NEW PERSPECTIVES ON THE ROLE OF THE STATE

Joseph Stiglitz, Senior Vice President and Chief Economist

The World Bank

It is an honor for me to contribute to this Festschrift in honor of Mark

Perlman. Both through his writings and service to the economics profession as the long
time editor of the Journal of Economic Literature, Mark has had a lasting impact. He
sought to break out of the mold of the standard neoclassical paradigm that had come to
dominate the economics profession during the second half of this century, and equally
importantly, he encouraged others to do the same. His broad historical background not
only made clear the limitations of that approach, but also gave him a broader perspective
to look at these current fashions--he knew that they too would someday pass.
This paper is also dedicated to the memory of Professor Recktenwald. An earlier
and shorter version of this paper was presented at the occasion of my receiving the
second biennial Rechtenwald Prize, at Nuremberg, on February 4, 1998.1 The topic of
this paper reflects Professor Rechtenwalds lifelong interests in the subject of public
economics, as well as Professor Perlmans lifelong skepticism of the neoclassical paradigm
and his emphasis on the role of collective action. It puts forward a view of the role of the
state which explicitly takes into account the deficiencies of the market, yet recognizes the
key limitations of the state.
Those of us who have devoted so much of our interest to the study of public
finance and public economics more generally, do so based on three premises:
(1) Collective action is important;
(2) There is scope for improving the efficiency and responsiveness of government;
(3) Rational, scientific analyses combined with careful historical research can shed light on
how this can be most effectively done.
1

On that occasion, Professor Neumann presented an excellent account of my contributions to the

My experience over the past five years in the White House and at the World
Bank, has reinforced my conviction on each of these counts and my belief that there is
much that the public sector can do both to improve its performance and to improve the
lives of the people whom it is supposed to serve.
I want now to describe how theory, experience, and history have changed our
perspectives on the answer to four key issues:
(1) What government should do;
(2) At what level of government should various activities be conducted;
(3) How government should do what it does;
(4) How government relates to its citizens.
First, on the question of what government should do. The question most often
posed is whether government is too large. But this is not really the central issue. The
key question should be, is the government doing the right thing?
Our thinking about this has developed through several stages in recent decades.
Adam Smith, who is often interpreted to have provided the rationale for why markets are
better than government in addressing economic needs, actually imparted a more nuanced
message. He recognized the importance of collectively provided goods, the role of the
government in providing certain goods such as education. Over the succeeding 150 years,
this perspective became refined into what I call the market failures approach. The
market provides too much of some goods like pollution and too little of other goods
like research. About a decade ago, my research with Bruce Greenwald showed that the
scope for market failure was much greater than had previously been realized. We showed
that in the presence of incomplete markets and imperfect information, the market
equilibrium would not even be constrained Pareto optimal.2
In the meanwhile, a counterattack, attempting to delimit the scope for government,
was launched. It had three arguments: that government is harmful, that it is ineffective,

economics of information, for which I am greatly indebted.

2
See Greenwald and Stiglitz, (1986).

and that it is unnecessary. The extreme versions of these statements may be a peculiarly
American preoccupation, but the general ideas have spread across the globe and are used
in almost every discussion of policy.
The first proposition, that government is necessarily harmful to growth and
development, can be easily to refuted by pointing to East Asias progress over the past
few decades.3 Marked government intervention did not seem to impede the rates of
growth in Korea, Thailand, Singapore or the other high-performing East Asian economies.
In contrast, I would argue that the governments intervention has actually had an
enormous effect in promoting this unprecedented rapid economic growth, growth which
the recent crises, despite their severity, have not erased. This is not the place to discuss
the causes of those crises, but let me simply note that in many ways it was the
consequence of the state doing too little in some areas, i.e. pursuing rapid financial
liberalization without strengthening regulation or supervision.
A glance at the history of the United States development demonstrates that the
idea of selective state activism is not new. The U.S. government provided the initial
information and expertise for several key sectors which have contributed strongly to
United States growth. The federal government basically founded the telecommunications
industry, for example, when it financed the first telegraph line between Baltimore and
Washington in 1842. The state withdrew as soon as it had demonstrated the viability of
the new technology allowing subsequent development to come from the private sector.
The states catalytic role remains quite clear. More recently, the Internet was developed
by the Federal Government for a very small cost in relation to the huge effect it has had
on the way modern businessand increasingly modern lifeis conducted.
3

