State or market? Rethinking the Post-Covid interaction

Economic growth
Financial Economics

The pandemic exposed the fragilities of an interconnected world. Although less lethal[1] than other plagues, COVID-19 quickly exacerbated the planet’s fault lines. Due to the virus’ global spread, long ignored truths are now becoming self-evident. Aging[2] and climate change threaten humanity’s future. Half of the world’s population has no access to the internet. Inequality[3] corrodes the foundations of society, putting democracy at risk. Future shocks could exceed the ‘ability to respond’ of governments, businesses and citizens.

Yet, remarkable progress is possible. The pandemic stimulated human reactive capabilities. Vaccines were developed in months, not years - the fastest rollout in history. Unusually proactive, most governments launched ambitious ‘multi-year development plans’ - intervening in sectors deemed strategic for the future. The chance for a true transformation is real. Going forward, policymakers should aim at forging a better world, not at returning to the ‘pre-pandemic status quo’.

It’s time to create functioning societies. If not now, when? As innovation responds to unresolved needs, 2021 is the perfect time to start[4]. To build a sustainable, inclusive, more prosperous society, the objective is to maintain - within a democratic system - the balance between market and state. In other words, democracies cannot avoid the issues of: 1) individual freedom (i.e.: the right to self-realization); and 2) equity, at least as a principle of distributive justice (i.e.: fair sharing of costs and benefits). More concretely, it is imperative to re-think: i) democratic rules – as most policy-choices impact future generations, well beyond the electoral cycle[5]; ii) economic and cultural growth, to build livable cities, stronger communities, green manufacturing (i.e.: social well-being); and iii) ‘equal opportunities’, by redefining basic entitlements for all citizens (e.g.: education, health and environmental protection).

The funds are there, but money alone is insufficient. The world responded to the COVID-19 crisis with massive policy stimuli: USD10 trillion, 12.5 percent of global ‘gross domestic product’ (GDP), slightly less than China’s GDP and three times more than during the 2008 financial crisis[6]. Yet, resource-abundance has rarely led to economic development. In resource-rich countries, socio-political pressures induce policy failure, as powerful ‘pressure groups’ shape the policy-agenda to capture large rents. How can ‘post-COVID-19 recovery plans’ escape this destiny?

Changing the ‘status quo’ requires exceptional efforts. Top priorities are: 1) addressing population aging[7]; 2) greening the economy; and 3) attaining digitalization. However, vested interests make reforms politically unpalatable. Tackling ‘population aging’ - especially in high-income countries[8], where the median age is above 40 - requires: i) acknowledging that most pension systems are financially unsustainable; and ii) reducing the resources allocated to the most sizeable share of the electorate - the elderly. Italy is a case in point: in 2021, public sector retirees are likely to outnumber employees; in May 2020, the country paid more pensions (22.78 million retirees) than wages (22.77 million workers). ‘Greening the economy’ is likely to be as challenging: every year governments across the world subsidize fossil-fuels (coal, oil, gas) for an amount equivalent to Japan’s GDP, produce electricity by burning them, and authorize the chopping to ‘non-forest use’ of an area the size of Belgium[9]. Yet, the ‘greening agenda’ entails[10]: i) ending  fossil-fuel subsidies; ii) addressing ‘indirect carbon-footprints’ of electric vehicles[11]; and iii) stopping deforestation. Also ‘bridging the digital divide’ is easier said than done; digital education - i.e.: providing internet to every child, in every home or classroom - demands massive investments[12].

Who takes the lead? Moving beyond an empty dichotomy. The question “state or market?” is poorly posed[13]. The dichotomy between “intervention - state - planning - equity” and “laissez faire - private sector - market - efficiency” stems from inappropriate consequential reasoning: the state can be inequitable[14] and the market inefficient[15]. Debates about primacy should end: state and market are complementary - not substitutes. Whenever governments and markets have worked well together, the results have been spectacular: ‘moon landing is the most quoted, quintessential example.

Both states and markets must play a leading role. To overcome the antagonism, pragmatic policymakers must foster a public-private cooperation based on principles and value added. When enacted. it does work. For example, both Lufthansa and Alitalia are state-owned[16], but Lufthansa is able to perform in global markets. Making sure that each sector plays its role effectively: i) enables both the production and distribution of goods and services (i.e.: an efficient economic system); ii) nurtures innovation across multiple sectors (i.e.: a higher ‘growth potential’); and iii) ensures equality of opportunity via redistribution (i.e.: social justice).

