The Role of Government in the Economy

Capitalism and its Discontents

By Michael J. Boskin, May 1999

Adam Smith, regarded by many as the intellectual godfather of modern economics and the case for a decentralized competitive market economy, focused his heaviest guns on mercantilism, a topic, by the way, not without relevance today. In the almost two and a quarter centuries since Smith wrote The Wealth of Nations, economic systems have developed in various forms in different places. Serious scholars as well as a much larger number of pundits have debated their relative economic success and moral underpinnings. Within our own profession, the center of gravity has waxed and waned among different schools of thought and political and economic persuasions. It was not all that long ago that Friedrich Hayek and then Milton Friedman were relatively lonely voices calling for restraining, indeed reducing, the role of government in the economy.

What I would like to do briefly is review a few such episodes in economic and intellectual history, to shine some light on the recent calls for abandoning the capitalist model (or, more accurately, usually some highly distorted caricature of the capitalist model) in favor of some alternative. These episodes include during the Great Depression, communism; in the post-World War II period, market socialism; as recently as the 1980s, the convergence of all economic systems to heavily managed gigantic welfare states; in the 1990s, calls for a "third way," based on some other system of values; and the almost hysterical recent calls from hedge fund managers, prime ministers, pundits and even economists who should know better to "do something" about "global capitalism." Commentaries with titles such as The Crisis in Global Capitalism, Global Capitalism RIP, Collapse of Capitalism, Who Lost Capitalism? and The Free Market's Crisis of Faith deserve a response, for their prescriptions of capital controls and even larger government almost certainly will cause great harm to those the authors claim to want to protect.

My own strongly held belief is that a limited government-based capitalist economic system not only is the system most likely to deliver the greatest economic progress but is the model most consistent with substantial personal economic and political freedom. However, I want to focus primarily on results, to play the role of positive scientist, not moral philosopher, despite the temptation to do so given that Adam Smith himself was a professor of moral philosophy. Let me emphasize that I am discussing large differences in the economic role of government. Criteria for determining the appropriate role of government are discussed below.

THE GREAT DEPRESSION

Many of us are too young to have known from personal experience but recall, from what we were taught and what we read, that, in the Great Depression of the 1930s, a large number of intellectuals and others in Western Europe and North America turned to communism or at least lent it a sympathetic ear, given the horrible destitution of that period. (In the United States, real gross domestic product fell by one-third from 1929 to 1933 and the unemployment rate reached almost 25 percent.)

Many writers had emphasized booms and busts in economic systems or economic history. These were not, of course, confined to the post-Industrial Revolution capitalist market economies. In earlier times, a bad agricultural harvest could devastate a country operating under a monarchy or feudal system. But Marx, and others, had preached the collapse of capitalism and its tendency to exacerbate booms and busts. Whether it is the case that an economic system that leads to substantial economic progress is more subject to episodic downturns than those that do not is an open question, but I know of no convincing study that suggests this is more likely in a modern mixed capitalist economy than in other economic systems.

But the long-run improvement in the standards of living of large segments of the world's population has been greatest in the capitalist era, as has the correlated evolution of personal freedom. There has never been a period in human history that even remotely compares to the tremendous growth in material wealth and personal freedom in the period since Smith wrote The Wealth of Nations (see D. Landes 1998).

To be sure, large segments of mankind were left behind, both economically and politically. As a gross historical generalization, they were in societies that lacked both economic and political freedoms and competition. Although the capitalist economies have wide dispersions in the distribution of consumption, the average poor family in the United States has a standard of living well beyond that of the average Russian family, for example, and above that of the average American family of a couple of generations ago.(2) And the most entrenched poverty in the American economy occurs in pockets of a quasi-socialist economy, with little competition, private capital, or private incentives, such as inner-city public housing and schools.

