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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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External Limits of Governments

External Limits of Governments

Chapter:
(p.75) Chapter 7 External Limits of Governments
Source:
The Limits of the Market
Author(s):

Paul De Grauwe

Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780198784289.003.0007

Abstract and Keywords

The fundamental cause of limits to government action is the same discrepancy between individual and collective rationality which limits the market system. Individuals resist the attempts of government to harm private interests in favour of the collective. The big challenge of governments is therefore to bridge the difference between individual and collective rationality. This is best achieved in democratic forms of government of an inclusive type. Inclusivity makes it easier for the government to achieve consensus on decisions necessary to promote collective interests. The individuals who are harmed by the collective action are compensated by the others, so they will agree more easily to interventions. Decisions can take a long time, but when made are backed by broader support. Exclusive authoritarian regimes have serious problems gaining support because it is easier for private interests to infiltrate such political systems, so there the discrepancy between private and collective interests is greater.

Keywords:   inclusive systems, exclusive systems, democratic systems, authoritarian systems, collective action

There are limits to governments which prevent politicians from following the normative prescriptions of economic theory. In this chapter we will address the external limits of governments. In Chapter 8 we will discuss their internal limits.

As in the market system, the external limits of governments relate to externalities. Here I will defend the following proposition. The fundamental task of governments is to promote the collective interest (for instance a clean environment) where the market does not. We saw above that the market fails in the face of externalities. When that happens governments must step in. However, as we saw previously, that is also the moment at which the discrepancy between individual and collective interests is widest. If there is no discrepancy, governments do not need to intervene. That is only necessary when the discrepancy is too large.

Government Action Struggles to Get off the Ground

This means that governments must step in in unfavourable circumstances. It is in cases of large differences between individual and collective interests that governments should take action. This makes government action extremely difficult.

If a company causes a great deal of pollution, this in fact indicates that from the perspective of society, production, employment, and profits are too high. In order to uphold the collective interest (in this case a clean environment), the government will need to impose a tax (p.76) on the company, reducing production, employment, and profits. The more the company pollutes, the higher the tax will need to be and the greater the drop in production, employment, and profits.

There is no escaping it. In order to promote the collective interest, the government will have to harm private interests. What are the private interests in this case? We have the company shareholders, whose shares will drop in value; there are the managers, who will receive smaller bonuses; and there are the employees who will lose their jobs due to reduced production.

These private interests will organize to persuade politicians not to levy the environmental tax. The interests of the owners, managers, and employees clash with those of the many people harmed by pollution. The government will have to weigh up the interests of the two groups (which in fact overlap). That is not an easy task for various reasons.

Firstly, once again, there is an information problem. Given that it is very difficult to determine scientifically the magnitude of the harm from pollution, the information will almost inevitably be manipulated. The representatives of manufacturers in polluting industries will commission studies to downplay the impact of the pollution. For instance it recently transpired that large American companies subsidized reputable, ‘independent’ think tanks to carry out research to show that the negative effects of global warming were exaggerated.

Secondly there is also an important asymmetry in the collective action of different interest groups. This phenomenon has been brilliantly analysed by Mancur Olson in his book, The Logic of Collective Action.18 The industries which pollute the environment have large, concentrated interests to defend. An environmental tax can have a substantial negative effect on the turnover and profit of polluting companies. They will therefore be prepared to commit considerable resources in order to combat an environmental tax. Since they are not so numerous, they will also find it easier to organize and take collective action. For the many millions of people bearing the costs of pollution the situation is different. They do not experience these (p.77) costs in the same intense manner as the producers. The victims, although much more numerous, find it less easy to exert political influence, only succeeding if the costs of pollution are extremely high.

Democracy Helps

Governments must therefore mediate between the interests of the minority, which employs every means it can to ensure its interests are served, and a majority of people who incur damage. It is not clear beforehand which direction the government will take. Much will depend on the democratic quality of the institutions. In many countries the minority wins. In these countries the government systematically chooses in favour of the large polluting businesses. This is possible because there is no functioning democracy in place. Politicians are bribed by polluting companies, without any mechanism to put a stop to it. This is referred to as ‘crony capitalism’, where the government systematically defends capitalist interests. Companies exploit their labourers unpunished, destroy the environment, and conspire to push up prices. Politicians, who are bribed or even control large parts of the industry themselves, openly defend the capitalists. A symbiosis arises between government and capital.

In other countries the quality of the democratic authorities ensures that the voice of the majority dominates. This is the case, for example, in Scandinavian countries, where strong democratic institutions, including an independent press, counterbalance the polluting companies.

