The state & growth: what's the mechanism?

Whenever he was faced with a blustering student - which was often - my old economics tutor, the late Andrew Glyn, would ask: "What's the mechanism?" This is the question we should ask about the TPA's The Single Income Tax report. It says:

There is a long history of macroeconomic studies which have found that economies where public spending is a lower share of national income tend to see stronger economic growth.

Pages 130-42 of its report (pdf) provide empirical evidence.

It's in this context that mechanisms matter. There are (at least) four important, and often overlooked, features of mechanisms.

1. They vary across times and places. The TPA has in mind the idea that lower taxes stimulate entrepreneurship and investment. That's perfectly plausible. But isn't it possible that this mechanism would be weaker than usual now, given that the dearth of monetizable investment opportunities and the lack of supply of credit? The fact that lower public spending has often raised GDP growth does not suffice to show that it will do so here and now.

2. The precise type of spending matters. If by "public spending" you mean spending on airport "security", I'm with the TPA. But if you mean, say, instead spending on early years childcare, I'm not: this can raise growth both by freeing up women to enter the labour market and by raising human capital in the longer term.

3. Institutional quality matters. Public spending which is funnelled into the pockets of bureaucrats would depress growth. But spending which has positive outcomes, such as raising educational attainment (harder than it seems (pdf)) or cutting transport congestion wouldn't.

4. There's a distinction between the long-term and short-term.In the long-term one way in which spending can affect growth is by affecting social norms.But this effect can be amibguous.On the one hand, small government might boost entrepreneurial spirits and self-reliance because youngsters believe there are few state jobs available to them. But on the other hand, the same distrust of the state which breeds small government might be an obstacle to growth-enhancing public spending; look at the state of US roads or public education.

Thinking in terms of mechanisms, then, helps us reconcile (sort of) the TPA's evidence with Lane Kenworthy's observation that the Nordic nations have combined high spending with good economic performance; they - perhaps unusually, perhaps not - have had the right sort of spending; points 2 and 3 have worked in their favour.

I'd just make some other observations.

First, it's perfectly coherent to believe that the relationship between public spending and growth varies from nation to nation. The fact that the Nordic countries have achieved good growth with high public spending does not create a case for other nations to raise public spending, if bad institutions cause that spending to go on boondoogles and bureaucrats rather than upon measures to raise outcomes.

Secondly, your attitudes to 1-4 are, I suspect, hugely conditioned by your priors. If you have faith in entrepreneurial spirits and scepticism about governmental quality, you'll side with the TPA on points 1-4. If you have faith in government but not in entrepreneurial spirits you won't. Cross-country studies don't much help.

Thirdly, this is no place for "bigthink." What really matters are the microeconomic details such as the precise types of spending and the institutions through which it is channelled.

Comments

[Luis Enrique]

further on the "type of spending" point, careful empirical work tends to find that higher government spending of certain categories (so called productive expenditure) is associated with higher growth.

see here

http://www1.worldbank.org/publicsector/pe/pfma06/CJE.pdf

[also a lot of empirical work is shoddy in this realm, as the paper above argues, regressions are often misspecified]

[Andrew]

Great post.

A macroeconomist who recognises that detail matters and mechanisms vary with time and place. Wonderful.

[Woj]

I second Andrew's comment. The debate on stimulus versus austerity too often obscures the details of how public funds are actually spent. Hopefully people will start to follow your lead.

[Matthew Sinclair]

Thanks Chris, interesting post. I included a simple explanation of how I see the mechanism in a post responding to Nick Pearce at the IPPR on this issue:
http://www.taxpayersalliance.com/economics/2012/05/spending-deliver-stronger-economic-growth.html

The only point I would add is that the variation between countries might not be good news for the UK. See page 172 of our report, evidence seems to be that infrastructure does less for growth in developed than developing economies. Presumably because they're building things like roads whereas we're wasting money on things like HS2.

Best,
Matt

[Paolo Siciliani]

"The fact that the Nordic countries have achieved good growth with high public spending does not create a case for other nations to raise public spending, if bad institutions cause that spending to go on boondoogles and bureaucrats rather than upon measures to raise outcomes."

The point is, though, what if bad institutions also affect the provision of "public" services by private operators? In that case the public would waste their money on (private) boondoogles and bureaucrats all the same, or renounce to pay for the service altogether, which might be worse for short-term or long-term growth.

I think your framework works when private spending is crowded-out, which as you argued in point 1 is not the case nowadays. Otherwise, you are simply claiming that private boondoogles are more palatable than public ones, whatever.

The key question than is, if there are bad institutions, what is the easiest way to improve on them, when "public" spending is in the hands of private lobbyists or public bureaucrats? And let's not come up with the story that market discipline will keep private providers honest, because this doesn't wash, not unless you put a strong regulatory regime in place, which kind of fudge the argument I would have thought. (By the way, this is not about macro stuff, but industrial organisation, micro and behavioural economics.)

[Stephane Genilloud]

It is impressive how good economics often sounds like a statement of the obvious.

And it is no less impressive that many economists and policymakers so often lack the common sense required for understanding such kind of economics.

[fake]

I would argue that the Nordic countries do have small governments, they are only large as a %.

Their governments are tiny compared to ours in pure numbers, the more numbers the bigger the risk of money being spent on boondoogles and bureaucrats.

[Greg Hill]

I'd add market structure to your list. A large part of the U.S. economy can be fairly characterized as monopolistic competition, where P > MC, and producers will happily produce more if there's more demand.

From a social point of view, resources in this sector are underemployed, and government spending, by increasing demand, via direct purchases and multiplier effects, will often, but not always, yield net benefits.

[bill james]

Good answers in return of this issue with solid arguments
and describing the whole thing regarding that.