Chapter 5. Political Economy
Chapter Overview
This chapter examines the proper sphere or range of state activity in the economy. It asks what
balance between states and markets most enhances individuals’ capabilities and contributes to the
good society. The chapter is divided into eight sections. The first section introduces the chapter
and distinguishes between state and market systems. The second section examines the
relationships between states and markets. The third and fourth sections discuss the advantages
and disadvantages of market systems. The fifth section describes the shifting balance between
states and markets. The sixth section analyzes the process of globalization and controversies
surrounding the Washington Consensus. The seventh section discusses the main ways that states
try to manage market systems. The final section evaluates whether market-oriented or state-
directed forms of political economy contribute most to people’s capabilities.
The first section of the chapter begins by distinguishing between markets and market systems
and explains the role played by states to determine the extensive and intensive growth of a
market system.
The second section of the chapter details how states make market systems possible by making
the ground rules that permit market systems to work. The quality of these rules determines which
countries have the most productive economies.
The third and fourth parts of the chapter evaluate the advantages and disadvantages of market
systems. The advantages include extraordinary economic dynamism, high levels of productivity,
and evidence that market systems seem to enhance the prospects of democracy and political
rights. The disadvantages include susceptibility to periods of boom and bust, high levels of
economic inequality among individuals, and harmful spillover effects.
The chapter then turns to the shifting balance between states and markets. It explores why high
levels of state intervention were widely accepted after World War II but fell into disfavor in the
1970s as many developed countries encountered slow economic growth, inflation, and high
levels of inflation. Supporters of markets made the case that too much state intervention in the
economy created the problems, and a greater role for the market could cure them. The
enthusiasm for an expanded role for the market began to ebb with the onset of the great recession
in late 2007.
The next topic is globalization and the controversies it has caused. This section explains that
globalization was not simply the consequence of impersonal forces, but was promoted by
individuals and institutions that benefited from its expansion. These individuals and institutions
supported policies known as the Washington Consensus. The section evaluates the case for and
against the Washington Consensus, which is called “neo-liberalism” by critics.
The following section turns to explore the different tools states use to influence the allocation of
resources in the economy and how well they use them. It discusses fiscal and monetary policy,
regulation, and nationalization.
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The final section evaluates whether countries in which market systems prevail do a better job of
enhancing people’s capability than countries with heavy state intervention. It finds that, in
general, organizing economies more along market lines does improve people’s capabilities, but
not consistently so.
Learning Objectives
Upon completion of this chapter students will be able to do the following:
5.1 Distinguish between state and market systems for producing and allocating goods and
services.
5.2 Explain how economies that rely on markets require states to work and are alternatives to
them.
5.3 Identify the advantages of market systems.
5.4 Identify the shortcomings of market systems.
5.5 Summarize the historical swings in the balance between states and markets.
5.6 Define globalization and evaluate whether it contributes to or thwarts the Good Society.
5.7 Describe the different ways states intervene in the economy.
5.8 Evaluate the performance of state and market systems according to the standards of the Good
Society.
Chapter Outline
I. INTRODUCTION
A. Considering the proper amount of state intervention
2. Post-Soviet Russia an example of too little state intervention
B. Focus of chapter is the proper sphere or range of state activity in the economy
2. Coordination through the market
D. Struggle between those who advocate a minimalist role for the state and those
who believe that there is a greater need for government is the defining political
question of our age
1. The term market system refers to an economy in which production for profit is
intended for and coordinated through private exchanges between buyers and
3. Today almost all countries use market systems to organize and coordinate
production
F. Market systems have become more extensive and intensive
1. Extensive growth of markets is growth of global trade, foreign investment,
and international financial transactions
2. Intensive growth of markets in having people rely more on markets to meet
needs that people once satisfied in other ways
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G. States determine how extensive and intensive markets are?
