Beast that Ronald Reagan tried to starve keeps growing

The former president Ronald Reagan hoped by cutting taxes, people would eventually accept less spending by the government. What's needed now is an innovative approach.

Ronald Reagan's approach to fiscal policy was pragmatic, but simply following his ideas will not solve issues such as the one playing out in the US. Mike Sargent / AFP

As the world watches the United States grapple with its fiscal future, the contours of the battle reflect larger social and philosophical divisions that are likely to play out in various guises around the world in coming decades.

There has been much discussion of how to cut government spending but too little attention has been devoted to how to make such spending more effective. And yet, without more creative approaches to providing government services, their cost will continue to rise inexorably.

Any service-intensive industry faces the same challenges. In the 1960s, the economists William Baumol and William Bowen wrote about the "cost disease" that plagues these industries. The example they used was that of a Mozart string quartet, which requires the same number of musicians and instruments in modern times as it did in the 19th century. Similarly, it takes about the same amount of time for a teacher to grade a paper as it did 100 years ago. Good plumbers cost a small fortune, because here, too, the technology has evolved very slowly.

Why does slow productivity growth translate into high costs? The problem is that service industries ultimately have to compete for workers in the same national labour pool as sectors with fast productivity growth, such as finance, manufacturing and information technology. Even though the pools of workers may be segmented, there is enough overlap that it forces service-intensive industries to pay higher wages, at least in the long run.

The government, of course, is the consummate service-intensive sector. Government employees include teachers, policemen, dustmen and military personnel.

Modern schools look a lot more like those of 50 years ago than do modern manufacturing plants. And, while military innovation has been spectacular, it is still very labour-intensive. If people want the same level of government services relative to other things that they consume, government spending will take up a larger and larger share of national output.

Indeed, not only has government spending been rising as a share of income; so, too, has spending across many service sectors. Today, the service sector, including the government, accounts for more than 70 per cent of national income in most advanced economies.

Agriculture, which in the 1800s accounted for more than half of national income, has shrunk to just a few per cent. Manufacturing employment, which accounted for perhaps a third of jobs or more before the Second World War, has shrunk dramatically. In the US, for example, the manufacturing sector employs less than 10 per cent of all workers. So, even as economic conservatives demand spending cuts, there are strong forces pushing in the other direction.

Admittedly, the problem is worse in the government sector, where productivity growth is much slower even than in other service industries. Whereas this might reflect the particular mix of services that governments are asked to provide, that can hardly be the whole story.

Surely, part of the problem is that governments use employment not just to provide services, but also to make implicit transfers. Moreover, government agencies operate in many areas in which they face little competition - and thus little pressure to innovate.

Why not bring greater private-sector involvement, or at least competition, into government?

Education, where the power of modern disruptive technologies has barely been felt, would be a good place to start. Sophisticated computer programs are becoming good at grading middle-school essays, if not quite up to the standards of top teachers.

Infrastructure is another obvious place to expand private-sector involvement. For example, it was widely believed that drivers on privately operated roads would constantly be waiting to pay tolls. Modern transponders and automatic payment systems, however, have made that a non-issue.

But one should not presume that a shift to greater private-sector provision of services is a panacea. There would still be a need for regulation, especially where monopoly or near-monopoly is involved. And there would still be a need to decide how to balance efficiency and equity in the provision of services. Education is clearly an area in which any country has a strong national interest in providing a level playing field.

As US president in the 1980s, the conservative icon Ronald Reagan described his approach to fiscal policy as "starve the beast": cutting taxes will eventually force people to accept less government spending.

In many ways, his approach was a great success. But government spending has continued to grow, because voters still want the services that government provides.

Today, it is clear that reining in government also means finding ways to shape incentives so that innovation in government keeps pace with innovation in other service sectors.

Without more ideas about how to innovate in the provision of government services, battles such as one sees playing out in the US today can only become worse, as voters are increasingly asked to pay more for less. Politicians can and will promise to do a better job, but they cannot succeed unless we identify ways to boost government services' efficiency and productivity.

Kenneth Rogoff, a former chief economist of the IMF, is professor of economics and public policy at Harvard University.