The Welfare Lives On (Alas)

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 now threatens to engulf not only Latin America, but 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, limits of the 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. Start with the left, and its conclusion that the current economic difficulties being experienced in parts of the world demonstrate that free markets don't work. Wrong, and not only because the economic "crisis" is proving 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 market capitalism. The benefits of free markets can be 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 it has, in many Asian countries.

Nor are the problems of Western Europe due to a reliance on free markets. In most EU countries labour costs are inflated to support a variety of redistributive 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 capital in Asia, labour in France, Germany and other Western European countries cannot flow to its highest and best use. Which is what accounts for the failure of those economies to create a single net new private sector job in twenty years.

But just as the left is indulging in a chortle too soon, so is the right. It is true, of course, 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 labour costs; the aging of the population, which will force fewer and fewer workers to support more and more retirees -- unless productivity improvements permit fewer and fewer workers to support more and more retirees without much pain, an often overlooked possibility; the increased disinclination of voters to allow overt increases in their tax burden to care for the increased number of pensioners; and the perception that the redistribution of incomes that is 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 a high price -- in order to preserve systems that permit them to redistribute incomes from unfavoured to favoured groups. 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 on the forces that threaten it, as politicians employ the weapons available to them to thwart the operation of all of those threatening forces.

They will thwart globalization with barriers to trade and the free flow of capital, and counter demographic trends and the unwillingness of voters to countenance higher direct taxes with a host of indirect and hidden taxes.

Start with globalization. The traditional analysis has it that competition for world markets between industrialized countries and those that are emerging from poverty will make it impossible for governments to continue to impose 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 truly horrendous social costs that are incident to Germany's luxurious welfare state.

But there are two caveats to be kept in mind. 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 manufactures do compete in a global economy -- autos, steel -- an unknown but large portion of services do not. Some do, of course: computer programmers in New Delhi and Manila compete with those in this country. But barbers do not; tailors do not; providers of cable television do not; personal trainers do not; renters of most real estate do not. These service businesses now account for some 70% of GDP in Great Britain. They are not affected by globalization, meaning that the employers of many service workers are not threatened by so-called "cheap imports", and therefore have neither the incentive nor the ability to move to lower wage countries to escape the ravishes 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. Of course, the French have always had an answer: protectionism. One former president of France told me that free trade is the law of the jungle, and that France would never subscribe to it. And it hasn't: whether it is a quota on the exhibition of American films, or 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 European Commission and the perk-laden European Parliament.

With the leftward lurch resulting from the recent elections in Europe, and the so-called world financial crisis, others are now prepared to follow the lead of France. Indeed, Germany, in which the husband-and-wife team of the Lafontaines -- oh, spare us these you-vote-for-one-and-you-get-two political couples -- has resurrected the worst version of what it takes to be the theories of John Maynard Keynes, is now adding to French dirigisme and protectionism a call for a government cartel to "harmonize" -- oops, "coordinate" taxes and social policies, and to eliminate competition among themselves for inward investment.

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 of 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 charge a very high premium for doing so. Just as protectionism is costly, so, too, are capital controls. But the adverse consequences 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 in the short-term. And politicians will vote for the short- over the long-run almost every time.

Furthermore, the victims of protectionism and of capital controls are many, and diverse; the beneficiaries of protectionism are few and concentrated. The victims are rarely aware of the costs being imposed on them; 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 of America's labour market system -- flexible labour costs and relatively full employment -- or a system that maintains relatively high labour costs but induces relatively high unemployment, quite consciously choose the latter. Which is their right. Of course, that involves large income transfers from those in work to those out of work. But that 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 call "the Anglo-Saxon model". Whether it will continue to do so is not certain, for it now has a Labour government with no effective opposition, either numerically or intellectually, and a stunning unawareness of the cumulative effect of such measures as a minimum wage, enhanced union power, and all of the baggage associated with the social chapter.

So the right had better back of chortling: the competitive threat incident to globalized markets will not certainly bring down the welfare state. It is equally likely that it will lead to more protectionism, more capital controls, and high-wage-plus-high-unemployment-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.

Governments can also find a way around the demographic problem 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 them substantially wealthier than the workers. Just as businesses continually hunt for new revenue streams, so do governments. With increases in income taxes no longer politically possible, the focus is on indirect taxes, particularly those that can be represented as being based on some virtuous principle rather then a selfish desire for more money. The attempt to impose huge taxes on tobacco in America was one such effort to promulgate a "virtuous" taxes -- a levy defended as being in the interest of the payer. Another such is an 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 Deputy Prime Minister John Prescott is continuing the Tory policy of increasing the real tax on petrol, having converted one of his two Jaguars to natural gas At the same time his colleague, Peter Mandelson, orders a moratorium on the construction of all new, clean gas-fired electric generating stations so that old, coal-fired one can continue to operate. While Prescott cools the globe by discouraging the burning of petrol, Mandelson heats it by encouraging the burning of coal. No small minds to be troubled by the hobgoblin of consistency in this Labour cabinet!

Such taxes are an enormous potential stream of revenue for governments. Harvard Professor Richard Cooper estimates that a world-wide carbon tax would yield $750 billion annually by 2020, equal to 1.3% of gross world product in that year. That is real money -- a significant pot from which leftish 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 market capitalism if it is materially to improve lives of the greatest number of the world's inhabitants, while 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.