Economic Theory

State intervention is more of a hindrance than a help to growth

“The starting point of any industrial strategy must be recognition that government impedes growth more than it facilitates it,” said former Treasury permanent secretary Nick Macpherson on Twitter last week.

A slightly unexpected view from a former senior civil servant, one might think. The economist Diane Coyle quickly waded in, describing such views as “nonsense”, and outlining how governments can boost the economy, though “research, standard setting for new tech, human capital and infrastructure coordination”.

Who’s right? Up to a point, both.

Absent any government at all, it is likely that our economy would be substantially weaker. Without the rule of law and its interaction with property rights, effective judicial and policing systems, and state provision of certain public goods and services that might be under-provided, it is likely the GDP potential of the economy would be lower. OECD evidence suggests that certain investments, such as provision of transport links and primary and secondary education, can be growth-enhancing too.

Of course, in reality infrastructure projects are often chosen using political rather than economic criteria, and so are not growth enhancing in practice, even if they could be in theory. And these need to be financed. If the revenues used to fund infrastructure projects come from highly distortionary and economically damaging taxes, on net they might retard growth.

Across OECD countries, four fifths of government spending does not fit into this “productive” category anyway. The overwhelming majority is transfer payments – cash moving from taxpayers to other groups – and government consumption.

Then there are regulations. While some improve the functioning of markets, the UK’s land use planning and energy laws in particular undermine the growth potential of the economy. Tight rules hamper labour mobility due to high and variable housing costs, cause unproductive retail, childcare and social care sectors, and encourage over-investment in real estate.

Little surprise then that when the Institute of Economic Affairs examined the evidence, we found that the “growth maximising” size of government was likely to be between 18 and 23 per cent of GDP. Of course, there are ways the government can enhance wellbeing beyond growth, yet other work suggests that the size of a “welfare maximising” government is likely to be around 27 to 33 per cent of GDP.

In contrast, UK government spending is forecast to be 39 per cent of GDP this year, and just 4.1 per cent of that is recorded as public sector gross investment. So Macpherson is surely right to say that the starting point for an industrial strategy should be to remove government-imposed blockages to growth, rather than to develop new projects and spending. At the very least, to the extent that an “industrial strategy” is being delivered, any funding for it should be substituted from existing government outlays.

Whether the particulars of the government’s specific industrial strategy deliver more economic growth is of course an empirical question.

I’m sceptical, both given the UK’s experience with intervention in industry, and the fact that plenty of the recommendations reflect conventional wisdom, whereas the industries and economic trends of the future tend to be unpredictable.

The government has pledged to found an independent “industrial strategy commission” to observe if the policies actually have the intended effects. Whether such a body would ever conclude that the whole idea is a waste of time even if it were the case is an open question.

What is crucial though is that the commission focuses on whether the interventions raise the rate of return on investment and the productivity of capital. And that must include comparing outcomes against what would happen if the resources were simply left in the private sector.

Certain interventions and investments undoubtedly could have a positive impact on growth. But given the level of government spending and regulation and the UK’s experience with industrial intervention before, Macpherson’s conclusion that “the starting point” should be about how government constrains growth seems uncontroversial.


This article was first published in City AM.

Ryan Bourne occupies the R. Evan Scharf Chair for the Public Understanding of Economics at Cato. He has written on a number of economic issues, including: fiscal policy, inequality, minimum wages and rent control. Before joining Cato, Bourne was Head of Public Policy at the Institute of Economic Affairs and Head of Economic Research at the Centre for Policy Studies (both in the UK).

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