Returning to the Great Depression, the most famous economic treatise of the time, Keynes's General Theory of Employment, Interest and Money, was viewed by Keynes himself as an attempt to salvage capitalism itself from the onslaught of communism. While parts of the General Theory have subsequently been questioned, revised, reinterpreted, or rejected, what Keynes saw himself as trying to do was much more than an intellectual exercise explaining how an economy could wind up in a low-level equilibrium with massive unemployment for extended periods of time, something that could not be readily explained in the classical model because wage rates would have fallen or some other mechanism would allow the economy to get back quickly to full employment. Rather, he viewed himself as proposing policies by which modern capitalist economies could mitigate some of the excesses of business cycles (although there is nothing in the periodicity and amplitude of those fluctuations to warrant the term <cycle>) and thereby preserve much of the basic microeconomic structure, individual decision making, and personal freedoms of market economies. Keynesian economics, of course, became an important part of the intellectual justification for the growth of government in the post-World War II era.

POSTWAR GROWTH OF GOVERNMENT

The post-World War II era has seen the expansion of the absolute and relative size of governments in most market economies and democracies. In the United States, for example, in the mid-1950s, during the Eisenhower administration, federal government spending was only $70 billion; today it is more than five times as large in constant dollars and a larger share of GDP. Also during the Eisenhower administration, one out of every seven dollars of the then absolutely and relatively much smaller government spending went to transfer payments; the other six were spent on purchasing goods and services, from defense procurement to the interstate highway system. Today the majority of the much larger absolute and relative size of federal spending, net of interest on the debt, is on transfer payments to people. Thus, it is not only the size but the role of government that has changed.

Of course, in Western Europe, government had become even larger--and done so earlier--than in the United States. By the 1970s, taxes and spending accounted for over half of GDP, massive transfers were undertaken, and substantial regulation, nationalization of key industries, and restrictive labor market rules were implemented or followed. Sweden, often the darling of Western intellectuals because of its economic performance in the early postwar period, had at one time almost 9 percent of its GDP devoted to industrial subsidies! At the same time, we had a communist, authoritarian, centralized, bureaucratic, command-and-control model, most often associated with the Soviet Union and other economies in Eastern Europe but also with important less-developed economies such as China. Not just Hayek and Friedman thought that these economies would collapse from the weight of all this government taxing, spending and regulation, which would not only mean a smaller private sector but substantial stifling of private initiative to work, save, invest, and innovate.

The other alleged "intermediate" model was the market socialism of then Yugoslavia. A popular prediction of politicians, economists, and pundits was that the world's economic systems would somehow converge somewhere in the region between the Swedish and the Yugoslav economies. The capitalist economies would grow larger welfare states, the communist countries would round off some of their rough edges, and we would all happily converge in the "middle." This of course was ridiculous and not just in hindsight.

Meanwhile, the United States did experience an explosive growth of government in the 1960s and 1970s, accompanied by high and rising inflation (as the then unindexed tax system dragged a large fraction of the population into higher tax brackets); more regulation (both of traditionally regulated industries and, for social purposes, often of a command-and-control structure); and huge growth and centralization of the government. Still, the total size of government in the U.S. economy relative to Western Europe was modest, about two-thirds as large as measured by the government spending and tax shares of GNP. The same could be said of Japan, the other major industrial economy.

THE CASE OF JAPAN

The rapid growth of Japan led to the next nonsensical attack on the limited-government capitalist model. The Japanese economy grew rapidly in the postwar period up to the 1990s, and the Japanese did many things that any economist would applaud. They had high rates of saving and investment, worked hard and long hours. The relative success of the Japanese economy and to a lesser extent the German economy led in the 1980s to calls for the United States to emulate these economies. How quaint these calls seem now, given the immense problems of the German and Japanese economies in the 1990s. The calls were for a larger role for government, worker/business/government councils, government direction of private pension funds into "needed infrastructure" (a proposal both in President Carter's 1980 reelection campaign and in Clinton's 1992 campaign), managed trade, and an industrial policy of the government picking winners and losers for subsidies and protection (see L. Tyson 1993; R. Reich and I. Magaziner 1982).

Indeed, I recall in 1989 when I was first sworn into office as CEA chairman, the first thing I did was put my personal standing and credibility on the line with President Bush to help stop a multibillion-dollar "let's catch up with the Japanese in analog HDTV" (high-definition TV). The fear of the Japanese in the late 1980s was incredibly palpable. They were growing rapidly, we were growing slowly; there was large Japanese investment in the United States (although hardly mentioned were the larger British and Dutch foreign investment in the United States); many predicted they would overtake or outcompete us (see L. Thurow 1992). Some panicked pundits and political figures, joined by some powerful business interests and some economists and would-be economists, clamored for the government "to do something."