For a review, see World Bank (1993) or Stiglitz (1996). Among the most ardent advocates of the view
that governments have had adverse economic impacts has been Milton Friedman. See for instance
Friedman [1996 (1962)]. While he persuasively identifies several important instances in which
governments have had negative impacts, a full account must balance these failures with the successes; and
while there have been isolated cases of strong growth with a very limited role of government (e.g. Hong
Kong--but even there government played a much larger role, e.g. in housing and infrastructure, and
financial market regulation--than advocates of free market doctrines typically recognize), these are the
exception. The major success stories, from the United States, to Japan, to the other Asian tigers, all
involved governments assuming key roles.

I could easily give other examples of successful state activism over the past few
centuries. Most people believe, for example, that the enormous increase in productivity
of agriculture in the United States in the 19th century can be traced back to the
establishment of the Land Grant colleges in the Agricultural Extension Services that began
in 1863 by the Morrell Act. More broadly, the role of the Federal Government in
education in the United States actually began in 1785, even before the U. S. Constitution
was ratified.
Although it is unambiguously clear that governments do make mistakes, the
previous examples show that it is far from clear that governments are harmful. On
balance, the impressive list of government achievements -- stimulating economic growth,
attacking inequality, and providing safety nets to provide just a few examples -- shows
that the state can be a beneficial partner in growth and development, and in raising living
standards more broadly.
Anecdotes of success or failure are, perhaps, not as convincing as the argument
put forward by critics of a large governmental role, who contend that governments
necessarily have adverse effects. They look for behaviors that are inherent in the political
process, identifying discrepancies between incentives of politicians and those of the
people they are supposed to serve.4 Such agency problems are important, but of
course they arise in the private sector as much as they do in the public; and they are more
important in those lines of activity where performance in general (and individual output in
particular) is hard to assess.5
The discussion below shows how today governments, like businesses, can work
to mitigate these problems. The more general point is that the presence of such problems
is a factor which determines what government should do or how it should do it; but there
are still key roles which government needs to perform, as discussed further below.
Among these, one of the more widely accepted is that of stabilization. But critics

4
5

See, e.g. Buchanan (1986).

See Edlin and Stiglitz (1995)

of government action (like Milton Friedman) have even argued that in this realm
government has failed. But these criticisms of governments macro-economic
performance is not substantiated by detailed empirical analysis. Stiglitz (1997) shows
that since World War II economic downturns have been shorter while expansions longer
than prior to World War I, and that, while in the earlier period, downturns were
predictable (and thus, presumably, could have been avoided by timely government
actions), since World War II, they have not been. Stiglitz interprets this to suggest that
government has taken actions to offset any anticipatable downturn; it is only
unexpected events--like the oil price shock--that give rise to downturns. By contrast,
in the earlier period, recoveries were random; since World War II, the longer the
downturn, the more likely the recovery in the following period. Again, Stiglitz interprets
this to imply activist government policies limit the duration and severity of recessions.
The evidence from the United States and East Asia also addresses the second
critique of the state: the statement that anything the Government does will be undone by
the private sector.6 This second argument about the states ineffectiveness is used most
often in the debate about monetary policy, but even this narrow argument contains flaws.
The theorems developed by new classical macroeconomics that demonstrate
governments inability to affect the economys expansion and contraction, for example,
rely on very special assumptions that account neither for the asymmetries of information,
the lags in responses, nor for the governments inability to change the relative prices faced
by firms and households. A closer look at the literature shows that, in fact, private sector
reactions generally do not undo the actions of the Government.
The final critique of the state is in some sense the deepest question: Why do we
have a Government in the first place instead of just voluntary organizations, firms,
households, and collectivities?7 I would answer that question by invoking the welldeveloped theory of collective goods. Although recognition of the scope for voluntary

6
7

This idea has been most closely associated with Lucas (1976).
See, e.g Coase (1960).

organizations and collective action taken by voluntary organizations has grown over
recent years, few would argue that public goods such as national defense could be
privately provided without a real problem with free riding.8 Most societies have
recognized this and allowed the state, the only organization with universal membership
and certain powers of compulsion, to intervene and alleviate this free riding problem.9
Everyone in a particular area must be a citizen of the relevant state, and this citizenship
includes both obligations and benefits.

