Our new Minister for Finance on the limits of the market

The Limits of the Market: The Pendulum Between Government and Market

Author: Paul De Grauwe

ISBN-13: 978-0198784289

Publisher: Oxford University Press

Guideline Price: £25

Global leaders recently gathered in Beijing to discuss plans to spend more than $1 trillion on roads, ports and other projects in 60 countries. The One Road, One Belt initiative aims to link nearly two thirds of the global population.

As this occurred, the European Commission published a reflection paper on how to respond to a global economy where technology “will transform our lives at unprecedented speed”. It concludes that the European Union and European governments can manage this change more effectively for their citizens.

Circumstances are very different elsewhere. Venezuela is battling an inflation rate of 1600 per cent. The bolivar is now so weak that shopkeepers weigh it in an effort to measure their means of payment. The prospect of chaos is not a wearily received soundbite in this part of Latin America.

A cause of such disparate economic opportunities and risks is the balance between the market economy and the role of government. This debate is as old as the study of economics itself.

Adam Smith argued in 1776, in The Wealth of Nations, that government had an important role to play in a market economy. Contrary to perception, Smith contended that the state had a necessary role in the enforcement of contracts, the protection of property, public works and education. He argued that the collective consequences of self-interest, or the "invisible hand", enable the market economy to meet other needs.

John Maynard Keynes argued for a more interventionist role for government. He believed that the Great Depression of the 1930s demonstrated that government policy was vital to compensate for the inadequate demand generated by the market economy.

Economic pendulum

This debate, fundamental to economic policy-making, is elegantly analysed in The Limits of the Market by Paul De Grauwe. The author, a Belgian economist, is one of the leading analysts of currency and monetary unions.

He begins with an acknowledgement of the great economic pendulum or the shifting boundaries between market and state. “The triumph of the market state was visible everywhere” across the 19th century. This position ebbed due to world wars and the apparent attraction of centrally planned economies. The balance of power then shifted as globalisation turbocharged the strength of market economies. De Grauwe reflects that “it is as if market and economy are locked in a perpetual battle”.

The author explains this oscillation by questioning the limits of both market and government. He then identifies these shortcomings as either internal or external limits.

Collective or public goods are central to this analysis of the challenges to the market economy. These goods are crucial to the success of both society and economies. Examples include a good education system or a clean environment. The existence of a public good benefits everyone, however their creation is frequently difficult, with their existence relying on the contribution of all.

The role of government is clear: to provide these goods. The author contends that “the fundamental task of governments is to promote the collective interest where the market does not”.

The cause of this is the difference between individual and collective well-being. If this difference becomes too wide, and insufficient public good are available, then the prospects for the market economy are ominous. “If this happens the social consensus in favour of the free market system is undermined”.

Collective rationality

This leads to an analysis of the role of government. Three responsibilities are recognised: supplying public goods, redistribution and dealing with the consequences for all of individual choices (or externalities).

The limits of government are again caused by the difference between individual and collective rationality. De Grauwe identifies a crucial limitation. The efforts of government to redistribute wealth and income could undermine the ability of the market economy to generate prosperity. Just as the author identifies limits to support for a market system he argues excessive intervention could undermine public support for government.

As government or the market system pushes against its own limits the pendulum of support for either swings back and forth. Theories of linear progress for either system are rejected. History is a pattern of cyclical support.

This analysis yields a paradox. The stability of the market economy depends on non-market institutions. Democratic processes and bodies create the stability that allow capitalism to flourish. The creation of public goods and the enforcement of law cannot be left to the devices of the “invisible hand”. Governments and public agencies are simply vital.

So, this slim volume packs a punch. Despite this size, however, it still attempts to do a little too much. Chapters on the work of the French economist, Thomas Piketty, and the difficulties of the Eurozone are insightful and clear. However, they are slightly awkward bookends to the analysis of markets and governments.

De Grauwe also over-simplifies the sources of support for either government or the market system. He argues that the market derives support from our rationality. Governments alternatively are “the mechanism by which our emotions are expressed”. This is too simple. There are clear limitations to the role of rationality in explaining the dynamics of the market economy.

Elegant and clear

That said, there is so much to commend in this volume. It is an elegant and clear exposition of the forces that influence the shape of societies, not just economies. This makes the conclusions all the more worthy of consideration when the author asks if the market economy is locked into an unsustainable path with potentially grave consequences for all.

Economic degradation and increasing levels of inequality may lead to the “overturn of the market system”. This could happen at a time when support for political institutions are worryingly low. Prospects, in the absence of reform, could be deeply ominous.

I am more optimistic. Government interventions can be progressive and effective. International cooperation is fracturing but the EU and like-minded partners can make a big difference. However, there is no room for complacency. This superb work is not only a call to action but a compass to guide efforts.

Paschal Donohoe is the Minister for Public Expenditure and Reform.