Government versus Market: A Historical
and Contemporary Perspective*
Vito Tanzi
*For presentation at the Instituto Fernando Henrique Cardoso,
Brazil, April 2013.
Government versus Market: A Historical
and Contemporary Perspective
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There are no more important or difficult questions in
economics than:
What should be the economic role of the state?
With what instruments that role should be played?
Can an optimal role be determined?
Intuitively one feels that the economic role of the state in a
country may be too small (Guatemala?) or too large
(Denmark or France?).
But in relation to what level? And how should it be
measured? With respect to public spending? Tax levels?
Regulations? Monetary or other tools?
Government versus Market: A Historical
and Contemporary Perspective
 Governments exist to prevent hell and not to create heavens
on Earth. We need to be skeptical of politicians that promise
heaven. Let us remember Soviet Russia.
 In their work, economists have discussed “positive” (what
governments actually do), and normative” (what they should
do) roles.
 They have also discussed the use of different policy
instruments by governments.
Government versus Market: A Historical
and Contemporary Perspective
 Over many years, famous economists theorized about the
desirable role of the state. (Smith, Bastiat, Say, Mill, Pigou,
Musgrave, Samuelson, and others).
 Some advocated a minimalist role ( Friedman, Hayek,
Buchanan); others a larger role.
 In the past the economic role of the state had been smaller.
After the Great Depression and, especially, after World War
Two, it became larger in many countries.
 In the 1940s and 1950s economists developed a “normative”
role that was focused on “market failure”. The main role of
governments was seen as correcting for these market failures.
Government versus Market: A Historical
and Contemporary Perspective
 At that time economists identified an increasing number of
market failures, that justified a growing economic role for the
state and especially for more public spending.
 As James Buchanan, a conservative economist, put it: “The
1950s were dark days for classical liberals. Big government
[became] an idea tolerated across the political spectrum”. He
argued that this change inevitably restricted personal liberty.
Government versus Market: A Historical
and Contemporary Perspective
 Private markets can fail because of:
(a) pure public goods and quasi public goods;
(b) significant positive or negative externalities;
(c) natural monopolies and monopolistic practices.
These failures were assumed to justify governmental
intervention.
 In more recent years, other failures have been added to the list
such as: (a) incomplete markets, (b) asymmetry in
information, (c ) myopia and other irrational behavior by
citizens, and others justifying more government intervention.
Government versus Market: A Historical
and Contemporary Perspective
 However, markets are not static. Therefore, the normative
role of the state should change with time.
 More government because of: (a) increasing complexity and
objectives, and more asymmetry in information, (b) growing
urbanization, (c) and some other reasons.
 Less government because of : (a) more developed private
market including financial and other markets; (b) more
information readily available; and (c) more exchanges with
other countries.
 However, “government failures” have become more
evident. See the School of Public Choice.
Government versus Market: A Historical
and Contemporary Perspective
 Conclusion: the more efficient and more developed a
country’s market becomes, the less need there should be for
the intervention by the state.
 However, the concept of market failure had been related,
mostly, to the role of the state in the allocation of resources.
If allocation had been the only guide to the government role,
it would require public spending and taxes of only around
15% of GDP. This is the level that existed in many countries
before the Great Depression. In Brazil, in 1960, taxes were
still only 17 % of GDP.
 Most countries now spend much more than that. In Brazil
taxes are now 36% of GDP. Why the change?
Government versus Market: A Historical
and Contemporary Perspective
 In the 20th century, two new government roles became very
important: the redistribution of income and the stabilization
of the economy. See (b) Adam Smith, for the allocation of
resources;(b) Adolph Wagner, for income redistribution, and
(c) John Maynard Keynes, for stabilization.
* Because of these new responsibilities, the role of the state
was much expanded. Tax and spending went progressively up.
The objective of preventing Hell on Earth changed into trying
to promote Heaven.
 After World War Two some landmark social legislation.
Government versus Market: A Historical
and Contemporary Perspective
 An expanded and optimal government role requires:
(a) A benevolent Gov.t focused on the “public interest”.
(b) A well informed, and technically efficient Gov.t.
(c) A Govt. that is capable of balancing the needs of the
present generation against those of future generations.
Therefore no public myopia.
(d) The absence of principal-agents, rent seeking, and
corruption problems, within the public sector.
 Therefore, the Gov. would need to have: (a) the knowledge
accumulated in Google; (b) the wisdom of King Solomon; and
(c) the saintly personality of Mother Teresa.
 Obviously most governments do not meet these requirements.
Government versus Market: A Historical
and Contemporary Perspective
 A brief digression on a difficult issue:
 Industrial policy and the explicit promotion of economic
growth have generally not been considered legitimate
government roles.
 Adam Smith’s mercantilism and Hayek’s fatal conceit.
 Contrast with Antonio Serra, writing in 1613.
 See also the rise of state capitalism and of Sovereign Funds
in recent years.
Government versus Market: A Historical
and Contemporary Perspective
 Two contrasting experiences with industrial policy in the
allocation of resources are worth studying:
 (a) Argentina in the 1950s-1970s and Korea in the 1970s
and 1980s. The first a failure. The second a success.
 The limits and dangers of industrial policy; but also of
dogmatism.
Government versus Market: A Historical
and Contemporary Perspective
 Let us now consider income redistribution:
 It is now an important objective of policy.
 Should government policies be pro poor. or pro Ginis
reducing? Universal or focused?
 Should the government be concerned only with income
levels? Or with creating opportunities and protection for
all?
 Should it be concerned with protecting citizens against
particular risks (illnesses, old age, illiteracy,
unemployment)?
 Should the protection be for everyone? Or only for those
unable to get it from the market because of low income?
