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Why the State and Market Must Work Together

From the Fung Global Institute:

Many of the current economic and financial problems trace their roots to governance failures, says Fung Global Institute President Andrew Sheng. That means the solutions lie in finding the right balance between the state and the market -- which is precisely what China and India are trying to do now. The more I study the Indian and Chinese growth models, the more I realise that the current debate over the state versus the market is a false dichotomy.  Both the state and the market are social institutions that are not independent of each other.  Indeed, they are inseparable, interactive and interdependent.    Human development or evolution is a complex interaction or feedback between the two.  In Small is Beautiful, EF Schumacher wrote: “Maybe what we really need is not either-or but the-one-and-the-other-at-the-same-time”.  India and China could not have become global powerhouses of growth without the leading role of the state in planning for development.  But those states that have worked with markets have succeeded better than those that worked against markets.

Professor John Kay of London Business School defines the market as a relatively transparent, self-organised, incentive-matching mechanism for the exchange of goods and services, usually in monetary terms.   In plain language, the market helps to match a willing buyer and a willing seller under certain rules of the game to determine the market price.   The market clears when it functions properly, but market failure occurs when it is imbalanced.

Professor Kay reminds us that capitalism is less about ownership than “its competitive advantages – its systems of organisation, its reputation with suppliers and customers; its capacity for innovation”.
Because of globalisation and technological change, we are living in a situation of change within change, as if the nation state is not in total control of our destinies. State policies over money supply, exchange rates and trade cannot be independent of what is happening globally.   No man, no company, no state is an island. Globalisation has changed the rules of the game irreversibly.

Why is the state so much bigger and more powerful than before?

In the 19th century, most governments were not larger than 15 per cent of GDP, in terms of their expenditure. By 1960, the size of governments in OECD countries had doubled to 30 per cent of GDP. Today, the average has increased further to 40 per cent of GDP.   The state has grown because there has been demand for more and more state services. But there is also concern that bureaucracies tend to grow to perpetuate themselves.

I find it useful to think about the state as a market-like institution for the exchange of power (in non-monetary terms). Power comes from social delegation – the people give power to the state to protect them and to fairly enforce social rules and laws.   Hence, the “state as market” has the same dilemmas as the market – information asymmetry and the principal-agent problem.

In large countries like India and China, there are many levels of government – central, provincial, city, town, village and rural governments – each with its own departments and even enterprises. Most citizens find it difficult and confusing to deal with complex bureaucratic power. The Peruvian economist Hernando de Soto was one of the first to point out that rural poverty exists because the poor’s property rights are not protected adequately, and their transaction costs are extremely high because of complex government. In other words, markets are efficient and stable, when the state is efficient and stable.

It is not surprising from recent experience that financial crises are results of governance failures.   As the European debt crisis amply demonstrates, financial markets cannot clear when the fiscal condition of the state is on shaky grounds and when there is no mechanism to make fast, simple, clear decisions.

Finding the right balance between the state and the market is the real challenge for all economies today.   As 20th century British philosopher Bertrand Russell reminded us, “people do not always remember that politics, economics and social organisation generally, belong in the realm of means, not ends”.   Today’s demands on the state to provide stability, growth and social equity are complex, because recent dominance of free market ideology has led to serious problems of wealth and income disparities and environmental degradation. Realising that large states with geopolitically significant human and ecological footprints cannot consume like the US or Europe on a per-capita basis, China and India are each embarking on ambitious 12th five-year plans to change their growth models so that their economies are more environmentally sustainable, with greater social inclusiveness.

But large economies with many layers of government struggle between centralisation and decentralisation of people, resources and power. For systems to be stable and sustainable, they have to be adaptable to complex forces of change from internal and external shocks.   To maintain integrity, there are complex trade-offs between winners and losers in each society. Such rules and bargains are difficult when the causes and effects of losses are unclear (such as crises), and when vested interests resist change for fear of losing what they have. Vested interests are often unwilling to change because they value present gains far more than uncertain futures. Politics is the compromise of contending interests.

The belief that markets are always right assumes that markets always balance. The market, however, cannot balance when the state cannot balance contending interests. The main reason for the advanced countries’ debt crisis is that they are postponing the cost of their present high level of consumption to future generations.

This raises a fundamental problem. However you call it, central banks’ quantitative easing is ultimately state intervention. The rise in Spanish bond yields, despite the European Central Bank’s long-term refinancing operations, suggests that the market is believes there are there are limits to the growing euro public debt. At the same time, global financial markets are watching carefully whether inflation in China and India will rekindle global inflation.

In other words, the anchor of global financial stability rests on state-debt stability.   Even the state cannot escape being priced by the market.

For a detailed presentation of "Systemic Statecraft for Managing New Green Inclusive Growth" click here.

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