The role of the state in finance and money: implications for economic stability.

Author:Cargill, Thomas F.
  1. Introduction

    This paper considers the relationship between the State and the country's financial and monetary regime. The financial and monetary regime consists of private financial institutions and markets, government financial institutions, government sponsored enterprises, financial regulatory and supervisory government institutions, and the central bank. These components vary widely from country to country depending on its stage of economic development, history, national goals, and political institutions, but in all economies, the regime is theoretically responsible for facilitating the savings and investment process, providing a stable financial environment by limiting liquidity crises, preventing disintermediation and rapid shifts from higher forms to lower forms of money, and providing a stable monetary environment by stabilizing the value of the nation's medium of exchange. The State from the beginning has assumed some role in the financial and monetary regime, but from the beginning of the twentieth century to the present, the State's influence has rapidly increased.

    The responsibilities of a financial and monetary regime are so obvious and necessary for economic growth that they require no further discussion; however, what is not emphasized sufficiently is that the State is less concerned with ensuring that the regime's responsibilities are fulfilled and more concerned with expanding its own role in finance and money, influencing the flow of funds to support industrial policies, and using the regime to accommodate the State's bias toward fiscal imbalance. In this process, the State establishes a complex feedback mechanism between the private and public sectors that satisfies the State's incentives to maintain and enhance its power and, at the same time, provides incentives to crony capitalists to support the State. The outcome is not only an inefficient allocation of capital over time, but at discrete points in time, financial and economic crises. The financial and economic crises arise from the discretionary power vested in individual agencies or authorities that more often than not generate policy failures. They also arise because the State creates incentives for the private sector to engage in imprudent lending and investing (see e.g., Robinson and Nantz [2009]; DeGennaro [2009]; and Block, Snow, and Stringham [2008]). The incentive structure established by the State is not limited by standard budget constraints; that is, spending other people's money is inherently inefficient. That the State's role is inefficient and destabilizing is not, however, the conventional wisdom.

    In contrast, the conventional wisdom emphasizes market failure as the cause of economic and financial distress and offers the State as the means to resolve market failure. This view emerged as a dominant theme in the post-World War II period as a result of the Great Depression and the success of the State's victory over Germany, Japan, and Italy. It was partially interrupted for about a three-decade period in the latter part of the twentieth century as much of the world embraced liberalization to varying degrees. This was a remarkable period in historical perspective that some refer to as the Age of Milton Friedman (Shleifer 2009), but by the end of the first decade of the new century, the conventional view returned stronger than ever both in terms of attitude and policy. The Great Recession in the United States, Japan's third lost decade, and the International Financial Crisis of 2008-2009 are widely attributed to excessive liberalization, especially financial liberalization, while at the same time, the success of China's State-directed market economy is viewed as the model of the future.

    It is remarkable how rapidly the enthusiasm for liberalization has waned in light of the historical record of policy failures like the Great Depression, the Great Inflation, and now the Great Recession, as well as the theoretical and empirical contributions of public choice economics. A good part of the answer is to be found in public education, which has an inherent incentive to present a market-failure view of periods of economic and financial distress and to either ignore or downplay the State's role in policy failure. Most students are educated in government schools and taught by government employees, most of whom are members of a public-employee union. The fact that most voters, journalists, and politicians are the product of this educational system partly accounts for the receptive audience to the conventional view of the State's role in the financial and monetary regime.

    This paper discusses how that role has generated economic instability and interfered with the regime's ability to fulfill its legitimate objectives. It also discusses why the deregulation and liberalization efforts in the latter part of the last century have met so much resistance.

    These themes are developed in the following sections: Section II emphasizes that a large body of research suggests the three most important periods of economic and financial distress in the United States-the Great Depression (1929-1941), the Great Inflation (1965-1985), and the Great Recession (2006 to the present, attributing the start to the collapse of housing prices in early 2006)--are at least equally the result of State policy failure as they are of market failure. Of the three, the Great Depression is the most significant in terms of the expanded role of the State and, as such, this section illustrates how public education presents a misleading interpretation of the Great Depression and establishes a receptive audience for the conventional view of the State's role in money and finance. Section III outlines the financial reform process at the end of the last century that helps explain why financial liberalization emerged, why it was resisted, and why it was less than successful, and it discusses to what degree and under what conditions the State's role might be reduced or possibly divorced from a country's financial and monetary regime. A short concluding section ends the paper.

  2. The State and Economic Distress in the United States

    The conventional wisdom by any standard is not consistent with the historical record of the State's role in the financial and monetary regime. In some cases, the State improved the regime's stability; for example, regulation and supervision over...

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