Why government spending doesn’t pay

Published in Business Spectator (Melbourne), 20 March 2014

Given the troubles of Europe’s welfare states, it is hard to deny that large public sectors have a negative impact on economic growth. Where government grows too big it crowds out private activity, redirects resources from productive to unproductive uses, and stifles the economy with extra regulation and bureaucracy.

Though most economists would probably accept that there is a negative correlation between the size of government and economic growth, they would nevertheless often qualify this stylised fact: Yes, they would argue, big government can reduce economic activity. But if government focussed spending on investment rather than consumption, then the growth effect of government spending could still be positive.

The implicit assumption is that government spending is neither inherently good nor bad. It all depends on what government actually spent its money (or rather the money it had to raise in taxes or borrow).

A new paper published by the Centre for Policy Studies, a leading British think tank, suggests that there is no reason for such optimism. Not Paved With Gold: Government ‘Investment’ Does Not Equal Growth, authored by economic consultant and investment analyst Brian Sturgess, comes to a much more sobering conclusion: There is no positive correlation between economic growth and public investment spending.

In his study, Sturgess analyses growth and spending data for 19 European OECD countries over a period of 15 years from 1996 to 2011. His first, rather unsurprising finding is that the traditional roles of the state as a provider of law, defence and public order are completely eclipsed by other activities. On average, governments now only direct 19 percent of their total spending to their core responsibilities. However 10 per cent are spent on subsidies and infrastructure, 12 per cent on education, 15 per cent on health and 38 per cent on social security.

Even among the most ardent free-market economists, very few would argue against the state’s role in law, defence and public order. However, it is clear that looking at governments’ budgets today this is not really what we are talking about when discussing whether government has become too big. It is all the other functions that have driven the growth of government. Sturgess’ question is what increased government spending has achieved in these areas. In particular, he set out to establish if there was an empirical relationship between different types of government spending and economic growth.

Sturgess’ answers will disappoint anyone who believes that one can neatly differentiate between ‘good’ and ‘bad’ government spending. According to Sturgess, outside the state’s core functions, pretty much all government spending is bad spending (or at the very best neutral spending). Sturgess argues that government spending does not increase growth.

The best growth effect of all government spending Sturgess identified is in the area of education. In fact, there is no growth effect at all. Governments may spend more or less on education but it does not have a statistically significant effect on economic growth. So to put it positively, more education spending does not do any economic harm.

For other areas of government spending, the net effects are far worse. In health, for example, more government spending actually correlates with significantly less economic growth. “The estimated relationship implies that reducing the average proportion of resources devoted to public health expenditure from 6.5 per cent to 6.0 per cent among the OECD countries studied would be associated with an increase in real economic growth of 0.4 per cent per annum,” he writes. “This is a large amount of resources that could be allocated to other uses. Over a longer period of time the impact is more dramatic because of the effect of compounding.” Perhaps more health spending makes a population healthier (although even that is debatable) but it does not help the economy.

For social security spending, the numbers look even worse. The money spent on sickness and disability benefits, old age pensions, transfers to family and children, unemployment, housing and other benefits are growth killers. For every additional percentage point of GDP dedicated to such elements of social security, annual GDP growth is about 0.2 per cent lower.

Clearly then, government spending on education, health or social security does not make the economy grow faster. But what about actual government investment in infrastructure? It is a widely held view that such investment can improve economic performance. For example, the European Commission claims that investment in roads lifts productivity and in this way contributes to economic growth. But does it really?

“Comparing average road infrastructure expenditure by country over the period 1996 to 2010 to average real GDP growth produces no evidence of the existence of any relationship between the two economic variables,” Sturgess concludes. “The calculated correlation coefficient between average infrastructure expenditure on roads as a proportion of GDP and average real GDP growth for each country over the period analysed was an insignificant minus 0.066.” So building roads is obviously not the productivity lifting panacea that many politicians believe it is.

There are a number of potential objections one could raise against Sturgess’ findings. First of all, correlation does not equal causation. This is to say that it is possible that higher public spending on, say, health and lower economic growth rates have nothing to do with each other. They just happen to occur together. One might also say that just aggregating all spending on education is too blunt since it does not differentiate between, say, investment in better teachers (often highly productive) and investment in, for example, new school halls (often less so).

Having said that, Sturgess’ main claim is entirely plausible: That government cannot grow an economy by appropriating more resources to itself. Markets are very good mechanisms for allocating resources via the price mechanism. By destroying the price mechanism, and by also undermining the incentives to disciplines of the market place, government almost by definition weakens the economy’s potential.

Sturgess therefore writes that his “results show no relationship between the main sectors of public expenditure and real GDP growth. This should not be surprising as it has been the view of many economists for a long time that the larger the size of the state, the lower a nation’s prosperity.”

As plausible and unsurprising as these findings are, it is useful to hold the cold, hard empirical facts against political rhetoric promising public ‘investment’ for a growing economy. Nothing could be further from the truth.

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