Market vs.

State ALPI 2023

Adnan Muminović
 Ideas have consequences…
• No stronger evidence of the power of ideas exists than the fact that totalitarian
governments, without exception, go to extreme lengths to control the ideas that people
encounter. If ideas have no consequences, dictators and tyrants would spend no energy
and treasure on preventing people from publishing whatever they please and saying
whatever they wish. Nor would governments waste money on spreading propaganda;
• Consequently, widespread misconceptions about the market and the state inevitably
lead to economically harmful policies;
• What we think, we become…
• What we are interested in macroeconomics, amongst other things, is the role that the
state has in managing the economy, with the aim of (ideally) promoting the common
good;
• However, before we turn to the role of the state, let us marvel about the miracle of the
market.
Positive and Normative Statements
• In general, statements about the world are of two types: Positive statements are
descriptive. They make a claim about how the world is. Normative statements, on
the other side, are prescriptive. They make a claim about how the world ought to
be;
• A key difference between positive and normative statements is how we judge their
validity. We can, in principle, confirm or refute positive statements by examining
evidence. By contrast, evaluating normative statements involves values as well as
facts. Deciding what is good or bad policy is not merely a matter of science. It also
involves our views on ethics, religion, and political philosophy (Mankiw, 2008);
• Confirmation bias;
• President Harry Truman once said that he wanted to find a one-armed economist.
When he asked his economists for advice, they always answered, “On the one
hand, … On the other hand…”
 The Differences
• At the beginning, it is important to note that, throughout this
presentation, these differences should be understood in terms
of ‘ideal types’ — a concept which was developed by Max
Weber in order to better understand problems;
• Furthermore, as noted by Rodrik, in their zeal to o promote
the power of markets, leading liberal economists drew too
sharp a distinction between the market and the state and, in
effect, presented government as the enemy of the market.
They therefore blinded us to the evident reality that all
successful economies are in fact mixed.
 The Miracle of the Market

• When we talk about the free market, we have a tendency to

personify, or to anthropomorphise it. It’s as if we attribute
certain emotions or intentions to it. Yet, the free market is
exactly the opposite of that;
• According to Polanyi, a market economy is an economic
system controlled, regulated and directed by market prices,
while the order in the production and distribution of goods is
entrusted to this self-regulating mechanism.
 The Miracle of the Market

• Every day each of us uses innumerable goods and services…

We never stop to think how many people have played a part in
one way or another in providing those goods and services…
 The Miracle of the Market

“One of the most notable facts of life in modern market

economies is that each and every one of the things that we enjoy
as consumers is something that no person knows in full how to
produce.”
— Donald Boudreaux, The Essential Hayek —
 The Miracle of the Market
Look at this pencil…

• None of the thousands of persons involved in producing the pencil

performed the task because he wanted a pencil. Some among them
never saw a pencil and would not know what it is for…
 The Miracle of the Market

• What brought them together and induced them to cooperate?

“It is natural to assume that someone must give order to make
sure that the ‘right’ products are produced at the ‘right’ amounts
and available at the ‘right places’. That is one method of
coordinating the activities of a large number of people — the
method of the army.”
— Milton Friedman, Free to Choose —
 The Miracle of the Market
• Adam Smith maintains that most productivity gains
occasioned by market exchange come from the division of
labour, or specialisation, as well as the pursuit of the peoples’
self-interested. In one of the most famous thoughts in
economic history, Smith finds that ‘it is not from the
benevolence of the butcher, the brewer, or the baker, that we
expect our dinner, but from their regard to their own interest.
We address ourselves, not to their humanity but to their self-
love, and never talk to them of our own necessities, but of
their advantages.’
 The Price System - A Mechanism for
Communicating Information

