Dangers from the political allocation of capital

Congressman Jim Saxton penned and distributed a very good short outline of a few complaints about government overreach into the private economy. Saxton is the ranking Republican member on the Joint Economic Committee. He opens with a 2001 quote from one of Barack Obama‘s chief economic advisors, Larry Summers:

In many ways some of the ideas of [Friedich] Hayek and [Milton] Friedman about how markets best provide incentives, and best provide information, and best collect information may in a sense be even more true today, because of the changes that information technology is bringing, than they were at the time when they were propounded.

If you think about it, it cannot be an accident that it is the same 15-year period when communism fell, when command-and-control corporations like General Motors and IBM had to be drastically restructured, when planning ministries throughout the developing world were closed down, and when the Japanese model of industrial policy proved to be a complete failure.

There is something about this epoch in history that really puts a premium on incentives, on decentralization, on allowing small economic energy to bubble up rather than a more top down, more directed approach, that may have been a more fruitful approach in earlier years.

— Lawrence J. Summers,

71st Secretary of the Treasury, and Adviser to President-Elect Barack Obama

What follows are several excerpts from Rep. Jim Saxton’s research report. It’s reassuring to learn that even though we rarely see our Republican members of Congress working to move public opinion in any serious way, at least some of them will know what to say if they ever try.

The report opens:

“Since the financial crisis began in August 2007, the federal government has become increasingly involved with U.S. banks and other financial institutions and U.S. financial markets.”

Saxton gives a few examples:
The Federal Reserve has greatly expanded the size, duration, and scope of its credit facilities.

The Department of the Treasury has agreed to (1) inject up to $100 billion of taxpayer funds into Fannie Mae and another $100 billion into Freddie Mac, (2) purchase up to $250 billion of preferred shares in banks, and (3) purchase $40 billion of preferred shares in American International Group (AIG).

He continues – emphasis is ours:

“Although central governments play a large role in allocating capital in many Asian and European economies (1) through government-owned banks, government pension funds, and other government owned financial institutions, or (2) through industrial policies that direct credit to and encourage investment in favored firms, industries, regions, or groups, a historical strength of the U.S. economy has been the relatively small role that the federal government has played in allocating credit and making investment decisions.

The limited number and scope of government-owned financial institutions and the absence of an industrial policy in the United States has allowed private investors, private banks, and other private financial institutions to allocate credit and make investment decisions based on economic criteria without undue political interference. Subject only to general laws and regulations, private investors, banks, and other financial institutions may seek the highest returns consistent with their risk tolerance.”

He gives the rationale for the government’s interventions in the banks and other financial institutions. They were designed to “encourage banks and other financial institutions to replace government capital with private capital after market conditions improve.”

The problem is – “policymakers may nevertheless be tempted to use the leverage arising out of these federal interventions to affect credit and investment decisions.”

The crux:

“This raised an important question – how would the political allocation of capital affect the performance of the U.S. economy?”

He answers it:

“The political allocation of capital misdirects investment based on political criteria. Product innovation and process improvement in firms suffer. Over time, diminishing productivity gains slow real income growth and reduce real GDP well below its potential.”

Why does this happen?

“Economists attribute the deterioration of economic performance under the political allocation of capital to several factors:

• Inability of policymakers or bureaucrats to incorporate all of the widely diffused and rapidly changing knowledge conveyed by prices into allocating credit and making investment decisions;

• Both legal and practical restraints on political decision-making in a constitutional republic that:

o Reduce responsiveness to changing conditions and prospects, and

o Produce biases

Against entrepreneurship and innovation, and

For existing constituencies;

• Division of firm resources away from managing the business toward lobbying policymakers and influencing the bureaucracy; and

• Potential for corruption.

Click here for part two.