Why Government Fails So Often: And How It Can Do Better (43 page)

Perhaps most important, Americans are profoundly skeptical that the government is competent to direct subsidies in the right forms to the right technologies at the right times. As
chapter 4
discusses, this skepticism is firmly embedded in our political culture; it has only deepened over time. But it has been magnified by some recent incidents in which the government promoted unsuccessful “green” technologies, wasting large subsidies that were poorly targeted and managed; in some cases, politicization of these subsidies is alleged. The most notorious case was Solyndra, which received $535 million in federal loan guarantees for low-cost solar cell production before closing its doors, partly due to unexpected Chinese competition.
¹³⁵
(It is cold comfort to American taxpayers that Solyndra’s main competitor in
China also went bankrupt due to unforeseen market shifts.
¹³⁶
) Large subsidies to electric carmakers like Fisker and Coda Holdings have also failed, as they have in other countries.
¹³⁷
Even Tesla Motors, sometimes touted as the exception to this pattern of failure, has survived only through a combination of large subsidies primarily benefitting its extraordinarily wealthy investors. As the
Wall Street Journal
put it, “even if Tesla’s cars do sell, the policy question is why billionaires in California couldn’t have financed the business themselves. Why should middle-class taxpayers whose incomes are falling still pay to subsidize the purchase of cars that only the affluent can afford?”
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The ethanol fiasco is a far more important, costly, and even tragic example of government failure in promoting particular technologies that advantage specific political interests. Far from merely being pure technocratic choices, these efforts are almost always politicized both at their inception and after vested interests become entrenched. Under pressure from some environmentalists, the Bush administration decided that ethanol would soon become plentiful and cheap and could be pivotal in reducing fossil fuel consumption. Congress agreed, and mandated a year-by-year gallon quota for biofuels, predicting that the United States would produce about 240 million gallons a year by 2011; even with lavish subsidies, the actual figure was about seven million.
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But at the same time, it also required automakers to improve fuel efficiency in their cars, which reduces gasoline demand.

What has ensued (if one is charitable) is a classic case of unforeseen and perverse consequences. Under the statutory biofuel formula—which ignores supply, demand, or price conditions—lower-than-expected fuel demand means that gasoline blends must contain higher-than-expected amounts of ethanol. To produce the ethanol, huge quantities of corn must be processed and burned as fuel rather than being used for human food or livestock feed. (Brazil uses sugarcane as its ethanol feedstock rather than corn, which is less fuel-efficient but has stronger support from Midwestern corn, wheat, and soybean producers and the ethanol industry—together known as the ethanol lobby.) This ethanol-driven demand for corn consumed almost half of the drought-depleted crop in 2012—a vastly higher
percentage than predicted in 2005—and the formula demands much more by 2015. Indeed, it diverts as many calories from the world market
every year
as some of the worst famines experienced in the last fifty years.
¹⁴⁰
Because the United States supplies 60 percent of global exports, this diversion—exacerbated both by the shortage of refined gasoline because of an export exemption from the ethanol requirement and by a severe drought—has raised corn and food prices significantly throughout the world. This has increased world hunger, especially in poor countries with corn-based diets, alarming world food programs.
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Ethanol policy has also had other perverse effects. It has raised domestic gasoline prices, which especially hurts lower-income drivers, increased the price difference between premium and regular gasoline, which in turn affects new car models that require or recommend the use of premium, and encouraged refiners to export their gasoline to foreign markets where the quotas don’t apply, further tightening the domestic market and raising prices. Desperate for ethanol to meet the mandated quotas, gasoline refiners must buy up “ethanol credits” in what was a thinly traded market, ratcheting up the prices even further.
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Nor does the program even produce significant environmental benefits, for ethanol is neither “clean” nor energy-efficient in its cycle of manufacturing, transportation, and consumption; it actually lowers fuel economy.
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To the consternation of the food, livestock, and poultry industries and environmental advocates, but to the delight of the ethanol lobby, which has profited greatly from the policy and exerted powerful influence in the 2012 election year, the EPA refused to relax the ethanol requirement, finding that the requirement did not “severely harm” the economy.
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With ethanol policy, apparently, nothing succeeds like failure.

REDIRECTING MARKETS

Policy makers sometimes want to channel existing market activity into areas that they believe have been neglected. An important
example is the Community Reinvestment Act of 1977 (CRA), designed to increase bank lending to low-and moderate-income (LMI) neighborhoods thought to be victims of stereotype-driven “redlining.” The law states that all banks insured by FDIC have an obligation to meet the credit needs of the LMI areas in which they are chartered to do business, consistent with safe and sound banking practices, and requires the bank regulators to examine banks to assure compliance with this obligation and to take this information into account when considering banks’ applications for regulatory approvals. (Beginning in the 1960s, Congress had already prohibited discrimination in credit and housing markets on the basis of race, sex, or other personal characteristics.) Starting in 1989, the CRA and its implementing regulations were amended to provide for public disclosure of the nonconfidential results of the regulatory compliance assessments and ratings of each bank; to require use of this information in considering merger applications; to address complaints that the regulatory process was too burdensome, process-oriented, and politicized; to require studies and reports on the CRA’s effect on credit in LMI areas, including default rates; and to increase uniformity among the various regulatory agencies.

