There’s nothing like a good Facebook debate to provide fodder for explaining core ideas in political economy. I recently expressed concern about the risks of a proposal in Oregon to allow students to pay for their education at state schools by having their postgraduation wages garnished by 3 percent for 24 years. In response, a friend asked why it’s great for private firms, but not government agencies, to be risk-takers. Preempting the response that the public sector uses “our money” and the private sector doesn’t, the friend pointed to the damage that “Wall Street and the banks did with ‘our money’ when they took all those risks last decade” to show that private-sector risk isn’t so great either.
Let’s see if we can untangle the two parts of this argument. First, why is private risk-taking good and public risk-taking not so good? As in much of political economy, there are two related reasons.
First, my friend’s attempt to avoid the “it’s not their money” argument is understandable. After all, actors in the public sector do not have their own funds at risk. Therefore their incentives to manage those funds wisely and take only reasonable risks are much less than if the money were their own. If you give me $2,000 of your money as a gift to use at the blackjack table, I’m going to take risks that I would not take with my own money. You can point all you want to supposed examples of poor private-sector risk-taking, but that’s not a response to the underlying reality of systemically poor incentives in the public sector.
In fact, the incentive structure of the public sector is such that the risks which actors are likely to take are ones that are rational in terms of their political payoffs, regardless of social benefit. In other words, risks that are likely to get votes (such as creating a way to finance college that can be called “tuition free”) are likely to be taken whether or not they actually use resources in ways that enhance value. This tuition program might be a significant waste of resources, but that’s a separate question from whether it will garner votes or campaign support. Not only does the public sector lack the incentives to manage resources wisely, it has positive incentives to manage them poorly. This is why public-sector risk-taking is often criticized — it’s premised on political gains rather than the creation of value.
Second, and less appreciated, is the question of knowledge. The public sector lacks an effective feedback system to inform it about what risks would be worth taking and, after the fact, which ones actually made people better off. Even if political actors are motivated to create value for citizens, they also need knowledge about what choices would accomplish that. In the private sector, things that firms produce usually have prices determined in the marketplace, which means those prices are reliable sources of knowledge about what people value. The prices can therefore be used to judge which risks are worth taking. When used to calculate profit and loss, prices can inform private-sector actors after the fact as to whether a risk was worth taking.
Market prices reflect economic value, not political value. The risks that private firms take in a genuinely competitive market are premised on their informed judgments of what will create value and the learning they are able to do based on the profit and loss of prior ventures. Prices serve as, to use Ludwig von Mises’s words, “aids to the mind” that help make private risk-taking both more rational up front, because firms can use prices to budget and estimate, and over the long run, because firms can learn from profit and loss. There is no comparable social-learning process geared toward value creation in the public sector.
Finally, the example of the housing boom and bust proves too much. Yes, the private sector took excessive risks, but that was because of irrationally risky programs put in place by the public sector! In addition to the Fed’s artificially low interest rates, the housing boom was caused by a whole variety of new and risky government programs designed to make homeownership more affordable for more people. These programs distorted the incentives facing private actors, leading them to take risks they otherwise wouldn’t have taken. These programs were also a perfect example of political actors adopting programs that will get votes (“Let’s make housing more affordable!”) rather than being guided by what uses of resources would actually create value. The result was massive wealth destruction.
So the Wall Street folks are not an example of how the private sector messes things up with “our money.” Instead, this case perfectly encapsulates what’s wrong with public-sector risk-taking: It is divorced from the incentives and knowledge signals that guide the private sector. It pleases politicians who want votes, and it scrambles the signals for the private sector. In the end, value is destroyed.
The distorted incentives and the lack of knowledge facing the public sector are why libertarians are so skeptical of public-sector risk-taking. We know that taking wise risks isn’t just a matter of having a good heart — it is much more a matter of having a good pair of eyes and ears in a world that provides us the relevant information. That’s what the market does for private-sector actors.
