New Evidence on Government and Growth

By KEITH MARSDEN

In the early 1980s, Ronald Reagan embraced the ideas of a small group of economists dubbed "supply-siders." They argued that lower taxes and slimmer government would stimulate growth, enterprise, harder work and higher levels of saving and investment. These views were widely ridiculed at the time, dismissed as "voodoo economics."

Barbara Kelley

Reagan did succeed in lowering some taxes. But a Democrat-controlled Congress weakened their impact by raising government spending sharply, resulting in large budget deficits.

A quarter of a century later, many more countries have cut taxes and reined in heavy-handed government intervention. How far have they gone down this path, and with what success?

My study, "Big, Not Better?" (Centre for Policy Studies, 2008), looks at the performance of 20 countries over the past two decades. The first 10 have slimmer governments with revenue and expenditure levels below 40% of GDP. This group includes Australia, Canada, Estonia, Hong Kong, Ireland, South Korea, Latvia, Singapore, the Slovak Republic and the U.S.

I compared their records to the 10 higher-taxed, bigger-government economies: Austria, Belgium, Denmark, France, Germany, Italy, the Netherlands, Portugal, Sweden and the United Kingdom. Both groups cover a representative range of large, medium and small economies measured by their gross national incomes. The average incomes per capita of the two groups are similar ($27,046 and $30,426 respectively in 2005).

Most governments have reduced their top tax rates and spending-to-GDP ratios over the last decade or so, according to data published by the OECD, IMF and World Bank. But slimmer governments have done so at a faster pace, and to significantly lower levels. Their highest tax rate on personal income fell to a group average of 30% in 2006 from 36% in 1996. Top corporate rates were lowered to an average of 22% from 30%. Their average ratio of total government outlays to GDP fell to 31.6% in 2007, from an average peak level during the previous two decades of 40.4%

Investment growth jumped to an average annual rate of 5.9% in 2000-2005, from 3.8% over the previous decade. Exports have risen by 6.3% annually since 2000. The net result was a surge in economic growth. The IMF reports that GDP soared in the slimmer-government group at a 5.4% average annual rate from 1999-2008 (including its forecast for the current year), up from a 4.6% rate over the previous decade.

Over that same period, the bigger-government group was more timid in its tax reductions. Their highest individual rates declined to an average of 45% from 49%, and corporate rates to 29% from 35%. Furthermore, their average spending-to-GDP ratio only fell to 48.3% from a peak of 55.2%.

The bigger-government group therefore failed to gain any competitive advantages in global markets by generating or attracting larger investment funds. Their investment growth slowed to an average annual rate of 0.8% in 2000-2005, from 4.1% in 1990-2000. Their export growth rate almost halved to 3.1% annually in 2000-2005, down from 6.1% in 1990-2000. The bottom line is a drop in their average annual GDP growth rate to 2.1% in 1999-2008, from 2.3% over the previous decade.

Nor did they balance their books. They ran budgetary deficits averaging 1.1% of GDP in 2006, whereas slimmer governments generated an average surplus of 0.3% of GDP. Their net government debt averaged 39.2% of GDP in 2006, more than four times higher than the latter's. Interest payments on their debt took 2.3% of their GDP, compared with an average of just 0.5% in the slimmer-government group.

Slimmer-government countries also delivered more rapid social progress in some areas. They have, on average, higher annual employment growth rates (1.7% compared to 0.9% from 1995-2005). Their youth unemployment rates have been lower for both males and females since 2000. The discretionary income of households rose faster in the first group. This allowed their real consumption to increase by 4.1% annually from 2000-2005, up from 2.8% in 1990-2000. In the bigger-government group, the growth of household consumption has slowed to a 1.3% average annual rate, from 2.1% during the 1990-2000 period.

Faster economic growth in the first group also generated a more rapid increase in government revenue, despite (or rather, because of, supply-siders suggest) lower overall tax burdens.

