The Birth of Modern Economy: Government (Part 2)

This article is the second (a continuation) and last part of our previous article: The Birth of Modern Economy: Government (Part 1) in which we discussed about how government came into being and shared some thoughts related to the subject. We have by now built enough understanding regarding the rationale behind the existence of government, and based on this new knowledge, we will discuss more intimately the roles of government within our free market economy and the extent of their impacts on our modern society economically. Let’s not waste time and dive into this exciting new adventure right away!

2. Government and Economy: A genuine love story


Because government is one of the the highest organized bodies in a country and is endowed with the authority to oversee domestic affairs and protect national interests, government is one of the most, if not the most, crucial factors in allowing our beloved market economy to exist and persist.

Its major role is that of a social planner that optimizes social welfare through facilitating/ensuring efficient and equitable transaction and allocation of resources while maintaining stable economic growth. It does so by, inter alia:

– Ensuring peace and stability

Economic growth is not possible without peace and stability. Warring states will allocate resources to the mass production of weaponry, the gathering of intelligence (through the act of espionage, etc), and the recruitment and training of military personnel, none of which contributes to the welfare of the human society. Regardless, a state under threat, whether from internal or external force, will inevitably have to put itself in this position. This is treated as a strategic interaction between rational agents that can be explained by an economic branch called “game theory”.

Shake hand or No shake hand? A long over-due question, but it is fun to keep asking!

Let us consider the decision process undergone by two opposing factions in a country, say Tiger and Dragon, when civil war is imminent. Both face two alternatives: War or Peace (i.e. Strike or Back off). If Tiger chooses “peace”, but Dragon chooses “war”, then Dragon will commit to activities as aforementioned (producing arms, spying, etc). This gives Dragon the edge when it strikes since Tiger chose “peace” and is not prepared to defend itself or take the offensive stance against Dragon. The scenario would be the same if the two factions reverse roles.

Of course, the end result is disastrous for the whole nation (a lose-lose situation for everyone), and a huge blow to the free market, our engine for growth. Supply and demand will be manipulated, and consequently, resources will be transferred away from the market of commodities. Consumable outputs, that can satisfy basic human needs, will then be reduced, and since wealth is measured by these types of outputs, people of the nation will become poorer in real term. This holds truth for both civil war and world war.

Tragic end indeed. But, in most cases, when put under such pressure as aforementioned, nation or conflictingh forces within a nation will much more likely engage in war than promoting peaceful resolutions. Why? Because rational people are paranoid and doubtful. It will be extremely difficult to come to an agreement without a higher being that can forcefully end the war and ensure all parties of their own safety and security by punishing those violating the truce/peace agreement.

Hence,without a central government (national or global) with the absolute authority to enforce laws/rules and regulations, stability will be lost. This is due to the simple fact that rational decision makers of both opposing factions (vying for supremacy) will have no choice but to produce arms and wage war to avoid being consumed by the others.

As wars are basically conflicts over power and domination, the formation of a strong central government can bring back peace and stability through whatever means (aggressive or peaceful). In the case of wars between nations, the existence of an authority figure with similar characteristics to a world government like the UN that has the power to impose sanctions on warring nations can help quell the war and turn for more peaceful alternatives. So, in most cases, peace and stability can be brought about by higher authorities like the government. Again, why?

To reiterate, government possesses the highest power and authority that make its presence crucial in providing a sense of safety and secruity that people need (as already mentioned), a sense of obligation that ties people together, and a sense of fear that prevents smaller factions from rebelling; thus, government’s existence is conducive to peace and stability of its nation.

With peace and stability in place, resources can flow freely. Goods and services can then be produced to suit the actual demand of the people, and the free market can operate at full capacity to seek the right state of equilibrium that maximizes social welfare.

