Economists have invariably had mixed emotions about the role of the state.
They have been at their most polemical when denouncing government policies that they believe are mistaken. Maynard Keynes was a bitter critic of those that got it wrong. He resigned from the British delegation at the Versailles Peace Conference in 1919 and published later that year The Economic Consequences of the Peace, a coruscating attack of the terms of peace imposed on Germany. Keynes was the source of an oft-repeated quote which mocks economists and those that listen to them1.
“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”
Chapter 24, General Theory of Employment, Interest, and Money, John Maynard Keynes, 1936
The conventional definition is that a state is a political association, representing a population, with sovereignty over a geographic area. Its powers, therefore, are exercised over people and land or, using the terms applied in this book, over the relationship and the process. States appear to have existed since the first towns were established. They defined a community comprising people and the land and dwellings they occupied. What is the modern state emerged in the 16th century in Europe when sovereigns institutionalised their powers into law. Nicolo Machiavelli may have been the first to describe the state in the terms that we now understand in his book The Prince2. The first theorists of the state are regarded to be Thomas Hobbes3, who regarded it as a necessary evil to counter the greater evil of civil disorder, and John Locke, the originator of the idea of the liberal state and of the separation between church and state.
Evidence of constitutional government, or one that followed rules in the way it exercised its powers, can be found in Mesopotamia in the Sumerian era more than 4,000 years ago. The city state of Athens had a code that amounted to a constitution. Aristotle in the 4th century BC was one of the first to distinguish between normal law and constitutional law. Roman law was systematically codified in the 5th century of the Christian era. Similar attempts to define the rights and obligations of the ruler and ruled are found in ancient civilisations in India, the Far East central and South America and elsewhere.
Written constitutions calling for legislative bodies became more common following the European settlement of North America. The Colony of Connecticut adopted what is considered to be the first constitution in North America in 1639. Britain’s Bill of Rights of 1689, though falling short of being a comprehensive constitution, defined in writing the prerogatives of the sovereign and parliament. All American colonies adopted constitutions by 1777 and the US constitution was adopted in 1788. Thereafter, written constitutions became the liberal ideal. The constitution of the French republic was adopted in 1791. Constitutional government spread across the world, reaching the Austrian Empire in 1861, the Ottoman Empire in 1876, the Japanese Empire in 1889, the Russian and Persian empires in 1906 and the Chinese Empire in 1912. The constitution of the state of Pakistan, written in 1947, was the first attempt to reconcile the Islamic Sharia with constitutionalism. The Islamic Republic of Iran, declared in 1979, is the most ambitious attempt so far to express Sharia principles in constitutional terms. The road to constitutional government has been long and challenging. But it is now the rule throughout the world.
States through history have attempted to alter economic outcomes to serve their purposes. Constitutional government, which converted subjects with obligations into citizens with rights, legitimised state action in every area of life and encouraged unprecedented economic intervention. The constitution of republican France allowed Napoleon Bonaparte to mobilise people and resources for war. In 1792, the US congress adopted a programme of tariffs and import restrictions to promote output in the new American republic. Britain’s Corn Laws, which were also seen as a way of raising revenue for the state without resorting to domestic taxation, echoed American protectionism. More comprehensive attempts by the state to manage economies emerged during the depression which started in 1873, a period when falling food prices led to growing agricultural distress in Europe and North America. In response, Germany and France abandoned free trade and Republican Benjamin Harrison won the 1888 US presidential election on a protectionist ticket. Britain was the only major power that resisted protectionist pressures in this period. From the final quarter of the 19th century, governments began to take action against monopolies. America’s Sherman Antitrust Act of 1890 was the first comprehensive government attempt to promote competition by forcing the division of large firms, notably John D Rockefeller’s Standard Oil4. Conventional historians usually regard this legislation as the high point of America’s pre-1914 progressive era5.
Government intervention in economic affairs during the First World War ranged from price controls to state ownership of the means of production and probably reached its most sophisticated level during the conflict in Germany. In response to post-war downturns, governments continued interventionist programmes to alleviate unemployment, particularly in the manufacturing sector. The Soviet Union, created in 1922, initially allowed free markets to flourish but changed course and gave the state primacy in all areas of economic activity. It developed an ideology based on the idea that communism, where all property would be collectively-owned, could be achieved through comprehensive state intervention in economic affairs.
The apparent achievements of the Soviet Union, which were based on false reporting of production increases, were admired in countries severely affected by the global depression which began with the Wall Street Crash of October 1929. Most governments abandoned free trade in the 1930s and sought to manage economic development by raising tariffs, competitive exchange rate depreciation and low interest rates. Maynard Keynes’ General Theory of Employment, Interest and Money, published in 1936, is deemed to be the seminal inspiration for large-scale government intervention through public spending and taxation. The unprecedented management of economies during the 1939-45 war set the scene for a new era for government economic policy which involved permanently high levels of government expenditure, deficit financing, complex tax codes, low interest rates and fixed exchange rates. For more than 30 years after 1945, the state was seen as the key factor in economic affairs with a legitimate role both as a producer of goods and services and as an economic regulator.
The rise and fall of the Washington Consensus
A new attitude towards the role of the state emerged during the world downturn of 1979-81 which was characterised by relatively high levels of unemployment combined with high and rising rates of inflation; an unpleasant condition named Stagflation. Influenced by a new generation of neoclassical academic economists, notably Milton Friedman, governments accepted that they couldn’t and shouldn’t try to do everything. The priority from the late 1970s was caution and consistency: policies that promoted stability through careful management of the money supply to contain inflation, flexible exchange rates, the elimination of excessive budget deficits, moderate levels of personal taxation and a limit to the proportion of total output accounted for by the activities of governments and government agencies.
