21st Century Policies – John Kay

44 progressive politics vol 2.2

John KayIn the century before the fall of the Berlin Wall, socialism defined the language ofpolitical economy. Not just for its supporters, but also for its opponents. Today,that position is reversed: the vocabulary of the political right frames the terms ofeconomic debate. Globalization and privatisation have displaced capital and classas terms of discourse. The claims of economic determinism and historicinevitability, once made on behalf of socialism, are today made for a blind faith inmarket forces: a new fundamentalism which I call the American Business Model(ABM). That model fulfils the same psychological need for simple, universal

explanations of complex phenomena oncemet by Marxism. Its adherents display thesame ingenuity in attributing all economic

ills to government that their predecessors displayed in attributing all economic illsto class oppression.

The claims of the American business model are of four kinds.

self interest rules – self-regarding materialism governs our economic lives

market fundamentalism – markets should operate freely, and attempts toregulate them by social or political action are almost always undesirable

the minimal state – the economic role of government should not extend muchbeyond the enforcement of contracts and private property rights. Governmentshould not itself provide goods and services, or own productive assets.

low taxation – while taxation is necessary to finance these basic functions of theminimal state, tax rates should be as low as possible and the tax system shouldnot seek to bring about redistribution of income and wealth.

This description of how markets work succeeds in being at once repulsive andfalse. Its central error is its neglect, even denial, of the central economic role ofcommunity. We live and work in communities, we buy and sell in communities. The values of communities guide our transactions, and regulate our economicbehaviour. And it is in communities (not markets) that we share the principal risksof economic life. Social interactions between individuals are not alternatives tomarket relationships: they are the means by which market relationships function.

The motivations of the ABM – instrumental and individualistic – are therefore selfdefeating. It is wrong to claim that profit is the purpose of a market economy, andthe production of goods and services a means to that end: the purpose is theproduction of goods and services and profit is the means. The happiest people are

The Truth About Markets

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not those who most single-mindedlypursue their self-interest: the mostprofitable companies are not the mostprofit oriented. The explanation ofthese apparent paradoxes is that wecan achieve our personal or corporategoals only through relationships withothers. Successful individuals, and

successful companies must thereforeadapt their behaviour and theircapabilities to the norms and values ofthe communities in which they operate.

Not only are the claims made for theABM ill-founded: the attempt to make the world conform to the model has damaged both the effectivefunctioning of the market economy and its political legitimacy. That is thecentral lesson of the corporate boom and bust of the last decade. By misunderstanding the nature of the American victory in the cold war,the ideologues of the ABM haveundermined that victory. Through theirfailure to appreciate the strengths of the market economy, they haveexposed its weaknesses.

But if the American business model isnot a plausible description of howmarket economies function, why is theAmerican economy so successful? The answer is that the ABM does notdescribe the American economy. As Tocqueville understood almost two centuries ago, association – the creation of social and economiccommunities – was a distinctive

characteristic of American society fromits inception. “The most democraticsociety on earth is found to be the onewhere men in our day have mostperfected the art of pursuing the objectof their common desires in commonand have applied this new science tothe most effect.”

In modern America, the most importantvehicle through which men (andwomen) pursue the object of theircommon desires is the corporation.Corporate man, the epitome of theAmerican submergence of theindividual in the company, was oncethe butt of jokes. In the 1990s, the roleof corporate man was subordinated to that of the heroic CEO. But the older picture was a more accuratedescription of how the real Americaneconomy – epitomised in the dailyactivities of Procter and Gamble andGeneral Electric – actually functions.Corporate men and women are the socialindividuals who make the economiclives of Americans rich and fulfilling.

The deep seated failure of the ABM isin underestimating the complexity ofthe institutions of the market economy,failing to recognise how effectiveeconomic organisations are necessarilyembedded in the society, politics and culture of their communities. This embeddedness extends to everyaspect of economic life.

The embedded marketThe assumptions of the ABM are false:but that does not imply that theiropposite are true. There are peoplewho still think that economicbehaviour is mostly altruistic, thatpolitical mechanisms of allocation arealways preferable to the anarchy of the market, that government shouldcontrol and preferably own all

productive assets, and that highlyprogressive taxation should beimposed to bring about an egalitariandistribution of income and wealth. But the historic failures of economiessubject to centralised political controlare too obvious for this to be asustainable position for the moderncentral left.

Yet the polarisation of politicaleconomy created by the ABM leads toan equivalent polarisation of views onthe proper economic role of the state.Within the ABM that economic functionis to define and enforce the rules of themarket economy. By contrast, thetraditional socialist conception is that

the state should determine throughdemocratic process how societywishes scarce resources to beallocated. Government can then directthe activities of businesses andhouseholds in order to bring thatallocation about.

Neither of these descriptions offers afeasible description of the role ofgovernment in a modern economicsystem. The institutions of the modernmarket economy developed withoutcentral direction. The co-evolution oftechnology and institutions has beenthe source of continuing increases inprosperity in the western world for twocenturies and more. Government is anagent in that evolution, not a bystander:but government cannot control theprocess and should not seek to.

