The Banking Dead

Rethinking the State and the Economy

On December 16, 2011, in economic theory, tax policy, by Jon Lewis

Government versus Markets: The Changing Economic Role of the State. Vito Tanzi. Cambridge University Press, 2011, pp. 376, $35.00 If the past is any guide to the present, many voters in the 2012 presidential primaries, as well as in the general election, will make their choices based upon the personalities of the candidates. While unfortunate, [...]

Government versus Markets: The Changing Economic Role of the State. Vito Tanzi. Cambridge University Press, 2011, pp. 376, $35.00

If the past is any guide to the present, many voters in the 2012 presidential primaries, as well as in the general election, will make their choices based upon the personalities of the candidates. While unfortunate, this is not entirely without good reason. It would be preferable, however, if the majority of the voting public were able focus less on the quixotic personalities in the race, and more on the most pressing, and interrelated, issues of our time; namely, the size and scope of the federal government and the national debt. Whatever one might think of their methods or their ideology, the American public has the Tea Party largely to thank for bringing attention to the debt crisis and the unsustainability of the current entitlement system.

In Government versus Markets, Vito Tanzi (formerly the director of the Fiscal Affairs Department of the International Monetary Fund) opens with the premise that, “[t]here is no more fundamental question in economics than what role the state or the government should play in a country’s economy.” Although some might dispute this characterization as demonstrating a bias toward macroeconomics, it is inarguable that the relationship between the state and the private sector is likely to be significantly redefined in the next decade. The question, of course, is in what direction. Will the next decade witness a move toward greater federal government involvement in education, energy, and health care or toward a smaller government that does less, but with greater fairness and efficiency? Or something in between?

In what can best be described as a sweeping intellectual history of the role of the state in modern industrial economies, Tanzi demonstrates how, from the late nineteenth century onward, the state has taken on an increasingly greater role in the economy. With references to economists Adam Smith, Karl Marx, and John Maynard Keynes, as well as to Bismarck’s social insurance legislation in Germany, which the author rightly notes “had a major impact on the world and must be seen as a major and perhaps the most important landmark in social legislation,” the author successfully integrates economic history with political philosophy. In Chapter 8, for instance, the author devotes his attention to both the voluntary exchange theory and public choice, citing the work of James Buchanan.

In Tanzi’s assessment, in the first half of the twentieth-century in industrialized countries, “the government became a huge insurance company and intermediary for the citizens.” This, of course, did not come without a cost; namely, increased taxation and spending. In a passage particularly relevant to the fiscal morass in which we currently find ourselves, Tanzi, in the book’s introduction, reminds the reader that there is a direct correlation between current fiscal policy and the future role of the state in the economy. “When governmental intervention comes through higher spending and higher taxes, as it often does, it can change for future years the economic role of the state and the status of a country’s public finances.” It would seem that, at times, large segments of the American public have forgotten Milton Friedman’s pithy observation that there is indeed no such thing as a free lunch.

In light of the ongoing public debate over income inequality, Tanzi’s discussion of the subject matter, albeit not the central focus of Government versus Markets, is worth consideration. He contends that, “in a competitive and globalizing world, reduction in income inequality, although important, cannot be the sole of the main objective of economic policy. If that were the case, the policies pursued by the planned economies in the past, and by Cuba and North Korea today, would be praised and imitated.” Indeed, if twentieth-century has taught us anything, it is that well-intentioned social engineering projects aimed at reducing income inequality have, unless constrained by an open, pluralistic political system and a commitment to the rule of law, will often backfire, which lead to greater misery for a larger number of people.

If the state’s power in the economy has increased throughout the past century, what is the likely role of the state in the future? It is here that Tanzi makes his most provocative contentions. Regulations, rather than the government’s taxing and spending powers, will become more influential. He suggests that governments have focused too much on replacing the private market with the public sector and too little on preventing market failure. A fundamental principle to guide the state’s economic role, Tanzi posits is an “ambitious normative option,” wherein governments should focus on the prevention of market failure, more than on remedying failure after the fact. Of course, regulatory policy is hardly an uncontested terrain. For this reason, it is likely that Tanzi suggests that, “a clear, binding, legal guideline may be necessary” to deal with the myriad political problems associated with regulatory policy, such as regulatory capture. This is perhaps much easier said than done.

In terms of fiscal policy, Tanzi enumerates four possible developments that, either by themselves or in combination, can contribute to large reductions in debts and fiscal deficits: substantial drops in interest rates for government debt; high economic growth; unanticipated inflation; “and reforms in taxes and in public spending associated with a major change in the role of the state in the economy that lead to large reductions in public spending and/or significant increases in tax levels.” It is the last approach – one, it should be noted, that is not altogether different from the path suggested by Congressman Paul Ryan – that Tanzi suggests is the better option.

Tanzi appears to call for a form of “libertarian paternalism,” a term that he uses in quotes. In this approach, the government’s focus would be on reducing risks, rather than correcting ex post preventable outcomes. Under this approach, the government would have a direct role in assisting the deserving poor. With lower taxes and less spending, the middle class would use its larger share of post-tax disposable income to buy protection from the market place and some social services formerly provided for by the government. “This,” opines Tanzi, “is not an easy way out from the current fiscal mess, but it may be the only realistic one for many countries over the long run.” Policymakers supportive of expanding the federal government’s role in health insurance would be well advised to take Tanzi’s arguments seriously.

In conclusion, Government versus Markets is an excellent and highly thoughtful book that deserves a wide audience. It is no longer possible to believe that the current fiscal trajectory in the United States is sustainable over the long term. Although reduced taxation and spending will come at a significant cost, it is likewise true that continuing business as usual will come at an even greater cost, particularly for the recent college graduates who are inheriting a future with limited opportunity.

Jon Lewis (c) 2011

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