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Stopping the growth of government

Published in The National Business Review (Auckland), 31 August 2013

In previous years Dr Oliver Hartwich spoke at The Centre for Independent Studies ‘Consilium’ conference about the future of capitalism and about Europe’s economic and social decline. His presentation to this month’s gathering in Queensland is closely linked to these topics.

What I have previously argued, at Consilium and elsewhere, is this: Since the beginning of the Global Financial Crisis, or indeed the Great Recession as it is now often referred to, we have been witnessing not a crisis of capitalism but mainly a crisis of government: It is a crisis of governments that have grown too big, too intrusive, too taxing, and too indebted.
This is most clearly on display in Europe.

But this is not just a European problem. The growth of government is a phenomenon in most developed nations. Government has been growing since the beginning of industrialisation, and this growth has accelerated since the First World War.

Today, I would like to speak about how much government has grown. I will also go through some of the theories explaining this growth of government, mainly from a public choice perspective, and then we need to talk about the debt burden this has left behind.

Finally, I will be looking at ways in which the trend of increasing public expenditure might be reversed – that is, if it can be reversed at all. Within systems of representative democracy and in a world that is undergoing a fundamental demographic change towards older societies there may be some doubts about that.

To begin with some history, the first economist to hypothesise about an ever-growing government was Adolph Wagner.

Wagner was a leading Kathedersozialist in Imperial Germany, that means he was an academic socialist, and he is best known for Wagner’s Law. In its simplest form it states that demands for publically delivered social services will increase the size of government over time.

Wagner had observed some growth of government in his lifetime. He lived from 1835 to 1917. However, when he first theorised on Wagner’s Law in the late 19th century, government was still tiny – at least by today’s standards.

In 1870, general government expenditure in Germany accounted for 10 percent of the economy. It was virtually the same in the United Kingdom at just over 9 percent, only 6 percent in Sweden and 7 percent in the United States. Australia, by the way, had one of the largest government sectors at the time, accounting for more than 18 percent of the Australian economy.

The average government sector in Western countries accounted for a little more than 10 percent of GDP in 1870. On the eve of World War I, this had risen to 13 percent. The War then led to a quick jump in government spending, for very obvious reasons, and by 1920 it stood at 20 percent. But in the Interwar period, it never fell back to the previous level. In fact, the Great Depression pushed it up even higher.

On the eve of World War II, it had reached 24 percent. And then another wartime government expansion followed, which after 1945 continued as developed countries expanded their welfare states.

This was also exacerbated by the rise of Keynesian economics, which provided governments a licence to borrow and spend their way out of trouble – by the way, Keynes himself once said that government should never get larger than 25 percent of GDP!

As a result of all these development, on the eve of the Global Financial Crisis, in 2007, Western governments accounted for 42 percent of their economies on average, ranging from 35 percent in Australia to 53 percent in France.

What we can see here is a pattern, which was described by American economist Robert Higgs in his book ‘Crisis and Leviathan’ as the Ratchet Effect. In times of real or imagined national emergencies, mainly wars and recessions, government takes over previously private rights and activities. When the crisis then passes, government retrenches somewhat, but never to the same level as before.

Whether it is Wagner’s Law or Higgs’ Ratchet Effect: There is obviously something systematic about government growth, which makes it all the more frightening from an economic liberal’s point of view.

What is equally worrying from a liberal perspective is the changing composition of government spending over the past one and a half centuries. The core functions of the state are law and justice, defence and public order, and the provision of public goods.

But it is not in these core services where the bulk of government growth has occurred. Instead, we find that government has mainly grown because of the expansion of the welfare state.

To give you some figures, at the beginning of the 20th century, social transfers as a percentage of GDP were somewhere between zero and 1.4 percent of GDP in the Western World. At the end of the 20th century, most developed nations redistributed between 20 and 30 percent of GDP through the welfare state.

As a matter of fact, Australia had one of the lowest shares of social transfers at around 15 percent of GDP back then – but that figure alone is about as large as the whole of government spending a century earlier.

There is probably some truth in both Wagner’s Law and in Higgs’ Ratchet Effect: Governments have expanded in times of crisis, and they have done so also to meet the public’s growing expectations of social services. In effect, government growth is really the growth of the redistributive state. It’s the state that robs Peter to pay Paul – and often it also robs Peter to pay, well, Peter.

