A Companion to the History of Economic Thought - Chapter 27 pdf

Medema 27.1 INTRODUCTION The question as to the appropriate role for government within the economic system is as old as economic thought.. This has a number of implications, but for pres

C H A P T E R T W E N T Y - S E V E N

The Economic Role

of Government

in the History of

Economic Thought

Steven G Medema

27.1 INTRODUCTION The question as to the appropriate role for government within the economic system is as old as economic thought For much of that history, the economy was seen as but one piece of a larger social system and the study of economics, or political economy, as one facet of a larger social theory Only with the advent

of commercial society and the organization of economic activity more overtly within the context of the market did the perception of the economy as a quasi-independent part of the social system begin to gain currency This has a number

of implications, but for present purposes one stands out: the earlier economic literature envisioned a system wherein government and economy are integrally linked aspects of the social system, whereas in later literature government and economy – or government and market – are often viewed as independent spheres

of action, with corresponding questions as to how much one should “intrude” upon the other

The perspectives that motivate or underlie the discussion of the appropriate economic role for government are many and diverse; the resulting analysis thus reflects diverse and often contradictory accounts of the appropriate economic tasks for government This vast topic requires the selective adoption of an organ-izing principle, and that adopted here is “the economic role of government as a

response to the forces of self-interest.” While this necessarily excludes a variety

of contributions and perspectives, it provides the vehicle for a useful analysis of how the economic role of government has been viewed throughout the history of economic thought and analysis, and the forces that have motivated these views

27.2 PRE-CL ASSICAL ECONOMICS One defining characteristic of much pre-classical economic thought is its natural-istic, or natural law, orientation – an orientation reflected in the roles ascribed to

government by these scholars This a priori approach to the subject made the role

of government something given rather than something to be worked out We find here no deep theory of governmental behavior and no serious analysis of the ability of government to carry out the tasks ascribed to it by these authors There

is, rather, an assumed natural order of things and consequent statements of how government should act so as to facilitate the operation of a social–economic system that comports with the dictates of natural law

27.2.1 The Greeks and Scholastics

The Greek contribution to economic thought arises primarily through the works

of Plato (e.g., in Republic and Laws) and Aristotle (e.g., in Politics and Ethics) Their analysis centered around the polis, or city–state, and what, ideally, would

constitute “the good life.” An important aspect was justice, including the role to

be played by the governing authority The economic upheaval against which Plato and Aristotle discussed economic issues was seen to be a consequence of the surge in economic growth following the liberalization of commercial activity, including the expansion of international trading activity Given what they saw as the undesirable effects of economic growth, their analysis centered on the estab-lishment of a relatively stationary state of economic activity accompanied by a reasonable standard of economic well-being

For Plato and Aristotle, the most straightforward means of attaining their objectives for the ideal state was through relatively strict limits on commercial activity in which the state was to play a central role A system of laws should be

so structured as to facilitate a stationary state with a reasonable level of economic well-being for all citizens Aristotle saw the market as a “creature of the state” (Lowry, 1987, p 237); with this came prescriptions for the regulation of commer-cial dealings For example, both Plato and Aristotle recognized that a satisfactory level of material well-being required the harnessing of the division of labor This should be conducted such that natural roles were enforced (Plato) or at least given effect by government (condoning slavery, by Aristotle) Both Plato and Aristotle objected to the internationalization of the division of labor, which they believed introduced base influences into society; various government actions – such as separate domestic and international trading currencies – were recom-mended to mitigate incentives to seek private gain through foreign trade Commercial activity in general was frowned upon, and at best was seen as a

necessary evil to equalize needs and possessions Policies – including prohibi-tions against lending at interest, the elimination of profits, and statutory fixation

of prices – were recommended to control commercial activity

Certain significant parallels existed between the respective analyses of the Greeks and the Scholastics, derivative of St Thomas Aquinas’s attempt to reconcile Church teachings with the work of Aristotle Their analysis of the relationship between man and his creator, an aspect of which is the relation between individuals

in a social context, led the Scholastics to consider commodity exchanges and monetary issues from a Christian moral perspective The “economic problem,” in

a sense, was man’s sinful nature, the effect of which, if left unchecked, was to promulgate outcomes contrary to the dictates of Christian justice if unchecked by religious and civil laws