Clearly, the Japanese markets were not nearly as open as ours or as they should be, as a rich industrial country benefiting from the global trading system. But the notion that we should spend billions of dollars to catch up with them in a policy chosen by government bureaucrats and congressional staff seemed ridiculous to me. Knowing I would be accused of being an ivory tower academic, I called the CEOs of the firms that would likely be involved and asked to speak with their top scientific people. Every single one of them told me that we would never catch up but, even more important, that analog would soon be surpassed by digital, probably within ten years.

Of course the digital age came even sooner, and analog HDTV became obsolete. Led by then Senator Gore and House Majority leader Gephardt, the calls for an American industrial policy were intense. The Congress demanded the administration list all critical technologies, presumably as a prelude to government subsidies replacing market decisions. Fortunately, President Bush said no to the HDTV subsidies, and we did not waste billions of dollars trying to emulate some other economic system.(3)

Much more fundamental, whatever the merits of a particular case, was the misreading, or perhaps misappropriation for political purposes, of Japanese economic history. Japan's success had little or nothing to do with the government's micromanagement of the Japanese economy. As we have seen in the 1990s, that micromanagement has caused severe problems and made it immensely difficult to unwind foolish economic policies. In fact, the notion that the Japanese government was heavily subsidizing "sunrise" industries while we were foolishly ignoring them flies in the face of facts. In Japan, heavy subsidies in terms of protection, direct subsidies, tax breaks, and the like went to industries such as textiles, mining, and agriculture (Beason and Weinstein 1994), which is perhaps not surprising to anybody who studies politics because they were entrenched industries with strong political constituencies and large employment. The same "we know better than the market" Japanese bureaucracies tried to get the Japanese auto companies in the 1950s to produce a version of the Volkswagen Beetle; instead they went their own way and were highly successful. Those same bureaucracies tried to prevent Sony from getting into the consumer electronics business. And their fifth-generation computing project as well as the analog HDTV effort have been colossal failures. The Japanese government tried to end the subsidies to the electronics firms a few years ago but had to back down under intense political pressure. Well, does anyone still believe most Americans would benefit much from emulating the German or Japanese models?

MORE VERSUS LESS GOVERNMENT INTERVENTION

The American economy, which has been, even during our most difficult episodes, the largest and most productive economy with the highest standard of living among the industrial economies (Boskin 1993), appeared triumphal in the 1990s as we came out of the nationally brief, mild 1990-91 recession (although it was regionally severe, lasting longer and reaching deeper in the Northeast and California than in the rest of the country). The fall of the Berlin Wall and the collapse of the communist countries, together with more access to the then Soviet Union, demonstrated beyond doubt how pathetically poor the communist economies were. Combined with the stagnation of Western Europe and the collapse of the Japanese economy, events temporarily short-circuited this attack on the greater reliance on markets and individual initiative, less reliance on government. Governments all over the world were trying to emulate economic systems they saw as more successful, as their citizens called out for more personal freedom and greater economic progress.

The practical lesson on the damage done by excessive government is learned from comparing economic performance in the United States and Western Europe during the past three decades. Although worker compensation has been growing more slowly for the past twenty years than in the previous two decades, the American economy has been flexible and dynamic enough to provide employment to virtually all those who seek it. Compare that performance with the sorry state of Western Europe, where the unemployment rate is now 11 percent, more than double that of the United States.

There were 30 million more working-age people in Western Europe in 1994 than in 1970. The labor force, however, grew by only 19 million, and unemployment and government employment swelled. And there were 1 million fewer-private sector employees in Western Europe at the beginning of 1994 than at the beginning of 1970! What a stark indictment of an inflexible, protectionist, highly regulated, and overtaxed economic system. By comparison, there were about 40 million more working-age people in the United States, the labor force grew even more, and, desspite a small increase in unemployment and government employment, the overwhelming bulk of the workers found productive private-sector employment. The problem of Western Europe offers us a window on our future if we allow a marked expansion in government's role.

