President Obama’s call for greater government investment in energy infrastructure has drawn predictable criticism, not the least from many who style themselves as defenders of the free market.  On Wednesday morning following the State of the Union address, The Wall Street Journal ran an editorial entitled “The Great Misallocators”.  The editorial criticized both the President and Jeffrey Immelt, CEO of General Electric, for promoting government investment in energy infrastructure.  The Journal complained that government directed investments are “made for political purposes, rather than for their highest potential return.”  It contrasted government investment to the free market, which lets “capital flow to the companies and individuals with the best ideas.”

For all their criticism of environmentalists for confusing science with religion, the Journal and its fellow travelers are guilty of the same offense.  The hazards of government investment are real and obvious.  Politics does play a role in investment decisions and funding priorities are too often based on sound bites and electoral calculus rather than efficacy.  But at the same time the free market is far from being an infallible invisible hand.  There is no doubt that government does certain kinds of investing far better than the private sector.  Had John F. Kennedy said in 1960 that we would be landing a man on the moon by the end of that decade and that we were going to rely on the free market to do it, we would all still be staring at the moon today wondering whether it was made of Swiss cheese.

The free market is a powerful tool for allocating economic resources.  But it is limited in two respects that are particularly applicable to new energy technology investments.  The first limitation is the free market’s inability to account for cost externalities.  If all the costs of two commodities are included and covered by their respective market price, then the market can make a rational, price-based decision between the two commodities and the more price efficient will prevail.  But where one of the commodities does not have to reflect its costs in its price—because it can release some of those costs into the atmosphere or have them paid as part of a common defense budget—the free market breaks down and it cannot make a rational choice.

Direct and indirect subsidies have a similarly disruptive effect on the efficacy of the free market.  For example, it is undisputed that the Chinese government is making huge direct and indirect investments in advanced batteries and vehicle electrification.  As a consequence, it appears to the free market that it is far more economic to manufacture advanced batteries and electric vehicles in China than in the United States (or anywhere else in the world).  The Chinese clearly see long term strategic and economic benefits for their country if they can become the leader in new energy technology.  If the Chinese are wrong and have overestimated those benefits, then the United States should happily take advantage of the subsidies that Chinese taxpayers are so generously and foolishly providing.  But if the Chinese are on to something--that new energy technology may be to the next two decades what information technology was to the last two decades--then relying on the free market to compete with the Chinese is a trap, not an option.

The second limitation on the efficacy of the free market is its structural blindness to long term return.  Private sector investment is driven by attempts to maximize return on investment (ROI).  The ROI of an individual investor or equity fund manager is like a school report card, the professional significance of which is often underestimated by those outside the financial community.  Because of the way that ROI is calculated mathematically, it becomes almost impossible for a fund manager to achieve an acceptable ROI on any investment that does not make a return on investment within 5 years.  Accordingly, there is tremendous bias in the private investment community in favor of shorter term investments.

Unfortunately, the short term bias of private sector investment runs head-long into the realities of new energy technology.  Increasing the efficiency of advanced batteries and solar cells to the point where they can compete with cheap forms of fossil fuel may take decades.  The development and procurement cycles for products that will use new forms of energy, such as power plants and cars, are generally longer (and in the case of power plants, much longer) than the cycles for most consumer goods and business equipment, so adoption of new energy technology will necessarily be slow.  The longer time necessary to generate returns is further complicated by the size of the investments that new energy technologies generally require.  The $25 million of private investment that Google required to go public would probably not pay for the loading dock at an advanced battery plant.

The real question when it comes to investing in new energy technology is not how we make the investment, but whether we make it at all.  That is a legitimate question and calls for honest debate.  But if our answer is the same as that of the Chinese--that new energy technologies will be a loadstone of the future economy and are worth investing in today--then the government, despite all of its shortcomings and inefficiencies, must take the lead.  The efforts of the financial and technology communities must focus on reducing those shortcomings and inefficiencies, not condemning them in favor of quasi-religious free market concepts.