NEW PERSPECTIVES ON THE ROLE OF THE STATE

Joseph Stiglitz, Senior Vice President and Chief Economist

The World Bank

It is an honor for me to contribute to this Festschrift in honor of Mark

Perlman. Both through his writings and service to the economics profession as the long

time editor of the Journal of Economic Literature, Mark has had a lasting impact. He

sought to break out of the mold of the standard neoclassical paradigm that had come to

dominate the economics profession during the second half of this century, and equally

importantly, he encouraged others to do the same. His broad historical background not

only made clear the limitations of that approach, but also gave him a broader perspective

to look at these current fashions--he knew that they too would someday pass.

This paper is also dedicated to the memory of Professor Recktenwald. An earlier

and shorter version of this paper was presented at the occasion of my receiving the

second biennial Rechtenwald Prize, at Nuremberg, on February 4, 1998.1 The topic of

this paper reflects Professor Rechtenwalds lifelong interests in the subject of public

economics, as well as Professor Perlmans lifelong skepticism of the neoclassical paradigm

and his emphasis on the role of collective action. It puts forward a view of the role of the

state which explicitly takes into account the deficiencies of the market, yet recognizes the

key limitations of the state.

Those of us who have devoted so much of our interest to the study of public

finance and public economics more generally, do so based on three premises:

(1) Collective action is important;

(2) There is scope for improving the efficiency and responsiveness of government;

(3) Rational, scientific analyses combined with careful historical research can shed light on

how this can be most effectively done.

1 On that occasion, Professor Neumann presented an excellent account of my contributions to the

2My experience over the past five years in the White House and at the World

Bank, has reinforced my conviction on each of these counts and my belief that there is

much that the public sector can do both to improve its performance and to improve the

lives of the people whom it is supposed to serve.

I want now to describe how theory, experience, and history have changed our

perspectives on the answer to four key issues:

(1) What government should do;

(2) At what level of government should various activities be conducted;

(3) How government should do what it does;

(4) How government relates to its citizens.

First, on the question of what government should do. The question most often

posed is whether government is too large. But this is not really the central issue. The

key question should be, is the government doing the right thing?

Our thinking about this has developed through several stages in recent decades.

Adam Smith, who is often interpreted to have provided the rationale for why markets are

better than government in addressing economic needs, actually imparted a more nuanced

message. He recognized the importance of collectively provided goods, the role of the

government in providing certain goods such as education. Over the succeeding 150 years,

this perspective became refined into what I call the market failures approach. The

market provides too much of some goods like pollution and too little of other goods

like research. About a decade ago, my research with Bruce Greenwald showed that the

scope for market failure was much greater than had previously been realized. We showed

that in the presence of incomplete markets and imperfect information, the market

equilibrium would not even be constrained Pareto optimal.2

In the meanwhile, a counterattack, attempting to delimit the scope for government,

was launched. It had three arguments: that government is harmful, that it is ineffective,

economics of information, for which I am greatly indebted.2 See Greenwald and Stiglitz, (1986).

3and that it is unnecessary. The extreme versions of these statements may be a peculiarly

American preoccupation, but the general ideas have spread across the globe and are used

in almost every discussion of policy.

The first proposition, that government is necessarily harmful to growth and

development, can be easily to refuted by pointing to East Asias progress over the past

few decades.3 Marked government intervention did not seem to impede the rates of

growth in Korea, Thailand, Singapore or the other high-performing East Asian economies.

In contrast, I would argue that the governments intervention has actually had an

enormous effect in promoting this unprecedented rapid economic growth, growth which

the recent crises, despite their severity, have not erased. This is not the place to discuss

the causes of those crises, but let me simply note that in many ways it was the

consequence of the state doing too little in some areas, i.e. pursuing rapid financial

liberalization without strengthening regulation or supervision.

A glance at the history of the United States development demonstrates that the

idea of selective state activism is not new. The U.S. government provided the initial

information and expertise for several key sectors which have contributed strongly to

United States growth. The federal government basically founded the telecommunications

industry, for example, when it financed the first telegraph line between Baltimore and

Washington in 1842. The state withdrew as soon as it had demonstrated the viability of

the new technology allowing subsequent development to come from the private sector.

