Tue, Jan 17, 2012 - Page 9 News List

A strong balance sheet gives the state flexibility in the markets

By Michael Spence

In the 66 years since World War II ended, virtually all centrally planned economies have disappeared, largely as a result of inefficiency and low growth. Nowadays, markets, price signals, decentralization, incentives and return-driven investment characterize resource allocation almost everywhere.

This is not because markets are morally superior, though they do require freedom of choice to function effectively. Markets are tools that, relative to the alternatives, happen to have great strengths with respect to incentives, efficiency and innovation.

However, they are not perfect. They underperform in the presence of externalities (the unpriced consequences — for example, air pollution — of individual actions), informational gaps and asymmetries, as well as coordination problems when there are multiple equilibria, some superior to others.

However, markets have more fundamental weaknesses. Or, rather, most societies have important economic and social objectives that markets and competition are not designed to achieve. In today’s rapidly globalizing world, the most important of these objectives — expressed in various ways through the political and policymaking process in a wide range of countries — are stability, distributional equity and sustainability.

Consider stability. We live in a world of largely decentralized networks of increasing complexity: electronic networks, networks of supply chains and trade, financial networks that link the balance sheets of disparate entities. Market incentives cause actors to operate or modify parts of the network in ways that maximize efficiency locally. However, the presumption — an article of faith — that the whole remains stable and resilient has no theoretical or empirical support. Indeed, it seems inaccurate.

For example, it has been known for some time that networks that are efficient are often not resilient, because resilient networks have inefficient redundancies. Resilience is a public good, created by the right kind of redundancy.

In a decentralized structure, redundancy tends to be undersupplied in the process of local optimization. That is why the tsunami that hit Japan last year disrupted many global supply chains: They were (and still are) too efficient from the standpoint of withstanding shocks.

In financial markets, local optimization seems to lead to excessive leverage and other forms of risk-taking that undermine the stability of the system. Much research is needed to understand which interventions or restrictions on individual choice are needed to make certain kinds of market equilibria stable. However, markets clearly do not do this well by themselves.

Next, consider how labor-saving technological change and the integration of several hundred million new workers into global markets have affected income distribution, returns to education and employment opportunities almost everywhere.

In particular, the share of national income going to capital and human capital (highly educated people) is rising on a broad front, fueling increasing concentration of wealth.

Even so, income distributions vary widely among the developed countries. For example, in the US, the top 20 percent earns, on average, 8.4 times more than the bottom 20 percent. In the UK, the same ratio is 7.2, and it is only 4.3 in Germany (compared with a whopping 12.2 in China). These differential outcomes reflect distinctive combinations of market forces and social contracts.

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