– Eliminating Asymmetric Information and Enforcing property rights

Exchange/Trade is the essence of free market economy; in other words, the presence of free market and capitalism heavily depends on the level of exchange/trade (volume, velocity, ubiquity, etc), which in turn depends on the ease of exchange and most importantly, the degree of security and reliability (risk) under which exchange is conducted. This means that parties going into trade of a particular product/service/asset expect to have their trading partners abide by the the terms of contract on top of they themselves having the rightful ownership of whatever they gain through trade. This strongly demands fully disclosed information from all trading parties, high credibility and a great sense of integrity in addition to the guts to trust each other, which is highly unlikely unless all trading partners are familiar and have carried out numerous successful transactions with one another.

However, such an ideal scenario is rare in a world of over 7 billion people where day-to-day interactions with stragers are frequent. Because people are profit-oriented, opportunity snatching, and from time to time short-term thinkers (hyperbolic discounting), they have the incentive to cheat (or so we think of each other). Thus, even when contracts have been made, there are those who find it more profitable to violate certain terms and conditions. Such actions are indeed detrimental in the long-run.

This is worsened by the lack of information during trade, and that is to say the market rarely operates under complete and perfect information. Buyers normally are not fully aware of the full details (have no full knowledge) of the products they buy. They are mostly afraid of the overlooked defects of the products they are planning to purchase. Sellers, likewise, do not always possess fully disclosed information about the buyers. This is a great concern in particular businesses like insurance sellers. It is indeed costly for the insurance company to sell cheap life insurance to someone who has terminal illness like cancer or advanced heart disease. Likewise, the auto-insurance company is prone to losing more if they end up selling cheap car insurance to individuals who like to race (increasing probability of causing damage to the car). In economics, this situation is known as “Adverse Selection”. Some other time, individuals who are covered by car insurance might become less cautious with their driving, increasing the likelihood of car accidents. Individuals with life insurance might also be less concerned with their diet, causing them to be more susceptible to disease, and thus, incur more cost to the insurance company. This type of human behavior is known as “Moral Hazard”.

As a result, a world with no laws enforcement, no higher being that can impose a clearly defined set of laws, rules and regulations, and property rights on people, trade is extremely difficult. Not to say that trade is impossible under such scenario, but the volume and velocity (frequency) of trade/exchange would decrease significantly.

Reducing/elimating such trade barriers is one of the many vital roles that government play on a daily basis. Their existence alone induces observance of laws, and thus, binding contracts and lawful recognition of private properties (either of factors of production or final products). Failure to comply, such as in the case of encroachment on individual’s rights to use or transfer his resources as he sees fit by any other individuals or groups, fraudulent deal, or violation of terms of contract would incur costly punishment (as a form of negative reinforcement). Being rational and cost-minimizing beings, therefore, people would strive to avoid such cost and behave in manners that promote exchange. Of course, things like contract is made by human, and thus, there bounds to be loopholes to be exploited, but this is not much of a concern knowing that people are being more meticulous than ever in response to the incentive to gain more and lose less.

What is of chief importance is being assured that one has the rightful ownership of properties one gained through lawful means, and this sense of security and peace of mind will drastically lower the level of risk associated with each transaction (especially, between large corporations), facilitating and allowing trade of larger volume or of assets of greater value to be made even more frequently.

When resources can flow freely and more fequently, allocations of such resources can then be more responsive to the dynamic nature of the free market, enabling greater turnover rate (more transactions at a given period of time) and thus higher efficiency (smaller deadweight loss) and consequently, better social welfare. It drives up the aggregate demand by encouraging more investments and consumptions; thus, expanding the market, causing more outputs to be produced, and more employment. Perhaps, what is most important to remember is the fact that successful reduction of asymmetric information and effective enforcement of property rights, achievable by the employment of government’s authority, are the requisites that must be satisfied for free market and capitalism to function and for greater economic performance.

