Data in New World Bank Report Shows that Large Public Sectors Reduce Economic Growth

Posted by Daniel J. Mitchell

When Ronald Reagan said that big government undermined the economy, some people dismissed his comments because of his philosophical belief in liberty.

And when I discuss my work on the economic impact of government spending, I often get the same reaction.

This is why it’s important that a growing number of establishment outfits are slowly but surely coming around to the same point of view.

This is remarkable. It’s beginning to look like the entire world has figured out that there’s an inverse relationship between big government and economic performance.

That’s an exaggeration, of course. There are still holdouts pushing for more statism in Pyongyang, Paris, Havana, and parts of Washington, DC.

But maybe they’ll be convinced by new research from the World Bank, which just produced a major report on the outlook for Europe. In chapter 7, the authors explain some of the ways that big government can undermine prosperity.

There are good reasons to suspect that big government is bad for growth. Taxation is perhaps the most obvious (Bergh and Henrekson 2010). Governments have to tax the private sector in order to spend, but taxes distort the allocation of resources in the economy. Producers and consumers change their behavior to reduce their tax payments. Hence certain activities that would have taken place without taxes, do not. Workers may work fewer hours, moderate their career plans, or show less interest in acquiring new skills. Enterprises may scale down production, reduce investments, or turn down opportunities to innovate. …Over time, big governments can also create sclerotic bureaucracies that crowd out private sector employment and lead to a dependency on public transfers and public wages. The larger the group of people reliant on public wages or benefits, the stronger the political demand for public programs and the higher the excess burden of taxes. Slowing the economy, such a trend could increase the share of the population relying on government transfers, leading to a vicious cycle (Alesina and Wacziarg 1998). Large public administrations can also give rise to organized interest groups keener on exploiting their powers for their own benefit rather than facilitating a prosperous private sector (Olson 1982).

In other words, government spending undermines growth, and the damage is magnified by a poorly designed tax policies.

The authors then put forth a theoretical hypothesis.

…economic models argue that the excess burden of tax increases disproportionately with the tax rate—in fact, roughly proportional to its tax rate squared (Auerbach 1985). Likewise, the scope for self-interested bureaucracies becomes larger as the government channels more resources. At the same time, the core functions of government, such as enforcing property rights, rule of law and economic openness, can be accomplished by small governments. All this suggests that as government gets bigger, it becomes more likely that the negative impact of government might dominate its positive impact. Ultimately, this issue has to be settled empirically. So what do the data say?

These are important insights, showing that class-warfare tax increases are especially destructive and that government spending undermines growth unless the public sector is limited to core functions.

Then the authors report their results.

Figure 7.9 groups annual observations in four categories according to the share of government spending in GDP during that year. Both samples show a negative relationship between government size and growth, though the reduction in growth as government becomes bigger is far more pronounced in Europe, particularly when government size exceeds 40 percent of GDP. …we provide new econometric evidence on the impact of government size on growth using a panel of advanced and emerging economies since 1995. As estimates can be biased due to problems of omitted variables, endogeneity, or measurement errors, it is necessary to rely on a broad range of estimators. …They suggest that a 10 percentage point increase in initial government spending as a share of GDP in Europe is associated with a reduction in annual real per capita GDP growth of around 0.6–0.9 percentage points a year (table A7.2). The estimates are roughly in line with those from panel regressions on advanced economies in the EU15 and OECD countries for periods from 1960 or 1970 to 1995 or 2005 (Bergh and Henrekson 2010 and 2011).

These results aren’t good news for Europe, but they also are a warning sign for the United States. The burden of government spending has jumped by about 8-percentage points of GDP since Bill Clinton left office, so this could be the explanation for why growth in America is so sluggish.

Last but not least, they report that social welfare spending does the most damage.

Governments are big in Europe mainly due to high social transfers, and big governments are a drag on growth. The question is whether this is because of high social transfers? The answer seems to be that it is. The regression results for Europe, using the same approach as outlined earlier, show a consistently negative effect of social transfers on growth, even though the coefficients vary in size and significance (table A7.4). The result is confirmed through BACE regressions. High social transfers might well be the negative link from government size to growth in Europe.

The last point in this passage needs to be emphasized. It is redistribution spending that does the greatest damage. In other words, it’s almost as if Obama (and his counterparts in places such as France and Greece) are trying to do the greatest possible damage to the economy.

