Wednesday, February 23, 2011

The Market vs. State Debate

An analysis of the arguments for and against state intervention in market activity
In his article “The Quarrelsome Boundaries of Economics,” Hugh Stretton writes, “of all the economic boundaries, the most talked-about these days—and often the most misleading—is drawn between ‘market’ and ‘government’” (2004: 14). Of course, there is not always one clearly marked boundary between market and state as the quotation by Stretton may imply. Rather, the correct mix of government and market depends on the economic, social, and political context of the particular state (or entity) in question. This essay will analyze the progression of the state versus market debate beginning with the general theories proposed by Smith and Marx, and then will focus on the specific policy prescriptions of Keynesianism, monetarism, new classical macroeconomics, the real business cycle theory, and new Keynesianism. It will conclude with a brief discussion of how the state versus market argument has shaped development economics and why the debate is so important to developing countries. From an in-depth analysis of both sides of the argument it becomes clear that because the objectives of markets and states are not inherently complementary—and because the stakes are so high—we cannot look at the debate simply as market or state; the question must be how much state and how much market.

In his seminal work The Wealth of Nations, Adam Smith proposed the idea that the coordination of all the economic actors within a society, including producers, suppliers, and consumers, could be left to the economic actors themselves (Bowles and Edwards, 1993: 31). Bowles and Edwards point out that this idea was revolutionary in that it “asserted that a rational order might arise without any person or institution consciously attempting to create or maintain order” (1993: 31). [1] Allowing the ‘invisible hand’ of the market to drive economic activity was believed to be the most efficient method of coordinating diverse actors and reaping the greatest revenue from their efforts. According to Smith, a system based on individuals maximizing their returns would maximize the returns to society as a whole. Classical economics thinking formed the basis for those who champion limited government intervention and dominated early growth theory within the broader development economics debate.

The economic theories of Karl Marx are also critical to contextualizing the current state versus market debate. Marx added important elements to the understanding of capitalist markets put forward by Smith. For example, Marx noted that “the conditions under which people make trades are crucial elements in how the economy works” (Bowles and Edwards, 1993: 35). Put more simply, power relations not only matter, they shape how people engage in and with the market economy. Marx believed that the solution to the challenges power posed was not a market-based state, but a communist one in which the community’s needs dominated. Marx’s analysis underscores the complexity inherent in market-based economies—a fact that one might look over in a cursory reading of Smith—and laid the foundation for those who argue that the state must intervene in market economies. Marxist thought also influenced development economics and can be clearly seen in dependency and sturcturalist theories.
Adam Smith and Karl Marx both presented these economic arguments before the current state versus market debate materialized. In fact, the state was rather limited in its capacity to influence economic activity when Smith and Marx were alive; it was not until the early twentieth century that governments were able to exert greater control over market forces.[2] Beginning in the late nineteenth century, however, “central banking and financial regulations were introduced in order to deal with…financial instability” while “social welfare legislation and anti-trust regulation were [enacted] in order to” correct the inequitable distributions of laissez-faire capitalism (Chang, 2003: 45). Not long after, nationalist movements and calls for independence by colonial states led many western governments to increase their involvement in the affairs of their colonies as a way of maintaining empire. The Second World War and the need to quickly (re-)develop states precipitated “a dramatic swing to interventionist policy regimes across the world” (ibid). However, perhaps the event that most influenced calls for increased state intervention was the Great Depression.[3]

Before the Great Depression, the classical economic view of markets as inherently stable prevailed (Snowdon and Vane, 2005: 9). The turbulence that followed the US stock market crash of 1929 resulted in a sharp fall in growth, rising unemployment, and increased inflation. Classical economists believed that this downturn would self-correct given time. When it became clear that classical economic theory “could not adequately account for either the length or depth of the economic decline experienced by the major economies of the world,” the debate over how the state should interact with the market system shifted away from earlier theories (ibid).
John Maynard Keynes was profoundly influenced by the events of the 1920s and 1930s. Keynes recognized that the Depression represented a flaw in the classical model’s complete reliance on the price mechanism (Snowdon and Vane, 2005: 13). From the experiences of the Great Depression he concluded that the market system was inherently unstable and that the state must intervene to ensure its viability. Because such instability is largely caused by fluctuations in demand, the government should employ fiscal and monetary policies to achieve full employment (Snowdon and Vane, 1997: 5). Keynes prescribed increased government spending and/or tax cuts to boost aggregate demand and believed that once full employment had been reached and output levels returned to normal, the government could step back and the market could take over again (Smithin, 1996: 47).

