He Who Laughs Next-to-Last

Chortling has become the expression of choice in political debate these days.

The Left chortles that the age of free-market capitalism on the Thatcher-Reagan model is over, consigned to the dustbin of history by the so-called financial crisis that has swept from Asia to Russia and threatens to engulf Latin America, Western Europe, and, best of all from the point of view of the Left, the United States.

The Right chortles that the end of the welfare state is nigh, consigned to the same dustbin by demography, the limited willingness of democratic societies to endure higher direct taxes on income, and what has come to be called globalization.

Both sets of chortlers have it wrong. Let’s start with the Left and its wrongheaded conclusion that the current economic difficulties being experienced in parts of the world demonstrate that free markets don’t work. That is incorrect, and not only because the economic "crisis" is proving to be as self-limiting as economic booms.

The problems of Asia are not due to any excesses of free market capitalism, but to an insufficiency of free enterprise. The benefits of free markets are obtained only when resources are free to flow to their highest and best use. When capital is misdirected to cronies, or when the interlocking structure of the banking and industrial systems feeds debt capital into clapped-out enterprises at interest rates that no free market would sustain, ruin is sure to follow. And in many Asian countries, it has.

Neither are the problems of Western Europe due to a reliance on free markets. In most EU countries, labor costs are inflated to support a variety of redistribution schemes, firing is made so difficult that it becomes imprudent to hire, and the benefits of not working approximate those of working. In short, like Asian capital, labor in France, Germany, and other Western European countries cannot flow to its highest and best use. That is what accounts for the failure of those economies to create a single net new private sector job in the last twenty years.

Tenacious Welfare States

But just as the Left is indulging in premature chortling, so is the Right. Granted, the welfare state is under threat from four powerful forces: the so-called globalization of the world economy (which is putting downward pressure on unit labor costs), the aging of the population (which will force fewer and fewer workers to support more and more retirees, though productivity improvements may alleviate the pain—an often-overlooked possibility), the increased disinclination of voters to accept overt increases in their tax burden to care for an increasing number of pensioners, and the perception that the redistribution of incomes (the essence of the welfare state) is directing funds not to the deserving poor but to a population that has been led by mistaken policies to prefer welfare to work, dependence to independence.

But conservatives seem to be overlooking the fact that the world’s politicians do not want to reform their welfare states, that they have the weapons available with which to resist reforms, and that they are willing to pay a high price—or have their citizens pay it—to preserve systems that permit them to redistribute incomes from disfavored groups to favored ones. We are, therefore, not going to see the end of the welfare state as we have come to know it, but will instead see a counterattack by politicians against the forces that threaten it. Politicians will institute barriers to trade and the free flow of capital to thwart globalization, and they will establish a host of indirect and hidden taxes to counter demographic trends and the unwillingness of voters to countenance higher direct taxes.

Consider globalization. The traditional analysis has it that competition for world markets between industrialized countries and those emerging from poverty will force governments to stop imposing heavy costs on employers, lest they flee to more congenial climes. And there is some evidence to support this thesis: two of Germany’s largest exports have been investment and jobs, as employers attempt to get out from under the truly horrendous social costs that are incident to Germany’s luxurious welfare state.

But two caveats are in order. The first is that the title "industrialized economy" is no longer a completely accurate description of most of the countries we tend to classify as such. A more accurate name would be "service economy." That distinction is important because whereas the great bulk of manufacturers do compete in a global economy (autos, steel, etc.), an unknown but large portion of services do not. Some do, of course: computer programmers in New Delhi and Manila, for instance, compete with those in the U.S. and Europe. But barbers do not, nor do tailors, providers of cable television, personal trainers, or most renters of real estate. These service businesses now account for some 70 percent of GDP in Great Britain, and close to that in most advanced economies except for industry-oriented Germany. They are not affected by globalization, and, therefore, the employers of many service workers are not threatened by so-called "cheap imports." As a consequence, they have neither the incentive nor the ability to move to lower-wage countries to escape the ravages of the welfare state. These employers are not, of course, helpless in the face of mounting social costs, but neither are they as flexible as the globalization aficionados pretend. The owner of a barber shop cannot sell imported haircuts.

More important, governments are not powerless in the face of globalization. It has merely taken them time to figure out just how to fight back. The French, of course, have always had an answer: protectionism. One former president of France told me that free trade is the law of the jungle and France would never subscribe to it. And it hasn’t. Be it a quota on the exhibition of American films, a limitation of imports of bananas from Latin America (an exercise in which they have enlisted Britain), or the use of subsidies to shore up banks, airlines, and farmers, the French have found and will find ways to protect their welfare state from the competition of more efficiently produced goods. The governing elite is prepared to have the citizenry pay a fearsome price to preserve its power over the distribution of incomes. And the citizenry will be increasingly impotent to do anything about it, as power flows to unaccountable bodies such as the demonstrably corrupt European Commission and the perk-laden European Parliament.

