Why Government Fails So Often: And How It Can Do Better (41 page)

While failing to achieve its most obvious and measurable goal, the government’s war has also inflicted immense collateral damage on American society and on source countries, causing street violence, entrenching gangs and organized crime, facilitating illegal weapon flows to drug lords,
*
encouraging youths to leave school prematurely, destroying families, filling prisons (with little deterrent effect),
⁷²
and much more. At the same time, experts have proposed many ameliorative policies, some of which are politically feasible—including legalization.
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Deregulation of illegal drugs (and some other regulated industries) tends to be only partial, however, which leaves some of the same black market issues in place while also creating some new ones.
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SIMPLIFYING MARKETS

The most common form of market simplification is to provide consumers with better information in more standardized formats. Improved disclosure policies possess the political advantage that disparate political forces can often agree upon them; compliance costs seem low; they respect consumers’ choices; and they promise to make those choices better informed and more rational (although much behavioral psychology suggests that such disclosure may not actually affect the deeper sources of consumer irrationality).
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Recent research, and the examples that follow, demonstrate that regulating through information disclosure is far more complicated and problematic than policy makers think.

Review of the empirical studies shows that policies aimed at improving information often fail on a variety of grounds.
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First, information
imperfections in product markets and workplaces do not seem to cause significant welfare losses. Product-and workplace-related illness and injuries and adverse drug reactions have declined or remained stable, but the declines are due to market forces, not government regulation. Federal Trade Commission advertising regulation “raise[s] doubts about whether [it] has enabled consumers to make more informed choices.” And studies of disclosure programs seeking to protect investors, air travelers, and motorists find that the costs sometimes exceed the benefits. Some reasons for this ineffectiveness include consumer inattention to the mandated information, inaccuracies in that information,
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consumer loyalties to particular vendors, regulatory limits on disclosing some potentially useful information, and higher direct or indirect regulatory costs. The many federal regulators of financial institutions—the Fed, the Comptroller of the Currency, the FDIC, the Commodity Futures Trading Commission, the Consumer Financial Protection Bureau, and others—impose varying disclosure rules that can actually obscure consumers’ and investors’ understanding.
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(I ignore
state
regulators here.) Labeling requirements can produce benefits, Winston finds, but some of them may well have occurred anyway through market-driven disclosure or through media attention to the hazards.
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He also finds that state-level programs regulating advertising, occupational licensing, and “lemon laws” do no better.
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A recent study of New York and San Diego programs mandating that restaurants post government sanitation ratings finds grade inflation, inconsistency, misallocated inspection resources, and no discernible reduction in food-borne illness.
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Christine Jolls, an expert on behavioral law and economics, has studied the Family Smoking Prevention and Tobacco Control Act of 2009, which mandates large graphic health warnings, similar to those already required in many other countries, on cigarette advertisements
and packaging. (These mandates have been judicially enjoined for now on the ground that they unconstitutionally compel speech by tobacco companies) Knowing precisely what risk information to require and in what format is tricky; if it is wrong it can mislead consumers who rely on it. The very information on which regulators must rely for determining these facts and deciding these disclosure-relevant questions is
itself
prone to confounding ambiguities, provider tactics, and systematic errors. Experts hotly contest the precise facts about the risks in question (e.g., smoking, salt consumption, fatty foods, breast cancer screening, prostate surgery, and countless other practices). Regulators must draw their policy inferences—about what risks to disclose, and how—from consumer surveys, laboratory experiments, and other sources whose results reflect consumers’ existing ignorance, irrational cross-cutting biases (psychologists have identified over forty of them in laboratory contexts!), and understandable confusion about the meaning of the questions they are asked. Jolls finds that the act’s mandated warnings are somewhat effective in reducing factual misperceptions of smoking risks, but that even gripping, highly salient warnings cannot easily reduce these misperceptions.
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Only three years after the Dodd-Frank financial and corporate reform law was enacted, some of its disclosure provisions are already backfiring. According to a
New York Times
analysis, the law’s ostensibly simple requirement that each public company disclose the ratio between the chief executive’s compensation and the median salary of its employees is encountering all sorts of complications that should have been obvious at the outset. Even more perverse, the SEC estimates that the provision requiring firms to disclose the “conflict minerals” used in their products will cost them $3–4 billion just for initial compliance; industry estimates are as high as $16 billion. Yet this immense cost is evidently producing few benefits and is actually making some situations worse. For example, disclosure of the median salaries of “all” employees can mislead the public by including relatively low-paid workers in less-developed countries, while disclosing executives’ compensation by revealing what their counterparts in other firms are paid has encouraged them to demand even higher salaries.
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SUBSIDIZING MARKETS

Government often seeks to alter market outcomes by subsidizing private actors in hopes of influencing their decisions—to save, invest, consume, or engage in other kinds of transactions—in ways that policy makers consider socially desirable. Some of these, such as social net programs, are redistributive by explicit design, but all of them are redistributive in effect (that is, they move resources from one group to another).

These subsidies can take a number of different forms using a variety of techniques: direct cash or near-cash subventions (e.g., food stamps, Social Security); loan or other guarantees that reduce the cost of capital (e.g., student loans, Federal Housing Administration mortgages) or the risk of loss (e.g., the Pension Benefit Guaranty Corporation); exemptions or deductions from otherwise applicable taxes (often called “tax expenditures”); regulatory exemptions (e.g., for small businesses); public investment in private companies (bailouts of failing companies like American International Group); provision of free or below-cost benefits (Veterans Administration hospitals); special competitive advantages (e.g., lower borrowing costs for megabanks); and many others. Taken together, these subsidies comprise a substantial portion of federal domestic spending (assuming that one treats tax expenditures, say, as equivalent to government spending for this purpose).

