Bending History

We may be approaching in economics what Thomas Kuhn in his seminal book, The Structure of Scientific Revolutions (reference [S2]), called a paradigm shift. Kuhn laid out scientific history in periods of “normal science”, “scientific crisis”, and “paradigm shift”, to be followed yet again with a period of normal science with the new normal being defined by a new paradigm. This would continue until the normal science could no longer describe observed phenomena with accuracy, causing a scientific crisis. During the crisis scientists would search for a new paradigm to describe these phenomena. Once a successful paradigm was generally accepted, history would progress to a new normal science period.

All over the world under the influence of Keynesian economics, economies are performing horribly. This is especially true in China, Europe, Japan, and the United States.  One might cavil that economics is not really a science (see How Seriously Can We Take Economics As A Science?), but I believe it is “science-like” enough to think about its historical development in the terms of Kuhn’s structure. Clearly, although it is not universally accepted, Keynesian economic doctrine is currently dominant over almost all governments, including China, Europe, Japan, and the United States. It is the “normal science” that has now entered a period of crisis because of its bad performance in describing the behavior of economies. For a more detailed account of exactly how Keynesian economics has underperformed in specific countries, see here and here and here and here for China, see here and here and here for Europe, here and here and here and here for Japan, here and here and here for the United States. All over the globe, the justification for unlimited state spending has made Keynesian ideas the favorite economic ideas of the political Left.

So what kind of paradigm shift might succeed the old Keynesian paradigm? Given the superior neoclassical results of the Reagan administration over the Keynesian results of the Obama administration, the coming paradigm shift might be to the older paradigm of neoclassical economics. A 2005 post on heritage.org by Daniel Mitchell questioned the efficacy of government spending in creating economic growth. It postulated a relationship between GDP growth rate and government spending as a percentage of GDP that uses much the same kind of reasoning that Arthur Laffer used in postulating his Laffer curve. Called the Rahn curve, it is postulated to look something like the figure below. Click on the image for greater resolution.

When government spending is 0% of GDP, i.e. there is no government, presumably GDP growth would be close to 0% because government would not be enforcing contracts, and would not be ensuring public safety with police and armed forces. As government spending increased, at some rate of expenditure somewhat below 100% (probably way below 100%!), growth rate would also drop to zero. If the government starves the private sector too much of needed capital, there will be no economic growth; indeed, beyond some rate of government expenditure, we would expect the GDP growth rate to be negative. In between the two extremes there should be a government spending rate at which GDP growth is maximized.

The fundamental question is: How much does government spending and debt affect GDP growth? One way of attacking the problem is to compare statistics between countries with very different levels of government intrusion in the economy. Mitchell in the heritage.org post made just such a comparison  between the original 15 members of the quasi-socialist EU and the pre-Obama United States in the figure shown below. The data is for the year 2004. Click on the image for greater resolution.

As you can see, government spending, tax revenues and government debt for Europe were considerably larger than for the United States. According to the World Bank, the 2004 per capita GDP of the EU-15 was $27,864, while for the U.S. the figure was $41,922, approximately 1.5 times the EU-15 per capita GDP. This data should be highly suggestive that less government rewards the citizenry with higher incomes. Note also that in pre-Obama 2004, the U.S. government debt was 29,6% of GDP, whereas now under the Keynesian policies of Obama it is 103%!

Other evidence is offered by the awakening of India from the nightmare of socialism to a morning in partially and increasingly free markets. The linked post on Forbes.com by Jerry Bowyer is a review of a PBS documentary series on a changing India that premiered last Sunday night and will be airing over the next couple of months. Consider this trailer for the beginning of the series. When the British quit India, they bequeathed to it a socialist economy in which India remained for a number of decades and did not prosper. But experience, the old school-of-hard-knocks, is a mighty teacher. In the words of Bowyer,

But India learned.

That’s one of the beautiful things about democratic rule; it gives people the most powerful tool for acquiring knowledge of which man is capable, the tool of trial and error. Socialism did the one thing that it always manages to do with great efficiency: it proved that it was an error.

Beginning in 1991 under the leadership of Manmohan Singh, then India’s Finance Minister and later its Prime Minister, India began a liberalization policy that would take it away from socialism, much as China’s initial liberalization took it away from socialism. Corporate investment in India did not increase as a share of GDP until after the reforms. The initial reforms were composed of the following policies.

• Fiscal consolidation and limited tax reforms.
• Removal of controls on industrial investments and imports to allow foreign participation.
• Reduction in import tariffs.
• Creation of a more welcoming environment for foreign capital.
• A dirty float of India’s rupee and making the rupee convertible for current account transactions
• Opening energy and telecommunication sectors for private investment, both domestic and foreign.

In 1994 a National Stock Exchange was launched to facilitate private ownership of companies. Even now India is continuing to attempt to reduce the role of the national government in the economy by reducing the burden of taxes. Also read here.

India’s increase in growth after 1991 is fully apparent in the graph shown to the left. Click on the image for greater resolution. The full story is one of a country that has accomplished a great deal to remove its economy from the stranglehold of government, yet has a great deal farther to travel to get to a mostly free economy. There are signs that, although recent GDP growth has been below 5%, India is bottoming-out, and with a new free-market friendly government, it may soon surpass China in growth.

From developing countries beginning to grow by adopting free-market policies to the comparison of more rigidly controlled economies to economies that are more free, we can see increasing evidence that history will be bent away from the Keynesian direction it took ever since the Great Depression.

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