While viewing common property as the ideal (evidenced in communal mon-astic institutions), the Scholmon-astics believed that private property was optimal for society as a whole, owing to the negative incentive effects that common property provides for sinful, worldly people – a religious variant of Aristotle’s position Unlike Plato and Aristotle, the Scholastics were more favorably disposed to commercial activity, generally believing that market outcomes would satisfy the dictates of justice in the absence of monopoly or fraud Following Aquinas, the early Scholastics supported prohibitions on lending at interest, although this view slowly eroded as later scholars came to understand the opportunity cost of lending Concern over the harmful effects on purchasing power that could come with macroeconomic fluctuations led many Scholastics to support some degree

of price control – the regulation of prices within certain upper and lower limits –

in order to mitigate fluctuations in the value of money

For both Greek and Scholastic writers, relatively extensive government activity was a necessity to create a harmonious social–economic order Instead of an over-arching theory of the state, there was a set of supposedly naturally ordained ends that government could (and should) assist society in attaining In particular, the operation of self-interest was seen as promoting outcomes inconsistent with those prescribed by nature or by God; government action was necessary to prevent, or at least minimize, the more base impacts of self-interested behavior

27.2.2 Mercantilism

Mercantilist political economy differed from its predecessors in the relative lack

of emphasis given to questions of value and distribution, but the mercantilist goal of nation–state building, combined with their notion that national political– economic strength entailed running a trade surplus payable in bullion, engen-dered a view of government policy involving extensive regulation of economic affairs Continuity with Greek and Scholastic thought is found in the view that individual self-interest, if given free reign, would run against the national inter-est, although moral qualms were replaced by the mercantilists’ more worldly concerns Self-interest was bound to engender excessive consumption of both domestic and foreign goods, thereby diminishing the quantity and raising the price of goods for export (reducing their competitiveness on world markets) and

increasing imports – thus harming the trade balance and the nation’s stock of precious metals

Mercantilism melded political and economic policy under the nationalistic banner That political and economic objectives were mutually reinforcing can

be seen by noting that bullion accumulation was accompanied by the develop-ment of military (including naval) power, which protected both nation and trade shipments; the acquisition of colonies, which brought empire, sources of raw materials for manufacturing, and markets for exports; and the slave trade, which supplied low-cost labor For the mercantilists the test of policy proposals was the effect on the nation’s stock of precious metals As Lars Magnusson (1993,

pp 6–8) has pointed out, mercantilism departed from previous thinking by view-ing the economic system as “an independent territory with its own distinctive laws.” Here, economic welfare “more than anything else depended upon the statesman’s ability to rule according to the laws dictated by an independent economic realm;” such was necessary because of the inability of self-interested private action, as translated through the market mechanism, to maximize national wealth defined as stocks of precious metals

This was to be accomplished through a scheme of economic policy of which import restriction and export promotion were only the most obvious com-ponents Other policies included the regulation of precious metal exchanges, including prohibitions on bullion exports, exchange control, protecting the quality

of coinage, and related regulations restricting the hoarding of bullion and its conversion into plate, jewelry, and so on in order to ensure sufficient circulating currency to fuel the nation’s economic activity Strategic policies favoring certain important national industries and protecting infant industries were popular, as were labor-related policies – including loose immigration and tight emigration rules, and subsidies to encourage workers to relocate to manufacturing centers – which served to keep labor supply up and wages low, thus facilitating the price-competitiveness of exports

