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« Aid Effectiveness beyond Accra: good governance & anticorruption 2010 | Main | Capture and the Financial Crisis: An Elephant forcing a rethink of Corruption? »

Unfettered Free Market, Financial Crisis and Political Backlash: How about a Market-Friendly Approach Instead?

By Kaufmann | October 7, 2008

The end of the 1980s brought about the demise of the Soviet Union and its then satellites.  With the failure of socialist planning, gloating took place among some Western circles who declared absolute victory for free market capitalism. 

Almost twenty years later, as we approach the end of the first decade of the new millennium, we are in the midst of a US-led major crisis of the Western financial system. Very different quarters are gloating now, blaming it on the failure of capitalism, and suggesting that a return to a system with socialist overtones is not only preferable, but unavoidable.  Many point out that even the essence of the bailout plan, put together by a free market administration in the US, already points in that direction…!

Crisis tends to provide fodder for extreme ideological positions and hasty policy-making.  On the ideological front, last century’s most tragic example was Hitler’s rise to power in the aftermath of the great recession.  History shows that the cycle of crisis and resulting revamp of political and economic models, associated with extreme ideological swings of the pendulum, do end in either extremely controlled or extremely uncontrolled systems.  On each extreme of such pendulum, crucial checks and balances are lacking, whether it is the lack of political and market competition in an authoritarian socialism, or the lack of government oversight and regulation of finance in an unfettered market democracy.

The absence of checks and balances are associated with large scale abuses, paving the way for yet another crisis.  The new crisis results in another over-reaction cycle, with checks and balances likely to remain wanting this time on the other extreme of the pendulum.

From such perspective, it may be useful to provide some perspective on the ideological and policy reactions to the current financial crisis.  For the sake of debate, let me make the following claims here:

1. The demise of the Soviet Union exposed fundamental flaws in planned systems as a substitute to monetized and market-based capitalist systems.  Yet this historical development did not provide evidence that the optimal form of capitalism was of the unfettered free market variety.  In fact, drawing from the lessons of decades of development experience, the 1991 World Development Report, entitled ’The Challenge of Development’ (full disclosure:  I was one of the co-authors), did not advocate an unbridled free market with minimalist government.  Instead, it put forth the notion that a ’market-friendly’ approach to the role of the state was needed, one where the government had to effectively fulfill basic core functions to support, safeguard and complement the market.  Some of the public goods that an effective government had to provide included primary education and basic health, social safety nets, defense, the proper regulatory role in financial markets, anti-monopoly policies levelling the playing field for private sector development and enabling entrepreneurship, and growth.
2. The financial sector has traditionally been viewed as a unique sector, given its role in oiling the whole economy and recognizing the broad systemic implications of any failure in a major financial sector entity.  This has traditionally justified the call for much broader oversight and regulation in this sector than in other sectors of the economy.  But over-reacting to a financial sector crisis and supporting restrictive regulations of the economy’s real sector, including trade, food and labor markets, would not be justified.
3. Further, as a political knee-jerk reaction to the crisis, there is even the danger of over-regulating the financial system itself, to such an extent that credit and entrepreneurial activity (which unavoidably involves risk taking) are choked for a much longer time.  There is no question that government oversight and regulations of financial activity need to be strengthened as compared to the regulatory laxity that has pervaded over the past decade or so.  But the devil will be on the details of ‘how’ and ‘what’ to regulate.  Sarbanes-Oxley (SoX) may have been full of good intentions, but in the aftermath of Enron et al, the excessive regulatory zeal of SoX overshot its target.  As I blogged before, such over-reaction often takes place due to the political and legislative imperative to ‘act resolutely’ through blunt legal and regulatory fiat in the heat of a crisis.
4. In figuring out the ‘how and what devil-in-the-details’ of the next stage of financial sector regulations it will be important to distinguish between very different types of regulations:  those that enhance transparency and information flows; those that force people benefiting from the risks to face also the downside costs (and not only benefit from the upside — in other words, an ‘aligning of incentives’, heretofore absent); those that provide for improved oversight and supervision of the whole system (with emphasis on systemic risks), and those that put retraints on financial institutions.  Enhancing transparency, which should be at the core of the reforms, would be a win-win without imposing a social cost.  To the contrary, it addresses asymmetric information in this context (a silent issue has been the failure of governance, vested interests, and corruption, which warrants a separate blog entry). 
   It would also be a win-win to adopt policies that align (downside and upside risk) incentives for those mortgage lenders and derivative brokers that take risks.  Yet other regulations by fiat have costs (restricting entrepreneurship and growth) as well as benefits (lowering risk).  Thus they need to be weighed carefully to prevent any over-reaction on regulatory fiat.  Some regulations, such as some of the conservative prudential regulations may make eminent sense, while others  may not, such as draconian capital controls on cross-border financial flows, for instance.  And forcing banks to increase capital when risks increase may cause credit to fall, precisely when the opposite is needed.

A financial crisis can have vasts costs and consequences around the globe, particularly in the short-to-medium term.  But such consequences, and the political rethoric around it, ought not cloud the need to engage in a reasonabale debate about appropriate ideological, systemic and policy responses, which will have wide ranging ramifications for the longer term. Moving from an unfettered free market ideological stance to a pragmatic and middle-of-the-road market-friendly role for the government may be warranted: one that balances the need for continuing private entrepreneurship and market-led innovation with the checks and balances of government oversight and pro-transparency regulations.

Topics: Public Financial Management, Public-Private Linkages, Transparency | |

2 Responses to “Unfettered Free Market, Financial Crisis and Political Backlash: How about a Market-Friendly Approach Instead?”

1. ahmad Says:
   October 12th, 2008 at 3:30 pm

   nice debate, howevere, there are some points need more light; what about the global organizations,

   and to what extent the real estate crisis affected the whole financial system?.

2. In Defense of Capitalism - Economix Blog - NYTimes.com Says:
   October 14th, 2008 at 3:23 pm

   [...] the Kaufmann Governance Post, Daniel Kaufmann, the director of global programs and governance at the World Bank Institute, says: [...]

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