By: Shahid Ahmed
The process of development is generally defined as sustained growth in the output of goods and services plus a steady improvement in key health, education and other social indicators (e.g. the UN Millennium Development Goals for developing countries). It translates into improved welfare for individuals, families and society and a reduction in poverty and deprivation. Development has traditionally assumed a partnership between the State and private enterprise, the latter delivering physical goods and services to consumers while the former plays a coordinating role, provides public goods and ensures an equitable distribution of rewards. Prior to World War II development was not deemed to be the central objective of State policy; promoting full employment and maintaining internal (prices) and external (balance of payments) stability took precedence. To these, social and environmental objectives were added later and so development acquired primary importance across the world. It is now considered coterminous with progress.
For more than three decades after World War II the consensus was that a mixed economy was the best way to promote development, usually within a framework of State planning. Indeed, in many cases the State had to take a leading role in the development process not only in terms of building institutions and policy support but also in directly providing those goods and services that the private sector was unable to do. This approach was particularly true in developing countries. In the developed countries the United States was a major exception, being primarily private-sector driven, but even there a vibrant, not-for-profit sector was active in the provision of health, education and financial services, the last-named in the guise of credit unions. By and large, the mixed economy delivered rapid output growth and high levels of social welfare between 1950 and 1975.
However, following two major oil shocks (1973/74 and 1979/80), chronic macroeconomic instability, high inflation and output losses undermined the mixed economy model and a radically different approach to development came into being in the early 1980s – embodied in the so-called Washington Consensus. In this, the role of the State was sought to be sharply curtailed, budget deficits were to be squeezed or eliminated altogether, taxes lowered and publicly-owned assets were to be privatised, including even natural monopolies like utilities. In addition, the allocation and pricing of inputs and outputs was to be determined by market forces and the State was to play the role of a mere enabler, providing institutional oversight, policy support and so-called light touch regulation, with the private sector providing the goods and services. Side by side, the forces of globalization, such as free trade, FDI and cross-border capital flows, were not to be resisted and, over time, import tariffs were to be reduced to very low levels for countries to find their respective niches in the global division of labour. This approach was also known as neoliberalism and, more pejoratively, as market fundamentalism.
Some 30 years later, the events of 2008-09 have shown that faith in a primarily private sector-led, market-driven model of capitalism has proved to be overblown. Indeed, neither developed nor developing countries have been immune to its shortcomings. Markets in most economies have failed to allocate resources in an optimal manner, critical goods and services have been consistently under-provided, light touch regulation has produced asset bubbles and bouts of instability while the idea of unchecked profit-maximisation has turned out to be a poisoned chalice especially in the financial sector. Meanwhile, globalisation has created opportunities through regulatory arbitrage for crises to migrate across borders exploiting weaknesses in national economies and often magnifying them. The historian Eric Hobsbawm likened the West’s financial sector meltdown in 2007-2009 to the coming down of the Berlin Wall in 1989. A post mortem is underway but a new consensus on the way ahead has yet to emerge. This review attempts to outline the nature of the relationship between the State, enterprise and development and how it might be refashioned to further the interests of society as a whole.
After a relatively uneventful 1980s the global economy has had to contend with several massive crises with global repercussions: the 1997-98 Asian financial sector-led disaster, the collapse of the IT-related stock market boom in 2001 and the catastrophic financial sector meltdown of 2007-2008 (not forgetting here the 1987 stock market crash in the US). The world economy is currently experiencing one of its most protracted slowdowns in the last 100 years. Indeed, there are strong reasons for asserting that the panacea of free markets has proved to be worse than the disease of a mixed economy and it is important to understand why.
