(This policy bulletin is extracted from FMF Occasional Paper Jobs creation and government policy, published by the FMF in 2001.)
The role of government in the economy
The role of governments in the economy was laid out in a wonderful essay by the late economist Karl Brunner, “The Poverty of Nations”. A person in an economy can use resources in only one of four basic endeavours: he can produce, trade, influence the political process in an effort to redirect greater resources to his advantage, or protect himself against the wealth-redistributing efforts of others. In the first two uses – production and trade – the total welfare generated by the economy increases. In the language of economists, these activities represent a positive-sum gain. However, the latter two efforts – redirecting the flow of resources or protecting against the wealth-redistributing efforts of others – are zero-sum, or even negative-sum, games. They add no value and therefore generate a lower standard of living for the citizenry as resources are directed away from production and trade. Government institutions – laws, rules, regulations, and the judicial system – influence each of the resource allocation decisions.
The influence of government as a wealth-redistributing body is well known in both eastern and western economies. As we have had ample opportunity to observe, government wealth redistribution via explicit or implicit taxation necessarily lowers the incentive to create and accumulate wealth, thereby lowering the potential productive power of the economic system. But governments also promote production and trade, because they are assignors and protectors of property rights, and provide for the enforcement of private contracts. These are wealth-enhancing activities that help the productive capacity of an economy blossom. Thus, governments have two necessarily contradictory and coexisting modes, “the protective mode” and “the redistributive mode”.
These modes of government suggest why arbitrary borders along a political boundary generally signify regions of varying prosperity. They are the frontiers of a government’s authority and, as such, they mark the varying degrees of both the protective and redistributive modes. Either of these two government roles can contribute to a barren economic landscape. Too little protective power, or too much redistributive effort, inhibits the creation and retention of wealth within a particular government’s borders, and retards equilibrating forces that attempt to provide for a more comparable standard of living.
Now that the concrete and barbed-wire walls that separated the eastern and western European economies no longer exist, we can expect to see a narrowing in the wealth differentials between the two regions. However, until a legislative and judicial infrastructure has been built that allows the protective state to exist in a meaningful sense, the large gap in economic well-being cannot be closed.
A necessary precondition for the accumulation of capital is the protection of property rights. Those countries that make the most rapid progress in adopting western legal, financial, and accounting practices will usher in a new era of prosperity for their economies. Similarly, until the redistributive modes of many Western European economies are substantially curtailed, the stagnation in their standards of living is certain to persist.
The ability of governments to influence the creation of wealth, documented in a recent study produced by a consortium of research institutes – including the Fraser Institute in Canada, CISLE in Mexico, the CATO Institute in the United States, and the Free Market Foundation in South Africa – has generated a great amount of interest. That work attempted to gauge, in a methodical way, the economic freedom of a broad cross-section of nations. The conclusion from examining more than 100 countries over a 20-year period was that governments with a strong commitment to economic freedoms – free personal choice, the freedom of exchange, and the protection of private property – tended to be faster-growing, wealthier countries. No nation with a persistently high economic freedom rating during the 20-year period failed to achieve a high level of income. Furthermore, the 17 countries with the most improved freedom ratings all had positive and generally strong growth rates, while the 15 countries where economic freedoms declined recorded real per capita GDP deficits.
This Occasional Paper can be downloaded here.
AUTHOR Jerry L Jordan. This Policy Bulletin may be republished without prior consent but with acknowledgement to the author. As always the views expressed in this Occasional Paper are those of the author's and are not necessarily shared by the members, directors or staff of the Foundation.