Under Conservative Prime Minister Margaret Thatcher, the British government elected in 1979 pursued policies of deregulation and privatisation which involved the sale of government assets to private investors. Their apparent success, coupled with the persistent influence of leading economic thinkers, encouraged the global adoption of similar policies. US President Ronald Reagan, elected in 1980, rhetorically championed deregulation and privatisation, though his period in office is primarily associated with tax cuts and budget deficits rather than neoclassical purity. The collapse of communism in Europe in 1989 decisively discredited arguments in favour of extensive and discretionary government intervention in economic affairs. That year, the economist John Williamson coined the term the Washington Consensus, named because the headquarters of the UN supranational agencies of the IMF and the World Bank which had adopted these principles were based5. It comprised 10 policy recommendations:
- Fiscal policy discipline;
- Redirection of public spending from subsidies toward broad-based provision of key pro-growth, pro-poor services like primary education, primary health care and infrastructure investment;
- Tax reform to broaden the tax base and moderate marginal tax rates;
- Interest rates that are market determined and moderately positive in real terms;
- Competitive exchange rates;
- Trade liberalisation;
- Liberalisation of inward foreign direct investment;
- Privatisation of state enterprises;
- Deregulation to end regulations impeding market entry or restricting competition other than for safety, environmental and consumer protection grounds, and prudent oversight of financial institutions and,
- Legal security for property rights.
The initial conviction that the Washington Consensus represented a lasting orthodoxy that would satisfactorily replace the post-war Keynesian consensus was quickly challenged by events. The Asian Crisis of 1997 was at least partly-blamed on the deregulation of capital markets that the Washington Consensus seemed to promote. Argentina, which adopted much of the consensus, suffered a severe economic shock in 19967. This was followed by the dotcom bust, which was again blamed on ill-considered deregulation. The 2007/08 credit crunch delivered the largest economic shock the global economy has experienced since 1945 and is regarded as simultaneously to have finally discredited the Washington Consensus.
The Covid crisis that erupted globally in 2020 seems to its metaphorical epitaph.
The quest for a new rationale for government economic action
Economists are now facing the challenge of developing a philosophy to guide intervention in economic affairs. Governments were obliged to take action in response to startlingly adverse trends in macroeconomic indicators since the summer of 2008. The US opted for a policy of large-scale financial assistance to the banking industry to allow it to resume lending for essential activities and a sharp increase in public infrastructure investment. In total, the planned increase in US government spending amounted to more than 10 per cent of GDP in 2009/10, the largest co-ordinated programme of public expenditure in history. The European response was more nuanced: there have been moderate increases in government spending and selective support for banks, though the UK has did more than its neighbours because of the importance of the financial services to the British economy.
European governments then tried to reverse the upward trend in public spending, though this is proving to be easier said than done in countries encountering record levels of total and youth unemployment. The US under President Obama tended to resist this pattern, though its principal instrument for reviving output and job creation has been monetary policy.
Agreement emerged, nevertheless, during the Group of 20 meeting of the leaders of the world’s leading economies in London in April 2009 that governments should increase spending and take other measures to counter the depression. These proposed measures were vigorously attacked by many economists, not all of them champions of laissez-faire. Nobel prize-winning economist Joseph Stiglitz, a Keynesian, denounced Obama’s economic policies in an interview published in April 2009.
“All the ingredients they have so far are weak, and there are several missing ingredients… (The people who designed the plans are) either in the pocket of the banks or they’re incompetent.”
Interview with Bloomberg, 17 April 2009.
A more comprehensive assault on government economic recovery programmes came in a report by 12 economists published in May 2009 by the UK’s Institute for Economic Affairs (IEA), the free market think tank8.
The IEA case, which is in line with more than 100 years of neoclassical economic thought, has profound intellectual appeal. It, nevertheless, fails to address the challenge presented by the rise of the service economy and the dominance of intangibles in the economies of advanced economies which are the ones that have been most affected by the sub-prime crisis and the credit crunch. The IEA argues governments recklessly pursued easy money policies. This led to a huge accumulation of liquidity which artificially inflated the prices of all assets. Financial institutions, responding rationally to trends in asset prices, mistakenly expanded their lending and thereby gave them a further upward twist. Regulators are inherently incapable of monitoring the trillions of transactions involved in global financial markets. Therefore, when they act, they are as likely to do the wrong thing as the right one. Taxation has made the situation worse not better. The IEA policy proscriptions are robust: depositors should accept they are creditors and their savings are not guaranteed, banks should be allowed to fail and governments should closely control money supply growth. The underlying criticism is familiar and echoes the powerful case against the capacity of governments to plan economies originally made by Ludwig Von Mises in 1920 and repeated on his book Human Action published in 19499.
“The paradox of “planning” is that it cannot plan, because of the absence of economic calculation. What is called a planned economy is no economy at all. It is just a system of groping about in the dark. There is no question of a rational choice of means for the best possible attainment of the ultimate ends sought. What is called conscious planning is precisely the elimination of conscious purposive action.”
Chapter 26, The Impossibility of Economic Calculation Under Socialism, Human Action, Ludwig Von Mises.
Von Mises’ assertion that it is impossible for governments to plan economic activity echoes the idea of the powerlessness of both the state and the corporation to control the intuitively-defined value-creating communities that dominate service economies. As previous chapters have argued, human beings seek value-creating relationships naturally and spontaneously. Value creation is maximised in an environment where the individual is liberated to develop his or own interactive relationships without external intervention. Intuitively-defined value-creating communities are the location of all value-creating activity in service economies. Von Mises might find these conclusions pleasing. But they originate in a radically different understanding about how value is created. Von Mises begins with the purposeful individual. The argument of this book is that engine of the service economy are intuitively-defined communities where value-seeking individuals develop constructive interactive relationships.
The policy conclusions that can be deduced from the general observations about the character of economic production in service economies are also similar. Governments should normally not seek to intervene in value-creating interactive behaviour and there is no in principle case for government ownership of value-creating communities. Government economic action should be to assist the members of such communities by removing obstacles to value-creating interaction and to the development of processes such interaction requires. Government action that distorts the capacity of value-creating individuals to achieve constructive interaction is damaging.
