The capitalist welfare state

At the LSE-blog (politics and policy), Terry Hathaway argues that ethical consumption is "dangerous to the values ethical consumers seek to promote".

According to Hathaway "[t]he seduction of ethical consumption comes with the idea that making purchasing choices is akin to voting", and he clearly dislikes Friedman’s idea that acting on the market is similar to voting in a democracy.

Sure, there are obvious differences between buying stuff and voting in a democracy. But when Hathaway goes on to explain why ethical consumerism is different from voting, almost all of his examples are cases when ethical consumerism is strikingly similar to voting:

"ethical consumption is akin to voting in a system where many of the desired goods are not available for purchase"

Correct, but so is voting is a democratic election. Many positions that a particular voter would like to vote for may not be supported by any candidate or party.

"A consumer may buy a hoover that was made with limited pollution seeking to ensure clean air for instance. However, they will not realise their interest unless everyone else makes similar choices."

Correct, but this collective action problem applies to voting as well. The policies I vote for will be implemented only if enough voters vote the way I do.

"Democracy is not a system whereby everyone makes their own choice and the outcome for society follows from these individual choices. Democracy is where the views of both majorities and minorities are aggregated (with, ideally, conflicts between different interests being resolved in the process of this aggregation) in a system of collective decision making"

Actually, an aggregation mechanism will not resolve conflicts between different aspects. Rather it will generate a collective decision based on individual choices. Furthermore, we know from social choice research (Arrow’s theorem) that the aggregation rule may very well result in paradoxical or seemingly irrational outcomes.

I agree, however, that a free debate in a democratic society will ideally resolve conflicts between different interests, and generate better decisions. Ethical consumerism may well be part of such a debate.

"Even the most hyper-vigilant, well-informed shopper cannot know everything […] the consumer must buy in partial ignorance"

Again, correct. And again it applies to voters as well. We buy, we vote, we simply act in partial ignorance.

"there is a degree of ambiguity in just quite what or who you are voting for by purchasing something that complicates the idea further. For example, buying a Fairtrade Nestle KitKat from an Asda works as support for Fairtrade, support for Nestle, support for the particular product and support for Asda […] a consumer’s "vote" for a particular product may support one of the consumer’s values, but it could also equally (and simultaneously) support a value they oppose"

Again, correct. And again, the same goes for voters in a representative democracy.

"if consumer are the ones determining the market then corporations are effectively non-actors (or heavily-bounded actors) who do not take decisions in terms of production, marketing and retail in line with their financial bottom line. This discourse thus presents a bizarre inversion of reality, whereby consumers are collectively responsible for corporate decisions, rather than corporations themselves"

This, I believe, is not correct. Consumers determine only demand, market outcomes are determined by demand and supply. Of course, one can on ethical grounds question both what (some) consumers are willing to pay for and what (some) suppliers are willing to sell. The same goes for politicians and voters.

"purchasing as voting is a weak feedback mechanism at best and there are other actors who are able to influence the system."

Correct again, but correct for both ethical consumerism and democratic voting.

In my opinion, the conclusion that ethical consumerism is dangerous to the values ethical consumers seek to promote, is still correct. The reason, however, is the general pattern that good intentions sometimes have unintended consequences.

I believe that Hathaway is right about the reason for such unintended consequences. As he nicely puts it, we all act in partial ignorance.

The latest issue of EconJournalWatch contains a number of short papers on the fact that economist who oppose a lot of economic regulation is likely to oppose a welfare state with income redistribution as well.

In my piece, I suggest that this is not necessarily the case, and that there are good reasons to support a “Hayekian welfare state" that combines economic freedom with some well-designed social insurance schemes.

So far, some actually seem to agree with me. Sam Bowman at the Adam Smith Institute writes:

An economy in which everyone is paid according to their productivity may be very brutal for people who are not very productive and cannot change that. We may wish to redistribute income for their welfare.

We might also want to redistribute money to encourage the sort of experimentation that drives innovation […] I am with Bergh. A ‘Hayekian welfare state’ would do almost no regulation of the economy, but redistribute quite a bit of money for welfare reasons. This looks not just possible, but very desirable.

Finally, it should be noted that while a Hayekian Welfare State may be an interesting theoretical possibility, there are probably no existing examples. Sweden and the nordic countries come close in some aspects (such as the Swedish public pension system), but in other areas these countries are highly regulated (such as the Sedish labor market).

According to the compensation hypothesis, the large welfare states of Scandinavian countries is a response to the economic volatility these countries suffer as a result of being exposed to international markets.

The standard reference is Katzenstein (1985), though the idea can be traced back at least to Cameron (1978) and Lindbeck (1975).

These days, another idea regarding compensation, welfare states and economic openess, is gaining ground. The idea is that welfare states are compensating for the problems caused by high taxes using economic openess and otherwise market friendly policies (references provided below).

The original compensation hypothesis rests on two empirical claims:

First, that countries with with larger public sectors tend to be more open.

Second, that countries that are more open are more exposed to risk.

While Katzenstein is often cited by political scientists, the first claim was made popular among economists by Rodrik (1998), who joined Katzenstein and Lindbeck in interpreting the correlation as a causality running from ‘‘exposure to external risk to government spending" (Rodrik, p. 988).

Interestingly, the second claim remained untested for a long time. When it evetually was put to empirical test, it was found to be wrong.