On the relative merits of capitalism and socialism, as we hear today calls from economies in transition to return to central planning, let me share with you a personal experience. I was an economics major in college some years after Soviet premier Nikita Khrushchev shouted to an American president, "We will bury you!" Khrushchev was not talking about military might. He was projecting the growth of the Soviet economy relative to the slower growth of the American economy. Khrushchev proclaimed that the Soviet economic system, with its central planning, bureaucracy, controls, and state enterprises, was a superior economic engine. After all, industrial production grew more rapidly in the USSR than in the United States, and it had no unemployment and no inflation. Of course, although prices did not rise, goods were not available on the shelf at these unchanged prices; although everyone nominally had a job, there was unemployment and massive underemployment; and some of that extra steel went to produce unneeded ball bearings and hence was melted back down for future steel production.

Little did I know as an economics undergraduate that a couple of decades later President Bush would dispatch me to Moscow to help President Gorbachev with Soviet economic reform. When I arrived in Moscow in 1989, in addition to Gorbachev, who knew very little economics, I met with the head of the state planning agency (Gosplan), the finance minister, and the head of the Central Bank.

The head of Gosplan was supposed to preside over price reform in the Soviet Union and thus the move to a free market. At our first meeting he inquired of me, "Who sets the prices in your economy?" Flabbergasted, I explained that, although we had a few industries that were regulated by the government, for the overwhelming bulk of products the interaction of numerous producers and still more numerous consumers determined prices in our economy. Furthermore, repeating Adam Smith's famous dictum, I said that this invisible hand of the market produced the greatest good for the greatest number. The head of Gosplan repeated, "So who sets the prices in your economy?" Thinking that there might have been something wrong with the translation, we went back and forth several times. It was clear he could not imagine an economy in which somebody in the government did not set the prices. He pulled out a 1960s-style giant computer printout that listed the prices for virtually every product in the Soviet Union. America had a market economy, I was the American president's economic adviser, he had been told by Gorbachev that I would help, so who, he thought, was better able to determine what the new prices should be?

I next went to the Finance Ministry in the Kremlin, where I discussed making the ruble convertible with Finance Minister Pavlov (who subsequently became prime minister and was involved in the coup against Gorbachev). After a to-ing and fro-ing similar to that with the head of Gosplan, trying to explain concepts, Pavlov motioned for me to wait in his office and disappeared through a secret door behind his desk. Remember, this was when there was still a Soviet Union, a Warsaw Pact, and a Communist Party. A few minutes went by, and I started feeling a bit like a character in a Robert Ludlum novel, worrying that no one at the embassy knew exactly where I was. Finance Minister Pavlov eventually returned, handed me a little case, and motioned for me to open it. Inside was a coin, the first Soviet version of the convertible ruble. On one side was printed 1 ruble and on the other side, 1 dollar. Well, I've won teaching awards in my day, but I knew I had a long way to go.

Needless to say, when I returned to Washington to debrief the president, the Treasury secretary, the Federal Reserve Board chairman, the National Security adviser, and the CIA director, I was pretty pessimistic about Gorbachev's chances of pulling off Soviet economic reform. I told them it's going to be a rough road; think in decades, not years. This group can't possibly pull it off; either they'll be gone, or a political backlash will stop the reforms.

CONVERGENCE OF ECONOMIC SYSTEMS

My personal journey is thus echoed in the intellectual and historical experiences of the past quarter century. As mentioned above, back in the 1960s, 1970s, and 1980s--and I am told occasionally still on some college campuses--the prevailing view was that the world's social and economic systems would somehow converge toward a central tendency, somewhere, say, to the left of where Sweden was in the 1970s. The communist economies, it was said, would round off the rough edges by allowing a littler freer rein to private incentives, whereas the advanced capitalist economies would evolve into ever larger welfare states with more government planning, intervention, and control in their economies. We would all happily converge roughly on the same system, with roughly the same results.