The great French economist Frédéric Bastiat put this very elegantly: “Government is the great fiction, through which everybody endeavours to live at the expense of everybody else.”

Economic research, particularly in the school of public choice, has tried to analyse in greater detail how and why government grows. This is not just an exercise of academic interest. Because if we understood better the forces pushing forward the boundaries of the state, we might know how to push them back.

Unfortunately, what economics teaches us is pretty sobering. Gordon Tullock, one of the founding fathers of public choice economics, first described the practice known as ‘log rolling’. It means that in a representative democracy, voting coalitions can be formed.

Politicians support each other’s pet projects so that in the end an increased number of projects get realised which otherwise would have failed to win majorities. This is not just a theoretical possibility. In his farewell message to politics, the independent MP for Lyne, Rob Oakeshott, pointed out that $1.2 billion had been invested in his constituency.

One may well wonder how much Lyne would have received without Oakeshott’s support for the Labor minority government.

Gary Becker, the Nobel Prize winning economist, added a theory on the influence of lobby organisations to the political decision-making process. It helps to explain how interest groups manage to generate funding for their political causes. One typical way is to stress the public goods character of their industries.

So for a teachers’ union, it is much more promising to campaign for more teaching jobs, rather than higher teacher wages.

Another view on spending decisions in a democracy focuses on the size of interest groups. This goes back to Mancur Olson’s work.

Put simply, Olson’s theory predicts that small groups with highly specific interests, say Australian car manufacturers, will always find it easier to push through their demands than large groups with very diverse goals, say Australian taxpayers.

For an individual Australian taxpayer, it is not worth protesting much about the subsidies paid to Ford, Toyota and Holden. But for Ford, Toyota and Holden it makes a lot of sense to lobby for increased taxpayer support.

Studying economics, I am afraid, is not the best way of becoming an optimist. On the contrary, it is a sobering exercise because it reveals clearly why government has grown and what factors have driven this growth. It is a combination of growing expectations of redistribution, combined with log-rolling in representative democracies, and the influence of lobby groups and bureaucracies.

Government has grown so much in many Western countries that the increased demand for public services and redistribution could not be met by tax revenue alone, and continued borrowing has left behind an enormous burden of government debt.

I will spare you going through the official debt to GDP ratios in the developed world. And I do so for two reasons: First, you would all be very familiar with them by now, because we have been talking about little else throughout the Great Recession and the euro crisis. And second, the figures are largely meaningless because they do not give you a realistic picture anyway.

The official debt to GDP measure ignores what is going to be the biggest driver of government spending and government debt for the next decades, and that is demographic change. And on that, I need to give you a few figures at the risk of turning you into insomniacs, because they may rob you of your sleep.

According to the World Bank, the age dependency ratio – that is ratio of those typically not in the labour force and those typically in the labour force – currently stands at around 50 percent in most Western countries. By 2050, this ratio will go up to 66 percent for Australia, 68 percent for the UK, 78 percent for Germany, 82 percent for Italy and 89 percent for Japan.

Another way of looking at it is the development of the median age. In 1950, the median Italian was 29 years old. By 2050, the median Italian will be 52 years. Over the course of a century, across the developed world, median age has shifted upwards by around 20 years.

What this means is that with current expectations for healthcare and state pensions, government debt will spiral out of control. On a business-as-usual assumption, the OECD estimates that all developed countries would reach debt to GDP ratios of between 250 and 600 percent by 2040. Or, put more simply, they will all be bankrupt.

So what can we do about this today? I am afraid, there are no simple answers. But one thing is clear: By far the greatest threat to public finances in the long term is demographic change. This has the potential to dwarf all previous expansions of government. The sums are almost too large to imagine.

Any attempt to limit the growth of government and government debt has to tackle the ageing population first. But you should not wait with ultimately unavoidable pension and healthcare reforms until pensioners form the majority of the voting public.

From economic research we know that a larger government sector reduces the growth potential of the economy. We also know that more government debt further decreases an economy’s growth potential.

Shrinking government spending and government debt is vital if we want future generations to enjoy prosperous lives. Unfortunately, given the mechanisms of representative democracy in an ageing society, this looks like an impossible task.

To say it with the old Irish joke: I wouldn’t start from here.

But we have to start here. And we have to start now.

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