07/31/2012 02:28 pm ET Updated Sep 30, 2012

The Battle for Capitalism and Freedom

By Robert Dell

"There is still a tendency to regard any existing government intervention as desirable, to attribute all evils to the market, and to evaluate new proposals for government control in their ideal form, as they might work if run by able, disinterested men, free from the pressure of special interest groups ... [T]he difference between the actual operation of the market and its ideal operation--great though it undoubtedly is -- is as nothing compared to the difference between the actual effects of government intervention and their intended effects."

--Milton Friedman in Capitalism and Freedom (1962)

"[O]ur predecessors understood that ... the danger of too much government is matched by the perils of too little; that without the leavening hand of wise policy, markets can crash, monopolies can stifle competition, and the vulnerable can be exploited."

--Barack Obama in his "Remarks to a Joint Session of Congress on Health Care" (2009)

The Economist proclaimed Milton Friedman "the most influential economist of the second half of the 20th century... possibly all of it." July 31 marks his 100th birthday and this year marks the 50th anniversary of the publication of his profound and lucid case against faith in government activism in favor of the strong presumption for freedom of enterprise and laissez faire, or, in some cases, self-limiting, transitional, market-friendly policies. Capitalism and Freedom may be the most influential pro-market, limited government manifesto of the modern era. When Ronald Reagan began his political career, it was Capitalism and Freedom that he was reading, annotating and carrying around in his pocket.

However, in a 2006 interview with Russ Roberts, Friedman downplayed the impact of the book, acknowledging that government policy failures were still pervasive and costly; the public still without any strong preference for greater reliance on markets. Had he lived to hear President Obama's signature health care speech, Friedman certainly would have regarded Obama's concept of "the leavening hand of wise policy" as a more prevalent view of how government can, should and does operate than his own view. Indeed, given that most government expansion since 1962 has been shown to be politically motivated in origin, coordinated by adept special interests, and either counterproductive or excessively wasteful in its effects, it is a striking sign of the temper of our times that the Obama metaphor was not widely criticized, being regarded as neither controversial nor conceited.

But if faith in government activism is the epistemological basis for government expansion and resistance to market-based reforms, what accounts for the resilience of this faith in the face of omnipresent government failure? In The Audacity of Hope Obama himself conceded that "no small number of government programs don't work as advertised." And economist Clifford Winston of the Brookings Institution, which decades earlier Friedman had criticized as a bastion "for bigger and greater government," has concluded that "scholarly research has consistently found substantial failure in government's efforts to correct market failures." The research also suggests that the welfare cost of government failure may significantly exceed that of market failure.

Opinion leaders -- including conservatives -- widely exhibit two mutually reinforcing intellectual habits -- both suggested by Friedman -- that encourage this faith. The first is to superficially attribute to market or business failure bad business practices that are more substantively and fundamentally the product of government failure in the form of bad policy-induced incentives. The second and related practice is to disregard the very notion of government failure, including the dysfunctional incentives under which government officials frequently operate, and the entire body of scholarship known as public choice theory.

As an example, consider the recent television debate between Ron Paul and Paul Krugman, in which Krugman remarked that the recent financial crisis "was brought on by an expansion of what amounted to private money in the form of things like repo, which were uncontrolled and turned into an enormous crisis when they collapsed." In superficial hindsight, had powerful, selfless regulators wisely controlled the growth of near-money deposits, such as repo, they might have avoided the financial crisis in the same way that the judicious control of subprime and Alt-A mortgages could have averted the mortgage and housing crisis.

But more importantly, government affordable housing policies are particularly blameworthy for degrading mortgage underwriting standards, for driving the growth of high-leverage, substandard mortgages (to an unprecedented 49 percent of total U.S. mortgages) and for triggering the common shock reassessment of the prospective solvency of major banks (i.e., the financial crisis). Likewise, government tax and regulatory policy rewarded the excessive growth in securitized assets, which investors were financing with their unregulated deposits. Business does not generally tolerate indecipherable complexity in its transactions, but banks (and other investors) were effectively compensated by government for doing so in the case of securitization.

Stanford's Anat Admati and others have noted that shadow banking entities directly implicated in the crisis would not have been able to operate without commitments and guarantees from sponsoring banks within the regulated system. A systemic financial crisis did not break out among independent hedge funds investing in asset-backed securities with "things like repo." Although quite a number of these funds failed, the systemic fallout came from the threat of insolvency from large, global sponsoring banks (e.g., Citigroup, UBS, Merrill Lynch, Lehman Brothers) which, for years preceding the crisis, had been regulated for capital adequacy through a combination of regulatory discretion and the Basel Accords. Why is there an apparent need for capital adequacy regulation within traditional and securitized banks? Largely because government has subsidized their overuse of debt relative to equity through decades of depositor/creditor rescue policies and through its own capital adequacy regulation methods!