The Limitations of the State

Despite its unique powers, however, certain constraints prevent the state from
competing effectively with the private sector. The first set of constraints are prudential
restrictions created by citizens. Most societies have recognized that the same
characteristics that enable the state to promote the collective good can and have been be
used for damaging ends. Legal frameworks of due process, mandatory provisions for
equal treatment, and extensive regulation of the civil service are some of the most common
examples of the ways that these dangers have been addressed. Although prudential, these
constraints also mean that the Government cannot function as effectively as the private
sector. A public sector supervisor, unlike a private manager, cannot simply hire the
person he or she believes to be the best for the job and pay him or her accordingly. On
the one hand, these kinds of regulations make sense as safeguards against corruption and
cronyism in the government. They prevent the taxpayers from having to pay unjustly
high salaries to people whose skills have been mistakenly overvalued. On the other hand,
civil service codes can make it difficult for the government to attract good workers.
The second set of constraints has to do with the nature of the government and its

Even in the case of externalities when information about impacts on different individuals is imperfect and
costly to obtain, voluntary solutions may not work well. See, e.g. Farrell (1987). Transaction costs, too,
may be far higher for voluntary solutions.
9
For a more extensive discussion of these perspectives, see Stiglitz (1989)

inherent lack of ability to make binding commitments. The Government enforces the
commitments of the private sector, but it cannot make commitments of the same kind. To
be sure, courts can ensure that legislation complies with the Constitution and that the
government fulfills its contracts with private citizens. But ultimately, the only device the
government as a whole can use to enforce its commitments is to create transaction costs,
the cost of revising or reneging on its agreements. These range from very low in the case
of a politicians campaign pledge to very high in the case of constitutional provisions.
Nevertheless, the state can basically break almost any commitment if it is willing to
undertake those transaction costs.
In summary, the state has both powers and limitations which set it apart
distinctly from other forms of organization in our society. There are different ways in
which societies can engage in collective actions, each with their strengths and weaknesses;
and different extents to which collective and private actions can be used to address
societal needs. We should focus our attention on determining what blends of public and
private action are most effective, e.g. in addressing the market failures and distribution
issues that motivate the need to go beyond pure market solutions. And the answer will
depend on the circumstances of each country; while market failures may be more
significant in less developed countries, so too the ability of government to address them
maybe more limited. Thus, there is not even an a priori view about the appropriate
scale of government in the process of development.

Evolution of Thought about the Role of the State

Thought about the appropriate role of the state has evolved through three main
stages over the past 50 years.
We accepted and in fact encouraged a large role for the state in the years just after
World War II. Russias success in growing from a less developed state to what seemed, at
the time, to be a modern economy, was considered by some to be an inspirational model.

There was an emphasis on planning and many countries went so far as to establish
planning commissions. The planning mentality influenced the way people thought about
politics as well; some textbooks written around that period agonized about a trade-off
between democracy and economic growth. Within the World Bank, my predecessor
Hollis Chenery contributed many interesting ideas as well as some very sophisticated
planning models to the debate.
Nevertheless, a growing number of economists believed that these models left out
incentives, institutions, and other key factors that make economies work. The belief in the
value of the large planning state began to erode in the 1970s and even Chenerys later
work demonstrates his growing understanding of the limitations of the planning approach.
The intellectual basis for central planning came under strong attack on the grounds that
one simply could not have the level of information required to run a modern, complex
economy in any centralized place. Given these limitations it is not surprising that their
success was short-lived. People in the highly interventionist countries sacrificed
economic opportunities as well as democracy and freedom.
We should remember, however, the origins of the planning-interventionist
strategies: markets by themselves seemed to have failed to generate development. The
market failures approach, to which I alluded earlier, provided a theoretical structure which
helped explain why markets could not be relied upon. But the problems were even
deeper: they concerned inadequacies in entrepreneurship and innovation, topics which the
traditional economics paradigm gave short shrift, though they had been at the center of
some of the earlier discussions of development, e.g. Schumpeter [1942, 1986 (1946)].
As the limitations of the central planning in the Soviet system became apparent, many
sought to combine the allocative efficiency of free-market prices with socialism to create
market socialism. Nevertheless, I would argue that the idea of market socialism really
failed to understand what makes market economies work. In Whither Socialism I
attributed this flaw in market socialism to misguided notions within neoclassical

