Tuesday, November 23, 2010

Is progress history?

Over the past year I have read five or six books about progress. Matt Ridley’s book, ‘The Rational Optimist’ (discussed here and here) was the most optimistic. Ronald Wright’s book, ‘A short history of progress’, is probably the most pessimistic.

A Short History of ProgressWright’s book has the virtue of being short and easy to read. His message is that past civilizations have generally failed and that we are making the same mistakes. He notes that we have the advantage of knowing where those past societies went wrong. As you might guess, however, he suggests that we haven’t got much time to mend our ways. He says that if we don’t act now, ‘this new century will not grow very old before we enter an age of chaos and collapse that will dwarf all the dark ages in the past’ (p.132). Wright’s book was published six years ago, so if his analysis is correct the age of chaos and collapse will soon be upon us.

Cartoon by Nicholson from "The Australian" newspaper: http://www.nicholsoncartoons.com.au/

Anyone interested in a summary of Wright's book will not find it too difficult to find one elsewhere. What I want to do here is to attempt to identify what makes Wright so pessimistic about the future of civilization.

An obvious starting point is his view of human nature. Wright doesn’t believe in the innate goodness of humanity. He suggests that ‘prehistory, like history tells us that we are at best the heirs of many ruthless victories and at worst the heirs of genocide. We may well be descended from humans who repeatedly exterminated rival humans – culminating in the suspicious death of our Neanderthal cousins some 30,000 years ago’ (p. 31). Furthermore, an inability to foresee – or to watch out for – long range consequences of our actions may be inherent in our kind (p. 108). We are doomed by hope. Hope drives us to invent new fixes for old messes, which in turn create ever more dangerous messes (p. 123). Homo sapiens is still ‘an Ice Age hunter only half-evolved towards intelligence; clever but seldom wise’ (p. 132).

Wright acknowledges that humans have been influenced by culture. In fact, he suggests that culture is a key to our success: we are ‘experimental creatures of our own making’. Yet culture also poses risks to us: ‘As cultures grow more elaborate, and technologies more powerful, they themselves may become ponderous specializations – vulnerable and, in extreme cases, deadly’ (p. 30). He describes this as a ‘progress trap’. The wreckage of past civilizations litters the earth because their populations grow until they hit the bounds of food supply, while the concentration of wealth and power at the top of large scale societies gives the elite a vested interest in the status quo.

According to Wright’s view, all large-scale societies are locked into some kind of path dependency – leading them to outrun natural limits and collapse. How then does he explain the success of modern civilization despite all the failures that have occurred in the past? His explanation seems to be that nature has been forgiving. When societies failed there was natural regeneration and human migration to lightly settled areas. Civilization has been exceptionally long-lived in Egypt and China as a result of ‘generous ecologies’ - extra topsoil brought in from elsewhere by water and wind.

I think Wright’s pessimism stems from his views on both human nature and culture. His model doesn’t seem to recognize that humans have biological instincts that encourage cooperation and that this enables rules of conduct to evolve to meet changing circumstances. His model fails to take account of cultural evolution. Our ancestors may have helped destroy mega-fauna through their hunting practices, but hunting and gathering rules evolved in the more successful societies to avoid wanton destruction of valuable resources. Further rules followed including those relating to ownership of animals, grazing rights, land ownership etc. – all serving to encourage more efficient use of scarce resources.

Whether societies collapse or survive and prosper depends largely on the rules they live by. People in advanced western societies live by rules that have evolved to encourage mutually beneficial exchange, specialization and innovation, to ensure valuable resources are not wasted and to avoid environmental degradation.

Is modern civilization locked in to a path that will lead to chaos and collapse if we don’t immediately mend our ways? I don’t think so. Once the hyperbole about running out of resources is cleared away, the only real concern that remains in my view relates to environmental pollution that cannot be controlled by any one government acting alone. Even here there are grounds for optimism. Despite their many failings, the governments of major countries show enormous goodwill toward the future of humanity. We can be reasonably confident that concerted international action will be taken if a major environmental catastrophe ever actually threatens the future of humanity.

Thursday, November 18, 2010

Did the ratchet effect apply to post-war government spending in Australia?