The sharp decline in mass unemployment during the Second World War gave Keynes’ ideas exceptional authority throughout the world. In fact, the following quarter century was characterized by such a ‘golden era’ of growth that some of the flaws in Keynes’ arguments were rendered (at least temporarily) insignificant (Snowdon and Vane, 2005). However, inflation and unemployment quickly rose in the wake of the 1970s oil shocks, the move from the gold standard, and the collapse of the Bretton Woods institutions. These drastic changes gave rise to a new wave of economic models—notably the monetarist, new classical macroeconomics, and the real business cycle theories—that harkened back to the classical notion of market stability and limited government (Snowdon and Vane, 2005: 15, 18, 23). It appeared that the increased government role in market activity prescribed by Keynes had failed in the long-term.
These new schools of thought shifted back to the classical argument of market primacy, arguing that markets were stable unless disrupted by irregular monetary growth and that, even when disturbed, markets would quickly return to their normal levels (Snowdon and Vane, 2005: 24). Because these models favored limited government intervention, they opposed budget deficits and large public debt (Dornbusch and Fischer, 1996: 33).

According to the monetarists, government stabilization policies were often counterproductive because of the lag between a policy’s implementation and its effect, and uncertainties surrounding the ‘natural’ levels of unemployment (ibid: 25; Snowdon and Vane, 1997: 8). Therefore, the government should avoid intervening in the market. For similar reasons, new classical macroeconomists supported a rules-based approach to state monetary policy (the policy ineffectiveness proposition), arguing that arbitrary government action only served to increase overall economic uncertainty (Snowdon and Vane, 2005: 26). Smithin adds, this “unpredictable element of government policy actually emerges as one of the various shocks which [drives] the business cycle” and thus represents just “one more shock with which the private sector has to contend (1996: 54). In order to increase output and reduce unemployment, governments should only pursue policies that “increase the microeconomic incentives for firms and workers to supply more output and labor,” such as programs that promote savings and investment (Snowdon and Vane, 1997: 13).

The real business cycle approach added that every stage of the business cycle—boom and boost—represented a distinct equilibrium that economic actors will adapt to on their own (Snowdon and Vane, 2005: 27). The best government stabilization policy was therefore considered to be no policy at all. The ‘hands off’ championed by Adam Smith in the eighteenth century was alive and well.
The preceding theories paved the way for the emergence of neo-liberalism and the Washington Consensus during the 1980s and early 1990s. Both models, which have become synonymous in most literature despite John Williamson’s original intent, drew upon new classical macroeconomic and monetarist policies, advocating limited state intervention, liberalization, privatization, and deregulation, among other ‘hands off’ programs. [4] In neo-liberalism and the Washington Consensus “market fundamentalism” prevailed (Williamson, 2000: 256). With the rise of these policies, the debate of state versus market became firmly established in the market primacy camp.

Neo-liberal thinking dominated development theory and practice throughout the 1990s. Market-based theories promoted by the World Bank and IMF, particularly structural adjustment programs (SAPs), were forced upon developing states as ‘quick-fixes’ to problems of growth. In many cases, loans and foreign aid were pledged on the condition that the recipient government would heavily limit its role in the market. Such policies, however, ultimately failed to spur growth and reduce poverty. The Washington Consensus in particular failed as a theory because of its inability to neither explain the rise of many East Asian economies, nor prevent the economic crash many suffered in the late 1990s. This reality led to a resurgence of Keynesian thinking in the debate over state versus market and a shift back to a state-led approach.
New Keynesian models responded to the assertion that markets are inherently stable.
According to the new Keynesian school, markets do not always rapidly self-correct. The theory’s main contribution centered on the claim that prolonged periods of unemployment can actually result in hysteresis (Snowdon and Vane, 2005: 27).[5] Because the market cannot address hysteresis, the state must intervene with programs that facilitate the transfer of skills to the unemployed and with stabilization policies to prevent long periods of low output. Joseph Stiglitz’s call for government intervention as a complement to markets (such as through education and research and development) and greater state involvement in building ‘human capital’ is an example of new Keynesian thought and clearly represents the shift away from the neo-liberal thinking of the 1980s (Stiglitz, 1998).

Post-Keynesian models, just as the new Keynesians did, investigated where the market failed and developed long-term policies to correct market instability. They argued that the flaw of a market-based economy was not so much the price system, as Keynes originally proposed, “but [was] the lack of a reliable mechanism…to ensure that an adequate aggregate level of investment spending [would] always be forthcoming” (Smithin, 1996: 56). In short, the state should take all necessary action to spur private and public sector investment. These programs should be long-term in nature and not just meant to ‘fine tune’ market fluctuations (ibid). This was a departure from earlier state-centered models that envisioned the state micromanaging economic affairs; the post-Keynesian approach promoted a role for government that focused on the ‘big picture’ and not market minutiae.