Expanding Government Power

Most European governments are now in the hands of Left-leaning politicians. Rather than reform their labor markets, they are opting for fiscal relaxation to induce a Keynsian demand-side response: lower interest rates and an end to competition among members of the EU for inward investment. The cartel of governments envisaged by the Germans and the French would force Britain to raise its taxes and labor costs to Continental levels and impose restrictions on imports to shield the Eurocartel from outside competition.

This is merely one manifestation of a broader effort by governments from Berlin to Beijing to Brussels to wrest control of the market for capital—and, therefore, for investment—from the forces of supply and demand and redeposit it in the finance ministries of governments. That is what all the recent talk about controlling capital flows is all about.

We know, of course, that if capital cannot flee from countries that have swollen welfare states or kleptocratic regimes, it will never enter those countries in the first place, or will charge a very high premium for doing so. Just as protectionism is costly, so, too, are capital controls. But the adverse consequences of these controls are felt in the longer term, while the sought-after benefits—maintenance of exchange rates at uneconomic levels, and protection of social spending—are realized quickly. Politicians will vote for the short- over the long-run almost every time.

Furthermore, the victims of protectionism and capital controls are many and diverse, but the beneficiaries of protectionism are few and concentrated. The victims are rarely aware of the costs being imposed on them, whereas the beneficiaries and the kleptocrats who aid them are acutely aware of the benefits accruing to them.

There is worse. Most governments of European Union countries, given a choice between America’s labor-market system (flexible labor costs and relatively full employment) and a system that maintains relatively high labor costs but induces relatively high unemployment, quite consciously choose the latter. That is their right, of course. But that choice involves large income transfers from those who are working to those who are not. That, however, is what the welfare state is all about—putting a large portion of national income in the hands of government elites to distribute as they see fit. So far, Britain has held out against this alternative to what the French derisively call "the Anglo-Saxon model," but whether it will continue to do so is far from certain. Britain now has a Labour government with no effective numerical or intellectual opposition and a stunning unawareness of the cumulative effect of such measures as the minimum wage, enhanced union power, and all the baggage associated with its adoption of the cost-increasing work rules embodied in what Europeans call the "social chapter."

So the Right had better back off chortling: the competitive threat incident to globalized markets will certainly not bring down the welfare state. It is equally likely that it will lead to more protectionism, more capital controls, and high-wage-plus-high-income-transfer systems. In short, governments will not easily surrender their welfare states, and they have the power to maintain them, justifying their actions on humanitarian and egalitarian grounds.

Stealth Taxes

Governments can also find ways around the demographic problems they face: the rising number of retirees relative to workers, and the disinclination of the remaining, fewer, active workers to pay higher and higher taxes to support more and more retirees (many of whom are substantially wealthier than the workers supporting them). Just as businesses continually hunt for new revenue streams, so do governments. With income tax increases no longer politically possible, the focus is on indirect taxes, particularly those that can be represented as being based on some virtuous principle rather than a selfish desire for more tax money. The attempt to impose huge taxes on tobacco in America was one such effort to promulgate a "virtuous" tax—a levee defended as being in the payer’s own interest. Another such is the proposed energy (or carbon) tax, ostensibly designed to induce people to use less energy and thereby prevent global warming.

The Greens in the German coalition government are particularly keen on making motoring so expensive that Helmut Kohl will be forced to cycle around town, and Britain’s Chancellor of the Exchequer Gordon Brown has recently massively increased the real tax on petrol. At the same time, his government has ordered a moratorium on the construction of new, clean, gas-fired electric generating stations so that the old coal-fired ones can continue to operate. While the Chancellor cools the globe by discouraging the burning of petrol, others in the Labour government heat it by encouraging the burning of coal. No small minds troubled by the hobglobin of consistency in this Labour cabinet!

These new taxes are an enormous potential stream of revenue for governments. Harvard Professor Richard Cooper estimates that a worldwide carbon tax would yield $750 billion annually by 2020, equal to 1.3 percent of gross world product in that year. That is real money, a significant pot from which Leftist governments can ladle out funds to the chosen beneficiaries of their welfare states.

So, like the Left, the Right is doomed to disappointment. The Left will find that it must rely on some variant of free enterprise if it is materially to improve the lives of the greatest number of the world’s inhabitants. The Right will have to learn to live with a gradually expanding welfare state. Chortling by either side at the problems of the other is definitely premature.