The states catalytic role remains quite clear. More recently, the Internet was developed

by the Federal Government for a very small cost in relation to the huge effect it has had

on the way modern businessand increasingly modern lifeis conducted.

3 For a review, see World Bank (1993) or Stiglitz (1996). Among the most ardent advocates of the viewthat governments have had adverse economic impacts has been Milton Friedman. See for instanceFriedman [1996 (1962)]. While he persuasively identifies several important instances in whichgovernments have had negative impacts, a full account must balance these failures with the successes; andwhile there have been isolated cases of strong growth with a very limited role of government (e.g. HongKong--but even there government played a much larger role, e.g. in housing and infrastructure, andfinancial market regulation--than advocates of free market doctrines typically recognize), these are theexception. The major success stories, from the United States, to Japan, to the other Asian tigers, allinvolved governments assuming key roles.

4I could easily give other examples of successful state activism over the past few

centuries. Most people believe, for example, that the enormous increase in productivity

of agriculture in the United States in the 19th century can be traced back to the

establishment of the Land Grant colleges in the Agricultural Extension Services that began

in 1863 by the Morrell Act. More broadly, the role of the Federal Government in

education in the United States actually began in 1785, even before the U. S. Constitution

was ratified.

Although it is unambiguously clear that governments do make mistakes, the

previous examples show that it is far from clear that governments are harmful. On

balance, the impressive list of government achievements -- stimulating economic growth,

attacking inequality, and providing safety nets to provide just a few examples -- shows

that the state can be a beneficial partner in growth and development, and in raising living

standards more broadly.

Anecdotes of success or failure are, perhaps, not as convincing as the argument

put forward by critics of a large governmental role, who contend that governments

necessarily have adverse effects. They look for behaviors that are inherent in the political

process, identifying discrepancies between incentives of politicians and those of the

people they are supposed to serve.4 Such agency problems are important, but of

course they arise in the private sector as much as they do in the public; and they are more

important in those lines of activity where performance in general (and individual output in

particular) is hard to assess.5

The discussion below shows how today governments, like businesses, can work

to mitigate these problems. The more general point is that the presence of such problems

is a factor which determines what government should do or how it should do it; but there

are still key roles which government needs to perform, as discussed further below.

Among these, one of the more widely accepted is that of stabilization. But critics

4 See, e.g. Buchanan (1986).5 See Edlin and Stiglitz (1995)

5of government action (like Milton Friedman) have even argued that in this realm

government has failed. But these criticisms of governments macro-economic

performance is not substantiated by detailed empirical analysis. Stiglitz (1997) shows

that since World War II economic downturns have been shorter while expansions longer

than prior to World War I, and that, while in the earlier period, downturns were

predictable (and thus, presumably, could have been avoided by timely government

actions), since World War II, they have not been. Stiglitz interprets this to suggest that

government has taken actions to offset any anticipatable downturn; it is only

unexpected events--like the oil price shock--that give rise to downturns. By contrast,

in the earlier period, recoveries were random; since World War II, the longer the

downturn, the more likely the recovery in the following period. Again, Stiglitz interprets

this to imply activist government policies limit the duration and severity of recessions.

The evidence from the United States and East Asia also addresses the second

critique of the state: the statement that anything the Government does will be undone by

the private sector.6 This second argument about the states ineffectiveness is used most

often in the debate about monetary policy, but even this narrow argument contains flaws.

The theorems developed by new classical macroeconomics that demonstrate

governments inability to affect the economys expansion and contraction, for example,

rely on very special assumptions that account neither for the asymmetries of information,

the lags in responses, nor for the governments inability to change the relative prices faced

by firms and households. A closer look at the literature shows that, in fact, private sector

reactions generally do not undo the actions of the Government.

The final critique of the state is in some sense the deepest question: Why do we

have a Government in the first place instead of just voluntary organizations, firms,

households, and collectivities?7 I would answer that question by invoking the well-

developed theory of collective goods. Although recognition of the scope for voluntary

6 This idea has been most closely associated with Lucas (1976).7 See, e.g Coase (1960).

6organizations and collective action taken by voluntary organizations has grown over

recent years, few would argue that public goods such as national defense could be

privately provided without a real problem with free riding.8 Most societies have

recognized this and allowed the state, the only organization with universal membership

and certain powers of compulsion, to intervene and alleviate this free riding problem.9

Everyone in a particular area must be a citizen of the relevant state, and this citizenship

includes both obligations and benefits.

