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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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Who Can Save the Market System from Destruction?

Who Can Save the Market System from Destruction?

(p.65) Chapter 6 Who Can Save the Market System from Destruction?
The Limits of the Market

Paul De Grauwe

Oxford University Press

Abstract and Keywords

Economists have developed an important theory on the question of how governments should tackle externalities. The great proponent of this theory was Arthur Cecil Pigou, an English economist of the first half of the twentieth century. He argued that if a company generates external costs by emitting harmful substances, the government should determine the magnitude of the costs and impose them on the company. This is best achieved by taxes or imposing quantitative limits on the emissions. Similarly, in order to reduce inequality economists favour a progressive tax system This chapter teaches us what governments should do. We know what controls can rescue the free market from its downfall. These controls can only be implemented by governments. But is this knowledge sufficient? We often know what governments should do. But that does not mean it is what they will do.

Keywords:   growth vs inequality, redistribution, personal income tax, externalities, quantitative limits

In the previous chapters we argued that if the market system were left to its own devices, it would hit its limits. This clash might lead to the system sustaining serious damage, if it is not destroyed completely. I also argued that within the market system no self-regulating mechanisms exist to prevent this clash. The question then is whether there are mechanisms outside the market system to curb this destructive trend and thus prevent its downfall.

In this chapter we will see that in principle such a mechanism exists, made possible by government policy. We will begin by developing the theory that constitutes the foundation of the role of government as a regulator of the market system. We will also discuss three domains in which the government has a role to play: in tackling externalities, supplying public goods, and redistribution.

The Role of Governments: Externalities

Economists have developed an important theory on the question of how governments should tackle externalities. The originator of this theory was Arthur Cecil Pigou, an English economist of the first half of the twentieth century. He argued that if a company generates external costs by emitting harmful substances, the government should determine the magnitude of the costs and impose them on the company. This is best achieved by levying taxes.

(p.66) Of course, once again, we run into an information problem. How can the government estimate the external damage caused by one individual company? As I argued previously, this is extremely difficult. Governments can, however, work on a trial-and-error basis. Initially a tax is imposed, for example five pounds per tonne of sulphur emissions, and the effect is measured afterwards. If sulphur emissions fall insufficiently, the tax is raised until we approach the optimal tax rate, that which ensures that sulphur emissions are so low that they no longer pose a risk to health.

Pigou also distinguished between positive and negative externalities. Negative externalities cause harm which must be tackled by government through taxes. There are also positive external effects. The classic example is renovation of house facades in the city. This brightens up the street, benefiting others beyond the house owner. Governments can encourage such activities with positive external effects by providing subsidies for renovations.

Here it is interesting to consider whether the emission of harmful substances should be fought using taxes or rather using quantitative limits on emissions (as the European system of emission standards attempts to do). Taxation is an indirect method, quantitative restrictions a direct one. Economists have been weighing up which approach is the most efficient.

The answer is not immediately clear and has led to fierce debates among economists. A principle people generally agree on is that efficiency is best served if the government develops techniques which are also used in the market system. This is the case with the European approach to controlling CO2 emissions, which is based on negotiable emission standards, working as follows. Every year the European Commission sets the maximum permissible quantity of CO2 which large energy users (electricity companies, the steel or chemical industries, etc.) are allowed to emit. Assume that the limit is one million tonnes. The European Commission then divides emissions rights totalling one million tonnes between the companies which emit CO2. This distribution is free and generally in proportion to each (p.67) company’s past emissions. If the company wants to expand, it will need to emit more, and it can buy the right to do so on the market. These CO2 emissions rights will typically be supplied by companies which emit less CO2 than the rights they have been allocated. Supply and demand of emissions rights come together in a market and a price is established. The clever thing about this system is that the companies are incentivized to use production techniques which emit little CO2, enabling them to sell their unused rights. This makes the quest for CO2-efficient technologies profitable. We effectively simulate a market mechanism.

This system of imposing restrictions on the market is very attractive. It does, however, assume the existence of an institution outside the market, in this case the European Commission, to set the global emissions levels. The market cannot do this on its own strength.