4. Review whether market-oriented or state-directed forms of political economy
contribute most to people’s capability
II. STATES AND MARKETS
A. Like the state, market systems have disciplinary power
1. Not accurate to say states are about rules and compulsion while markets are
about choice and individual expression
2. Markets control and coordinate people’s behavior through the mutual
interaction of buyers and sellers
B. Market systems need states to succeed
1. States create a common currency, facilitate trade and exchange, and enforce
contracts
2. States supply public goods such as transportation networks and police
protection that markets cannot furnish themselves
3. States make capital viable and promote economic growth and structure
markets so that investments pay off
4. Example: the development of the Internet explains how markets require states
5. States make market systems possible by making the ground rules that permit
market systems to work
C. Quality of rules helps explain why some states have better economic performance
than others
1. High quality of political institutions and rules helped make Venice center of
international economy in mid-seventeenth century
2. London emerged as center of world capitalism rather than Paris in eighteenth
century because Britain had better rules and institutions than France
3. In Why Nations Fail, Acemoglu and Robinson argue that getting institutions
right is why some nations prosper and others fail
a. Some nations create inclusive institutions—such as property right, the rule
of law, public services, political pluralism and political capacity—that
encourage productivity
b. Other nations create extractive institutions that discourage work, savings,
investment and innovation
D. Political economy is the balance between political and market forces within a
country
1. A country’s political economy is critical in determining whether society will
meet the minimal conditions of the good society
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2. Too much state control or too much market control fails to produce results that
would meet standards of the good society
III. THE ADVANTAGES OF MARKET SYSTEMS
A. Nixon and Khrushchev’s “kitchen debate”
B. Soviet model of planned economy no match for American capitalism
1. Market systems were nimble and innovative
2. Planned economies immobile, fell behind
C. Advantages of market systems
1. Extraordinarily dynamic
a. Promote the development of new products and more efficient production
methods and technologies
b. Competitive pressures encourage firms to innovate constantly
c. Creative destruction replaces old products, technologies, and production
methods with new ones
2. Enormously productive
a. Application of science, advances in communication and transportation,
and more efficient ways to deploy and motivate labor all contribute to
higher levels of labor productivity
b. Result is rising per capita incomes, higher standards of living, and larger
gross national products
3. Enhance the prospects of democracy and political rights
a. Market economies block threat of an all-powerful state by removing
economy from state control
b. Market systems separate economic power from political power
c. Market systems are not a guarantee of democracy and individual freedom
as Nazi Germany and the introduction of markets to communist China
demonstrate
IV. THE DARK SIDE OF MARKETS
A. Markets are highly volatile
1. Example of housing bubble in the United States and the Great Depression
2. Periods of booms and busts
3. Swings can be socially destructive with loss of jobs and incomes
B. Markets generate extraordinary inequality
1. Global expansion of markets and technological change tend to depress the
bargaining power and earnings of those without valued skills
2. Global expansion of markets tends to increase the bargaining power and
earnings of those with valued skills
C. Market systems create harmful spillover effects or externalities
1. Some of the costs of the consequences of producing or using products are not
included in the cost of the product
2. Firms acting in a self-interested manner have incentives to avoid paying for
cleaning up the pollution they create because it would hurt their profits to do
so
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3. Firms that produce products that cause pollution do not include the cost in
the price of the product, the cost of firm’s production are borne by society
4. Example of global warming, estimated cost to society is $7 trillion
V. THE SHIFTING BALANCE BETWEEN STATES AND MARKETS
A. States do more than just enforcing the rules that allow market systems to operate
B. Degree to which states should intervene in the marketplace and impose their
priorities on it is a source of tremendous conflict within most societies
1. How much should the welfare state intervene to alter market outcomes?
2. How much should sate intervene to offset spillover effects?
3. How much should state intervene to reduce market volatility?
C. Following World War II, substantial state intervention was accepted practice
1. Europe and United States
a. Intervened to correct perceived deficiencies of markets during 1930s
Great Depression
b. Intervened after World War II to create welfare systems that protected
people from the ravages of unemployment, sickness, and old age
c. Managed their budgets and money supply to tame market volatility
d. Some countries nationalized industries to ensure the production of
essential goods and services
e. Growth of the welfare state, public enterprise, and state efforts to guide
4. Policies to manage the economy shifted to reflect the new consensus
a. States sought to balance their budgets, lower their tax rates, reduce
regulations, privatize state-owned firms, and curb the power of unions
b. State spending continued to grow but focus shifted toward making markets
work better
c. Welfare state was reformed to promote employment and work
d. Regulations shifted to encourage competition
E. Global recession of 2007 cast doubt on market model once again
