Government and growth: a Rorschach test

 

Tyler Cowen links approvingly to a new paper by Andreas Bergh and Magnus Henrekson of the Research Institute of Industrial Economics, calling the paper "useful and wise". The paper shows a negative relationship between government size and GDP growth among rich countries. The upshot:

An increase in government size by 10 percentage points is associated with a 0.5 to 1 percent lower annual growth rate. We discuss efforts to make sense of this correlation, and note several pitfalls involved in giving it a causal interpretation.

Notice that last sentence, especially the phrase "pitfalls involved in giving [the correlation] a causal interpretation." This is indeed very wise. Here are three (of the many) possible interpretations of Bergh and Henrekson's findings:

Interpretation 1: Government is good for a rich country. More government allows a country to reach a higher level of per capita GDP. Since rich countries experience conditional convergence, countries with large governments have low growth because their large governments raised per-capita GDP and hence caused growth to slow.

Interpretation 2: Government is bad for a rich country. The countries that are now rich finished converging long ago, and are now diverging, due to institutional differences. Because large governments are an inferior institution, countries with small governments are outgrowing those with large governments.

Interpretation 3: Government is neither good nor bad for a rich country within the observed levels. As countries become richer (and therefore grow slower, as in Interpretation 1), they exhibit a social preference for more government services. Hence, the causation is from GDP to government size.

Which interpretation do you believe? I predict that it will depend on your politics. Socialists will tend to favor Interpretation 1, libertarians will tend to favor Interpretation 2, American liberals will probably tend to favor Interpretation 3. It is my guess that Tyler Cowen favors Interpretation 2, but I could be wrong.

What do other scholars say? In a survey of growth economics, Xavier Sala-i-Martin of Columbia University writes:

The size of the government does not appear to matter much [for rich countries]. What is important is the “quality of government” (governments that produce hyperinflations, distortions in foreign exchange markets, extreme deficits, inefficient bureaucracies, etc., are governments that are detrimental to an economy).

This would tend to fit with my own priors, and my own politics.

So why did Tyler Cowen post the link? Did he want to give us a Rorschach test? Did he hope that we'd naturally gravitate toward Interpretation 2, and conclude that government is bad? I think that when linking to papers, it's good practice to vet the papers carefully and present them in a neutral fashion. In the case of Bergh and Henrekson's paper, the following paragraph struck me as the most telling:

Finally, while there is close to a consensus on the sign of the correlation [between government size and growth], there is also consensus on the fact that causality is very hard to establish with certainty using the method of instrumental variable estimation—or any other method currently available. In fact, it is close to conceptually meaningless to discuss a causal effect from an aggregate such as government size on economic growth. Thus, several scholars in our view have rightly concluded it is more fruitful to analyze separately the mechanisms through which different taxes and expenditure affect growth. Not all taxes are equally harmful, and some studies identify public spending on education and public investment to be positively related to growth.

To me, that seems very useful and wise indeed.