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Politics and markets: How governments help and hurt economies

Lots of political rhetoric is spewed across news and the social media. Most of it is just ideology, repeated and spun by pundits or posted across the social media, appearing as Facebook facts” where propositions come to be accepted as political truths. But the reality is that so much of what passes as political fact is simply ideology; untested assertions or simply statements about the world that fail to stand up to rigorous social science scrutiny.

This is the case with assertions about taxes, or voter fraud, or a slew of many other propositions. Two of the most cherished theories held dear to many conservatives are that the government cannot innovate and that the pathway to economic recovery is through austerity and cuts in government spending and taxes. Both of these myths are convincingly challenged in two recent books, Mariana Mazzucato’s “The Entrepreneurial State,” and  Mark Blyth’s “Austerity: The History of a Dangerous Idea.”

Mazzucato begins her book by constructing the stereotype of a dynamic innovative private sector where the engine that drives businesses is the “creative destruction” that economist Joseph Schumpeter once described in contrast to the dull, risk-aversive bureaucratic behavior of the government. The myth is that government cannot innovate; it instead impedes creativity and job creation, and that the best way to foster economic growth is by limiting government activity in the economy, including taxes and regulation on businesses and creative individuals.  Government in effect crowds out entrepreneurial activity. A wonderful theory, but how accurate is it?

Government as risk taker

Mazzucato offers ample empirical evidence to challenge this myth. Her work is drawn heavily from examination of U.S. and European economic policy and data. What she actually finds first is that government is often a risk taker, providing a significant portion of the venture capital that has produced some of the most important technological innovations since World War II. On one score, U.S. research and development (R&D) tax credits and investments in military technology, the Internet, and in drugs have provided most of the capital in these fields, yielding some of the most important and significant inventions in these areas. 

Mazzucato points out how Apple’s Ipad, Ipod, and Iphone all were made possible by technology investments underwritten by the U.S. government.  Agencies and programs such as the Defense Advanced Research Projects Agency, the Small Business Innovation Research program, and the Orphan Drug Act (some of which were created under Ronald Reagan) have been remarkably good at fostering innovation.

The second point that Mazzucato makes is that the government often funds innovation at stages and in places where private sector venture capital dare not go. Private venture capital rarely funds projects in the infancy stage where the risk is too great and the expectations of payoff are slim. Venture capitalists are smart – they do not enter the fray until the real risks are diminished and, they invest with a short time horizon there is a likelihood of a profit. Venture capitalists are not gamblers – they want to invest but only on good bets and when their returns get quick results.  Venture capitalists invest at later stages in technology of business development and often get out quickly. 

Not so with the government. Mazzucato points to how the government often invests at early stages where payoffs are less certain and the risks are greater, paying the way for businesses and venture capitalists later on to profit. Government socializes early risks, is willing to underwrite more risky but long-term investments, and in effect helps nurture the conditions that make private entrepreneurial activity possible. Government thus does not so much crowd out innovation but instead facilitates first a “crowding in” and then a “dynamizing in” of investment and innovation.

Questioning austerity

In contrast to Mazzucato, who challenges the myth that government activity crowds out business activity, Blyth assails austerity as a political economic policy. Simply put, austerity argues that during recessions or in other times when the economy is performing badly, the cure is to cut government spending, thereby freeing up capital for investment. The idea is based on Say’s Law – supply creates demand – a staple theory of supply-side and neoclassical economic thought. It is the idea that once enough cuts have taken place – the damage and destruction that has occurred to the economy as a result of high wages, taxes, or government spending – a new economic equilibrium were be reached whereby investors will again invest and business will hire individuals. Yet the power of Blyth’s book both is to question the theory of government austerity and then look to its practice to see if as applied it has actually led to situations where governments can “cut their way to prosperity.”

