Column : The aftermath of crises

Written by Michael Walton | Michael Walton | Updated: Oct 16 2008, 07:25am hrs
In the wake of the ongoing financial implosion, questions are being raised over the nature of capitalism. Is a capitalist development path necessarily fraught with heightened risk, increased inequality and excessive influence of business Can societies make choices over the form a market economy takes Or does the competitive dynamic of global exchange allow only a lean and ruthless form of capitalism These issues are as relevant to India as to rich countries.

A major focus now is on financial regulation. But here I want to look at the management of household risks. In the US, current debate has concerned protecting homeowners and depositors. It will soon turn to extensions of unemployment insurance. In India it concerns what the state should do for the health, weather and employment risks that dominate the lives of most Indians.

The history of now-rich OECD countries suggests the following two observations.

First, large expansions in state-mediated management of household risks occurred when the political influence of middle and poorer groups became salient. Bismarcks pioneering introduction of accident, sickness and old age insurance for workers in the 1880s was in response to the threat from the Marxist Social Democrats. The United Kingdoms landmark Beveridge Report, written at a time of great social solidarity in the Second World War, led to the post-war creation of the National Health Service, unemployment insurance, and old age pensions, all revenue-financed and all involving generalised rights for all citizens. In the US, the New Deal was created in the 1930s in the wake of the Great Depression, also a time of solidarity with those who suffered, since that could be me.

Second, it is hard to find profound first-order effects on long-run productivity in rich capitalist societies. Sweden, Denmark, Germany and Finlandfamous for the extent of their social provisioningare all in the top seven countries in the World Economic Forums Global Competititeveness Rankings, closely following the US and Switzerland.

A country like Swedens high productivity looks like a puzzle for economists, who expect sharply increasing efficiency costs from high taxation, and potentially large disincentive effects from transfers. The economic historian Peter Lindert provides some answers: the tax and benefit system in Sweden is carefully designed to minimise disincentive effectsand indeed has much better incentive properties than the US tax-subsidy system!

Thats the good news: extensive risk management systems are consistent with capitalist development. Indeed, both the historical experience and cross country analysis by economist Dani Rodrik suggests that openness to global markets is associated with more, not less, social provisioning, as citizens demand more protection.

The bad news is that it is easy to make a mess of the design.

The communist model of enterprise-based, cradle-to-grave social protection was one element of the dismal long-run performance of that economic system. Many Chinese state enterprises still struggle with this burden. Most Latin American countries imported the Bismarckian model and linked social protection to the labour contract, again a result of pressures from urban workers. But this led to deep labour market dualism, increased informality, slow growth of formal enterprises, and significant inequalities of social provisioning.

So, what does this imply for India India has a vigorous democracy, high levels of patronage and relatively weak social solidarity between middle and lower groups because of caste and other social divisions. While still poor, India is already some 40% richer than Germany in the 1880s and in a few years could be about half as rich as the UK in 1946.

With democracy and rising aspirations, demands for household risk management will only rise in intensity. This is a good thing. Adverse shocks have immense costs for those affected, and private and informal insurance mechanisms suffer systematic market failures.

However, there are significant design challenges. Indias heritage is a blend of social benefits tied to formal sector jobs with adverse incentives for firms to formaliseand a wide array of social programmes that fail to reach many of the poor, and are often embedded in patronage. By contrast, the National Rural Employment Guarantee Schemes right-to-work and accountability mechanisms seek to strengthen citizenship and reduce patronage, potentially fostering a virtuous cycle with local democracy. But the implementation problems it has faced are indicative both of the threat to the existing patronage structures and the broader political economy challenge of programmes targeted to the poor. Longer-term political support requires a coherent mix of risk management schemes that benefit both middle and poor groups.

Capitalism, democracy and risk management institutions are potentially powerful complements. The crash on Wall Street is not a reason to repress capitalism, but to get the underlying social and political institutions right.

The author is at the Harvard Kennedy School, Institute of Social and Economic Change, and the Centre for Policy Research