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10.3 The Role of Government

What governments do, or do not do, will obviously have an important impact

on economic growth and stability. Fiscal, monetary and exchange rate policies,

along with policies towards international trade, competition, regulation,

the labour market, education, technology, healthcare and the provision of key

institutions such as property rights, all have a profound influence on economic

performance. During the nineteenth century the economic role of

government, as measured by government expenditure as a percentage of

GDP, was around 10 per cent. By 1996 the government expenditure/GDP

ratio had risen to an average of 45 per cent in developed OECD countries (see

Tanzi and Schuknecht, 2000). This expanding role of government activity in

all countries during the twentieth century reflects the influence of several

factors, in particular:

1. the impact of two world wars;

2. the Great Depression and subsequent Keynesian revolution;

3. the initial post-1945 influence of the Soviet state-led model of development;

4. rising military expenditures associated with the cold war and global

ideological competition between the USA and the USSR;

5. the influence of socialist/humanitarian thinking and a growing concern

for greater equity via income redistribution;

6. the rise of welfare state capitalism;

7. the general recognition by economists of a wider range of important

market failures beyond those initially identified by Adam Smith, particularly

widespread distortions created by externalities, imperfect information

and the problems of aggregate instability (Stiglitz, 2000, 2002).

At the beginning of the twentieth century the role of the state in the

economic sphere was minimal. However, over the past one hundred years we

have witnessed a dramatic change in the balance of economists’ vision of the

appropriate role of government in economic affairs. For the first 75 years of

the twentieth century the role of the state expanded but during the last quarter

of the twentieth century there has been a marked change in economists’

thinking on the desirability of this trend. This change, in large part, reflects

the fact that over the past 25 years there has been an unmistakable convergence

of beliefs among economists in the power of a market economy to

deliver rising living standards compared to any known alternative.

What should be the role of government in an economy? This important

question has been debated throughout history and permeates all important

public policy issues. The current borders of the state have been mainly

determined by historical events combined with developments in economic

analysis that recognized the importance of both market failure and government


While the 1950s and 1960s represent the high-water mark of economists’

belief in the capacity of governments to correct market failures, the 1970s

and 1980s witnessed increasing scepticism about the expanding role for

government and saw a return of economists’ faith in markets. Among economists

there was a growing recognition of various forms of government failure.

The state was doing much more, but doing it less well. Even in the case

where a government is attempting to act as a benevolent social planner and

intervenes to correct market failures, it must do so via the use of agents

(bureaucrats) who actually implement the strategy. Because these agents are

likely to be self-interested and difficult to monitor, government interventions

invariably provide opportunities for rent-seeking behaviour and corruption.

From the 1970s onwards, the debate on market failure versus government

failure gathered momentum and became a key feature of the economics

literature. Many economists, influenced by the critiques of economists such

as Peter Bauer, Milton Friedman, James Buchanan, Friedrich von Hayek,

Robert Lucas Jr and Anne Krueger, began to accept that the state was trying

to do too much. In many countries this had deleterious effects on the efficient

functioning of markets, economic growth and stability. The idea of government

acting as a ‘benevolent social guardian’ and the dubious assumption

that state agencies are populated by ‘selfless bureaucrats’ had been severely

eroded by experience. This does not imply that capitalism is a perfect system,

that markets always work efficiently, or that there is not an important role for

government. But it does mean that throughout the world ‘governments have

come to plan less, to own less, and to regulate less, allowing instead the

frontiers of the market to expand’ (Yergin and Stanislaw, 1999). Markets and

effective accountable government are complementary (see World Bank, 1997;

Snowdon, 2001b; Stiglitz, 2002).