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ment and private economic agents (regulation), between politicians and bureaucrats (oversight), and between citizens and government (accountability). I conclude that the quality of state performance depends on the institutional design of all these mechanisms, and that well-designed institutions will allow and induce governments to intervene in the economy in a way that is superior to what occurs in a noninterventionist state.


To understand the rationale for state reform, we need to look back at the history of debates about the proper role of government in the economy. These debates have gone around in circles, with arguments about market failures being countered by claims about regulatory failures. As one reviews the history of these controversies, they appear almost as a boxing match, with the state and the market alternately on the ropes.

In a standard neoclassical model of the economy, there are markets for everything, now and for the future; everybody knows everything, and they know the same things; and there are no public goods, no externalities, no transaction costs, and no increasing returns. Since under these assumptions the market generates the first best allocation of resources, state intervention, in any form or fashion, is but a transfer of income; in turn, transfers of income, by causing rates of return to diverge from the competitive allocation, reduce incentives and misinform about opportunities. This conclusion follows directly from this model of the economy: since the state has nothing to contribute, anything it does is pernicious. The market wins round 1.

Yet the very fact that this model must be characterized at least in part negatively—by the absence of public goods, externalities, transaction costs, and monopolies—indicates an immediate problem. In the presence of these "failures," markets no longer allocate efficiently. This was the observation underlying the doctrine of state intervention enshrined in the 1959 Bad Godesberg Programme of the S.P.D.: "markets whenever possible, the state when necessary." The general prescription that emerged from this observation was that markets should be left alone to do what they do well—allocate private goods in those cases where the private rate of return does not deviate from the social rate—while the state should provide public goods, facilitate transactions, correct externalities, and regulate monopolies due to increasing returns. Round 2 goes to the state.

Neoliberals attacked this view in several ways: (1) by arguing that in the absence of transaction costs, the market can deal efficiently with market imperfections under a suitable reassignment of property rights (Coase, 1960); (2) by pointing out that the notion of market imperfections, including public goods, is unclear, and no theory specifies them ex ante (Stigler, 1975); and (3)

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