The Limitations of the State

Despite its unique powers, however, certain constraints prevent the state from

competing effectively with the private sector. The first set of constraints are prudential

restrictions created by citizens. Most societies have recognized that the same

characteristics that enable the state to promote the collective good can and have been be

used for damaging ends. Legal frameworks of due process, mandatory provisions for

equal treatment, and extensive regulation of the civil service are some of the most common

examples of the ways that these dangers have been addressed. Although prudential, these

constraints also mean that the Government cannot function as effectively as the private

sector. A public sector supervisor, unlike a private manager, cannot simply hire the

person he or she believes to be the best for the job and pay him or her accordingly. On

the one hand, these kinds of regulations make sense as safeguards against corruption and

cronyism in the government. They prevent the taxpayers from having to pay unjustly

high salaries to people whose skills have been mistakenly overvalued. On the other hand,

civil service codes can make it difficult for the government to attract good workers.

The second set of constraints has to do with the nature of the government and its

8 Even in the case of externalities when information about impacts on different individuals is imperfect andcostly to obtain, voluntary solutions may not work well. See, e.g. Farrell (1987). Transaction costs, too,may be far higher for voluntary solutions.9 For a more extensive discussion of these perspectives, see Stiglitz (1989)

7inherent lack of ability to make binding commitments. The Government enforces the

commitments of the private sector, but it cannot make commitments of the same kind. To

be sure, courts can ensure that legislation complies with the Constitution and that the

government fulfills its contracts with private citizens. But ultimately, the only device the

government as a whole can use to enforce its commitments is to create transaction costs,

the cost of revising or reneging on its agreements. These range from very low in the case

of a politicians campaign pledge to very high in the case of constitutional provisions.

Nevertheless, the state can basically break almost any commitment if it is willing to

undertake those transaction costs.

In summary, the state has both powers and limitations which set it apart

distinctly from other forms of organization in our society. There are different ways in

which societies can engage in collective actions, each with their strengths and weaknesses;

and different extents to which collective and private actions can be used to address

societal needs. We should focus our attention on determining what blends of public and

private action are most effective, e.g. in addressing the market failures and distribution

issues that motivate the need to go beyond pure market solutions. And the answer will

depend on the circumstances of each country; while market failures may be more

significant in less developed countries, so too the ability of government to address them

maybe more limited. Thus, there is not even an a priori view about the appropriate

scale of government in the process of development.

Evolution of Thought about the Role of the State

Thought about the appropriate role of the state has evolved through three main

stages over the past 50 years.

We accepted and in fact encouraged a large role for the state in the years just after

World War II. Russias success in growing from a less developed state to what seemed, at

the time, to be a modern economy, was considered by some to be an inspirational model.

8There was an emphasis on planning and many countries went so far as to establish

planning commissions. The planning mentality influenced the way people thought about

politics as well; some textbooks written around that period agonized about a trade-off

between democracy and economic growth. Within the World Bank, my predecessor

Hollis Chenery contributed many interesting ideas as well as some very sophisticated

planning models to the debate.

Nevertheless, a growing number of economists believed that these models left out

incentives, institutions, and other key factors that make economies work. The belief in the

value of the large planning state began to erode in the 1970s and even Chenerys later

work demonstrates his growing understanding of the limitations of the planning approach.

The intellectual basis for central planning came under strong attack on the grounds that

one simply could not have the level of information required to run a modern, complex

economy in any centralized place. Given these limitations it is not surprising that their

success was short-lived. People in the highly interventionist countries sacrificed

economic opportunities as well as democracy and freedom.

We should remember, however, the origins of the planning-interventionist

strategies: markets by themselves seemed to have failed to generate development. The

market failures approach, to which I alluded earlier, provided a theoretical structure which

helped explain why markets could not be relied upon. But the problems were even

deeper: they concerned inadequacies in entrepreneurship and innovation, topics which the

traditional economics paradigm gave short shrift, though they had been at the center of

some of the earlier discussions of development, e.g. Schumpeter [1942, 1986 (1946)].