– Authorizing and enforcing the acceptance of legal tender, i.e. coin and paper money (That, plus a bit of history of gold standard and fiat money)

Without government, these would be just a bunch of worthless papers with no intrinsic value

Prior to this article, we have discussed about transaction, and how the economy transformed from “barter economy” to “money economy”. Note that, however, money economy did not start off as the money economy we know today. Initially, we had something called “gold standard”.

History of trade made simple, transaction began with a simple barter economy where people exchange goods/services with other goods/services directly without the employment of any medium of exchange. But, due to the rising diversity of products, this method of trade became increasingly difficult (Please refer to The Birth of Modern Economy: Transaction Evolution for more information regarding why money economy is preferred to barter economy). For the reason stated in our previous article, our economy gradually switched to the more practical money economy. However, we did not start right off with paper money. Originally, the concept of paper money was rather foreign, and people used durable commodities like rice, salt, etc as the mediums of exchange. Later (or probably at around the same time), there were societies who began using gold and silver (and other precious metals) which are both durable, portable, and rare (hard to duplicate) as money.

Note that, though seemingly much differ in their characteristics and physical compositions, what things like rice and precious metals like gold and silver share in common is “intrinsic value”. When we say they possess intrinsic value, what we mean is that the mediums of exchange themselves are useful or valuable on their own (people want/need them regardless) without having to rely on people having faith in them. Let me make this concept clearer for you via a few examples. Think about rice. Rice is edible, and even in a world where rice is not treated as a medium of exchange, people still eat rice. It is still a staple crop. It provides nutrient, and it gives life. Gold, though not sharing these traits, is still valuable on its own because gold is rare, and wherever you go (in almost every single one of the 200+ countries), gold is accepted and can be exchanged for other goods and services (even if you are not in possession of the local currency).

The problem is that it is not convenient enough, and people do not feel secured carrying precious metals like gold around with them, especially considering all the weighing and assaying processes undergone to ensure the quality and quantity of gold. This causes lots of difficulties for large volume trade. Consequently, when the financial intermediary called “BANK” came into existence, people started to deposit gold/silver and found it much more convenient to carry a piece of paper/note issued by the bank (certifying their ownership of the amount of gold they deposit) as a means for trade. Later, this new medium of exchange became so popular that government decided to print notes and mint coins backed by precious metals like gold and silver. That is to say the exchange rate of money is fixed at a certain rate against gold/silver. For instance, from 1834 to 1933, the US fixed the price of gold at $20.67 per ounce. Every country did the same, and from it, international exchange rate would be determined.

The one merit of gold standard is that under this system, inflation is very low (averaged at about 0.1% a year). This results in a more stable economic environment. However, gold standard is theoretically thought to be subject to random adverse supply shock, especially when new gold repositories are found and a large amount of gold is suddenly injected into circulation, which can lead to depreciation of the gold-backed money. Still, the actual impact on inflation as observed during the time the system was in effect was not as big as predicted. Probably, what really led to the official abolition of gold standard in 1971 by the United States was the reason that gold standard put too much restriction on the government’s ability to control the economy. With gold standard in place, monetary policy is almost non-existent as the government can only print new money when more gold is found. The problem is that, during the war, most countries were heavily in debt, and the inability to raise money to pay the debt proved to be a great burden. The abandonment of gold standard helped solve this problem.

Another equally important reason is what happened during the infamous US great depression of the 1930s. The fact that gold standard allows people to cash in their deposits in exchange for an equal value of gold severely cut short gold reserve, and this scenario played out during the depression (people felt pessimistic about the future, and therefore, many withdrew the deposited gold from their banks) when the unemployment was high and deflation was widespread and persistent. This drastically reduced gold supply in circulation, raising interest rate even higher, making it more and more expensive for businesses to borrow. But, without the ability to freely create artificial inflationary effect to combat deflation and rising interest rate, the US government was powerless against the great depression. Of course, the depletion of gold reserve made it worse. Under such pressure, the US government eventually decided to cut all tie with gold standard, and this allowed new money to be printed and re-stabilized the economy. Of course, during that time, it was just a short break from the gold standard, The US then went back to adopt the system, and the era of gold standard did not officially end until 1971 (due to similar reasons).

