Arthur Pigou Warned of the Failures of Government

Many market advocates, especially public choice scholars, are scornful of Arthur C. Pigou, Cambridge economist. I think the reason is that Ronald Coase, not entirely unfairly, used Pigou as his foil in criticizing the idea that problems with externalities could only be solved by the state.

But as is often the case, the original text is much more nuanced than the work of the followers. Marx, for example, is interesting and worth reading; many self-styled Marxists are not. I have found the same to be true of Pigou. In fact, I’d say that Arthur Pigou founded public choice.

The reason is that Pigou, to his credit, recognized that the concepts of “market failure” and “externality” actually require an investigation of the specific institutions of state intervention. He may have been too optimistic about the prospects for improving state action, but he had no illusions about the problem states faced in acting correctly.

Coase’s critique of Pigou is rather strident. In “The Problem of Social Cost” (1960), Coase says that Pigou “deals with divergences between social and private net products which come about because [quoting Pigou] ‘one person A, in the course of rendering some service, for which payment is made, to a second person B, incidentally also renders services or disservices to other persons (not producers of like services), of such a sort that payment cannot be exacted from the benefited parties or compensation enforced on behalf of the injured parties.’”

Pigou tells us that his aim in part II of The Economics of Welfare is

to ascertain how far the free play of self-interest, acting under the existing legal system, tends to distribute the country’s resources in the way most favorable to the production of a large national dividend, and how far it is feasible for State action to improve upon ‘natural’ tendencies.

To judge from the first part of this statement, Pigou’s purpose is to discover whether any improvements could be made in the existing arrangements that determine the use of resources. Pigou concludes:

But even in the most advanced States there are failures and imperfections.… There are many obstacles that prevent a community’s resources from being distributed … in the most efficient way. The study of these constitutes our present problem.… Its purpose is essentially practical. It seeks to bring into clearer light some of the ways in which it now is, or eventually may become, feasible for governments to control the play of economic forces in such wise as to promote the economic welfare, and through that, the total welfare, of their citizens as a whole.

Coase responds: “Pigou’s underlying thought would appear to be: Some have argued that no State action is needed. But the system has performed as well as it has because of State action. Nonetheless, there are still imperfections. What additional State action is required?” (Coase 1960).

Coase is right, of course. Pigou really did say those things. But he also was careful to note that what later came to be known as the market-failure paradigm should be applied with care. Usually, the logic of Pigouvians goes like this: markets fail (by externalities, asymmetric information, etc.), so the state should act. Of course, that would only be a complete prescription if one is reasonably certain that the actual actions of the state are likely to be an improvement over the actual results obtained from the market.

The main thrust of the public choice movement was to correct this naïve optimism about the state. There are two main types of problems identified in the work of James Buchanan, Gordon Tullock, and the other scholars who developed the public choice critique starting in the 1960s.

The first is information: It may be true that prices do not reflect the full opportunity cost, or “social cost,” of resources. But without prices the state is just as blind! The government has an information problem no less profound than market systems’. Knowing the correct level of Pigouvian tax, in the absence of prices, is not just difficult; it’s impossible. The dispersed knowledge of value is possessed by no single individual, and no bureaucratic technique can fully solve that problem. The information problem is not solvable by imagining that the state is an omniscient dictator.

The second problem is incentives: there is no reason to expect that those in power are motivated solely, or perhaps even primarily, by the public good. The bureaucrats making guesses about corrective taxation may have their own conception of the public good, of course. Or they may be motivated by some other motive. But the human beings who make up the state are motivated by their own goals; the places where they work are called “agencies,” after all. The principal-agent problem is profound, and not solvable by imagining that the state is a benevolent dictator.

In short, the public choice critique argues that the Pigouvian model, by assuming that the state is an omniscient, benevolent dictator, assumes away all the problems of social choice, information, and incentives that confound actual policy. This is a valid critique of Pigouvians, I believe. Is it an accurate critique of Pigou himself?

It is not. A fair reading of Pigou reveals that he is actually one of the founders of the public choice critique. He should get credit for that. In his 1912 book, Wealth and Welfare, Pigou said:

It is not sufficient to contrast the imperfect adjustments of unfettered private enterprise with the best adjustments that economists in their studies can imagine. For we cannot expect that any State authority will attain, or even whole-heartedly seek, that ideal. Such authorities are liable alike to ignorance, to sectional pressure, and to personal corruption by private interest. A loud-voiced part of their constituents, if organized for votes, may easily outweigh the whole.

I sometimes give that quote, without the reference, and ask people to identify the source. The most common responses are Hayek or Buchanan. But no, it was Pigou. Notice that he gets both information and incentive problems right here. The state doesn’t know what to do, and if it did it might not want to do it. That, in a nutshell, is the origin of public choice.

Later, in “State Action and Laissez-Faire” (1935), Pigou again sounded a note of caution:

In order to decide whether or not State action is practically desirable, it is not enough to know that a form and degree of it can be conceived, which, if carried through effectively, would benefit the community. We have further to inquire how far, in the particular country in which we are interested and the particular time that concerns us, the government is qualified to select the right form and degree of State action and to carry it through effectively….

High-sounding generalisations on these matters are irrelevant fireworks. They may have a place in political perorations, but they have none in real life. Accumulation of evidence, the balancing of probabilities, judgment of men, by these alone practical problems in this region can be successfully attacked.

I should note that this argument — that Pigou was not really a Pigouvian, and might even be seen as a precursor of public choice — is made in much greater detail by Steve Medema (“Economics and Institutions: Lessons From the Coase Theorem,” 2014).

My point is just that it strengthens the public choice argument to argue that Pigou himself recognized the problem and admonished followers to pay attention to information and incentives. Naïve followers of statist remedies often forget that part, and being able to cite one of their own in this regard is important.

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