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  1. Long reads
8 January 1999

The welfare state lives on (alas)

You think redistribution is doomed? Cheer up. Irwin Stelzer, lover of the free market, sees (to his

By Irwin Stelzer

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, by the limited willingness of democratic societies to endure higher direct taxes on income, and by what has come to be called globalisation.

Both sets of chortlers have it wrong. Start with the left, and its conclusion that current economic difficulties demonstrate that free markets don’t work. Wrong. The problems of Asia are not due to an excess of free market capitalism, but to an insufficiency of it. We get the benefits of free markets 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. That is why those economies have failed to create a single net new private sector job in 20 years.

But just as the left is indulging in a chortle too soon, so is the right. It is true that the welfare state is under threat from four powerful forces: the globalisation of the world economy, which is putting downward pressure on labour costs; the ageing of the population, which will force fewer and fewer workers to support more and more retirees (though it is often overlooked that productivity improvements could easily allow them to do so); the growing disinclination of voters to pay more tax to support those 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 those who have been led to prefer welfare to work, dependence to independence.

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But what conservatives overlook is that the world’s politicians do not want to reform their welfare states. Further, they have the weapons to resist reforms, and 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 not, therefore, going to see the end of the welfare state as we know it, but will instead see a counter-attack on the forces that threaten it.

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Politicians can thwart globalisation: they can set up barriers to trade and the free flow of capital. They can use a host of indirect and hidden taxes to counter demographic trends and the unwillingness of voters to countenance higher direct taxes.

Start with globalisation. According to the traditional analysis, growing competition for world markets – between industrialised countries and those 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 the truly horrendous social costs that are required by Germany’s luxurious welfare state.

But we should keep two caveats in mind. The first is that the title “industrialised economy” is no longer a completely accurate description of most of the countries we tend to classify as such. “Service economy” would be better. That distinction is important because, while the great bulk of manufacturing competes in a global economy (cars, steel), a large portion of services does not. It is true that computer programmers in New Delhi and Manila compete with those in Britain. 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 per cent of Britain’s GDP. They are not affected by globalisation and so are not threatened by “cheap imports”. Such employers have neither the incentive nor the ability to move to lower-wage countries. The owner of a barber’s shop cannot sell imported haircuts.

More important, governments are not powerless in the face of globalisation. It has merely taken them time to figure out just how to fight back. 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 the limitation of banana imports from Latin America, or the use of subsidies to shore up banks, airlines and farmers, the French have found ways to protect their welfare state from the competition of more efficiently produced goods. The citizenry pays a fearsome price so that the governing elite can 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.

Now that Europe has predominantly left-wing governments, others are ready to follow France’s lead. Indeed, in Germany, the Lafontaine husband-and-wife team (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 J M Keynes and added a call for a cartel of governments to harmonise – oops, co-ordinate – taxes and social policies so as to eliminate competition 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 the recent talk about controlling capital flows is all about.

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 are capital controls. But the adverse consequences are felt in the longer term, while the benefits – uneconomic exchange rates and protection of social spending – are realised in the short term. Politicians will go 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.

What’s more, most EU governments, given a choice of America’s labour market system (flexible labour costs and relatively full employment) or the alternative (relatively high labour costs and relatively high unemployment), quite consciously choose the latter. 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: 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 the baggage associated with the social chapter.

So the right had better back off chortling: the competitive threat of globalised markets is not at all certain to 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: the rising number of retirees relative to workers, and the disinclination of the remaining workers to pay higher taxes to support retirees who are often substantially wealthier. 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” tax – 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, Peter Mandelson, when he was at the Department for Trade and Industry, ordered a moratorium on the construction of all new, clean, gas-fired electric generating stations so that old, coal-fired ones could continue to operate. While Prescott cools the globe by discouraging the burning of petrol, Mandelson heats it by encouraging the burning of coal. The hobgoblin of consistency does not trouble this Labour cabinet.

Such taxes are an enormous potential stream of revenue for governments. The Harvard professor Richard Cooper estimates that a world-wide carbon tax would yield $750 billion annually by 2020, equal to 1.3 per cent of the 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 the 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.

The writer is senior fellow at the Hudson Institute and a columnist for the “Sunday Times”