A policy agenda for government in the service era
But this does not mean that government intervention can never have any purpose. The starting point is for governments to recognise the value-creating communities which are replacing the industries and markets that dominated the era of tangible production. This is a profound challenge.
The state and its agencies function in many ways like tangible-era corporations. Large institutions capture vast amounts of data which is distilled to facilitate policy-making at the highest levels of government. This leads to the formulation of programmes of action that focus on people as homogenised aggregates: heads of households, retirees, the sick, the poor, business owners and so on. They are applied at the direction from the top of government departments and ministries. More often than not, this is done at a national level with the goal of standardising service delivery across the whole of an economy.
Seen from this perspective, government policy takes the deficiencies of the behaviour of tangible era service businesses at the level of the community and applies them at the level of the state. Consumers of public services are regarded as the subjects of government spending rather than participants in the interactions necessary for these services to create value through constructive relationships. Government employees, instead of seeing themselves as autonomous individuals liberated to create value with their customers through spontaneous interaction, are treated as components of a process in a huge national machine.
The perverse result is higher real government expenditure that fails to produce concomitant increases in public satisfaction. In the UK, government spending on healthcare in 2008/09 was more than 150 per cent higher than it was in 1997, the year of the election of New Labour under former UK Prime Minister Tony Blair. Education expenditures doubled over the same period.
The outcomes of one of the most sustained period of public spending in British history are, at best, mixed. Key performance indicators (KPI) used to measure government performance suggest higher public spending has delivered strikingly positive results: more efficiency in the use of healthcare facilities, declines in hospital waiting lists, improvements in public health, record numbers of children with at least some educational qualifications and almost half of each age cohort entering post-18 education. Doctors’ pay has increased sharply with some earning more than $250,000 a year. Many public servants are now paid as much as their private sector counterparts. And yet, there is persistent evidence of dissatisfaction and disappointment with the quantity and quality of government-provided services. For example, before the 2007/08 credit crunch, a record number of children were being educated outside the UK state-school system, evidence, some critics claim, of widespread parental discontent with the results of the huge amounts of additional taxpayers’ money spent on education.
The analysis developed in this book suggests why there is conflict between evidence supplied in the form of KPIs, which indicate sharp increases in the performance of government agencies, and public perception of changes in public services. The objective factors — the processes — which include returns on investment, service use, efficiency and employee productivity all seem to have gone up. But the subjective factors, or the impression people have of what has happened, haven’t, at least not as much as the KPIs indicate.
The problem facing public decision-makers seen from this perspective is not policy. It is structure. Government departments, and not just in the UK, are attempting the impossible: to be masters of the process and of the relationship. Like tangible era businesses who attempt this trick, they are likely to find themselves doing neither well. The Coca-Cola formula is a possible solution. This would involve spending more on marketing and administration than on actually producing the thing that is sold. But whether that is a practical option for Britain’s National Health Service (NHS) is questionable. Voters paying tax for healthcare are unlikely to respond positively to the idea that the government is spending almost as much on advertising as it does on treating the sick.
The logic of the arguments presented in this book prompts the adoption of a different approach: separate the process from the relationship. That would entail those responsible for the physical components of healthcare delivery being concentrated into a single or multiple healthcare process businesses. The relationship components, similarly, should be detached and organised in ways that maximise value-creating interaction with consumers of healthcare. This, of course, is easier said than done. In attempts since the 1980s to increase the efficiency of healthcare provision, UK governments have attempted to separate some relationship activities, mainly operations and maintenance, from processes through what is known as contracting out. The deficiency of this approach, and its failure decisively to deliver measurable increases in performance, is that tangible-era methods have been used to manage contracted-out services which span relationship as well as process activities. Interactive service relationships have been assessed using digital KPIs that can never identify or measure value-creation.
An alternative approach to healthcare provision has been through commissioning new hospitals, probably the most complex and expensive structures you can build, using private finance models. This involves inviting companies to bid for contracts to build hospitals on the basis that they will also finance their construction and, in some instances, operate them10. On completion, the hospital is delivered to the government which pays for the building in stages.
The concept is based on the idea that competition and the private-sector’s quest for profitability will lead to the creation of a better hospital at lower lifetime costs. Once again, the results have been mixed. And once again, the deficiencies in tangible era business philosophies have been exposed.
What is the objective of the company building the hospital? Is it to reduce the cost of the process it is making or maximising the value created by the constructive interaction between healthcare professionals and the patients using that hospital? The latter might require spending more on the hospital than the cost-minimisation priority effective process management requires. What are known as private-public-partnerships (PPP) and public finance initiatives (PFIs), attempts to finance government services using non-government sources of investment, continue to be seen as a way of increasing the efficiency of public spending and the satisfaction it engenders among consumers of the services it provides.
The analysis presented in The End of the Market suggests that privatisation, in whatever form it takes, is a secondary factor. Unless there is a separation of government service provision into a relationship component and a process component, the outcomes will probably continue to disappoint. And bundling build and operate services together will once again require a business to try to do two irreconcilable things: master the process and the relationship simultaneously.
The logic of The End of the Market suggests that governments may be qualified to tackle the main process component of public service provision which is the construction of infrastructure: roads, railways, ports, airports and large public buildings. The extent to which competition and private finance can be effectively introduced into this process will be discussed later. But as this analysis suggests, government attempts to control the relationship component of service provision will invariably fail.
The priority is to restructure public service providers to liberate its employees to interact more spontaneously with customers. This may eventually call for the government monopoly over areas of public service provision to be conceded, or for changes to policies to make it easier for new providers of services that are at present dominated by government agencies to enter those sectors. One example might be to allow a team of education service providers, organised to maximise interactive value-creation, to use educational processes owned by the state: the schools. The costs associated with these relationships, both in delivering the process and supporting the relationship through gift exchanges partly expressed through the payment of money, could be borne by the state or the local government authority.
