YOU DECIDE: Does bigger government hurt the economy?

Date posted: September 3, 2010

Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.

Media Contact: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

By Dr. Mike Walden
North Carolina Cooperative Extension

I’m going to venture into a thicket of controversy in this column. The size of government and its impact on the economy and on our broader society is a red-hot topic today, and it’s easy to understand why. Government — especially the federal government — has significantly increased its involvement in the economy in recent years.

First was the trillions of dollars, much of it borrowed, spent by the government in fighting the recession. This has increased both the annual budget deficit and long-term debt. Second came two large pieces of legislation — one focusing on health care and the other on financial services — that will result in the federal government taking much larger roles in two of the largest sectors of the economy.

Yet with the economy still struggling and unemployment uncomfortably high, there’s a rising chorus of voices saying the growing size of government rather than being a help to the economy may have become a hindrance.

So there’s a new debate about the size of government and its role in the economy. On one side are those who say it was only the actions of government that saved us from a depression that may have exceeded the downturn of the 1930s. This viewpoint also says a more active government is needed today to address both the inequities and complexities of the modern economy.

The opposing side says bigger government holds the economy back in two ways. First, it spends money ineffectively, using funds that could have been allocated more productively by the private sector. Second, in increasing taxes to support a larger government, private spending and private investments — which boost the economy — are deterred.

As is my approach, I will not favor one side or the other in this debate. Actually, I think there is merit in both arguments. What I will try to do is frame the debate about the tie between the size of government and the economy on logical grounds and then give some findings that address the issue.

The debate about government and its impact on the economy revolves around a “big tradeoff,” a term coined by the late economist Arthur Okun. Okun argued the economic pie was best made bigger by private individuals and private companies pursuing their own self interests. This leads to resources being used most efficiently, meaning the economy gets its biggest bang for the buck spent. This is the essence of the free market system.

But everyone may not like how the economic pie is divided by this system, and the pie may have some rough edges. Hence, we may want another force — government — to change some of the slices and to smooth off some of the edges. Government does this by re-distributing some income and by establishing some regulations over what individuals and businesses can do. The recently passed health care legislation and financial services regulation bill can be viewed as actions in this direction.

In Okun’s words, therefore, there are two goals for the economy: efficiency, meaning growing the economic pie so living standards can rise, and equity, relating to some “fair” distribution of the slices of the pie. Every society debates over how much attention to give to each goal.

However, Okun saw a problem in pursuing these twin objectives. To get more equity, the economy would have to sacrifice some efficiency. In other words, to slice the pie more equally, the pie won’t be as big. This is Okun’s “big tradeoff.”

There’s actually empirical evidence backing up Okun’s claim. A just-published book exhaustively analyzed scores of studies relating the size of government to economic growth. The conclusion: countries with larger governments do grow more slowly. Numerically, the relationship is in the range of a half to one percentage point decline in the economic growth rate for every 10 percent increase in the relative size of government.

So the argument can be made that if the government had refrained from intervening in the economy during the recession, the necessary adjustments to production and prices would have occurred faster, and the economy would now be growing at a more rapid pace. Likewise, it can be argued that the health care and financial services legislation may slow future economic growth.

If accurate, the larger question still remains, is the loss in economic growth worth it? Did the government’s actions during the recession cushion the damage of the downturn, particularly to vulnerable households? And will the health care and financial services bills expand the coverage of medical care and of safe and secure financial dealings to more people?

This is the big tradeoff, and it’s an issue that is, by no means, new; it’s just wrapped in different packaging today. It is, perhaps, the central issue in government and one on which every generation will have to decide where it stands.

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Related audio files are at http://www.ncsu.edu/waldenradio/

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