The ratchet theory suggests that government spending tends to ratchet up in times of crisis (wars, social upheavals, recessions) and then to remain at the new higher level. It has been put forward as an alternative to Wagner’s law (discussed in an earlier post).

In terms of the ratchet mechanism, the explanation for upward movement in government spending may appear straight forward, reflecting public demands for the government to ‘do something’ to help solve a problem. The process is not entirely mechanistic, however, because public demands for government action can vary depending on ideological factors e.g. changing perceptions about the role of government in helping people who are adversely affected by a recession and about the effectiveness of deficit spending. It is also possible for the upward movement to occur for opportunistic reasons e.g. politicians with an ideological leaning toward big government ‘never want a serious crisis to go to waste’.

A variety of reasons have been put forward to explain why public spending might remain at the new higher level after the end of the crisis. The most mechanistic explanation is status quo bias – the tendency of people to choose to maintain the status quo rather than to change a policy. For example, once tax rates have been increased to fund war time spending, status quo bias may favour retention of higher tax rates.

In addition, new programs created during a crisis may tend to develop a life of their own by creating interest groups with a vested interest in their continuation - including newly created bureaucracies that will fight to prevent themselves from being eliminated.

However, the ratchet theory does not provide a complete explanation of the growth of government. In his review of Robert Higgs’ book, ‘Crisis and Leviathan’, Gary Anderson notes that while most historians argue that the Civil War was the pre-eminent crisis in American history, ‘following this particular crisis, government sank like a stone relative to the growth of the private economy’.

Dick Durevall and Magnus Henrekson did not find strong support for the ratchet theory in their recent study of trends in size of government in the UK and Sweden from the beginning of industrialization until the present:
There is no consistent evidence of a ratchet effect in either country. There is some evidence of an asymmetric effect in both countries in the post-war period, but this is reversed in subsequent periods. Hence there is no clear evidence that government exploits recessions and crises to permanently shift the government spending ratio upwards’ (p. 22).

In New Zealand, government spending as a percentage of GDP seems to have fallen during WW2 as well as in the latter half of the 1950s and the 1990s. At the same time, as noted by Bryce Wilkinson, ‘the timing of the increases in the state’s share looks opportunistic’. Wilkinson suggests that growth in government spending reflects ‘changing ideas about the role of the state and the increasing power of vested spending interests’ (‘Restraining Leviathan’, 2004: Figure 5, p.41).

It is also difficult to see a consistent ratchet effect in the following chart for Australia showing estimates of government spending as a percentage of GDP over the period from 1939 to the present. The increase that occurred in the 1970s has not been reversed, but during the 1950s the Menzies government seems to have managed to defy the ratchet effect by reducing government spending to levels close to those in 1939.

I have never previously thought that I might one day have reason to praise the economic achievements of the Menzies government. It seemed to me that the Menzies government’s greatest claim to support free enterprise was to have removed war-time price control, rationing and import controls (more or less and belatedly). However, the efforts of this government in reducing the size of government during the 1950s deserve high praise.

Summing up, it seems to me, to be important not to downplay the role of ideology in influencing trends in government spending. During some periods there may be a tendency for government spending to ratchet up in response to crises. Changes in government spending may also be influenced by changes in the power of interest groups (for example as changes occur in the age structure of populations). In the end, however, ideas about the role of government matter a great deal.

Saturday, November 13, 2010

How important is the 'size of government' component of economic freedom indexes?

A few months ago a guest blogger on ‘The Baseline Scenario’ blog, StatsGuy, wrote a post entitled ‘Good Government Versus Less Government’. It was described as a ‘must-read’ in a post by Tyler Cowen on ‘Marginal Revolution’ and received a great deal of attention on a range of other blogs including Scott Sumner’s (here).

StatsGuy draws attention to the fact that the size of government component of the Heritage Foundation index of economic freedom is negatively correlated with the other components of this index. He concludes that the Heritage Freedom index is really a composite of measures that get at two different things: good government, and less government. His bottom line:
Overall, the Good Government factors tend to dominate, and drive a lot of the correlation with good economic and quality of life outcomes. When one splits out the factors, the case for Less/Weaker Government weakens substantially, and the case for Clean/Non-Corrupt/Efficient government strengthens considerably’.

