1. Introduction

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One of the key discussions among economists revolves around the role the State should play in the economy. This is primarily due to the absence of a universally accepted economic theory on state intervention, leading to a convergence of diverse ideas from various economic perspectives.

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Karnik (1996) contends that this discourse was long dominated by two conflicting paradigms: the capitalist model, characterized by a limited role for the State, and the centrally planned paradigm, wherein the State assumes a robust role while markets have restricted involvement. Consequently, the juxtaposition of private ownership of capital and free enterprise against state control of the factors of production formed opposing principles that would shape international politics and economics throughout the 20th century (Stiglitz, 2000:14).

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In its classical manifestation, the capitalist model favored markets with minimal state interference in economic activities. However, it did not preclude state involvement in other indispensable aspects essential for the proper functioning of society. Thus, the State was far from being as weak as initially proposed.

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In modern economies where the basic principles of the capitalist economic model prevail, capital assets such as businesses, factories, mines, and railways can be privately owned. Labor is exchanged for monetary wages, and capital gains are the pursuit of the owners of the means of production.

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In this context, the question arises: What would be the way to measure the degree of capitalism in a modern economy? Maybe, the primary method for assessing the intensity of capitalism in a country is the role of the State; the greater the State's intervention in economic activities, the lower the degree of capitalism, and vice versa.

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Pardina (2020) proposes the following factors to consider when determining the degree of capitalism in a country: the legal robustness of legal institutions, the type of regulation established for the development of business and labor activities, and the level of openness or protectionism regarding trade and the circulation of goods. Thus, countries with greater economic freedom are considered more capitalist. In comparison, those with less economic freedom are more statist, with little or no economic freedom and a pervasive presence of the State in economic activities.

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This paper explores diverse theoretical viewpoints regarding the State's role according to different schools of economic thought. The document comprises six sections. Following a concise introduction, Section 2 delves into the State's role from the neoclassical school of economic thought. Section 3 scrutinizes the Keynesian approach, while Section 4 offers insights from the Public Choice School. Section 5 reviews the Austrian School's perspective, succeeded by an analysis of Institutional Economics in Section 6. The paper concludes by presenting key findings and insights derived from the examination of these economic schools of thought.

 

2. The Neoclassical Approach

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It is crucial to highlight that the neoclassical school of economic thought lacks a unified theory regarding the state's involvement in the economy. In its early development, the state was not integrated into its theoretical framework, being considered an exogenous variable. However, contemporary variations of this approach, such as public choice theory and new institutional economics, have chosen to treat the state as an endogenous variable, deeming it pivotal for the functioning of modern economies.

In general, when examining state intervention from the neoclassical standpoint, attention is drawn to the two Fundamental Theorems of welfare economics.

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The First Welfare Theorem underscores the notion that in competitive markets, where numerous buyers and sellers participate to the extent that none can influence market prices, equilibrium allocations are Pareto efficient. In other words, competitive markets are indispensable for achieving an efficient allocation of resources without unnecessary waste.

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The Second Welfare Theorem posits that a competitive economy can attain all Pareto-efficient allocations, provided the initial distribution of resources is appropriate. Therefore, each Pareto-efficient allocation is achievable through a decentralized market mechanism.

 

As a result, the necessity of a "Benevolent Planner" (the State), possessing the wisdom of a theoretical economist or utopian socialist, is deemed unnecessary. Competitive firms, driven by profit maximization, can perform on par with the best possible planners (Stiglitz, 2000:73). Consequently, the second welfare theorem offers a substantial justification for favoring the market mechanism.

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According to Karnik (1996), the Second Welfare Theorem confines the role of state intervention, allowing it solely through the utilization of global taxes and transfers. This intervention avoids distorting the decision-making of economic agents, as it only induces an income effect and lacks a substitution effect.

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In this manner, the neoclassical perspective on state intervention can be summarized by the following characteristics:

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• The State is rational and, therefore, seeks to maximize its utility.

• Its intervention should be minimal and avoid interference with the market.

• Its focus should be on individual rights, especially in the regulation of property and contracts, essentially specifying property rights.

• Its involvement ought to stimulate the economic environment where individuals pursue their interests without interference, thereby enhancing efficiency by establishing an operational framework.

• It should promote a competitive environment that facilitates the decentralization of production and exchange through the operation of a free market to attain optimal efficiency.

 

However, the neoclassical school doesn't completely exclude the State, and to justify its intervention, it emphasizes "market failures." When these failures occur, the State steps in to "correct" them, even when markets are efficient. The need for government intervention is determined by:

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• Establishing property rights and enforcing contracts.

