Rise of the market state

WHEN the Berlin Wall fell in 1989, free market fundamentalists crowed that it was the end of central planning and the triumphalism of their philosophy. Twenty years later, with excesses of fiscal spending and having to bail out the banking system, the Western economies all have very large state involvement in the economy and fiscal deficits are historical huge by any standards.

No country today can claim with an honest face that their banking systems are totally private owned. Many are still being kept on life support by huge deposit guarantees and cheap funding by central banks, including large state ownership. In order to generate employment, governments are spending unprecedented amounts.

How big is the size of the state in the total economy? The more advanced economies tend to have very large governments. France has government expenditure around 50% of GDP and the US at 40% of GDP. By comparison, China and Indonesian government expenditure are only 20% of GDP. According to historical data, for most of Chinese history, government revenue never exceeded 10% of GDP.

Government has grown in size due to growing demand for government services. The minimum government services are defense, security, health, law, infrastructure and education. Government was not always financed by taxation. Throughout history, government has been financed sometimes by monopoly over certain activities, such as sales of salt, tobacco or alcohol. Thus, including state-owned enterprises into the sphere of government activity would increase the size of the public sector.

As Asia grew faster than the West, there has been considerable unease that Asian governments have been much more intrusive and mercantilist than the advanced economies. When Japan became the first Asian economy to join the ranks of industrial countries, the Japanese government was quite keen to push the Japanese model of development, especially the positive role of the public sector. In the 1980s, the Japanese government financed a World Bank Study on the Asian Miracle.

The World Bank economists, who were imbued by free market philosophy, were initially unwilling to accept the fact that governments have a major positive role in economic development. But as they dug into East Asian growth, they realised the strong role government played in fostering sound markets. Indeed, without an active role of Asian governments in building up the infrastructure, devoting resources to education and health and providing political stability and protection of property rights, Asian markets could not have grown so fast. The World Bank economists admitted that Asian state-market cooperation succeeded because the state “mimicked” the market.

Even though the free market World Bank economists hated the idea of governments “picking the winners”, they had to admit that Asian technocrats somehow did select the key industries to develop, but with crucial input from the market. They did not pick winners from thin air, but worked with the market and had good feedback on when to advance and when to retreat.

With the failure of central planning, free market philosophy gained dominance. Throughout the advanced economies, the philosophy was to reduce the role of the state and roll back government intervention. For the developing economies, the advice was to privatize, whereas for the advanced economies, former government activities became joint-ventures through what is known as Private-Public Partnerships. When the governments could not afford to undertake any infrastructure investment, the private sector was invited to invest through Build-Operate and Transfer contracts.

In many countries, this strategy worked and efficiency did increase. But in other countries, privatisation became “piratisation”, in which politically connected elites enjoyed the perfect game – private profit at public expense. Indeed, while economists argued for free markets, the democratic movement was arguing for exactly the opposite, more and more government intervention to deal with social justice, protecting the environment and better social infrastructure.

The global financial crisis has laid bare the free market dogma. The market cannot solve all problems and may create excesses that need to be curbed. If regulation is too market friendly, the system may be captured so that “too large to fail” institutions can hold whole countries to ransom. Indeed, global banks have become larger than national governments who were forced to bail them out with public debt. In less than five years, the US public debt has doubled to 100% of GDP. Governments have been forced to be more intrusive in markets because of the high cost of moral hazard.

Actually, where Asian government has succeeded is not whether the government led the way, but where the balance between government and the market was delicately calibrated. Economies work well where governments knew how to let the market work where it functioned best and the government concentrated on what it did best. The idea of Hong Kong being the freest market in the world is a bit of a myth, considering that half of Hong Kong citizens live in government owned low-cost housing and the government provided superb social welfare. Positive non-intervention did not mean no intervention.

It meant that the government provided the environment for the private sector to thrive, without competing directly with the private sector. How far the pendulum has swing is demonstrated in the recent report that US regulators have begun to ask hedge funds not to destroy trading records on euro bets, as Europe and the US step up scrutiny of the funds’ role in the Greek debt crisis. I still remember when Asian governments asked the developed markets to investigate the role of hedge funds, the advanced market regulators were so skeptical of market manipulation that they set up task forces to prove that the hedge funds were not responsible for the market turmoils in Asia.

By contrast, China recently approved the use of short selling, whereas in 2008 the leading Western banks were the first to complain to their regulators to ban naked short-selling on their stocks to prevent their meltdown.

Regulators investigating the role of hedge funds speculating on the euro would be wise to start measuring the proprietary trading position of their large banks and prime brokers first to find out whether these positions are larger than those of the hedge funds. During the Asian crisis, I learnt that it was not always your enemies who are acting against your interests. If you have friends like these, who needs enemies?

● Datuk Seri Panglima Andrew Sheng is adjunct professor at Universiti Malaya and Tsinghua University, Beijing. He has served in key positions at Bank Negara, the Hong Kong Monetary Authority and the Hong Kong Securities and Futures Commission, and is currently a member of Malaysia’s National Economic Advisory Council. He is the author of the book “From Asian to Global Financial Crisis