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The Limits of the MarketThe Pendulum Between Government and Market$

Paul De Grauwe

Print publication date: 2017

Print ISBN-13: 9780198784289

Published to Oxford Scholarship Online: January 2017

DOI: 10.1093/acprof:oso/9780198784289.001.0001

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The Utopia of Self-Regulation in the Market System

The Utopia of Self-Regulation in the Market System

(p.55) Chapter 5 The Utopia of Self-Regulation in the Market System
The Limits of the Market

Paul De Grauwe

Oxford University Press

Abstract and Keywords

This chapter questions whether the market contains self-regulating processes which can prevent the system from ending in self-destruction. There is no in-built mechanism which can internalize the external costs created by the market system. Only an external organization, the government, can do this. Capitalism itself is not capable of preventing an inevitable clash with its limits. Technological revolutions, in particular the digital revolution, do not currently raise productivity sufficiently to generate the resources needed to prevent environmental decline. Kuznets has turned out to be wrong in his belief that a highly developed capitalism would cause income inequality to drop. Piketty, Saez, and Atkinson point out that inequality in the most developed capitalist countries has recently increased. The regulatory mechanisms must therefore come from outside the market system, and indeed from the government.

Keywords:   regulation, self-regulation, technological progress, role of government, inequality

The reader may have detected some pessimism in the previous chapters. It seems inevitable that the market system will come up against its limits, with all the consequences that entails. But are there no mechanisms within the market system itself to prevent this inevitable slide into catastrophe? It is an important question. It is also a question of the market’s ability to regulate itself.

In this chapter we will explore three possible internal regulators. The first relates to the capacity of free markets to internalize external costs, the second to technological progress, and the third to saturation effects.

Can Markets Regulate Themselves?

We already came across the idea of a self-regulating market when we talked about financial markets. The idea has rather lost its sheen since the financial crisis, but remains popular among market fundamentalists, who state that the self-regulating character will ensure that the market system finds a stable equilibrium. Let us take the example of the environment. We have argued that businesses which emit harmful substances do not take into account the external costs they create. This leads them to produce excessive pollutants, with negative effects for the environment, thus creating a ‘public bad’ which no one can avoid.

(p.56) The market fundamentalists’ reply to this accusation is that the cause of the problem lies in lack of clarity in property rights. Since air and water are freely available goods, they are seen as big rubbish tips where everyone can freely dump harmful chemicals. It would therefore be sufficient to establish ownership rights over air and water. If my piece of air and pool of water is polluted, I can turn to those who have caused the damage and demand compensation. The clever market fundamentalist will also conclude that the problem lies in a lack of market. If there were a properly functioning market for air and water to which everyone had property rights, then there would be no environmental problems.*

That is true, of course, but it is also extremely theoretical. How will we establish those ownership rights? This is an incredibly complex information problem. How far does my ownership right over air and water extend? If the right is infringed, who is guilty? There are literally millions of people around the world who have inflicted damage on me. Where are they? Will the court in London to which I turn to enforce my rights be able to solve the information problem? And what about the billions of people who have all been harmed by billions of others? How will they account for their damage?

But even if we can solve this information problem, we run into a contradiction. In the end it will be institutions outside the market which establish and enforce these ownership rights. It can only come from government. Firstly parliament (hopefully not a dictator) will have to enshrine those property rights in law. Secondly other institutions, the courts and the police, will have to be able to enforce those rights.

Some diehard market fundamentalists will object that everything can be arranged by voluntary agreements. I come to an agreement with a few billion people to compensate them for the damage I have caused and vice versa. Everyone negotiates with everyone else, because (p.57) in a globalized world more or less everyone generates external costs. The costs of these negotiations, however, are so high that this solution cannot be taken seriously. We have to delegate these negotiations to specialists, namely politicians.

There is no way around it. Government institutions will have to step in and apply restrictions to the market system.

Technological Progress

In Chapter 4 we referred to the possibility that the market system might succeed in reducing the use of scarce resources and energy through technological progress. We then saw that this technological progress is driven by the fact that in a growing economy the price of resources and energy increases, forming a financial incentive to look for technologies to reduce usage. I emphasized that this mechanism is absent when it comes to pollution. In the market system nothing prevents companies and consumers from generating external costs unless the government puts a stop to it. In other words, there is no internal regulator for the environment to put pressure on external costs. That regulator must come from outside the market system and can only be organized by the government.

Technological progress, however, may be able to offer some relief. Digital technologies create unprecedented possibilities for increased productivity. This is strongly emphasized in Erik Brynjolfsson and Andrew McAfee’s recent book.13 These authors see almost infinite new possibilities, which can also be used to tackle pollution.

That is a very optimistic vision of the future: new technologies will save us from our downfall. If that is true, we are still left with the question I posed in Chapter 4, namely whether those technological revolutions will offer alternatives in time. Global warming continues unabated. Will the new technologies be ready fast enough to stop the emission of CO2? That currently seems very doubtful.

