Our future economic success rests on the balanced sum of state and market

PUBLISHED : Saturday, 14 April, 2012, 12:00am
UPDATED : Saturday, 14 April, 2012, 12:00am


The more I study the Indian and Chinese growth models, the more I realise that the debate over the state versus the market is a false dichotomy. Both the state and the market are inseparable, interactive and interdependent social institutions.

Human development is a complex interaction between the two. In the words of Small is Beautiful author E.F. Schumacher, '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 state's leading role in planning for development. But those states that have worked with markets have done better than those that worked against them.

London Business School professor John Kay defines the market as a relatively transparent, self-organised, incentive-matching mechanism for the exchange of goods and services. In other words, the market helps to match willing buyers with willing sellers under certain rules to determine market price. Market failure happens when the market is imbalanced.

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, the national state is not in total control of our destinies, and state policies on money, exchange rates and trade cannot be independent of what is happening globally.

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

In the 19th century, most governments were not larger than 15per cent of gross domestic product. By 1960, their size in OECD countries had doubled to 30 per cent. Today, the average is 40per cent. The state has grown because of greater demand for state services, but there is also concern that bureaucracies tend to grow to perpetuate themselves.

It's 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 the power to the state to protect them and fairly enforce social rules. 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, each with their own departments and even enterprises. Most citizens find it difficult and confusing to deal with complex bureaucratic power. 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 the results of governance failures. As the European debt crisis amply shows, financial markets cannot clear when the state is on shaky fiscal ground and there is no mechanism to make fast, simple, clear decisions.

Finding the right balance between the state and market is the real challenge in all economies today. As British philosopher Bertrand Russell said, '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 the 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 embarking on ambitious 12th five-year plans to change their growth models to become more environmentally sustainable, more socially inclusive economies.

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. There are complex trade-offs between winners and losers in each society. Such bargains are difficult when the causes and effects of losses, such as crises, are unclear, and when vested interests resist change for fear of losing what they have. Politics is the compromise of contending interests.

The belief that markets are always right assumes that markets always balance. The market cannot balance when the state cannot balance the contending interests. The main reason for the debt crisis in advanced countries is the move to push the costs of consumption today onto future generations.

This raises a fundamental problem. Whichever way you term it, central bank 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 markets are saying that there are limits to the euro public debt. At the same time, global financial markets are watching to see if inflation in China and India will rekindle global inflation.

The anchor of global financial stability rests on state debt stability. The state cannot escape being priced by the market.

Andrew Sheng is president of the Fung Global Institute