There are at least four main reasons: one, other than in a few countries, the increased reliance on markets has produced no sustained acceleration in the pace of either growth or productivity, nor any significant improvement in stability on the macroeconomic front with the freeing up of exchange and interest rates. This is true of both developed and developing economies. For example, among the former the US and UK are plagued by lacklustre growth and chronic current account and budget deficits. Within the latter, in the bulk of developing countries overall progress is no faster than it was before except in the last few years as China’s impact on the global economy has become more visible. There are a small number of exceptions, notably countries in East and South-East Asia, some in Latin America and, more recently, India (economies in Africa have benefitted primarily from higher commodity prices in the last few years). Amongst the developed countries, notwithstanding recent difficulties, only Germany, Holland, Austria and the Scandinavian economies are the exceptions as are Australia and Canada, the latter two being essentially natural resource producers. However, even in these countries it is the case that their more robust development almost certainly owes a great deal to the direct intervention of the State, especially in the provision of high quality physical (roads, railways and ports) and non-physical (education, health, retraining and social protection) infrastructure and in the articulation of national goals. Two, the gains from growth and development have been primarily captured by the upper income groups with a huge increase in inequality as measured by the Gini coefficient virtually across the world. There has been little or no trickle down. In fact, the bottom fifth of the population has seen its real income stagnate for the last 30 years in the developed economies while in the developing economies a real breakthrough in reducing endemic poverty continues to recede into the long term future. Whether in the developed or in the developing economies it is hardly credible that a system that excludes large numbers of people from better jobs and higher incomes will make either growth or development sustainable in the long term. Three, few, if any, developing country governments have been able to offset the inexorable increase in inequality by channeling higher public resources into health, education, public transport and social housing. Even in India, for instance, despite acceleration in the GDP growth rate in recent years there has been very little impact on the social indicators since the late 1990s. This relative failure may well be down to poor policy implementation and ineffective governance; it is more likely to be the result of an over-reliance on market forces to deliver socially desirable outcomes. Four, globalization has brought internationally transmitted shocks, such as financial crises, to the very heart of developing countries via the integrated nature of financial markets and cross-border banking, a consequence of globalization. Countries have not only suffered substantial output losses as in the 1997-98 Asian crisis, in the deflation of the IT-driven stock market bubble in 2002 and after the financial crisis of 2008 but continue to remain in thrall to the fickleness and vagaries of international finance.
Mitigation of these adverse effects has not even been attempted because tax buoyancy has hardly improved in most developing countries and most countries face a fiscal crisis. In developed countries, the richest have invented sophisticated tax avoidance schemes and tax havens are flourishing. Moreover, since the philosophical underpinnings of the Washington Consensus and of neoliberalism have precluded higher public spending on goods that are consumed by the lower income groups the State, too, has willy nilly accepted the notion that higher taxes on the rich are a non-starter and acquiesced in the on-going neglect of public services consumed by the poor. Meanwhile, the response of the market has been to cater almost exclusively to the needs of the middle and higher income groups – the growth of high priced private schools, universities and hospitals are good examples of this phenomenon. Indeed, other examples of market failure of a more structural nature can be found in the chronic lack of investment in low cost housing, in paltry expenditures by pharmaceutical firms in the development of anti-malaria treatments and even, perhaps, in the recent large scale conversion of sugar cane and maize into ethanol as an additive for motor car fuel, a phenomenon that has sharply raised the price of a wide variety of foodstuffs, a major expense for the poor, but has kept the price of petrol low.
The immiserisation of the poorest in the developing countries, i.e. those having to survive on less than $1.20 a day in the developing countries has been a particularly shameful feature of the last 20-30 years with hardly any contrition on the part of the ruling elites of these countries. A further lesson of the last 20 years is that given the size and urgent need for higher social spending, especially on public goods, it cannot be realistically left or out-sourced to philanthropists and NGOs, as is often urged; such spending must remain an unequivocal State commitment and responsibility if the poor are to be given a decent start in life. In fact, the underlying neoliberal assumption that State spending crowds out the private sector is almost certainly false. On the contrary, evidence suggests that the public sector, through investment in infrastructure, technical education and public goods, tends to crowd in private investment, as has been demonstrated in East Asia and parts of Latin America.
