Government and Markets in a Well Functioning Economy

ETHOS Issue 09, June 2011

The financial crisis in 2007–2009 prompted a major rethink of the relationship between the state and markets. Dispelling the myth that competitive markets and self-interested individuals alone are sufficient to ensure efficient outcomes or stable economies, the crisis emphatically demonstrated how unregulated, unfettered markets can fail in ways that undermine even the most advanced economies.

One key lesson from the crisis is that markets often need proper government supervision and regulation to function efficiently. This understanding becomes all the more important as markets become increasingly complex and sophisticated – not just in finance, but also in areas as diverse as healthcare and energy.

STATE AND MARKETS: A BRIEF HISTORY

The evolution of economic thought in the past 200 years has profoundly influenced our notions about the right balance between states and markets. In the 18th and early 19th centuries, the writings of Adam Smith, David Ricardo and others attributed economic growth to the operation of the “invisible hand” of markets. Relying only on prices to allocate resources and ration demand, markets ensured that the interactions between a multitude of agents – each making economic decisions based only on his self-interest – resulted in outcomes more efficient than what central planners can achieve. Markets benefited society at large, with no requirement for active state intervention beyond the provision of a few public goods, such as law and order.

This laissez faire thinking reigned unchallenged throughout the late 19th and early 20th centuries, until the Great Depression. British economist John Maynard Keynes (1883–1946) argued that markets were inherently uncertain, and if left on their own, could self-depress rather than self-correct. Government intervention was necessary to boost aggregate demand during periods of high unemployment. This “Keynesian Consensus” recommending activist economic policies eventually came to shape the policies of Western governments from the 1950s to 1970s. It was premised on the ability of governments to manage aggregate demand and maintain full employment without causing inflation.

But the consensus began to fray almost as soon it achieved the heights of intellectual dominance in the West. Friedrich Hayek (1899–1992) and Milton Friedman (1912–2006), among others, believed that the government’s ability to affect real outcomes was transient at best and harmful at worst. They argued that the costs of government failure often outweighed those of market failure, and that the state’s clumsy interventions in the market – by depriving people of choice and responsibility – could do more harm than good. The experience of stagflation (the combination of inflation with high unemployment) in the 1970s also raised serious doubts about the Keynesian proposition that activist government policies were both possible and desirable. These ideas greatly influenced economic reforms in the Thatcher and Reagan administrations and led to the privatisation of nationalised industries, tax reductions to reduce the burden on businesses, curbs on union power, deregulation and the promotion of competition, and more broadly, a reduced role for government in the economy throughout the 1980s and 1990s.

In the 1990s and early 2000s, a greater awareness of the social and economic costs of unrestrained capitalism and of the inability of unfettered markets to deal with externalities and market failures led to more nuanced views on the appropriate state-market relationship. Economists such as Amartya Sen, Joseph Stiglitz, Paul Krugman and Dani Rodrik emphasised the critical interdependence of governments and markets, in which one could not function properly without the other.

While acknowledging the indispensable role of markets and prices to signal scarcity and allocate resources between competing claims, these economists and others also emphasise situations in which the unregulated interactions between economic agents can produce outcomes that are less than socially desirable. The existence of “market failures” provides a prima facie case for the Government to improve outcomes through specific interventions. Market failures can generally be classified into four categories:

• Informational failures occur when people or firms do not have sufficient information or are uncertain about future costs and benefits, and consequently cannot form stable or rational expectations about the future. In other instances of informational failure, one part of the market (e.g. the seller) has more information than another (the buyer), leading to outcomes where the party that is information disadvantaged is unable to make decisions that are in his own interests.
• Missing markets occur because prices do not always reflect the full costs or benefits to society. When markets fail to price in the external or spillover effects of one’s actions, it can lead to outcomes that are privately optimal but socially sub-optimal. Unregulated markets will tend to over-produce and over-consume goods with negative externalities (e.g. air or noise pollution); they will also tend to under produce goods with positive externalities (e.g. public health). There will also be under-provision of public goods such as national defence, which are nonexcludable and non-rival, and hence almost impossible for commercial producers to charge users for.
• Coordination failures occur when actions that are rational for an individual are irrational collectively. For instance, it is rational for individual fishermen to catch as many fish as possible, but if all fishermen did this, the fishery would collapse. This is known as the “Tragedy of the Commons”. These coordination failures are the primary reason why challenges such as global warming are so difficult to resolve.
• Monopoly power occurs because barriers to entry are significant enough to deter new firms from entering the market, hence entrenching a dominant position for the incumbent firm. In many occasions, this dominant position is preserved through anti-competitive practices such as predatory pricing and dumping. Without competitive pressure, the incumbent firm has far fewer incentives to keep prices low, provide an adequate supply and improve its products.