Such an approach calls into question the regulatory environment in which the interactive public service relationship business operates. Whether it will be possible, or even desirable, to maintain the system of rules and regulations weighing on most public service providers in these circumstances is questionable.
It is difficult to justify the costs involved in training a general practitioner, the most expensive of all vocational training programmes, when most of the time their skills are deployed in assisting people with elementary or even imagined ailments. The UK’s NHS, for all its merits, produces one of the most extraordinary enigmas in economics. Some of the most expensively-trained professionals who earn more than 95 per cent of Britain’s working population are providing services to people who are living close to poverty. If it was an act of charity, this would be laudable. But as a means of creating value, it makes little sense. As a way of delivering services efficiently, it is almost laughably bad.
Government and intangible capital
As has been argued through this book, the concept of intangible capital is one that has emerged recently as the result of incremental legislation and little-known changes in accounting principles. There are powerful intellectual arguments against recognising any further extensions in the capacity of corporations to treat intangibles as if they were financial assets. Radicals argue that the tendency for intangible capital to expand seen over recent trends to be reversed.
The arguments in favour of this line of thinking are fundamentalist and utilitarian. The fundamental argument is that the only reason that property exists is to eliminate or reduce conflict over scarce resources. Since intangible capital by definition is infinitely reproducible at low or now costs, it can’t be scarce and, consequently, property in it serves no social purpose. The utilitarian argument is that there is no clear evidence that expansions in the right of a corporation or an individual to claim ownership over an intangible has made society as a whole better off.
An extension of the utilitarian argument is that the way rules governing intangible capital inherently favour the rich and powerful. A large corporation, which benefits from tax concessions for research and development, is advantaged compared with self-employed scientists and small companies. Large corporations have the resources to contain or crush self-employed creators and small creative enterprises. They also have the resources to support lobbying campaigns for extensions of intangible asset rights that favour their interests.
The distortions that result can be illustrated by imagining a self-employed person going to a bank and asking to borrow $1m on the grounds that he or she has stored in her head ideas that will be converted over time into products, services, revenues and profits. That person would almost certainly be shown the door. In contrast, companies are granted the right through their existence as incorporated entities to convert intangibles, ideas in the heads of their employees and the spreadsheets of their finance team, into assets which can then be the collateral for borrowing and expansion.
The effect is obvious at a global and international level. Research shows that the risk of failure of a start-up business is enormous and less than one in 10 last more than five years. The cost of failure to the self-employed and small business entrepreneur lacking the safety-nets and networks corporations provide can be financially and personally devastating. This helps explain why so many people who would love to become self-employed or set up their own business opt instead for the anonymous security of working for a large corporation or the state.
The continuing dominance of large corporations in so many parts of large economies has a further consequence. Most big firms have their headquarters located in major metropolitan centres, despite the fact that operational costs are invariably higher than they are in smaller towns and rural areas. One of the reasons why this happens is that senior big company managers prefer to live and work in major centres like New York and Los Angeles. They can afford the relatively high property prices and they can benefit from close proximity to their peers and the cultural amenities which tend to be located in major conurbations. With most large firms based in big cities, talent is drawn from smaller towns and rural areas, denuding them of the skills and resources needed to support new income and job-creating businesses.
A by-product of the growing capacity of large corporations to count intangibles as assets, therefore, is the concentration of employment in knowledge-based economies in the metropolitan centres of advanced economies. This is stimulating still further migration from small cities to the larger ones and from the country to the town, with the consequent pressure on the physical infrastructure of major cities. This process is particularly intense in developing nations.
These observations lack comprehensive empirical support but are intuitively valid. They suggest that economists should consider more closely the impact on social and economic development at the national level of further extensions in the idea of intangible capital.
This issue is a legitimate one for governments and legislatures to consider as well. At a time of growing income inequality in every advanced economy and a growing gap between living standards of the residents of wealthy districts of large cities and the those of the rest of the population, further study is surely overdue of the principles supporting government policy towards intangible capital and the implications of what appears to be a wholesale extension of property rights in intangibles being promoted by corporations and their allies in the state.
Government and infrastructure
Service era economics can also be applied to infrastructure. Tangible economics depends upon the idea of a tradable item, the ownership of which is transferred at the moment that a transaction takes place. For a transaction to occur, a market price, or an administered equivalent, must exist. The practical application of this idea has proven to be impossible in particular circumstances11. You buy and consume a bar of chocolate. But can you buy or consume the use of a stretch of a motorway? How can tangible economic thinking be applied to what are called public goods12, things where an additional unit of consumption involve no additional increase in costs, or in circumstances where the increase in costs occur in large intermittent slabs13.
A road is built at several million dollars for each mile. Should the right price for using it be the marginal cost when the road opens, which is enormous, or when it’s operating at full capacity, when it’s effectively zero? How should maintenance be treated? Should heavy vehicles be charged more than light ones because they inflict more wear on the road? Should people using a road also be charged for the benefits they enjoy at the end of their journey, which might in fact be some distance from the new road’s end? And, should road owners who secure income from users of their roads delivered efficiently to them by the new one pay as well?
What about the impact on congestion on other roads of the new road and on the environment? And of the contribution efficient road networks deliver to defence and national security?
This subject has tested the intelligence and, at times, the sanity of generations of economists. As we learned in chapter 1, the struggle of the French engineer Jean Dupuit to justify the construction of a bridge led to the development of the idea of diminishing marginal utility. Public infrastructure projects like roads and railways have for decades tested the validity of tangible-era economics. And so far, tangible era economics has been the loser, though this has not discouraged heroic attempts by some economists to apply their principles to such projects. They may ultimately discover a coherent intellectual solution that satisfies tangible-era economic thinking. But for the moment, public goods are treated as exceptions to the rule. Tangible-era economists regard them as special cases where their ideas, for the moment, don’t seem to work.
Service era economic thinking, however, has no such problem. Roads, railways and other infrastructure public goods are definitively unexceptional. They are processes that support value-creation. The only challenge for service-era economists is that they should be available in sufficient quantity, of the right quality, in the right place and at the right time at the lowest possible cost. Whether they are the product of government investment or private initiative is a matter of indifference. All that matters is that they exist when needed.
