Why Big Govt Works

In previous posts, we’ve seen that every rich country in the world has one thing in common: a really, really big government. And some of the richest countries in the world have the biggest governments. Up till about 1900, governments generally taxed and spent less than 10% of GDP – US government spending in 1900 was about 7% of GDP. But today the world’s richest countries tax and spend 30 to 55% of GDP – the few who spend less instead have major ownership and-or controlling interests in firms and banks. What’s more: those rich countries only became rich AFTER their big governments were in place. The flipside is that every country today that’s gone small – is poor. This plainly contradicts the conservative dogma that large government is inimical to economic growth – but the essence of dogma is that it doesnt require facts to persist, and actually does quite well in a factual vacuum.

According to a very simple economic model, there’s no way that an economy should be able to grow – much less grow well – with its government sucking up 40 to 50% of all the value created, and distributing it according to political decision-making. The free market is far better at allocating resources to fetch the highest return. In a perfect market, whoever wants something the most – and has the means to obtain it – will obtain it – by paying a higher price for it than others. Markets work by aggregating the wants and needs of many individuals – they dont have to meet and chat, they dont even have to know each other – they simply express their preferences by buying and selling at what emerges as the market price.

In order for countries to grow fast with a big government making large-scale resource-allocation decisions in place of the market, that government’s decisions have to be pretty good – as good as the market, if not better. Again, according to conservative dogma and very simple economic models, government just cant do it. But the facts say otherwise. And so do the theories.

It helps to start by looking at what those big government are lavishing all those sums on. In 1900, governments didnt do a whole lot: roads, security, the post office, elementary schools. All tolled, it didnt add up to much, and it still doesnt. The extra spending that’s been added on top falls generally into 3 major categories: education, healthcare and insurance.

Education has become a big-ticket item in the developed world. A typical rich country’s government spends about 5% of GDP on education – about the same as what the US spends each year on social security (the largest single item in the federal budget). Public education itself has moved beyond debate – not even conservatives question the value of taxing and spending for education (though they’ll question the form that that spending should take – to voucher or not to voucher, eg).

But it’s fair to ask WHY governments should be involved in education at all – why cant it be left to the markets? What makes the market for education different from the market for plasma TVs, pet grooming or accountancy? The primary obstacles are access to capital and externalities. A 6 yr old cant walk into a bank and take out a loan to pay for his education, using his future income as collateral. Even if he could, much of the benefit of his education goes to other people – education facilitates better decisions (in the voting booth, eg), and raises income, allowing him to spend more (which becomes other peoples’ income) and pay more in taxes. Education reduces social ills too.

When you dont enjoy the full benefit of a given action, you’re less likely to do it as much. If, as in education, the buyer (or investor) got the full benefit of his expenditure (or investment), there might be no need for public education. But since he doesnt, the government has to step in take up the slack.

Education can be thought of as the process by which we create human capital – and human capital is precisely the thing that makes a rich country rich. We might do a thought experiment: take 2 rich countries – let’s say Japan and Germany – and imagine what would happen if they were bombed back to the stone age – factories, buildings, bridges, roads, housing – imagine that every physical structure was annihilated. I’d wager than within a generation, they would be rich countries again. (!) The reason is that the wealth of a rich country is NOT in physical structures, nor is it in private equities or real estate, nor is it in the ground in mineral wealth – it’s in human capital.

If education is the process by which human capital is created, healthcare is what sustains it. Sick people are not productive – and when we die, our human capital dies with us. In the 19th century, even the most productive countries in the world werent terribly productive. US per capita GDP in 1900 was about the same as Paraguay’s today. In 1928, the US was only about as productive as present-day Botswana. When people got sick – not that medical care of the time could do much – it simply would not have been cost-effective to spend a lot to heal them. What’s different today is that the average resident of a developed country has an enormous stockpile of human capital. Human capital can be crudely calculated as the present (discounted) value of all future income – so a person who will make $50k/yr for 20 more years has human capital worth $1 million (before discounting).

In developed countries, middle-age people with average incomes commonly have human capital of well more than $1 million – and this is the reason why, as countries grow richer, it’s profitable to spend more and more on healthcare. (The fact that we spend a fortune on old people’s healthcare – despite their reduced human capital – will be the subject of another day’s meditation.) But why, we should ask, cant we leave healthcare to the private market? Even in the US – with the most privately-financed healthcare in the developed world – the government’s share of healthcare spending is about 45% – about 8% of GDP.

To be continued tomorrow: why the countries whose governments went heavy investing in health and social insurance cleaned up….

PS: Did anyone else notice on the Daily Show last night – John Stewart sharing a pizza with utensil-wielding NYC mayor Bill de Blasio – that Stewart fails to correctly FOLD his slice? Such is ever the case when Jersey boys impersonate real NYers – they can only sustain their farce for so long….

Refs:

http://data.worldbank.org/indicator/SE.XPD.TOTL.GD.ZS?order=wbapi_data_value_2010+wbapi_data_value&sort=desc

http://en.wikipedia.org/wiki/List_of_countries_by_spending_on_education_%28%25_of_GDP%29

http://www.usgovernmentspending.com/education_spending

http://www.qwema.ca/calc/humancapital.aspx

http://en.wikipedia.org/wiki/Jon_Stewart#Early_life

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