The democracy deficit

By Adam Creighton

Last year the United States and a handful of European countries teetered on the brink of default. Only four years earlier the International Monetary Fund, gatekeeper of economic orthodoxy, proclaimed in its 2007 World Economic Outlook that global economic prospects looked to be “favorable” and “world growth will continue to be strong”. It was equally sanguine about the efficacy of financial regulation.

The IMF should have been more cautious, even without the luxury of hindsight. For one, most western countries had accumulated massive public debts already – despite relatively benign economic growth in most western countries from the early 1990s. Italy, for instance, already had public debt of 100 per cent of GDP in 2000. In America debt had been broadly trending up since the 1980s. In Britain, the Blair and Brown governments oversaw large public deficits for most of the 1990s and 2000s. Such largesse is manageable with low interest rates and robust growth, but not otherwise.

In fact, conditions have been in place for a public debt crisis at the heart of western democracy for decades. They did not suddenly emerge in 2008.

Voters should watch with jaded bemusement as the political and bureaucratic elites grope around for ‘solutions’. Typically they propose using taxpayers’ money to bail out creditors, or enacting ‘austerity measures’ to cover public finances with a fig leaf of fiscal rectitude. These are ultimately futile because they fail to treat the fundamental causes. They are like treating a rotting tooth with painkillers – perhaps effective only in alleviating the problem for a short while.

The point is, even if we could magically eradicate all the debt, another debt crisis would ultimately arise again. What causes this vicious spiral?

Winston Churchill famously said, “Democracy is the worst form of government except all the others that have been tried”. His claim can’t be faulted, but that doesn’t mean democracy is without fault. In fact democracy, whatever its virtues, has fanned the public debt crisis. It might be government by the people, but not necessarily for them.

Democratic doubts

Doubts about the stability and efficacy of democracy have a long pedigree. Liberals in the 19th century, like the brilliant French aristocrat Alexis de Tocqueville, worried that rule by majority would lead to erosion of individual rights, as groups used the power of the state to fleece minorities. He worried that democracies would suffocate their citizens with wellmeaning regulations that sapped their desire for free will and individuality – “it would degrade men without tormenting them”, he wrote.

John Stuart Mill, the British liberal who is routinely considered the quintessential man of moderation and advocate for women’s rights, supported universal suffrage but only if more educated people received relatively more votes. Otherwise, he thought, the large bulk of the population, for the most part ignorant, would pursue ‘class based’ legislation to the long-run detriment of society.

Economists from the later 20th Century have tended to worry about the consequences of voters’ ignorance of the political system. This doesn’t mean voters are irrational. On the contrary, economists can elegantly explain the public’s gobsmacking lack of knowledge about political processes and outcomes: an individual vote is highly unlikely to be decisive in any way. Therefore, people devote commensurately little effort to evaluating the policies of alternative political candidates.

Looked at another way, the mechanism of democracy subsidises bad decisions. The costs of voting recklessly are borne not by the individual voter, but by society at large and even future generations. Equally, the benefits of considered choices accrue to other people for whom the voter cares little. This sort of analysis is especially relevant in a country like Australia, where voting is compulsory.

If the random choices of ignorant voters cancelled each other out roughly, on average, then this might not matter much. In that case, the politically interested and aware slice of the population would cast the deciding vote.

But how realistic is this? Professor Bryan Caplan argues in his book The Myth of the Rational Voter that most voters exhibit ‘systematic biases’. This is especially true for economic policy, which also happens to be the bread and butter of government decision making. In particular, he argues people prefer feel-good economic fallacies to evidence and economic logic: they prefer make-work schemes to conservation of labour and efficient production, they distrust free trade and free markets, and they hold a permanently pessimistic view about the state of the economy and its ability to flourish independently of government interference.

Kaplan argues convincingly that these views are primordial, entrenched and people derive satisfaction from upholding them independently of their usefulness. In the jargon, beliefs are not a means to an end; people hold ‘preferences over their beliefs’. And those preferences tend naturally to feature the fallacies mentioned above.

In Australia

My favourite example in Australia is the first homeowners grant, a policy of demonstrable futility and inefficiency. It pushes up house prices, in effect providing a subsidy to the sellers of property, not to mention the economic costs of raising the revenue in the first place. But it sounds nice to voters, appealing to their anti-market biases, so sadly it looks set to stay.