economics.10 Market socialists believed strongly in the power of the price system partly
because neoclassical economics claimed that prices were the core mechanism that makes a
market economy work. We now realize however, that this neoclassical paradigm leaves
out entrepreneurship, innovation, and other important dimensions that are central to the
market economys success. Market socialist economies may have been a bit more
successful than the command-and-control economies, but they still did not capture the
whole flavor of the market economy and clearly did not achieve anything like what those
who advocated this approach had hoped.
A general consensus that planning and state intervention was not likely to deliver
economic progress formed by the end of the 1980s. Nearly all economists recognized that
the government couldnt run everything and many went further to argue that government
was the problem rather than the solution.11 The prevailing line of thought gave markets a
primary place and assigned the very limited role of correcting market failures to the
government. Market failures were narrowly defined as well, leaving government to focus
on maintaining income stability, providing public goods, and correcting major externalities,
like those associated with the environment.
Dissatisfaction with this particular perspective grew as many countries followed
these policies without achieving much higher growth. In contrast, we witnessed the
experience of the East Asian countries who achieved rapid growth without following
many of the prescriptions, especially the ones pertaining to liberalization and
deregulation.

States as a Complement to Markets

This led to the third view, which places markets at the center, but recognizes that

10

The pendulum seemingly swung from one extreme to another: from a very strong role of Government, in
the planning models, to the opposite extreme that stressed a minimalist role for government and
emphasized government failures (such as those that resulted from rent-seeking) rather than market failures.
11
See, for example, Krueger (1986, 1990).

governments play an important role in making markets work well. It sees the role of the
state not just to implement Pigouvian taxation to correct externalities but to complement
markets by helping provide the information and institutional, human and physical
infrastructure required for markets to exist and function well.
The working of the financial sector illustrates the complementarity between the
state and the market. We all recognize the importance of the financial sector, for example.
In the wake of the Mexican crisis in 1995 and the more recent crises in East Asia, the
topic is getting a lot more resonance than usual, but even before that there was
widespread recognition of the importance of a healthy financial sector because of its role
in mobilizing and allocating savings. We should all recognize the role of the state in this
sector: virtually every country that has an effective financial system has a large regulatory
role for the government and a strong legal system that protects the rights of minority
shareholders.
The Czech experiment in developing capital markets highlights the importance of
these legal foundations for capital markets. A weak legal structure and the absence of a
securities and exchange commission has allowed companies to, in effect, steal from the
minority shareholders. People have no confidence in a securities market where these
kinds of events can occur.12
Government action in the financial sector can be seen as illustrating the
complementarity between the state and private sector. When the government performs its
regulatory role well, the private sector can also perform its role well, with competition
among the financial institutions for gathering funds and performing efficient financial
intermediation.
The evolution of the technology in telecommunications and electricity sectors
demonstrates the need for flexibility in determining the extent of state involvement. We
used to think of electricity and telephone services as natural monopolies where one could
have either a state enterprise or a single firm and a strong regulator to prevent abuse of
12

See Levine (1999).

10

monopoly power. Economics departments taught this approach and countries

throughout the world practiced it. Changes in technology, however, have forced us to
alter our views. We were slow to recognize the developments which reduced the scope
for natural monopoly and made some forms of competition quite viable, but we now
realize, for example, that we can have competition in the generation of electricity. Longline transmission may still be a natural monopoly, but several countries including the
United States and Britain have moved to an open-access system where anybody can link
their generating plants to the transmission grid. These countries now have effective
competition and less state involvement in electricity generation.
Telecommunications policy has evolved in a similar fashion and, while local
service remains highly concentrated, long-distance service has become quite competitive.
The role of the state in these sectors has had to be redefined along the way. Regulatory
concerns in these sectors have changed, for now regulators must watch to make sure that
particular elements of natural monopoly are not leveraged to get monopoly control over
other potentially competitive sections of the industry.
The meat-packing industry offers a mundane, but illustrative, example of need for
flexible, evolving, government action in the face of changing technology. Government
regulation of the meat-packing industry began as a confidence-inspiring measure to assure
citizens that the meat they bought was safe. After Upton Sinclairs The Jungle
graphically exposed the unsanitary conditions in Chicago stockyards, meat-packing
companies themselves pushed for more stringent state regulation. The government
complemented the private sector by establishing a credible system for visual inspection.
With the discovery of nearly-invisible disease-causing microbes and advances in
microbiology, however, the government has had to adapt its inspection strategy. As the
government has switched to more sophisticated risk analysis systems, it has had to
overcome opposition from the meat inspectors. With the advent of meat irradiation, it
has also had to prove the safety, rather than just the efficacy, of its techniques. There has
clearly been a constant role for the government in ensuring meat safety, but how it

