know this. Hence, who would seriously imagine that the US government would let Israel or Egypt go bankrupt (as long as these countries act accordingly with US foreign policy interests)? And this of course is reflected in market pricing of the default risk of Israel and Egypt.

So in the same way as investors would investors could be betting on the US federal government (or state governments) to bailout major US cities then in the same way investors would rationally bet on countries like Israel or Egypt being bailout if they were to get into financial troubles. As a result we should expect financial markets to under-price the risk of a government default in for example Egypt and similarly is this is likely to make the Egyptian government less fiscally responsible. Whether or not moral hazard has been the main driver of Egyptian fiscal decisions or not is hard to say, but it remains a fact that Egyptian public finances been a mess for decades.

IMF lending and moral hazard

Does all this sound far-fetched? Not at all if you look at numerous studies of what determines for example IMF lending. The US of course is the large contributor to the IMF and the US has a major say in how IMF funds are used.

Hence, for example a very interesting paper by Axel Dreher, Jan-Egbert Sturm and James Raymond Vreeland published earlier this year shows that “political important” countries face “softer conditions” for IMF loans than politically non-important countries.

I believe that it is very likely that US foreign aid motives distort the market pricing of default risk in certain particularly Emerging Markets and as a consequence increases global moral hazard problems.

So if you think moral hazard played a role in Detroit’s bankruptcy you should also consider what role moral hazard has played in recent events in Egyptian financial markets and it is hardly a coincident that the Egyptian financial markets rallied when the anti-US Muslim Brotherhood was ousted – effectively making a new IMF loan for Egypt more likely.

PS If you want to understand what is the problem with the ECB’s OMT program then you should just think about moral hazard. And while I certainly do not think that monetary easing is not moral hazard, “credit easing” done in the way the ECB is doing it certainly is. Also see my earlier post on why monetary easing is not a bailout, but ECB style credit polices are.

Update: Jim Pethokoukis has a very good piece on National Review Online on how to revive Detroit.

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