“Adam Smith’s flash of genius was his recognition that the

prices that emerged from voluntary transactions between buyers
and sellers — for short, the free market — could coordinate the
activity of million of people, each seeking his own interest, in
such a way as to make everyone better of.”
— Milton Friedman, Free to Choose —
 The Miracle of the Market
• Hayek inquired about the best way of utilising knowledge, stressing
that the dispute is not about whether planning is to be done or not —
since all economic activity is is some sense planned — but whether
planning is to be done centrally, by one authority for the whole
economic system, or is to be divided among many individuals;
• ‘The data, from which the economic calculus starts are never for the
whole society given to a single mind (i.e. the state) which could
work out the implications and can never be so given… The
knowledge of the circumstance of which we must make use never
exists in concentrated of integrated form but solely as the dispersed
bits of incomplete and frequently contradictory knowledge, which
all the separate individuals possess.’
 The Miracle of the Market

“If we possess all the relevant information, if we can start out

from a given system of preferences, and if we command complete
knowledge of available means, the problem which remains is
purely one of logic... This, however, is emphatically not the
economic problem which society faces.”
— Friedrich Hayek, The Use of Knowledge in Society —
 The Miracle of the Market

• Hayek noted that ‘man has been able to develop that division
of labour on which our civilisation is based because he
happened to stumble upon a method which made it possible’
i.e. the price system.
 The Price System - A Mechanism for
Communicating Information

“We must look at the price system as such a mechanism for

communicating information if we want to understand its real
function… The most significant fact about this system is the
economy with which it operates, or how little the individual
participants need to know in order to be able to take the right
action.”
— Friedrich Hayek, The Use of Knowledge in Society —
 Transmitting information
• Suppose that, for whatever reason, there is an increased demand
for lead pencils. Stores will order more pencils from their
wholesalers, who will order them from the manufacturers. They,
in turn, will order more wood, more brass, and more graphite
used to make the pencil;
• In order to induce their suppliers to produced more of these
items, they will have to offer higher prices for them;
• The producers of wood do not know whether the demand for
pencils has gone up because of a baby boom, or because 14.000
more government forms have to be filled out in pencil — and that
doesn’t even matter.
 Transmitting information

• Suppose that a forest fire or strike reduced the availability of

wood…
• Or, what happens if oil prices rise? Hand saw vs. chain saw.
 Providing incentives

• One of the beauties of a free price system is that the prices

that bring the information also provide both an incentive to
react to the information and the means to do so;
• Prices provide an incentive to act on information not only
about the demand for output, but also about the most efficient
way to produce a product.
 Distributing income

• Skills and effort.

• However, in every society, however it is organised, there is
always a dissatisfaction with the distribution of income;
• On the other side, if your income will be the same whether
you work hard or not, why should you work hard.
 The Miracle of the Market
“Our modern prosperity springs from the use of the knowledge of millions
of diverse individuals spread across the globe. This knowledge is typically
very detailed, local, and quickly changing. No government can ever
collect such knowledge and then properly digest and productively act
upon it. The only practical way we know to ensure that as much of this
knowledge as possible is discovered, properly digested, and productively
acted upon is to rely upon millions of people each to discover a few “bits”
of this knowledge and then, individually, to put each of those bits to use.
By dividing among millions of people the task of discovering and acting
upon knowledge, no one person is overwhelmed with having to absorb
and use more knowledge than is humanly possible.”
Donal Boudreaux, The Essential Hayek
The Tension between Planning and Freedom

• Designing an economic plan involves a choice between

conflicting or competing ends, inevitably leading to a
situation whereby the ‘central planner’ imposes its scale of
preferences on the community for which the plan is made.
Such ‘planning leads to dictatorship because dictatorship is
the most effective instrument of coercion and the enforcement
of ideals, and as such essential if central planning on a large
scale is to be possible.’
The Tension between Planning and Freedom

• To illustrate his point, Hayek provides the following example:

‘In deciding how many pigs are to be reared or how many
buses are to be run, which coal mines are to operate, or at
what prices boots are to be sold, it will always be necessary to
balance one against the other the interests of various persons
and groups. In the end somebody's views will have to decide
whose interests are more important… To produce the same
result for different people it is necessary to treat them
differently.’
The Tension between Planning and Freedom

• He admits that there will always be inequalities which will

appear unjust to those who suffer from them, disappointments
which will appear unmerited, and strokes of misfortune which
those hit have not deserved. However, inequality is
undoubtedly more readily borne, and affects the dignity of the
person much less, if it is determined by impersonal forces
than when it is due to design;
• Tension between planning and the rule of law.
However, there is no such
thing as a free market!
 The Illusion

