Why Big Govt Works – Part 3

Before the 20th century, government didnt do a whole lot – but there wasnt much a government could do. The fact that private markets dont do a very good job providing healthcare and education wasnt so big a deal then: the return on investment for education was low, so no big opportunity was being missed. And since human capital stocks were also much lower, there was no big bang in investing in healthcare either – not that 19th century medicine offered much. (The gains in life expectancy during the 19th century are more attributable to improved sanitation.)

Come the 20th century, things changed. The returns to education took off – people who stayed in school enjoyed big increases in income – and as incomes rose, people became more valuable, and sickness and death became far more costly – and thus medical care became cost-effective. After WW2, every country which would become rich struck on this same formula: heavy taxation and commensurately heavy public investment in health and education.

In 1950, even the Western countries who made it through WW2 with their infrastructure intact werent particularly wealthy. Australia, Canada, Sweden and Denmark – then ranked 5,6,7 and 8 in per capita GDP – had similar incomes to present-day Botswana, Bulgaria, Peru and Turkmenistan. Fast forward to today, and we see that under their big governments, those western countries grew their per capita GDP by a factor of 10. The US, with its much smaller govt, only saw per capita GDP increase by a factor of 5.

Beyond health and education, social insurance is the budget item that rich governments spend the most on. While a typical western government spends about 5% of GDP on education and 10% of GDP on health care, it spends 10 to 20% of GDP on social insurance – excluding health insurance. As seen in yesterday’s post, insurance markets are beset by difficulties of adverse selection and asymmetric information. The solution – for insurance markets to provide a valuable service – has been heavy government regulation, if not wholesale direct government provision, as is commonly the case with social insurance.

When conservatives whine and cry about social insurance, they make generic arguments that are equally applicable against ALL forms of insurance. Typical conservative blather in opposition to unemployment insurance and welfare, e.g., is indistinguishable from opposition to every other form of insurance. If UI is bad because it lets people be rude to their boss and picky about their next job; then auto insurance is bad because is facilitates riskier driving; and homeowners’ insurance is bad because it encourages people to use their fireplace more (while cleaning their chimney less); and health insurance is bad because it makes people more likely to ski; and bailouts are bad because they make banks more likely to undertake risky investing; and of course old age insurance (aka “social security”) is bad because it lets you save less for retirement – etc., etc. What these arguments have in common is that they are all fundamentally TRUE.

Acquiring insurance changes your behavior – this is referred to as “the moral hazard problem.” Obtaining insurance to cover yourself in case of a particular loss often alters your behavior in such a way as to make that loss more likely. In other words, insured people behave worse than uninsured people. – But not that much worse – and that’s the key insight. In order to obtain an insurance benefit, you generally have to incur a loss – losses are unpleasant, and insurance rarely covers the full cost. People dont like losing their job or crashing their car – and the stats bear this out.

Unemployment isnt any higher in places where benefits are cushy. In Europe, a generous welfare state is accompanied by high labor force participation and low poverty. Further, generous welfare doesnt bust budgets: the government debt in most western European countries is lower than that of the US. In Scandinavia – where social insurance is most generous – government debt is half that of the US.

If you complained to friends that your car insurance was a rotten investment because you hadnt had a wreck or severely injured someone – they might think you were loopy. Complaining that Social Security is a “bad investment” is no less silly. Social Security is an INSURANCE program, not a mutual fund – it helps to call it by its more precise name: old age and survivors’ insurance. As with most forms of insurance, the way to come out ahead is (usually) to suffer a really bad loss. You can do quite well with your social security “investment” by dying young and leaving behind a family to collect, or by becoming disabled, or by outliving your savings. In the way that life insurance takes care of your family in case you die, old age insurance takes care of you in case you dont – or your family in case you do. Sheer genius.

Unlike health and education, the relationship between public spending on social insurance and economic growth is one of the most complex and subtle areas of economics. One theory is that generous social insurance subsidizes risk-taking – people are more likely to gamble on career choices with a reliable safety net – and in the aggregate, taking risks grows the economy. Another theory is that by taking care of old people through old age insurance, their children have more to invest in themselves and their own children. Another theory is that, by reducing poverty, social insurance ensures that children are able to realize their full potential. Child poverty is associated with inferior outcomes later in life in every dimension. Adults who began life in poverty tend to have shorter lives, lower incomes, reduced employment and higher crime rates.

WIth its weaker social insurance regimes, the US child-poverty rate is over 20% – the highest in the developed world. Hungary and the Czech Rep., with just one-third of US income, have half the child poverty. The US has a higher child-poverty rate than Latvia, Estonia, Greece or Portugal! The US doesnt just have the MOST child poverty in the west – it also has the WORST. Unicef found that American poor kids were much further below the poverty line than poor kids in other countries.

And while the US has more poverty than any western country, it also has less social mobility: kids born into American poverty are far less likely to escape than kids born into poverty elsewhere. In America, the income strata you’re born into is much more predictive of where you end up. Indeed, the American dream has packed up and returned to the old country….

Conservatives would have you believe that a smaller government is better for economic growth – but that view is utterly at odds with the facts. Countries that spent generously on health, education and social insurance since WW2 experienced the best economic growth ever seen in human history. While the US spent a lot on education, it remains the only developed country without universal health insurance, and still tries to get by on minimal social insurance – American growth has suffered as a consequence. Before the industrial revolution and the explosion of technology, individual human beings had much less potential. There has never been so much knowledge and skill to acquire, nor better medical care to remain healthy – and the only way to take advantage of these opportunities and maximize growth is through public investment: in health, education and social insurance. It takes a big government to accomplish all that – but in the end, we’re all richer for it.











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