Limits of the Market
Paul De Grauwe
London School of Economics
Wonders of Capitalism
Capitalism (market system) only system that has been
capable of providing increasing material welfare for
large parts of population.
Other systems have failed
In particular Communism
Contrast between 2 systems
Cyclical movements capitalism
If all is so well with capitalism why has it
regularly been rejected, to be reinstated later?
History of capitalism is one of cyclical
movements.
Periods of strong growth of capitalism:
Second half 19th century
1980-2008.
But capitalism becomes victim of its own success
and hits its limits.
Governments take over.
This happened in the early 20th Century and
especially after Great Depression:
Large parts of the world turned to Communism,
Elsewhere governments took over command of
economy.
marginale tarieven op hoogste inkomens
0%
100%
10%
20%
30%
40%
50%
60%
70%
80%
1900 90%
1902
1904
1906
1908
1910
1912
1914
1916
1918
1920
1922
1924
1926
1928
1930
1932
1934
1936
1938
1940
1942
1944
1946
Bron: Piketty, Capital in the 21st Century
1948
1950
1952
Hoogste tarieven personenbelastingen
1954
1956
1958
1960
1962
1964
1966
V.S.
V.K.
1968
Frankrijk
Duitsland
1970
1972
1974
1976
1978
Cyclical movements
Cyclical movements do not end when
governments take over.
These governments in turn hit their limits as
during the 1970s
From 1980s triumphant return of markets
Markets and governments seem to
permanently circle around each other,
Ready to take over when the other fails
to be pushed away by the other again.
Questions I want to raise
What are the limits that constrain the evolution of the
market and that make its success temporary?
And what are the limits of the state that each time lead
governments to retrench from the economy?
Are we condemned to repeat these cyclical movements
in the expansion and contractions of markets and
governments?
Is there a magic equilibrium possible between these
two systems?
Origin of the limits of the market
Limits arise because individual rationality and
collective rationality are not in tune.
In contrast with the “invisible hand” of Adam Smith
I will make a distinction between
External limits
Internal limits
External limits
Very generally: individuals do not take into
account the external effects of their decisions
Example of polluting firm
Creates costs outside the firm (external costs)
And does not take these external costs into account
in calculating the cost of what it produces
Nothing in market system forces firms to take these
external costs into account
These costs are not “internalized”
Effect:
Social cost of production exceeds costs imputed by
the firm
Too much is produced of goods with external costs
Environment deteriorates
As the market expands this gets worse
Globalisation enhances this
Old and new globalisation
“New globalisation” is very different from “old
globalisation” (Richard Baldwin)
Old globalisation was based on strong reduction of the
cost of moving goods, while the cost of moving ideas
and people did not decline at the same rate.
The ICT revolution has changed this
It has made it possible to substantially reduce the cost
of moving ideas.
As a result, it became possible to “unbundle”
production stages
and transfer many of these to other countries
This has created long “global value chains”
that encompass many borders
leading goods to frequently cross the same borders
while with each border crossing new components have
been added
New globalisation amplifies external costs because it
multiplies transportation
Climate change
Extreme example of this problem
Because most of the external costs cross the
borders making it impossible to allocate the
costs to all those who are responsible for them.
CO2 emission uncontrollable.
Two views: linear and non-linear
Optimistic view: the world is linear
Global warming
CO2 emission
Pessimistic view: the world is non-linear
Global warming
CO2 emission
If non-linear model prevails it will lead to catastrophe if
not stopped
Collateral damage will be imposed on market system: it
will be rejected and authoritarian systems will take
over.
This is also what happens during wars.
External costs
in financial markets
Bankers do not take into account the risks they create
outside their own banks (external risks)
These are important because banks form a network of
borrowing and lending with other banks
Domino effect when one bank gets into trouble
Banks take too many risks because they do not take
these systemic risks into account
Great instability of financial system
Internal limits
Kahneman:
System I: emotional dimension
Love, hatred, fear, sense of justice (fairness)
System II: calculating and rational
Computes costs and benefits of individual decisions
System I is fast; system II slow and “lazy”
Interaction between two systems (Damasio)
Balance between two systems necessary to make us
happy.
Market system calls upon rational and calculating
capacity of individuals (system II).
These react to financial incentives and competition.
