Wednesday, December 15, 2010

Does big government result in more housework?

Government Size and Implications for Economic GrowthI found this to be the most interesting question explored in ‘Government Size and Implications for Economic Growth’, by Andreas Bergh and Magnus Henrekson. Before I explain, however, I want to provide some comments on the author’s conclusions about the effects of size of government on economic growth.

Bergh and Henrekson base their conclusions about the effects of size of government on economic growth on a review the recent econometric literature using panel data for high-income countries. They conclude: ‘In rich countries there is, indeed, a robust negative correlation between total government size and growth’ (p.30). They qualify this conclusion by noting that, as with many other econometric studies, the issue of causation has not been completely settled (p.33). They explain the ability of the Scandinavian welfare states to maintain modest economic growth despite big governments in terms of relatively strong performance of those countries with respect to other aspects of economic freedom. These conclusions are consistent with my own review of the relevant literature (background paper for the NZ 2025 Taskforce) and modest econometric efforts.

The reservation I have about the review of the literature by Bergh and Henrekson is somewhat technical – so some readers may prefer to skip this paragraph. My reservation concerns the authors’ enthusiasm for Bayesian Averaging of Classical Estimates (BACE), a technique used to deal with possible sensitivity of parameter estimates to the inclusion of different control variables in regression models. A recent paper by Antonio Ciccone and Marek Jarocinski suggests that margins of error in international income estimates are too large for such agnostic growth empirics to be reliable. In any case, in my view the economic reasoning that tells us that the economic costs of taxation rise approximately in proportion to the square of the tax rate provides a more powerful case against big government than the results of cross-country econometric studies. (The authors appear to attribute this insight to the Swedish economist, Jonas Agell (p.17), although it should more appropriately be attributed to much earlier work by Arnold Harberger, or possibly even to Alfred Marshall.)

It is well known that the economic cost of high tax rates arises in part from the substitution of leisure for income. Some would argue that this is beneficial because many people obtain more happiness from spending time with family and friends than from working. One reason why the argument is spurious is because it may be rational for individuals to sacrifice some current happiness to provide their children with a better education, fund early retirement or pursue any number of other objectives that are important to them.

Another reason why the argument is spurious is that what economists talk about as a choice between income and leisure is often actually a choice between time spent on paid work and time spent on unpaid household chores. It is doubtful whether people obtain much more pleasure from housework, weeding the garden and childcare than from working for pay. Bergh and Henrekson make the good point that high rates of labour taxation provide an incentive for consumers to produce such services themselves in the home rather than to work longer hours in order to purchase them in the market place. The authors suggest that this explains why hours of unpaid work are substantially greater in Sweden than in the US and hours of paid work are correspondingly lower in Sweden than the US.

The authors also provide a graph comparing average hours worked per person in Sweden and the US over the period 1956 to 2003. It shows that while average hours worked in Sweden were substantially higher than in the US during the 1950s, when Sweden’s tax rates were much lower, the situation has been reversed in recent decades.

Over the last couple of centuries the ancestors of the vast majority of people in high-income countries have managed to obtain the benefits of participation in a market economy – the benefits of exchange and specialization on the basis of comparative advantage, resulting in much higher living standards and providing greater opportunities for skill development and incentives for further innovation. High taxes associated with big government provide the opposite incentives - encouraging people to shun the market and to produce services for themselves. Self-sufficiency is not without its attractions, but I doubt whether many people would freely choose the poverty experienced by their ancestors, even if that was the only way they could ensure a supply of fresh, organically-grown vegetables.

1. An error in the second last paragraph has now been corrected. Thanks very much to BW for noticing that!

2.When I think again about the final paragraph, the ancestors of the vast majority of people in high-income countries were living in market economies even prior to the industrial revolution. A move to self-sufficency would entail a move much further back in history.

Sunday, December 12, 2010

When does greater economic freedom promote distrust?

There are some fairly obvious reasons why societies characterized by low levels of inter-personal trust tend to be highly regulated. In a society where people tend not to trust each other there is likely to be less adherence to social conventions and there is likely to be more political pressure for the use of government regulation to deter anti-social behaviour. Causation can also be expected to work in the other direction. In a society where it is impossible to conduct market transactions without breaching some regulation it is only to be expected that many people will wonder whether those with whom they are dealing can be trusted not to dob them in to the authorities. Regulation promotes low trust.

So, what is likely to happen to levels of inter-personal trust following substantial deregulation in a highly regulated, low-trust society. As a general rule I think it would be reasonable to expect that greater reliance on market disciplines would generally promote more trustworthy behaviour. Individuals and firms would find that it pays to develop a reputation for trustworthiness and this would result in higher levels of inter-personal trust. Such attitudes could be expected to be associated with public support for deregulation policies.

