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Monday, September 24, 2007

A workable balance

The discussion in the comments to the revisiting statism post touched upon the idea of a mixed economy. I expressed my preference for a mixed economy that was largely free. In light of the matter it seems like this article by Mark Skousen could provide some food for thought.

Too much government and the economy chokes. Too little, and it cannot function. Is there a Golden Mean?

Each year the Fraser Institute publishes their Economic Freedom of the World Index (see, which measures five major areas of government activity in more than 100 countries: size of government, legal structure, sound money, trade, and regulation.
The most surprising thing about the study, according to its author James Gwartney, a professor of economics at Florida State University, is the importance of legal structure as the key to maximum performance for an economy. “It turns out,” he told me in a recent interview, “that the legal system — the rule of law, security of property rights, an independent judiciary, and an impartial court system — is the most important function of government, and the central element of both economic freedom and a civil society, and is far more statistically significant than the other variables.”

Gwartney pointed to a number of countries that lack a decent legal system, and as a result suffer from corruption, insecure property rights, poorly enforced contracts, and inconsistent regulatory environments, particularly in Latin America, Africa, and the Middle East. “The enormous benefits of the market network — gains from trade, specialization, expansion of the market, and mass production techniques — cannot be achieved without a sound legal system.”

Milton Friedman identifies the legitimate roles of the state: “The scope of government must be limited. Its major function must be to protect our freedom both from the enemies outside our gates and from our fellow-citizens: to preserve law and order, to enforce private contracts, to foster competitive markets. Beyond this major function, government may enable us at times to accomplish jointly what we would find it more difficult or expensive to accomplish severally.” Adam Smith suggests that this “system of natural liberty” will lead to a free and prosperous society. As Smith declares, “Little else is required to carry a state to the highest degree of opulence from the lowest level of barbarism, but peace, easy taxes, and a tolerable administration of justice.”

My thesis is that as a society moves from zero government to point P, economic well-being increases to peak performance. Then, as it adopts a larger and less necessary government, its growth diminishes, and can even turn negative if government becomes too burdensome and controlling.
Hayek makes the following point in The Fatal Conceit:
The more one learns about economic history, the more misleading then seems the belief that the achievement of a highly organized state constituted the culmination of the early development of civilisation. The role played by governments is greatly exaggerated in historical accounts because we necessarily know so much more about what organised government did than about what the spontaneous coordination of individual efforts accomplished.

Governments have more often hindered than initiated the development of long-distance trade.

Rather, it would seem as if, over and over again, powerful governments so badly damaged spontaneous improvement that the process of cultural evolution was brought to an early demise. The history of China provides many instances of government attempts to enforce so perfect an order that innovation became impossible. What led the greatly advanced civilisation of China to fall behind Europe was its governments' clamping down so tightly as to leave no room for new developments, while Europe probably owes its extraordinary expansion in the Middle Ages to its political anarchy.
(back to Skousen)
Several economists have attempted to determine the ideal level of government spending as a percentage of GDP. In the 1940s, Australian economist Colin Clark said that the maximum size of government should not exceed 25% of GDP. Anything higher would hurt economic growth. Professor Gerald W. Scully, of the University of Texas at Dallas suggests that the tax rate ought not to exceed 23%. World Bank economists Vito Tanzi and Ludger Schuknecht analyzed 17 countries during the period 1870 to 1990 and concluded that public spending in newly industrialized countries should not exceed 20% and in industrialized countries not more than 30%.

Is optimal government (point P) the same for every country? This would make an interesting study, but I suspect that differences in culture and socio-economic circumstances suggest that some nations require more government than others. As Benjamin Franklin states, “A virtuous and laborious [industrious] people may be cheaply governed.”9 And a lazy, dishonest people must be expensively governed.

Almost every country in the world today is to the right of Point P, and could grow faster and enjoy a higher quality of life by reducing the size and scope of government. Countries from China to Ireland to Chile have demonstrated how dramatically the economy can improve by cutting back the state. I’m sure even Hong Kong, #1 in the Fraser Institute’s study in terms of performance and freedom, could benefit from some improvements by scaling back some types of government services. According to the latest surveys of economic freedom by the Fraser Institute and Heritage Foundation, countries on average are becoming more free, and not surprisingly, the world’s economic growth rate is rising. After noting that government represents 40–50% of GDP in most developed nations, Tanzi and Schuknecht conclude, “we have argued that most of the important social and economic gains can be achieved with a drastically lower level of public spending than what prevails today.”

In short, most countries could use less government, but a few countries could use more of the right kind of authority. There is an optimal size and structure of government, and when it is reached, the result is, in the words of Adam Smith, “universal opulence which extends itself to the lowest ranks of the people.”

While I think that it is important to be skeptical about our ability to know something like optimal size and role of government with any precision, it may be possible to learn more through such observation and trial and error experimentation in incremental policy steps. In comparison to centrally planning and directing any meaningful portion of our complex economy and society, learning more in this area of the public- private mix should be doable.


Bret said...


I'm quite surprised you didn't include the research by Nobel Laureate James Mirrlees:

"One of Mirrlees's main contributions was his pathbreaking work on optimal income taxation—a progressive tax that included incentives for earning. An adviser to the British Labour Party in the 1960s and '70s (an era of higher taxes and a more centralized control of the economy), Mirrlees started his work with the assumption that the government should take money from the rich and give it to the poor.

His conclusions were surprising. Working from this assumption and making further assumptions about people's skills and the effect that tax rates have on the incentive to earn, Mirrlees computed the top marginal tax rate for high-income earners. He found that this optimal rate was not 83 percent, the top rate in Britain at the time, but instead only 20 percent. Moreover, he concluded that the marginal tax rate should be about 20 percent for everyone, which would make the optimal structure something very close to what is now called a flat tax rate. “I must confess,” wrote Mirrlees, “that I had expected the rigorous analysis of income taxation in the utilitarian manner to provide arguments for high tax rates. It has not done so.”

Not only is growth and quality of life maximized by moving "left" to point "P", but redistribution is also maximized by reducing and flattening taxes.

The only reason to have high marginal tax rates is to increase the power of government relative to its populace and reduce the welfare of the poor. I don't like either of those.

erp said...

... that the legal system — the rule of law, security of property rights, an independent judiciary, and an impartial court system — is the most important function of government, and the central element of both economic freedom and a civil society, and is far more statistically significant than the other variables.”

True and an informed citizenry is an integral part of it all. Our schools are turning out illiterates and innumerates with little or no knowledge of history, geography, etc. This is the most pressing problem we face because voters can't make informed decisions if they can't reason out the issues.

Bret said...

erp wrote: "...voters can't make informed decisions..."

Even worse than voters making uninformed decisions is when voters make MISinformed decisions because of the information they're presented in school and elsewhere. Uninformed decisions might be random, in which case a relatively small group of informed voters can cause the correct outcome because the random voting can cancel itself out. However, when many voters vote based on bad information, there's no possibility for a corrective mechanism.

erp said...

Quite so. I was trying to be a bit tactful. What are we doing about it? A third generation of kids are entering schools run by the teachers unions. Their parents and grandparents have also been brainwashed.

Howard said...


I was waiting for a series of posts on taxation to unveil Mirrlees...


We can just chip away at the misinformation that's out there...
also would like to see vouchers and choice for all students/parents to sidestep near monopoly of government school systems that are especially failing those most in need of a good education.

erp said...

Howard, my point is that parents don't know any better either, nor do grandparents.