Crowded house: the Welsh economy

The Welsh Economy

The Economist this week reports on two very interesting academic studies on the effects of increased government spending which could have a profound impact on our understanding of the Welsh economy.

The first study, by Harvard Business School academics, investigates whether higher government spending can "crowd out" private consumption and investment -- i.e. the phenomenon were government uses up financial and other resources (including personnel) that would otherwise be used by private enterprise. As an 'economy' is basically an aggregate of the actions of literally hundreds of millions of different people and organisations making diverse informed decisions on how to spend their money, the biggest problem faced by economists is to isolate just the factors they want to study -- in this case what influence increased government spending has on the private sector -- however the Harvard Business School academics hit on a very ingenious solution:

"When American politicians become chairmen of congressional committees, they are able to direct federal spending to their home states. To take one example, Richard Shelby, a Republican from Alabama, became chairman of the Senate intelligence committee in 1997. Before that Alabama averaged $6m less in annual federal earmarks, or specific funding, than other states. After his appointment the state received $90m more than the average.

Chairmanships are based on seniority. They require another senator or congressman to lose their seat. Appointments have little relationship with economic activity in the state concerned, and extra spending will occur at all stages of the [business] cycle. It is a truly independent variable.

The academics examined 232 appointments across 42 years. They found the average state receives a 40-50% boost in earmarks in the year following a chairman’s appointment, an increase that persisted for the rest of his tenure. Private firms reacted by reducing capital expenditure (by 8-15%) and research and development (by 7-12%); employment and sales growth also suffered. This test appears fairly robust, as it covered a wide variety of states and was also reversed when the chairman stood down."

Furthermore the second study highlighted by The Economist and conducted by academics associated with the OECD discovered through statistical analysis of a panel of 145 countries between 1960 to 2007, that a 1% rise in government consumption as a share of GDP eventually reduced private-sector consumption by 1.9%.

If these findings are correct, what does this tell us about the Welsh economy were public spending as a share of GDP has, according to the latest figures, reached 69.1% -- second only in its reliance on the public sector to Northern Ireland?

Public spending as a share of GDP (source: CEBR)

I have previously written how, despite the Welsh Assembly spending more per capita than any other UK region on economic development, Wales still remains at or near the bottom of most indicators of economic health such as GVA, unemployment and business failures. The Institute of Welsh Affairs, which commissioned the research (and which counts the sainted Gerry Holtham on its management board), opined that the causes for this underperformance were general cack-handedness and a lack of accountability and transparency. However, bearing in mind the results of the above studies, is it not more likely that the growth of the Welsh private sector is in fact being artificially stunted due to the crowding-out effects of an overlarge public sector? It surely cannot be healthy for Wales that the government spends £7 out of every £10 spent in this country.

Furthermore, in the past both Rhodri Morgan and Ieuan Wyn Jones have given speeches saying that the problem is not that the Welsh public sector is too large, but that the private sector is too small. But surely this is putting the cart before the horse -- under normal circumstances a country can only afford a public sector which can be sustainably paid for by its private sector. If the findings of the above studies are correct then they will have profound implications on our understanding of why the Welsh private sector is so stunted.

(Finally, before I am accused of hypocrisy for having called for Welsh Assembly support for the port of Holyhead just days ago, please note there is a big difference between targeted and limited government support and a structurally over-large public sector.)