Time to rethink the role of Government

While their reputation has suffered at the hands of economists, it is time for governments to show that they have wised up

It must be tough being repeatedly told that you are stupid but that is what governments have had to put up with.  Mainstream economic theory tells us that markets know best and clumsy governments only get in the way.  But the global financial crisis has highlighted that financial markets are not smart enough to be left to their own devises.  This is just one of several areas where it would be wiser to bring back government as a power for good.

The Invisible Hand was always seen the clever one

Economists like to think that markets are the smartest thing around.  Markets refer to not just places where anything from sausages to shares are sold, but also to the economic system where numerous companies compete to offer goods or services.   The clever thing about markets is that prices and output can change to reflect demand from consumers and this helps to determine the best allocation in an economy.  The best bit is that this optimal outcome is not based on decisions made in one controlling body but market information gleaned from the individual decisions of consumers and firms. 

This belief stems all the way back to the father of economics, Adam Smith, who argued over three centuries ago that the private actions of individuals in the market would work for the public benefit.  Governments, on the other hand, are seen as more of a heavy hand in the economy.  Governments get in the way by creating red tape that strangles business and misallocating resources by dishing money out to favourite sectors.  Examples of misspent money abound as do unworthy recipients of taxpayer cash.  

Yet, all economists would also agree that some government actions are needed for markets to function properly.  Basics such as national defence and policing are essential for any business to operate and can only be provided by governments.  Companies also rely on a supply of workers with some degree of education as well as communication and transport infrastructure.  So while some level of government intervention is necessary, the extent to this is something that is defined by politics.   

The trend started by Thatcher and Regan has been for an increasingly shrinking role for government in the economy.  Economic theory was enlisted to make the case for smaller government which came as a backlash against decades of expanding government.  Much of the initial cases for privatizations and deregulation were justified due to numerous areas where government had overextended itself.  Yet, faith in markets and distrust of government has become so embedded in politics that cases where more government might be good are dismissed.  Governments are so timid in their actions that much of policy to do with the economic recovery has been outsourced to central banks (which creates its own problems).

Who looks stupid now?

Government policy does not always work out as hoped.  But bureaucrats are not alone in making mistake – just think of Enron or BP.  Yet, the most obvious example of where government involvement has been missed is the finance sector.  Deregulation over the past few decades let loose forces that even the banks themselves were not smart enough to understand.  Banks messed up in terms of the seemingly common sense notion of putting long-term survival ahead of short-term profits.  

More proactive government policy would have gone a long way to preventing many elements of the crisis and is something that we should apply now with the benefit of hindsight.  But the notion that more government is good can also be applied elsewhere.  Transport infrastructure has been neglected amid the trend for smaller government while other areas such as R&D and training for workers could do with more government input.  Governments which are not willing to take an active role in the economy leave voters feeling frustrated and opens the way for the rise of populist parties.

This is not an argument to re-establish government dominance over the economy.  A bigger government need not involve significantly higher taxes and large welfare payments.  But, there are parts of the economy where action is needed to ensure the public good and only government can respond to this.  While politicians on the right need to be more accepting of the positive effects of government, it is up to left-wing parties to make a better case about the good that government can achieve.  It is time that we were all smarter in the way they think about government.