1. States rescued failing banks and pumped money into their economies to
prevent them from collapsing
2. Faith in the recuperative power of the market gave way to a new belief in the
restorative power of states
VI. GLOBALIZATION
A. Globalization evident in the growth in transcontinental flights between 1960 and
2000
1. Similar pattern of globalization evident in areas of trade, investment, labor,
technology and ideas
B. Globalization refers to the increasing flow of money, people, skills, ideas, and
goods across borders
C. Until recent recession, trade between countries grew
1. Increased trade was due in part to lowering of trade barriers that opened
markets to foreign competition and increased foreign direct investment
2. Increased trade led to more firms manufacturing and selling goods outside of
their home markets
D. Global supply chain
1. Different steps in the manufacturing process take place indifferent countries
2. Barbie dolls are manufactured partly in the United States and partly in
Taiwan, Japan, China and Hong Kong
3. iPod manufacturing process goes through Taiwan, Japan, and Korea
E. Economic exchange leads to more cultural traffic
F. Promoting globalization
1. Globalization is not simply the result of impersonal forces
2. Globalization has been actively promoted by multinational corporations,
United States government, and international agencies including the World
Bank and the International Monetary Fund
a. World Bank provides loans and grants to countries for development
projects
b. International Monetary Fund loans money to countries so they can pay
their bills
3. Washington Consensus
a. Balance government budgets by cutting spending
b. Open markets to foreign trade and investment
c. Sell off nationalized industries to private investors
G. Criticism of the Washington Consensus
1. Critics call Washington Consensus policies neo-liberalism
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2. Balancing government budgets hurt the poor by requiring cuts in social
services in order to achieve balanced budgets
3. Opening markets to foreign trade and investment increased unemployment
and caused native businesses to fail
4. Weakened democracy by requiring countries to conform to IMF and World
Bank conditions in order to obtain assistance
5. In summary, critics say “neoliberalism” rationalized policies that justified
exploitation of less-developed countries by multinational corporations and
their political allies
H. Defense of the Washington Consensus
1. Balanced budgets were necessary to stabilize a country’s currency from wild
fluctuations in value
2. Removing trade and investment controls was needed to attract foreign capital
and create competition for inefficient and poorly managed local companies
3. Privatizing state businesses was vital to increase their competitiveness and
efficiency
4. Lack of growth in developing countries is due to political failure and
corruption, not market failure
I. Debate between supporters and critics of Washington Consensus reprises the
argument between those who see only the benefits of markets and those who see
only their dark side
1. Supporters concentrate on the positive benefits
a. Believe the policies encourage a “race to the top”
b. Firms in less-developed countries make larger profits, pay workers more
than they would have earned as farmers, and give them an opportunity to
learn new skills
c. Point to examples like Giant Bicycles that began making bicycles for
Schwinn and became an independent producer with its own brand
2. Detractors concentrate on negative consequences
a. Believe the polices encourage a “race to the bottom”
b. Each country must compete to have the lowest wages, lowest taxes, and
fewest regulations in order to attract foreign investors who now have the
whole world to choose from
c. Leads to repression of labor unions
d. Multinationals move operations to countries with even lower wages
J. Record of Washington Consensus is uneven
1. Chile is a success story, but most Latin American countries that embraced
Washington Consensus were not success stories
2. Several Asian countries that did not follow the Washington Consensus,
including South Korea, Taiwan, and Thailand experienced great success
3. Employers are looking for political stability, good infrastructure and a skilled
work force, as well as low wages and regulations
4. Some developing countries have profited enormously from globalization,
while others have been victimized by it
K. Globalization has varied outcomes because of differing institutions and governing
coalitions
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1. Open economies will not lead to prosperity unless there are supportive
institutions and governing coalitions
2. Example of Haiti, where open markets did no good because country was
corrupt and misgoverned
3. The key is whether states have the foundations in place for markets to work
well, such as strong infrastructure, an educated workforce, and the rule of law
VII. FORMS OF STATE INTERVENTION
A. Fiscal policy
1. Fiscal policy includes policies on government taxation and spending
a. States can stimulate the economy and reduce unemployment by spending
more money than they take in, running budget deficits
b. States can dampen inflation by taking in more money than they spend,
withdrawing money from circulation, discouraging investment
2. States differ considerably in the proportion of their economy devoted to taxes
and state expenditures
a. Americans enjoy a lighter tax burden than citizens in other rich
democracies
b. Taxes are a lower proportion of GDP in the U.S. than in any other rich
democracy; only Korea recorded lower state spending as a percentage of
its economy
c. At the opposite end of the spectrum is Denmark, where state revenues and
spending amount to more than half of GDP
B. Monetary policy
1. Monetary policy is the manipulation of interest rates to influence economic
conditions
2. High interest rates tend to discourage borrowing and spending and are used to
counteract tendencies toward inflation
3. Low interest rates encourage borrowing and spending by making loans cheap