• Ensuring competition by overseeing the existence of a sufficiently large number of firms, preventing any one of them from influencing prices.

• Providing public goods that are, by nature, not profitable for private production, as the marginal cost of an additional individual enjoying the good is zero.

• Enforcing the law in the presence of negative externalities.

• Addressing incomplete markets (education services, health services, unemployment insurance, etc.).

• Dealing with incomplete information (consumers are unaware of relevant information about products or services).

• Tackling issues such as unemployment, inflation, and other economic disruptions.

 

3. The Keynesian Approach

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The Keynesian theory originated in 1936 with the publication of "The General Theory of Employment, Interest, and Money" by economist John Maynard Keynes (1883-1946). This theory contradicted the tenets of the free market and, unlike its predecessors, advocated for the active presence of the State as an economic stabilizer through fiscal and monetary policies.

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Keynes proposed state intervention during crises through public spending on infrastructure (fiscal policy), providing goods and services (social programs), and injecting money directly (monetary policy) to restore economic balance and stimulate private sector investment. Thus, Keynes attributed to the State the responsibility to "manage" demand and, consequently, employment levels.

 

According to this theory, three main metrics should be closely monitored by governments: interest rates, taxes, and social programs. Concerning interest rates, the Keynesian economic theory suggests that during prosperity, the central bank should increase them to control economic booms. Conversely, during a recession, it encourages the government to reduce interest rates to stimulate borrowing, fostering investment and ultimately pulling the economy out of recession.

 

Regarding income taxes, the Keynesian proposal suggests that in times of prosperity, governments should increase income taxes or introduce entirely new taxes to participate in economic growth. Conversely, during economic downturns, reducing income taxes for individuals and businesses is recommended, providing additional financial capital in the private sector for investment and economic stimulation.

 

Social programs aim to provide skills training to individuals to stimulate the job market with a pool of qualified workers. Thus, during economic booms, the proposal is to reduce government spending in this area as it becomes less necessary. Conversely, an increase in social program spending is suggested during economic recessions to stimulate the job market with a skilled workforce.

 

It is worth mentioning that, despite advocating for significant state intervention in economic activity, Keynes did not endorse a predominant role for the State. He declared, "But apart from this, there is no outright advocacy for a system of State socialism that encompasses most of the economic life of the community. It is not the ownership of the factors of production that the State should assume. If it can determine the overall amount of resources devoted to increasing those means and the basic rate of remuneration for those who own them, it will have done all that is necessary" (Keynes, 1936).

 

The consolidation of Keynesian theory was possible due to the Great Depression and the devastating effects of World War II. Alonso (2010) asserts that the prevailing institutions provided the ideal scenario for implementing a new Keynesian-based economic structure supported by states.

 

4. Public Choice School

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The Public Choice School is considered a subdivision of microeconomics based on methodological individualism. It emerged in the 1950s and gained public recognition when American economist James M. Buchanan received the Nobel Prize in Economics in 1986. The Public Choice theory encourages the study of rules, laws, and institutions that could improve how the State intervenes in the economy, applying normative analysis to economic studies.

 

Previously, in political science, it was believed that while individuals pursued their personal goals in the market, the State sought the common good. However, the Public Choice theory argues that the behavior of bureaucrats and politicians is no different from that of other economic agents. Therefore, their primary goal is to maximize the public budget, primarily serving their interests and seeking the common good only as a secondary objective.

 

In this way, the State is considered a group of officials who, while aiming for the public interest, also act in their own interest, maximizing their utility. Thus, the State acts partially in favor of certain groups, even if it sacrifices economic efficiency in the process. In Buchanan's words, the theory "replaces ... romantic and illusory notions ... about the functioning of governments [with] ... notions that embody more skepticism."

 

The Public Choice perspective expresses skepticism about the supposedly benign nature of the government, unlike more interventionist schools of thought like Keynesianism. The emergence of Public Choice economics reflects dissatisfaction with the implicit assumption, held by Keynesians and/or neoclassicists, that the government effectively corrects market failures.

 

The most significant finding of the Public Choice School was discovering flaws in government intervention in the economy (Vargas, 2002). According to Ayala (1992), the main criticisms from the perspective of Public Choice towards state interventionism include:

 

• The claim is that interventionism led to enormous resource waste by supporting rent-seeking and non-productive economic activities. The creation of rents is said to generate solidarity between bureaucracy and benefiting groups, fostering state growth, and, as a counterpart, lower efficiency in resource allocation. Therefore, the state should be minimal, and the market is the only guarantee of controlling the trends toward indefinite growth of rent-seeking interventions.

