January 14th, 2012
02:30 PM ET

Spence: Mind over markets

Editor's Note: Michael Spence, a Nobel laureate in economics, is author of The Next Convergence. For more, visit Project Syndicate or follow it on Facebook and Twitter.

By Michael SpenceProject Syndicate

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. But they are not perfect; they underperform in the presence of externalities (the un-priced consequences – for example, air pollution – of individual actions), informational gaps and asymmetries, and coordination problems when there are multiple equilibria, some superior to others.

But 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. But the presumption – often 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. But, clearly, markets do not do this well by themselves.

Consider, next, 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% earns, on average, 8.4 times more than the bottom 20%. In the UK, the same ratio is 7.2, and it is only 4.3 in Germany (compared to a whopping 12.2 in China). These differential outcomes reflect distinctive combinations of market forces and social contracts.

Income distributions are influenced by taxation and fiscal policy, which usually have redistributive effects, directly and through the provision of social services and insurance. But these distributions are also affected by policies and investments that focus on the supply side, and that produce education and skills that match (or don’t match) a rapidly evolving global structure of labor demand.

Part of the challenge is that demand for labor moves to supply, rather than vice versa, because labor mobility in the global economy is limited. To assume a constant level and composition of labor demand would be as mistaken as taking current passenger demand as a fixed reference point in planning public-transportation systems. In this and other cases, supply influences demand over time (Steve Jobs, for example, understood this better than most).

That is why it is crucial to think about potential demand in tackling this kind of matching problem. As with stability, markets cannot be relied upon to deal effectively with this problem on their own. Public policy and public-sector investment matter, too.

Attention is increasingly – and, in my view, rightly – being focused on the role of the state, and in particular on the state’s balance sheet. Experience in developing and advanced countries alike suggests that states with substantial and healthy balance sheets are better positioned to deal with today’s stability, distributional, and sustainability challenges. The benefits are several, including an ability to withstand shocks and mount countercyclical responses, as well as a capacity to recycle income to households during periods like the present, when the share of income that goes to capital is rising (with adverse distributional consequences).

In addition, countries periodically need to be able to mount and sustain public-sector investment in technology, or to engage in risk-sharing, in order to adapt to shifting competitive conditions or respond to shocks. Minority public ownership can provide resources, while retaining the benefits of competition, and ensure that some of the returns accrue to the general public via government revenues.

Some of this will run counter to existing orthodoxy, and may provoke a healthy debate.  A relatively narrow focus on efficiency and growth, at least in many advanced countries, may have worked in the early decades after WWII, when distributional patterns were benign and instability rare. Today that is not enough. Stability, equity, and sustainability challenges have become crucially important, and the role of the state in relation to markets may need re-thinking as a result.

Re-orienting policy frameworks to longer time horizons, with a more balanced and forward-looking focus on stability and equity (without losing sight of efficiency and innovation), seems essential to meeting the needs, hopes, and expectations of people everywhere. Indeed, that is the key to addressing sustainability, to which I will turn next month.

The views expressed in this article are solely those of Michael Spence.

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Topics: Ideas

soundoff (4 Responses)
  1. sadfruit

    Sorry professor. Nobody in America is interested in your scholarly work. We are much more interested in our war machines, how many we are going to kill, and how many we have killed. Or politicians who are going to promise something like "change". Sadly, you are not needed.

    January 15, 2012 at 5:03 am | Reply
  2. j. von hettlingen

    The economies in Western Europe after World War II were on the whole quite sound. Each initally focussed on its individual market and its agents. With the creation of the European Commn Market a top-down approach was imposed. The economies turned into a large aggregate. A bigger market led to an interdependence of stability, distributional equity, and sustainability. The expansion of the European Union was an over-optimistic enterprise. Some countries like Greece, Spain and Portugal benefited from their memberships, yet neglected to invest in their human resources and modernise their industries.

    January 15, 2012 at 5:09 am | Reply
  3. Ironicus

    An excellent article!

    That "minority public ownership" would be in addition to taxes, yet would not really be a tax, but a share-holding.
    Clever idea.

    It could help provide some stability and perhaps a greater sense of share-holding equity in the sense that governments would feel more "connected" and concerned about the private sector they oversee and maybe even make better informed decisions as a result?

    Farther up in your article, I would have added an observation that a "balanced" economy is will appear to be "unbalanced" to those who hold the common fallacy of viewing a government budget like it's somebody's check-book ....and that sustainability is a much more accurate measure of "balance" and not the level of debt vs income or silly ideas like that.

    But maybe you don't agree with that. I haven't read enough of your papers yet to say for sure either way.
    Regardless, your article is excellent.
    My little addition would only be a poke at people who have "budget-balancing" issues anyway.

    January 15, 2012 at 12:15 pm | Reply
  4. matt

    Markets will never be highly efficient to satisfy industry and the masses–largely due to decades of crony capitalism around the world.

    January 15, 2012 at 8:38 pm | Reply

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