MADRID -- The triumph of democracy and market-based economics -- the “End of History,” as the American political philosopher Francis Fukuyama famously called it -- which was proclaimed to be inevitable with the fall of the Berlin Wall, soon proved to be little more than a mirage. However, following China's intellectual pirouette to maintain one-party rule while embracing the capitalist credo, history's interpreters shifted their focus to the economy: Not everybody would be free and elect their government, but capitalist prosperity would hold sway worldwide.
Now, however, the economic tumult shaking Europe, the erosion of the middle class in the West, and the growing social inequalities worldwide are undermining capitalism's claim to universal triumph. Hard questions are being asked: Is capitalism as we know it doomed? Is the market no longer able to generate prosperity? Is China's brand of state capitalism an alternative and potentially victorious paradigm?
The pervasive soul-searching prompted by such questions has nurtured a growing recognition that capitalism's success depends not only on macroeconomic policy or economic indicators. It rests on a bedrock of good governance and the rule of law -- in other words, a well-performing state. The West overlooked the fundamental importance of this while it was fighting communism.
The standard-bearers of the Cold War were not just the United States and the Soviet Union, but, in ideological terms, the individual and the collectivity. When competing in newly independent or developing countries, this ideological opposition became Manichean, fostering a fierce suspicion, if not outright rejection, of rival principles. As a result, strengthening state institutions was too often seen in the West as communist subterfuge, while the Soviet bloc viewed the slightest notion of individual freedom and responsibility as a stalking horse for capitalist counter-revolution.
Leading economists have long argued that the West's greater reliance on markets resulted in faster and more robust economic growth. But viewing the state and the market in terms of their inherent conflict no longer reflects reality (if it ever did). Indeed, it is increasingly obvious that the threat to capitalism today emanates not from the state's presence, but rather from its absence or inadequate performance.
Consider recent events in Argentina, which is facing certain economic losses as anxious investors have second thoughts about the country in the aftermath of the government's nationalization of energy giant YPF. That response is only logical, as investors seek the security of a well-functioning legal system to protect them from capricious political decisions.
Mexico provides further proof that the market alone is not enough. An efficient judiciary and effective policing are necessary for capitalism to thrive. In Brazil, the government is daring, for the first time, to address the lawlessness of the overcrowded favelas that ring the country's large cities. Or consider Ghana's prosperity and how, like Brazil's, it is going hand-in-hand with improved governance. At the opposite extreme, Venezuelan President Hugo Chávez's undermining of his country's institutions, prodding it onto a narco-state trajectory, places Venezuela alongside Haiti as an exception to Latin America's recent economic success.
More generally, the world's thriving countries are those with strong and effective institutions, backed by legal frameworks that guarantee the rule of law. Latin America and Africa are not the only examples that prove the point. The European Union's internal problems, and its ongoing sovereign-debt crisis, are clearly linked to the weakness of its institutions, and, on Europe's periphery, it still confronts feckless democracies.
Indeed, on Europe's doorstep, the show trial and imprisonment of former Ukrainian Prime Minister Yulia Tymoshenko is jeopardizing her country's international economic standing. In particular, President Viktor Yanukovich's contempt for the rule of law has put Ukraine's relations with the European Union in cold storage, with a comprehensive free-trade and association agreement on hold pending the release of Tymoshenko and other political prisoners. Meanwhile, political trials in Egypt are attracting international attention and deterring foreign investment.
In Asia, China is exposing the fallacy of looking at state capitalism as a competing alternative to liberal capitalism. Approaching them as alternatives is, in fact, little more than an intellectual remnant of the Cold War, much like the concept of “state capitalism” itself. With its remarkable ability to adapt, China is making strides to accommodate the rising power of its markets and people. In the process, officials are acknowledging the importance of good governance, as demonstrated by recent efforts to justify the purge and investigation of Bo Xilai as an example of the Communist Party “safeguarding the rule of law.”
Adam Smith, that icon of market theory, argued that wealth is created when public institutions enable the “invisible hand” of the market to align interests. The Cold War distorted that wisdom. In a world free of that era's ideological constraints, it is time to say loud and clear that the future of capitalism is linked to effective governance and the rule of law, and thus to the consolidation of well-functioning states.
*Ana Palacio is a former Spanish foreign minister and former senior vice president and general counsel of the World Bank. © Project Syndicate 2012