• Among the central theses of Karl Polanyi’s ‘The Great

Transformation’ is the idea that self-regulating markets never
work and that their deficiencies are so great that government
intervention becomes necessary. As Joseph Stiglitz points out
in the foreword of the book, there is today no respectable
intellectual support for the proposition that markets by
themselves lead to efficient, let alone equitable outcomes and,
declaring the ‘myth of the self-regulating economy virtually
dead.’
There is no such thing as a free market
• Every market has some rules and boundaries that restrict freedom of
choice. A market looks free only because we so unconditionally accept its
underlying restrictions that we fail to see them. (Chang, 2011);
• To begin with, there is a huge range of restriction on what can be traded
and not just bans on obvious things like people, narcotic drugs, human
organs, votes etc;
• For instance, wages in rich countries are determined more my immigration
control than anything else, including any minimum wage legislation.
Interest rates are set by the central bank;
• So it means that if wages and interest rates are (to a significant extent)
politically determined, then all the other prices are politically determined as
well.
There is no such thing as a free market

• In 1819 new legislation to regulate child labour, the Cotton

Factories Regulation Act was introduced in the British
Parliament, causing huge controversy. Opponents saw it as
undermining the sanctity and very foundation of the free
market;
• I similar reaction was caused when environmental regulations
appeared a few decades ago.
There is no such thing as a free market

• Today, most people accept these regulations as ‘natural’;

• Thus seen, the ‘freedom’ of a market is, like beauty, in the eye
of the beholder. Wee see regulation when we don’t endorse
the moral values behind it.
 The ‘Long-run’ Fallacy
• At this stage, it is important to note here that free market proponents
do not deny the existence of economic crises. However, they look at
them merely as temporary deviations, after which the free market
returns to its natural equilibrium. According to Skidelsky, the short-
run typically stands for the period during which a market
temporarily deviates from its long-term equilibrium due to some
shock. Consequently, this way of thinking suggests that government
should leave it to markets to reestablish their natural equilibrium
positions;
• Polanyi, however, criticised the the ‘long-run’ assumption as
meaningless stating that in no case can we assume the functioning of
market laws unless a self-regulating market is shown to exist.
 The ‘Long-run’ Fallacy

• One of Polanyi’s fundamental points is that market liberalism

makes demands on ordinary people that are simply not
sustainable. Workers, farmers and small business people will
not tolerate for any length of time a pattern of economic
organisation in which they are subject to period dramatic
fluctuations in their daily economic circumstances. It requires
that millions of ordinary people throughout the world have the
flexibility to tolerate a prolonged spell in which they must
survive on half or less of what they previously earned.
 The Holy Trinity
• While economics encompasses a large and evolving variety of
frameworks, according to Rodrik, it appears to be single-
mindedly focused on markets, rationality and selfish behaviour,
which interact in a ‘perfectly competitive market’;
• Such simplified view leads to obvious conflicts with the way
the world actually operates and leaves out the fact that people
have other motives besides material ones, that rationality is
often overshadowed by emotion or erroneous cognitive
shortcuts, that some producers can behave monopolistically,
and so on. This, for instance, explains the increased popularity
of the field of behavioural economics.
The Free Market Is Not Neutral
• The Ultimatum Game (Güth, Schmittberger & Schwarze, 1982);
• Markets not only allocate resources and distribute income, they also
shape our culture and human development. They are as much political
and cultural institutions as they are economic;
• Sense&Nonsense;
• It may may lead to the erosion and disappearance of valuable traits such
as feelings of solidarity with others, the ability to empathise, the capacity
for complex communication and collective decision making (Bowles,
1991);
• And, it may crowd out social norms (Sandel, 2012) — day care centres in
Haifa (Gneezy & Rustichini, 2000).
The Boundaries of the Market and Market Failure

