This paper analyzes market and government failure through the lens of systemic dysfunction rather than individual institutional blame. Using the 2008 financial crisis and Deepwater Horizon as case studies, the author demonstrates how market failures arise not from markets or governments alone, but from complex interactions of incentive structures, information asymmetries, and regulatory frameworks. The paper argues that government responses to market failure often involve bail-outs and transfers benefiting politically influential groups, and explores how both institutions can be reformed through better alignment of risk-taking incentives, increased transparency, and structural regulation.
Being regulated by people, it is a reality that, like people, neither markets nor governments are perfect. They both fail (Lee and Clark, 2013). The responsibility for this failure is generally positioned at the door of either positive or negative externalities. The undersupply of public goods and an excess of pollution are both considered to be market failures. Although both of these can result from market activity, government activity can have just as dire an effect on markets and their failure.
Generally, governments create market failure through transfers connected to politically influential groups and their desire to benefit regardless of the consequences, often at the expense of others. Regardless of the core reasons for market failure, however, the common response is to expand the power of government in order to mitigate and correct market failures. This approach was widely evident during the large-scale economic downturn in the latter part of the first decade of the new millennium. In order to effectively understand market failure, it is important to recognize that both markets and governments are equally capable of failing.
Keech, Munger, and Simon use two significant case studies to explain the failure of markets and government responses to them. The first they examine is the recent economic downturn. With these case studies, the authors' intention is to demonstrate how neither markets nor governments can be blamed individually when complex organizations fail. Instead, it is a wider-scale failure of entire systems including a conglomeration of incentives, decision-maker information, and the arrangement of other systems in place to contribute to the function of the market, government, or combination of the two.
In addition to the Deepwater Horizon crisis, Keech, Munger, and Simon (2012) address the recent economic downturn. The crisis began with the collapse of the mortgage market. In an attempt to increase the diversity of people who qualified for mortgages and to promote an "affordable housing" drive, the government pressured banks to relax their lending standards. While banks were unwilling to do this, the incentive structure drove the creation of lending businesses outside of the traditional banking system, whose standards were far more relaxed.
The authors demonstrate how this downturn was the result of a failure to use information correctly to create the right incentives for lenders. These non-bank lenders simply repackaged and resold the loans to create a profit for themselves. At the same time, financial institutions operated under the assumption that, while they would profit in prosperous times, the government would assist them in times of less prosperity.
This assumption proved prescient. The widespread reports of government bail-outs for large financial institutions were common during the downturn. At the heart of the downturn therefore was the combination of financial and government systems that led to a real estate bubble, which collapsed when it could no longer sustain the weight of defaulted high-risk loans. One cannot lay exclusive claim to either the specific market or the government, since there was wide-scale market failure and a specific government reaction to it.
While many citizens suffered, the government made good on its promise to provide bail-out money to large financial institutions. Many have questioned the morality of this, since it goes against many core values, including respect, personal development, responsible stewardship, and integrity. Many have criticized the government's actions as lacking the basic purpose of government, which is to care for its citizens.
The disconnect between the suffering of ordinary households and the protection afforded to financial institutions highlights a fundamental tension in how systemic failure is addressed. When ordinary citizens lost homes and savings, while bank executives retained their positions and received bonuses, the government's choices appeared to prioritize institutional stability over individual welfare. This raised questions about whether government solutions to market failure can themselves constitute a failure of governance.
"Alignment of incentives and transparency can prevent future crises"
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