The end of the gold standard marked the birth of a new medium of exchange, the same money and coin, but ones based on faith, on arbitrary order by the government, called “Fiat Money”. In fact, the word “Fiat” is derived from Latin meaning “Let it be done”. This is exactly what Fiat Money is all about. Fiat money does not hold intrinsic value. Paper money and coin are not edible, and they cannot be used for any other purposes besides being the medium of exchange. Plus, 1,000 Japanese yen can only be spent in Japan, not elsewhere. British pound is not accepted in the US, and vice versa for the US dollar. Of course, currency of powerful nations, that is conceived to be safe haven for investment, like the US dollar is probably more valued than any other currencies, but it is still useless on itself and is not accepted in most countries as a medium of exchange.

You see, any currency we know nowadays is fiat money, and thus, a country’s currency solely relies on an arbitrary decree by its local government that officially recognizes it and lawfully enforces public acceptance of the currency as a common medium of exchange used to meet financial obligation within that particular country. That is why it is called “Legal Tender”. Google the term for definition.

Without government who holds the power and authority to officially recognize, authorize and enforce the use of fiat money (the modern money we earn and spend daily), such a system would never work. This is because fiat money is created out of thin air, and is only of value if people find their government credible. That is why the collapse of the central government can dramatically change the economic landscape of a country, rendering the money backed by the old government useless, completely eroding the purchasing power of all the money its citizens possess. To put simply, fiat money: its potency relies on the power of government. If the old government is forcefully dissolved, so can the fiat money used in that government’s regime as the new government might want to adopt a different currency under their regime for political reasons.

This would be a disaster that would put the entire country into mass panic and introduces an era of economic instability and uncertainty.

For this particular reason, government is an extremely important entity that supports the foundation of our economy, and that is why revolutions on impulse (that do not bring forth smooth transition) and aggressive transitional justice almost always crippled the economy and impoverished the country for decades. Thus, gradual change to the system of government is mostly preferred, and any abrupt change should be done with caution and with well-thought procedure that ensures long-term economic stability and security.

– Regulating the market to avoid market failure

In most of our discussions, we treat free market equilibrium that is achieved through countless interactions between buyers and sellers, an equilibrium that swings according to the force of demand and supply, and that operates under no or minimal government intervention as the most efficient mode to maximize social welfare. We reason that the greater efficiency of free market economy (as opposed to command economy/central planning) is the result of its effective self-correcting system in response to the market dynamics. Free market, thus, can better allocate resources to where they are most needed by letting price fluctuates freely according to the changes in demand and supply. This type of economy is also known as “price-coordinated” economy. In such an economy, the rise or fall in price will result in the rise or fall in profit, and thus, incentive. People then respond to this change in incentive by producing more of what is more profitable (i.e. higher price due to supply shortage or excess demand) and less of what is less profitable; hence, resources are allocated to where they generate greatest return (thus maximize welfare). This is way more efficient than central planning where one person with imperfect and incomplete information/knowledge of the entire market is in charge of overseeing the production/supply of thousands of goods/services, something which is virtually an impossible task if we take into account the rapidly increasing scale and scope of goods in our modern economy.

This sounds nice and neat, doesn’t it? But remember, free market is not miraculously operated by an invisible hand that knows it all (as the conventional belief). Free market is in essence the ultimate product of numerous interactions/exchanges every single second, every minute, every hour, everyday, every month, every year between producers and consumers. It goes without saying that in such a profit-oriented human-driven world, free market is not immune to errors.

One such scenario is in the situation of asymmetric information which results in moral hazard andadverse selection as described ealier, which shows that free market operating under imperfect and incomplete information is not optimal due to the lack of trust (i.e. the realization that people have the incentive to cheat the system) rendering it more difficult and costly for transactions (esp, those of large volume) to materialize.