Markets work, but notalways and not perfectly.Self interest is animportant economicmotivation, but not an exclusive one.

If economic regulationrequires a gun for itsenforcement, it willinevitably fail.

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The truth about marketsMarkets work, but not always and notperfectly. Pluralist market structurespromote innovation, and competitivemarkets meet most consumer needs,but there is no general reason tobelieve that market outcomes areefficient.

Self-interest is an important economicmotivation, but not an exclusive one.We need the approbation of ourfriends, the trust of our colleagues, thesatisfaction of performing activitiesthat are worthwhile in themselves andgive others pleasure. These motivesare not materialistic, but that does notmean they are not economic. They arean essential part of the mechanismsthrough which successful businessoperates.

For the evangelists of the ABM, therules of the market economy areobvious and universal. But marketeconomies have been successfulrelative to other societies preciselybecause the rules that govern them arenot obvious to frame and easy toimplement. If they were, they wouldhave been widely and successfullyimitated. This has not happenedbecause these rules are embedded,complex, and hard to write down. We do not understand many of thesemechanisms, although advances ineconomic thinking in the last thirtyyears have helped extend analysisbeyond the simplification of the ABM.Social interactions and politicalinstitutions – such as brands and trustrelationships – allow the developmentof sophisticated products whichconsumers are confident to buy anduse without needing to understandthem. Market economies handle wellthe coordination problems of logistics

– reliable deliveries of components tomanufacturers and overall balancesbetween supply and demand. They doless well when even temporaryimbalances are intolerable – as inelectricity supply, when the lights goout. But markets do not necessarilysucceed at all, or succeed in producinggood outcomes, when other forms ofcoordination are required, as fornetworks and standards.

And markets for risk and capital,dominated by speculative traders, areprone to bubbles and overshooting.Fluctuations in securities marketsdestabilise markets for goods andservices, and divert resources fromproductive activities to unproductivetrading in existing assets.

The very concept of a market for labouris offensive to many people, and withcause: workers are citizens as well assuppliers of labour, and enjoy rightsthat are not held by apples, pears,software – or corporations. Laws thatprohibit slavery, and regulate theorganised sex industry are hardlycontroversial. They restrict freedom ofcontract on the grounds that evenvoluntary transactions may degradesociety and deprive individuals ofdignity. But these proper arguments forregulation are of much widerapplication. The issue is not whether

the labour ‘market’ should be subjectto social and legal regulation, but itsnature and extent. That is a matter formoral judgement, social values andempirical evidence.

Many services cannot be provided incompetitive markets. Public goods liketransport infrastructure, environmentalprotection, police and defence, and theframework of rules within which themodern market economy operates.Water and electricity distribution, roadand rail networks, air traffic control arenatural monopolies. Other services–like education and health – could beprovided by competitive markets butare not, for reasons that most peoplefind compelling.

And the distribution of income andwealth and the process by which thatdistribution is established must, likethe structure of market institutionsitself, enjoy legitimacy if the marketeconomy is to survive and evolve. Inthe absence of such legitimacy, richpeople dispute property rights in thecourts, and poor people dispute them in the streets. And if there is nogeneral acceptance of the justice of the distribution of income and wealth, political power is contested in ways that preclude effectiveeconomic development. This has been depressingly true for too long inmost of Latin America, and is todayreproduced in modern Russia.

Economic policy in theembedded marketBecause markets are embedded insocial institutions, it is not only, ormainly, by voting that we influence thedevelopment of the market economy.Economic policy is not simply a list ofthings the government should do. Wemake economic policy as consumers,

Scholars andinnovators compete inthe market for ideas,supermarkets competein the market forgroceries, universitiesin the market forstudents.

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employers, entrepreneurs andshareholders. We influence economicpolicy when we conform to the normsand values of the market economy –and when we resist them. Economicpolicy is as much about socialattitudes and customary behaviour asabout law and regulation.

So it is a mistake to see economicpolicy as a matter of defining theboundaries between state and market.In an embedded market, such

boundaries cannot be clear cut. Thenotion that the provision of publicservices, or the pursuit of socialobjectives, can be decentralisedthrough a process of tightly definedcontracts is a chimera, except innarrow areas where outcomes can beprecisely described and methods ofachieving these outcomes are obviousand widely accepted. For example,activities like street cleaning orhospital laundries.

This perspective on contractualisationand decentralisation matches theexperience of the private sector itself.General Motors would once distinguishsharply between customisedcomponents whose production thecompany must itself control, andcommodity purchases which couldsafely be outsourced from the

cheapest supplier: until Toyotademonstrated that better productquality, faster, leaner production, andmore flexible response to changingmarket conditions could be achievedby trust relationships among a keiretsu

of favoured suppliers. The manufactureof complex products in a moderneconomy has become possible only bymaking permeable the boundariesbetween firm and market. The deliveryof complex services in a modern statewill be possible only by makingpermeable the boundaries betweenstate and market in a similar way.