• A market failure is a situation where free markets fail to allocate

resources efficiently;
• There are several types of market failure such as:
• Monopolies;
• Missing or incomplete markets (defence, education, healthcare);
• Public goods and externalities (climate change);
• Financial crisis (predatory lending);
• Inequality.
The Boundaries of the Market and Market Failure

• The price system plays a key role in coordinating the activities of

millions of individuals - indeed, today, billions of individuals in the
new global economy. The problem is that the price system knows
neither limits nor morality…
• ‘If real estate and oil prices rise, then people should move to the
country or take to traveling about by bicycle (or both). Never mind
that such adjustments might be unpleasant or complicated; they
might also take decades, during which landlords and oil well owners
might well accumulate claims on the rest of the populations so
extensively that they could easily come to own everything that can
be owned, including rural real estate and bicycles, once and for
all.’ (Thomas Piketty, Capital in the 21st Century)
The Boundaries of the Market and Market Failure

• The standard response from trade economists is to argue that the

gains from trade are sufficient to more than adequately compensate
the losers, ideally through job training that will equip them with
new skills. And thus, every major piece of trade legislation has
been accompanied by a host of worker-retraining measures, as well
as a phasing in of new rules to allow workers time to adjust.
• In practice, however, this adjustment has often failed to
materialise. This is partly a failure of implementation, but it is also
a failure of concept: it is not clear what kind of training can
transform a 55-year-old assembly-line worker into a computer
programmer or a Web designer.
 ‘Bounded Rationality’
• Chang notes that people do not necessarily know what they are doing,
because our ability to comprehend even matters that concern us directly
is limited, or in the words of Herbert Simon we have 'bounded
rationality'. This means that very often the main problem is not the lack
of information, but our limited capacity to process that information;
• Consequently, some regulation work not because government
necessarily knows better than those that are being regulated, but because
they limit the complexity of the activities. The financial crisis of 2008
provides a good example of 'how the complexity of the world we have
created... has vastly outpaced our ability to understand and control it.’
• How many possible moves exist in an average game of chess?
 The Average Game of Chess

1 000 000 000 000 000 000 000 000 000 000 000 000
000 000 000 000 000 000 000 000 000 000 000 000
000 000 000 000 000 000 000 000 000 000 000 000
000 000 000 000
 The Role of the State in the Economy
Positive and Normative Statements

• So, even if we acknowledge the boundaries of the market, the

question remains what the state should do and, more
importantly, how it should do it.
Where does Government Enter into the Picture?

• Although the question of the state’s role in the economy and wealth creation
was discussed in Han Dynasty China (81 BC) and by the fourteenth-century
Arab scholar Ibn Khaldoun, according to Skidelsky, it was not asked in
Europe before modern times partly because there was no state in the modern
sense;
• To some extent government is a form of voluntary cooperation, a way in
which people chose to achieve some of their objectives through
governmental entities because they believe that is the most effective means
in achieving them;
• In any case, even Hayek himself admitted that ‘in no system that could be
rationally defended would the state just do nothing. An effective competitive
system needs an intelligently designed and continuously adjusted legal
framework as much as any other.’
 The Role of Government

• The role of government has changed dramatically over time in

most societies and has differed widely among societies at any
given time.
 The Role of Government
“According to the system of natural liberty, the sovereign has only three duties to
attend to; three duties of great importance, indeed, but plain and intelligible to
common understandings: first, the duty of protecting the society from the violence
and invasion of other independent societies; secondly, the duty of protecting, as far
as possible, every member of the society from the injustice or oppression of every
other member of it, or the duty of establishing an exact administration of justice;
and, thirdly, the duty of erecting and maintaining certain public works and certain
public institutions, which it can never be for the interest of any individual, or small
number of individuals, to erect and maintain; because the profit could never repay
the expense to any individual or small number of individuals, though it may
frequently do much more than repay it to a great society.”
— Adam Smith,
An Inquiry Into the Nature and Causes of the Wealth of Nations —
 The Role of Government

• Adam Smith’s third duty raises the most troublesome issues.

He himself regarded it as having a narrow application. It has
since been use to justify an extremely wide range of
government actives.
The Role of the State in the Economy

• The simplest way to measure the change in the government’s

role in the economy and society is to look at the total amount
of taxes relative to national income.

