Despite the rhetoric about the private sector being the only ‘wealth creators’ there is no evidential base for ‘crowding out’ argues Andy Cumbers

It really does feel like back to the future. Tories talking about shrinking the state, revelling in model local authorities contracting out services and attacking jobs in the public sector. But of course, the economic context of 2009 is markedly different from the late 1980s and early 1990s when the Conservative Party was last in power. At the height of the financial crisis in 2008, there were grounds for hope that the political tide had turned against neoliberalism and its emphasis upon competition, individualism and market deregulation. Hitherto zealots of the free market, such as the British Conservative party and even the Republican Administration of George W. Bush were forced to speak the language of state regulation and intervention.

As the banking crisis began to ripple through to the rest of the economy, with a collapse in the housing market, the freezing up of credit to business and a general downturn in consumer demand, it appeared that the political classes might be rediscovering the benefits of a more sophisticated economics. Hayek and Friedman might be giving ground to Keynes, Polanyi and even Marx.

However, as the initial shock to the financial system wore off and state intervention appeared to have at least temporarily stabilized the banking system – at massive cost to the taxpayer – it became clear that the grip of free market philosophy on the political mainstream remained as strong as ever. Recent months have seen a dramatic shift in media and policy discourse. Away from a concern with irresponsible bankers and the need for greater financial regulation, to dire warnings about government deficit and the growth of the public sector relative to the rest of the economy.

In the UK, a weakened Brown Government, with its economic identity crisis amidst the collapse of its own variant of deregulated neoliberalism, and shorn of any progressive economic philosophy to fall back on, has allowed the Conservatives and their business friends to seize the initiative and resurrect cherished Thatcherite nostrums. It is in this context, that the political debate has moved with frightening haste to a discussion of the size of public sector cuts needed, rather than any sense of a deeper analysis of the workings of the economy. A Guardian ICM poll taken in July captured this shift in mood with over 64 per cent of voters thinking that government should be reducing public spending.

… a weakened Brown Government… has allowed the Conservatives and their business friends to seize the initiative and resurrect cherished Thacherite nostrums.

This is a bizarre turn of events. Just at the time when neoliberalism is failing and neoclassical economics has been exposed as a vacuous and erroneous intellectual project, financial and business elites have succeeded in deflecting attention on to the public sector. Worse still, flawed arguments about the public sector ‘crowding out’ private investment in market economies are being resurrected by the Conservatives and meeting little opposition in public debate. On the Left, to borrow a phrase, we need to highlight a number of inconvenient truths that dismantle such arguments.

Inconvenient Truth Number One: there is no evidence that increased government spending will crowd out private sector investment and frustrate economic recovery

The general definition of crowding-out is when government spending pushes out private investment by producing disincentive effects, such as rising interest rates induced by government borrowing requirements, and consuming goods and services produced by the private sector, meaning that the private sector has to procure goods and services from an external source (i.e. import). The problem with this thesis, as I wrote in an earlier article in Scottish Left Review and at greater length with Kean Birch in the journal Scottish Affairs in 2007, is that there is simply no empirical evidence, contemporary or historical, either from the UK or at an international level to support this.

If we look at the UK, Treasury figures for 2005, they show that public sector investment has declined significantly since the late 1960s, from 7.1 per cent of GDP (1967-8) to less than one per cent by the mid 1990s, before rising under the current Labour Government to 1.6 per cent in 2004-5. In contrast, public expenditure has fluctuated considerably over the past three decades. Rising public expenditures in the 1970s reflected the particular circumstances of the time: rising oil prices, inflation, wage pressures, balance of payments problems and growing unemployment. Government expenditure may have contributed to rising inflation and interest rates but was unlikely to be the key factor.

Subsequent increases in expenditure during the 1980s and 1990s, up until 1997, were largely due to the effects of the economic cycle. In particular, the recessions of the late 1970s / early 1980s and early 1990s and rising unemployment were the main reasons for the rise in the state sector under the Thatcher and Major administrations.

