U.S. Economy Does Better When Government Butts Out

Given the apparent triumph of American-style capitalism, it seems quite remarkable that the collapse of communism is less than a decade old. We now compare the performance and debate the relative advantages and disadvantages of the American model, the European model and the Asian model. The central theme of that debate--what is the appropriate role of government in taxes, spending, transfer payments, regulation, labor market mandates, etc.--is a narrower version of the earlier debate between capitalism and communism.

Let’s start by noting what happened in the former East and West Germany. Both were shattered by World War II. Both had similar problems and opportunities. The East was dosed with communism--the heavy hand of state planning, controls and government intervention, regulation and state ownership of virtually everything. The West was dosed with capitalism and grew into an economic superpower--struggling now under the burden of economic integration with the East--while the East stagnated.

When the two Germanys were reunited, the standard of living in the West was five times that of the East, which had a spoiled environment, decrepit capital stock and demoralized labor force. That is about as close as we get to a natural experiment in economics. And the answer was unambiguous. There is no longer any doubt about whether there are two alternative paths to economic prosperity. Socialism and central planning do not work. Only capitalism and free markets, in various forms, do.

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But what of the more modest--but still important--difference in the role of government among the welfare states of Western Europe; the partially managed economies of Asia; and the more open, competitive, freer economy in America?

Although the American economy has greatly outperformed the other advanced industrial economies for some time, let us not be swept away by this talk of economic nirvana. It is hoped that the period of low inflation, low unemployment and steady growth will continue, but we have not banished business cycles, killed inflation or traded an “old” economy for a “new” economy in the last 12 months.

Remarkable developments in the private sector, combined with improved economic policy starting with President Reagan and Federal Reserve Board Chairman Paul Volcker, set us on a new path to low inflation, lower tax rates and less government micro-management of the economy.

The robust private sector, together with this economic policy environment, has produced a 15-year economic expansion interrupted by a mild nine-month recession nationwide (but longer and far more severe in California). This is a far better performance than those of the other leading industrialized economies, each of which has recently been at or near recessionary levels.

Indeed, compared with 1970, there are about 45 million more working-age Americans, the labor force has grown even more, unemployment and government employment have increased only slightly and an overwhelming number of people have found productive private-sector jobs. In Western Europe, where there are about 35 million more working-age people, the labor force grew by only 24 million, unemployment and government employment swelled, and there are currently 1 million fewer private-sector employees. What a stark indictment of an inflexible, protected, highly regulated and overtaxed economic system.

The sorry state of Western Europe--and the great reluctance of Europeans to do anything serious about it--offers us a window on our own future and ample fodder for what we should avoid.

Sensing that the argument for bigger government in America was not going to be bolstered by the comparison to sickly Western European economies with their massive unemployment, leading intellectuals and politicos in the U.S.--some current and former Clinton administration officials among them--argued for increased government control of the allocation of investment, especially in commercial technology. Pointing to the alleged success of so-called industrial policy in Japan, led by the Ministry of International Trade and Industry, the argument was that foreign governments’ heavy subsidy of particular technologies and industries would enable them to dominate world markets, so we had to do the same.

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Now, I have been a staunch supporter of government financing of science and technology when it is generic and private firms would be unable to appropriate the returns from the research and the expected benefits to society exceed the expected costs (under very rigorous cost-benefit tests). But the notion that the government could pick winning versus losing industries and technologies is foolish. Indeed, on closer inspection, the industries receiving heavy subsidies and protection in Japan were agriculture and mining, not high tech. Although Japan did have some high-profile high-tech initiatives, such as fifth-generation computing and (analog) high-definition television, they have been dismal failures, overwhelmed by American private-sector technological expertise.

These comparisons of economic systems are important reminders because of the proclivity of politicians to propose government solutions to problems despite the evidence of recent decades that they are likely to be far more expensive and far less effective than predicted. If we are to avoid our own version of the severe economic problems recently suffered by Europe and Japan, we must remain vigilant on the principles of a dynamic, flexible and open private-market economy. That means our federal, state and local governments must be limited to what they need to do and can do well.