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Advice on strategic issues for governments

A crisis of ideas

David Skilling
11 November 2011

As Keynes famously noted, ideas matter more than is commonly understood. The prevailing ideas shape how events are interpreted and which policy approaches are possible. And so changes in the intellectual environment will likely exert real influence over how the role of government changes over time. In that context, this week’s Observer considers how ideas about the role of government in the economy have been shaped by the crisis, and how the intellectual centre of gravity may move over the coming years.

The era of big government was over
The intellectual consensus across many advanced economies over much of the past 20 years has been on the side of a limited role for government. Although there was national variation, there was a widespread move to reliance on markets with deregulation, privatisation and public sector reform. The free market emphasis, as captured in the Washington Consensus, was a highly influential way of thinking about policy. Bill Clinton, in his 1996 State of the Union address, announced that “the era of big government is over”. In general the role of the government was seen to be to set the rules and then get out of the way. This was an understandable sentiment in a decade characterised by strong growth, the ‘great moderation’ of volatility, and the spread of technological innovations. In the match-up between capitalism and socialism, there was one clear winner.

But although this was a nice story, it was not quite true. And over the past decade it has become increasingly apparent that many of the extraordinarily successful performers (particularly in Asia) relied on approaches that combined markets with an active role for government, and that some countries that had embraced market fundamentalism had not performed particularly well. The relationship between market-based reform and economic outcomes turned out to be a complicated one, and many began to note the importance of government policies and institutions, and political leadership, in promoting and sustaining growth. As a consequence, the pendulum began to swing back towards a view that the government could have an important, constructive role (tempered by an awareness that government could also get things wrong).

Apres le deluge
And then came the crisis, one of the most significant economic and financial events of the past century. The immediate reaction to the financial crisis was consistent with the pendulum moving back. Alan Greenspan gave his famous mea culpa (“Yes, I’ve found a flaw”) and in the words of the Newsweek cover story, ‘We Are All Socialists Now’. There were calls for a ‘New New Deal’ in the US, a Bretton Woods 2.0, alternative measures to GDP, and much tougher financial market regulation. Just as policy failures and the economic malaise of the 1970s, together with a new intellectual agenda, provided the platform for Reagan and Thatcher to redraw the policy landscape in the 1980s, there was an expectation of a substantial change in the role of government.

But a few years on from the start of the financial crisis, remarkably little has changed (apart from eye-wateringly large amounts of fiscal stimulus). Proposals for tighter regulation, more redistribution, and a more active government role have not made much progress, and the role of government is recognisably the same as it was before the crisis. There has not been a sea change in the intellectual climate. There are many reasons for this: the stimulus packages of many governments have not achieved the economic objectives that were set, and governments do not seem to have answers; many of the world’s economic problems are seen to be due to excessive amounts of sovereign debt and political mis-management, rather than simply to be the fault of the private sector; and, relatedly, public trust in government has reduced over the past few years. So perhaps, as they say in France, it is a case of “the more things change, the more they stay the same”.

On the horizon
But as has been noted in various contexts, there is a common tendency to over-estimate the effect of a shock or a change in the short-run and to under-estimate its effect over longer horizons. Although it may not look like it at the moment, my judgement is that the crisis will reinforce the shift towards a more active role of the government in the economy. Because the crisis was fundamentally due to ideas that led to an excessive reliance on markets, I think the crisis will ultimately have an influence on ideas about the role of government. Indeed, previous shifts in the dominant intellectual approach have come after periods of crisis – the New Deal after the Great Depression, the new domestic and global institutions after 1945, and the movement towards markets after the over-reach of Keynesianism in the 1970s. And this time, this change in the intellectual space will interact with the structural challenges and opportunities presented by the intense globalisation process; the pressure on the income distribution, concerns about competitiveness, increased exposure to external shocks, and so on.

Because of this, governments, corporations, and investors should not expect a continuation of the current intellectual agenda. I think there will be a tendency for a shift back to a more deliberate role for government in managing the effects of globalisation, and trying to shape the functioning of markets. This may not mean a bigger government (indeed, structural fiscal constraints in many countries will constrain major spending initiatives), but a government that aims to more deliberately shape or manage the economy. The current intellectual centre of gravity does not seem sustainable in the face of emerging economic realities; as one observation in this regard, the various ‘Occupy’ movements are receiving sympathetic coverage in the Financial Times because of a sense that they raise some reasonable issues (and even Marx is staging a comeback in parts of the economics commentariat). The point is that we should not over-interpret the absence of change over the past few years. For better or worse, what many advanced economy governments do will very likely look quite different in ten years than is the case now.