In 2001, Iversen’s (2001) noted that , in the post-war period, the more open OECD economies appear to have experienced lower output volatility than did more closed economies. Later, Down (2007) noted that according to economic theory, expansion of international trade that entails integration into larger markets should give rise to risk diversification, and thus should promote rather than reduce economic stability. The openness-volatility link was questioned on similar theoretical grounds also by Kim (2007), who also noted that a statistical analysis of a panel data set from 175 countries (1950–2002) finds no significant effect of openness on volatility.

In other words, the idea that exposure to international markets causes volatility for small countries, and that these countries develop welfare states to compensate for this volatility, was shown to be empirically wrong: more open economies are not necessarily more volatile externally or internally.

The new version of the compenation hypothesis probably starts with Iversen (2005), who noted that economic openness may be instrumentally important for countries with generous welfare states:

Labor-intensive, low-productivity jobs do not thrive in the context of high social protection and intensive labor-market regulation, and without international trade countries cannot specialize in high value-added services. Lack of international trade and competition, therefore, not the growth of these, is the cause of current employment problems in high-protection countries. (p- 74)

Iversen is given empiricval support by Epifani and Gancia (2009), who show that countries with high taxes benefit from globalisation via a terms of trade mechanism. Essentially, higher production costs are passed on to consumers globally because exporters in high tax countries have market power and can increase prices to levels well above marginal costs.

In 2006, I suggested (Bergh 2006) that welfare states compensate not only through economic openess, but by applying market friendly policies in all areas other than government size. This paper tended to constantly annoy at least one referee, and never got published. The idea appears later in Bergh and Henrekson (2011):

Welfare states with high taxes can compensate negative growth effects from large government by applying other growth-promoting policies. (p. 887)

The idea is perhaps most easily illustrated using the Economic Freedom Index, as shown by the table below (taken from Bergh and Henrekson 2011).

The table shows that the Scandinavian countries do exhibit growth rates similar to (or even higher than) Anglo-Saxon countries, but they also have similar levels of economic freedom – once you control for their large public sectors.

In conclusion: To explain why some countries have developed larger welfare states than others, we can no longer say that they are compensating for volatility induced by international markets. Rather, economic openess is an important way for high tax countries to keep their economies competitive.

To explain variation is welfare state size, other factors are needed (such as variations in historical trust levels, as suggested by Bergh and Bjørnskov 2011).

References:

Bergh, Andreas, Explaining Welfare State Survival: The Role of Economic Freedom and Globalization (April 19, 2006). Available at SSRN:http://ssrn.com/abstract=897746

Bergh, A., and Bjørnskov, C. (2011). Historical trust levels predict the current size of the welfare state. Kyklos, 64, 1-19.

Bergh, A., and Henrekson, M. (2011). Government Size and Growth: A Survey and Interpretation of the Evidence. Journal of Economic Surveys, 25, 872–897.

Cameron, David R. 1978. “The Expansion of the Public Economy: A Comparative Analysis." American Political Science Review 72:1243-61.

Down, Ian (2007) “Trade Openness, Country Size and Economic Volatility: The Compensation Hypothesis Revisited" Business and Politics, Volume 9, Issue 2, Article 3: 1-20

Epifani, Paolo, and Gancia G Gino. 2009. “Openness, Government Size and the Terms of Trade." Review of Economics Studies 76 (2):629–68.

Iversen, T. (2001). The new politics of the welfare state: Oxford University Press.

Iversen, Torben. 2005. Capitalism, Democracy and Welfare. USA: Cambridge University Press.

Katzenstein, Peter. 1985. Small States in World Markets: Industrial Policy in Europe. Ithaca, N.Y.: Cornell University Press.

Kim, So Young. 2007. “Openness, External Risk, and Volatility: Implications for the Compensation Hypothesis." International Organization 61:181-181.

Lindbeck, Assar. 1975. “Business Cycles, Politics, and International Economic Dependence." Skandinaviska Enskilden Bank Quarterly Review 2:53-68.

Rodrik, D. (1998). Why do more open economies have bigger governments? The Journal of Political Economy, 106, 997-1032.

Finally, here’s a recent blog-post by Dan Mitchell showing that the new version of the compensation hypothesis has reached the blogosphere.

The book is out now! Buy it at google play, or at ebooks.com or get the hardback at amazon.

The book already has a really nice customer review at amazon:

The same author wrote a very similar book a few years back (I would guess this is an translation with updates). I have only read the Swedish version, but I have waited for this English version for a LONG time. Every time someone have asked me why my native Sweden is successful (in terms of GDP, HDI, competitiveness index, happiness index) I always wanted to refer to this book because no other piece spell it out as well.

Read the full review here!

My working paper "The Rise, Fall and Revival of a Capitalist Welfare State: What are the Policy Lessons from Sweden?" has now been accepted by the journal New Political Economy (which was my first choice, although it took a while)

During the review process I was asked to add and explain a number of things that I initially intended to spare the reader, so the accepted version is longer than the working paper that has been available for some time now.

The (not proof read) forthcoming version accepted can be downloaded here, and the working paper can (still) be found here.

http://www.andreasbergh.se/storage/Bergh-NPE-forthcoming.pdf

C. Fred Bergsten in the Washington Post on Sweden:

The Swedish model for economic recovery

[…] Sweden remains a social welfare society, and government spending still accounts for half of its economy; it finances all education and health care, as is common throughout Europe. Sweden did not dismantle the social system but, in addition to drastically reducing its costs, adopted macroeconomic and structural reforms to make it sustainable and greatly enhanced its efficiency by privatizing the delivery of many educational and medical services. […]