History has performed that experiment. Compare the former East and West Germany. Both were shattered by World War II. Both had similar problems and opportunities. One was dosed with communism--the heavy hand of state planning, controls and government intervention, regulation and state ownership of virtually everything. The other, once Ludwig Erhard's reforms had created a currency in which people had confidence and freed up prices from postwar controls, was dosed with capitalism. The West grew into an economic superpower--struggling now under the burden of economic integration with the East--while the East stagnated. When the two Germanys were reunited, the standard of living in the West was five times that in the East, which had a spoiled environment, a decrepit capital stock, and a demoralized labor force. Indeed the saying among East German workers was, "They pretend to pay us and we pretend to work." That is about as close as we get to a natural experiment in economics. And the answer is unambiguous. There is no longer any doubt about whether there are two alternative paths to economic prosperity. Socialism and central planning do not work. Only some form of capitalism and free markets, despite their problems, works over the long haul.

CRITERIA FOR DETERMINING SIZE AND ROLE OF GOVERNMENT

I focus here on major differences in the role of government in the economy and society across a broad spectrum, not disagreements over this or that program or the relative size of the government within a modest range around where it is now in the United States. What I believe is that the greatly expanded role of government that some have called for would be a tragic economic mistake. I also believe that arguments over specific programs that might lead to a minor decrease or increase in the relative size of government will almost certainly wind up reflecting politics. But those arguments must also reflect the well-articulated and economically well-understood criteria for evaluating such programs: rigorously enforced cost-benefit analyses, meaning that the government financing of activity is potentially desirable if the expected benefits are likely to exceed the expected costs; if the activities cannot be undertaken by the private sector (perhaps because the benefits cannot be appropriated by the private firms); and if our usual notions of balancing marginal social benefits and costs to deal with externalities and public goods apply. Decisions that affect national defense and basic research are amenable to the applications of such rigorous criteria.

Analogous criteria have been developed for optimal tax systems, transfer programs, and government regulation. My own reading of the evidence, to the extent I can divorce it from my own philosophical predilections, is that we could lower tax rates; have less and more-flexible regulation; have more market incentives in regulation, education, and job training; slow spending growth; reform taxes, budgets, and social insurance; and so on, resulting in a somewhat smaller government. All these are likely to lead to a better performing economy and, at least after temporary transitions, improve the well-being of the vast majority of our citizens and the functioning of the programs. But that is another story for another time. My purpose here is to talk about major differences over the relative size of government, despite the deservedly intense political debate about modest changes in the size and role of government, which is important not only for ideological and economic reasons but because development of new programs, or the relentless expansion of existing programs, can over time lead to that sizable expansion of government with which I am primarily concerned here.

IMPERFECT MARKETS VERSUS IMPERFECT GOVERNMENT SOLUTIONS

Markets sometimes fail. Imperfect markets, however, must be compared to imperfect government solutions implemented by fallible people. Thus, when we try to correct perceived externalities, we must insist on strong, sound science and flexible market mechanisms, not on scare tactics and command and control. When competition is stifled, naturally or otherwise, we need sensible rules, antitrust laws, or regulation or some combination thereof enforced in a sensible manner. We need serious protection of private property through contract and bankruptcy law and consistent accounting standards and supervision of financial markets in a way that maximizes openness and transparency. These are important foundations of well-functioning, market-based economies. In my view, the risk is that the problems we face in the American economy will lead to too much, not to not enough, intrusion of the government in the marketplace.

The current hysteria over hedge funds is an example. The problem wasn't the financial instruments themselves. Futures, options, and other derivatives generate sizable net benefits when properly used in hedging various risks. Of course, there are also potential costs in their misuse or abuse. When ridiculous amounts of leverage provided by banks and brokerages with little or no knowledge of the positions of the funds to whom they lend was combined with positions that were not market neutral, potential bankruptcy loomed. This is no different conceptually from highly leveraged borrowing short and lending long betting on interest rate stability--the saga of the S&L industry in the United States; nor is it very different from Asian banks or industrial companies borrowing in dollars and lending in baht or rupiah, pocketing the spread, betting on currency pegs to continue indefinitely, unhedged; nor is it very different from Western banks' Russian investments, hedging with Russian banks. None of this has much to do with capitalism per se. It has a lot to do with foolish financial decisions pressing at the limits, moral hazard, and mispriced risk.