While the economic theories discussed so far give different reasons for advocating more or less government intervention, as Snowdon and Vane point out, “economists tend to disagree more over theoretical issues, empirical evidence and the choice of policy instruments than they do over the ultimate objectives of policy” (2005: 7). Unlike economists, however, the objectives of the state and market are not always in agreement.[6] It is therefore necessary to step back from the detailed policy discussion and focus on the broader debate surrounding why it is necessary for the government to influence market activity in the first place.

To begin, it is important to note that “the basic idea of democratic very different from the rules that govern the capitalist economy” (Bowles and Edwards, 1993: 411). Because democratically elected governments are responsible to their entire population, policies tend to be collective in nature. Businesses and corporations, on the other hand, are responsible to boards of investors; therefore business policies and practice will not necessarily benefit the general public (ibid). What is more, because the market has become increasingly complex, the government is needed to ensure the welfare of its population. As Stretton notes, “when you buy socks or apples you can see what you’re getting. When you buy insurance or antibiotics you can’t, and only government can discipline the suppliers and make sure you get what you pay for” (2004: 14).

Market failure literature focuses on the government’s role in safeguarding the public and lists three instances when the state should intervene in market activity: to provide public goods, ensure competitive markets, and encourage positive externalities (while preventing negative externalities). These arguments follow a ‘moralist’ or ‘paternal’ understanding of the state (Chang, 1996: 8-12).

Opponents of the market failure approach point out, however, that technological innovation can eliminate the ‘public-ness’ of public goods. Also, even if a good is public the state does not necessarily have to provide it: “private goods provided by ‘political entrepreneurs’ can overcome the free-rider problem by bringing individual cost/benefit structures in line with the social (or group) cost/benefit structure” (Chang, 1996: 9). State attempts to prevent monopolies might actually create more monopolies in the long-term. And it is often argued that almost every good has positive and negative externalities; government involvement has the potential of just creating more (ibid: 8-12). Like classical economic theory, these arguments place great faith in the market; however, they neglect the fact that technological innovation may need to be fostered by the state (through funding of research for example), that there is no guarantee that ‘political entrepreneurs’ will provide public goods, and that just because public goods have externalities does not mean the government should avoid providing them.
The political economy literature criticizes the market failure approach (and indirectly Keynesian-based models) because it assumes that the state will always act in the public’s best interest. Marxists, for example, point out that the state can gain autonomy from society if there is no group strong enough to compete with it (Chang, 1996: 18). The interest group approach notes that because corporations can capture state regulatory agencies, the only way to prevent interest groups from dominating the state is by depriving the state of regulatory power (ibid: 20). The self-seeking bureaucrat approach argues that bureaucrats are no different from ordinary individuals and will use their positions to pursue their own interests (ibid: 22).

The government failure approach builds upon the political economy argument that the state should not intervene because of the potential for corrupt dealings. For example, adherents to the government failure school state that government intervention creates waste and results in resources being diverted to unproductive activities (the rent-seeking argument) (Chang, 1996: 27-29). The argument also states that since governments never have complete information, the state cannot “collect and process all the information relevant for the correction of market failures” (Chang, 1996: 25).
The models discussed raise important points that merit consideration when debating government intervention in economic activity; however, the political economy and government failure approaches offer few alternatives besides complete disengagement (Chang, 1996: 32). Because state and businesses objectives are not always complimentary, this is not an option. Chang’s “new institutional approach” begins to reconcile the two sides by proposing ways in which the government can become involved in market activity without adversely affecting the economic system. For example, centralizing decision-making and fostering positive state-business relations will limit informational asymmetry; granting more power to non-elected bureaucrats can reduce state vulnerability; and employing public tools of intervention can decrease rent seeking behavior (Chang, 1996).[7] The “new institutional approach” is an encouraging example of how the debate of state versus market has evolved. It is no longer a question of whether or not the state should intervene, but how the state can best bring about positive growth. Government intervention does not have to supersede or dominate the market; rather it can complement market activity so that public revenues—in every sense of the term—are maximized.

