Is Big Government Necessarily a Bad Thing?

by: Shareholders Unite

Suddenly, capitalism is in flux. The superiority (or at least, perceived superiority) of the Anglo-Saxon free market model has waned. What's next? Critics of the bailout and expansionary fiscal policy to stimulate the economy scare us with a socialist vision of big government. Some corners of the US political spectrum orchestrate a tax revolt. Do they have a point? A cool, detached look at some stylized facts goes a long way to dispel these fears..

So here are five stylized facts and some conclusions

First, the superiority of the Anglo-Saxon model has never been a universal truth. In the 1980s, the Japanese model was all the rage. The social-market model of Germany has also been much in vogue for long stretches of time, so this perceived superiority was something of the last decade or so, after the mid 1990s when labour productivity growth took off and the creative destruction of entrepreneurial spirits seem to reign supreme.

But until that time, growth in labour productivity (the single most important economic statistic) was considerably higher in Northern Europe (let alone Japan), so it matters which period one is studying, and what preferences one has.

Second, speaking about preferences, yes, Americans are richer than Europeans, on average. But the latter have (on average, Europe is a diverse place) lower crime rates, universal health care (at much lower cost than US), and much longer holidays. It's a matter of taste which is better.

Third, some European countries, like Sweden, Denmark, Finland, The Netherlands, have levels of Government spending and taxing (as % of GDP) that would really scare the hell out of many Americans if they see these figures (40-55%).

Yet, are these countries socialist? Hardly. In fact, all of them have rather dynamic, innovative market economies and (until recently at least) well performing economies. Again, it's a matter of taste, but to say that a government share of 40 or 50% of GDP necessarily means a stifled socialist economy is simply belied by the example of these countries.

Fourth, there are a couple of tendencies which automatically tend to increase the government share of the economy when a country becomes richer. One important mechanism is known as 'Baumol's disease'. Industry can raise labour productivity year-on-year, but this is very difficult in much of the public sector, and this has important consequences.

Government is in education, health-care, national defence, governance, all sectors for which it is very hard to raise labour productivity (through automation). However, for the sake of labour market competition and issues of fairness, it has to offer similar salaries as industry.

Industry can raise wages and pay for it through increases in labour productivity, and overall labour cost will remain flat. If the public sector raises wages at similar rates, but without the offsetting increases in labour productivity, it means that its labour costs will increase, relatively to industry (or the private sector at large, although this is a bit of a simplification).

Which means the public sector is slowly getting more expensive, even without a single new policy initiative!

Is this bad? Not necessarily, because higher incomes in the private sector also increase tax income, at least partly offsetting the increase in public sector cost, and;

Fifth. As people get richer, their preferences change. They place more importance on a safe environment, on healthy products, on a cleaner environment, better schools for their children, better healthcare, etc. all sectors which make disproportionate claims on the public sector (through regulation, justice, law enforcement or direct government involvement).

So, apart from Baumol's disease, here is another mechanism that tends to disproportionally increase demands on the public sector as economies get richer.

Market fundamentalism

Virtually none of these above arguments appear in the US media, not even the more serious one. There seems to be a knee-jerk reaction that bigger government is necessarily bad. Part of this can be attributed to America's (somewhat idolized, perhaps) history of self-made people.

But it often runs into extremes. Much of the present crisis is attributable to the simplistic market fundamentalism (we already wrote about that here), in which markets are always right, government is always the problem, never the solution (except if one's company is threatening to go bankrupt), and regulation is a dirty word.

It can also be seen in the attitude of the new government (notwithstanding Obama's very liberal voting record) towards what is clearly the most practical solution to the banking crisis, temporary nationalization, like Sweden did in the early 1990s.

We find it difficult to believe that Summers and others are not aware of that, the problem is that it is perceived as political suicide because it smacks of socialism. The latter is curious indeed, because there is a very good capitalist principle at work in temporary nationalizations; those who pay, should be able to determine policy.

That is, since the government is already effectively providing most, if not all the capital, it should not only get a return on that (as they did in Sweden only a few years after buying the banks), they should also be able to determine bank policy.

One advantage, we wouldn't have had to worry about all the excess nonsense (corporate jets, bonuses, etc.) that was still going on at banks that were already on public life support (instead, we could have kicked these people out). Another advantage, banks could have resumed lending again.

It's perhaps too much of an inconvenient truth that state run Chinese banks, despite collapsing exports (far worse than anything that has hit the US), are lending at record pace. That's countercyclical policy necessary in a deep recession.

The same knee-jerk reactions were visible against the stimulus package. Socialism, we read from the market fundamentalists. Yet what is the alternative? Balance sheets shrink further, creating self-reinforcing feedback loops with consumption and investment, and possibly with falling prices.

No good will come out of that, we know that since Irving Fisher in the 1930s. But ideology seems to have a stronger hold in the US than economic rationality.

Better government is more important than smaller government

Whether big government is necessarily bad government has a lot to do with how the state, and more especially the political process, is organized. In many developing countries the state seems to be seen as a instrument to enrich one's family (Soeharto, Mobutu) or clan (Mugabe), for instance.

This is not usually a recipe for efficient governance, although Indonesia under Soeharto is in quite a different league compared to Mobutu's Zaïre Mobutu, let alone Mugabe's Zimbabwe.

America's political process seems especially prone to special interest (most of all, from big finance, as has been argued very persuasively by former chief economist of the IMF, Simon Johnson), which doesn't particularly bode well for efficient government either.

Witness the curious disconnect between the adherence to a rather simplistic version of market fundamentalism and the way all kinds of special interest (farming, big energy, financial sector, big three car manufacturers, etc.) are protected and receive almost tailor made regulation (or the lack of it) which seem to come directly from industry lobbyists.

Such practices are widespread in many countries (one visit to Brussels might testify to that), but in the US they seem particularly successful and often display a more or less direct link to campaign finance.

One important condition of efficient big government is therefore that special interests are kept at bay. For this, the presence of a bureaucratic class which regards itself as the guardian of 'the national interest' often helps a lot here.

This is one of the reasons that Japan, and other Asian countries, thrived economically, policy-making was often in the hands of capable bureaucrats with a longer time horizon compared to politicians. Some of the results are immediately visible. In many Asian countries, the public infrastructure is much better than that in the US (go to any airport, train station, etc.).

The US still has a nucleus of this, much of the ICT revolution originated in semi-public (largely defence) agencies, and the industrial revolution before that thrived largely because the excellent educational system the US once had, producing scores of engineers without which those robber barons could not have thrived.

The US needs less of it's simplistic market fundamentalist ideology (coming directly out of a 20 year old economics101 textbook, which could never account for the success of Japan and other Asian countries), which bares most of the blame of the present mess, and start with a more 'evidence based' practical economic policy, based on what works.

That will rekindle the wealth creating animal spirits, as it is not socialism that we are pleading for, but a less simplistic and dogmatic, more practical version of capitalism.