This consequently shifts the debate about infrastructure processes from issues about how they should be created to whether they should exist at all. This is a question beyond economists to attempt since it can only be addressed by the community or communities that the infrastructure is designed to serve. The choice will be the product of an interactive process within the relevant communities. They may take time to make it and their choice might be wrong. But tangible-era economics and the market-clearing price only matters when the cost of the process, the infrastructure, is in review. This is relevant to the choice but is not decisive.
Service economics and the natural environment
The next question is what does service economics suggest should be done with the natural environment, which includes land and rivers, mineral resources and air?
Tangible economics has also struggled with this issue, particularly with the concept of externalities, or by-products of tangible transactions such as the pollution produced by power stations and the improvement to the environment caused by someone planting a tree in their back garden14. These are things that hurt or help people that are not party to the original transaction and, therefore, have paid nothing to avoid them or received nothing for producing what others have enjoyed15.
The solution has been to suggest that the establishment of enforceable property rights will optimise the use of land and minerals. An investor, tangible-era economists argue, will rationally use his or her land and mineral rights to ensure they deliver the maximum long-term returns to investment. The goods and services he or she produces from land and mineral rights will be sold at market-clearing prices that ensure the consumer makes the right decisions too. Environmental degradation and irrational exploitation of mineral resources are much more likely when land and minerals are owned by the state, an institution crippled by the impossibility of planning.
This argument received strong validation from the appalling environmental consequences of central planning in the Soviet Union and the former Communist states of Europe. The Chernobyl disaster of 1986 is cited as the most extreme example of the disasters that can result when there are no private property rights and no property owners to restrain government planners.
If this line of thinking is valid, however, it suggests that it is better for everyone ultimately if every speck of land, every stretch of river and every beach were privately-owned. There would of course have to be special case treatment for natural resources that are public goods, like rivers. Perhaps the solution is to have the River Thames Company with the exclusive rights to develop the revenue-generating potential of Britain’s longest river? The challenge to the Amazon rain forest could be addressed in a similar manner.
Such initiatives are so unlikely as to be effectively impossible. But they are consistent with the logic of tangible-era economic thinking that has introduced revenue-raising tolls for potable water supplied to remote areas of low-income developing countries. And, within its own terms, there is no difference between privatising sewage treatment in a village in Chad and the possibility of establishing a company to develop the economic potential of the moon. Neoclassical purists argue that both are better than government action to build water-reuse facilities and colonise the planets.
Where tangible era economics seriously goes off the rails is with the air. How should we address worries about forecasts that the production of carbon dioxide is inexorably leading to global warming?
There have been two tangible-era responses.
One is to make a market in bads, the tangible observe of goods. Carbon emissions are bads, so what you need to do is provide an incentive for people to buy them. In other words, the right response, if global warming is occurring, is to create a market-clearing price for carbon. The only crazy thing about this idea is that anyone seriously thinks it can ever work
The default position for tangible-era economists when considering global warming due to human action is to deny it’s happening. This has the merit of, at least, providing a course of action that conforms with tangible-era economics, which is to do nothing at all. It is in line with a long tradition in tangible-era thinking. If something occurs that appears be beyond the capacity of the market-clearing price to change, its existence is denied or treated as a special case.
Communism and Naziism, movements that dominated every aspect of the 20th century, are consequently deemed to be beyond rational comprehension or to have been utterly unconnected to market price-clearing behaviour. The idea that Hitler’s actions may have been, even in part, a consequence of the market clearing price is simply ruled out from the start. As the preface argued, Hitler’s Germany was only possible because of the existence of the idea of the market-clearing price which his regime managed to create a genocidal war economy.
Service-era economics has no problems with these challenges. The natural environment is a process — like clothes, houses, computers and roads. It is essential — like clothes, houses, computers and roads — for constructive human interaction. The only thing that matters is that it exists in the right quantity, in the right quality, at the right time, in the right place and at the lowest possible price. If the market-clearing price makes this happen, that’s great. But if it doesn’t, then other methods should be used.
Any debate about the balance of private and public action is essentially pointless. It’s the outcome, value-creation, that matters, not the process. If tangible-era instruments work, use them. But if they don’t, find better ones.
The distribution of wealth and income in the service era
The justification for the existence of public services in most countries is that, inefficient as they may be in achieving declared objectives, they constitute a vital if imperfect way of distributing income and wealth to the poor and help reduce the dangerous tensions that can emerge as the result of large and growing differences in living standards.
The arguments presented in this book shed fresh light on the issue. Human well-being can only be increased through increased value-creating interaction which will encourage the development and adoption of technologies that reduce process costs that in turn liberate people to concentrate more of their energies on value-creation itself. So the starting point for those seeking to alleviate human misery is an examination of the ways that tangible era institutional arrangements are discouraging the very activity that is essential for increased happiness and the production of more of the tangibles necessary to facilitate constructive human interaction.
But this demands proper recognition of the existence and the operation of the communities in which individuals are creating value. As has been argued, this requires intuitive skills more than technical ones and for government employees seeking to increase value-creation to participate as stakeholders in the activities of these communities. Policy initiatives will be more relevant and effective when they flow from the needs of these communities, which rarely correspond with the market and societal categories governments invariably target.
Policies should be divided between those that help facilitate the constructive interactions that create value-creating communities and those designed to promote the development of the processes that support them. As examples cited in this chapter suggest, government measures that do not differentiate between relationships and processes produce sub-optimal results. And action to remove obstacles to spontaneous human interaction may involve the government doing less rather than more.
The final question is whether income distribution should be a public policy issue in the post-tangible era. As this analysis suggests, value is an intangible that exists in the minds of the parties involved in a value-creating interaction. So long as value is created and shared satisfactorily, the essential element of an economic system is operating satisfactorily and the resulting distribution of value and, consequently, of income can be deemed to be fair.