The answer is not to curtail the flow of global capital. The problems of the Asian and Russian economies are not primarily due to "global capitalism," a phrase now sometimes employed as if some communicable disease were encompassing all of humankind. The fundamental problems that led to the original crisis were severe imbalances in the Asian economies that were growing at an unsustainable pace, heavily leveraged risks with poorly supervised financial institutions, and domestic economic policies that could not support the exchange rates at which they had pegged, given the declining inflation in the United States and their higher inflation rates. This is not just conjecture or opinion but straightforward Economics 101 that has been taught for decades: A country cannot maintain price stability (or, more generally, a particular stable inflation rate) and fixed exchange rates if prices are not stable (or inflation rates differ) elsewhere. Fixed exchange rates mean domestic monetary policy cannot be independent and vice versa. The only way to reconcile the dilemma is a far worse course--controlling the free flow of capital. It is not theoretically, let alone practically, possible to reconcile fixed exchange rates, independent domestic monetary policy, and free flows of investment capital; something must give. This was the core problem facing countries such as Thailand, Indonesia, and South Korea and the primary cause of their financial crises. Unfortunately, some countries are retreating into capital controls; surely their need for foreign capital to supply both funds and the market discipline that properly priced foreign risk capital brings will be decisive to their long-run prospects.

Clearly, we need a serious reexamination of our international financial institutions. The combination of changing world economic conditions, mission creep, and a mixed record of success, including some recent failures, suggests that a serious rethinking of the purposes, procedures, resources, and operations of these institutions is an urgent priority. The IMF should be playing the role of convenor of private lenders, lest lender runs on countries analogous to depositor runs on banks occur unnecessarily. The role of global lender of last resort requires a rapid determination of the difference between illiquidity and insolvency, something not easily done in a political context.

But let us not confuse traditional economic mistakes with fundamental problems of economic systems. For these economies to retreat back toward protectionism, capital controls, and even greater centralization of decision making in government would be a disaster for the mass of humankind. Sensible improvements in the supervision of their financial institutions and better central bank policies are the place to start. For example, higher reserve requirements for short-term deposits and sensible risk-based capital requirements for financial institutions, if necessary, make a lot more sense than capital controls or taxes.

CONCLUSION

My conclusion is simple. In addition to their strong moral base in personal freedom, capitalism and competitive markets work to deliver substantial economic progress; communism, socialism, even large bureaucratic welfare state "third ways" do not work. They sap individual incentive, initiative, and creativity and ultimately cannot deliver sufficiently rising standards of living to meet the expectations of their citizens for better material lives for themselves and their progeny. Episodic economic downturns or other perceived market failures create great opportunity for misplaced permanent expansion of government's role in the economy.

Clearly, we have learned that government has a number of important roles to play in our economy and that we must remain vigilant to make sure that it plays only those necessary roles in the least intrusive manner possible. A consistent rules-based monetary policy, the lowest possible level and rates of taxation, less command and control in favor of more flexible market-oriented incentive regulation, slower growth of government spending including entitlement reform, and expanded open rules-based trade are surely the lessons of economic history and would surely be Adam Smith's wise prescription today.

The theme of this year's NABE conference is "Winners and Losers of the 21st Century." Surely a large part of the answer to that implicit question is "those who can stay closest to the limited government capitalist model in the face not only of the natural tendency of the government's role in the economy to grow, but also the incredible impending demographic pressures that will greatly reinforce this tendency."

The calls for capital controls, greatly expanded taxes and spending, vast new regulation, extensive industrial policy, and dangerous protectionism threaten our economic progress and personal liberty. Such calls by pundits and decriers of capitalism are frequent and occasionally frenetic, both inside and outside the economics profession. Of course, as economies evolve and conditions change (e.g., due to changing demography), the role of government based on the sound market principles enunciated above may reasonably ebb and flow. But capitalism once again needs its defenders, teachers, exemplars, and champions. The alternative models have proven historically, intellectually, and practically bankrupt. We would all be better off if the decriers of capitalism remained permanently discontented.