11

performs this duty has changed significantly over the years.

Although we can still create a long generic list of the core elements that the
government must provide to complement the private sector, we have become increasingly
aware the ideal role of the state in each country is more difficult to determine. The role of
the state in providing the institutional infrastructure of an economy has become more
apparent. We recognize that this may be one of the most important ingredients in
differentiating between the economies that have been successful in economic growth and
development and those that have not.
Indeed, it is increasingly recognized that the failure of so many of the countries in
the former Soviet Union to make an effective transition to a market economy was
precisely because they failed to provide the institutional infrastructure (e.g. the legal
underpinnings) for a market economy.
What the government should do will clearly change with the changes in technology
and the changing circumstances of each country--with changes in the market and the
institutional capacity of government. But while there is no simple formula, no single
recipe, the analysis of this section should have made clear that what is required is
balance: more than a minimalist role, but less than an all-encompassing role, a role in
which the government focuses on areas of relative strength, where there are well identified
lacuna in the market. But the market complementarity view goes beyond the simplistic
approach which says that certain areas (like defense) should be the domain of the public
sector, while others (like making steel) should be the domain of the private. The public
and private sectors often need to work in tandem as partners within the same arena, as
we noted in the context of financial markets.

At What Level Should the State Act?

Throughout the world, there is increasing emphasis on devolution and
decentralization, on the notion that more of the responsibilities of government should be
conducted at the local level. The motivations for these changes are complex--involving

12

matters of politics as well as principles. I do not have time here to review all the relevant
considerations, but I do want to target a theme which I stressed in the previous section:
that changes in the world necessitate rethinking the appropriate balance.
From the normative perspective, there are two simple principles: The first
principle states that decisions, the impact of which is local, should be made locally: local
public goods (public goods, the benefits of which are received by those in a particular
locality) should be provided by local communities. To enhance the likelihood of
congruence between marginal (social) benefits and costs, those who benefit (the local
community) should also be made to pay, as federal subsidies tied to the provision of
particular local public goods may lead to distorted resource allocations.
But devolution of decision-making and finance is not without its costs: there may
be limits in the extent of redistribution. Localities cannot impose taxes on mobile factors
(such as capital), since they respond by moving to a locale with lower taxes. Localities
may have difficulties in imposing taxes on higher income individuals, because they too are
mobile. Redistribution thus must occur at the level of the nation-state--though even this
is becoming more problematicincreasing globalization renders many high-income factors
highly mobile across nation-states.
Thus, in the United States, there was a great deal of concern that delegating more
responsibility for welfare to the states (and providing them with lump sum funds) would
result in a race to the bottom. By lowering benefits, each state could not only reduce
its tax burden directly (thereby making itself more attractive to high productivity mobile
factors), but the lower welfare payments would induce out-migration of welfare
recipients, reducing the burden on taxpayers further. The empirical evidence in support
of this race to the bottom seems weaker than theory might have predicted.
More broadly, while globalization has restricted the scope of actions of the nation
state, the stress on devolution has taken away other responsibilities, leaving the national
state potentially far weaker.
The debate about devolution/decentralization involves several other elements:

13

participation and voice (the importance of which is stressed in the discussion below) may
be more effective at the local level; decentralization enables decisions to be made that
more accurately reflect the preferences of the citizens and that employ their local
information; decentralization may enhance democratic accountability. Finally, the
devolution of decision making may allow for more experimentation.
But there are factors (beyond the limitations on redistribution) which militate
against decentralization. There is, in particular, concern that the capacities (for decision
making/governance/administration) at the local level may, in some places at least, be weak.
Perhaps the strongest drive for--and the greatest reservations concerning-devolution are associated with politics: Many advocates of devolution of welfare
believed, for instance, that support at the state level for welfare would be weaker than at
the national level. Devolution was thus a strategy for cutting back welfare. And these
concerns were precisely what motivated welfare advocates to oppose devolution. There
is not a well developed theory to explain why the constellation of political forces that
play out at the local/state level should differ from those at the national level, but there is
evidence that there is indeed a difference.