27.2.3 Physiocracy

The backlash against mercantilist thinking was first significantly found among the eighteenth-century French physiocratic thinkers who reacted against Colbert’s policies promoting manufacturing at the expense of agriculture These policies, combined with wars and high tax burdens, impoverished the agricultural peasant proprietors and retarded productivity advances in the agricultural sector The physiocrats saw the world as comprising a set of self-evident truths aris-ing from natural law These natural laws extended to the economic system, and physiocrats considered agricultural production the cornerstone of economic activity, arguing that it alone generated a net product – a surplus of output over input; manufacturing was sterile The net product was the sole source of funds for investments in increased productivity François Quesnay and the other physiocrats saw the maximization of this surplus as providing the means

of advancing agricultural technology to match the production of other nations Unchecked, consumers would make excessive expenditures on manufactured

goods (luxe de decoration); this, combined with the mercantile system in place,

worked to impede the growth of the net product

All policy proposals were to be judged by their effect on net product The physiocrats therefore were steadfastly against policies restricting agricultural pro-duction in favor of manufacturing – such as prohibitions on agricultural exports that kept food prices, and thereby manufacturing wages, low Against mercant-ilist policy, Quesnay argued that the sole function of the state is the provision of security – national defense and the appropriate system of laws (those harmon-izing with natural law) The physiocrats’ opposition to government interfer-ence with commerce is evident from Quesnay’s essay “Corn,” where he argues that “all trade ought to be free It is enough for the government to watch over the expansion of the revenue of the kingdom’s property; not to put any obstacles

in the way of industry; and to give the people the opportunity to spend as they choose ” (in Meek, 1962, p 79; see also p 237) This freedom entailed freedom

in the production and circulation of goods, the reduction or elimination of transport tolls, improving transportation infrastructure, and eliminating the tax system oppressing agriculture in favor of a single tax on the net product

But physiocratic support for laissez-faire was, in actuality, selective (Samuels,

1962; Steiner, 2002) In addition to the loosening of restrictions on agricultural production, they advocated agricultural price supports, legal limits on interest rates to minimize the cost of borrowing for agricultural proprietors, and restric-tions on the export of manufactured products – because export promotion led to political pressures to hold down food prices in order to keep manufacturing wages/costs low As Samuels (1962, p 149) has pointed out, far from proposing

a minimalist and inactive state, the physiocrats looked to achieve their aims

“through the agency of the political state,” the substitution for mercantilist poli-cies of polipoli-cies that favored the agricultural sector and the interests it represented – as evidenced in Quesnay’s statement in “Maxims” that “the government’s economic policy should be concerned only with encouraging productive [i.e., agricultural] expenditures and trade in raw produce ” (in Meek, 1962, p 233)

Quesnay’s Tableau was deployed to “demonstrate” both the error of Colbert’s

policies and the benefits of physiocratic policy proposals

27.3 CL ASSICAL ECONOMICS

27.3.1 Adam Smith and the system of natural liberty

The physiocratic revolt against mercantilism was extended by Adam Smith in the

Wealth of Nations For Smith, the wealth of a nation consisted in the value of its produce rather than in the national stock of precious metals or the net product of agriculture, and government’s role was to facilitate the growth of national wealth,

so defined In this sense, Smith demonstrated an important commonality with the mercantilist and physiocratic writers, but the accomplishment of the goal of maximizing the value of output required a very different role for government than that posited by earlier writers

Smith’s critiques of mercantilism and physiocracy were parallel; he saw their respective favoritisms as promoting flows of resources to the favored sectors

in amounts greater than would otherwise obtain The question is whether this

is good for or harmful to the interests of society Smith is unequivocal: “Every individual is constantly exerting himself to find out the most advantageous em-ployment for whatever capital he can command It is his own advantage, indeed, and not that of society, which he has in view But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to society” (Smith, 1776, p 421) Self-interest is not some-thing to be suppressed, as with the Greeks and Scholastics, nor even to be shunted down a particular road, as with the incentives offered by the mercantilists and physiocrats Rather, the free play of self-interest is said to redound to the benefit of society as a whole In Smith’s view, the individual is “led by an invis-ible hand to promote an end which was no part of his intention” (p 423) Given this propensity on the part of the individual and the associated positive (if unintended) consequences:

