Big government and economic development

Noah Smith has an interesting piece on big government and economic development. Namely, there is a strong correlation between the size of government and economic development. The bigger the government, defined as government spending as a percentage of GDP, the richer the country. This relationship is fairly strong. Take, for example, the Economic Freedom Index published by the Fraser Institute. The index is constructed by five metrics, size of government, property rights, sound money, international trade, and regulation. Of these, four are strongly positively correlated with GDP per capita. One, size of government, has a negative correlation.

The point being, the typical libertarian story about the importance of government spending on economic development is false, or at least, incomplete. Noah, however, then makes a common error. He confuses size of government with strength of, government. State capacity, as it is commonly described in the economics literature, is not necessarily defined by government spending as percentage of GDP. Think of state capacity as the ability of a state to get things done. Singapore, for example, has a great deal of state capacity, yet the size of government is small compared to other developed countries, 17% compared to 40% for the UK.

It is possible to have a small government that is strong, a big government that is strong, and a small government that is weak. It is very difficult to have a big government that is weak. This is because a weak government is unable to tax enough of the economy for it’s spending to qualify as a big government. This dynamic creates a bias where big governments are going to be relatively well off because they have strong states which boost economic growth.

I also think Noah is mistaken when he identifies public goods as the reason big government is necessary. Examining America’s budget, it is clear only a fraction of it is spent on public goods in the traditional sense. The big ticket items, military spending, social security, medicare, are not public goods. The latter two are transfers, and America’s military spending does not count as a public good (for Americans at least). Even railroads, which Noah mentions and are generally considered to have been one of the most transformative innovations, only increased GDP in 1890 by 2.7%. Given that rich and poor countries are separated by wealth magnitudes of 30 or more, a 3,000% increase, it would take 1200 public goods on the order of railroads to account for the disparity in wealth.

A more plausible explanation for the importance of state capacity is free trade, though in a fairly roundabout way. States are better thought of as a coalition of different interest groups. In the middle ages, this group was a number of local lords, princes, etc. Each of these territories would impose a small tax. Even though each tax was small, the sum was large, making trade prohibitively expensive in many cases. State capacity is important because a strong state would be able to crush these local taxing authorities, creating an internal free trade zone. Britain, for example, had higher tariffs than France during the first half of the 20th century, when the industrial revolution began. Britain’s advantage was far freer internal trade.

In the modern world there are no longer local princes and lords. There are largely analogous actors though. Latin America, which I am more familiar with, has extremely strong unions. Mexico, for example, only recently eliminated the practice of buying and selling teaching positions. This was heavily protested by the teachers union. These interest groups protect their rents, ensuring low economic growth. A weak state is dominated by these interest groups. A strong state is able to overcome them.

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