Some other researchers have similarly objected to the inclusion of size of government in economic freedom indexes. For example, Peter Lindert describes this as ‘guilt by definition’ on the grounds that it tends to make big government and the welfare state look bad merely by describing this national attribute as contributing to lower economic freedom (‘Welfare states, markets and efficiency: the free lunch puzzle continues’, 2007: 6).

At least one contributor to the discussion of StatsGuy’s post made the point that if economic freedom has two different dimensions, a lack of correlation between those dimensions does not necessarily mean that one of them is irrelevant. For example, it is possible for both size of government and quality of government to be important to economic growth.

I recently had an opportunity to test whether this is so in preparing a background paper for the 2025 Taskforce, which was established by the New Zealand government to advise how average incomes in that country could be raised to equate those in Australia by 2025. The analysis provides some support for the view that size of government is an important component of economic freedom indexes.

The analysis uses the Fraser Institute’s index of economic freedom because this provides a consistent measure of institutional quality over a longer time period than the alternatives. The data set relates to ‘advanced economies’ as defined by the IMF – this data set includes high income jurisdictions with small governments, such as Hong Kong and Singapore, as well as OECD countries. The regression, based on panel data, explains average per capita GDP growth in each decade in terms of several variables including two components of economic freedom at the beginning of each decade, the size of government index and ‘other economic freedom’. The relevant regression results are presented in Table A 2.3, p 43 (the right hand column).

The coefficients on both the size of government and ‘other’ economic freedom variables were significantly greater than zero - suggesting that smaller size of government has a positive effect on economic growth. The magnitude of the estimated coefficient on size of government is about half that on ‘other’ economic freedom, but that is about twice as large as I had expected it to be on the basis of the weight of size of government in the economic freedom index (20%).

One fairly obvious question that might be asked is that if size of government is so important, how is it that some countries with big governments, an obvious example is Sweden, have managed to maintain relatively strong economic performance. I have attempted to answer this question in the chart below which compares per capita incomes in Sweden and Australia (Penn World Tables, rgdpch with some extrapolation using IMF growth estimates). The results of the simple analysis presented in the chart suggest that if Sweden had not undertaken substantial economic reforms (including some improvement in the size of government component of economic freedom as well as other components) it would have performed poorly. The chart also suggests that Sweden’s economic growth performance could have been much better if it had a smaller government.

This analysis doesn’t tell us that every country could become a paradise if only it had a small government, or that countries with big governments are dreadful places to live. It just suggests that big government is not a free lunch . The lack of correlation between the size of government and other aspects of economic freedom is interesting, but it doesn’t mean that size of government doesn’t matter.

A colleague has suggested that I should have mentioned that the size of government of most of the countries included in this ‘advanced’ country data base used in the regression analysis reported above is now much larger than it was prior to the 1960s.
It might also be worth noting that recent World Bank research suggests that in low income countries government spending on infrastructure, education etc. can have a positive effect on economic growth if (a big if) the countries concerned have favourable institutional characteristics.

Sunday, November 7, 2010

Can New Zealand catch up to Australia?

Is New Zealand disadvantaged by economic geography to such an extent that it cannot hope to catch up to Australia’s average income levels, even with further improvements in institutions and policies? That is probably the most important question considered in the second report of the 2025 Taskforce that was released a few days ago.

The 2025 Taskforce was set up by the New Zealand government after the 2008 election to recommend how the gap between average incomes in Australia and New Zealand could be closed. Incomes of New Zealanders have generally risen less rapidly than those of Australians over the last 40 years, resulting in a gap between average incomes of around 35 percent in recent years. After the 2008 election, the NZ government committed to closing this income gap by 2025.

Since the Taskforce presented its first report last year, Philip McCann - an economist with expertise in economic geography – has advanced the view that New Zealand’s geographical disadvantages prevent it from becoming a high productivity economy. McCann has implied that structural features that are advantageous in the current era of globalization differ so much from those exhibited by New Zealand that this economy could not reasonably be expected to have relatively high productivity. He suggests ‘this is true irrespective of the degree of flexibility in the domestic labour market, the degree of transparency in the local institutional environment, or the levels of cultural aspirations for success’ (‘Economic geography, globalisation, and New Zealand’s productivity paradox’, New Zealand Economic Papers, Dec. 2009: 299).

