`We hope the fund is maintaining its push for a more flexible exchange rate, far- reaching reforms in the banking sector and more privatization.

Mr Timothy Ash, head of emerging-market research at Royal Bank of Scotland in relation to an IMF rescue package for Ukraine during the global financial crisis. The Royal Bank of Scotland had just been nationalized as a result of failed speculation and catastrophic mismanagement.

The ‘mixed economy’ in which public provision of a wide range of services and economic infrastructure, such as telecommunications and electricity networks, coexisted with a largely capitalist market economy was one of the most striking features of the political and economic settlement that emerged in Western economies after 1945. Public ownership was not new. Governments in many countries had played a role in providing infrastructure, social welfare systems and services such as health and education. But, before World War II these measures had generally been seen, by supporters and critics alike, as steps towards full-scale socialism, defined in traditional terms as the elimination of private ownership of the means of production.

The one exception, first noted by John Stuart Mill was that of industries that are ‘natural monopolies’ in the sense that the efficient scale of operation is so large that costs are minimized when there is only a single firm in the market. In this case, Mill noted, "it is the part of the government, either to subject the business to reasonable conditions for the general advantage, or to retain such power over it, that the profits of the monopoly may at least be obtained for the public." The alternatives proposed by Mill, that natural monopolies should either be regulated or publicly owned have proved to be the only serious policy options, despite occasional attempts to argue that unregulated private monopolies may be benign, such as the theory of ‘contestable monopoly’ put forward by William Baumol and his co-authors in the 1980s.

The experience of the Depression and World War II produced a fundamental shift in thinking about the roles of governments and markets, described by Sheri Berman as ‘the social democratic moment’. Rejecting both 19th century classical liberalism, and the mechanistic determinism of orthodox Marxism, social democrats saw themselves, in the words of Australian historian as ‘civilizing capitalism’. From the Swedish ‘Folkhemmet’ (people’s home) to the British reforms based on the Beveridge Report to Roosevelt’s New Deal and Four Freedoms, social democrats put forward a vision of a society in which markets and business enterprise played a central role, but one subordinate to the needs of a just society. In addition to Keynesian macroeconomic management and the social policies of the welfare state, this vision required governments to make investments in the physical and economic infrastructure needed to ensure prosperity.

The growth of government intervention was supported by a series of new developments in microeconomics, collectively called the theory of market failure. In the 1920s, AC Pigou developed the idea of externalities as a way of incorporating obvious (but previously disregarded) features of industrial society such as air pollution into economic analysis. Pigou’s analysis is still in use today, and forms the basis for policy proposals such as the idea of a carbon tax to limit emissions of carbon dioxide and other greenhouse gases.

Then in the 1930s, Joan Robinson and Edward Chamberlin independently developed the idea of monopolistic competition, extending earlier work on industry structures such as monopoly (dominance of a market by a single seller) and duopoly (two sellers). The rise of game theory in the 1940s and 1950s, due to von Neumann, Morgenstern and Nash, provided a rigorous basis for analyzing markets that did not fit the standard competitive framework.

The development of modern theories of information and uncertainty, also deriving from the work of von Neumann and Morgenstern suggested a range of ways in which market transactions might lead to suboptimal social outcomes. The classic instance was Akerlof’s discussion of the ‘lemons’ problem. This is the idea that the sharp decline in value of new cars, occurring as soon as they are driven out of the showroom reflects the fact that cars resold soon after purchases are likely to be those regarded by the initial buyers as ‘lemons’. In the absence of an easy way to detect such lemons, buyers of good cars will be unwilling to sell at the low price available for slightly used cars, producing a self-sustaining equilibrium in which the only near-new cars on the market are lemons.. Such ‘asymmetric information’ problems are particularly severe in the context of insurance markets where they go by the name ‘adverse selection’.