The state must set the framework for the markets to function ... State intervention is needed to kick-start growth: in the initial phases of development, when a country is far[17] from the ‘technology frontier’, the market alone cannot get the economy off the ground[18]. For instance, the state played an essential role in kick-starting industrialization[19] in Italy, Japan and South Korea. By setting both the legal and institutional framework[20], the state secures the enabling environment[21] for competition and innovation. If the state fails, the markets cannot follow a trial-and-error ‘discovery process’, operate in a vacuum and fail themselves - hence requiring the state’s corrective action.

… but in the long run, innovation needs a competitive private sector. As the economy approaches the ‘technology frontier’, state intervention loses strength. Eventually, barriers to entry, patronage and political corruption protect incumbent businesses[22]. Inevitably, investments in R&D decline, harming growth[23]. To develop ‘new business models’ and create new companies, entrepreneurs need an environment where ideas can connect and ‘creative destruction’ can play its role – via competitive pressures and generational turnover. As higher dynamism and competitiveness lead to rising R&D investments, innovation triggers the evolution of the economic system - increasing the country’s growth potential. Today, in South Korea’s innovative economy, large companies coexist with start-ups and SMEs.

For the state to be effective, policy design requires a holistic approach ... In public policy, dependencies and unintended consequences matter. For example, ‘climate change’ and ‘population aging’ are key drivers of migration and cannot be ignored when designing immigration policies. Also, ‘deforestation’ not only leads to ‘global warming’, but also drives wild animals closer to humans - increasing the likelihood of viral infections, via ‘cross-species leaps’. As a result, most decisions cannot be taken in isolation: solving problems in one place is likely to create new ones, elsewhere. Also, well-intentioned policy choices can often provide perverse incentives - and obtain the opposite of their stated objectives. The phenomenon is known as the “cobra effect”: in India, during British rule, the authorities’ bounty on dead cobras resulted in a larger cobra population[24]. In other words, policy making: 1) relies on a complex, interrelated context; and 2) can lead to unpredictable, non-linear outcomes.

... and well-designed conditionalities. It’s not all about money: ‘resource management’ is key. Seventy years ago, the Marshall Plan transformed Europe by placing ‘pro-market’ conditions[25] on its abundant financial aid. Today, to manage an unprecedented debt issuance without compromising the future of the new generations, governments must be able to design, implement, and enforce conditionalities. When designed and implemented correctly, ‘conditional financing’ can: 1) steer resources towards the strategic objectives; 2) avoid speculative capture, by ensuring the productive use of public resources; and 3) push the private sector towards inclusive, sustainable growth[26].

Governing is not easy. Competent professionals are needed. In absence of: i) intelligent leaders to design it; and ii) a lean bureaucracy able to enact it, a conditionality-based approach is often ineffective and can lead to unforeseen consequences – such as extra cobras in Delhi’s streets. To provide ‘complex solutions to complex challenges’, policy makers need to be competent enough to assess the task ahead, and address it by taking suitable risks. Even to use funds effectively, a degree of creative thinking is essential[27]. In short, democratic systems need to elect - and the state needs to hire - according to talent and merit, not patronage. Skilled managers need to be put in positions of power to serve citizens and businesses - and properly rewarded.

The great reset: achieving a dynamic public-private equilibrium. The state needs to enable the markets, but - contrary to the dreams of planners and technocrats - development cannot be ‘state-managed’. For the business environment to lead to innovation, the state needs to protect ‘public goods’ such as: i) competition; and more broadly ii) the entrepreneurial spirit. Policymakers must achieve a practical, dynamic balance in the state-market mix. For example: 1) to protect democracy, the expansion of state’s responsibilities must go hand in hand with higher accountability; 2) debt/GDP ratios should increase only if debt-financed activities lead to long-term competitiveness and sustainable growth[28]; 3) to attract international capital, structural reforms must be supported, not voided, by abundant financing; 4) strategic industries must be transformed with investments in infrastructure and technology, not saved if unproductive or obsolete[29]; and 5) bailouts, if any, should be subject to strict conditions, such as internalizing ‘negative externalities’ - for example, the adoption of climate targets; e.g.: France’s five-year domestic ‘emissions-reduction targets’).

