Insurance

Since a previous post tried to answer an Austrian argument regarding how large parts of the (Greek) population are dependent on government, I would like to use the opportunity to elaborate a bit on a number of political economy arguments in favor of big government (and taxation). These will mostly revolve around the issues of scale, insurance, sectoral balances and investment, although I am sure others can think of more.

Scale

What distinguishes the iPhone is basically exactly that. For most people the iPhone is a product which differs significantly from other cell phones, provides social status and higher utility than a much cheaper smartphone. In other words, the main achievement of Apple is that it can sell the iPhone with a large profit margin.

Yet Apple is not in the business of making Ferraris. Its aim is not to produce and sell several hundred iPhones. On the contrary, its business model is centred around manufacturing millions of iPhones which it will sell at a high enough price to achieve a large profit margin yet not so high that it will threaten its sales volume. Its profits depend on a scale effect meaning that it depends on earning a lot per product yet coupled with a large volume of production.

Although Apple can affect its profit margin (through marketing, brand name, product design and features), the scale effect is an externality from its own viewpoint. In order to achieve this effect it requires a large enough base of medium/high income customers and an infrastructure that can support its large distribution and retail network. Ideally Apple would like to not bear any cost for maintaining these networks yet reap all benefits from their existence.

The same goes for almost all companies in the world which base their business model on mass production instead of scarcity. Their P&L statements contain sales proceeds and direct costs entries yet no entry for the cost of the scale effect which they leverage in order to achieve their profits.

Although this scale effect is to a large extent an «emergent property», meaning that as all these companies pay for their costs and investments a large customer base emerges it also depends on a central government to provide for all the infrastructure and networks needed for «the market» to operate. This might be the rule of law, enforcement of contracts, transportation networks, payment systems, standardisation of equipment and networks and so on.

In this sense, taxes can be seen as payment for the provision and maintenance of all these networks that allow the scale effect to continue.

To a large extent, what distinguishes a wealthy from a poor person is the ability to self-insure through market mechanisms. A person with high enough income and wealth can cushion itself against bad luck, self-insure using a legally binding contract with a specialized firm against tail risks such as health issues and accidents, buy a high level of education and acquire a long-term contract to provide for his retirement along with his large stock of savings. A poor person will find it very difficult to self-insure against typical risks (such as health problems), have a very small stock of savings to use in a rainy day (ie unemployment) and will not be in a position to acquire high quality education unless it is provided at low/no cost. Such a person might not have access to housing at reasonable prices while his low income, frequent unemployment spells and inexistent wealth would make retirement very painful and entering (and staying) in a retirement plan quite unlikely.

Almost the only way to provide insurance for poor people (health, unemployment) and a level playing field in areas such as education against high income people is through centrally provisioned services by the government. The government will be the one to create an education system accessible to all people, institute unemployment benefits (paid by all employees), provide housing to low-income communities and some form of universal health insurance scheme which will not allow people to suffer from illness only because of low income.

Sectoral Balances

I think that most people have understood by now that there is no way to avoid the sectoral balances of saving in any economy. By definition total saving must be zero which means that the private sector can net save only if the external of government sector is a net borrower. Unless a country can very quickly move its external balance (which is quite difficult to achieve, especially with regards to exports) this suggests that the government is the sector of choice to allow the private sector to net save in a downturn (especially through automatic stabilizers).

Actually, one of the major reasons why the Great Depression did not happen again is exactly the fact that governments are much larger today than they were during the 1930’s which maintains demand both through government purchases and large swings in the government deficit. Absent a large enough government sector, downturns would be «corrected» through very large changes in the unemployment level just as they did during the Great Depression.

Investment

Although I touched this subject in the scale effect section I think it is quite important to warrant a separate section. The main idea is that apart from their own capital stock, all households and firms in an economy require a large public capital stock consisting mainly of networks such as transportation, communication, electricity and others. Although these networks are extremely important and would make it mostly impossible to conduct market transactions in their absence, the fact is that their benefits are diffused among the general population.

As a result, they remain an externality from the point of view of each individual and firm which means that each of them would like to use them without paying for them. The main way to overcome this difficulty is for the government to construct and maintain these networks and pay for their construction through the general tax system.

Conclusion

I think that the main idea is clear. From the point of view of each individual scale effects, social capital (law, contracts) and infrastructure appear as externalities which are diffused among the general population. Unless a central player acts to introduce and maintain them it is almost impossible for the private sector to coordinate in providing for them while covering their costs. Moreover, insurance is a privilege for the rich (and healthy) and only pooling and central provisioning can allow for less fortunate individuals to enter the market without having the rules of the game rigged against them from the start.

In other words, a private economy by construction includes inequalities and market failures which require a central actor to overcome them. One of the most significant market failures is an economic downturn when the private sector in the aggregate wishes to increase its net saving yet only another sector can provide the necessary assets by increasing its liabilities. Unless the idea is to achieve the desired net saving through mass unemployment and hardship, the government sector is the next best thing.