Sunday, May 9, 2010

Government and Growth of the Economy

Before the late nineteenth century, government was a very small percentage of gross domestic product in most Western countries, typically no more than five percent. But with the twentieth Century came the growth of governments across the Western world, to the point now where government expenditures are forty or fifty percent of gross domestic product.
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. However, calling forth a role for government is a slippery slope. Where does the responsibility end? Is it to protect everyone from everything?
As governments move beyond the core functions, economic growth is adversely affected. Government spending undermines economic growth by displacing private-sector activity. Government is significantly less efficient at any function than is the private sector.
So if some government is necessary but too much government slows economic growth, there must be some “optimal” size of government. As I noted in an earlier post, economists have popularized the existence of an optimal size of government in a figure called the Rahn curve. 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.

In the figures you can see the relationship between size of government and growth of the economy in OECD countries. The "unseen", referring to Bastiat's broken window fallacy, is the cost of a slower rate of economic growth. A 2 percent decline means from 3 percent per year growth, means it would take 72 years for the economy to double rather than 24. How many lives are lost because of this slower growth? How many diseases not discovered, drugs not found, technologies not created?

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