Is Small Government Always the Best Solution?

Across the world, the global economic crisis has renewed interest in issues related to economic inequalities among both lay and expert audiences. Debates about their origins, importance and possible mitigation measures can seem rather curious from a Slovak’s perspective. Many economists in Central and Eastern European countries are often uncritically convinced of the superiority of a small state — one that regulates markets only to a very limited extent. Given the negative historical experience with central planning, such convictions are perhaps understandable. Nevertheless, among advanced industrialized societies, we find multiple well-functioning varieties of capitalism.

A Simple Model of the Welfare State
and Its Limitations

The study of economic inequality has long preoccupied many academic economists, sociologists and political scientists. In academic circles, an article by Allan Meltzer and Scott Richard was particularly influential. Meltzer and Richard built a mathematical model that suggested that, in democratic countries with unequal incomes, one should expect a great deal of redistribution.

Low-earning votes will, according to this model, support economic measures that would redistribute resources to them at the expense of those who earn more. The wealthy will, however, not be completely expropriated, since even the poor voters realize that tax hikes or welfare payment increases decrease overall economic efficiency. As a result, such public policies can put at risk the government’s ability to redistribute a sufficient amount of resources.

Because Meltzer and Richard’s model of the welfare state was relatively simple and offered clear-cut predictions, it immediately became a foundation for many other studies of economic inequality. It soon became clear, however, that the model’s predictions do not correspond to reality. Countries with unequal incomes, in fact, redistribute less than countries that exhibit greater inequality. Relatively unequal countries such as the United States or the United Kingdom thus redistribute fewer resources than the relatively equal Nordic states such as Sweden or Norway.

Liberal and Coordinated Market Economies

The paradoxical finding that equal countries engage in a great deal of redistribution suggests that social policy cannot be reduced to a Robin Hood-like mechanism that takes from the rich and gives to the poor. It appears, instead, that a variety of other, still well-functioning, varieties of capitalist economies are possible.

British economist David Soskice and American political scientist Peter Hall classify advanced industrialized economies as belonging to one of two basic types: liberal and coordinated market economies.

In a liberal market economy — a model that we typically find in Anglo-Saxon countries — the government plays a relatively small role. Welfare payments are modest, targeted only exclusively at the poor, and designed to incentivize individuals to find employment as fast as possible.

The welfare state is more robust in coordinated market economies, where we find a relatively high level of welfare support. Often, coordinated economies also feature universal social insurance systems in health care and pensions.

Both liberal and coordinated market economies can ensure a high standard of living and fast rates of economic growth. Why is that so? In both varieties of capitalism, economic institutions complement one another and, in doing so, ensure that the overall economy remains efficient.

Danish political scientist Torben Iversen pointed out that a particularly important complementarity arises from the interplay between the welfare state and the educational system. According to Iversen, different welfare systems motivate individuals to acquire different types of skills. Such skills can be either general or specific. General skills are transferable and can be applied in many industries and occupations. Examples include managerial or communication skills, but can also include the ability to adjust to a new environment. Specific skills (such as, say, the ability to operate complicated pieces of machinery), on the other hand, are especially useful in particular industries or even in particular firms.

The strong welfare state that we find in coordinated market economies often offers its citizens protection against the termination of their jobs. This type of social policy gives individuals an incentive to acquire specific skills that will enable them to recoup their human capital investments. Relatively high welfare payments, furthermore, enable the unemployed to decline a job that does not take advantage of their specific skills.

By contrast, the limited role of the welfare state in liberal market economies incentivizes individuals to invest in general skills, as these will enable them to find new employment quickly, if the need arises.

What About Central and Eastern Europe?

Most of the existing research on varieties of capitalism has focused on the advanced economies of Western Europe, as these have had a long and uninterrupted history of capitalism. During the period when post-communist countries were undergoing a transition from a centrally planned to a market-based economy, countries such as Slovakia were difficult to classify as either liberal or coordinated.

The market economy has, however, already established solid roots in Central and Eastern Europe. The Swedish economist Magnus Feldmann, for instance, classified Estonia as an example of a liberal market economy that has undergone a swift and radical liberalization. On the other end of the continuum lies Slovenia as a representative of coordinated economies in the region. The Slovenian reforms unfolded more gradually, and retained a significant role for social dialogue. Despite their recent economic difficulties, both Estonia and Slovenia are regarded as the success stories of post-communist economic transitions.

The Choice for Slovakia: Small or Big Government?

The far-reaching reforms of the tax, welfare and pensions systems during the second Dzurinda government brought Slovakia closer to the Estonian model of liberal capitalism. A relatively small welfare state therefore represents, to an extent, the status quo.

In its current form, the Slovak welfare system motivates individuals to focus on acquiring general skills that can be easily transferred between occupations. Such a system can be useful if we, for instance, regard professional services as the future of the Slovak economy. A more significant role for the welfare state would, on the other hand, give people an incentive to build up skills that are more applicable in specific industries or firms.

The examples of Anglo-Saxon and Scandinavian countries, as well as of Estonia and Slovenia in the post-communist world, demonstrate that both liberal and coordinated market economies can promote prosperity. As the success of these economic models depends on mutual complementarities between economic institutions, a transition to a coordinated economy would required multiple extensive reforms. One risk inherent in such reforms is that we might end up with a mixed liberal-coordinated model that would, in the end, work less efficiently.

A choice between a small or a big government would also have implications for gender equality in Slovakia. A greater role for the welfare state could, perhaps somewhat paradoxically, threaten gender equality in the Slovak private sector. Women could find themselves at a disadvantage in the workplace, if, say, motherhood prevented them from investing in their specific skills.

As a consequence, we could expect a greater concentration of women in the public sector, as is the case, for instance, in Scandinavian countries. On the other hand, the preservation of a relatively limited welfare state will lead to a relatively equal position of men and women on the labor market.

Marek Hlavac is a Ph.D. candidate in Political Economy and Government at Harvard University.