How Should the State Act? Market-like Mechanisms and Participation

Until recently, the preoccupation with shrinking the size of the state led many
economists to neglect the vital task of understanding how to improve the state. In the last
few years, both through the observation of the private sector and of successful
governments, we have developed a much better idea of how the government can function
better.
An important component is the use of market-like mechanisms. One lesson from
successful states is that they use market-like mechanisms to improve their efficiency.
These include:

14

(i) Using auctions both for procuring goods and services and for allocating public
resources
(ii) Contracting out large portions of government activity
(iii) Using performance contracting, even in those cases where contracting out does
not seem feasible or desirable
(iv) Designing arrangements to make use of market information. For instance, it
can rely on market judgments of qualities for its procurement (off-the-shelf
procurement policies); it can use information from interest rates paid to, say,
subordinated bank debt to ascertain appropriate risk premiums for deposit
insurance.

Another lesson governments can learn from businesses is to be more responsive to

citizens. This is well-illustrated by the United States Reinventing Government
initiative. Based on observing the private sector, our first step was to ask each
department in the government for a statement of purpose and suggestions for improving
the ways in which their actions contributed to this purpose. This participatory exercise
helped set an agenda for where the reforms would go. In some areas we could combine
the two main innovations, client responsiveness and performance measures. We found
that surveys were very helpful performance measures which improved our client
responsiveness. The success of strategy was particularly evident in Social Security. We
found that just by changing the vocabulary and treating citizens as clients, we made
progress in changing the attitudes of public agencies.
Although government has much to learn from business, there are important
differences between the two. In most of its core areas, government has a dominant
position if not a monopoly. That is why the participation, voice to use Hirschmans
term,13 is so important, to determine not just what the government does but also how it
13

Hirschman (1970).

15

does it. This not only makes governments serve the interests of its citizens rather than its
own interests, but also can help it implement policies more effectively. Michael Bruno,
for instance, emphasized the importance of consensus building in ending inflation.14 The
reason for this should be obvious: if workers believe that they are not being fairly treated,
they may impose inflationary wage and other demands, making the resolution of the
inflationary pressures all but impossible.
At the microeconomic level, government aid agencies and non-governmental
organizations have been experimenting with ways of providing decentralized support and
encouraging community participation in the selection, design and implementation of
projects. Recent research provides preliminary support for this approach: one study
found the success rate for rural water projects that involved participation was
substantially higher than the success rate for those that did not.15 It is not just that
localized information is brought to bear in a more effective way; but the commitment to
the project leads to the long-term support (or ownership in the popular vernacular)
required for sustainability.
Both in the public and in the private sector there are important agency problems,
where the interests of managers (politicians, bureaucrats) differ from those that they are
supposed to serve. There will never be a perfect congruence of interests, a complete
resolution of agency problems, especially in areas where appropriate performance criteria
is hard to define and performance is hard to measure. But openness in government and
the encouragement of greater participation may reduce the magnitude of these agency
problems in the public sector, and at the same time dispel some of the distrust between
government and those that it is supposed to serve.16
CONCLUDING REMARKS
I began this lecture with the observation that collective action is important. What
14

Bruno (1986)
See Narayan-Parker (1995)
16
See Stiglitz (1999) for a discussion of the eviscerating role of secrecy, even in modern democracies such
15

16

the government should do and how it should do it needs to evolve, with changes in the
world (including changes in technology) and with our changing understanding of that
world. Research in the economics of the public sector has, I believe, enhanced our ability
to redefine the role of the state, and provided us insights into how to make the
government both more efficient and more responsive. The challenge is to translate these
understandings into practice: to create a modern public sector, more able to provide
effectively those collective goods which are so essential to the well-being of all of us.

as the United States.

17

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