When market system expands rational capacities
gain in importance.
They become the sole criterion of individual
success.
Other individual characteristics of the emotional
System 1 are repressed.
Many people who care about fairness in income and
wealth distribution, who have intrinsic rather extrinsic
motivations and for whom cooperation matters
are dissastified by a system that does not attach
importance to these motivations..
Market system produces a lot of material
welfare,
but represses feelings that matter to make
individuals happy
Competition and cooperation
Many individuals find a lot of satisfaction and
happiness in cooperation.
At the same time many individuals find satisfaction in
competition.
The firm is marvelous invention that combines
cooperation (internally) with competition (externally)
But when the market system expands it breaks the
balance, when inside the firm competition takes over
from cooperation.
This is often the result of financial markets with their
short-termism
Individual and collective welfare
(again)
All this can be summed up as follows: expansion
of market leads to widening gap between
individual and collective welfare
Result: system is rejected; it is perceived as
unfair, cold and brutish.
Social consensus that free market system needs
for its survival is undermined.
Increasing income and wealth inequality makes
this outcome increasingly likely..
Aandeel top 10% in totaal inkomen
50%
V.S.
V.K.
45%
Duitsland
Frankrijk
40%
Zweden
aandeel in totaal inkomen
35%
30%
25%
20%
1930 1940 1950 1960 1970 1980 1990 2000 2010
Bron: Piketty, Capital in 21st Century
Free market system (globalisation) leads to
winners and losers
Lots of winners of globalisation.
The most important winners are the hundreds of
million people (mostly in Asia) who were pulled out
of extreme poverty thanks to globalisation.
Also winners in industrial countries,
People working in export industries
Shareholders of Facebook, Google, Apple, etc.
Top football players
The losers are the million of workers in
industrial countries
Who lost their jobs
or experienced deep cuts in their wages
global elite
Increasing income
emerging markets
Decline middle
income rich
countries
Poorest
Self-destroying success
When market system hits its limits the state is
strengthened.
Dynamics is created that shrinks the market,
when market system leads to destruction of
environment
when inequality becomes unacceptable.
There is something self-defeating in market
system.
Absence of self-regulations
Capitalism is not capable of self-regulation that
will prevent hitting its limits.
These regulatory systems can only be created
and maintained by governments. .
How to marry individual and collective
rationality?
Essence of the theory
Tax those who generate external costs; this forces
them to internalize these costs.
Redistribution of income and wealth
Social security
This is necessary to save capitalism
Paradoxically those who oppose these policies
are the real enemies of capitalism.
Knowledge insufficient for action
We know what should be done
But will it be done?
Not necessarily, because governments also hit
their own limits
These make it difficult to impose the collective good on
individuals who only care about their private welfare.
Also in politics there is wide gap between collective
and individual rationality.
Limits to political system
Individual interests fight governments that want
to promote collective welfare.
This reduces the capacity of governments to act.
And creates danger that governments are
instruments of individual interests.
Key issue: what type of governance gives best
guarantees that those in power will pursue the
common interest?
Democracy:
least bad system
Challenge: bridge the gap between individual
and collective rationality.
Difficult but chances of succes greatest in
democratic systems.
In these systems consensus building about what
should be done easiest.
Allows for bottom-up pressure from the people
towards the politicians so as to force them to do
something about environment and inequality
Autoritarian systems fail dismally
Private interests infiltrate these political
systems much more than democratic
systems.
Result: discrepancy between private and
collective interests is much larger than in
democratic systems.
Weak bottom-up pressure
Cyclical movements between
market and state
History of last 200 years: cyclical movements in
power of markets versus governments.
Question is: will this history repeat itself?
If so: will the recent expansion of the market be
temporary and lead to a return of the state as
the leading force in the economy?
Is this likely to happen?
I would say yes,
It will be very difficult to control the
environmental effects of economic growth.
Negative environmental effects threaten to
become so overwhelming that they will
destabilize societies.
Authoritarian political systems are likely to
take over the commands of the economy.
Similarly the pressure to deal with inequality
may be too weak to avoid political upheaval
Conclusion
Future looks somber
But this should not be reason for despair.
Le mythe de Sisyphe
We are condemned to act.
“Il faut s’imaginer Sisyphe heureux”