The stakes are high: don’t compete, cooperate! Each country’s future trajectory will depend on its political leaders’ vision and skills, and on the speed and the quality of the policy response. Policy-makers must resist the temptation to simplify a ‘complex operating environment’ into a simple choice of ‘state or market’; rather, they must create the conditions under which an ‘effective policy framework’ and ‘competitive market mechanisms’ can, together, foster development. Concretely, a competent public sector needs to make use of conditionalities to enable the private sector to help the transformation. Inevitably, organized and innovative countries will come out ahead, while slow and bureaucratic ones - characterized by powerful rentiers, little competition, low growth and high debt - will suffer the most. Policy mistakes will cost exponentially; economic, political, and social outcomes will diverge radically. Complexity will keep rising[30], driven by hyper-connectivity, artificial intelligence and social changes. For citizens to regain trust in both the state and the market, courage is needed. Steve Jobs used to repeat: “People crazy enough to think they can change the world are the ones who do”.

Article based on material prepared for the session: “Public intervention in the economy and innovation: can they coexist?” Exssa, December 21, 2020.

[1] Pandemics develop in idiosyncratic circumstances, i.e.: different diseases spread in diverse social and political contexts. Comparisons are possible via the ‘case fatality rate’ (CFR) – i.e.: the “number of reported deaths per number of reported cases”. So far, COVID-19 has a lower CFR (approx. 2.1 percent) than: 1) Ebola: less than 30,000 cases; average CFR: 50 percent; 2) Avian influenza A: i) H5N1 - 649 cases, CFR: 60 percent; ii) H7N9 - 571 cases, CFR: 37 percent); 3) MERS-CoV: 2,502 cases, CFR: 34 percent; 4) SARS-CoV: 8,422 cases, CFR: 15 percent; and 5) 1918 influenza (known as Spanish Flu, occurred during World War 1): H1N1 - 50 million deaths; CFR: 2-3 percent.

[2] At the global level, in 2018 - for the first time in history – ‘persons aged 65 or above’ (‘over 65’) outnumbered ‘children under five years’ of age (‘under 5’). By 2050: 1) the number of ‘over 80’ is projected to triple, to 426 million (from 143 million in 2019); 2) ‘one-in-six’ persons will be ‘over 65’(16 percent of the world population), up from ‘one-in-11’ in 2019 (9 percent); and 3) in Europe and Northern America, ‘one-in-four’ could be ‘over 65’. In G20 countries, the average number of ‘retirees per worker’ is projected to rise substantially.

[3] Virus-containment measures – by bringing about: i) the worse peace-time recession in a century; and ii) low schooling and rising illiteracy – risk: 1) making 80 percent of the world’s population worse off, and 20 percent better off; and 2) leading to a return to per capita-incomes of the 1990s, setting the ‘economic clock’ back by 30 years.

[4] According to entrepreneur Steve Jobs: “you keep going, (…) live with the problem, think about it and resolve it”. According to economist Joseph Schumpeter, innovation does not require a ‘new creation’, it is not a real invention. It is - for example - combining existing materials in a way never seen before, anticipating new needs. “The entrepreneur does not invent, he innovates”: he changes the organizational methods of the company, modifies the production processes, launches new products and opens new markets.

[5] During crises, a multi-year approach is essential. However, in democracies the ‘electoral cycle’ - by forcing policymakers to focus on the ‘short term’ - does not provide enough time to address ‘long term structural challenges’, such as, for example: 1) reforming key institutions – such as the ‘electoral law’ or the ‘legal and judiciary system’; or 2) providing ‘equal opportunities’ – needed to minimizepopulism and nationalism’, as ‘inequality of opportunities’ hampers development.

[6] In Italy, the total is worth 20 percent of 2020 GDP, more than the Marshall Plan, which - worth a total of 11.5 percent of the Italian GDP at the time - transformed the country between 1948 and 1952.