HOW GOVERNMENT CAN HELP MARKETS FUNCTION BETTER

The fact that market economies mostly function well might appear to be a vindication of the effectiveness of unfettered markets and Adam Smith’s “invisible hand”. Hundreds of thousands of highly differentiated products and services are readily available to consumers. To serve these consumers, firms, banks and other financial intermediaries are linked through a highly developed and sophisticated system of investment, production and distribution chains. This well-oiled system seems to run on autopilot in response to the forces of demand and supply, mediated only through prices. There is no central intelligence – neither is there a need for one – to guide or coordinate the activities of market economies.

What is often under-appreciated, however, is that well-functioning markets are embedded in a larger environment that creates the necessary conditions for their effective operation. Markets do not function as well without a certain degree of macroeconomic stability, trust and confidence that contracts will be honoured, measures to curb monopoly power, and wide acceptance of markets. These preconditions for markets to work well are achieved through establishing the right institutional conditions.

Institutions are the rules that govern and shape human interactions; such rules underpin all functioning societies and economies. Four categories of institutions, based on the work of economist Dani Rodrik, are recognisable in the most advanced economies:

• Market-enabling institutions, such as the rule of law, secure property rights and independent judiciaries, provide economic agents with the tools for conflict management and for the recognition of rights and responsibilities. They enable dispute resolution and the enactment of long-term contracts. Without such institutions, the economy would be little more than a bazaar.
• Market-regulating institutions, such as competition commissions, provide a check on the abuse of market power, improve the extent to which market prices accurately reflect social costs and benefits (for instance, through the taxation of goods which produce negative externalities), and ensure that there is sufficient competition to prevent firms from abusing whatever monopoly power they may have.
• Market-stabilising institutions, such as fiscal rules and independent central banks, reduce volatility in markets and the economy. The central bank also serves as a lender of last resort to prevent self-fulfilling banking crises due to panics. In a similar vein, fiscal rules that limit the Government’s ability to spend contribute to macroeconomic stability.
• Market-legitimising institutions are those that enhance and maintain public support for market economies. They redistribute income, provide social insurance, and are an important source of social stability. These institutions are conducive to long-term development because they help to give citizens a stake in economic development.

PRINCIPLES FOR EFFECTIVE GOVERNMENT INTERVENTION

Institutions matter because markets are embedded in a larger social and political environment; good institutions help set the rules and norms which are conducive for economic development. However, policymakers must ensure that these institutions and interventions do not “squeeze out” the effective operation of markets. Very often, the central question for governments is not state versus markets, but how governments should intervene in markets.

Based on the relative strengths of government institutions and markets, it is possible to establish a set of principles that policymakers could consider when designing or taking into account interventions:

Do no harm. Governments can make mistakes and should know its limits. There are some things that states must provide – e.g. secure property rights and national defence. However, it is useful to remember the cautionary note by Financial Times commentator and economist Martin Wolf that “the mechanism of the state is at least as defective as that of the market. Throughout history, it has been far more so.”¹ Governments should set themselves a high burden of proof that their interventions are more likely than not to improve market outcomes.

Mimic markets, and ensure the right incentives. The Singapore Government generally prefers to support and augment the proper functioning of markets, and to use price-based interventions (e.g. an externality charge) rather than through command-and-control measures such as outright prohibitions. By working through markets and prices, the Government maintains incentives for people to economise on scarce resources and to take into account the externalities they are creating.

Intervene surgically. Effective interventions target the market failure specifically, and minimise “collateral damage” from unintended impacts. The WIS scheme deals with widening income inequality by raising the wages of low-wage workers in a “surgical”, targeted manner. These limited interventions are more efficient than those that distort relative prices (such as measures to depress the prices of certain goods) or those that require large-scale government involvement to monitor and enforce.

Be prepared to rethink the case for government interventions. Finally, governments should take a pragmatic, adaptive and learning-by-doing approach when determining the right state-market balance. Technologies and market conditions change. Areas that required government intervention in the past may no longer require it, or may require it in a different form. The Singapore Government’s approach has generally been a non-ideological one. In many areas of public policy, its role has evolved significantly. For instance, in the areas of electricity generation and telecommunications, the state no longer owns and operates these utilities but performs a regulatory role.

NOTES

1. Wolf, Martin, Why Globalization Works (USA: Yale University Press, 2004)