The particular aspect of geography that McCann considers to be most disadvantageous to New Zealand is its relative lack of agglomeration economies associated with large cities. These agglomeration economies arise from knowledge exchanges, better networking and coordination, a nursery role for new enterprises, improved labour market matching processes and greater competition.

McCann argues that agglomeration economies can explain the decline in New Zealand’s per capita incomes relative to Australia because of the way the world has changed. One strand of the argument has to do with the increasing importance of knowledge-intensive activities that can often be undertaken at lower cost where face to face contact is possible among the various participants. Another strand is that with closer economic integration between Australia and New Zealand the economy with relatively larger agglomeration economies, i.e. Australia, has become a relatively more attractive location for capital investment and employment of highly skilled workers.

McCann sums up: ‘ ... although New Zealand underwent fundamental institutional reforms in the 1980s and 1990s, at exactly the same time as this was taking place the landscape of global economic geography was shifting in favour of other places. It may well be that the deregulatory reforms limited some of the most adverse aspects of these shifts, thereby minimising the productivity gap. Yet the point still remains that the world changed, and the world of the late 20th and early 21st centuries is very different from the world that provided New Zealand with almost a century and a half of productivity advantages’ (p. 300).

How does the Taskforce respond? The Taskforce acknowledges that both New Zealand and Australia have been disadvantaged by geography. It notes that according to recent OECD research the impact of greater distance to markets is equal to around 10 percent of GDP per capita for both countries. However, it judges the evidence in support of the view that New Zealand’s small population limits the potential to obtain agglomeration effects to be weak. In particular, Auckland’s position within the regional hierarchy of Australasian cities is not declining – the population of Auckland has been growing faster than the populations of Sydney and Melbourne. The Taskforce also points out that there is no evidence that New Zealand suffered an adverse shock from globalization during the 1980s; that migration from New Zealand to Australia is disproportionately of highly skilled workers as agglomeration theory implies; or that the relative performance of small countries has declined in the past 20 years.

The Taskforce concludes: ‘... modern growth theory provides stronger support for the importance of institutions and policy than it does for geography, especially in the deterministic interpretations of economic geography’ (p. 41).

Sitting in Australia, current concerns in public policy discussions about the emergence of a two-speed economy in this country make the agglomeration theory of relative decline in New Zealand’s economic performance seem rather odd. Rather than a concern that agglomerations centred on Sydney and Melbourne are leaving the rest of Australia behind, the main concern is that New South Wales and Victoria (along with other states) are being left behind as economic growth steams ahead in Western Australia and Queensland, as a result of rapid expansion of the minerals sector and related industries. There is also reason for concern that, over an extended period, the particularly poor performance of the New South Wales government has detracted from the substantial location advantages that Sydney should enjoy.

If we reject the idea that Australia’s alleged agglomeration advantages make it impossible for New Zealand to close the income gap, where does that leave us in terms of explaining New Zealand’s relatively poor economic performance? The Taskforce pours cold water – correctly in my view - on another geographical explanation, namely Australia’s good luck in having plentiful supplies of mineral resources to export to rapidly growing markets in China and India. It is only in the last few years movements in Australia’s terms of trade have been much more favourable than in New Zealand. Moreover, New Zealand also has substantial mineral and hydrocarbon resources.

I think that leaves us with having to explain New Zealand’s relatively poor economic performance in terms of policies that are less favourable to economic growth. That also poses a problem because the impression given by various international comparisons of institutions and policies is that since the mid-1990s there has not been much to choose in overall terms between the economic policy environments in New Zealand and Australia. It seems likely, however, that New Zealand has not performed so well in the areas that have mattered most from a growth perspective. For example, one major problem discussed by the Taskforce is the effect of relatively high levels of government spending in discouraging investment in export industries - via impacts on the real exchange rate as well as tax rates.

The Taskforce has expressed the view that closing the gap in average income levels by 2025 will require policies that are superior to those in Australia in their focus on growth. It seems to me that those who believe that New Zealand has geographical disadvantages should logically be strong supporters of that view (unless they reject the objective of closing the income gap). The greater the geographical disadvantage, the greater the policy superiority New Zealand will need in order to meet the objective of closing the income gap by 2025.