[7] ‘Population aging’ brings about rising pressures on the ‘productive population’, as it leads to: i) lower fertility; ii) declining labor forces; and iii) an increase in the ‘dependency ratio’ - a demographic indicator that measures the number of ‘dependents’, i.e. ‘non-working-age individuals’ (aged ‘zero to 14’ and ‘over 65’), supported by the number of ‘working-age individuals’ (the total population aged 15 to 64).

[8] Globally, 80 percent of ‘over 65’ lives in the 20 most developed economies, which together produce 85 percent of global GDP. Japan, Italy and Germany share similar demographic indicators. Emerging economies, now relatively young, are also expected to age rapidly.

[9] On average, every minute 2,400 trees are cut down; every year, between 15 to 18 million hectares of forest are destroyed, an area the size of Belgium.

[10] Greening: a complicated agenda. The challenges are massive: 1) decarbonize the energy system; 2) stop deforestation; 3) redirect USD 5.5 trillion of fossil-fuel subsidies - approximately 6.3 percent of 2019 global GDP - toward green infrastructure; 4) provide incentives and policy support - via, for example: i) guarantees; and ii) insurance; to 5) attract private capital into green investment (e.g.: clean energy, water and agriculture); 6) deploy renewable-energy technologies; and 7) start reforestation.

[11] Face the indirect carbon-footprint and pollution of electric vehicles. In absence of infrastructures apt to produce ‘green-electricity’, zero-emission electric cars are irrelevant. For example, in Japan and Germany, coal and gas are used to generate more than half of the electricity consumed every year. Additionally, electric cars rely on: 1) pollution-prone manufacturing; 2) energy-intensive batteries; and 3) rare-earth elements. They also increase emissions from tires. As a result, an electric car with would need to drive 100,000 kilometers (62,000 miles) to produce overall less CO2 than a gasoline-driven car.

[12] Significant capital needs to be allocated to: i) subsea cables (a strategic resource); ii) hardware; and iii) software.

[13] Asymmetrical comparisons are misleading. Comparisons - if any - must be made either in theory (e.g.: ideal state versus ideal markets) or in practice (real-life state versus real-life markets). After the Second World War (WWII), many countries adopted planning, with state-intervention in the economy. In the 1980s, it was the turn of “less state, more markets”.

[14] When power is asymmetrically distributed and democratic institutions are weak, public intervention is ineffective. For example, the poorest groups lack the ability to influence the political process and the country’s economic and social decisions.

[15] Market failures and distortions (imperfect competition, agent interdependence, incomplete markets, public goods, no large-scale coordination, insufficient and asymmetric information), wealth distribution and merit goods are well known examples.

[16] For decades, Lufthansa has been profitable, Alitalia hasn’t - as its challenges predate COVID-19. Alitalia is fully owned by the ‘Government of Italy’ since March 17, 2020. The ‘Federal Republic of Germany’ holds a 20.05 percent share in Lufthansa as of July 6, 2020 – when the German government re-capitalized the airline with €6bn of taxpayers’ money, twice the amount Italy spent on Alitalia. In 2020, during the pandemic, in order to avoid job furloughs Lufthansa pilots volunteered “a 45 percent pay cut, for more than two years”. For ground staff, Lufthansa requested pay cuts of “up to 23 percent of employees’ pre-tax salaries”.

[17] Typically, the distance from the ‘world technology frontier’ is calculated as the “percentage distance to the country with the highest total factor productivity (TFP)” - normally the United States. Firms that operate at the frontier tend to be: i) more productive (and more likely to patent); ii) more profitable; iii) younger; iv) larger; and v) part of a multinational group than other firms.

[18] Early state intervention can spur early-stage growth accelerations by: i) addressing market failures, acting as an ‘investor of first resort’; ii) mobilizing capital and de-risking large-scale investments; iii) removing barriers to credit markets; iv) fostering the adoption of technologies already in use in other countries; and, as a result, v) spurring growth and create jobs.

[19] In Italy, after WWII, semi-public institutions - such as IRI, ENI, IMI, Mediobanca - catalyzed investments and kick started industrialization. In the economic take-off of Japan and South Korea (second industrial revolution), the state played an essential role, as state-supported conglomerates drove the industrial take-off. In this initial phase, corruption and patronage coexist with growth. Patronage and favoritism were widespread both in post-war Italy and in Korea in the 70s.

[20] A set of clear and stable rules that are fair to all, from international law to tax incentives – and the required regulatory, supervisory, and evaluative functions.