As the limitations of the central planning in the Soviet system became apparent, many

sought to combine the allocative efficiency of free-market prices with socialism to create

market socialism. Nevertheless, I would argue that the idea of market socialism really

failed to understand what makes market economies work. In Whither Socialism I

attributed this flaw in market socialism to misguided notions within neoclassical

9economics.10 Market socialists believed strongly in the power of the price system partly

because neoclassical economics claimed that prices were the core mechanism that makes a

market economy work. We now realize however, that this neoclassical paradigm leaves

out entrepreneurship, innovation, and other important dimensions that are central to the

market economys success. Market socialist economies may have been a bit more

successful than the command-and-control economies, but they still did not capture the

whole flavor of the market economy and clearly did not achieve anything like what those

who advocated this approach had hoped.

A general consensus that planning and state intervention was not likely to deliver

economic progress formed by the end of the 1980s. Nearly all economists recognized that

the government couldnt run everything and many went further to argue that government

was the problem rather than the solution.11 The prevailing line of thought gave markets a

primary place and assigned the very limited role of correcting market failures to the

government. Market failures were narrowly defined as well, leaving government to focus

on maintaining income stability, providing public goods, and correcting major externalities,

like those associated with the environment.

Dissatisfaction with this particular perspective grew as many countries followed

these policies without achieving much higher growth. In contrast, we witnessed the

experience of the East Asian countries who achieved rapid growth without following

many of the prescriptions, especially the ones pertaining to liberalization and

deregulation.

States as a Complement to Markets

This led to the third view, which places markets at the center, but recognizes that

10 The pendulum seemingly swung from one extreme to another: from a very strong role of Government, inthe planning models, to the opposite extreme that stressed a minimalist role for government andemphasized government failures (such as those that resulted from rent-seeking) rather than market failures.11See, for example, Krueger (1986, 1990).

10

governments play an important role in making markets work well. It sees the role of the

state not just to implement Pigouvian taxation to correct externalities but to complement

markets by helping provide the information and institutional, human and physical

infrastructure required for markets to exist and function well.

The working of the financial sector illustrates the complementarity between the

state and the market. We all recognize the importance of the financial sector, for example.

In the wake of the Mexican crisis in 1995 and the more recent crises in East Asia, the

topic is getting a lot more resonance than usual, but even before that there was

widespread recognition of the importance of a healthy financial sector because of its role

in mobilizing and allocating savings. We should all recognize the role of the state in this

sector: virtually every country that has an effective financial system has a large regulatory

role for the government and a strong legal system that protects the rights of minority

shareholders.

The Czech experiment in developing capital markets highlights the importance of

these legal foundations for capital markets. A weak legal structure and the absence of a

securities and exchange commission has allowed companies to, in effect, steal from the

minority shareholders. People have no confidence in a securities market where these

kinds of events can occur.12

Government action in the financial sector can be seen as illustrating the

complementarity between the state and private sector. When the government performs its

regulatory role well, the private sector can also perform its role well, with competition

among the financial institutions for gathering funds and performing efficient financial

intermediation.

The evolution of the technology in telecommunications and electricity sectors

demonstrates the need for flexibility in determining the extent of state involvement. We

used to think of electricity and telephone services as natural monopolies where one could

have either a state enterprise or a single firm and a strong regulator to prevent abuse of

12See Levine (1999).

11

monopoly power. Economics departments taught this approach and countries

throughout the world practiced it. Changes in technology, however, have forced us to

alter our views. We were slow to recognize the developments which reduced the scope

for natural monopoly and made some forms of competition quite viable, but we now

realize, for example, that we can have competition in the generation of electricity. Long-

line transmission may still be a natural monopoly, but several countries including the

United States and Britain have moved to an open-access system where anybody can link

their generating plants to the transmission grid. These countries now have effective

competition and less state involvement in electricity generation.

Telecommunications policy has evolved in a similar fashion and, while local

service remains highly concentrated, long-distance service has become quite competitive.

The role of the state in these sectors has had to be redefined along the way. Regulatory

concerns in these sectors have changed, for now regulators must watch to make sure that

particular elements of natural monopoly are not leveraged to get monopoly control over

other potentially competitive sections of the industry.