All of these possibilities were grouped under the heading of ‘market failure’. The view that governments should act to correct market failures where they occurred was used to justify a wide range of government action, and in particular the provision of goods and services by governments and government owned enterprises. Government provision of health services, for example, could be justified by the limitations of insurance markets, while public ownership of infrastructure utilities was justified as a response to problems of monopoly and oligopoly.

Paradoxically,the crowning theoretical achievement of neoclassical economic theory, the demonstration by Arrow and Debreu of the existence and optimality of a competitive general equilibrium, also provided the theoretical basis for the theory of market failure. Arrow and Debreu showed that if competitive markets existed for every possible commodity, in every possible time and place and under every possible contingency, the resulting allocation of competitive resources could not be improved upon for everyone. But that’s a very big if.

It is obvious that the complete set of time-dated, place-specific,contingent markets required for the Arrow-Debreu proof does not exist, and cannot possibly exist. But a large literature in the economics of finance explores the idea that if financial markets are sufficiently well-developed, the instruments traded in this markets can effectively encompass all relevant possibilities, the real world will be close enough to that of the Arrow-Debreu model that conclusions about the optimality of competitive equilibrium remain valid. This idea does not have a standard name, but we can call it the complete financial markets hypothesis.

The complete financial financial markets hypothesis makes sense only if these markets are efficient, in the sense of the strong form of the efficient markets hypothesis discussed in Chapter 2. Given the powerful evidence against the strong efficient markets hypothesis, this is obviously problematic. But there are even bigger problems. The complete financial market hypothesis requires much more than the existence of markets for bonds, corporate stocks and associated derivatives. It requires that households should be able to insure themselves, at reasonable cost, against such risk as unemployment, business failure, ill-health or a decline in the value of their home. With the exception of health insurance, which exists mainly as a result of public mandates, and publicly-provided‘unemployment insurance’ which is not really insurance, none of the required markets exist.1

The problems explored in the market failure literature can be interpreted as pointing to the absence of many of the markets needed to satisfy the complete financial markets hypothesis and thereby guarantee the optimality of competitive market equilibrium. Arrow, in particular, made this point, and showed that general equilibrium theory gave only the most qualified support to market liberalism.

For much of the 20th century, then, the general movement of economic policy in capitalist societies was towards an expanded role for the state, including an expansion of the scope and extent of public ownership of industry. In the light of movements towards a greater role for markets in communist countries, it was widely anticipated that capitalist and communist economic systems would converge in a ‘mixed economy’.

The term ‘mixed economy’ was popularized by British economist Andrew Shonfield to describe the economic system of the postwar era. This system was not a compromise between comprehensive state socialism and free market capitalism, as is often supposed. Rather, in seeking a market system actively managed by governments the mixed economy transcended this dichotomy. It was, and remains, unlike the vaporous offerings of Tony Blair and Bill Clinton in the 1990s, a genuine ‘Third Way’.

During the era of the mixed economy, the boundaries between the public and private sector were regularly readjusted, and not always in the same direction. While the predominant trend was for the role of the state to expand through the nationalization of existing private enterprises or the establishment of new public enterprises, it was quite common enough for publicly owned enterprises to be returned to the private sector2. By 1970, the success of the welfare state and the mixed economy seemed undeniable. Hopes turned to the prospect of a further transformation, not fully defined, in which the remaining inequalities and injustices of capitalism would be greatly reduced, if not eliminated.

The most promising proposals centered on notions of industrial democracy. In Sweden, the peak union body, the LO put forward a proposal, developed by economist Rudolf Meidner to require all companies above a certain size to issue new stock shares to workers, so that within 20 years the workers would control 52% of the companies they worked in.

But it was not to be.

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1 Robert Shiller has long argued that new financial instruments could reduce the riskiness of investments in home ownership, but his efforts to promote the development of such instruments have had only limited success
2 The phrase commonly used at the time was ‘denationalization’. Peter Drucker used ‘reprivatization. An earlier usage under the Nazis is noted ).

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