The “austerity” debate

The “fiscal austerity” debate rages on. I think it is very unproductive and detracts from the discussion that should be going on, and that pertains to monetary policy. Nevertheless I decided to “butt in”.

In the top part of the table below are the 6 OECD countries which registered the lowest increases in the G/Y ratio between 1960 and 2007 (brake point defined to avoid the “distortions” that followed the onset of the crisis). In the lower part the countries that registered the largest increases.

The last three columns show the average real economic growth rates in the first 13 years of the sample, in the last 13 years and the change in growth between the two periods.

Notice that the weight of government (G/Y) increased in all OECD countries between 1960 and 2007. However, the differences are substantial. In those countries where G/Y rose less the average increase was 10.6 percentage points while in those countries that the government share increased most, the average rise was 25 points.

As seen in the last three columns, growth was more strongly reduced among the countries that experienced the largest increase in G/Y: -2.8% which compares to -0.5% for the countries with the lowest increase in G/Y.

Note that three of today´s “crisis countries” – Greece, Portugal and Spain – are also countries that saw the largest increase in the share of government and the largest loss of dynamism, with economic growth rates falling significantly.

It would be interesting to see if the opposite case – a reduction in the weight of government – is associated with higher growth. For the time period under analysis – 1960 – 2007 – we observe four cases in which there was a substantial and persistent decrease in the G/Y ratio. These are:

1. Ireland, where between 1986 and 2003 the ratio fell from 52.3% to 33.2%. While between 1977 and 1986, a period during which G/Y went from 43.7% to 52.3% average growth was 3.4%, between 1987 and 2003 growth was 6.2% on average.
2. New Zealand, where between 1990 and 2003 the ratio fell from 53.6% to 35%. During this period average growth was 2.9%, compared to 1.8% in 1970 – 1990 during which G/Y went from 34.4% to 53.6%
3. UK, where between 1981 and 1990 the ratio dropped from 48.5% to 39.7%. During this period growth averaged 3.4%, which compares favorably with the 1.8% growth observed during 1971 – 1981, when the G/Y ratio increased from 41.8% to 48.5%. This was an interesting outcome given that in 1981 a document signed by 364 economists, many of them famous, radically opposed the 1981 Thatcher budget, alleging that the “proposed policies will deepen the recession and threaten social and political stability…”
4. The Netherlands, where between 1990 and 200 the ratio dropped a little more than 10 percentage points real growth averaged 3.3%, compared to 2.1% between 198o – 90, a period during which G/Y was relatively stable around 55%.

I find this quote from a little book called “Common Sense Economics” by James Gwartney, Richard Stroup and Dwight Lee (page 79) very pertinent:

Government is a little bit like food. Food is essential, but when consumed excessively, it leads to obesity, energy loss, and other health-related problems. Similarly, when constrained within proper boundaries, government is a powerful force for prosperity. But when it expands excessively and undertakes activities for which it is ill-suited, it undermines economic progress.

For convenience I´ll call “proper boundaries of government” the “core functions”. The chart below shows the share of “core functions” for a sample of countries.

The “Core Functions/GDP” estimate is for 2006. However, the changes over time in the share of core functions of government are not large. For example, in 1960, core functions in Canada were 13% of GDP compared to 17% in 2006. Another characteristic of the share of core functions is that, in addition to showing relatively low changes over time, the difference among countries at a moment in time is relatively low (especially when compared to the large variations between countries at a moment in time in the total share of government observed in the Table).

So yes, “too much government can be bad for the economy´s health”!