In reality, of course, these politicians are simply trying to buy votes. But they need to understand that this shallow behavior imposes very high costs in terms of foregone growth.

To elaborate, this video discusses the Rahn Curve, which augments the data in the World Bank study.

As I argue in the video, even though most of the research shows that economic growth is maximized when government spending is about 20 percent of GDP, I think the real answer is that prosperity is maximized when the public sector consumes less than 10 percent of GDP.

But since government in the United States is now consuming more than 40 percent of GDP (about as much as Spain!), the first priority is to figure out some way of moving back in the right direction by restraining government so it grows slower than the private sector.

Freedom vs. Entitlements

Posted by Ian Vasquez

A new World Bank working paper by Jean-Pierre Chauffour (author of the Cato book, The Power of Freedom: Uniting Human Rights and Development) finds that freedom is the root cause of development. In contrast to economic, political and civil freedoms, Chauffour finds that “beyond core functions of government. . . the expansion of the state to provide for various entitlements, including so-called economic, social and cultural rights, may not make people richer in the long run and may even make them poorer.”

Should We Break Up the Banks?

Posted by Mark A. Calabria

When it comes to banking policy, there are few people I respect more than Jonathan Macey and Arnold Kling; so when these two, independently, argue that we should be breaking up the largest banks, it is idea that merits consideration.  Yet I still have my doubts.

First, lets start with what we are fairly certain of.  There is a large empirical literature that suggest most US mega-banks are beyond their efficient size.  There is a good survey of the literature by former Fed Economist Allen Berger .  So, at a minimum, the academic literature suggests the largest banks are beyond a size that is justified by the social benefits.

However, there is also a small literature that suggests more concentrated banking systems are more stable, and less prone to crisis.  Some of this literature has grown out of research efforts by the World Bank.  While this literature is largely cross-country comparisons, recalling our own banking history gives several examples - the savings & loan crisis, the mass of small banks failures in the 1920s and 1930s, and current day Georgia – where lots of small bank failures have been associated with significant economic damage.  So, at minimum, there is some question of whether breaking up the largest banks would give us a more stable, less crisis-prone system.  In fact, there is considerable evidence to suggest that breaking up the banks would make our financial system more fragile.

To some extent, the debate over breaking up the large banks is about reducing political power.  The argument is that, because of their vast resources, these large banks unduly influence and capture our political system.  Undoubtedly, I believe the largest banks have substantial influence over both our legislative and regulatory systems.  However, so do smaller banks.  From my seven years as staff on the Senate Banking Committee, I would definitely argue that the Independent Community Banks Association (ICBA), as a group, has far more pull than does say Bank of America, as a single company.  One need only witness the various exemptions for small banks in the Dodd bill, for instance from the consumer protection bureau, to illustrate the lobbying power of small bankers.  One could also argue that the economic history of progressive era legislation, like the Sherman Act, is one of smaller, organized interests winning against larger sized firms.  Despite its appeal, the assertion that bigger is always better in politics is just an assertion.  Yet this is at heart an empirical argument, and perhaps one that can be tested.  Until then, I still have my doubts.

On What Planet Is Lindsey Graham a Free-Trader?

Posted by Sallie James

I’ve just started reading a new article by economists at the World Bank and the Peterson Insititute. The gist of the paper is that greenhouse gas emission targets will have little effect on “carbon leakage”, the apparently-largely-theoretical phenomenon whereby carbon-intensive industries move to less regulated jurisdictions in response to stringent emissions regulations in their original home.  So we can strike that off our list of worries.

The authors do reach the conclusion, though, that output of energy-intensive products will decline in response to emissions caps and the political temptation for “carbon tariffs” will be strong (see here why that is a bad idea). Basing the carbon tariffs on the carbon content of imports–as opposed to, say, the carbon content of domestic production displaced– will lead to significant falls in developing country exports. Music to protectionists’ ears, perhaps, but not exactly a recipe for international cooperation or global prosperity.

I’m still digesting the substance of the paper, but I was struck by what I think is a pretty large oversight/mischaracterization in the second paragraph.  The authors refer to the “internationally-minded” Sen. John Kerry (true in the serves-on-the-foreign-relations-committee-and-speaks-French sense, I guess) and the “free-trade oriented” Senator Lindsey Graham (R, SC).