Shifts in economic theory have been widely mirrored in development economics and general development theory. In fact, since the rise of development theory in the 1940s, academics and practitioners have primarily moved between calling for greater state involvement on the one hand and asserting the benefits of market primacy on the other. Structuralism, for example, departed from classical economic growth theories by advocating heavy state involvement in import-substitution and industrialization (ISI) programs as Keynesian theories gained ground. When the short-comings of such policies became apparent—ISI is difficult to pursue beyond consumer goods, de-linking from the global economy is not economically realistic, and ISI programs do not guarantee broad-based social progress—neo-liberal theories grew in influence and the Washington Consensus came to dominate development practice.
Finding the right balance of state versus market is important to all states, however the debate is particularly significant to developing countries. First, developing states cannot be expected to compete in ‘free markets’ under the same conditions as industrialized countries because they often have not had the opportunity to establish competitive domestic industries. Therefore, state intervention is almost always necessary in some form or another (through tariffs or state subsidies, for example). Economic theorists must understand this reality and developed countries should ensure that “newcomers or latecomers to the game [i.e. global markets] are provided with the time and the space to learn so that they [become] competitive players” (Nayyar, 2003: 78). That these issues are being discussed in development literature exemplifies the growing understanding that the state can complement the market under the right conditions.

The idea of the state supplementing the market can also be seen in recent calls for governments to consider issues such as the informal economy and unpaid housework when designing economic and social policy. This approach ensures that women and children—those most frequently excluded from market-based approaches to economics—are more visible (Elson, 2000). Including social welfare programs in economic policies will ensure that “human capabilities” are maintained and that the market has a pool of healthy, educated, and able people to draw from (ibid: 28).

The arguments in this paper have been presented without any real-world context. Therefore one may conclude that there exists one ideal ‘mix’ of state and market. The reality is much more complex. As Rodrik wisely points out, context matters: what works in one state might not work in another (2004). While countries such as South Korea have been able to exert greater government control over markets because of political, social, and cultural factors, the same policies have failed in other states characterized by different environments. It is therefore important that theorists, practitioners, and policy makers learn from the state versus market debate and design systems that create the best balance of state and market for their particular social, political, and economic environment.


Chang, H. The Political Economy of Industry. London: Macmillan Press. 1996.

Chang, H. Rethinking Development Economics. London: Anthem Press. 2003.

Dornbusch, R. and S. Fischer. Macroeconomics, 3rd ed. Johannesburg: Lexicon Publishers. 1996.

Elson, D. (ed.) “Progress of the World’s Women.” New York: UNIFEM. 2000.

Nayyar, D. “Globalization and Development.” Rethinking Development Economics. Chang, H. (ed.) London: Anthem Press. 2003.

Rodrik, D. “Growth Strategies.” Cambridge, Massachusetts: Harvard University. 2004.

Snowdon, B. and H. Vane. A Macroeconomics Reader. London: Routledge. 1997.

Snowdon, B. and H. Vane. Modern Macroeconomics. Cheltenham, UK: Edward Elgar. 2005.

Stiglitz, J. “More Instruments and Wider Goals: Moving Towards a Post-Washington Consensus.” Annual WIDER Lecture, Helsinki. 1998.

Stretton, H. “The Quarlesome Boundaries of Economics.” A Guide to What’s Wrong with Economics. Fullbrook, E. (ed). London: Anthem Press. 2004.

Williamson, J. “What Should the World Bank think about the Washington Consensus?” The World Bank Research Observer. 15(2). 2000.

[1] It is significant to note that Smith’s argument is even more revolutionary when one considers that it came “at a time in which selfishness was considered equivalent to immorality” (Bowles and Edwards, 1993: 31).
[2] Ha-Joon Chang presents several reasons for the state’s restricted economic abilities, including limited budgetary capacities due to the lack of an income tax in most countries, weak or non-existent central banking systems, constricted monetary policy capability, widespread private ownership of industry and financial institutions, limited regulation policies, and a general lack of investment planning (2003: 45).
[3] It should also be noted that the Great Depression also “gave birth to modern macroeconomics as surely as accelerating inflation in the late 1960s and early 1970s facilitated the monetarist counter-revolution” (Snowdon and Vane, 2005: 9)
[4] For a discussion of Williamson’s intent in coining the phrase ‘Washington Consensus’ and how the term has come to be equated with neo-liberalism, see Williamson, 2000.
[5] Hysteresis effects imply that individuals who have lost their jobs during an economic downturn may remain unemployed even during subsequent periods of economic growth because of loss of skills and/or motivation. A definition of hysteresis as it applies to economics can be found at: (accessed March 2008).
[6] This is partly because, as Chang notes, defining the ‘free market’ and agreeing on state objectives can be extremely complicated (2003: 48).
[7] A detailed discussion of the new institutional approach is beyond the scope of this paper; the options listed are just several of those presented. For more information, see Chang 1996.