However, evidence presented in a paper by Philippe Aghion et al, entitled ‘Regulation and Distrust’, suggests that an opposite tendency was more common in countries undergoing transitions away from socialism in the 1990s. Data from the World Values survey indicates that levels of inter-personal distrust increased in most of these countries during that period. There were also substantial increases in distrust of civil servants, justice systems and business. Most households perceived that corruption had increased. The surveys suggested that there was also an increase in tolerance of corruption (bribe taking) and a reduction in the proportion of the populations who considered tolerance and unselfishness to be important attributes to teach children. Not surprisingly, there was also an increase in the proportion of the populations who disliked competition and private ownership of firms.

The authors suggest that those findings are a consequence of low levels of social trust prior to transition. Their model predicts that in a low trust society entrepreneurs will tend to be less civic-minded (because they need to pay bribes in order to enter the business) so liberalization of entrepreneurial activity will tend to result in an increase in negative externalities (e.g. pollution) and an increase in corruption. They conclude: ‘Liberalization of entrepreneurial activity starting from a low level of social capital has increased corruption, invited a demand for greater state control of economic activity, and reduced trust’. At the end of their paper the authors suggest that public education might provide a way forward for transition economies by leading the way toward greater ‘civicness’, lower regulation and higher productivity.

One of the merits of the model put forward by Aghion et al is that it is capable of explaining why many people in countries with bad governments may want more government intervention. The benefits of liberalization of entrepreneurial activity are perceived to be outweighed by the costs.

I am not convinced, however, that the poor outcomes of reforms in transitional economies should be attributed to low levels of social trust prior to transition. An alternative explanation is that the reform process was poorly managed so that instead of a transition from socialism to competitive markets – permitting mutually beneficial exchange that had previously been prevented - these countries underwent a transition from socialism to crony capitalism following the collapse of communist governments. The evolution of attitudes to business may reflect the rent-seeking entrepreneurship to which people were exposed. Under the prevailing circumstance it may not have been possible for the reform process to have been better managed in the transitional economies, but this means that their experience may not be of much relevance to other low trust, high regulation countries.

Rather than focusing on the transitional economies as a group it might be interesting to consider whether different reform strategies adopted in different countries (including other countries such as China and India in the analysis) have had different effects on levels of social trust.

Wednesday, December 8, 2010

Would a fair-minded person say that devastation of the Australian apple crop is a price worth paying for cheaper apples?

‘I don’t think any fair-minded Australian would think that the devastation of the Australian apple crop is a price worth paying for cheaper apples.’ Please discuss.

That might be a reasonable examination question for an introductory economics course. The weaker students would probably be distracted by the allusion to fairness and the images that the word ‘devastation’ brings to mind and forget all the economics they had been taught.

There are several ways the stronger students could answer. One point they could make is that a fair-minded person would be open to weighing up the economic benefits and costs of the proposed policy action. They could raise the question of how large the value added by the Australian industry might be after making appropriate adjustments to remove price distortions, such as those resulting from import barriers. A further point they could mention is that market systems have evolved because fair-minded people have been persuaded in the past that the outcomes of market competition were generally preferable to outcomes that applied when governments attempted to protect local producers from external competition. In that context the relevant issue is whether individual consumers would voluntarily pay a higher price for the Australian product in order to prevent devastation of the Australian crop.

There are other relevant considerations, but they do not alter the general point that fair-minded people would accept that the price that needs to be paid for preservation of local industries is not always a price worth paying. If that were not so, our living standards would probably not have improved since the 18th century when regional communities within all countries were all largely self-sufficient.

How does it change the way we view this issue if we are told the quoted statement was made by Craig Emerson, Australia’s Minister for Trade, in commenting on the WTO’s recent ruling against Australian quarantine restrictions preventing apple imports from New Zealand? (The quoted statement was in an article by Geoff Kitney in the Australian Financial Review of Wednesday 1 December, p 49.) The Minister was talking about the possibility that the Australian apple industry might be devastated by a plant disease rather than by price competition from New Zealand apples. Does that make a difference?

One relevant consideration is that the part of the Australian industry that is most vulnerable to import competition from New Zealand will not need to be protected from imported diseases. It will no longer exist.

A paper entitled ‘Australia’s quarantine mess’, by ANU academics Malcolm Bosworth and Greg Cutbush, suggests that the annual cost to Australian consumers of the ban on apple imports was around $250 million per annum. This represents a very large proportion of the domestic industry’s gross value of production of around $300 million and perhaps 10 times more than local growers’ profit in a normal year.