Blyth begins by discussing John Maynard Keynes’ concept of the “paradox of thrift.” Individually it might make sense in tough economic times for one person to refuse to spend or invest and instead save. But multiply such a policy across millions of individuals and businesses and what one gets is a recession. With no one willing to spend or consume, no businesses are willing to invest.

Merely getting tax cuts will not induce businesses to hire since no one is going to buy their products. What results instead is a variation of a reverse prisoners’ dilemma where no one invests for fear that the economy will not rebound. The paradox of thrift in economics is Keynes’ rejoinder to Say’s Law;  a challenge that merely cutting taxes or placing more money in peoples’ or businesses’ hands will stimulate the economy. Instead, so long as the risk that others will not spend or consume continues, the economy will not pick up. Thus, the need for government to stimulate demand.

Up to this point austerity is no more than a forceful defense of Keynesian economics. But Blyth goes after bigger game, challenging those, such as Tea Party advocates who single-mindedly want to cut government spending as part of a broader battle to reduce government debt. Their argument, as Blyth describes it, sums up as “more debt doesn’t cure debt,” is assuring but simplistic and wrong for many reasons.

Fallacy and unfairness

schultz portrait
David Schultz

On a theoretical level it assumes that what is good for one individual (saving) is good as a national policy. This is the fallacy of composition. Second, austerity is unfair. It asks the poor and middle class who did not benefit from the economic good times to pay for the mistakes of the rich when the economy goes bad. By that, in 2008, it was the finance sector and the banks that brought on the recession and austerity meant that they were bailed out while the poor suffered and continue to do so by cuts to food stamps and other social welfare programs.

Third, austerity just does not work in theory as an economy theory. This is the strength of Blyth’s book. Many point to Germany as an example of how austerity works successfully or conversely, why a lack thereof is the cause of Greece’s problems. Both are exceptions. In the case of Germany, which has run a high-savings export-driven economy, it only works because in part other countries run deficits. Not every country can run surpluses and be export driven. If no one consumes then there are no exports to buy. Germany is a unique case, as is Greece because of its  high degree of corruption. Simply cutting debt or spending to turnaround an economy does little to stimulate investment, it places burdens disproportionally on the poor, and it fails to lift the GDP over time. 

Instead, the more successful world economies balance debt-management with investments along the line Mazzucato suggests, providing support for demand and an infrastructure that facilitates growth.

Together Mazzucato and Blyth paint a theoretical and empirical picture that severely damages arguments that the minimalist state is the pathway to economic growth and entrepreneurial activity. They describe a more nuanced picture of how government and business can work together to sustain economies while producing economic fairness and equity.

They move the discussion beyond ideology, where all too often many anti-tax, anti-government advocates sit. Policymakers in Minnesota and across the country wishing to get a better understanding of what governments really do and how they can make a difference would be well suited to read these books. The same can be said of advocates of the myths Mazzucato and Blyth attack.

David Schultz is a professor of political science at Hamline University and the 2013 Leslie A. Whittington national award winner for excellence in public-affairs teaching. He blogs at Schultz’s Take, where this commentary first appeared. 

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Comments (1)

  1. Submitted by Ilya Gutman on 01/03/2014 - 08:09 pm.

    Let’s be honest

    The author’s suggestion that the two books analyzed in the article are above ideology is laughable. The first book is written by Mariana Mazzucato, a frequent contributor to the British Guardian and the Institute for New Economic Thinking, an entity founded by George Soros. The second one is Mark Blyth, a professor in the British Brown University and the main critic of the austerity idea. These two people are as progressive as it can be and by no means can they “move the discussion beyond ideology.” Of course, they are entitled to their opinions and the author of this MinnPost article may agree with them, but we should all understand that they all promote very specific ideas.

    And to counter those ideas, all one has to do is ask a few questions. First, if governments are so innovative and brave, how come the Soviet Union collapsed? And second, if austerity is bad and government spending is good (and Greece is just an exception), how come all southern European countries are following the footsteps of Greece?

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