• The argument is that the state did not pay enough attention to the proper allocation of resources when selecting investment projects. "Government failures" occurred, such as insufficient administrative capabilities, the use of inappropriate technologies, and poor estimation of internal and external market prospects.

• State interventions were unable to foresee and anticipate adverse macroeconomic effects (fiscal deficit, growth, hyperinflation, over-indebtedness) due to budgetary and financial laxity.

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In conclusion, the Public Choice perspective diminishes the importance attributed in the Keynesian tradition to problems related to the potential instability of the system, especially to the inefficient allocation of resources. In other words, Public Choice challenges Keynesian ideas of unbalanced budgets resulting from public policies and explicitly proposes restoring a balanced budget as a major goal, even as a constitutional requirement (Ayala 1992:78).

 

5. Austrian School of Economics

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Unlike the neoclassical and Keynesian schools, which approve of government intervention due to existing market failures, the Austrian School does not justify it. From this school of thought, there are no market failures, and if they are recognized, they are considered to arise from government interventions that distort market prices.

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Indifference toward public intervention in the market stems from the assumption that the government will never comprehend the complex economic system and, therefore, will be unable to gather information dispersed among consumers adequately. The theoretical justification for laissez-faire policies and market support comes from the conclusion that the market efficiently allocates resources and solves the coordination problem.

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From this economic thought perspective, when the government opts for regulation, it creates problems due to market complexity. These problems led the government to develop more regulations to solve issues that arose because of previous regulations. Thus, a vicious circle is created that, in the long run, moves the economy towards centralized planning (Holcombe 2014, 108; Hayek 1944).

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Specifically, Mises and Hayek opposed government price controls, as this action, regardless of good intentions, generated harmful consequences for consumers by acting against market logic. For example, if a government believed the price of a basic good (milk or bread) was too high and inaccessible to many consumers, price controls would be implemented without considering the economic consequences. The modified price would further encourage the consumption of the good, stimulating high demand but maintaining the initial supply. This would lead to a scarcity of the controlled-price goods in the market, causing a shortage.

 

"The authoritarian intervention in the mechanism of the economic system based on private ownership of the means of production has failed in the goal that the government intended to achieve with that means. This intervention has not only failed to achieve the end promoted by those who advocated it but has even been counterproductive to that end because the 'evil' that it sought to combat has not been eliminated but rather has been further aggravated" (Mises, 1927:76).

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However, Mises does not categorically reject government participation, as he asserts that the State is an absolute necessity because it is responsible for playing the most crucial roles: protecting private property and, above all, peace, as only in peace can private property unfold its potential (Mises, 1927:45).

 

Despite the need for the government to achieve peace and social cooperation, Mises warns of the risks it poses to freedom. In his work "Liberalism" of 1927, he decisively states that governments have been responsible for the greatest evils in history. He argues that the main characteristic of a government is the enforcement of its decrees through violence; those advocating for more intervention ultimately call for more coercion and less freedom.

 

"We call the State apparatus the social apparatus of compulsion and coercion that forces people to obey social rules; the rules according to which the State proceeds are called Law, and the organs that are responsible for operating the coercive apparatus constitute the Government" (Mises, 1927:43).

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On the other hand, Hayek, an active member of this school of thought, opposed market regulation, labeling it as "interventionism," as he believed that all regulation was an attack on economic freedom. However, he argued that part of the public resources obtained from taxpayers should be used by the government to ensure a minimum income for the nation's inhabitants. Additionally, it could help mitigate the harmful effects of possible natural disasters on the population (Cue-Mancera, 2000).

 

 

6. Institutional Economics Approach

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Institutional Economics, also known as neo-institutionalism, used the neoclassical model as a reference but included some modifications. For example, while neoclassical economics advocates the market mechanism as the best way to organize factors of production (capital and labor), institutional economics considers this view partial because it does not include the most crucial factor for the efficient functioning of a market: the institutional and organizational structure of the economy.

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The main proponent of this approach was economist Douglass North, who combined neoclassical and public choice ideas to produce a unified theory of state intervention, earning him the Nobel Prize in Economics in 1993 for his contributions to institutional economics. According to Alfonso (2010), North's contributions to institutional economics can be summarized as follows:

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• North defines institutions as the "rules of the game in a society or the man-made constraints that shape human interaction" (1993; 13). These can be formal (rules, laws, constitutions) or informal (behavioral norms, conventions, culture, and codes of conduct, among others) that "together define the incentive structure of societies and specifically economies."