But the absence of the processes required for this to happen — or for it to occur at all — cannot be viewed with indifference because it leads to value-creation to fall below its potential. If this is the result of a poverty of tangibles, there is a strong case for action to alleviate it through government investment in power, water, water reuse, public transport, education and health facilities and housing. Service era economics, therefore, can justify anti-poverty measures in tangibles to an extent that tangible-era economics never can. It provides compelling arguments in favour of such action because this can increase greater value-creation and, consequently, real economic growth16.
Whether reducing the gap between rich and poor, or seeking to constrain the extent to the rich become relatively richer, should be a matter of public policy is more debatable. Service era economics suggests that income differentials are less important than facilitating the increase in human happiness which occurs as the result of spontaneous interactive relationships within intuitively-defined, value-creating communities. So long as the processes necessary for value-creation exist, government action to change the distribution of value, other than to remove the obstacles to its production, won’t work and could be counterproductive.
There is, consequently, no compelling case for government redistributive measures at the level of the relationship as there is at the level of the process.
Some might find this passive and even inhumane, but it is not. The point is that those wishing to help the poor and reduce inequality should discharge the obligations they feel by direct, immediate and unmediated action. Increase your gift-giving to the poor and the relatively poor. But, more important, seek to encourage constructive human interaction within the communities where you are active or seek out individuals and communities that are dedicated to the challenge of reducing poverty and inequality by unmediated value-creation interaction.
Those who conclude this philosophy is identical to laissez-faire attitudes to poverty and inequality are mistaken. The capacity of tangible era economics to reach conclusions about these issues depends upon scientifically measuring the quantity and distribution of tangibles. In principle, people with more things should be happier and more productive than people with fewer things, but there is no way to prove that they definitely will be. People with fewer things could be less happy, but it’s possible that they may not be.
Critically, in the tangible era, an unequal distribution of tangibles, however ethically lamentable it might be, provides the incentives for people to acquire the skills and make the effort necessary to master tangible production and consumption. Inequality in the tangible era is neither good nor bad. It’s necessary. Attempts to eliminate it, or even reduce it, will be ultimately counterproductive. The best that tangible-era economists say is that rich people who feel bad about being rich should address their psychological needs by being generous through gift-giving to the poor. There may be a case for this to be enforced by the state, but attempts to achieve equality or a centrally-ordained distribution of income and wealth will damage and even destroy the wealth-creating engine of the tangible era.
Service era economics, in contrast, validates government action to increase the production — and change the distribution — of tangibles used in value-creating interactive relationships and communities to reduce poverty and, consequently, alter income distribution. But this does not reduce the obligation that people may feel to help those less fortunate than themselves.
The challenge for the wealthy is particularly resonant. As this book argues, encouraging the concentration of tangibles in the hands of a few, though arguably ethically wrong, was both the inevitable outcome and the requisite condition for the efficient working of the economy in the tangible era. Unless it happened, at least to some extent, the improving exigencies of the market-clearing price would not work their magic and deliver increased production, consumption, saving and investment. Extreme wealth and income inequalities that occurred may not have been morally acceptable, but they were at least defensible, particularly if the wealthy were also generous.
In the intangible era, great concentrations of tangible wealth and extreme inequalities in the distribution of tangibles may still occur, but they serve practically no economic purpose. They may indeed actually reduce value-creation if tangibles that might have been deployed to facilitate constructive human interaction principally serve the purpose of advertising the wealth and status of their owners. Service economics suggests that tangibles are legitimate subjects of government value-creation promotion policies. But it might be better for their owners to recognise that processes only create value when they are shared and produce nothing when they are monopolised. This does not require an ideological revolution.
All that is needed is a proper understanding of how service economies work.
The challenge of the banking industry
This chapter will conclude with a discussion of the implications of service era economics for the government’s relationship the banking and finance industry. This requires some explanation of the role of money. The theory of money is one of the most sophisticated and complex elements of economics.
The IEA report of May 2009 held governments largely responsible for the 2007/08 credit crisis and criticised their response. It argued that financial institutions were essentially reactive, though not entirely unblameworthy. The analysis in The End of the Market shows, however, that the challenge for both government and business presented by the rise of service industries is the detachment of the relationship from process in service interaction. This chapter has argued that governments need to revise policies to take into account the behaviour of value-seeking individuals within intuitively-defined communities. But so do businesses. So do banks.
Basic economic theory says that money serves three purposes17: it’s a unit of account to enable people buying and selling things to talk in a common language. It’s a medium of exchange; people exchange a good for money and money for a good. Thirdly, it’s a store of value. Using service economic era thinking, these functions can be divided into two: those that are a process and those that are in effect a relationship. The unit of account and the medium of exchange, are, essentially, processes, mechanisms that make a money economy work. The store of value function, however, is essentially a relationship. In this capacity, money defines the claim over resources by the holder of the money.
Banks, more than any other types of firm, are essentially involved in making money out of money. Consequently, they are involved in processes as well as relationships. As the previous chapters have argued, this constitutes a conflict of interest that will reduce economic efficiency. And, despite the fact that banks are deeply involved in service relationships, they are structured like tangible-era businesses. They have centralised bureaucracies, powerful senior managers at the top of pyramid-shaped decision-making structures and processes designed to capture huge amounts of information about the saving and borrowing of its customers, who are defined as members of large market segments: low-income, middle-income, high-income, high net-worth and so on. The deficiencies of banks are identical to the deficiencies of government bureaucracies. The impossibility of economic calculation that Von Mises argued will always defeat government planners will also frustrate banks using tangible-era methods of operation in the service era. Less regulation or better regulation will not help financial institutions seeking to participate in the intuitively-defined communities where value-creating relations occur in services.