Perhaps the most egregious failure of public policy in the last 20-30 years has, however, been to give the financial sector unchecked freedom to ‘cater’ to the full range of consumer needs, an eminently reasonable objective on the face of it. In fact, an ocean of private and public indebtedness has been generated in the process. This has made finance dangerously vulnerable to even minor errors of judgment in how risks are assessed. These errors then balloon into a collective loss of confidence in the sector stretching across borders through contagion, involves the State in huge bail-out obligations and encourages moral hazard. Moreover, despite international efforts at the BIS going back to 1988 the sector’s own inability to pre-empt bouts of illiquidity and insolvency betokens a fundamental problem in post-1980 capitalism, i.e. the unregulated pursuit of profit, excessive risk-taking by the financial industry driven by moral hazard, a lack of balance between the public and private sectors in most economies and the withdrawal of the State from playing the role of a fair arbiter in the equitable distribution of rewards and public resources. This withdrawal is most visible in the financial sector in which financial institutions have been allowed to grow to such a size that they now completely dwarf corporate bodies in other sectors of the economy. There is evidence, too, that off-balance sheet activity is rife in the banks whose primary objective is to nullify compliance and prudential regulation of the sector. In addition, fiduciary obligations to depositors are all but ignored. As a result, the sector has created massive systemic risks for regulators, savers and governments, i.e. for the whole of society, in the event of the failure of even a single modestly-sized institution.
This alarming state of affairs manifests itself in the asymmetrical distribution of influence and power between, say, the wealthiest 10 or 15 per cent of the population and the rest. The picture can be best described as one of ‘regulatory capture’ on a national scale by the richest and most influential. This phenomenon is visible in the readiness with which colossal resources have been made available to bail out the banks in 2008-2009. Against this, the reluctance to countenance any meaningful increase in spending, say, on the alleviation of poverty or on social protection, on the grounds of fiscal prudence negates even the pretence of equity in political decision-making and is disingenuous in the extreme.
In many developing countries the bulk of banking has been either in the hands of the State or was nationalized at some stage in the past. This had led to a plethora of bad debts and governments had been forced to make good the periodic losses made by banks. In many such countries both governments and businessmen saw easy access to bank credit a convenient means of rent-seeking. Proponents of market-based reforms confidently touted the privatisation of banks as the solution to the principal agency problem and of moral hazard. But the solution of a largely privately-owned banking system has proved to be a mirage. Such is the reality of political power and the demonstration effects of wealth that with the State available as a back-stop, risk-taking has multiplied, corporate and household leveraging has mushroomed and, in its efforts to preserve high profits, private enterprise has resorted to convoluted and opaque accounting practices, outright tax avoidance and to anti-competitive behaviour such as cartelization and market manipulation, on an industrial scale. Indeed, the latter have been developed in the far more complex financial markets of the advanced economies. But in both developed and developing countries we now live in a world where instances of corporate abuse are a daily occurrence.
The US and UK provide very apt case studies of what a market-driven model of capitalism can lead to. The 1970s were a difficult period for both countries. The first oil shock was followed by the rise of the East and South East Asian economies, a second oil shock and the rapid closure of many low-skill industries in the developed economies but more particularly in the US and UK. Pressure on corporate profits caused by inflation and high interest rates meant that R and D expenditures were cut, wages were squeezed and labour unrest was widespread. In consequence, productivity growth declined and structural external deficits emerged in the 1980s. The US and UK lost their competitive edge in a range of manufacturing activities, notably cars, consumer electronics, machine tools, steel and computers that had hitherto been their preserve. However, neither politicians nor most mainstream economists in the two countries considered these developments as anything other than temporary blips.
As we know now, the effects of this ‘hands off’ approach by the State have been catastrophic in both countries. Banks have ceased to be providers of working capital, their primary function, and have become much more involved in complicated financial engineering whose purpose is simply to boost balance sheet growth. In the freewheeling atmosphere of the 1990s and early 2000s, the effects of light touch regulation have been compounded by the development of information technology and by the use of new and esoteric technology-driven financial products, such as trading in securitized loans and derivatives. Up to the early 1980s only the very largest private companies used to issue bonds. With the invention of high-yielding junk bonds and constant search for higher profits this restraint ceased to function. As a consequence, activity in the financial sector, such as hostile takeovers, junk bonds, leveraged buy-outs and trading in complex financial instruments, has multiplied with bankers giving themselves mammoth rewards in the process.
