Wednesday, April 23, 2008

Would free markets give too little growth?

These days we often hear people argue that economic growth should be reduced because it is associated with adverse environmental and social consequences. My response is that adverse spill-over effects (negative externalities) associated with economic growth do not provide a case for government action to reduce economic growth. There may be a case for government interventions directed specifically at ameliorating particular problems, but intervention is not warranted unless it is established that the benefits clearly exceed the costs.

How should we respond to the argument that the market determined rate of economic growth would be too low because growth has desirable moral consequences? Benjamin Friedman argues that a rising standard of living fosters greater opportunity, tolerance of diversity, social mobility, commitment to fairness and dedication to democracy (“The moral consequences of economic growth”, 2005). He suggests that this provides a case for government intervention to foster economic growth.

When I began reading Benjamin Friedman’s book I decided to ask myself the same set of questions as I have asked myself when reading stuff written by the anti-growth brigade.

1. Does the author establish that there are externalities worth considering from a public policy perspective? My answer is a qualified “yes”. I think he provides a lot of evidence that economic growth does foster greater opportunity, tolerance of diversity, social mobility, commitment to fairness and dedication to democracy.

However, I agree with Will Wilkinson’s assessment that the author “often seems to infer the workings of the psychological mechanisms that link growth to moral consequence from the fact that he has judged something morally suspect” (here). For example, he makes the dubious judgment that increases in government spending on social welfare are evidence of moral improvement and that moves toward limited government are evidence of moral decline.

2. Does he establish a causal link between economic growth and the external effects that he wants governments to address?

Before I read the book I wondered whether Friedman had ruled out the possibility that the externalities he observed were attributable to economic freedom rather than to rising living standards. I think he successfully avoids this issue because his hypothesis is specifically about the consequences of rising living standards – that when we feel that our living standards are improving we are less concerned about our relative position in the distribution of wealth.

Nevertheless, Friedman has not established a link between economic growth as conventionally measured and positive externalities such as tolerance of diversity. He defines economic growth to mean “a rising standard of living for a clear majority of citizens” (p4). But he doesn’t discuss how living standards relate to measured economic growth. If individuals freely choose to work less hours per week as their income rises, should this count as an improvement in their living standards over and above the improvement in their incomes? I think it should count, but it is not reflected in conventional measures of economic growth.

The micro-foundations of Friedman’s analysis seem to me to make a great deal of sense. If we gauge ourselves to be doing well by comparison with our past living standards (or our parents living standards) then we are less likely to be concerned about keeping up with the Joneses or keeping ahead of the Smiths. I was surprised, however, that the author does not cite a large body of psychological research in support of this supposition. This is probably because not much psychological research has been undertaken that is directly relevant to this benchmark question. More work is needed in this area.

3. Would the benefits of the interventions that he proposes be likely to exceed the costs?

Who knows?. It seems to me that the author’s proposals for increasing investment is the kind of policy that might be considered to achieve some of the outcomes of a free market by a government with ideological objections to free markets. Some of his other proposals, for example those relating to introduction of more competition in public education, are consistent with greater reliance on free markets – despite the authors view that market forces would produce too little growth.

To sum up, I don’t think that Benjamin Friedman’s book makes a strong case that the rate of economic growth determined in free markets would be too low. Nevertheless, it makes a valuable contribution in pointing out positive social consequences of economic growth at a time when there has been much focus on supposed adverse consequences and even proposals to reduce growth by taxing wealthy people more heavily – on the grounds that their wealth makes other people feel miserable. I agree with Roger Kerr’s comment that this book provides a strong counter argument – namely that insufficient economic growth makes people doubt that they are making progress in their own lives, which is why they compare themselves with others and so experience feelings of envy and resentment.

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