Daron Acemoglu and James Robinson distinguish here between inclusive and exclusive political systems.19 An inclusive political system is based on the rule of law. It is an open system, in which all citizens can share in economic prosperity and have the chance to take initiatives. Exclusive political systems are closed systems, in which a small elite make the political and economic decisions and take a large proportion of the economic surplus for themselves. The majority of the population is excluded.

(p.78) The problem of an exclusive political system is that the discrepancy between collective and individual interests is too great. The political pressure which the victims of pollution exert becomes ever greater. Since there are no democratic channels (such as elections), this political pressure must be exerted through protests, social action, and violence, destabilizing the system. This can lead to political upheaval which seriously damages the market system.

We run into the following paradox. Democracy is needed to safeguard capitalism in the long term. Democratic institutions make it possible to identify collective interests quickly and give them a voice. This forces politicians to promote collective interests instead of the individual interests of the rich and influential. In this way democratic institutions bring stability. The discrepancy between collective and individual interests does not grow to excessive proportions.

In his impressive book Martin Gilens20 analyses how the American political system promotes the interests of those with the highest incomes. This is closely related to the fact that in the US money is the determining factor in winning elections. To a certain extent it could be said that the US is also a victim of crony capitalism. That makes it very difficult for the government to take care of the public domain, such as the environment.

Better known examples of crony capitalism appear in countries in Asia, Africa, and Latin America. Many countries are also unstable. In time there will be revolution and violence, which will damage the mechanism of the free market system. As I concluded previously when I talked about inequality, the true enemies of capitalism are the capitalists themselves.

I argued above that political action to reduce the discrepancy between individual and collective interests is difficult to get off the ground, but let us now assume that the government is working to promote the (p.79) collective interest, even when that is at the expense of private interests. Where do the limits of necessary government action come from?

I argued earlier that every government action which attempts to defend collective interests will harm private interests. Such policies are also coercive in character. To start with, taxes must be levied, and they are imposed on individuals against their will. Furthermore, the entirety of the collective action is aimed at changing the behaviour of individuals. That can be achieved gently through the price mechanism. For example a tax on products which pollute the environment will raise their price. Consumers remain free to buy the product, but because it has become more expensive, many consumers will buy less of it. Coercion is unavoidable, even with this soft approach, because it involves levying a tax. There are some harmful activities, however, which cannot be tackled softly and must be prohibited. Punishments follow for those who fail to respect the prohibition.

These are top-down control mechanisms which attempt to rein in individuals, distancing us from the market system, which is based on free enterprise. In the market system no one orders the baker to bake bread. He does so of his own free will and in pursuit of profit. He decides for himself how long to work and how much bread to bake.

The problem of lack of freedom crops up particularly in the case of the environment. Deterioration of the environment in many countries, and especially global warming, creates existential problems for the human race. There is rising pressure on governments to do something about it, leading to more top-down control, which often feels stifling. People feel they are losing their freedom and respond by rejecting the policies involved. In many countries, especially the US, this takes the form of negationism, where people deny that there is a problem. As I argued above, part of this strategy of denial is inspired by self-interest and pursuit of profits among industrial companies. But it is also in part a psychological response to an ever more controlling and even repressive environmental policy. This limits what governments can do when they prioritize collective interests.

(p.80) In Conclusion

We observe that the fundamental cause of limits to government action is the same discrepancy between individual and collective rationality which limits the market system. Individuals resist the attempts of government to harm private interests in favour of the collective. The discrepancy here works in a different direction from the market system, where individuals make decisions which harm the collective good. Here the opposite applies. The government which steps in to defend the collective interest comes up against individual interests, restricting their radius of action.

The big challenge of governments is therefore to bridge the difference between individual and collective rationality. This is best achieved in democratic forms of government of an inclusive type. Inclusivity makes it easier for the government to achieve consensus on decisions necessary to promote collective interests, as in such systems the costs and benefits of government interventions can be more easily spread over the entire population. The individuals who are harmed by the collective action are compensated by the others, so they will agree more easily to interventions. This may mean that the decision process in such inclusive democratic societies can take a long time, but when decisions are made they are backed by broader support.

Exclusive authoritarian regimes have serious problems gaining support because it is easier for private interests to infiltrate such political systems. The result is that the discrepancy between private and collective interests is greater than in democratic societies.

Notes:

(18.) Mancur Olson, The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge, MA: Harvard University Press, 1965).

(19.) Daron Acemoglu and James A. Robinson, Why Nations Fail: The Origins of Power, Prosperity and Poverty (London: Profile, 2012).

(20.) Martin Gilens, Affluence and Influence: Economic Inequality and Political Power in America (Princeton, NJ: Princeton University Press; New York: Russell Sage Foundation, 2012).