By Harold James

For the last century, economic-policy debate has been locked in orbit around the respective roles and virtues of the state and the market. Does the market control the state, in the sense that it sets a limit on governments’ ability to borrow? Or does the state take charge when the market fails to perform socially necessary functions – such as fighting wars or maintaining full employment?

This old debate is at the core of today’s profound divisions over how Europe should respond to its debt crisis. The same question is dividing American politics in the lead-up to November’s presidential and congressional elections.

During the two decades prior to the financial crisis, most people – including most politicians – assumed that the market was supreme. Now the intellectual pendulum may be swinging back to the belief that state action can mop up markets’ messes – just as veneration of the state in the 1930’s followed market worship in the 1920’s.

Two decades ago, judicious European politicians looked for a “third way,” steering a zigzag course between the importance of market mechanisms and that of other social priorities, according to which the market needed to be directed. For example, when the Delors Committee prepared its report in 1988-1989 on how a monetary union could be established in Europe, experts devoted considerable attention to the issue of whether market pressure would suffice to discipline states. Many warned that it would not – that bond yields might converge at the outset, permitting spendthrift countries to borrow more cheaply than they otherwise could.

The result of the debates of the early 1990’s was a set of rough and ready rules on deficits and debt levels that was never taken quite seriously. Economists mocked them and Romano Prodi, the president of the European Commission at the time, called them “stupid.”

Until the second half of 2008, Europe seemed to have reached fiscal Paradise: the market did not differentiate between eurozone governments’ bonds. Some assumed an implicit debt guarantee, but that was always implausible, given that the Treaty on the Functioning of the European Union explicitly ruled it out. Rather, investors’ undivided confidence in all eurozone borrowers reflected something else – a general belief in the capacity of rich countries’ governments. Read more…

Harold James is Professor of History and International Affairs at Princeton University and Professor of History at the European Institute in Florence.

As published in www.project-syndicate.org on September 5, 2012.


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