Saturday, October 11, 2008

Collective Action

Here's a good test for distinguishing a thoughtful economic conservative from a slogan-based economic conservative: What does he or she think about the role of government in solving collective action problems? A thoughtful conservative will acknowledge that there are some things that markets are not very good at doing. National defense is an example nearly everyone (including the slogan-based conservatives) can agree on. In theory, if there were no government-run military, we could rely on private forces to protect against foreign enemies (albeit for a price) but in practice, this is wildly impractical. Likewise for other recognized public goods, such as roads and other infrastructure, fire protection, etc.

To be sure, one sometimes encounters smart conservatives who will point to examples from history of the market providing services we now generally regard as public goods, often claiming that the market provided them more cost-effectively than the govt now does. But these people are outliers. To the extent that they are not simply mouthing reflexively anti-government slogans, they should be understood to be sounding a caution: Beware of arguments rooted in claims of market failure, public goods, and the need to solve collective action problems, for once one begins down that road, there is no stopping (and it leads straight to serfdom). Thus stated as a warning, the point has some merit. Not every phenomenon that could be characterized as market failure, tragedy of the commons, a collective action problem or what-have-you necessarily calls for a government solution.

Against this backdrop, some of the conservative opposition to the various economic rescue packages makes some sense. To be sure, some of it is just plain ideology. Only an ideologue frets over whether a temporary, albeit very large, government equity stake in the U.S. banking industry would amount to "socialism." The obviously more salient question is whether it will work.

Putting aside opposition to anything too red (even if for bankers), some of the rational opposition to various bailouts stems from a legitimate worry that bailing out those who made bad investments will, in the long run, undermine the discipline of the market. Some of it (from the left as well as the right) may also be a form of not-exactly-economically-rational-but-also-not-irrational spite, as Sherry explained in a recent FindLaw column.

Here I want to suggest a third basis for opposition to a government rescue package: skepticism of collective action problems. Although the Dow is hardly a perfect proxy for overall economic well-being, let's consider it just that for the moment. None of the individual and institutional investors who were heavily invested in stocks benefited from the loss of roughly a quarter of the value of their portfolios in less than a month. Indeed, each investor would benefit if all the other investors had stayed put, but of course, their actions were not coordinated. As a result, we had a race to dump stocks, which only reinforced itself.

One way to understand the various bailout measures is as an effort by the investors as a group (through the government) to coordinate their actions. By injecting lots of money into the system and/or flushing out the bad debt, they can act together in a way that they can't act alone. In other words, in order to prevent individually rational actions (basically panic selling) from bringing down the whole economy, the government is attempting (via subsidies) to make buying (or holding onto) equity individually rational.

To be clear, that's not a perfect account of what's going on here. The bailout measures don't aim at all firms equally, focusing on banks and, in some proposals, housing. But in the big picture this is surely right: What it means to "restore confidence" in the markets is precisely to make otherwise risky transactions more attractive by reducing the risk.

So now the question: Is it rational to oppose these measures as reflecting too much faith in govt's ability to solve collective action problems? I tend to think so, although I also think that this is a crisis in which the government doing nothing would be worse than a number of things the government can be (and to some extent is) doing. What's needed from the thoughtful critics of the various proposals (and needed soon) is an account of why this particular collective action problem will solve itself---and the particular collective action problem I have in mind is not so much panic selling on Wall Street (which usually is self correcting) but the freeze-up in the credit markets due to rational fears that borrowers will go belly up before paying back.

Meanwhile, on the critical side, I will say that Treasury and the Fed are looking distressingly like the McCain campaign lately, i.e., haplessly trying one thing after another in the hope that something will work.

Posted by Mike Dorf