The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unneces-sary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be

so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it (p 423)

But it is not simply a matter of government officials being, in Smith’s view, incapable; for Smith, the market system does not require such overt direction Attempts by government to channel self-interest in some direction inhibit rather than promote the growth of wealth (pp 650–1) and, in doing so, enrich special interests at the expense of society as a whole Smith states the basic framework of his view of the economic role of government as follows:

All systems either of preference or restraint, therefore, being thus completely taken away, the obvious and simple system of natural liberty establishes itself of its own accord Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest his own way, and to bring both his industry and his capital into competition with those of any other man, or order of men The sover-eign is completely discharged from a duty, in the attempting to perform which he must always be exposed to innumerable delusions, and for the proper performance

of which no human wisdom or knowledge could ever be sufficient; the duty of superintending the industry of private people, and of directing it towards the employments most suitable to the interest of society (p 651)

What, then, is the appropriate role for government within such a system?

“According to the system of natural liberty, the sovereign has only three duties

to attend to,” the provision of national defense, the provision of civil justice, and

“the duty of erecting and maintaining certain public works and certain public institutions” which could not be profitably provided by the private sector but

which provide a net benefit to society (p 651) These last include the standard roads, bridges, canals, and harbors – which serve to facilitate commerce – but also education, to counteract what he saw as the mind-numbing effects of the division of labor, temporary monopolies given to joint-stock companies to facilit-ate new trade avenues, and religious instruction for clergy Smith also allows for exceptions to free trade to encourage and protect industries essential to national defense, to level the playing field for domestic products subject to tax at home, and retaliatory tariffs inducing other countries to lower their trade barriers

Smith was not a doctrinaire advocate of laissez-faire He was, on the one hand,

in favor of doing away with the trade restrictions of the mercantilists, apprentice-ship and settlement laws (which inhibited the free flow of labor), legal monopoly, and the laws of succession that impeded free trade in land But, in addition to the basic governmental functions noted above, he supported regulation of public hygiene, legal ceilings on interest rates (to prevent excessive flows of financial capital into high-risk ventures), light duties on imports of manufactured goods, the mandating of quality certifications on linen and plate, certain banking and currency regulations to promote a stable monetary system, and the discourage-ment of the spread of drinking establishdiscourage-ments through taxes on liquor (one of various regulations Smith advocated to compensate for individuals’ imperfect knowledge – or diminished telescopic faculty) (For an excellent elaboration of Smith’s rather broad-based conception of the appropriate functions for the state, see Skinner, 1996.)

Smith was inherently suspicious of government’s ability to properly manage economic affairs, but he also recognized that there were various policies that could improve national welfare Equally important, however, was Smith’s re-cognition that the market does not operate without government; indeed, Smith calls political economy “a branch of the science of a statesman or legislator” (p 397), making it, in part at least, a branch of jurisprudence Smith found in the system of natural liberty a regulating mechanism not discerned by previous commentators – a coordinating force keeping self-interest from becoming tot-ally destructive But he also understood that governmental action supplies the legal–institutional process through and within which markets function It was not government that Smith was opposed to; rather, he was after the appropriate set of policies to facilitate the growth of wealth

27.3.2 The nineteenth-century classical economists and

the program of economic reform

Many writers caricature both Smith and the nineteenth-century classical

eco-nomists as rigorous adherents of laissez-faire In both instances, the caricature is

misleading The classicals were strongly reformist, critical of numerous institu-tions of their time, and highly optimistic that the insights of political economy could be used to create socially beneficial economic policy