Government versus Market: A Historical
and Contemporary Perspective
 Consequences of universal versus focused programs. Cost and
quality of programs, poverty traps, horizontal inequity
considerations, free riders’ problems.
 The economic costs of a “nanny states”: inefficiencies in
spending; welfare costs of high and complex taxes;
macroeconomic problems; governance problems; reduction in
growth rates. See European crisis.
 But higher public spending leads to lower poverty levels.
Government versus Market: A Historical
and Contemporary Perspective
 What about the stabilization of the economy?
 A lot of controversy about the form it should take.
(a) reliance (only) on automatic stabilizers?
(b) reliance on “discretionary” stimulus packages?
(c ) extreme fine tuning?
(d) relative reliance on fiscal or monetary policy?
Can these policies be kept separated?. Are they?
 Heated debate during the recent “Great Recession” and the
euro crisis. The current fiscal mess in the USA, the UK,
Japan and the euro area.
Government versus Market: A Historical
and Contemporary Perspective
 There are major problems with discretionary, or active,
countercyclical fiscal policy:
 (a) Asymmetry in its use over time.
 (b) Technical problems.
 (c) Psychological reactions to high fiscal deficits and rising
public debt.
 (d) Sustainability of high fiscal deficits.
 (e) Eventual impact on borrowing costs.
Government versus Market: A Historical
and Contemporary Perspective
 High public debt levels and their impact on economic growth:
(a) high levels in individual countries.
(b) high levels in the world.
(c) strange, ongoing controversy about “growth” versus
“austerity”. About fiscal multipliers.
 Stabilization policy and the nature of recessions:
(a) induced by weakening of “animal spirits”.
(b) induced by imbalances and bubbles.
(c ) unemployment and the speed of recovery.
(d) current confusion of growth with recovery.
Government versus Market: A Historical
and Contemporary Perspective


G/GDP now ranges from about 10% in a few, poorer
countries to over 50% in some industrial countries (France,
Belgium, Italy Denmark):
(a) What is the desirable level? It depends but compare
Australia, Switzerland, Korea, Singapore, etc. with the high
spending countries.
(b) Does more spending promote greater welfare?
Theory not helpful. Some answers may come from the
impact of spending on socio-economic indicators. What
happens to relevant socio-economic indicators when
G/GDP rises? Is the relation positive: More spending better
indicators?
Government versus Market: A Historical
and Contemporary Perspective
 Need to separate the effect (on socio-economic indicators)
that comes from higher per capita income and from higher
public spending.
 Given the per capita income of a country, with their policies,
governments aim to generate, better socio-economic
indicators. Examples of socio-economic indicators.
Government versus Market: A Historical
and Contemporary Perspective

(a)
(b)
(c)
(d)
(e)
(f)
When public spending rises as a share of GDP, how is
public welfare affected? There can be significant costs
to increasing public spending. Examples:
Efficiency costs of higher and more complex taxes;
Servicing costs of public borrowing;
Inefficiency costs in the use of public revenue;
Costs due to corruption and complexity;
Costs due to principal-agents problems and rentseeking;
Costs in terms of inflation and growth.
Government versus Market: A Historical
and Contemporary Perspective
 Some conclusions from empirical studies:
 High public spending does not necessarily lead to
higher welfare; and it can generate macro-economic
problems and lower the growth rate.
 Relation between high public spending and levels of
desirable socio-economic indicators is not a smooth,
regular and positive one.
 Efficient governments are those that get good socioeconomic indicators with moderate public spending.
 However, higher spending leads to lower Ginis.
Government versus Market: A Historical
and Contemporary Perspective
 Estimating “public sector performance indexes” (PSPs).What
governments produce in terms od socio-economic indicators.
 Estimating “public sector efficiency indexes” (PSEs). Taking
taxes into account.
 Empirical conclusion: normally 30-35% of GDP in public
spending seem to be sufficient to achieve good socioeconomic objectives.
 Brazil is already over that level.
Government versus Market: A Historical
and Contemporary Perspective
 Some additional issues.
(a) There is growing reliance on policy tools other than
spending and taxes. Less transparency.
(b) Substitution between (good) regulations and public
spending?
(c) A more active, preventive role versus the traditional ex post
corrective role? The role of “libertarian paternalism” a la
Bloomberg?. Emphasis on creating more equal
opportunities?
(d) Growing complexity and government policy?
(e) Dealing with significant global externalities? Such as
environmental problems and global warming?
Government versus Market: A Historical
and Contemporary Perspective
 Some comments on less advanced countries.
 Greater need for a larger government role, but
lesser capabilities.
 Danger of making spending decisions by “labels”.
 Limited revenue and administrative capability.
 The large role of the informal economy.
 Complexity and the “termites of the state”.
 Desirability of keeping policies simple and focused.
Government versus Market: A Historical
and Contemporary Perspective
 Is there a fundamental law of the growth of public spending,
when additional resources are available from taxes or from
public borrowing?.
 Why public spending keeps growing after new programs are
introduced?.
 Some final comments on Latin American countries.
Government versus Markets: A Historical
and Contemporary Perspective
 Some basic references:
 Vito Tanzi, 2011, Government versus Markets (Cambridge University
Press).
 Vito Tanzi and Ludger Schuknecht, 2000, Growth of Public Spending in
Industrial Countries (Cambridge University Press).
 Vito Tanzi, 2013,” Taxation in Latin America: a long run perspective”,
Mimeo.
 Antonio Afonso, Ludger Schuknecht and Vito Tanzi, 2010. “Public
Sector Efficiency: Evidence for EU Member States and Emerging
Markets” in Applied Economics, 42.
 Vito Tanzi, 2008. “The Role of the State and Public Finance in the Next
Generation”, OECD Journal for Budgeting , June.