Another is the ease with which governments are able to enact vast spending programs in times of heightened uncertainty. In Australia, the Rudd government could play to people’s inherently pessimistic biases and unleash a gargantuan borrowing and spending program to ‘save the economy’ in early 2009. Even economists that supported such policies in theory reckoned it was too large.

Kaplan believes democracy fails not because it ignores voter’s demands, but “because it does what voters want”. The accumulation of excessive public debts, for instance, is a result of these systematic biases among voters. Pessimism and a preference for government spending to ‘stimulate’ growth are particularly insidious, as they encourage government borrowing and spending to ‘save the economy’ and ‘create jobs’.

The problems of voter irrationality are compounded by Keynesian economics (not to be confused with policies that Keynes himself would have endorsed). Keynesian economics proposes that government can manipulate the economic cycle – moderating inflation and unemployment – by borrowing and spending. In effect, it promises something for nothing: a macroeconomic free lunch.

Governments pursued policies to stimulate the economy before Keynes published The General Theory of Employment, Interest and Money in 1936. For example, attempting to stave off recession (unsuccessfully) the Republican President Hoover doubled the size of the United States budget in the four years from 1929 – a program he himself described in 1932 as “the most gigantic program of economic defense and counterattack ever evolved in the history of the Republic”.

But in the main fiscal principles before Keynes reflected Adam Smith’s 18th century dictum: “what is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom”. That is, government could borrow but only to pay for wars or build infrastructure, the public return to which exceeded the interest repayments. They would not borrow money at about 6 per cent per annum to pay a first homeowners grant or a baby bonus, as the Commonwealth of Australia does.

Forever changed

Keynes’ book changed everything. By the 1970s, the Republican President Nixon of the United States had famously said ‘we were all Keynesians now’.

Whatever the theoretical merit of Keynes’ General Theory (and that is still hotly disputed), it is a disaster when applied in a political context. Keynes gave politicians, already naturally inclined to ‘help’, formal justification for meddling in the economy. Keynes himself wrote that the policy conclusions stemming from his theory were best implemented under totalitarian conditions, when government did not have to curry favour with irrational voters.

Keynesian literature requires government spending measures (assuming they work), to be ‘timely, targeted and temporary’. But they never are. Their implementation is always delayed owing to poor information and the encumbrance of the political process. They are rarely targeted rationally, but instead directed at politically favoured groups (‘tradies’ or ‘first home buyers’ might ring a bell); and they are certainly not temporary. Australia's massive government stimulus was still being spent three years after the global financial crisis hit in late 2008 – a crisis the Reserve Bank governor said lasted about six weeks.

Keynesian economics suffers from the naive belief that governments are a blank slate on which economists can graft sensible policies in the public interest. But political decisions are not “some abstracted exercise within the political naiveté of the economist’s study”, as Nobel prize-winning economist James Buchanan put it. Economic advice must recognise the context in which it is given.

The practical consequences of Keynesian economics, then, is ever larger government deficits and public debt, as politicians easily expand spending but struggle to reduce it when times are good.

There are exceptions to the rule. The Howard government was unusual in overseeing reductions in public debt and budget surpluses year after year. Nevertheless, it also enjoyed record increases in revenue, and real government spending increased dramatically year after year too.

Recognising the drivers of poor public policy is not to say they are easily fixed. Democracy remains the best form of government, but that doesn’t mean we cannot limit its scope in our own interests.

One way is to have constitutional limits on government spending. Even Keynes thought 25 per cent was a reasonable figure, a far cry from the 35 per cent plus most western countries exhibit today. Such a cap would make large budget deficits more difficult to sustain, and thereby reduce the likelihood of another public debt crisis.

Second, it’s probably impossible to improve the quality of spending outcomes much in a democracy with universal suffrage. Voters’ irrational biases will inevitably produce policies which are inefficient, unfair or ineffective, or probably all three. But perhaps an independent fiscal commission could be charged with applying common sense to government revenue – devising transparent, simple and effective taxes that raise revenue efficiently.

Adam Creighton is the economics correspondent for The Australian. He was formerly senior adviser to the Leader of the Opposition and has written for The Economist and The Spectator.

Article last updated 31 January 2012