Below is Mark Pennington’s first guest post. As you can see, it will be an interesting week! – GC
I am delighted to have been invited to contribute as the guest blogger on Pileus this week and to air some of the central ideas in my new book, Robust Political Economy: Classical Liberalism and the Future of Public Policy. At the core of this book is a very basic but oft neglected idea – ‘failure’ is endemic to all social institutions because human beings are imperfect. By far the most important imperfection is that people are cognitively limited and thus they make mistakes. Robust institutions, therefore, are not those that eliminate failure, but those that reduce the consequences of inevitable human errors. Before we determine that a particular set of institutions ‘fail’ meanwhile, we must explain how and why an alternative set of institutions can do better.
Basic as this insight may appear, most public policy discussion assumes that government action is necessary to ‘correct’ for ‘failure’ in markets and civil society without adequate consideration of equivalent if not worse failures in politics. Nowhere has this tendency been more apparent than in the claim that the financial Armageddon of 2008 was a ‘systemic failure’ of ‘capitalism’ and that moves to regulate the operation of markets are now required to reduce the prospect of similar failures in the future. What such arguments neglect to explain is why the prospect of ‘systemic failure’ in the process of regulating capitalism is considered any less likely than the market failure it is supposed to cure.
Contrary to fashionable commentary, the classical liberal tradition has never claimed that markets are ‘perfect’ institutions populated by fully rational agents. Neither has it denied the possibility of ‘systemic’ market failure. In a world where learning via imitation is crucial for transmitting knowledge and where ‘herding’ behaviour may be prevalent it is entirely possible that many actors may learn the wrong things and simultaneously invest in mistaken ventures – as the sub-prime bubble so clearly demonstrated. The great advantage of markets, however, is that they reduce the possibility of such failure because potentially erroneous decisions are not backed by the force of law – private property affords those who dissent from the way the crowd is behaving the liberty to act differently.
By contrast the regulatory process which so many are now demanding should discipline markets, is not subject to an equivalent process of competitive testing. It is in the very nature of regulation that decisions are imposed on society as a whole in order to reduce behavioural heterogeneity. But if regulators are no more omniscient or rational than anybody else – and there is no reason to suppose that they are – then the consequences of any errors they make will be more far-reaching precisely because their decisions are backed by coercive authority. As Jeffrey Friedman has shown in a truly brilliant essay, though market failure played a role in the recent crisis, the scale of the meltdown was in large measure due to a series of systemic failures in monetary and financial regulation. From the decision of monopoly central banks to keep interest rates at excessively low levels, to the regulatory and fiscal inducement of government-backed mortgage companies to relax lending requirements for low income families, to internationally enforced capital regulations which induced banks to securitize risky mortgages, and the creation of legally protected monopolies in the credit rating business – the homogenising effect of all these measures virtually guaranteed that if mistakes were made, the consequences would be devastating.
The real lesson that must be learned from the financial crisis, therefore, is that regulators and politicians are just as prone to irrational and ill-informed conduct as is anybody else – but with their unique powers of coercion they have the capacity to do far more harm. Alas, as I aim to show in several of my contributions to Pileus this week, the area of monetary and financial regulation is but one of a raft of issues where policy-makers seem incapable of grasping this most basic principle of political economy.
 Friedman, J. (2009) A Crisis of Politics not Economics, Critical Review, 21 (2-3).