Thomas Piketty, Capital in the 21st Century

The Role of the State in the Economy
• With 7-8% of national income, it is possible for a government to
fulfil its central functions (police, courts, army, foreign affairs,
general administration, etc.) but not much more;
• The historic increase in government revenues was used for the
construction of the “social state”. It enabled governments to take on
ever broader social functions that can be broken down into two
roughly equal halves: one half goes to health and education, the
other to replacement of incomes and transfer payments. The goal is
to give equal access to basic goods: Every child should have access
to education, regardless of his or her parents’ income and everyone
should have access to health care, especially when circumstances are
difficult. (Thomas Piketty, Capital in the 21st Century)
The Case for Managing Aggregate Demand

• Skidelsky finds that ‘there has never been a real paradigm

shift in economics comparable to those occasionally
experiences in the natural sciences’ and that the Keynesian
Revolution came closest to it.
 Picking Winners?
• Chang makes the case that governments can pick winners,
sometimes even spectacularly well. Although he does not
mention him explicitly, he takes into account Hayek's
argument that those who are closest to the situation also have
the best information allowing them to make the best decision,
but notes that ‘sometimes being too close to the situation can
actually make it more, rather than less, difficult to see the
situation objectively.’ In the 1960s, for instance, the LG was
banned by the government from entering its desired textile
industry and was forced to enter the electric cable industry.
 The Entrepreneurial State?
• The idea of an entrepreneurial state — which to some might sound
like an oxymoron — has been put forward by Mariana Mazzucato in
her 2011 book and article titled ‘The Entrepreneurial State’. In it,
Mazzucato challenges the ‘common sense’ truth whereby the state
impedes innovation, entrepreneurship and dynamism, and which
holds that the state’s role in spurring innovation is simply to provide
the ‘conditions for innovation to flourish.’
• According to her, the role of the government in the most successful
economies has gone way beyond creating the right infrastructure
and setting the rules. Rather, it has been a leading agent in achieving
the type of innovative breakthroughs that allow companies and
economies to grow.
 Happiness?
• In March 2018, Finland was named the happiest country in the world
by the UN’s Sustainable Development Solutions Network’s World
Happiness Report (The Economist, 2018). The Report used global
polling data from Gallup to measure how pleased people felt with
their lives. The researchers tried to explain the differences using
variables such as GDP per person, social support, healthy-life
expectancy, freedom to make life choices, generosity, and freedom
from corruption. It suggest that that happy societies are those with
supportive social systems and institutions that make it harder for
people to fall through the cracks. Free education, generous parental
leave and a healthy work-life balance ensure that people have the time
and the means to pursue their pleasures, no matter how mundane.
 Promoting Public Health

• In 2016, graphic health warnings replaced cigarette brand

logos in new, standardised packing;
• In the United States, the Food and Drug Administration
requires calorie-counts on food from chain and take-away
restaurants by December 2016.
 4 Ways to Spend Your Money

• Milton Friedman on the 4 ways to spend your money;

• Tullock Lottery.
 The Pendulum Swinging

• The debate on the role of the state vis-à-vis the free market in
the economy thus continues and is unlikely to ever be
concluded. There will never be a ‘scientific’ solution to this
problem, which will forever remain a ‘value judgement’ and a
pendulum that is constantly swinging.
Public or Private Sector?
 A Warning…

‘What has always made the state a hell on earth has been
precisely that man has tried to make it his heaven.’
— Friedrich Hölderlin —
 To make good lemonade…

“Markets are the essence of a market economy in the same sense

that lemons are the essence of lemonade. Pure lemon juice is
barely drinkable. To make good lemonade, you need to mix it
with water and sugar. Of course, if you put too much water in
the mix, you ruin the lemonade, just as too much government
meddling can make markets dysfunctional. The trick is not to
discard the water and the sugar, but to get the proportions
right.”
— Deni Rodrik, Milton Friedman’s Magical Thinking —
 References
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Economics, 137(4), 2213-2262.
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• Read, L. (1958). I, pencil. Foundation for Economic Education.
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