In practice the European system of negotiable emissions rights shows how difficult it is for governments to impose such restrictions on the market. The intention was that the European Commission would reduce the quantity of global emissions rights, raising their price, which in turn would increasingly incentivize companies to use production techniques which involved low emissions. Unfortunately that has not worked so far. When the system started up in 2006, the price of a tonne of CO2 was around 20 euros. Companies wanting to emit an extra tonne had to pay 20 euros, and companies managing to save a tonne of emissions were rewarded for their good behaviour with 20 euros. In 2014 the price of a tonne of CO2 has collapsed to less than 5 euros. With the price so low, there is no longer much of an incentive to reduce emissions.

One of the main reasons for this failure is that the European Commission failed to stand up to intensive lobbying by the major energy-intensive industries, many of which received exemptions from their national governments. As a result the European Commission was far too generous in allocating CO2 emissions rights. This over-supply is the main cause of the collapse of the price of CO2.

(p.68) So there are many problems with the practical implementation of government regulation. A method might sometimes seem desirable from a theoretical perspective, as in the case of CO2 emissions rights, but not be chosen for practical reasons.

The Role of the Government: Public Goods

As we have discussed in detail, public goods do not arise automatically in a market system, mainly because the market system offers no solution to the free-rider behaviour of those who would like to benefit from public goods but do not want to pay for them. Again an external organization is needed to correct the market.

In democratic societies there is only one good way of achieving this. The scenario is as follows. Citizens indicate their preferences for public goods to the politicians who represent them. If a majority can be found in favour of building an extra railway line, for example, then politicians in a democratic country will listen and decide to do so, financing it through taxes. In actual fact, this is a very unattractive method because there is an element of compulsion involved. After all, there will be some opponents of the railway, who will also have to pay. Regrettably there is no alternative to this compulsion. As we saw previously, if funding is organized on a voluntary basis, there is a chance that the railway line will never be built, even if a large majority is in favour.

Here again the practical implementation of the theory is not straightforward. Often there is no consensus on the question of which and how many public goods are needed. Every decision to produce public goods also has side effects. The new railway, for example, will run on private land, which will have to be expropriated. The owners will not just give it up but will organize to disrupt the building of the railway (or prison, or waste incinerator, etc.).

We therefore need a strong government who can resist the pressure from interest groups. But how strong does the government need to be to do that? As strong as the Chinese government, which informs (p.69) house owners a week before work starts on a new road that the bulldozers are on their way? We probably would not want that. We will return to this problem in the following chapters.

This theory on the method of tackling externalities and public goods is normative. It tells us what the government ought to do. It is important to know this, as it enables us to formulate the restrictions the government should set on the working of the market system, which should in principle prevent it from causing its own downfall.

The Role of the Government: Redistribution

In the previous chapter we saw that the market system is indifferent to income and wealth distribution. There may even be ‘market equilibrium’ when some people have no income and are dying of starvation. Many people, however, see such an equilibrium as unacceptable.

In order to keep the market system socially acceptable, and to avoid dissatisfaction turning into violent rejection, an institution outside the market is required to redistribute incomes. The market itself will not do this. Only the government is capable of it. Paradoxically enough it is the government which is able to rescue the market system by redistributing income and wealth. The owners of capital who have acquired a larger and larger piece of the economic pie over recent decades form a danger to the survival of capitalism. In this sense capitalists are the greatest enemies of capitalism.16 In order to save the free market system, governments must tax the highest incomes and fortunes more heavily than they currently do.

Criticism of this approach rests on the idea that high taxes on top incomes have negative economic effects. People who earn millions and who are heavily taxed on their income above a million pounds, for example, would make less effort and show less initiative, which would negatively affect economic growth.

Who Can Save the Market System from Destruction?

Figure 6.1. Trade-off between growth and income equality

This vision is reflected in the form of a graph showing the relationship between equality and growth (see Figure 6.1). The horizontal axis shows the level of income equality, the vertical axis economic growth. (p.70) The relationship is negative. The economists see this as a trade-off, where we must sacrifice one thing to gain another. If we want more growth, we must allow greater inequality. The prospect of earning a great deal of money encourages people to develop new initiatives, which eventually boosts economic growth.