and are employed to fight recessions
4. Interest rates are largely determined by central banks that issue currency and
manage its value in foreign exchange
5. Differing degrees of insulation of central banks from political influence
C. Regulations
1. States can also influence economic actors by issuing regulations that set
explicit rules of behavior that firms must follow
a. One example of regulatory policy is setting minimum wages to prevent
firms from profiting by paying substandard wages
b. Another example is mandating environmental quality standards to prevent
firms from polluting the air and water
c. A final example is mandating product standards to prevent firms from
selling goods that are unsafe or unreliable
2. Some states are more committed to regulation than others
a. One way to measure states’ commitment to regulation is the number of
procedures and days it takes to start a new business
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b. Another is labor relations and whether regulations make it difficult to fire
workers, or give workers a role in management of a company
c. By the standard of labor relations, the U.S. economy is one of the least
regulated in the world
D. Nationalization
1. States try to influence economic activity by nationalizing industries in which
states own and control public enterprises
2. Examples include state-owned-and-controlled oil industry in Mexico,
Venezuela, and Saudi Arabia, where oil is a major export
3. States differ in the degree to which they nationalize industry
a. In socialist countries, such as Cuba and North Korea, the state owns and
controls all of the means of production
b. At the opposite end of the spectrum are countries like the United States
and Chile, where the few public enterprises that exist contribute a very
small percentage to the GDP
c. Some countries, such as Great Britain, once had substantially nationalized
sector but sold off their holdings to private investors
E. Other kinds of state intervention
1. Promoting mergers and acquisitions of firms to make them larger and more
competitive in world markets as Japan did after World War II
2. Brokering agreements among union and employer organizations as Germany
has done
F. Summary
1. Each country works out, through political struggle, its own balance between
states and markets
2. Mix of policy tools that states adopt is different from country to country
3. States that rely more on markets
a. Less redirection of the country’s income through taxes and expenditures
b. Do not exert much influence upon central banks that set interest rates
c. State regulations are not as numerous or intrusive upon managers
d. Public enterprises contribute little to the GDP
4. States that play a powerful role in determining who gets what
a. Redirect a larger proportion of the country’s income through budgets
b. Exert enormous influence over central bank policies
c. Have pervasive state regulations directing firms to do certain things
d. Public enterprises control the economy’s strategic industries
5. The Fraser Institute’s Economic Freedom Index evaluates countries according
to their degree of market control
VIII. STATES, MARKETS, AND THE GOOD SOCIETY
A. Do countries in which market systems prevail do a better job of enhancing
people’s capability than countries with heavy state intervention?
B. Physical well-being
1. Physical well-being defined by infant mortality rates
2. Differences in use of markets defined by Fraser Institute rankings
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3. Market systems are better able to meet the physical needs of citizens than
more state-directed economies
4. As economic freedom declines, infant mortality rates increase
C. Informed decision-making
1. Informed decision-making defined by adult literacy rates
2. Market systems are associated with higher levels of adult literacy rates
D. Safety
1. Safety defined by risk of civil war and homicides per 100,000 population
2. Type of political economy a country has is virtually irrelevant in determining
its risk of war
3. The average homicide rate is lowest for free market economies
4. For market-oriented, mixed, and status economies, market system seems to
have little effect on the average homicide rate
E. Democracy
1. Democracy is defined by the Economist Democracy Index
2. Strong positive correlation between the level of economic freedom and the
level of democracy
3. Some very strong anomalies related to wide range in scores among free
market countries
4. Some countries, such as Bahrain and Oman, have very high levels of
economic freedom but very low democracy ratings
5. The best we can say with some certainty is that market-oriented economic
systems may not guarantee liberal democracy, but there are no liberal
democracies that are not capitalist
F. Conclusion
1. Organizing economies more along market lines does improve people’s
capabilities, but not consistently so
2. Democracy may require markets, but markets do not require democracy
3. There is a correlation between market-based systems and high literacy rates
4. There is no correlation between market-based systems and civil wars, but
market-based systems are correlated with lower homicide rates
5. Except for the performance of countries in the free market group, capitalism
did not have much impact on homicide rates
IX. CONCLUSION
A. Market systems require states to ensure that property is safe, contracts are
enforced, and vital goods that the market cannot supply are available
B. Following World War II, countries embraced state intervention
C. There was a shift away from state intervention toward markets starting in the
1970s
D. The global recession that struck in the last quarter of 2007 revived faith in states
as a necessary and important defense against the volatility of market systems
E. States vary in their willingness to use fiscal policy, monetary policy, regulation,
and nationalization to interfere with market system
F. Freer markets are generally associated with higher capabilities but with
qualifications
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