Member of the Board Olli Rehn
Bank of Finland
Book review in Helsingin Sanomat
Paul De Grauwe, The Limits of the Market. The Pendulum between Government and Market. Oxford University Press, 2017. 192 s.


According to the old adage, revolutions devour their own children. Similarly, one of Europe’s leading economists, Paul De Grauwe, asserts that the market economy will consume itself unless the state, i.e. public power, again imposes limits on markets. He also warns that a naïve belief in the state's ability to manage the economy runs the risk of overshooting the mark with a recoil that returns policy to unbridled markets as in the early 1980s. Thus, a tension is created in this oscillating dynamic of market and state power.

Belgian native De Grauwe, currently chair in European Political Economy at the London School of Economics, considers the pendulum swing between the market and the state in this small, but weighty, book. He provides a clear case for mixed economies, an economics of balance.

De Grauwe distinguishes between two approaches to long-term economic development, the linear and the cyclical. Linear change is embodied in e.g. the theories of Karl Marx, Vladimir Lenin, Karl Polanyi and Joseph Schumpeter. These economists analyse capitalism’s development path and transitions to new societal models.

In contrast, De Grauwe offers a cyclical interpretation in which the dominant economic ideology shifts periodically. He argues that a critical turning point emerges whenever the dominance of the market or the state becomes so overwhelming that it eliminates the other’s countervailing effect and leads to an unhealthy hegemony over the economy.

De Grauwe notes that wide swings between state and market dominance have occurred over the past two centuries. He asks if this oscillation will continue. If it does, the expansion of the market over the last three decades should lead to the state reasserting the dominant role in determining the direction of economic development.

De Grauwe compares the Great Depression of the 1930s and the Great Recession of the late 2000s. Both periods saw the state constrain the market and strengthen the role of the public sector in managing the economy. Growth and employment in the global economy, however, recovered significantly faster after the 2008 financial crisis.

De Grauwe credits the contribution of economics to this remarkable achievement. The diagnoses of the causes of the financial crisis were largely correct, and the resulting monetary and fiscal stimulus policies implemented with international cooperation helped prevent a deflationary cycle and restore overall demand. His observations are a sound reminder of the importance of economics and why, despite the familiar criticisms of recent years for the inability of economists to predict the financial crisis, we still need the dismal science.

De Grauwe provides several examples of the market economy limitations. Income inequality may undermine the legitimacy of the market economy. The herding behaviour of financial markets may lead to instability. Climate change is the result of neglecting economic externalities.

An entire chapter is devoted to the debt crisis in the eurozone. It is an updated version of De Grauwe’s 2011 insightful diagnosis of the darkest moments in the euro crisis, an article that should already be regarded as a modern classic in economics. Tackling the unnatural increases in sovereign interest rates of certain euro countries, he boils the problem down to the constraints of the ECB, due to its perceived mandate, to actively respond to market panics as the lender of last resort.

He finds this to be the fundamental casting defect in the eurozone architecture.

As an antidote to this original sin of the EMU, De Grauwe argues that the ECB needs to act as the lender of last resort, even if it was never made explicit in the Maastricht treaty. In other words, a central bank must do what a central bank must do: the function of lender of last resort must be carried out in a monetary union, for the sake of financial stability that is essential for sustainable growth and job creation. De Grauwe’s article responded to the views of many economic policymakers and was presented in an analytically unequivocal manner. Recall ECB President Mario Draghi addressed a London investment conference in July 2012 and said: “The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” With that speech and the subsequent OMT decisions in August-September 2012, the ECB removed the denomination risk of a breakup of eurozone as a factor in market perceptions, and interest rates began to fall.

De Grauwe sometimes beats a dead horse in making his case. For example, he repeatedly praises Nordic achievements. Quite rightly, he emphasises the importance of high productivity as a primary source of real-economy competitiveness and prosperity. But this is self-evident when economic policy is otherwise prudent and an economy faces no asymmetric shocks. Where De Grauwe misses somewhat is in his underestimation of the importance of cost competitiveness. As seen in Finland’s structural recession of 2011–2015, even high-productivity countries can suffer a loss of cost competitiveness.

Finland’s Competitiveness Pact is helping to restore lost competitiveness of Finnish labour and production, as well as make up for the lost ground caused by the structural recession. Finland is also an example of a pragmatic mixed economy where the amplitude of pendulum swings has for decades been smaller than in most Western industrialized countries. This has been more of a benefit than disadvantage for us.

Even with its flaws, De Grauwe's treatment of markets and public policy as a pendulum swing (or swings) ¬feels more realistic in light of the previous century's empirical experience than most explicatory models based on the linear interpretation. He prescribes greater international policy coordination for dealing with economic problems, a view regrettably not in wide acceptance at the moment. Whatever the case, economists should have no lack of work teasing out the causes and magnitude of future pendulum swings.