These figures suggest that even if the introduction of apple diseases from New Zealand resulted in devastation of the Australian apple crop it is highly unlikely that any associated losses would exceed the $250 million per annum cost that the ban imposes on Australian consumers. As Bosworth and Cutbush point out, however, the probability of an incursion of any of the relevant diseases is very low under normal orchard hygiene practices, and even in the unlikely event of Australia-wide infection, annual costs of coping with the problem would be in the range of $3 to $10 million per annum. Bosworth and Cutbush also note that the apple diseases present in New Zealand have not prevented it from being one of the world’s top apple exporters.

I have previously thought of Craig Emerson as one of Australia’s most economically literate politicians. It is disappointing that he has seen fit to use his considerable rhetorical skills to imply that fair-minded Australians should always be in favour of protecting domestic industries, irrespective of cost.

Saturday, December 4, 2010

Can the industrial revolution be attributed to economic freedom?

Locating the Industrial Revolution: Inducement and ResponseBefore reading Eric Jones book, ‘Locating the Industrial Revolution’, I had thought that the reasons why the industrial revolution began when and where it did would have a lot to do with relative levels of economic freedom in England in the 18th and 19th centuries. The book seems to me to reinforce that view, even though it does not argue strongly in favour of it. The message I get from the book is that the political forces favouring greater economic freedom prevailed over opposing forces in those areas of economic policy that were most critical to economic growth at that time.

My prior view that the industrial revolution would have had a lot to do with relative levels of economic freedom was associated to some extent with dissatisfaction with alternative explanations such as that offered by Gregory Clark (discussed here). I admit, however, that my prior views were most strongly influenced by contemporary econometric evidence that greater economic freedom tends to promote higher economic growth. I would not be surprised if Eric Jones considers that such reasoning displays ‘too great a willingness to accept dubious data as proxies for the real thing, and too much of a preference for neat solutions’ (p. 6). He uses those words as a general criticism of economists.

The main question that Jones considers in this book is why the location of manufacturing industry shifted from the south to the north of England prior to the industrial revolution. This is an important question because the clustering of industry in the north provided an economic environment conducive to subsequent innovations, including use of coal-fired steam engines as an energy source.

Jones suggests that the economic history of England does not provide neat solutions to the problem of locating the industrial revolution. He claims:
‘There is no determinate solution to the puzzle of why the industrial revolution took place, and when and where it did so. All that can be achieved is a narrowing of the range of possible mixes’ (p. 245).

Jones sees problems with a simple explanation in terms of levels of economic freedom:
‘Ordinarily we might expect that economic growth would be spurred by market freedoms but there are problems with this line of argument. A number of the outcomes do not seem to have been stable. Free-market preferences within the judicial system were inconsistent, since the judges reverted to precedent when it suited them – not that every law was enforced. Protective duties were raised precisely when “a modest flow of works” was starting to extol the virtues of free trade. Nor was corruption decisively reduced until some way into the 19th century’ (p. 243).

However, similar objections have been raised against attempts to explain China’s economic growth in recent decades as a consequence of market freedoms. A point that is often overlooked is that in considering the potential for economic growth offered in a particular economy by a particular level of economic freedom the most relevant comparison is with levels of economic freedom generally prevailing in other economies with similar income levels. An improvement in economic freedom in a low income country can provide an impetus to more rapid growth even though economic freedom remains heavily restricted.

Jones suggests that the main factor responsible for the redistribution of manufacturing activity to northern England was market integration associated with improvements in transportation. The merging of markets led to greater competition and specialization on the basis of comparative advantage – with a greater focus on agriculture in the south and manufacturing in the north. He points out, however, that these improvements in transportation often had to overcome substantial political obstacles from wealthy land-owners, whose concern to protect the social status that land ownership offered (linked to landscapes, recreation and privacy) often outweighed their interest in increasing the rental value of their land. He suggests that privatising of rights of way – described as ‘judicial theft of the subjects rights’ – was an ‘astonishingly common’ adverse effect of the enclosure of the commons (p. 153). The merging of markets was only possible because the judges and parliament together increasingly embraced market ideology and overlooked, rejected or struck down local protectionist measures (p. 185).

It seems to me that Eric Jones has provided strong evidence that the industrial revolution occurred when and where it did because market ideology prevailed sufficiently to enable market integration, specialization on the basis of comparative advantage and the clustering of manufacturing industry. I am conscious, however, that he might suggest that in offering that summary my preference for neat solutions has gotten the better of me.