There is a grain of truth to this theory. If everyone is equal then few people will be prepared to exert themselves to take initiatives, and economic growth will inevitably drop.

Of course the question is how great inequality can be permitted to become. Figure 6.1 shows that when equality tends towards zero (which implies maximum inequality), economic growth reaches its maximum. But that seems improbable. When inequality is at its highest—when one person (or family) takes all the income, leaving none for anyone else—then it is unlikely that growth will be high. On the contrary, in situations of such extreme inequality economic growth will collapse, if only because this will be a society of revolutions and political instability.

We can summarize it as follows. Too much equality (as in communist regimes) is not good for economic growth. Too much inequality is (p.71) not good either, because it sets mechanisms in motion (such as social and political instability) which seriously endanger economic growth.

In a recent study the International Monetary Fund (IMF) explored the relationship between income inequality and economic growth in a large group of countries.17 The results are surprising. The IMF comes to the conclusion that on average the countries which grow faster are those with less inequality. The IMF also finds that redistribution policies generally do not inhibit growth. These results cast doubt on the simple picture presented in Figure 6.1.

Who Can Save the Market System from Destruction?

Figure 6.2. Highest personal income tax rates

Source: Piketty, <http://piketty.pse.ens.fr/en/capital21c2>

Who Can Save the Market System from Destruction?

Figure 6.3. Average annual growth in per capita GDP (in %)

Source: Piketty, <http://piketty.pse.ens.fr/en/capital21c2>

This also becomes clear from a comparison of Figures 6.2 and 6.3. Figure 6.2 gives the tax rates of the highest incomes from 1900 to 2010. (This is the same as Figure 1.3, with the addition of developments in rates since 1980.) Figure 6.3 represents economic growth in Western Europe and North America. We are now in a position to make a really (p.72) remarkable observation. During the post-war period, when tax rates were at their highest, economic growth reached a historic high. Since the 1980s tax rates have been dramatically lowered under the influence of a new market philosophy, and from that point on economic growth also dropped sharply. The prediction that lowering tax rates on the highest incomes would encourage private initiative, in turn leading to more investments and higher economic growth, has not been supported at all.

The mechanisms which ensure that countries with greater income equality generally experience higher growth (as in Scandinavia) relate to the socially and politically stabilizing effects of greater equality.

The reason why a redistribution policy, focusing on taxing the very highest incomes, does not have a negative effect on economic growth can be explained as follows. Above a certain income, taxation barely affects effort. A top manager who earns ten million pounds does not work any harder than one who earns ‘just’ one million. At that level intrinsic motivation (pleasure in management and power) plays a (p.73) much greater role. This means we can siphon off a much larger proportion of these top managers’ financial remunerations without economic loss.

The case is similar to that of top footballers, who easily top ten million pounds per year in the Premier League. Would their game suffer if the government were to siphon off their earnings above the first million? In my view they would play just as well, perhaps even better, because people with such absurdly high incomes become arrogant and end up spending more and more time on activities other than sports.

A drastic redistribution policy aimed at the top earners with extremely high incomes would thus eventually benefit the market system, strengthening support in society for the system and preventing it from reaching its internal limits. (p.74)

In Conclusion

This chapter has taught us what governments should do. We know what controls can rescue the free market from its downfall. These controls can only be implemented by governments. But is this knowledge sufficient? We often know perfectly well what governments should do. But that does not mean that governments will do what is necessary (as I suggested in this chapter). That is because governments are also subject to limitations. These make it difficult to impose what is good for society as a whole on individuals. Great discrepancies can exist between collective and individual rationality, in politics just as elsewhere. This is the subject of Chapter 7.


(16.) See Raghuram G. Rajan and Luigi Zingales, Saving Capitalism from the Capitalists (New York: Crown Business, 2003), and Thomas Piketty, Capital in the Twenty-First Century, trans. Arthur Goldhammer (Cambridge, MA: Belknap Press, 2014).

(17.) Jonathan D. Ostry, Andrew Berg, and Charalambos G. Tsangarides, Redistribution, Inequality, and Growth, IMF Staff Discussion Note (April 2014), <https://www.imf.org/external/pubs/ft/sdn/2014/sdn1402.pdf>.