[21] Concretely, the state must: 1) provide a: i) vision; ii) mission; and iii) a strategic medium-term plan, focused on sustainable growth; 2) equalize opportunities, by supporting the weak - also in the private-sector (e.g.: small and medium enterprises); 3) promote competition by: i) introducing clear and impartial rules (“level play field”); and ii) addressing information asymmetries and market failures; and 4) provide public goods and deliver necessary services.

[22] For example, in the US the Federal Reserve’s decision to purchase high-yield corporate bonds is likely to lift highly leveraged, unprofitable shale-oil producers.

[23] In modern-day China, the renewed centrality of state-owned enterprises in the economy risks stifling the creation of a widespread innovative environment.

[24] At the end of the XIX century, in India, under British rule, Delhi was infested with cobras. The government put a bounty on every cobra delivered dead. Attracted by profitability, many entrepreneurial citizens soon began to breed poisonous snakes. As soon as the British authorities canceled the bounty, breeders released the now-worthless snakes, and Delhi’s cobra population became larger than before.

In 1902, in Hanoi, Vietnam, under French colonial rule, the government paid a reward for each rat killed; the proof was a severed tail. Soon, colonial officials began noticing rats with no tails. Rat catchers would capture rats, sever their tails and release them back into the sewers - so that they could procreate, thereby increasing their revenues. Eventually, the rat population had increased.

In 1958, in China Mao Zedong launched the ‘Four Pests Campaign’ to remove mosquitoes, rodents, flies, and sparrows responsible for the transmission of pestilence and disease. Rewards were given for handing in dead animals. The wiping out of sparrows led to ecological imbalance, locust infestation and massive crop loss, and became a contributor to the Great Chinese Famine in which millions of people died of starvation. After rice yields substantially decreased, Mao ordered the end of the campaign.

In November 1989, Mexico City introduced a car-rationing scheme to curb air pollution. To circumvent the restriction, people bought more (used and highly polluting) cars. The air quality did not improve, and road congestion worsened. Three years later, the UN declared Mexico City the most polluted city on the planet.

In 2005, the UN ‘Intergovernmental Panel on Climate Change’ launched an incentive scheme to reduce polluting gases. If disposing of gases, companies got rewarded with carbon credits, eventually converted into cash. The more pollutant the gas, the higher the reward; one of the highest credits was attributed for destroying HFC-23, a waste gas byproduct of a common coolant. In order to destroy more HFC-23 and collect large credits, companies began to produce more coolant. In 2013, the European Union suspended credits for the destruction of HFC-23.

In 2016, to reduce traffic congestion and air pollution the Delhi government announced an odd-even scheme: cars with license-plates ending with ‘odd’ and ‘even’ numbers would circulate on alternate days. The scheme proved counter-productive, as it: i) encouraged people to buy more vehicles, resulting in more traffic; and ii) did not led to any decrease in air pollution levels.

[25]  European countries could benefit from the Marshall Plan only if they modernized their economic institutions and abandoned the mixed-economy models of the 1930s, to transform themselves into market systems.

[26] To align corporate behavior with the needs of society, firms can be required to: i) embrace competitive – rather than monopolistic - business procedures; ii) adopt targets to lower ‘carbon dioxide emissions’; iii) ensure a minimum level of social spending (e.g. social safety nets); iv) endure restrictions on dividends, stock buybacks, and executive bonuses, especially in tax heavens; and v) ensure a better relationship between workers and firms.

[27] For example, policy-makers need to understand the economic cycle to: i) fine-tune the optimal degree of ‘regulation’; or ii) prioritize job-creation over efficient service provision.

[28] For example, the scarcity of ‘shovel-ready projects’ and ‘execution skills’ should not authorize policy-makers to prioritize recurrent (e.g. salaries and benefits) over capital spending (e.g. fixed asset investments).

[29] Economic intervention - especially in ‘national-interest sectors’, such as energy, telecommunications, health-care and pharmaceuticals, airlines and automobiles - should not lead to an inefficient allocation of resources.

[30]Complex systems’ - enhanced by robotics, machine learning, augmented and virtual reality, digital manufacturing, adoption of frontier technologies - are unforgiving because by nature they grow or decay at exponential rates.

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