Slimmer-government countries seem to have made better use of their smaller health resources. Total spending on health programs reached 9.5% of GDP in the bigger government group in 2004, 1.6 percentage points above the average in the slimmer-government group. Yet slimmer-government countries have raised their average life expectancy at birth at a faster pacer since 1990, reaching an average level of 78 years in 2005, just one year below the average for bigger spenders. Average life expectancy is now 80 years in Singapore, although government and private health programs combined cost only 3.7% of its GDP.

Finally, spending by bigger governments on social benefits (such as unemployment and disability benefits, housing allowances and state pensions) was higher (20.3% of GDP in 2006) than that of slimmer governments (9.6%). But these transfers do not appear to have resulted in greater equality in the distribution of income. The Gini index measuring income distribution is similar for both groups.

Other forces clearly helped to narrow income disparities in slimmer-government economies. These forces include wage-setting practices, saving habits, the availability of employer-funded pension schemes, and income sharing among extended families.

Both groups reduced the share of defense spending in GDP over the past decade. The slimmer-government average fell 0.1 points to 2.2% in 2005, but this level was 0.5 percentage points above the bigger-government average. The average share of armed forces personnel in the total labor force in the bigger-government group fell to 1.1% from 1.5% in 1995, whereas it grew to 1.7% from 1.5% in the slimmer-government group.

Information on public order and safety expenditures is incomplete. But for the 11 countries for which data are available, slimmer governments seem to take their responsibilities more seriously. They spent an average of 1.8% of GDP on these functions in 2006, compared with 1.5% by bigger governments.

The early supply-siders were right. My findings firmly reject the widely held view that lower taxes inevitably result in cuts in public services, slower growth and widening income inequalities. Today's policy makers should take note of how tax cuts and the pruning of inefficient government programs can stimulate sluggish economies.

Mr. Marsden, a fellow of the Centre for Policy Studies in London, was previously an adviser at the World Bank and senior economist in the International Labour Organization.

While Doha Sleeps: Securing Economic Growth through Trade Facilitation

by Daniel J. Ikenson

Daniel Ikenson is associate director of the Center for Trade Policy Studies.
He is coauthor of Antidumping Exposed: The Devilish Details of Unfair Trade Law (Cato Institute, 2003).

Executive Summary

Improving the international trading system does not require new, comprehensive multilateral agreement. Countries can derive large gains from the trading system by engaging in reforms often referred to as trade facilitation.

In broad terms, trade facilitation includes reforms aimed at improving the chain of administrative and physical procedures involved in the transport of goods and services across international borders. Countries with inadequate trade infrastructure, burdensome administrative processes, or limited competition in trade logistics services are less capable of benefiting from the opportunities of expanding global trade. Companies interested in investing, buying, or selling in local markets are less likely to bother if there are too many frictions related to document processing or cargo inspection at customs, antiquated port facilities, logistics bottlenecks, or limited reliability of freight or trade-financing services.

According to recent studies from the World Bank and other international economic institutions, trade facilitation reforms could do more to increase global trade flows than further reductions in tariff rates. For many developing countries—particularly those that receive preferential tariff treatment from rich countries—reducing transportation and logistics-related costs through trade facilitation reforms would be much more beneficial than further tariff cuts.

But trade facilitation does not only offer promise to developing countries. All countries can benefit by removing sources of friction in their supply chains. The post-9/11 focus on minimizing the risk of terrorists exploiting porous international supply chains to sneak weapons of mass destruction into U.S. cities—obviously a vital objective —could hamper the capacity of Americanbased companies to attract investment and compete for markets. Likewise, U.S. prohibitions against foreign competition in transportation services and the political antipathy toward foreign investment in U.S. port operations raise the costs of doing business and increase the scope for trade facilitation in the United States.

School Choice Is Change You Can Believe In

Barack and Michelle Obama send their children to an upscale private school. When asked about it during last year's YouTube debate, Sen. Obama responded that it was "the best option" for his children.

Several hundred low-income parents in our nation's capital have also sent their children to private and parochial schools, with the help of a federal program that provides Opportunity Scholarships. Like Mr. and Mrs. Obama, most of these parents are African-American. And like Mr. and Mrs. Obama, they too believe the schools they've chosen represent the "best option" for their children.