Huh? A cursory glance at Senator Graham’s record indicates that in no serious sense could he be deemed “free-trade oriented.” Senator Graham has voted to lower trade barriers less than half (43 percent) of the time and has taken only 20 percent of opportunities to cut subsidies. That puts him in the “interventionist/internationalist” camp. Maybe the authors didn’t know about the Center for Trade Policy Studies’ “Free Trade, Free Markets: Rating Congress” tool, but surely Senator Graham’s co-sponsorship of the notorious Schumer-Graham legislation, among other transgressions, should have tipped them off.

Rory Stewart on the Deep Confusion Underpinning Our Afghanistan Strategy

Posted by Justin Logan

Rory Stewart has a terrific piece in the London Review of Books arguing that Beltway foreign-policy thinkers are “minimising differences between cultures, exaggerating our fears, aggrandising our ambitions, inflating a sense of moral obligations and power, and confusing our goals” when it comes to Afghanistan:

Policymakers perceive Afghanistan through the categories of counter-terrorism, counter-insurgency, state-building and economic development. These categories are so closely linked that you can put them in almost any sequence or combination. You need to defeat the Taliban to build a state and you need to build a state to defeat the Taliban. There cannot be security without development, or development without security. If you have the Taliban you have terrorists, if you don’t have development you have terrorists, and as Obama informed the New Yorker, ‘If you have ungoverned spaces, they become havens for terrorists.’

These connections are global: in Obama’s words, ‘our security and prosperity depend on the security and prosperity of others.’ Or, as a British foreign minister recently rephrased it, ‘our security depends on their development.’ Indeed, at times it seems that all these activities – building a state, defeating the Taliban, defeating al-Qaida and eliminating poverty – are the same activity. The new US army and marine corps counter-insurgency doctrine sounds like a World Bank policy document, replete with commitments to the rule of law, economic development, governance, state-building and human rights. In Obama’s words, ‘security and humanitarian concerns are all part of one project.’

This policy rests on misleading ideas about moral obligation, our capacity, the strength of our adversaries, the threat posed by Afghanistan, the relations between our different objectives, and the value of a state…

Stewart’s prognosis is at once dispiriting and fortifying.  On the one hand, “it is unlikely that we will be able to defeat the Taliban.”  More sharply, “30 years of investment might allow its army, police, civil service and economy to approach the levels of Pakistan.  But Osama bin Laden is in Pakistan, not Afghanistan.”  On the other, “the Taliban are very unlikely to take over Afghanistan as a whole.”  Why not?

It would require far fewer international troops and planes than we have today to make it very difficult for the Taliban to gather a conventional army as they did in 1996 and drive tanks and artillery up the main road to Kabul.

Even if – as seems most unlikely – the Taliban were to take the capital, it is not clear how much of a threat this would pose to US or European national security. Would they repeat their error of providing a safe haven to al-Qaida? And how safe would this safe haven be? They could give al-Qaida land for a camp but how would they defend it against predators or US special forces? And does al-Qaida still require large terrorist training camps to organise attacks? Could they not plan in Hamburg and train at flight schools in Florida; or meet in Bradford and build morale on an adventure training course in Wales?

So what on earth are we doing?  “No politician wants to be perceived to have underestimated, or failed to address, a terrorist threat; or to write off the ‘blood and treasure’ that we have sunk into Afghanistan; or to admit defeat. Americans are particularly unwilling to believe that problems are insoluble; Obama’s motto is not ‘no we can’t;’ soldiers are not trained to admit defeat or to say a mission is impossible.”

World Bank Criticizes Corruption in Argentina, Then Awards its Government $2 Billion

Posted by Juan Carlos Hidalgo

According to the Argentine daily La Nación [in Spanish], the World Bank warned yesterday about “corruption, money laundering, inflation, indebtedness and nationalizations in Argentina.” Then the WB went ahead and approved a series of loans to the country for approximately $2 billion.

The Argentine minister of Labor said that the credits were “a good sign of confidence” by the World Bank on the country.

The Compatibility of Growth and Human Rights

Posted by Ian Vasquez

Do trade and economic growth conflict with human rights?

Too often, human rights advocates present development as incompatible with rights. So-called development agencies like the World Bank often ignore rights, including personal choice, when they push for top-down growth strategies around the world. Jean-Pierre Chauffour will speak at the Cato Institute tomorrow on his new Cato book, The Power of Freedom: Uniting Human Rights and Development, where he takes the human rights and development “communities” to task for working at cross purposes and muddled thinking.

Sign up here or watch online to hear him present a development agenda that respects the full range of human rights. Susan Aaronson of George Washington University will comment.