Similarly, government money and banking policy has been made incoherent by the challenge of managing money as a store of value, or a relationship, and money as a process. Initial analysis of the 2007/08 credit crunch suggests the crisis was caused by a shortage of money as a medium of exchange precipitated by a loss of confidence in money’s capacity to store value. Owners of money, either in the form of tradable shares or as bank deposits, converted it rapidly into cash, precipitating a collapse in equity values and the short-term resources commanded by the banking system. What threatened the wider economy was the absolute shortage of liquidity within bank payment systems. To counter this, governments across the world injected huge amounts of new money into the system to serve as a medium of exchange and keep trade going.
The processes of the financial services industry — liquidity and the system of financial regulation — facilitate value-creation. In finance, as in all other areas of the service economy, value-creation is maximised when individuals are liberated to interact constructively through unmediated relationships. By increasing the amount of liquidity and depressing real interest rates, governments have distorted the cost of the processes required by individuals and the communities to create value. The result is that financial service relationships developed in the past will continue into the future, where they would have not otherwise have done. It is possible that these relationships were constructive. But it is equally possible that they were not. In short, well-intentioned government actions designed to increase production led to the emergence of unhealthy relationships, or at least increased the risk that they would emerge18.
But the banks have compounded the problem by introducing their own distortions into value-creation in the financial services sector. Derivatives devised to facilitate the market mediation of housing debt are doomed attempts to turn value-creating, unmediated interactive relationships into processes, tangibles that could be iteratively bought and sold. As has been argued, market mediation of financial service industry relationship interactions leads to the destruction of the value that the market mediation is designed to capture.
By seeking to master the process as well as the relationship — business competences which are beyond a single organisation to deploy simultaneously — banks treated relationships like processes and presented processes as relationships. Often, they presented themselves as providing independent advice to their customers with the goal of securing deposits and loan transactions. Their massive capacity to store and transfer digitalised financial information was dressed-up as part of the value-creating activities of their customers rather a facilitating process. The process competences of banks, their ability to store digital data, outstripped their relationship capabilities. The need to deploy processes efficiently in the pursuit of profit overtook their capacity to develop and sustain productive relationships. The resulting shambles was at least partly the product of the banks’ own systems. Government regulation compounded a trend that had its own dynamic. Both business and government are, in fact, victims of tangible-era thought.
Seen from the perspective of this book, the IEA recommendations are only partly right. The fundamental challenge is to separate process from relationship in the financial services sector. This will allow financial service firms to concentrate on one of the two requisite competences.
One is the capacity to liberate employees to form unmediated interactive relationships with customers that lead to value-creation. This will demand organisations that are hierarchically flat and focus resources into the relationship between its customers and its employees. Financial relationship firms require little or no long-term capital. But they will have to have employees with outstanding competences in human interaction who understand that payments expressed as the exchange of gifts are the essential foundation of productive service relationships.
Alternatively, banks should focus on the process, or the capability to master the technology to store, process and transfer vast amounts of digitalised information with total security. Process activities tend to be capital-intensive and require hierarchical management and tight internal disciplines. The goal of financial process firms is to reduce cost, since that will add most to the value-creation in interactive relationships that is consequently translatable into higher profitability.
The role of government requires redefinition to reflect the facts of economic production in a service economy. Regulation of financial relationships should focus on training and standards rather than directives based on the assumption that financial relationship firms will always tend to be dishonest and their customers irrational or lazy. A successful relationship business active in other sectors should be allowed to develop financial relationship competences. There is, for instance, no in principle reason why retailers, hospitality specialists and even healthcare and education service providers should not enter the financial service relationship sector.
A stronger government role makes more sense in the financial process. Since the IT industry has substantial economies of scale, or a tendency for long-run average costs to fall, one financial service process firm will be more efficient than several. Having a single financial service process provider would also facilitate the adoption of a single set of standards and connections to financial relationship service providers wherever they may be. A single financial process system would also be far easier to monitor than many competing systems. There is, therefore, an argument for the financial process, which comprises the digitalised financial information as well as the IT software and hardware, to be state-owned, or, at least, run on a low-profit basis. Events since the summer of 2007 suggest that is in fact the direction in which the banking industry of the UK at least may now be heading.
The idea that the financial processes, the tangible element of the financial services sector, should be state-owned will be greeted by shocked disbelief by Keynesian as well as free market economists.
But the argument in favour of owning financial processes has already been made by proponents of maximum market deregulation in other contexts.
According to the free market ideal, the only role for state is in defence and to provide a fair legal system. From the perspective End of the Market, defence and the courts are not exceptional. They are processes which facilitate value creation by reassuring value-seeking individuals active within the intuitively-defined communities that make up a national economic community that they are safe from foreign aggression and secure from internal disruption.
If this argument is sound, it is logical for it to be extended to the financial service process system, because it is so vital to the interactive relationships that lead to value creation.
Nothing is more important to the long-term survival of a society than its ability to protect its savings, now mainly digitally stored in financial process networks.
And of all the conclusions that can be reached about the consequences of the 2007/08 credit crisis, the most compelling is that the status quo has actually undermined the capacity on a global basis for this goal to be secured.
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Notes for Chapter 7
1 The Economic Consequences of the Peace, by John Maynard Keynes, 1919.
2 Niccolò di Bernardo dei Machiavelli (May 3, 1469 – June 21, 1527) was an Italian philosopher, writer, and politician and is considered one of the founders of modern political science.
3 Thomas Hobbes (5 April 1588 – 4 December 1679) was an English philosopher, remembered today for his work on political philosophy. His 1651 book Leviathan established the foundation for most of Western political philosophy from the perspective of social contract theory.
4 John D Rockefeller with four partners founded the Standard Oil Company (SO) on 10 January 1870. In 1906, the US government charged the company with restraining trade under the Sherman Antitrust Act. The federal court found against the firm in 1909 and ordered it to be dissolved. Two years later, SO announced plans to split itself up. The biggest of the new businesses to emerge was Standard Oil of New Jersey, originally called Esso (after the initials of the mother company SO). It was later renamed Exxon. The company accounted for half of the value of the original corporation. Standard Oil of New York, later Mobil, was the second largest part. Standard Oil of California (Socal), later known as Chevron, was separately incorporated, as was Standard Oil of Ohio (Sohio), bought by BP in the 1970s; Standard Oil of Indiana (Amoco), bought by BP in the 1990s; Continental Oil (Conoco) and Atlantic, which later became part of Atlantic Richfield and was then absorbed by Sun Oil.
