Weekly Market Update
In an election year such as this, it is virtually impossible to escape the daily bombardment of political rhetoric via mass media. Politicians typically have little compunction as they encroach into the arena of economics. As a result, people from all walks of life, including savvy investors, are often left confused and wondering which of the various economic theories and norms remain relevant. The goal of this piece is to consider what recompense we receive from government intervention in the economy. Some bitter divisions exist regarding the style of play that should be adopted to guide our nation as the slow economic recovery continues.
Now Introducing: the Sporting View of the Economic Role of Government
The essential role of government in economic activity can be understood by examining two basic functions:
1) government acts as a referee or an umpire enforcing rules in and around markets, and
2) on some occasions, the government will “suit up” and become a player in various economic contests.
First, government officiating is needed because we are imperfect humans living in an imperfect world. It’s not that government is smarter or more capable to direct others than any individual; we simply need to designate a third party to make sure everyone plays by the rules of the game. Government is tasked with defining, assigning, and enforcing private property rights. Private property rights provide the bedrock foundation for many other attributes of a capitalistic (market based) economy. Without government carrying out this function, free enterprise does not exist.
Also, like a conscientious sports official, government takes action to ensure that the game and quality of play in markets maintains its purpose and integrity. Think about it, most sports require some sort of officiating call or action for every play of the game. Officials can delay a game or even postpone it on account of hazardous conditions. Another example involves the international trade game. Here, our government employs specialists in the form of trade representatives and enlists the help of the executive branch and Congress to help ensure that our nation secures the best deals the global economy can provide. Not only is the government officiating but is also involved as an active participant in the international trade game. That’s quite a bit of intervention. This is tolerated because it makes sense. Each person in and around any sport or market activity has expectations of how that activity will satisfy specific wants and needs. Government exists to help ensure that market activities and outcomes play out smoothly and that wants and needs are met.
An Interesting Highlight Reel
Government’s role in the U.S. economy shows up vividly in the illustration below. This graph shows the volatility of our nation’s output (Real Gross Domestic Product) substantially reduced after World War II. Note that the annual percentage change in output is what is actually being measured in the graph.1
Also notice that the ups and downs are much less on the negative side beginning in the 1950s. To state this differently, after World War II our economy began utilizing a way to temper recessions so that they were not as severe. After government took on a larger economic role, recessions became shorter and much less severe. Notice how the percentage change in output has not fallen below -5% since the 1940s. This even holds true for the most recent recession. The greater economic stability portrayed above no doubt enhances certainty and peace of mind for all those engaging in U.S.-related activities.
The graph below shows that in our post-modern era, business revenues do not appear to be stunted by a government that also grew in size and scope over the same time frame. Like the mindful sports official that does all he can to move a game along while maintaining the integrity and quality of play, our government and the private sector can be viewed in much the same way.
Even though the graphic does not relate how much money went to government that would otherwise have been business revenues; suffice it to say that it’s obvious it wasn’t enough to prevent the business sector from growing! It’s even arguable that government intervention during that time frame contributed to the growth of the business sector displayed in the graph. Discussion of how this is possible is found in the next section.
Up Close and Personal With Government’s Role in Our Economy
Government has a wide range of powers. Along with this come great responsibility and the need to ensure that corrupting influences do not take hold. To do this we need to understand what else constitutes an economic function of government. When the scope of governmental activities exceeds certain basics, we need to seriously consider dialing back on this behemoth. These basics are couched in four types of market failures (situations where marketplaces cannot thrive or operate well) that government is tasked with correcting.
Perhaps the easiest market failure to understand is the case where ample competition does not exist. Monopoly or fewness of competitors leads to buyers being underserved in that market. High prices and less than desired output are the outcomes under monopoly. Our government is charged with calling foul when market participants undertake uncompetitive activities. Antitrust enforcement is tricky and has had limited success. This is because in some situations, one or a few large firms operating on a very large scale of production can achieve very low average costs. Despite that being true, it also gives rise to another dilemma. Without competition there are no natural incentives that influence the one or few big firms to pass the cost savings along to the buyers!
The next market failure concerns imperfect information and uncertainty. Real-world information can be one-sided, incomplete to both parties, false, untimely, etc. Government can help storehouse, distribute, and even create information where incentives to do so might not exist between competing parties. Doing so can actually help markets form and operate efficiently. For instance, having standards regarding food and drug labeling is something all of us can appreciate. In effect, government can make the “market game” easier to play by explaining the costs and benefits and monitoring the field of play.
The third type of market failure is externalities, both positive and negative. Positive externalities are unintentional benefits that occur from economic activities that spill over onto third parties. Negative externalities are costs that spill over onto third parties. Flu shots are a good example of a positive externality. When you purchase a flu shot, not only do you receive a benefit, those around you (who didn’t spend a dime) also benefit. Government, not being motivated by profits, is ideally positioned to encourage these kinds of activities. A good example of a negative externality is pollution. Pollution represents production costs that spill over onto innocent third parties. Again, it is the government that is uniquely qualified to discourage activities that generate spillover costs.
The fourth and final category of market failure is public goods. Public goods have the characteristics of being non-rival and non-excludable. Non-rival means that one person’s consumption of the good has no impact on another person’s consumption of the same good. For example, one person’s enjoyment (consumption) of U.S. national defense does not impinge on the more than 300 million Americans that all consume national defense at the same time without any meaningful portion control problems. Public goods such as national defense are also non-excludable, meaning that even if you don’t pay for it, you can continue to consume the good unabated. Even when a person does not pay their portion of taxes attributable to national defense and are thus jailed, they still enjoy and are protected by national defense!
Public goods simply have characteristics that make it difficult or even impossible for them to be offered, profitably, in a conventional marketplace. Government instead is uniquely positioned to ensure these goods are provided. Public goods also provide an example of how our government is called upon to “suit up” from time to time, for activity in the economic arena.
The Final Wrap-Up
To summarize, our government’s role in the economy includes the provision of private property rights and correcting for market failures. Market failure includes situations where the existing marketplace forces of demand and supply deliver outcomes that fall short of society’s expectations of high-quality, affordable goods and services.
As we continue through this year’s campaign season, it makes sense to remember the strategic playbook that has brought our country such great economic success over such a long time span. The momentum swings between conservative and liberal, laissez-faire and Keynesian influences have done relatively little to change the basic tenets of the economic role of government. In the coming months it might be beneficial to consider a personal game day strategy that pays far less attention to the sound bites aired this election season and much more to the assurance of having ideal conditions with which to compete on the economic field of play.
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The opinions expressed are those of Steven Petty and are no guarantee of the future performance of any American Century investment portfolio or any specific asset class relative to another. This information is not intended to serve as investment advice; it is for educational purposes only.
1Figures prior to 1929 are based on academically derived estimates of Gross National Product (GNP); GNP during the 1900-1929 period does not differ significantly from GDP, for the purposes of this discussion.
This information is for educational purposes only and is not intended as investment or tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.