The meat-packing industry offers a mundane, but illustrative, example of need for

flexible, evolving, government action in the face of changing technology. Government

regulation of the meat-packing industry began as a confidence-inspiring measure to assure

citizens that the meat they bought was safe. After Upton Sinclairs The Jungle

graphically exposed the unsanitary conditions in Chicago stockyards, meat-packing

companies themselves pushed for more stringent state regulation. The government

complemented the private sector by establishing a credible system for visual inspection.

With the discovery of nearly-invisible disease-causing microbes and advances in

microbiology, however, the government has had to adapt its inspection strategy. As the

government has switched to more sophisticated risk analysis systems, it has had to

overcome opposition from the meat inspectors. With the advent of meat irradiation, it

has also had to prove the safety, rather than just the efficacy, of its techniques. There has

clearly been a constant role for the government in ensuring meat safety, but how it

12

performs this duty has changed significantly over the years.

Although we can still create a long generic list of the core elements that the

government must provide to complement the private sector, we have become increasingly

aware the ideal role of the state in each country is more difficult to determine. The role of

the state in providing the institutional infrastructure of an economy has become more

apparent. We recognize that this may be one of the most important ingredients in

differentiating between the economies that have been successful in economic growth and

development and those that have not.

Indeed, it is increasingly recognized that the failure of so many of the countries in

the former Soviet Union to make an effective transition to a market economy was

precisely because they failed to provide the institutional infrastructure (e.g. the legal

underpinnings) for a market economy.

What the government should do will clearly change with the changes in technology

and the changing circumstances of each country--with changes in the market and the

institutional capacity of government. But while there is no simple formula, no single

recipe, the analysis of this section should have made clear that what is required is

balance: more than a minimalist role, but less than an all-encompassing role, a role in

which the government focuses on areas of relative strength, where there are well identified

lacuna in the market. But the market complementarity view goes beyond the simplistic

approach which says that certain areas (like defense) should be the domain of the public

sector, while others (like making steel) should be the domain of the private. The public

and private sectors often need to work in tandem as partners within the same arena, as

we noted in the context of financial markets.

At What Level Should the State Act?

Throughout the world, there is increasing emphasis on devolution and

decentralization, on the notion that more of the responsibilities of government should be

conducted at the local level. The motivations for these changes are complex--involving

13

matters of politics as well as principles. I do not have time here to review all the relevant

considerations, but I do want to target a theme which I stressed in the previous section:

that changes in the world necessitate rethinking the appropriate balance.

From the normative perspective, there are two simple principles: The first

principle states that decisions, the impact of which is local, should be made locally: local

public goods (public goods, the benefits of which are received by those in a particular

locality) should be provided by local communities. To enhance the likelihood of

congruence between marginal (social) benefits and costs, those who benefit (the local

community) should also be made to pay, as federal subsidies tied to the provision of

particular local public goods may lead to distorted resource allocations.

But devolution of decision-making and finance is not without its costs: there may

be limits in the extent of redistribution. Localities cannot impose taxes on mobile factors

(such as capital), since they respond by moving to a locale with lower taxes. Localities

may have difficulties in imposing taxes on higher income individuals, because they too are

mobile. Redistribution thus must occur at the level of the nation-state--though even this

is becoming more problematicincreasing globalization renders many high-income factors

highly mobile across nation-states.

Thus, in the United States, there was a great deal of concern that delegating more

responsibility for welfare to the states (and providing them with lump sum funds) would

result in a race to the bottom. By lowering benefits, each state could not only reduce

its tax burden directly (thereby making itself more attractive to high productivity mobile

factors), but the lower welfare payments would induce out-migration of welfare

recipients, reducing the burden on taxpayers further. The empirical evidence in support

of this race to the bottom seems weaker than theory might have predicted.

More broadly, while globalization has restricted the scope of actions of the nation

state, the stress on devolution has taken away other responsibilities, leaving the national

state potentially far weaker.

The debate about devolution/decentralization involves several other elements:

14

participation and voice (the importance of which is stressed in the discussion below) may

be more effective at the local level; decentralization enables decisions to be made that

more accurately reflect the preferences of the citizens and that employ their local

information; decentralization may enhance democratic accountability. Finally, the

devolution of decision making may allow for more experimentation.

But there are factors (beyond the limitations on redistribution) which militate

against decentralization. There is, in particular, concern that the capacities (for decision

making/governance/administration) at the local level may, in some places at least, be weak.