• North criticizes neoclassical theory in its principles of rationality and information. Humans are not entirely rational; their rationality is limited by institutions. Nor do they possess complete information because information in the market is always fragmented.

• The Pareto optimum is not achieved since imperfect competition exists in the economy; the utility and growth of some companies often lead to the destruction of others, as in the case of oligopolies.

• Each nation evolves differently according to its institutions in moral, economic, and political fields.

• The state must regulate behaviors, conduct, and property rights efficiently to create institutional frameworks where the economy can develop as a means of each country's development.

• The institutional study of the economy is the only valid method to improve the economic development index. Only through the modification of institutions from ethical, political, and economic perspectives can better economic development be achieved, bringing social benefits.

 

In the institutional economics approach, the analysis extends to include aspects marginalized in the neoclassical approach, which are now recognized as fundamental elements for the proper functioning of markets. These include the legal framework, power structures, access to information, individual formation (culture and values), and even characteristics of the political system—all of which are encompassed by what are called institutions or rules of the game and organizations or actors (Villareal, 2001).

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While the market is a price mechanism that allows interaction and adjustment between supply and demand, coordinating the decisions of economic agents, for it to function efficiently, it must be supported by a formal legal framework or informal rules, ultimately based on a legal system and/or trust among economic agents. Without this framework, it cannot operate and carry out various economic transactions (commercial, financial, productive, etc.).

 

Conclusions

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The examination of diverse economic schools of thought offers a comprehensive and nuanced understanding of how states should engage in economic interventions. The Keynesian theory, originating as a response to the Great Depression and World War II, advocates for active state involvement through fiscal and monetary policies to stabilize the economy and boost employment. Notably, Keynes did not endorse an overarching role for the state in owning the means of production; rather, he emphasized its capability to manage demand and uphold economic equilibrium.

 

Differing from the Keynesian viewpoint, the Public Choice School sheds light on the less-than-benevolent nature of government, asserting that officials prioritize personal interests, potentially compromising economic efficiency. This underscores the need to scrutinize incentives and decision-making within the governmental sphere.

 

The Austrian School presents a starkly contrasting stance, rejecting government intervention and contending that market issues often stem from prior interventions. This perspective champions market efficiency while cautioning against the perils of excessive regulation, which can set off a detrimental cycle of government interventions.

 

Institutional Economics, spearheaded by Douglass North, amalgamates elements from public choice theory and neoclassical economics, acknowledging the pivotal role of institutions in shaping economic interactions. It stresses the necessity of a robust institutional framework to ensure the effective functioning of the market.

 

These divergent approaches mirror the intricacies of the economy and underscore the significance of considering multiple viewpoints in tackling economic and political challenges. A profound comprehension of these economic schools of thought establishes a valuable groundwork for crafting economic policies that strive to harmonize stability, efficiency, and the preservation of individual freedom.

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References

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Alfonso, Vargas, L. A. (2010). La intervención estatal en la economía: elementos de análisis para el caso colombiano. IUSTITIA. Nº 8 ISSN: 1692-9403 pp. 381-398

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Ayala, Espino, J. L. (1992). Limites del Mercado, Limites del Estado. Ensayos sobre Economía política del Estado. Instituto Nacional de Administración Pública. México

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Cue, Mancera, A. (2000). La escuela austríaca de economía. Comercio exterior. Bancomext. pp. 1099-1106

 

Mises, Ludwig von (1927). Liberalismo [La tradición clásica]. Traducción: Juan Marcos de la Fuente

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North, D. C. (1993). Instituciones, cambio institucional y desempeño económico. México, Fondo de Cultura Económica (cuarta reimpresión), 2012.

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Keynes, J. M. (1936). Teoría general de la ocupación, el interés y el dinero. México, Fondo de Cultura Económica (decimotercera reimpresión), 1995.

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Stiglitz, J. E. (2002). La economía del sector público. (3a. ed.). Barcelona: Antoni Bosch.

 

Vargas Sánchez, Gustavo (2002). Introducción a la Teoría Económica: Aplicaciones a la Economía Mexicana. Editorial Pearson Educación; México.

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Villareal, René. (2001). La nueva economía institucional de mercado y el estado de derecho. Instituto de Investigaciones Jurídicas. Universidad Nacional Autónoma de México