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State Intervention Is More of a Hindrance Than a Help to Growth

05 Dec 2017

Ryan Bourne

The starting point of any industrial strategy must be
recognition that government impedes growth more than it facilitates
it,” said former Treasury permanent secretary Nick Macpherson
on Twitter last week.

A slightly unexpected view from a former senior civil servant,
one might think. The economist Diane Coyle quickly waded in,
describing such views as “nonsense”, and outlining how
governments can boost the economy, though “research, standard
setting for new tech, human capital and infrastructure
coordination”.

Who’s right? Up to a point, both.

The starting point for an
industrial strategy should be to remove government-imposed
blockages to growth.

Absent any government at all, it is likely that our economy
would be substantially weaker. Without the rule of law and its
interaction with property rights, effective judicial and policing
systems, and state provision of certain public goods and services
that might be under-provided, it is likely the GDP potential of the
economy would be lower. OECD evidence suggests that certain
investments, such as provision of transport links and primary and
secondary education, can be growth-enhancing too.

Of course, in reality infrastructure projects are often chosen
using political rather than economic criteria, and so are not
growth enhancing in practice, even if they could be in theory. And
these need to be financed. If the revenues used to fund
infrastructure projects come from highly distortionary and
economically damaging taxes, on net they might retard growth.

Across OECD countries, four fifths of government spending does
not fit into this “productive” category anyway. The
overwhelming majority is transfer payments — cash moving from
taxpayers to other groups — and government consumption.

Then there are regulations. While some improve the functioning
of markets, the UK’s land use planning and energy laws in
particular undermine the growth potential of the economy. Tight
rules hamper labour mobility due to high and variable housing
costs, cause unproductive retail, childcare and social care
sectors, and encourage over-investment in real estate.

Little surprise then that when the Institute of Economic Affairs
examined the evidence, we found that the “growth
maximising” size of government was likely to be between 18
and 23 per cent of GDP. Of course, there are ways the government
can enhance wellbeing beyond growth, yet other work suggests that
the size of a “welfare maximising” government is likely
to be around 27 to 33 per cent of GDP.

In contrast, UK government spending is forecast to be 39 per
cent of GDP this year, and just 4.1 per cent of that is recorded as
public sector gross investment. So Macpherson is surely right to
say that the starting point for an industrial strategy should be to
remove government-imposed blockages to growth, rather than to
develop new projects and spending. At the very least, to the extent
that an “industrial strategy” is being delivered, any
funding for it should be substituted from existing government
outlays.

Whether the particulars of the government’s specific
industrial strategy deliver more economic growth is of course an
empirical question.

I’m sceptical, both given the UK’s experience with
intervention in industry, and the fact that plenty of the
recommendations reflect conventional wisdom, whereas the industries
and economic trends of the future tend to be unpredictable.

The government has pledged to found an independent
“industrial strategy commission” to observe if the
policies actually have the intended effects. Whether such a body
would ever conclude that the whole idea is a waste of time even if
it were the case is an open question.

What is crucial though is that the commission focuses on whether
the interventions raise the rate of return on investment and the
productivity of capital. And that must include comparing outcomes
against what would happen if the resources were simply left in the
private sector.

Certain interventions and investments undoubtedly could have a
positive impact on growth. But given the level of government
spending and regulation and the UK’s experience with
industrial intervention before, Macpherson’s conclusion that
“the starting point” should be about how government
constrains growth seems uncontroversial.

Ryan Bourne
occupies the R. Evan Scharf Chair in the Public Understanding of
Economics at the Cato Institute in Washington DC.

Click here to view the full article which appeared in CATO Journal