This expansion of activity and rising p/e ratios of corporate enterprise in the financial markets have been instrumental in the creation and inflation of asset bubbles not just in the US and UK but in several other countries as well. Nth degree, i.e. needless speculation in the trading of derivatives has emerged as a central activity in the financial markets, giving the illusion of real value addition for the wider economy. In fact, however, because of a collective lack of risk aversion the financial sector (deemed as being too big to fail) has became an enormous systemic risk through these very activities – trading in CDOs, huge exposures to hedge funds and involvement in the astronomical OTC derivatives market which is almost ten times bigger than the global economy. Indeed, there is no evidence that the real economy has benefited from any of these innovations. It is true that many States have made windfall gains from the taxes that the financial sector has generated in the last 10 years. But, those gains have proved to be illusory and ephemeral and, in any event, have been more than cancelled out by the huge amounts that States affected by the financial crisis have had to commit to save their financial sectors from ruin.
Side by side with its gargantuan appetite for risk-taking the sector has inevitably generated opportunities and incentives for fraud and malfeasance. The libor scandal in the UK is just one example. In order to counter public disquiet the sector has bought itself both political protection and intellectual respectability with its vast financial resources (see last paragraph). The 2007-08 collapse of the financial sector has revealed not only the staggering complexity of the risks hidden away on bank balance sheets but the nexus of nods and winks between regulators and banks that have left tax-payers across the world with staggering liabilities in their efforts to restore the sector to solvency. In the process, the risk of moral hazard has been greatly magnified. While a number of senior bank officials have lost their jobs few have been prosecuted, thus far at any rate.
Some attempts at reform are underway, both within individual countries and in organizations like the IMF, BIS and EU. Many observers, however, still cling to the hope that this crisis of capitalism, for it is that, will ultimately pass. On the other hand, the depth of the problems that have arisen and the structural nature of the 2008-2011 downturn has led to a degree of soul-searching amongst policy-makers and academics and has raised many questions. What is the nature of the public-private social contract that is likely to provide a durable, long term solution to today’s problems: the Anglo-American market-driven model on which the Washington Consensus is based, the welfare-based social democracy approach of Western Europe or the State-dominated model that has transformed China in the last three decades?
There are major problems in each of the three models. The market-driven model has clearly failed to deliver high, stable growth with equity and has entrenched a tiny financial clique in virtually unchallenged political control. The Western European approach has saddled several States with unsustainable levels of debt as manufacturing has shifted to Asia, unemployment has increased and the tax base has shrunk. The Chinese model of a strong developmental State driving the process forward relentlessly through investment and exports owes more to its own recent history than to the influence of an ideology per se. In any case, it cannot be replicated by countries with low savings rates, ineffective governance and a plethora of non-tradable services in their GDP; by and large, it has limited relevance for developed countries. But whichever model of growth and development that emerges over the next few years should be able to pass three stringent tests: legitimacy, sustainability and stability.
The first test indicates that for any system to enjoy long term legitimacy it must manifestly satisfy the needs and expectations of the majority and not just those of the narrow ruling elite and its allies, friends and cronies. This is regrettably the case in many countries now in which the ruling elite exercises almost total control through its ownership of the media. As a result, inclusive growth has been made to sound like a platitude and has been derided especially in the Anglo-American media. But without some kind of redistributive fairness – the kind that has underpinned the social democracy of Western Europe to date despite the strains from large-scale immigration – sustained growth in the years ahead is unlikely to occur. A perceived sense of equity is particularly important in the form of less income inequality. The financial sector which currently operates with a massive implicit subsidy from the State is a case in point. Here, salaries and bonuses of senior management have reached levels that defy rationality. More important, losses made in the sector have been periodically socialized and gains privatized, as has happened in 2007-2009. Hence, is there not a strong intellectual case for public ownership of that part of the sector with which the public entrusts its savings? And what is to be done about moral hazard? Here, it should be stressed that a supposedly democratic polity alone cannot bestow such legitimacy, especially in developing countries; nor, for that matter, can the rule of law in the abstract, as both can be, and have been, rigged by minority sectional interests in many countries to their benefit. In other words, legitimacy has to be intrinsic, demonstrable and embedded within the system.