It is superficially attractive to demandthat the relationships between thestate and other agents should betransparent, precisely defined, andnon-discriminatory. But precision andflexibility are incompatible. The realchallenge is how to achieve forgovernment the relative informality ofcommercial relationships betweenfirms which is the real basis of thesuccessful market economy, withoutopening the door to the corruption andarbitrariness which the legal regulationof relationships between the state andprivate sector is intended to prevent.The worst outcome – and a commondanger – is to construct relationshipsbetween government and private firmswhich are formal in appearance butinformal in substance: the elaboratecontract is renegotiated, or set aside,whenever it comes under pressure.

The nature of regulationRelationships between state andmarket are therefore not simply, ormainly, matters of law, regulation andcontract. The atmosphere in which theyare conducted is critical. To repeat,economic policy is not simply, orprimarily, a question of what the

government should do. Government isonly one of the means by which thesocial context of the embedded marketis expressed. Concepts such asreputation and legitimacy are equallyimportant expressions of that context,and also play a central role inregulating economic activity.

Statutory regulation and selfregulation are not alternatives: theyare complementary. Law can only beenforced in a democratic society if itcorresponds to the behaviour mostpeople would engage in, or at leastwish to see engaged in, anyway. Andthis is even more true of economicregulation: its objectives are toocomplex, and its clients toosophisticated for crude enforcement towork. When the young Alan Greenspanwrote that ‘at the bottom of theendless pile of paperwork whichcharacterises all regulation lies a gun’,he was talking nonsense: if economicregulation requires a gun for itsenforcement, it will inevitably fail.

We cannot achieve truth in accountingreports or securities prospectusesunless the principles that drive therules are internalised by privatebusiness themselves. Withoutelements of external regulation, selfregulation rapidly degenerates into self congratulation – as it has inprofessions, such as law, accountancyand medicine – but external regulationon its own can never acquire thesubtlety and adaptability, nor theinformation which it needs to achieveits purposes. In the financial servicessector, as in others, the most powerfulvehicle of regulation is mutuallysupportive reputation – respectedtraders deal only with respectedtraders, and confer that respectgrudgingly. This mechanism has been

The experience ofeconomic planningunder social democracyis no more encouraging,if perhaps lesscalamitous, than theexperience of economicplanning undercommunism.

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allowed to unwind in the last twodecades when maximum greed withinminimal rules was the credo of themarket economy.

Politics and marketsIn an embedded market, legitimacycomes not only from the electoralprocesses of democratic policies butalso the demonstration of success in the competitive market place. The market place can take on a wideinterpretation in this context. Scholarsand innovators compete in the marketfor ideas, supermarkets compete in themarket for groceries, universities in themarket for students, political NGOscomplete in the marketplace for publicattention. Authority is derived fromsuccess in all these competitions.Indeed democracy itself is amarketplace in which the right toexercise political leadership iscontested.

This multiplicity of marketplacesillustrates the many ways in whicheconomic and political pluralism areassociated. While in principle one formof pluralism can exist without theother, the practical correlation betweenthe two is overwhelming. Virtually allsuccessful market economies aredemocracies, and have been so formost of their recent economic history.In the Soviet Union in the 1980s, theintroduction of elements of economicpluralism quickly destroyed politicalcentralism.

It is chastening that the experience ofdeliberate coordination of economicsystems and of economic developmenthas shown that such statecoordination is generally worse thanno coordination at all. The experienceof economic planning under socialdemocracy is no more encouraging, if

perhaps less calamitous, than theexperience of economic planningunder Communism. The fundamental,and intractable, problem is that suchintervention presupposes a knowledgeof the economic system and economic

environment which no one can validlyclaim to have. And those who do claimto have it are even less worthy of ourtrust than those who manage without it.

The correct lesson to draw is that themodern market economy, necessarilyembedded in a social, political and cultural context, is a sensitiveinstrument whose functioning weunderstand only imperfectly. If the dismal experience of plannedeconomies is instructive, so is thedismal experience of New Zealand: thecountry which from 1984 – 99 followedthe liberal prescriptions of the ABMmore vigorously than any otherdeveloped economy, and enjoyed theworst macroeconomic performance ofany developed country over the sameperiod. The lesson of Soviet failure isnot that the Soviet vision was thewrong vision, but the dangers of anysuch vision. All attempts to implementgrand economic designs are likely toend in failure.

Economic policy is best conducted as aprocess of piecemeal experimentationand improvement, properly subject andcontext specific. The form of industryorganisation that is right for electricitygeneration is not the same as the one

which is right for water supply. Themechanisms of regulation appropriatefor financial services is not the same as that for food retailing. This does not mean that there are no generalprinciples or relevant analogies, butthey are rarely obvious or compelling.Keynes once famously hoped thateconomics and economic policymaking would become a technicalsubject, like dentistry. It is time torenew the hope.

John Kay is one of Britain’s

leading economists. This article

is based upon arguments

developed in his new book

The Truth About Markets,

published by Allen Lane the

Penguin Press in May 2003.

Keynes famouslyhoped that economicswould become atechnical subject, likedentistry. It is time torenew that hope.

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