Stephen King: Politicians in Europe are fighting back against the domination of the markets

Action to 'improve' the functioning of a market can sometimes make the situation worse, not better

The ongoing financial crisis has exposed a paradox underlying the developed world's progress through the 20th and early 21st centuries. We have more globalisation, to the extent that savings and investment flow across borders much more easily. We also have less globalisation because, as the 20th century progressed, empires collapsed and were replaced with a proliferation of nation states. Put another way, free markets have given us more globalisation but political re-arrangements have resulted in less. The clash between these two opposing forces is one reason why we've ended up with so much economic instability, a theme I explore in my new book, Losing Control: The Emerging Threats to Western Prosperity (Yale University Press).

For individual nations, this is an awkward result. Should our leaders respond to market forces or, instead, should they be more carefully attuned to their local political antennae? If markets mostly work well, there is a strong case for arguing that short-term local political concerns should be put to one side: the free movement of factors of production both within and across borders should ultimately lead to a more efficient allocation of resources and, hence, a bigger global economic cake for everyone to feast upon.

Markets don't always work well, however. Sometimes they fail because they don't deliver the efficient outcomes expected of them. This is particularly the case within capital markets, where uncertainties are endemic. On other occasions, even when they're not failing, market forces lead to inequitable social outcomes. The efficiency with which resources are allocated says nothing, after all, about potential winners and losers.

As the economic crisis over the last few years has evolved, it's become increasingly obvious that political leaders have grave doubts over whether markets can provide all the answers. That leaves them with three possible approaches. First, they can try to identify market failures and then attempt to correct them. If, for example, incentive structures in the financial world lead employees to take risks which destabilise the broader economy, there may be a prima facie case for reform (splitting up banks to disentangle trading from commercial banking activities is one example of this). Pinpointing the precise source of failure is, however, a tricky issue. Action to "improve" the functioning of a market can sometimes make the situation worse, not better.

A second option is to throw sand in the works. If unfettered free markets lead to damaging economic and financial instability, then simply interfere to stop markets behaving so aggressively. The German Chancellor Angela Merkel's decision last week to ban "naked" short-selling falls into this category, as does the suggestion to impose a global "Tobin tax" on foreign exchange transactions (the "Robin Hood" version of this tax misses James Tobin's original point: the late economist's idea was not to raise money for worthy causes but, instead, to limit damaging speculative behaviour in the foreign exchange markets). Other examples include the use of capital and exchange controls and, as a likely outcome of the credit crunch, the introduction of a counter-cyclical capital ratio for banks, forcing them to be more conservative in their lending policies during economic booms.

The third alternative is to remove the influence of markets over economic decisions altogether. The Soviet Union and its motley empire of planned economies did this in extremis but it happens in all sorts of other walks of economic life. Public spending as a share of national income, for example, has increased enormously over the last 100 years. Before the First World War, the state controlled only around 10 per cent of the British economy's resources. Today, the share is approaching 50 per cent of GDP. Public services which we now take for granted – most obviously, the National Health Service – simply didn't exist before the Second World War.

It's difficult enough to decide the balance between market and non-market outcomes within states. Across nations, however, it's even trickier. What happens if the political preferences of a nation state don't accord with wishes of international capital markets? In the emerging world, the typical result has been a dose of hyperinflation, a currency crisis, a default or a combination of all three. Too often, emerging nations, dependent on unstable earnings from commodity exports, attempted to live beyond their means, becoming addicted to levels of debt they could never hope to repay. The inevitable crisis eventually hit both domestic debtors and international creditors.

Since the Second World War, the developed world has, for the most part, not had to suffer in quite the same way, often because self-imposed constraints – a mixture of currency and inflation targets – have brought nations to their economic senses before there was any chance of a major crisis.

Nevertheless, there have been plenty of occasions when the ability to print money – either to create inflation or to devalue the currency – has provided a useful safety valve for countries in fiscal difficulty. If inflation rises and interest rates don't respond immediately, the government debtor benefits at the expense of the domestic creditor. If, instead, the currency falls, the domestic government debtor benefits at the expense of the foreign creditors, so long as the foreign creditors provided funds in the domestic currency, and not their own currencies (there are plenty of foreign creditors nursing their losses following sterling's huge decline in 2008, for example). These actions can be described as "stealthy" defaults, certainly unpleasant but not always completely disastrous for a country's access to international capital markets.

Within the eurozone, however, the option to provide stealthy defaults simply doesn't exist. Nation states may still be sovereign in many respects but, having dispensed with the printing press, their options in the wake of a major debt crisis are limited to three: austerity, bailout or default. When the eurozone was first formed, investors appeared to believe that only the first two of these three were possible. As a result, bond yields throughout the eurozone converged to German levels. The game has now changed. The massive fiscal deterioration following the financial crisis has left many countries required to deliver austerity on scale that's almost unimaginably painful.

We know from the inter-war period that excessive austerity can lead to political upheavals of the most unpleasant kind. If investors insist on this kind of austerity, the obvious solution is to silence the markets. The IMF's involvement certainly muffles the markets but that, on its own, may not be enough. A more radical approach would be to augment the eurozone's monetary integration with a strong dose of fiscal integration, shifting the balance of power away from markets towards policymakers.

We take this for granted within countries: savings flow from North to South Italy, co-ordinated through Rome, and across the United States, co-ordinated by Washington. In both cases, the distribution of resources rests on political, rather than market, decisions. Could the same happen across countries? Yes, but only if each country recognised the benefits of pooled fiscal sovereignty, and chose to sacrifice its own sovereignty for the "greater good". That's still a long way off. Nevertheless, the euro can be seen as "work in progress" in trying to overcome the strains associated with the paradox of globalisation. Markets may have dominated over the last three decades but there can be no doubt that politicians are fighting back.



Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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