G-20 Summit: Be Wary of Big Government

As world leaders gather to refashion the global financial system, they'll be tempted to return to Keynesianism. They should resist the trap

By Shanker Singham

As we look anew at the key global institutions that have been buffeted by the current financial crisis, we find ourselves in Robert Frost's yellow wood, where two roads diverge. Just as in 1944, when the first Bretton Woods summit took place, we are faced with a stark choice. We will make the wrong choice if we embrace simplistic reasons for the current crisis and the broader economic slowdown. To read most of today's newspapers, one would assume the fiscal crisis was caused entirely by greedy Wall Street investment banks operating a casino with America's savings. However, the root cause of this crisis was not greedy investment bankers, and we must recognize the central role that government-led market distortions have played.

In the mid-1940s, three major economic events transpired that were to shape the next several decades. The most well known was the 1944 meeting at Bretton Woods, N.H., that launched the World Bank, International Monetary Fund, and General Agreement on Tariffs & Trade, the precursor to the World Trade Organization. The other two events are less well known. John Maynard Keynes, the redoubtable British official who had advised governments around the world on responses to the Depression, died. And Friedrich Hayek published The Road to Serfdom. While Keynes' memory was revered, Hayek was sent to an economic purgatory for expressing dangerous and antique notions of the benefits of unfettered free markets, protection of property rights, and a very limited role for governments.

For several decades, much of the world, and in particular Keynes' native Britain, embraced the key tenets of socialism, which involved redistribution of wealth and nationalization of industry—in short a key role for the government in the economy. It was only much later, in the 1980s, that Hayek was resurrected as a result of Thatcher and Reagan's coalition in support of free markets, property rights, and limited government. As Milton Friedman put it in a prologue to a 50th-anniversary reissue of The Road to Serfdom published in the 1990s, the world was wrong, and Hayek was right.

Keynes in the Saddle

Yet, a review of recent editorials and op-ed pieces would indicate that only the most hardened ideologue could possibly hold on to the tenets of Hayek. The path that has been trod for us by Keynes is so obvious to most commentators that even to suggest that government may have actually been responsible for the current crisis would be like spitting into a gale.

Many developing countries joined the world trading system in the 1990s, in particular China and India. Failure to account for government distortions, plus these countries' anticompetitive public-sector restraints of trade, meant that their exports were often more competitive than their ordinary business acumen would dictate. Meanwhile, imports into these markets were closed off.

These governments secured this result by artificially lowering companies' costs through government distortions, while blocking imports by means of obvious border measures and less obvious behind-the-border measures. The result has put downward pressure in particular on the U.S. dollar, which has contributed to a surge in oil prices and hence transportation costs. This was exacerbated by the inefficiencies in the developing world economy directly attributable to an anticompetitive regulatory environment, brought about through government restraints as well as the actions of their state-owned enterprises.

Without much needed domestic competition, inefficiencies took root, and demand was artificially ramped up. These inefficiencies vastly inflated demand for raw materials, such as oil and other commodities, which fueled industrial revolutions and once again contributed to surging commodity and basic food prices. Transportation costs increased to the point where the globalized, interconnected world's just-in-time supply chain started to experience deep strains.

A Boom Born of Distortions

Comparative advantage itself, the foundation of free trade, became less important than location, given the prohibitive scale of transportation costs.