Friday, April 16, 2010


A wise and frugal government, which shall restrain men from injuring one another, shall leave them otherwise free to regulate their own pursuits of industry and improve¬ment, and shall not take from the mouth of labor the bread it has earned. This is the sum of good government...
—Thomas Jefferson

Before the late nineteenth century, government spending was a very small percentage of gross domestic product in most Western countries, typically no more than five percent. In most cases this state of affairs had persisted for well over a century, often for many centuries. But with the twentieth Century came the growth of governments across the Western world, where government spending is as much as 100 percent gross domestic product.

Some authors attribute the rapid governmental growth of the twentieth century to war, international conflict, and crisis more generally. Robert Higgs (1987), in his Crisis in Leviathan, argues this position. He postulates a ratchet effect. For instance, state activity invariably expands in wartime, if only to fight the war. Taxes increase, resources are conscripted, and economic controls are implemented. When the war is over, some of these extensions of state power remain in place.

Is government necessary for a nation to succeed? Most economists believe government has as its most basic function the protection of people and property. In addition, many argue that a provision of limited set goods and services, called public goods, such as roads and national defense, is also a necessary role for government. But, Gwartney, J., Lawson, R. and Holcombe, R. “The size and functions of government and economic growth,” Joint Economic Committee, p. (V) (1998) state, “as governments move beyond these core functions, they will adversely affect economic growth because of (a) the disincentive effects of higher taxes and crowding-out effect of public investment in relation to private investment, (b) diminishing returns as governments undertake activities for which they are ill-suited, and (c) an interference with the wealth creation process, because governments are not as good as markets in adjusting to changing circumstances and finding innovative new ways of increasing the value of resources”. Daniel Mitchell concludes “government spending undermines economic growth by displacing private-sector activity. Whether financed by taxes or borrowing, government spending imposes heavy extraction and displacement costs on the productive sector.”;

Empirical evidence suggests the share of overall government spending that maximizes economic growth, is between 17% and 30 percent of GDP. In 2007 the OECD average of total final government expenditures was 40.4% of GDP, while for the Euro area the average was 46.2% of the GDP.

Several people have pointed to the Rahn curve as illustrating the optimal size of government. As the size of government, measured on the horizontal axis, expands from zero (complete anarchy), initially the growth rate of the economy—measured on the vertical axis—increases. As government continues to grow as a share of the economy, expenditures are channeled into less productive (and later counterproductive) activities, causing the rate of economic growth to diminish and eventually decline.

A substantial growth in average government expenditures has a corresponding decline in average economic growth. Barro, Robert A., (1989 “A Cross - Country Study of Growth, Saving and Government,” NBER WorkingPaper No. 2855) found that “the ratio of real government consump¬tion expenditure to real GDP had a negative associ¬ation with growth and investment.” A New Zealand Business Roundtable study found that “An increase of 6 percentage points in government con¬sumption expenditure as a percentage of GDP, (from, say 10 percent to 16 percent) would tend to reduce the annual rate of growth of GDP by about 0.8 percent.” A National Bureau of Economic Research study concluded that “An increase in gov¬ernment spending by 1 percentage point of trend GDP decreases profits as a share of the capital stock by about 1/10 of a percentage point.”

Although examples of OECD countries reducing government expenditures are few and far between, three instances of substantially reduced govern¬ment expenditures among the OECD countries occurred between 1960 and 1996: Ireland from 1986 to 1996, New Zealand from 1992 to 1996, and the United Kingdom from 1982 to 1989. In each case, the reduction in government expenditures led to periods of substantially improved growth. Conversely, a 10 percentage point increase in government expenditure as a percent of GDP from 1980 to 2006 was associated with approximately a six-tenths of a percentage point reduction in growth during the entire 15-year period.

What does this say about the significant increase in government spending in the U.S. over the past three years? It suggests a considerable slowdown in economic growth. Given that US government expenditures have risen as a percent of GDP by 28 percent since 2006, 6/10 of a percent of 28 percent will slow about 17 percent, from a growth rate of say 3.3 percent to 2.7, or from 2 percent to 1.66.

No comments:

Post a Comment