Such subsidies often suffer from systematic inefficiencies and inequities. Many of them are target inefficient (discussed in
chapter 2
) in the following senses: recipients would have engaged in the desired conduct anyway (without the subsidy), they do not need the subsidy, or both. For example, the government has given immense tax advantages (relative to a tax baseline) to various retirement vehicles such as individual retirement accounts (IRAs) even though they are used disproportionately by relatively affluent people who would likely have set up retirement accounts anyway and thus have little marginal effect on household savings.
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The favorable tax treatment of health insurance premiums disproportionately benefits “Cadillac” insurance plans
enjoyed mostly by corporate executives and members of strong labor unions.

Some government subsidies are, predictably, bad bets (defined in
chapter 2
) and, relatedly, create moral hazard (discussed in
chapter 5
). Consider some of our largest, most prominent programs.

Housing loans
. The most arrant example is the large number of recipients of subprime housing loans that Fannie Mae and Freddie Mac subsidized and pressed lenders both to give and not to foreclose against delinquency. Such government-promoted moral hazard was an important cause of the Great Recession and its protracted aftermath.

Indeed, more than five years later—
and even with all the benefits of hindsight
—the Federal Housing Administration (FHA) is following those agencies’ catastrophic examples. The FHA, which is legally required to be self-supporting, has created so much moral hazard in housing and housing finance markets and administered its loans so irresponsibly that it will almost inevitably require a huge Treasury bailout;
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only the amount is uncertain. Indeed, the FHA was $13.5 billion in the red at the end of 2012, even using an accounting method that includes assumed future earnings in current capital, which vastly understates the true deficit and which no private financial lender could get away with using.
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A study based entirely on foreclosure estimates made by the FHA’s own auditor and detailed individual loan data found that 40 percent of the loans made in 2010—several years
after
the housing bubble had burst and
after
the bailouts of the insolvent Fannie Mae and Freddie Mac had occurred—were made to borrowers who failed to meet the FHA’s own credit score and debt-to-income standards for viable loans. The study also found that the agency fails to adequately monitor the risks on its loans, fails to charge guarantee fees adequately reflecting the risk of nonpayment, and concentrates its loans in areas likely to generate very high foreclosure rates.
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Indeed, the FHA, which had been in better financial shape than Fannie and Freddie when the housing crash occurred, adopted the same disastrous game plan that they had used, relentlessly expanding its portfolio and pumping money into the plunging housing
market in order to prop up home prices with high-risk loans. Tragically, this pattern of high-risk loans continues: in the first quarter of 2012, the same share of the FHA’s outstanding loans, 40 percent, had subprime attributes.
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More than three years after an independent auditor found significant deficiencies in the FHA’s systems for monitoring loans, the agency still has not installed a more modern one.
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Low-income housing
. The federal government operates other housing subsidy programs. Although I cannot review them here in any detail, independent analysts generally find that those which subsidize housing developers, financial institutions, and municipalities are far more inefficient than Section 8 of the Housing Act of 1937 (as amended) and other programs that directly subsidize low-income consumers of housing. Section 8 has its own problems, chiefly in its implementation—for example, many landlords refuse to accept Section 8 tenants, the vouchers are not worth enough in low-vacancy, high-rent communities, and the program’s habitability conditions often go unenforced—but its target efficiency makes it a better policy instrument for meeting low-income housing needs than supply-side subsidies.

Student financial aid
. The provision of financial aid to college students is among the largest domestic programs. (Although I refer to it as a “program,” it is actually a suite of programs including direct loans, loan guarantees, grants, tax preferences, and institutional support.) Its general goals are desirable: to increase educational opportunity and thus assure individuals wider access to the American dream; to benefit the rest of society by expanding its human capital; and to overcome a supposed market failure in which only subsidies can induce private banks to finance education for young people given the uncertain prospects of their ability to repay.

The program has expanded to immense proportions since its start with the National Defense Education Act of 1958 and later extension through the Higher Education Act of 1965. An August 2013 government report shows that 57 percent of college students now receive federal aid, up from 47 percent only four years earlier.
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In July 2013, the Consumer Financial Protection Bureau (CFPB) estimated that the
total of outstanding student loans, almost all of them guaranteed by the federal government, reached $1.2 trillion—a 20 percent increase since the end of 2011
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—and almost doubled since the end of 2008. With the bill paid by taxpayers, the program is a classic example of “distributive” politics—broad coalitions that concentrate benefits and disperse costs. This form of politics spawns policies with ever-expanding benefits, vast inefficiencies, policy entrenchment, and political resistance to change.

Like many such distributive policies, it is poorly targeted. Relatively few of the subsidies go to low-income families; instead, they tend to transfer resources “from the less well off to the more well off.”
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And the Congressional Budget Office has found that these loans do not alter some students’ educational attainment.
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For them, they are simply a taxpayer-provided subsidy. A study that evaluated another program, Hope and Lifetime Learning tax credits, found that it did not have
any
effect on college attendance.
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One reason is that those who receive these credits would likely have attended college without them. And a new income-based repayment feature will actually most benefit high-income, high-debt people.
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This skewing of benefits to the middle and upper class is unsurprising; politicians across the political spectrum use the program in their appeals to better-off voters.
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In 2013, the Education Department’s own inspector general reported large and growing fraud, much of it facilitated by community colleges, committed by both student borrowers and Pell grantees, including over 34,000 participants in crime rings.
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As the
Wall Street Journal
editorialized, the new income-based repayment scheme further incentivizes delinquency: “Take out a big loan, work 10 years for the government repaying as little as possible, and then have your debt entirely forgiven…. Borrowers who enroll in [such] plans owe on average three times more than those who opt for the standard 10-year amortization schedule. They thus present the greatest risk to taxpayers….”
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