That “small government” advocacy has mixed with opposition to fiscal stimulus was, perhaps, inevitable. The stimulus opponent is also, on average, either libertarian or conservative, holding strong anti-state priors. But, Simon Wren-Lewis is right to scratch his head when the two arguments are explicitly turned into one. The fiscal stimulus debate has little to do with the more general disagreement over the optimal size of government. Further, legitimate criticisms of intervention tend to get buried beneath cruder arguments with little merit.

“Small government” has an ambiguous meaning unless we introduce a unit of measurement. The vagueness of term can be illustrated by means of a comparison between two hypothetical governments. One focuses entirely on the provision of law and justice, including national defense, spending an annual total of $100 million. The other provides some law and justice, but is also involved in banking regulation and border control, spending a total of $75 million. While $100 is certainly greater than 75, we could make the case that the second government is less optimal than the first. Therefore, rather than measuring the size of government by its budget, I think it’s more fruitful to think about size in terms of the number of different areas the government is involved in.

How is the optimal size of government determined? In economics, the foremost social task is the allocation of the scarce means of production. When we think of the allocation of scarce resources we think of the pricing process, but there are at least two ways of interpreting what prices do. The first is the non-nuanced approach, which almost assumes the pricing process to literally be the infamous “invisible hand” — it operates akin to magic. The more nuanced view of the pricing process is that its exact procedure is institutions-dependent. Institutions are developed by society over time, and as products of the human mind are very likely to be imperfect. In other words, the pricing process is not necessarily optimal and oftentimes we are driven to find alternative guides to resource allocation. Here is where the theory of the firm and the theory of collective action should begin.

It is optimal for the government to allocate resources when it has a comparative advantage in doing so. Remember, the idea behind comparative advantage is to minimize opportunity cost. If the pricing process always leads to optimal outcomes — and we can define optimality, to satisfy sticklers, as the potential for optimality, after considering the “frictions” (e.g. imperfect information) that symmetrically impact all institutions (those which are not necessarily unique to the market) —, there is no scope for alternative methods of allocation. But, we have good theoretical reasons to believe that the pricing process is not always optimal: market failure. A market failure by itself doesn’t imply the desirability of collective action, but it does mean that there’s an empirical question we have to answer: should we let the market failure be, can it be solved privately, or should we collectivize that industry?

When we talk about the size of government, then, what we are debating is its proper scope. When people advocate for a smaller government, what they really should be focusing on is what part of the current scope of government is non-optimal. Fiscal stimulus is part of the debate, but one part out of many. In fact, the debate over the desirability of fiscal stimulus is not even the most important one.

Consider that fiscal stimulus is temporary expenditure. In the New Keynesian model, fiscal policy becomes attractive at the zero lower bound. I am a fiscal policy skeptic, liquidity trap or not, but I would gladly trade support for a stimulus program, in exchange for reforms elsewhere. Even in an anti-stimulus framework, the impact of counter-cyclical fiscal expenditures is likely to be limited. Rather, I would focus on labor market regulations, including reducing the bureaucratic costs of hiring, eliminating the minimum wage (and replacing it with something like a basic income guarantee) — this may be more relevant for southern European countries than for the United States. We can challenge regulatory involvement in other industries, such as on milk products, licensing fees, and other things which may seem trivial, but add up. I found a 2008 number claiming that the total cost of compliance with U.S. Federal regulations is ~$1.75 trillion that year (12 percent of 2008’s GDP).1 These are all things, unlike fiscal stimulus, of a more permanent nature.

I don’t follow politics, and I don’t know what policy making is really like. I might be an idealist, but it seems to me that had the Republican party — supposed champions of small government — been willing to take on a more nuanced approach, they could have supported another stimulus package in exchange for regulatory reform. (Of course, if Republicans were really interested in small government they’d support cutting defense spending and healthcare reform.) Specifics matter. Constraining fiscal stimulus probably has very little impact on economic performance, but stimulating business investment by cutting costs could have a very strong impact. It’s not just fiscal stimulus that receives too much attention; we also waste our time going after programs with a high probability of providing net benefits, such as food stamps.

(I don’t talk about monetary policy in this post, but if monetary policy doesn’t accommodate the increase in demand for money, then no amount of regulatory reform is likely to offset the damage of tight money.)

Where I disagree with Wren-Lewis is on whether or not recessions are a good time to talk about the optimal size of government. When times are good, all the handicaps to growth no longer seem as important. For example, the impetus to reform Spanish labor markets was relatively weak when the Spanish economy was booming. Now that the economy is depressed, it is more obvious that labor market reform is very necessary. The same goes for other harmful interventions; they don’t seem as harmful when incomes are growing and the economy is booming. Politicians move on to what seems to be more important topics. But, we don’t need to reduce government expenditures to decrease the size of the state, if we measure size not by total money spent but by the amount of things the state is involved in.

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1. Although, I’m skeptical of any figure used by Heritage.