5 The alternative view was that President Theodore Roosevelt was an agent of the JP Morgan Group which wanted to break Rockefeller’s grip on the US energy market.
6 What Washington Means by Policy Reform, in Latin American Readjustment: How Much has Happened, edited by John Williamson, published by the Washington: Institute for International Economics, 1989.
7 Among the occasional moments of humour in economics was witnessed by the author is the occasion in 1994 when World Bank economist John Nellis enthusiastically recommended the key elements of the Washington Consensus at a conference in Cairo. He turned to Argentina, then the model for rapid privatization, and declared that its government had even privatised the zoo. Atef Obeid, then Egypt’s privatization minister and later prime minister, interrupted to point out that he had heard about the zoo in Buenos Aires. “Yes, it has been privatised,” he said. “But now there are no animals in it.” Nellis may have won the argument, but Obeid got more laughs.
8 Verdict on the Crash, Institute of Economic Affairs, London, May 2009. A letter from the authors published in the Daily Telegraph on 12 May 2009 summarised the reports main points as follows: “The prevailing view amongst the commentariat (reflected in the recent deliberations of the G20) that the financial crash of 2008 was caused by market failure is both wrong and dangerous. Government failure had a leading role in creating the conditions that led to the crash.
*Central banks created a monetary bubble that fed an asset price boom and distorted the pricing of risk.
* US government policy encouraged high-risk lending through support for Fannie Mae and Freddie Mac (which had explicit government targets of providing over 50pc of mortgage finance to poor households) and through the Community Reinvestment Act and related regulations.
* Regulators and central bankers failed to use their considerable powers to stop risks building up in the financial system and an extension of regulation will not make a future crash less likely.
* Much existing banking regulation exacerbated the crisis and reduced the effectiveness of market monitoring of banks. The FSA, in the UK, has failed in its statutory duty to “maintain market confidence”.
* The tax and regulatory systems encourage complex and opaque methods of increasing gearing in the financial system.
* Financial institutions that have made mistakes have lost the majority of their value. On the other hand, regulators are being rewarded for failure by an extension of their size and powers.
* Evidence suggests that serious systemic problems have not arisen amongst unregulated institutions. As such, no significant changes are needed to the regulatory environment surrounding hedge funds, short-selling, offshore banks, private equity or tax havens. A revolution in financial regulation is needed. The proposals of the G20 governments and the EU are wholly misconceived. Specific and targeted laws and regulations could restore market discipline. These should include making bank depositors prior creditors. This will provide better incentives for prudent behaviour and make a call on deposit insurance funds less likely.
* Provisions to ensure an orderly winding up, recapitalisation or sale of systemic financial institutions in difficulty. Banks must be allowed to fail.
* Enhancing market disclosure by ensuring that banks report relevant information to shareholders. This should be reinforced with central bank action to ensure that proper use is made of lender-of-last-resort facilities to deal with illiquid banks and the growth of broad money is monitored together with the build-up of wider inflationary risks.”
8 The Impossibility of Economic Calculation under Socialism, Ludwig Von Mises, 1920.
10 There are various forms of private finance initiative including build and own; build and operate; build, own and operate (BOO); build, own, operate and transfer (BOOT). Due to the failure of many public-private partnership projects, they have been renamed private sector participation (PSP) projects. The substance, however, remains essentially the same.
11 In Economics by Lipsey & Chrystal (2007), seven circumstances in which markets will fail even within the terms of conventional economic analysis: producers with excess capacity setting positive prices (a situation known as inefficient exclusion); common property resources (resources that can be used by everyone but belong to no one like common land and fisheries); public goods, like broadcast signals and public information; externalities (discussed below); asymmetric information, where one party to a transaction has more knowledge of its consequences than the other; missing markets and substantial monopoly power.
12 Paul Samuelson is credited as being the first economist to develop the theory of public goods in The Pure Theory of Public Expenditure which was published in 1954. The literature on the topic is now enormous. There is a continuing debate about the definition of a public good, but examples are generally accepted to include defence, law enforcement, lighthouses and clean air.
13 The theory of economic indivisibility is also enormous. It usually encompasses the challenge of pricing a marginal unit when it involves a large increase investment. For example, what is the right price to charge a customer who buys a rail ticket which requires the use of a new train?
14 The first complete statement of the economics of externalities, including proposals for public policy actions to deal with them, is generally regarded as having been made by Ronald Coase in The Problem of Social Cost, an essay published in the Journal of Law Economics in 1960. His main conclusion is was that law and regulation was not as effective as had been previously supposed and that market-price clearing solutions were probably superior.
15 The challenge to the concept of the market-clearing price presented by this issue is known as the free-rider problem.
16 The way that economists measure economies and their rate of growth is not dealt with in this book. Needless to say, however, it is hopeless at quantifying intangibles and, consequently, of diminishing utility in economies where intangibles are dominant.
17 Pages 444-445 of Economics by Lipsey & Chrystal (ibid) provides a complete explanation of money’s functions.
18 The most plangent attack on the way banking is management has been mounted by Austrian economists who argue that rules that allow banks to lend multiples of the amounts they have in their keeping promote the manufacture of liquidity which feeds asset price bubbles. They argue that “fractional reserve” banking should be banned and the role of central banks as lenders of last resort to the banking system, a guarantee that ensures the banks won’t be allowed to go bust, should be abolished. From the perspective of this book, the Austrian critique has merit but doesn’t go far enough. The quasi-monopoly that banks have over the electronic payments system, and in effect over the entire monetary system, should be ended. Their role in the financial system would consequently be restricted to providing financial advice.