Keynes was famously quoted as saying that “practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist”.
Those words could not be more apposite than at present. David Cameron and George Osborne appear to be plotting a pragmatic economic policy, instead of an ideological one, but in reality they are enthralled by an economic world-view that no longer prevails.
Until recent decades, there was a powerful school of economic thought which argued that there was weak economic evidence that the size of the state had a negative impact on economic growth. Hang on a moment, the reader might say. What about the Reagan-Thatcher years, or the strong theoretical grounds for believing there is a negative impact? All true, but the negative impact appeared to be everywhere but in the statistics.
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If you step back for a moment, it’s not hard to reason why the negative impact was difficult to find. Disentangling the simultaneity between a larger state causing lower growth, and lower growth causing a larger state, is quite a challenge. On top of this, until the 1990s, most academic studies didn’t differentiate between the effects of productive (e.g. infrastructure) and unproductive (e.g. welfare) spending, and distortionary (e.g. income) versus less distortionary (e.g. sales or lump sum) taxes. Unsurprisingly, the tax and spend mix is important for growth.
If you looked at the academic evidence 20 years ago, the correlation between a large state and lower growth was there for all to see, but the causation was unproven. That’s the world in which the majority of our political leaders still reside. They don’t want government to be too big, but they don’t want it to be too small either. Whether it’s David, George or Boris, One Nation, big government conservatism is the order of the day.
The problem with this approach is that it’s defunct. There is now an increasingly robust body of academic evidence – using far better methodology – showing the negative impact of government on economic growth. The more sophisticated the studies, the stronger the negative impact.
Although it’s difficult to argue a precise optimum size for government, it’s definitely the case that the current (and projected) size of the state is on the wrong side of the curve. Imagine a curve plotting the relationship between size and growth. At low levels of economic development, growth and size are positively related as the public sector provides basic infrastructure. But as the size and complexity of the state grows, negative feedback effects kick-in – so-called deadweight losses. The curve rises and then falls, and we’re definitely on the downslope. Shrinking the state will accelerate growth. But this simple message is still lost on politicians, who think that a state of around 40 per cent of GDP is hunky dory. Throw in the wider impact of the regulatory state and the burden of government probably easily exceeds 50 per cent of GDP.
Having started with the words of Keynes, I’ll finish with him as well. He stated that the maximum tolerable limit of government, in peace time, was around 25 per cent of GDP. I wish he’d been right, because we’d all be a lot better off. A 25 per cent state could push the sustainable rate of growth towards 3 per cent or even 3.5 per cent.
Smaller is beautiful. Size does matter. Less is more.