Now these parents have a question for Mr. Obama. Is Mr. Change-You-Can-Believe-In going to let his fellow Democrats take away the one change that is working for them?

Just a few days ago, Democrat Eleanor Holmes Norton (D.C.'s congressional delegate) told the Washington Post that "the Democratic Congress is not about to extend this program." Today that program will come under the congressional spotlight, when a House subcommittee takes up the annual appropriations bill for the District of Columbia that includes funding for Opportunity Scholarships for the 2009-10 school year. If Mrs. Norton and her allies in the teachers unions have their way, hundreds of African-American children with these scholarships will be forced back into one of the most miserable public school systems in the United States.

Just how rotten are the D.C. public schools? In a recent survey by Education Week, the D.C. public schools ranked fourth from the bottom in terms of graduation rates. Test scores for basics like math and reading are also near the bottom. It's not for lack of money: A recent U.S. Census Bureau report says the district school spending clocks in at more than $13,400 per child -- third highest in the nation. It takes a lot of money to run a school system as lousy as D.C.'s.

This dismal performance helps explain why so many have been willing to cross the usual political and ideological lines to try to give the district's kids a better shot at a decent education. Opportunity Scholarships have been endorsed by both the Washington Post and Washington Times. They have the support of the Republican president as well as the current and past Democratic mayors -- Adrian Fenty and Anthony Williams.

Even some of Mr. Obama's Democratic colleagues -- e.g., California's Dianne Feinstein -- have said that D.C. should be allowed to give the program a chance. In contrast, Mr. Obama's silence is thundering across the district.

This silence is all the more striking, given that the Ivy League-educated Democrat puts education reform at the top of his agenda. He has decried the "achievement gap" that is leaving African-American children behind. He has also noted -- rightly -- that America's system of public education is producing hundreds of thousands of children who will be condemned to the margins of American prosperity because they do not have the tools they need to succeed.

The question is whether, to paraphrase Hillary Clinton, Mr. Obama offers these children anything more than a good speech. It's true that Mr. Obama has endorsed merit pay, and in the past has suggested that schools should be able to sack bad teachers. But apart from a few feints and jabs around the margins, his proposals would do little to challenge a status quo that today serves teachers unions at the expense of students.

Back in D.C., those who have benefited from Opportunity Scholarships hope that the Democrat's presidential nominee will stand up for them. Tiffany Dunston used her Opportunity Scholarship to attend Archbishop Carroll High School, and graduated earlier this month as class valedictorian. Miss Dunston plans to attend today's markup session on Capitol Hill. She says she'd like Mr. Obama to "stand up" -- so more kids could get a chance for a good education.

Carleen McCarley hopes for the same. She looks at the Opportunity Scholarship that will allow her daughter Gabrielle to attend Metropolitan Day School as a lifeline. "I have a friend who does some work for Obama," she says, "and I tell her she needs to keep putting this in his ear."

April Cole-Walton hopes the candidate will be listening. Thanks to an Opportunity scholarship, her daughter, Breanna, will enter fourth grade this fall at St. Peter's Interparish School -- a safe and caring environment where she can learn. "If I could talk to Senator Obama," Ms. Cole-Walton says, "I would say, 'Give me a choice and give my daughter a chance.'"

These people have change they can believe in. The question is whether Mr. Obama will help them keep it. Or whether he'll be one more Beltway pol who speaks eloquently about public schools -- while making sure his own kids never have to step inside one.

Write to MainStreet@wsj.com

Time for a Modern Gold Standard

By Louis R. Woodhill

In the “Fact and Comment” section of the June 16, 2008 issue of Forbes magazine, Steve Forbes writes:

“But Bernanke mistakenly believes that the old gold standard somehow caused and deepened the Great Depression. Therefore, he is unlikely to adopt a modern gold standard, such as gearing monetary policy so that the dollar gold price remains in the $550- to $600-an-ounce range.”