The second test is that the new model must not be preoccupied with the short term, such as quarterly company results and share price movements as in the Anglo-American model. It should, instead, seek to build productive assets that will provide a steady stream of long term benefits on the collective effort invested by society as a whole (by the State, private capital, management and labour) over a time horizon, say, of 20-25 years, far longer than the private sector is currently accustomed to take into account. Germany provides a good example of this long term approach among the major economies as do others in Western Europe. China’s huge public investment in transport infrastructure will boost economy-wide productivity decades ahead. Within the sustainability matrix, the serious risks of global warming add another layer to the problem, risks that few countries are taking seriously.
Finally, the test of stability is not merely one in which unnecessary volatility and speculation in the financial markets must be ironed out. It is a test in which participants in the process of value addition are guided both by self-interest and by notions of fairness and the equitable sharing of rewards. There is little doubt that such a model of capitalism would be completely at odds with the neoliberal construct; it would not be possible without a long programme of public education across much of the world that squarely confronts the biases and propaganda of the media that decry any role of the State in the economy and society. The only real life examples of this model are the social democracies of Western Europe. Among developing countries Brazil and China have created social safety nets and are implementing credible anti-poverty programmes without experiencing a fiscal crisis or a significant slowdown in growth. However, inequality has increased significantly in both countries and social unrest has become more visible. Most countries, regrettably, appear to be flailing about with neither serious political will nor administrative capacity to deliver even a modicum of social protection to their most vulnerable citizens.
For these tests to be faced at the political level, society will need to resolve a number of awkward dilemmas. Capitalism is patently a double-edged sword. On the one side, it has made possible vast improvements in material conditions for hundreds of millions. It has incentivised and amply rewarded creators, makers and innovators who, in turn, have provided new technologies and improved products for the public. But, at the same time, it has opened up enormous opportunities for rent-seeking, corruption and greed that have effectively nullified the fundamental principles of merit, fairness and morality without which societies cannot function. It has done so by making negative human traits like avarice and envy respectable. And, in the process, it has created a class of the super-rich and sharply polarised societies everywhere. It has become incumbent that in seeking a new, more durable, socio-economic compact, all societies need to know where to draw the line between ever more material consumption and the attainment of a more broadly defined sense of individual fulfilment combined with the pursuit of collective community goals through other means. As has been pithily observed by Professor Michael Sandel “we have drifted from being a market economy to being a market society”. Here it should be stressed that efficiency in the use of resources must not be the sole criterion for judging whether any given socio-economic arrangement is the most desirable. It must not be forgotten that as people also live within an ethical framework society must ask whether it is moral for some people to seek to sell their organs, for companies to buy and sell the right to pollute, for governments to hire mercenaries to fight their wars and for elite universities to sell admissions to the highest bidder. Where do such values leave non-monetary but tangible human qualities like trust, honesty, social solidarity, friendship, loyalty and compassion? The truth is that most societies face a huge moral crisis on the basis of their current predilections and preferences.
Finally, economists Norbert Haring and Niall Douglas authors of Economists and the Powerful have traced how a supposedly neutral social science like Economics can become the handmaiden of right wing ideologues. The Rand Corporation (32 Nobel laureates are connected with it, one way or the other) has been at the forefront of this process that the authors call ‘corruptonomics’ in which neoliberal ideas have been dressed up in mathematics and presented as value-free science. In the general mass of notions and sentiments that make up society’s weltenschauung the ideas concerned with economic life and a sense of social justice play a central role in how deeply held views come about. Formal Economics has always been a vehicle for the ruling ethos of each era as well as a method of quasi-scientific investigation of economic and social phenomena. Today, largely driven by neoliberal ideas, we live in a world in which individual well-being or the well-being of small, powerful groups within society has been elevated to the level of a non-negotiable religious creed while the collective interests of society and the needs of the weakest have been relegated almost to the point of irrelevance. We are now to accept that higher taxes can never be levied on the rich, nor can spending on the most vulnerable in society be increased as it might “upset” the former. It is time that such a grossly distorted set of societal priorities be vigorously confronted. No political or economic arrangements should be presumed to be permanently inviolable. It is patently obvious that a new and more durable social contract has to be refashioned if the world is going to emerge from the present crisis. If human society is going to achieve a prosperous future built on social justice in the decades ahead it must first wrestle with some very awkward questions.