There is also a paradox that has been investigated by Robert Gordon of the University of Wisconsin. He comes to the conclusion that (p.58) although the digital revolution is important, it is less so than previous technological revolutions, the railways, telegraphy and telephony, the car, and air travel. These technological revolutions were at least as intrusive as the digital revolution, if not more so. They changed people’s lives more extensively, and according to Robert Gordon, had a larger effect on growth in productivity than the digital revolution of the 1990s.

The Utopia of Self-Regulation in the Market System

Figure 5.1. Annual growth in production per hour in the US (in %)

Source: Robert Gordon, ‘The Demise of US Economic Growth: Restatement, Rebuttal, and Reflections’, NBER Working Paper 19895 (February 2014)

Figure 5.1 illustrates some aspects of this, showing average annual growth in productivity (production per hour of labour) in the US since 1891. It is worth noting that the growth in productivity between 1891 and 1990 was around two per cent per year. Since then growth has dropped to less than 1.5 per cent per year. So far the digital revolution (p.59) of the 1990s has had remarkably little observable effect on growth in productivity in the country where it began. This has led Robert Solow, the great American economist who won the Nobel Prize for his contribution to the theory of economic growth, to the conclusion that the new technologies are visible everywhere except in productivity growth statistics.

We see a similar trend in other developed countries, including those of the EU, as represented in Figure 5.2. This is based on Thomas Piketty’s authoritative book Capital in the Twenty-First Century, which I will discuss in Chapter 12. Figure 5.2 shows the development of production per capita since the industrial revolution. These figures are not directly comparable with those of Figure 5.1, showing production per hour, which is a better measure of productivity. Production per capita (Figure 5.2) is also influenced by working hours.

We can see that since the 1990s growth in annual per capita productivity has slowed in Western Europe and North America.

It seems that we are returning to the ‘normal’ growth figures of the nineteenth century. Figure 5.2 also shows that the high growth in per capita production in the post-war period is an exception in the long history of growth.

The Utopia of Self-Regulation in the Market System

Figure 5.2. Growth production per capita since the industrial revolution (in %)

Source: Thomas Piketty, Capital in the Twenty-First Century (Cambridge, MA: Harvard University Press, 2014)

It therefore looks as if the digital revolution has not yet succeeded in raising productivity. Of course it is the case that there is a long lead time between the development of new technology and its application in large parts of the economy. New technologies run into resistance of various kinds. There are psychological sources of resistance: people who work with old technologies will not always switch to new ones because the change means part of their knowledge has become worthless. There are also economic sources of resistance: old machines and tools have to be disposed of early, factories have to be closed down and employees sacked. This leads to serious opposition (p.60) and delays to the introduction of new technologies. Finally it also takes a great deal of time to find applications for a new technology. True as all that is, it remains remarkable that after the outbreak of the digital revolution productivity growth is lower than in the previous fifty years. It is not so obvious that the digital revolution will provide us with the means to stop pollution.

Growth and Saturation

In 1930 John Maynard Keynes wrote a remarkable essay entitled ‘Economic possibilities for our grandchildren’, in which he argued that capitalism would be able to meet all of people’s material needs by around 2015 (i.e. by now) due to development of productivity. (p.61) People would arrive at the insight that non-material needs were more important than material needs and would work only five to ten hours per week, leaving them able to fully enjoy leisure, art, and culture. Capitalism would therefore reach a state of internal self-regulation which would push people to satisfy their emotional and spiritual needs once their material needs were met.

In their recent book How Much is Enough?, the Skidelsky father and son duo return to Keynes’s idea.14 They assume that what makes people happy is the ‘good life’, a concept developed by the Greek philosopher Aristotle. The core of the idea is that we can only be happy if we lead a good life in which we are able to develop fully as human beings. We achieve this through intellectual and artistic activities in an environment of tolerance and friendship. Of course these activities are only possible if our material needs are met. Once that is the case, non-material needs become the priority.

This vision of the development of human needs contains a built-in curb on material growth. As material prosperity increases people look for happiness in the satisfaction of non-material needs. This dynamics ensures that the drive for increasing material production drops, relieving pressure on the environment. Capitalism automatically leads to saturation for material goods and is therefore self-regulating.

The Skidelskys, however, are forced to observe that this dream of the good life has not worked out. The development of capitalism has not yet reduced the drive to possess ever more material goods. The promise that capitalism would automatically lead to satisfaction of non-material needs has not yet been fulfilled. This comes down to two phenomena.

Firstly the dynamics of capitalism are based on a continual quest for new products. Ten years ago there were no smartphones. No one really needed a smartphone, simply because no one could imagine such a thing. Now that they exist, the pressure to have one is irresistible, as is the case with many new products. Who these days does not want a tablet, a car with the latest electronic gadgets, or a smart TV? I am sure that if Keynes were alive today he would not be (p.62) averse to all these gadgets. By continually developing new, exciting products, capitalism shifts the saturation point for the satisfaction of material needs.

