The failure of big state became apparent in the early 1970s, when inflation began to run at rates that exceeded 10 %, economic growth slowed down to one-half of what it was in the period 1950–1973 and unemployment rose above the rate that was
considered “natural”50. Regarding inflation, numerous studies showed that its acceleration was due primarily to the increase in money supply to finance budget deficits. But the phenomenon of stagflation in an environment of slow or negligible growth was unprecedented, and as expected, it attracted keen interest by research economists. Some of them, following in the footsteps of Friedman (1976), focused on the relationship between the rate of inflation and total factor productivity and found that they are related negatively. Consistent with this finding are also the results obtained by Bitros and Panas (2001, 2006) with data from Greece, which showed that inflation reduces productivity, thereby slowing growth and increasing unemployment.
Some others suggested that the large and unexpected increase in the price of oil was mainly responsible for the phenomenon of stagflation. This, they argued, on the one hand increased production costs and accelerated inflation, whereas on the other rendered obsolete a large part of the productive facilities in contemporary democracies. Thus, as the obsolete machinery was gradually replaced by new energy-saving equipment, the increase in oil prices led to increased job losses since the replacement of equipment usually takes place with equipment which is more automated. But while this explanation sounded reasonable for the developments in the 1970s, it could not shed light on why hitherto the phenomenon of stagflation became almost permanent. For this reason, some other researchers turned their attention to the changes in the structure of free market economies that were brought about by the enlargement of the state. What they found was the side effects that we described in Sect.3.3above. Drawing on them, they concluded that the economy became far less flexible than before because with the expansion of the state: (a) The sector of voluntary exchanges, which is based on private incentives and entrepreneurship, was subjected to multilevel administrative and other constraints; (b) the spectacular increase of taxation reduced the net profitability of businesses and placed under bureaucratic control and management resources that might be employed by enterprises in Research and Development (R&D) and hence in innovations; (c) investment in public infrastructures, which is complementary to private investment and contributes significantly to total factor productivity, decelerated51and (d) the way the “welfare state” grew distorted the incentives of workers for hard work and biased their preferences towards consumption rather than investment.52In short, contemporary democracies seemed to have reached a phase of economic stagnation, and the challenge was how to change the alarming trends that favoured the further expansion of the state.
At this juncture, there emerged two leaders, Reagan in the USA and Thatcher in the UK, who tried vigorously to tame the Leviathan of big state. We will review
50The relevant data can be found in Eichengreen (2007a, 17–8).
51Baily and Kirkegaard (2004) and Lavelle (2008) describe in great detail all the weaknesses caused by the Leviathan state and its heavy interventions in the economies in the countries with advanced democracies.
52This side effect is analysed extensively in Bitros and Prodromidis (2004).
their policies and the results they achieved later. For now, we find it pertinent to note that, regardless of what they achieved in this regard, with their policies and mainly with their ideological stand, they opened wide avenues to the reforms that future leaders will need to introduce, if contemporary democracies are going to return to a path leading to societies where the citizens are the masters and not the politicians.
In summary, the case today is that the sovereignty of citizens in democracies has been replaced by the interests of an oversized state apparatus and of politicians who try at all costs to perpetuate themselves at the helms of political authority and reap the benefits associated with it. More specifically, depending on the particular country, politicians and civil servants control and manage from one-third to one- half of the value of goods and services produced by citizens without risking one penny from their pocket and indeed without increasing the prosperity of citizens commensurably with the taxes they pay. Contrary to what supporters of social democracy assert, the reason for establishing the so-called welfare state was neither the intense inequalities of income and wealth among citizens nor the strengthening of social cohesion or the feelings of solidarity. The main reason was the growing demands of organised business interests that captured the state in close cooperation with trade unionists and other invisible managers of political power.
“Keynesian” policies created major problems and distortions. The large increase in the tax burden eroded significantly the incentives of individuals to work hard and invest, and as a result, economic growth decelerated. The efforts of fiscal and monetary authorities to regulate the rate of unemployment through aggregate demand management raised the rate of inflation and influenced adversely the Total Factor Productivity (TFP). The running of public deficits on a permanent basis led countries into over indebtedness and turned politicians to managers of an enormous and harmful force, which undermines the very foundations of democ- racy; and with their far-reaching interventions into the economy, the authorities destroyed the flexibility of private markets and worsened the business cycle. From all these undesirable consequences of the Leviathan state emerged a new vision according to which the size of the state should shrink down to more efficient levels.
This is the vision of thenew classical democracy, which we shall discuss, after highlighting why social democracy is impossible.
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Digression on Social Democracy