The classicals, like Smith, were cognizant of the virtues of the market as

an allocation mechanism, but they also understood that the market could only

operate satisfactorily – harmonizing actions of self-interested agents with the interests of society as a whole – within a framework of legal, political, and moral restrictions Seeming hostility to government is manifest throughout classical economics (a legacy of Smith’s harsh critique of mercantilism), but a careful reading of the classical writings will reveal that the classicals had a relatively pragmatic view of the economic role of government (Robbins, 1952; Samuels, 1966; O’Brien, 1975) Witness J R McCulloch, who argued that “The principle of

laisser-faire may be safely trusted to do in some things but in many more it is wholly inapplicable; and to appeal to it on all occasions savours more of the policy of a parrot than of a statesman or a philosopher” (McCulloch, 1848, p 156; quoted in Robbins, 1952, p 43) Likewise, Nassau Senior argued, “the only rational foundation of government, the only foundation of a right to govern and

a correlative duty to obey is, expediency – the general benefit of the community” (Senior, 1928, vol ii, p 302; quoted in Robbins, 1952, p 45) The classicals were concerned with determining the set of policies promoting society’s best interests and were vociferously opposed to policies that they believed served the interests

of particular groups at the expense of the larger population Their consumption-oriented view led them to the belief that freedom of choice was desirable for consumers, and that freedom for producers was the most effective means of satisfying consumer desires The impersonal forces of the market, working through the system of natural liberty, would then serve to harmonize these interests – at least to a greater and more beneficial extent than other systems

The classical justification for private property (with its encouragement of industry) and security of contract (with its associated encouragement of exchange)

is found in this general utility, rather than from some preconceived notion of natural rights or natural law Robbins (1952, p 56) even suggests that Smith’s

“invisible hand” is actually government itself: it “is not the hand of some god or some natural agency independent of human effort; it is the hand of the law-giver, the hand which withdraws from the sphere of the pursuit of self-interest those possibilities which do not harmonize with the public good.” For the classicals, therefore, the state was neither a simple night watchman nor a broad planner The most basic function of government was the establishment and enforcement

of a system of law that would control, channel, and restrain individual action so that individual pursuit of self-interest would create the greatest happiness The accomplishment of this greatest happiness required far more than the establishment of a system of laws to facilitate the market, combined with the Smithian notion of defense, justice, and the provision of certain public works Indeed, the scope for government action expanded as the classicals’ period

unfolded The classicals were consistently opposed to monopoly, price (including

interest rate) regulation, and taxation and regulation of the production process (especially foodstuffs) But numerous additional functions – varying across writers – were ascribed to government as necessary to the public interest, including public health regulations, public provision of medical care, building regulations (to combat the emerging industrial slums), industrial safety and health regulations and employer liability for injuries caused by the failure to meet standards, regu-lation of prices charged by public utilities, and factory legisregu-lation restricting the

work of children The classicals generally supported the right of workers to form trades unions, except to the extent that membership was mandatory and unions had a monopolizing effect on the labor market (consistent with their general opposition to monopoly) Malthus and Ricardo favored the abolition of the Poor Laws, doing so largely because they believed the Poor Laws to be ineffective – reducing industry and increasing the population Later classicals advocated more moderate Poor Law reforms, making the position of relief recipients inferior to laborers in order to encourage work and reduce population pressure

J S Mill’s contribution in his Principles (originally published in 1848) is

emblematic of both the continuity within the classical tradition reaching back to Smith and a transition toward the increasing recognition of market failures that characterizes neoclassical economics Mill’s (1909 [1871], p 800), criterion for the boundaries of the appropriate functions of government was neither strict nor

a priori; it was “expediency.” Mill’s “necessary” functions of government, where the case for expediency is obvious, are extremely broad; even things seemingly as simple as the enforcement of property and contract cannot, according to Mill, be

as circumscribed as many would think In the case of property:

It may be imagined, perhaps, that the law has only to declare and protect the right

of every one to what he himself has produced, or acquired by the voluntary consent, fairly obtained, of those who produced it But is there nothing recognized as prop-erty except what has been produced? Is there not the earth itself, its forests and waters, and all other riches, above and below the surface? These are the inheritance

of the human race, and there must be regulations for the common enjoyment of it What rights, and under what conditions, a person shall be allowed to exercise over any portion of this common inheritance cannot be left undecided No function of government is less optional than the regulation of these things, or more completely involved in the idea of civilized society (p 797)

Likewise, with contracts, “governments do not limit their concern to a simple enforcement [of the product of voluntary consent] They take upon themselves to determine what contracts are fit to be enforced” (p 798)

In discussing the limits of laissez-faire, Mill criticized ideologues on both poles,

contending that the issue of the appropriate boundaries for government action

“does not admit of any universal solution” (pp 941–2) Mill found it import-ant to distinguish between two forms of government action: the authoritative,

in which certain types of conduct are prescribed or proscribed, and the non-authoritative, where government provides, for example, advice, information, services, institutions, and so on, which are thereby available but do not impinge upon freedom of choice and action The former, he argues, “has a much more limited sphere of legitimate action” and “requires a much stronger necessity to justify it” (p 942) Mill sees “a circle around every human being which no government ought to be permitted to overstep,” and, for him, this circle should include “all that part which concerns only the life of the individual, and does not affect the interests of others, or affects them only through the moral influence

of example” (p 943) Mill is arguing for freedom of individual action where

externalities are not present; where externalities do exist, however, the situation

is altered People are not always the best judge, he says – for example, regarding education for either themselves or their children He supports public provision

of education (pp 953–4), but he also maintains that government should not monopolize it He adopts a similar view with regard to public charity, coloniza-tion, scientific exploracoloniza-tion, and the maintenance of a learned class – functions that, as with public works, substantially further the interests of society but which, he argues, will not be provided in sufficient amounts through voluntary mechanisms

In spite of his relatively extensive elaboration of legitimate governmental func-tions, Mill contends that government is poorly organized to carry out many of the tasks that people would wish it to undertake, and that, even if well organ-ized, the related information issues and incentives are such as to make private efforts superior to governmental ones in carrying out many tasks (pp 945–7)

As such, a society should restrict “to the narrowest compass the intervention of

a public authority in the business of the community,” and the burden of proof should fall “on those who recommend, government interference” (p 950) His

prescription? “Laisser-faire, in short, should be the general practice: every departure

from it, unless required by some great good, is a certain evil” (p 950)

27.4 THE “INTERVENTIONIST” TURN: MARGINALISM AND

THE DEVELOPMENT OF NEOCL ASSICAL WELFARE ECONOMICS

The marginal revolution helped change how economists analyzed the economic role of government Normative analysis faded from the scene; writings on public finance largely ceased to discuss the appropriate role of government and were confined to how to raise the revenues necessary for the operation of govern-ment (Baumol, 1952, p 154) Discussion of the role of governgovern-ment shifted to the newly emerging welfare economics More than positivist philosophy drove these developments Externally, late-nineteenth- and twentieth-century economists saw the effects, both positive and negative, of widespread industrialization and

increasing congestion Internally, the tools of marginal analysis made possible the demonstration of the potential failings of the system of natural liberty and,

therefore, the possibilities of governmental policy actions for promoting, rather than diminishing, social welfare

27.4.1 Henry Sidgwick: dismantling the system of

natural liberty

Mill’s premonitions of externality-related market failure were further developed

by Henry Sidgwick Sidgwick (1901, p 402) accepted that “the motive of self-interest does work powerfully and continually.” Yet, he argued, the fact that the system works does not mean that it functions optimally in all times and places

“[E]ven in a society composed – solely or mainly – of ‘economic men,’ ” he wrote,

“the system of natural liberty would have, in certain conditions, no tendency to