Secondly, even if Europeans and Americans were to strive en masse for the satisfaction of non-material needs, this would not stop the rest of the world (another six billion people) from striving for material progress. Material prosperity among those six billion people remains very meagre. For them improvement in this aspect of their lives remains the first priority.

At this moment consumption per capita in the American population is around seven times that in China. This means that the Chinese will continue to attempt to raise their material consumption for a long time to come. There are a great many unfulfilled material desires in the largest segment of the world’s population. Nothing will convince them that it is better to strive for the satisfaction of non-material needs. The drive of so many people to reach the consumption levels of the Western world cannot be stopped.

It will therefore be a very long time before the internal regulator will guide the system from the satisfaction of material requirements towards non-material needs. Meanwhile the market system sails inevitably towards its limits.

Kuznets’s Dream

Based on a statistical analysis of US tax data between 1914 and 1948, the American economist Simon Kuznets came to the remarkable conclusion in 1953 that income inequality in the US had dropped substantially. Based on this fact, Kuznets decided that capitalism contains a law which ensures that as a country becomes richer, income inequality drops. He expressed this in what would later be called the Kuznets curve, as shown in Figure 5.3. The horizontal axis represents income per capita, the vertical axis income inequality. We can see that when income per capita rises, inequality initially rises. Once a certain level of wealth is achieved, income inequality begins to fall.

(p.63) The Kuznets curve had a great influence on generations of economists and policy makers, debunking the Marxist idea that capitalism would lead to increasing inequality. This optimistic theory implied that as capitalism developed it would lose the unattractive feature of income inequality and become more socially acceptable. According to Kuznets, a self-regulating mechanism ensured that capitalism would not lead to revolutionary developments, as Marx had predicted.

The Utopia of Self-Regulation in the Market System

Figure 5.3. The Kuznets curve

In retrospect it seems that Kuznets’s vision was just a dream, based on a very limited period of history, between the two world wars. During this period income inequality did indeed drop in many Western countries, as shown in Figure 4.2. This drop in income inequality had a great deal to do with the revolutionary circumstances evoked by the wars, which weakened the position of the highest income earners in many countries. This was also expressed in spectacular rises in taxes on the highest incomes, as mentioned in Chapter 1.

The empirical evidence collected since then by economists such as Atkinson, Piketty, Saez, and others point to increased income inequality since the 1980s.15 This was also illustrated in Figure 4.2 and is particularly true of the Anglo-Saxon countries. Piketty recently (p.64) investigated the reasons for this trend. We will discuss his theory in Chapter 12. Here it is sufficient to conclude that no self-regulating mechanism exists in capitalism to reduce income inequality and prevent the system from clashing violently with its limits.

In Conclusion

In this chapter we questioned whether the market contains self-regulating processes which can prevent the system from ending in self-destruction. We observed that there was no in-built mechanism which can internalize the external costs created by the market system. Only an external organization, the government, can do this.

Capitalism itself is not capable of preventing an inevitable clash with its limits. Technological revolutions, in particular the digital revolution, do not currently raise productivity sufficiently to generate the resources needed to prevent environmental decline. Kuznets has turned out to be wrong in his belief that a highly developed capitalism would cause income inequality to drop. Piketty, Saez, and Atkinson point out that inequality in the most developed capitalist countries has recently increased.

The regulatory mechanisms must therefore come from outside the market system, and indeed from the government. How this should be achieved and how government regulation in turn hits its limits are the themes of Chapters 6 to 8.


(*) This idea has been around a long time. Its origin is to be found in the famous Coase theorem which says that when property rights are properly defined an efficient outcome will emerge in which the cost of externalities will be paid by one of the parties in the contract.

(13.) Erik Brynjolfsson and Andrew McAfee, Race Against the Machine: How the Digital Revolution is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy (Lexington, MA: Digital Frontier Press, 2012).

() See Robert Gordon’s fascinating recent book, The Rise and Fall of American Growth: The US Standard of Living since the Civil War (Princeton, NJ: Princeton University Press, 2016).

() This is not the case in Asian countries such as China, where we see very high growth in productivity. This is because these countries are catching up historically, which enables them to introduce Western technologies on a grand scale without having to develop them themselves.

(14.) Robert Skidelsky and Edward Skidelsky, How Much is Enough? The Love of Money, and the Case for the Good Life (London: Allen Lane, 2012).

(15.) Facundo Alvaredo, Tony Atkinson, Thomas Piketty, Emmanuel Saez, and Gabriel Zucman, The World Wealth and Income Database (WID), <http://www.wid.world>, and Tony Atkinson and Salvatore Morelli, The Chartbook of Income (p.158) Inequality, VoxEU (2014), <http://www.voxeu.org/article/chartbook-economic-inequality>.