Assessments of the CRA’s effectiveness vary considerably. Some studies have concluded that the LMI credit market suffers from certain market failures that the CRA remedies, and that it has increased loans in LMI areas without higher default rates or harm to banks’ profitability,
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although a recent study finds that loans made just before CRA examiners are scheduled to appear are 15 percent more likely to be delinquent.
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Others have questioned the need for the CRA, arguing that banking is a competitive industry with strong incentives to make profitable loans wherever they can (the law does not require them to make unprofitable loans), that discrimination was illegal long before the CRA, that the financial services industry has been transformed in ways that invalidate the CRA’s orientation to local markets, and that the law’s ambiguity and lack of clear criteria invite regulatory overreach and manipulation and politicization by advocacy groups.
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Despite some critics’ claims to the contrary, however, there is little or no
evidence that the CRA contributed significantly to the 2008 subprime mortgage crisis.

REINTRODUCING MARKETS

Sometimes the level of inefficiency and unfairness created by a regulatory system becomes so great that political entrepreneurs are able to create reform coalitions consisting of policy experts, government regulators, politicians whose constituents would benefit from more competition, and firms eager to exploit open market opportunities—coalitions committed to allowing greater, or even complete, sway to market forces.
*
During the 1970s and early 1980s, driven partly by that era’s stagflation and the market distortions created by price controls, Congress (pushed by some reform-minded regulators) enacted landmark laws deregulating airlines, surface transportation, natural gas prices, and oil prices. These reforms largely succeeded; the airline example is discussed in
chapter 11
.

More controversial today is the dismantling of many federal banking controls that started in 1980, which shows how just how toxic for taxpayers (and investors) a policy of mixing regulation and markets can be. Congress, responding to powerful market forces driving change in the industry, enacted seven partial deregulation statutes that have helped to guide its transformation while attempting to catch up with those market forces. The statutes deregulated deposit insurance rates; dismantled geographic restrictions on branch and interstate banking; repealed the Glass-Steagall Act’s separation between commercial and investment banking; blurred distinctions among different types of financial institutions; and altered deposit insurance. These policy changes contributed—in ways too complex to disentangle here (or perhaps
anywhere
)—to enormous losses as large numbers of thrift institutions and banks failed during the next
decade (costing taxpayers some $125 billion) and to the grave financial crisis that began in 2007, whose cost to taxpayers will likely be even greater once the tally is complete.
¹⁴⁸
Indeed, many critics place much of the blame for this crisis on banks’ vast proprietary trading with depositors’ funds after Glass-Steagall’s repeal in 1999.
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Moreover, as
chapter 5
explained, the Dodd-Frank law has arguably paved the way for even larger bailouts of megabanks in the future.

MIDWIFING INFANT MARKETS

Innovative activity by firms may generate positive spillovers that benefit potential competitors and the public at large. Economist Joseph Stiglitz points out that knowledge about new products often has the attributes of a public good. The demonstrated feasibility of a new technology lets other companies enter the burgeoning market and create even more technologies.
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Yet because firms cannot capture these knowledge benefits as profits and will therefore underinvest relative to the socially desirable level, government subsidies can try to help fill this gap. Economic research, however, casts doubt on whether federal innovation policies have generally done so.
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Indeed, many scholars argue that the patent system is not only complex, costly, slow, and ineffective at protecting truly innovative products decreases innovation by tactical use of litigation to block entry, patent “trolls” who buy up patents to intimidate inventors and extract rents, and other anticompetitive techniques.
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Some reforms seem to have worked; the 1984 Drug Price Competition and Patent Term Restoration Act (the Hatch-Waxman Act) encouraged innovation competition in the pharmaceutical industry while also expediting the FDA approval process.
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Bureaucratic red tape inhibits some entrepreneurs from entering new markets. Thus, efforts to commercialize space exploration have been stymied by licensing and certification hurdles that have increased delay and costs without obvious justification.
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RECRUITING MARKETS FOR REGULATORY PURPOSES

With the rise of the environmental movement and regulatory programs in the 1960s, many economists argued that any desired level of environmental protection could be achieved at lower cost by utilizing economic incentives rather than, or in conjunction with, the dominant form of regulation known as command-and-control. (In practice, market-based regulation almost always operates in tandem with more conventional command-and-control techniques.
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) Indeed, in the last decade, the superiority of market-based regulatory techniques has become “a virtual orthodoxy.”
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These incentive-based policy instruments can take a variety of forms: taxes, subsidies, disclosure requirements, tort liability, and tradable permit (cap-and-trade) schemes, with the last of these being most popular. For climate change and air quality policy, most economists favor taxes on carbon, sulfur, and other major pollutants, but their pleas have fallen on deaf ears.
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With cap and trade, the regulatory agency specifies an acceptable overall level of pollution (the cap) and then distributes initial pollution permits to existing or potential polluters—preferably by auction—which the permit holders can trade with others, remaining under the cap. The permits’ price will vary according to supply and demand. Those able to control their pollution at a lower cost than the prevailing permit price will do so and sell their permits to those polluters whose control costs are higher than the permit price, which will induce firms to develop lower-cost ways to reduce their pollution. The list of market-based schemes of environmental regulation is growing
¹⁵⁸
—a tribute to their potential superiority to traditional command-and-control systems.

I say “potential” because when one moves from economic theory to the empirical evidence comparing the effectiveness of command-and-control and market incentive schemes, the picture becomes considerably murkier—and not just because of the methodological difficulties in making such comparisons, which are considerable. A broad
review of the research on incentive approaches finds that most programs are hybrids; that the two approaches suffer from some of the same weaknesses; that there are important differences within each of these categories—for example, command-and-control may use performance standards or input (technology) standards; that the political and legal dynamics surrounding each variant matter a lot; and that the design details are crucial to a scheme’s effectiveness.