Because Mr. Forbes is correct in saying that the only way out of our current economic and financial chaos is for the Fed to stabilize the dollar, two points must be made:

1. The old gold standard did, in fact, cause the Great Depression.
2. This fact should not discourage the Fed from establishing a modern gold standard.

In his 1991 book, Golden Fetters—The Gold Standard and the Great Depression 1919–1939, author Barry Eichengreen gives an excellent “play by play” account of the rise and fall of the old gold standard. His thesis is that the “classic” gold standard of 1880 – 1913 worked well, but the “interwar” gold standard of 1925 – 1931 was doomed from the start.

Golden Fetters is a work of great scholarship, but I believe that it misses the most fundamental flaw of the old gold standard—that it was based upon a lie.

One of the laws of the universe is, “Without integrity, nothing works”. A corollary is, “At the core of every business (or economic) disaster is a lie.” The Great Depression was the greatest economic disaster of all time, so at the heart of it had to be an enormous lie.

The old gold standard was based upon the collective promise of the participating governments to redeem their currencies for gold at a fixed price upon demand. From the beginning, there wasn’t enough gold in the world to honor this promise. This was the fundamental lie.

The lie was implemented via “fractional gold coverage” laws that allowed central banks to issue (typically) up to 2.5 times as much base money as the value of their gold holdings. Then fractional reserve banking was used to leverage the monetary base to create even more money. When the game of “let’s pretend” being played by governments, central banks, financial institutions, and the public collapsed, so did banks, employment, trade, and the gold standard itself. Because gold was the only real money, when the crunch came, everyone wanted to redeem their money for gold—at the same time.

So, why base the world’s monetary system on a lie? Why not just use 100% gold coverage for the monetary base and 100% reserve banking? The answer is, “because the resulting deflation would have been politically intolerable”. As the world economy became more differentiated, productive, and complex, there was a need for more and more money. Despite the many “tricks” described in Golden Fetters that were employed to “stretch” the available gold, the old gold standard was marked by chronic deflation. The U.S. GDP Deflator was more than 17% lower in 1929 than it was in 1920. When the “stretched” world money supply finally “snapped” in late 1929, the deflation accelerated, with the price level plummeting another 26% by 1933.

What the world learned from the old gold standard is that you cannot use anything physical as money and maintain integrity. Any commodity that is valuable enough to start using as money will be too scarce to continue using as money.

Today we have the “Bernanke Standard”. Like many other “fiat money” regimes around the world, the Bernanke Standard is also based upon a lie. In this case, the lie is that “money” and “capital” are the same thing, and that it is possible to regulate the value of money by manipulating interest rates. They are not, and it is not.

Since March, 2001, the dollar has lost about 70% of its real value, whether measured against gold or retail gasoline. During that time, the Fed lowered its Fed Funds interest rate from 5.00% to 1.00%, raised it to 5.25% and then lowered it to 2.00%. Clearly, there is no direct relationship between the Fed Funds rate and the value of the dollar. But why would there be? The Fed Funds rate is the price of a certain type of short-term capital, and capital is not the same thing as money.

Because, “Without integrity, nothing works”, the only way out of our current mess is to restore integrity to the dollar. We must have a monetary system that is not based upon a lie. A “modern gold standard” would do the trick.

Under a modern gold standard, the Fed would use its Open Market operations to force the COMEX price of gold down to (say) $500/oz and keep it there. At that point we would have a fiat currency whose value was defined in terms of the market value of gold. Unlike the old gold standard, gold would not be money, and monetary operations would not create any additional demand for gold. The monetary base would automatically expand and contract in response to market demand. Because the Fed has the power to deliver on a commitment to stabilize the value of the dollar against gold, a modern gold standard would have integrity.

Under a modern gold standard, the world would be certain of future value of the dollar. All of the economic costs currently devoted to hedging fluctuations in the value of money would be avoided. Interest rates would fall. The economy would boom. Crude oil prices would fall from today’s $134/bbl to $77/bbl—or less.

If we restore integrity to the dollar, our economy will start working again and the current climate of fear and anxiety will abate.