Government subsidization of debt relative to equity -- through tax, regulatory and monetary policies affecting both sides of bank balance sheets and their contingent balance sheets -- has been the dominant source of fragility and short-termism in the U.S. financial system. The Dodd-Frank Act gives more discretionary power to regulators and imposes costly new regulatory burdens, but without seriously addressing the central problem of equity capital adequacy. Needless to say, Krugman's repo story went unchallenged by Congressman Paul, the most visible national political spokesman for meaningful reductions in the role of government.

But no opinion leader ignores the theory of government failure more completely while extending its practice than the current occupant of the White House. The declaration in Obama's health care speech that "the vulnerable can be exploited" calls to mind the "insurance company abuses" he referenced earlier in the speech. But even top health care economists who are advocates of universal coverage and a "public option," such as Princeton's Uwe Reinhardt, find little evidence that claims disputes reflect systemic malfeasance within insurance companies.

Nevertheless, a chief concern with employer-sponsored health insurance has been its lack of reliability in covering unexpected high-cost illnesses. Under a worst case scenario, where an individual develops a costly long-term illness, then loses her job (or gets a divorce), she looses insurance coverage. She then has a pre-existing condition that makes insurance enormously expensive, if available at all. The employer-based system has effectively operated with put options to the insured and to taxpayers.

Yet the dominance of employer-sponsored insurance over individual insurance is wholly attributable to the former's favorable tax treatment. The prevalence of pre-existing conditions and the absence of life-long, portable health insurance are yet more sad examples of government failure. The tax exclusion for the employer-based system also penalizes lower-income workers relative to higher-income workers, who get a bigger tax break and are more likely to work at firms that offer insurance. Of course, those abuses were not covered in the Obama speech.

The Affordable Care Act, like the Dodd-Frank Act, continues a long practice of building on one government failure with another. The Obamacare mandates, along with other new regulations that protect the profits of large pharmaceutical and insurance companies, reflect the $400 million spent in 2009 on lobbying and the political influence these industries have with Congress to shape the legislation -- not "wise policy" that offers the public a protection benefit at a proportionate cost. "Let's be honest," said former Chief of Staff Rahm Emanuel: "The goal isn't to see whether I can pass this through the executive board of the Brookings Institution. I'm passing it through the United States Congress with people who represent constituents."

What constitutes wise economic policy? Economists across the mainstream ideological spectrum would probably agree that a policy would be wise if it met the following criteria:

1. The politically advertised and publicly-understood intentions of the policy correspond reasonably well to the actual results;

2. A credible case can be made that the total social benefits exceed the total social costs over the life of the policy;

3. The policy is efficient; there are no other policies that could have achieved comparable benefits at much lower costs.

4. The policy does not transfer resources from lower-wealth to higher-wealth households on a large scale.

Economic wisdom has sometimes informed net reductions in government influence. Some prominent examples: the nullification of Jim Crow laws; the elimination of the Civil Aeronautics Board and the Interstate Commerce Commission; the end of military conscription in favor of an all-volunteer force; military base closings under BRAC; welfare reform; education tuition vouchers; medical savings accounts. But what percent of new or expanded federal programs in the past half-century meet the criteria above? I challenge readers to provide three examples of government growth representing wise economic policy.

Public choice theory tells us that in the absence of legislative constraint or sufficient informed civic engagement, political success generally depends on the successful advancement of special interests to the detriment of the general interest. There are now more than 17,000 interest groups actively influencing the political process. Government officials are frequently rewarded for divorcing cost from benefit considerations, concealing costs, maximizing budgets and ignoring the long-term consequences of the policies they implement. There is generally no incentive for officials to reconcile the long-term social costs and benefits of their policies with the short-term costs and benefits to themselves.

In a recent paper, economist Allan Meltzer writes: "From its very beginning the Federal Reserve Board has been the conduit for political influence." But the Fed is the most politically independent government body in existence! The incentive problems responsible for the failure of the Fed to consistently put in place wise monetary policy and for Congress to conduct wise fiscal policy are basically the same as the ones responsible for the failure of the Fish and Wildlife Service to conduct a wise policy toward endangered species (as the private World Center for Birds of Prey has done) and for the failure of the Department of Housing and Urban Development to develop wise affordable housing policies (as the privately-led Habitat for Humanity International has done).

Bad economic policy is misunderstood by the public as the product of bad actors, but the deeper story is one of normal people performing under bad incentives. That is why "the leavening hand of wise policy" is about as useful a concept as the fairy godmother's magic wand. It is also why government expansion always merits Friedmanite skepticism.