Until the recent expenditure and borrowing explosion, the long term trend in both investment and expenditure had therefore been one of decline. Despite this, there has not been a corresponding increase in private sector investment, which, as a recent paper by the Institute of Fiscal Studies noted, continues to lag behind countries such as Germany, France, the United States and Japan

Internationally, there is no evidence to support the view that countries with high levels of government expenditure fare any worse in terms of economic growth or productivity than those with low government spend. Research undertaken on growth rates across OECD countries since the mid 1990s reveals no correlation at all between economic growth and the size of the state. There was however a positive relationship between increased government spending in the later 1990s/early 2000s and economic growth.

Inconvenient Truth Number Two: government spending produces important ‘crowding-in’ effects

Public expenditure in areas like education, the health service and public transport provides important markets and stimulates the private sector in other ways, most evidently through research and development spending. Recent work on the knowledge economy emphasises the important role played by the state and public sector institutions in anchoring and incubating new growth clusters such as biotechnology and the life sciences.

Researchers stress the importance of the qualitative nature of the relationships between state and business, between public sector actors and the private sector in fostering economic growth and more importantly adapting successfully to a dramatically changing global economy. Competitive success depends more and more upon the harnessing of key knowledge and skills, requiring long term commitments in a country’s human and technology resources, which firms with short term profit horizons are increasingly unwilling to undertake.

Internationally, there is no evidence to support the view that countries with high levels of government expenditure fare any worse in terms of economic growth or productivity than those with low government spend.

In some of the most successful economies, governments take a more active part in systems of national and regional innovation which involve intervention in education, training, R&D, labour market regulation and in the provision of finance and support for entrepreneurialism and innovation. In Finland, for example, government investment has been critical to the country’s successful entry into IT and communications sectors and to the emergence of Nokia as the world’s leading mobile phone producer. Crucially, the Finnish government expanded R&D expenditure from one to three per cent of GNP between 1980 and the early 2000s. Contrast UK government expenditure on science and technology, which remained static at 0.2 per cent of GDP, between 1987 and 2004.

Here in Scotland, the life sciences cluster – one of the few recent economic success stories which now employs around 33,000 people in 600 public and private organisations – would not have emerged without the institutional bases of the country’s elite universities, the research and development opportunities afforded by the National Health Service and the support of Scottish Enterprise. The public sector can play an important role in connecting science and technology in public organisations like universities with private sector commercialisation. A critical factor is the overall investment in Scottish higher education (and schooling), which is now 40 per cent more per capita than the rest of the UK.

Inconvenient Truth Number Three: those economies faring best in the current downturn are those with ‘big government’

Finally, the most recent evidence available suggests that those countries weathering the economic downturn best are those with sizeable welfare states and levels of government spending. OECD figures for unemployment show that the steepest rises in the year to May 2009 were in the deregulated economies of the US and UK (recording rises of 3.6 per cent and two per cent respectively) compared to the supposedly ‘crowded out’ economy of Germany (0.2 per cent). The hitherto celebrated free market tiger of Ireland, like many economies that have been opened up to broader global economic forces such as the Baltic states, has seen one of the most marked deteriorations in economic performance. Unemployment there has risen dramatically from 4.6 per cent in 2006 to 11.7 per cent in May 2009.

Overall, even in economies with a smaller government share of GDP, the effects of government intervention have been critical in staving off a greater downturn. As Paul Krugman and many other respected economists have pointed out, it is ‘big government’, and more specifically, the fiscal stimulus packages pursued by governments of all political stripes on both sides of the Atlantic has undoubtedly prevented a much greater economic meltdown.

Moreover, the sheer size of government in the modern economy and as a result its stabilizing effect, has almost certainly prevented a 1930s style economic depression. As Krugman has put it: alleviated the worst of the economic downturn, in contrast to the situation in the 1930s. Contrary to the reheated neoclassical arguments about crowding-out being espoused by the Conservatives, Keynesian style government stimulus programmes are crowding-in by maintain effective aggregate demand as private expenditure and investment have deteriorated.