Now, let us look at 2 more cases where market fails.

+ Public goods:

There are several sub-cases when it comes to public goods. We will however only consider a couple to not cause information overload. Consider the case of common resources like fish in a small lake in a small town. Normally, fish is renewable resource, but only to the extent that moderate fishing is practiced. When the rate of depletion reaches a certain threshold, fish will eventually run out. That is to say, over-fishing in that small lake will exhaust the total fish supply in the lake for sure. This is what usually happen when the lake is open to public use, without rules and regulations set in place. Because fishing is naturally not excludable (that is anyone can fish if they wish to), people will do so because if they don’t, someone else will and they will be made worse off. The case described is an example of the widely known and used term: “Tragedy of the Commons”. That is why laws on fishing are passed to prevent over-exploitation that can exhaust fish supply and ultimately destroy the ecosystem of the lake, a huge loss to the social welfare. This is also related to externality, a case we will discuss soon enough.

Another example of market failure related to public goods is… let’s think about street light. Think about it for a minute before you read on. Street light is within the category of goods from which everyone can derive benefits whether or not they contribute to its construction. You cannot exclude/ban anyone from standing walking pass the street light (say, if you built one) at night. After all, it would be built on public street. This problem is dubbed “free-riding” problem. I guess I have talked about it a few times before, but just to re-iterate for the sake of saving you some time from googling. Free-riding creates a situation in which the benefits of your purchase/production extend beyond you and the buyers of your products/services to some third party who did not contribute a single cent to the making/purchasing of the products. This lowers the incentive to supply because once someone makes the purchase or decides to produce, everyone else can instantly gain benefit free of charge. As a result, such products are normally non-existent or under-supplied in free market. This necessitates government intervention; it requires government to be actively engaged in this segment of the market to fill the missing gap.

+ Externalities:

Now, the two cases discussed above can all be related to externalities. But, just for the sake of clarity, let’s consider another case. Think about driving 4WD vehicle like pick-up trucks. Well, the interesting thing is that some studies show that driving these types of vehicle (I read about it once, but couldn’t find the link to the original source… sorry), while lowers the fatality rate of the owners of this particular vehicle in case of collision, can actually increase the fatality rate of the other party if he/she drives a smaller car like a sedan. This is because of: firstly, the fact that 4WD is normally a bigger and more sturdy built vehicle and driver’s seat is raised higher if compared to the smaller, less safe sedan; and secondly, 4WD drivers feel safer and thus more likely to drive less carefully (moral hazard). This is an example of consumption externalities, where the buyers of 4WD vehicle indirectly impose greater life threatening risk on the owners of smaller vehicle. This can thus be another reason for government to raise higher tax on 4WD vehicle as a form of compensation that makes more equitable the social return of individual investments (which, as seen in the example, is sometimes not provided by the free market).

The aforementioned reasons demonstrate the inherent imperfection of free market, and it justifies government intervention to correct and bring the market back to its socially efficient level.


By now, I hope that you have come to share some of my views on the importance of government in addition to the belief that gradual and well-thought transition from one regime to another, from old to new, is paramount to the establishment of a robust, resilient, peaceful and stable society that promotes inclusive economic growth. My last piece of advice to you is that while changes are good for overall social and economic improvement, changes can also lead to equally devastating outcomes. What really differentiates the former from the latter is the means through which such changes are achieved. When people are too focused on transitional justice, on revenge, they tend to see the change of regime/system/head/government as the ends in themselves as opposed to the means to achieving greater ends like economic growth and higher overall social well-being. People over-obsessed with such idea are also more likely to think in short-term, a complete opposite of what is needed to ensure inclusive and sustainable growth, which are long-term planning, proactive and flexible strategies, and objective-based and logical mindset that dares to defy common sense. One last thing to remember, means does not justify ends.

Hope you enjoy reading the article, and I am looking forward to seeing you in the next one.