Saturday, August 16, 2008


I recently listened the serie called "Intelekta" (link) on Radio Slovenia. The topics of the talk was classical liberalism and its direct and indirect effects on economic growth and development. Nobel laureate fromm 1973 and an imminent philosophical and economic thinker, Friedrich August von Hayek once famoulsy noted that society's course will be changed only by the change in ideas. Once ideas meet the minds of the individual initiative, the politico-economic measures will follow. Slovenia, still the wealthiest post-communist economy, enjoys moderately high standard of living while the future prospects of economic development are hampering the growth of output and productivity. My research (link) has shown an alarming evidence of Slovenia's score on economic growth and development: back in 1991, the relative gap in terms of standard of living between Slovenia and Estonia stood at 35-41 years, taking purchasing power parity and current prices into account. In 2007, the gap between Slovenia and Estonia reduced to 13 years. In simple terms, this implies that in 13 years, the level of living standard in Estonia will surpass the standard of living in Slovenia. In this briefing paper, I intend to draw a perspective on Slovenia's economic development and empirically alternatives to statist economic policy and Bismarckian welfare state.

The Empirical Side of Economic Policy

Back in early 1970s, David Nolan of the MIT, composed a chart, showing how each political ideology is derived from the mathematical treatment of marginal changes in two variables - personal and economic freedom. Today, this matrix is called Nolan chart (link). The usefulness of this matrix is of the high purpose since it can show revealed preferences of political parties as vote-maximizing agents in an oligopolistic political market. Kenneth Arrow, a Nobel-winning economist, devised an impossibility theorem, the assertion of which is that it is impossible to devise a constitution or voting system which offers more than two reasonable choices to the individual, or that will guarantee to produce a constant set of preferences for a group which correspond to the preferences of the individuals making up that group. Hence, the paradox of voting is that it is impossible to have rational and at the same time egalitarian choice. Assume a two-agent utility-maximizing model in the political market where both agents strive to maximize election output. Because both groups face a monotonic utility function, which means practically the same preferences under different set of policy measures, the empirical intuition is under what rules the agents will react. In Social Choice and Individual Values, Kenneth Arrow, proposed the rules of social choice (link). Unless clear rules are given in the game of economic policy, limiting the scope of government action, the use of discretion would always arise and be made permanent. This simple theorem referes to Arrow's general impossibility theorem and to the rules determining social choice. The behavior of utility-maximizing political agents is shown in the graph. The utility function y = u(x) is downward sloping. This movement reflects the fact that the first choice done by a political agent will inherently reduce the utility his competitor. It means that the support for one measure, say tax reform, will not be strong enough to pass it through. Each utility-maximizer in the political market will inevitably seek to maximize the utility sum of each square by reducing the utility of the competing agent per se. What determines the voting outcome is the rule of the margin - meaning that higher majority rule of one group will entail greater feasibility of social choice. From an empirical point of view, that could be the reason why political system with smaller number of utility-maximizing political agents tend to score higher on the scale of political freedom and quality of governance. In theoretical terms, the paradox of voting is that higher majority rule implies the full-scale fluidity of individual preferences transmitted into the machine of collective choice. Notably because individual preferences of choice can be fully processed only by the market mechanism, the collective choice always entails a contradiction in terms. Instead, it should be noted that transitivity and non-coercion are the main determinants of the welfare choice, not the aggregation of preferences.

Picture No.1: Political Competition and the Public Choice

Economic Theory and Policy: The Failure of Statism in Slovenia

After 17 years of transition from state-controlled to market-oriented economy, Slovenia is still the strongest economy in Central and Eastern Europe. A detailed view on the scoreboard of economic growth shows that throughtout 1990s, the overall growth of real productivity per head stagged compared to other countries in Central and Eastern Europe. The real reason for rachitic growth of factor productivity is not the insufficient amount of working hours in the market but the size of tax burden. Until the latest minor change in tax rate structure, top marginal income tax rate was 50 percent. Even now, when the top rate on earned income is 41 percent, the rate structure is not inclined towards the growth of productive behavior such as investment, entrepreneurship and labor supply. Additional tax burden levied on workers and entrepreneurs, such as employee social security contribution and mandatory employer social security contribuion, has downsized the potential growth of overall productivity - which is, in all empirical and theoretical aspects, the main determinant of wage level. The unparalelled growth of the corporate state triangle of government, employer associations and trade unions - initiated a collective bargaining which still attempts to determine wages via central-planning mechanism that is not based upon market-clearing price system. The overall consequence of collective determination of wages is that the relative price of labor services is mis-allocated, causing labor shortages and surpluses. At the same time, that is the reason why real private-sector economy in Slovenia is facing labor shortages of skilled labor supply. True, brain-drain is another consequence of labor shortages because of high tax rates that hinder productivity growth and human capital utilization in the real sector. The lack of privatization is reflected in the fact that state control in the Slovenian economy is at the same share as Soviet Union under Lenin when the latter launched New Economic Policy (link). Considering the data, the share of private sector activities in the GDP is, in Slovenia, the smallest in the region. When the last comparison was published, public sector activities composed 35 percent of the GDP compared to the regional average of 20 percent. The most alarming threat to Slovenia's macroeconomic stability is the expected increase in net financial liabilities and transfers into inter-generational accounts through pension and health-care system. From a rational and sustainable perspective, capital market is the best guarantee of savings utilization for the old-age as the long-run sustainability of the rate of return on portfolio investments determines the level of old-age income, not transfers such as "pay-as-you-go" or income distribution that skews the productivity of the labor supply. When all aspects of statism are taken into the empirical and methodological account, it does not seem surprising why Slovenia's comparative economic performance stalled while other economies in the region, such as Slovakia and Estonia, faced significant rates of output growth. If Slovenia's long run output growth rate increased from 3,0 percent to 4 percent in the long run, the gap in the standard of living between Austria and Slovenia would shrink from 58 years to 22 years, ceteris paribus. Perhaps that is the best possible evidence that stable and free institutions, pro-growth economic and tax policy, limited government spending, free world trade, the absence of government intervention is superior to cradle-to-grave welfare state and economic policy based on government intervention. Adam Smith once wrote that "...the highest level of prosperity occurs when there is a free-market economy and a minimum of government regulation." So true.

Rok SPRUK is an economist.

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