Redefining the Role of the State: Will Governments Play a Different Role in the Post-Crisis World?

The current global economic crisis has been dismissed by many evidence of the failure of the ‘unbridled’ capitalism of the past two decades.

Especially at the darkest moments of last autumn, many predicted a repeat of the kind of fundamental policy shift triggered by the Great Depression. Heeding US President Franklin D. Roosevelt’s call for bold experimentation, policymakers back then embraced a much more statist approach to economic management, a paradigm that ultimately endured into the turbulent 1970s.

Problematically, the current crisis is arguably at least as much due to governments as it is to excesses of the de-regulated market place. As in the late 1920s, the global crisis followed an extraordinary asset bubble.

While this was made possible by liberalisation and innovation, it was above all fuelled by the unusually loose monetary policy stance pursued by central banks in the wake of the dotcom bust of 2000-2001. With money cheap, a growing number of economies ended up with rampant asset price inflation which policymakers by and large did little to counteract or contain.

Rules-based policymaking is a good idea but only works if the right rules are followed. The supposedly laissez-faire decade did have a strong belief in technocratic policy-making.

However, the formal rules narrowly focused on consumer price inflation at a time when systemic risks were emerging elsewhere. The wise words of former US Federal Reserve Chairman William McChesney Martin, Jr. were left unheeded. Martin once famously stated that the key responsibility of the central bank was “to take away the punch bowl just as the party gets going.”

For most Western economies, the party was well underway by the middle of this decade while central bankers found themselves shrugging their shoulders in the face of mounting bubbles.

The challenge was made all the greater by the failure of many policymakers to stick to the rules that they had formally embraced. In spite of the lip service to transparency and governance, most Western governments continued to run substantial budget deficits throughout the extraordinary boom.

Not only did this add fuel to the fire but also left the authorities poorly prepared for counter-cyclical intervention when the crisis hit. For instance, the generally laudable Growth and Stability Pact of the European Union was repeatedly violated, typically with no sanctions.

The most impressive progress in anchoring economic policy in clear rules was seen in emerging markets that had learnt the hard way, either during the oil price depression or the crises of the late 1990s.

Many governments failed during the ‘00s by presiding over unsustainable policies. As a result, the proverbial pendulum is about to swing again. The challenge is ensuring that it will hit its target. Reinventing the state should involve two principal focus areas.

Firstly, macroeconomic policy should become clearly and consistently (in good times and bad) countercyclical and focused on preventing major imbalances. Secondly, regulation should seek to address market imperfections and prevent systemic risks. In either case, government intervention would not seek to supplant markets but, rather, ensure their smooth operations and the efficiency-oriented process of natural selection this ideally entails.

As governments are forced back to the drawing board, they must embrace their objectives with all due humility. After all, the Reagan and Thatcher revolutions were the direct result of governments overextending themselves. The state should not assume functions that the private sector is better equipped to undertake. This remains true of most kinds of economic activity!

Those suggesting that the current crisis might lead to the collapse of capitalism as we know it would do well to remind themselves of the fact that alternatives to capitalism collapsed before capitalism did. Moreover, policymakers cannot and should not seek to legislate away risks. An attempt to do so would stifle innovation and ultimately reduce growth. Governments should guide and maintain order while markets are left to seek optimal outcomes within this framework.

In their efforts to reinvent themselves, governments can play a constructive role by communicating clear principles, ideally jointly with market participants. They should then ensure that these commitments are adhered to in the public and private sector alike through a combination of internal risk management and formal regulation.

Governments can help raise common sense back on the pedestal that the global Ponzi scheme of myopic policy making and the culture of easy money pushed it off of.

Moreover, governments should seek to ensure that genuine rules of accountability are applied all key decision-makers in politics and business. Such norms should in turn be based not on profits or GDP growth but rather on longer-term economic stability and sustainability.

With the public expectations of affirmative action high, governments must guard against the lure of cheap populism. The actions of politicians are often motivated by the need to appear to be doing something rather than ultimate outcomes.

The purpose of reform is not change in its own right but change for very specific reasons. A bad reform can be worse than no reform at all. Already, the political agenda is being hijacked by people upset with bonuses rather than efforts to heel financial intermediation or reduce global imbalances.

But time and resources are finite. Disproportionate attention to secondary issues will inevitably mean less attention to the real priorities. Just as importantly, governments must abandon the false lure of magic bullets.

The world in constantly evolving and policymakers would be well to devise impartial and credible mechanisms for assessing the wisdom and effectiveness of their actions on an ongoing basis. The challenging task of shaping policy and running countries should not be entrusted to people who are not suitably qualified for it.

The need to ‘get it right’ is pressing. Not only is the return to sustainable growth necessary but challenges facing governments the world over are mounting. The West and emerging markets such as China and Russia are burdened by an ageing population and a shrinking labour force.

Commodity producers are challenged by finite endowments and policy changes. A failure to review current arrangements and seek more efficient solutions risks creating a rapidly mounting and ultimately prohibitive fiscal burden. A return to sensibility is long overdue.

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