Perhaps the strongest drive for--and the greatest reservations concerning--

devolution are associated with politics: Many advocates of devolution of welfare

believed, for instance, that support at the state level for welfare would be weaker than at

the national level. Devolution was thus a strategy for cutting back welfare. And these

concerns were precisely what motivated welfare advocates to oppose devolution. There

is not a well developed theory to explain why the constellation of political forces that

play out at the local/state level should differ from those at the national level, but there is

evidence that there is indeed a difference.

How Should the State Act? Market-like Mechanisms and Participation

Until recently, the preoccupation with shrinking the size of the state led many

economists to neglect the vital task of understanding how to improve the state. In the last

few years, both through the observation of the private sector and of successful

governments, we have developed a much better idea of how the government can function

better.

An important component is the use of market-like mechanisms. One lesson from

successful states is that they use market-like mechanisms to improve their efficiency.

These include:

15

(i) Using auctions both for procuring goods and services and for allocating public

resources

(ii) Contracting out large portions of government activity

(iii) Using performance contracting, even in those cases where contracting out does

not seem feasible or desirable

(iv) Designing arrangements to make use of market information. For instance, it

can rely on market judgments of qualities for its procurement (off-the-shelf

procurement policies); it can use information from interest rates paid to, say,

subordinated bank debt to ascertain appropriate risk premiums for deposit

insurance.

Another lesson governments can learn from businesses is to be more responsive to

citizens. This is well-illustrated by the United States Reinventing Government

initiative. Based on observing the private sector, our first step was to ask each

department in the government for a statement of purpose and suggestions for improving

the ways in which their actions contributed to this purpose. This participatory exercise

helped set an agenda for where the reforms would go. In some areas we could combine

the two main innovations, client responsiveness and performance measures. We found

that surveys were very helpful performance measures which improved our client

responsiveness. The success of strategy was particularly evident in Social Security. We

found that just by changing the vocabulary and treating citizens as clients, we made

progress in changing the attitudes of public agencies.

Although government has much to learn from business, there are important

differences between the two. In most of its core areas, government has a dominant

position if not a monopoly. That is why the participation, voice to use Hirschmans

term,13 is so important, to determine not just what the government does but also how it

13 Hirschman (1970).

16

does it. This not only makes governments serve the interests of its citizens rather than its

own interests, but also can help it implement policies more effectively. Michael Bruno,

for instance, emphasized the importance of consensus building in ending inflation.14 The

reason for this should be obvious: if workers believe that they are not being fairly treated,

they may impose inflationary wage and other demands, making the resolution of the

inflationary pressures all but impossible.

At the microeconomic level, government aid agencies and non-governmental

organizations have been experimenting with ways of providing decentralized support and

encouraging community participation in the selection, design and implementation of

projects. Recent research provides preliminary support for this approach: one study

found the success rate for rural water projects that involved participation was

substantially higher than the success rate for those that did not.15 It is not just that

localized information is brought to bear in a more effective way; but the commitment to

the project leads to the long-term support (or ownership in the popular vernacular)

required for sustainability.

Both in the public and in the private sector there are important agency problems,

where the interests of managers (politicians, bureaucrats) differ from those that they are

supposed to serve. There will never be a perfect congruence of interests, a complete

resolution of agency problems, especially in areas where appropriate performance criteria

is hard to define and performance is hard to measure. But openness in government and

the encouragement of greater participation may reduce the magnitude of these agency

problems in the public sector, and at the same time dispel some of the distrust between

government and those that it is supposed to serve.16

CONCLUDING REMARKS

I began this lecture with the observation that collective action is important. What

14 Bruno (1986)15 See Narayan-Parker (1995)16 See Stiglitz (1999) for a discussion of the eviscerating role of secrecy, even in modern democracies such

17

the government should do and how it should do it needs to evolve, with changes in the

world (including changes in technology) and with our changing understanding of that

world. Research in the economics of the public sector has, I believe, enhanced our ability

to redefine the role of the state, and provided us insights into how to make the

government both more efficient and more responsive. The challenge is to translate these

understandings into practice: to create a modern public sector, more able to provide

effectively those collective goods which are so essential to the well-being of all of us.

as the United States.

18

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