In the preface to The Limits of the Market, Paul De Grauwe, an economics professor at the London School of Economics, begins with two basic premises: first, that a centrally planned economy does not work; second, that pure market systems do not exist anywhere. According to De Grauwe, “The only relevant question, then, is how precisely that mixture should look”—that is, the correct mix of market freedom and public policy oversight.
He writes of a “Great Economic Pendulum”—that swings between greater and lesser government intervention—“cyclical movements” in economic history. To illustrate this, he describes a general decline in government involvement in the world economy during the first part of the 20th century. Then the Great Depression ushered in greater government involvement that continued through the middle decades of the century. That gave way to renewed market liberalization in the 1980s, which ended with the Great Recession. With this brief overview of modern economic history as his departure point, he begins to explain what he sees as the limits of capitalism.
“The limits of a market system relate to the fact that the connection between individual and collective rationality can be severed,” De Grauwe writes. He identifies two types of situations in which large numbers of people do not believe that their own interests are being met satisfactorily by markets. The first type, which he labels “external limits,” and others commonly call “externalities,” involves individual decisions that have a positive or negative effect on others. The second category, “internal limits,” involves the conflict between individuals’ “System I” decision-making—relying on intuition and emotion—and “System II” decision-making—relying on reason. These two systems are connected and require a satisfying balance between emotional and rational demands in order for the market system to work effectively. Often, however, this balance of individual and collective rationality is not maintained.
DeGrauwe argues that individuals do not take into account the external effects of their individual decisions. He offers three examples of this: climate change and global warming (“carbon dioxide as a harmful gas generating external costs across geographic borders”); financial markets (“a banking crisis where the system reaches its limits before collapsing and requiring a government bail‐out”); and public goods and the free‐rider problem (“the market system has no mechanism for creating public goods”).
He discusses how the expansion of the market system brings it to its “internal limits.” He identifies three mechanisms that lead to the discrepancy between individual and collective well‐being.
The first mechanism has to do with markets and distribution, whereby the price system leads to an inequality of income and wealth, a sense of injustice, and a desire for individual charity on the part of those able to purchase a good (“sharing with those not able to pay for a product”), as well as a possible revolt by those individuals in the lowest income groups (“protests and violent revolutions”).
The second mechanism has to do with intrinsic and extrinsic motivation. Intrinsic motivation means “that people are motivated to put their effort into their work or other activities because they are fulfilled by the work or activity itself.” Extrinsic motivation means “that people make an effort for the sake of the financial reward for a particular activity.” Reconciling these two diametrically opposed motivations is inherently challenging, as managers find it easier to focus on extrinsic motivations involving financial bonuses (which are easily eliminated when managers are confronted by company financial duress).
The third mechanism has to do with competition and cooperation in the market environment. Though both can encourage good market behavior, competition and cooperation can conflict with each other on both emotional and rational levels, resulting in an internal tension between individual and collective well‐being.
De Grauwe next addresses what he refers to as the “utopia of market self‐regulation.” While so‐called market fundamentalists argue that problems concerning the environment and public goods are grounded in a lack of property rights and solutions lie in somehow creating those rights, De Grauwe questions how such rights are possible. For instance, how can government establish ownership rights when people all over the world are negatively affected by air pollution? How does one identify billions of harmed people who will seek legal compensation from billions of other people who are responsible for their injuries, and in what court of law (De Grauwe calls this a “complicated information problem”)? But, as he notes, even if one were able to solve this information problem—that is, through the highly unlikely scenario of negotiating voluntary agreements with billions of people—the legislative branch will have to assign property rights in law (or negotiate those voluntary agreements), and the courts and police will have to enforce those rights—thus inevitably involving government institutions.
Given this need for government to ultimately save the market from its own destruction, De Grauwe discusses three domains where government policy and normative theory have a role in managing the market: externalities (by levying taxes on those engaging in undesirable behavior), supplying public goods (and eliminating the free‐rider problem in market responses), and redistribution (of income and wealth on the highest incomes, thus providing the socially and politically stabilizing effects of greater equality). However, he recognizes that, while the government may know what it must do, that does not always mean that it will implement such policies. Why? Because government is also subject to limitations.
According to De Grauwe, politicians are prevented from following the normative prescriptions of economic theory. The external limits of government, he writes, involve externalities related to the collective interest, say for environmental protection. This is a similar discrepancy that exists with the external limits of markets, but, unlike the market where individuals resist the efforts of governments to harm private interests in favor of the collective, the discrepancy works in the opposite direction: individuals make decisions that harm the collective good. In this case, the challenge for government (especially in democratic societies) is to close the difference between individual and collective rationality, thus gaining broader support from their citizens for the government’s decisions.
As De Grauwe points out, the free market appeals to the individual’s rational, calculating side at the expense of his or her emotional side. Thus, government appeals to the emotional side—or the dissatisfaction gap left by the free market—and is the mechanism through which emotions are expressed. To this end, government focuses its efforts on distribution problems, motivated by a universal sense of fairness. Emotional appeals to “fairness” win out over rational appeals to profit and efficiency.
Government, however, faces two limits. The first—redistribution at the expense of efficiency—holds that neither excessive equality nor excessive inequality is good for efficiency. Most capitalist regimes tend to reflect this principle. The second—a balance between emotion and reason—recognizes that the more governments work on redistribution the more they tax individuals and limit individual freedom. An example of this is embodied in a public‐pension system, where, if government does not keep moral hazard under control, the citizen’s sense of fairness is overwhelmed by too many “free‐riders” exploiting the system.
De Grauwe notes that discussions on the role of markets and government have been ongoing for centuries “between people who believed that the market system was the foundation of economic organization (and creates the economic value that makes it possible to maintain the public sector) or that the task was reserved for government (as it establishes and enforces property rights).” That traditional view is espoused by both market fundamentalists and government fundamentalists, and is often portrayed as a pyramid hierarchy, with either the market or government at the top. So who is in charge?
De Grauwe argues that such hierarchical thinking is wrong, as both the private and public sectors are necessary and it is equally important for both sectors to operate effectively. To that end he offers a nonhierarchal, elliptical portrayal of the relationship of market and government. As he explains: