Government should counteract business cycles.
Market failures signify corruption and inefficiency in the private sector. Such misconduct and misallocation of economic resources is usually thought to be the domain of the public sector, but actually it goes on eveywhere in the economy.
Wealth destruction by privately-owned firms is typical of economies with absent, lenient, or lax regulation and often exceeds anything the public administration does. Corruption, driven by avarice and fear, is common among entrepreneurs as much as among civil servants. It is a myth to believe otherwise. Wherever there is money, human psychology is in operation and with it economic malaise. Hence the need for governmental micromamangement of the private sector at all times. Self-regulation is a costly and self-deceiving urban legend.
Another engine of state involvement is provided by the thrift paradox. When the economy goes sour, rational individuals and households save more and spend less. The aggregate outcome of their newfound thrift is recessionary: decreasing consumption translates into declining corporate profitability and rising unemployment. These effects are especially pronounced when financial transmission mechanisms (banks and other financial institutions) are gummed up: frozen in fear and distrust, they do not lend money, even though deposits (and their own capital base) are ever growing.
It is true that, by diversifying risk away, via the use of derivatives and other financial instruments, asset markets no longer affect the real economy as they used to. They have become, in a sense, "gated communities", separated from Main Street by "risk barriers". But, these developments do not pertain to retail banks and when markets are illiquid and counterparty risk rampant, options and swaps are pretty useless.
The only way to effectively cancel out the this demonetization of the national economy (this "bleeding") is through enhanced government spending. Where fearful citizens save, their government should spend on infrastructure, health, education, and information technology. The state's negative savings should offset multiplying private savings. In extremis, the state should nationalize the financial sector for a limited period of times (as Israel has done in 1983 and Sweden, a decade later).
It is a maxim of current economic orthodoxy that governments compete with the private sector on a limited pool of savings. It is considered equally self-evident that the private sector is better, more competent, and more efficient at allocating scarce economic resources and thus at preventing waste. It is therefore thought economically sound to reduce the size of government - i.e., minimize its tax intake and its public borrowing - in order to free resources for the private sector to allocate productively and efficiently.
Yet, both dogmas are far from being universally applicable.
The assumption underlying the first conjecture is that government obligations and corporate lending are perfect substitutes. In other words, once deprived of treasury notes, bills, and bonds - a rational investor is expected to divert her savings to buying stocks or corporate bonds.
It is further anticipated that financial intermediaries - pension funds, banks, mutual funds - will tread similarly. If unable to invest the savings of their depositors in scarce risk-free - i.e., government - securities - they will likely alter their investment preferences and buy equity and debt issued by firms.
Yet, this is expressly untrue. Bond buyers and stock investors are two distinct crowds. Their risk aversion is different. Their investment preferences are disparate. Some of them - e.g., pension funds - are constrained by law as to the composition of their investment portfolios. Once government debt has turned scarce or expensive, bond investors tend to resort to cash. That cash - not equity or corporate debt - is the veritable substitute for risk-free securities is a basic tenet of modern investment portfolio theory.
Moreover, the "perfect substitute" hypothesis assumes the existence of efficient markets and frictionless transmission mechanisms. But this is a conveniently idealized picture which has little to do with grubby reality. Switching from one kind of investment to another incurs - often prohibitive - transaction costs. In many countries, financial intermediaries are dysfunctional or corrupt or both. They are unable to efficiently convert savings to investments - or are wary of doing so.
Furthermore, very few capital and financial markets are closed, self-contained, or self-sufficient units. Governments can and do borrow from foreigners. Most rich world countries - with the exception of Japan - tap "foreign people's money" for their public borrowing needs. When the US government borrows more, it crowds out the private sector in Japan - not in the USA.
It is universally agreed that governments have at least two critical economic roles. The first is to provide a "level playing field" for all economic players. It is supposed to foster competition, enforce the rule of law and, in particular, property rights, encourage free trade, avoid distorting fiscal incentives and disincentives, and so on. Its second role is to cope with market failures and the provision of public goods. It is expected to step in when markets fail to deliver goods and services, when asset bubbles inflate, or when economic resources are blatantly misallocated.
Yet, there is a third role. In our post-Keynesian world, it is a heresy. It flies in the face of the "Washington Consensus" propagated by the Bretton-Woods institutions and by development banks the world over. It is the government's obligation to foster growth.
In most countries of the world - definitely in Africa, the Middle East, the bulk of Latin America, central and eastern Europe, and central and east Asia - savings do not translate to investments, either in the form of corporate debt or in the form of corporate equity.
In most countries of the world, institutions do not function, the rule of law and properly rights are not upheld, the banking system is dysfunctional and clogged by bad debts. Rusty monetary transmission mechanisms render monetary policy impotent.
In most countries of the world, there is no entrepreneurial and thriving private sector and the economy is at the mercy of external shocks and fickle business cycles. Only the state can counter these economically detrimental vicissitudes. Often, the sole engine of growth and the exclusive automatic stabilizer is public spending. Not all types of public expenditures have the desired effect. Witness Japan's pork barrel spending on "infrastructure projects". But development-related and consumption-enhancing spending is usually beneficial.
To say, in most countries of the world, that "public borrowing is crowding out the private sector" is wrong. It assumes the existence of a formal private sector which can tap the credit and capital markets through functioning financial intermediaries, notably banks and stock exchanges.
Yet, this mental picture is a figment of economic imagination. The bulk of the private sector in these countries is informal. In many of them, there are no credit or capital markets to speak of. The government doesn't borrow from savers through the marketplace - but internationally, often from multilaterals.
Outlandish default rates result in vertiginously high real interest rates. Inter-corporate lending, barter, and cash transactions substitute for bank credit, corporate bonds, or equity flotations. As a result, the private sector's financial leverage is minuscule. In the rich West $1 in equity generates $3-5 in debt for a total investment of $4-6. In the developing world, $1 of tax-evaded equity generates nothing. The state has to pick up the slack.
Growth and employment are public goods and developing countries are in a perpetual state of systemic and multiple market failures. Rather than lend to businesses or households - banks thrive on arbitrage. Investment horizons are limited. Should the state refrain from stepping in to fill up the gap - these countries are doomed to inexorable decline.
Also Read
The Dismal Mind - Economics as a Pretension to Science
Economics - The Neglected Branch of Psychology
The Distributive Justice of the Market
Scavenger Economies and Predator Economies
Notes on the Economics of Game Theory
The Disruptive Engine - Innovation and the Capitalist Dream
Market Impeders and Market Inefficiencies
Moral Hazard the Survival Value of Risk
The Ubiquitous Britannica 2015
Encyclopedia Britannica is now online and as a DVD. The print edition has been discontinued.
Pears Cyclopaedia 2014-5 Edition: Human Knowledge Encapsulated
Pears Cyclopaedia is the last remaining one volume reference work.
Envy as the Foundation of Capitalism
Envy is either destructive, or, as in the case of capitalism, constructive.
