The End of Socialism but Not The End of Social Welfare

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Dr. Allan H. Meltzer is an American Economist and the Allan H. Meltzer professor of Political Economy at Carnegie Mellon University’s Tepper School of Business. He is the author of a large number of academic papers and books on monetary policy and the Federal Resrve Bank. Dr. Meltzer’s two volume books, “A History of the Federal Reserve”, are considered the most comprehensive history of the central bank.   He is considered one of the world’s foremost experts on the development and application of monetary policy. Currently he is also President of the Mont Pelerin Society.

Dr. Meltzer originated the aphorism “Capitalism without failure is like religion without sin. It doesn’t work.”

This Paper was presented in the September 2012 Mont Pelerin (Society) Meeting, Prague, Chekia


Socialism – public ownership of all (or most) productive assets – failed whenever it was tried.  Only two avowed socialist states remain – Cuba and North Korea.  Cuba is dragging itself slowly toward some private ownership.  Literally no one admires North Korea.

For reasons that Freidrich Hayek and some other founders of this society understood well, most socialist states were authoritarian and non-democratic.  India and Britain are obvious exceptions.  Both tried so-called democratic socialism.  Both eventually increased free market arrangements.  Growth rose and poverty declined markedly.

Only capitalism achieves growth in living standards and personal freedom.  Freedom depends on ownership of physical and human capital because capital permits people to become one’s own boss.  But freedom and capitalist development require the rule of law.  Rule of law mandates that all citizens are equal before the law and to the extent possible all are treated the same.

Hayek claimed that the rule of law contributed greatly to the success of British and U.S. capitalism.  Socialist countries rarely observe the rule of law.  They work to apply someone’s idea of a utopian society.  What they believe is good and right replaces the rule of law with decrees that allegedly achieves conformity to the socialist ideal.

In contrast, capitalism adapts to many different cultures.  Capitalism in Japan differs from capitalism in Western Europe, as these differ from U.S. capitalism or state capitalism in China and elsewhere.  In free societies, people choose the rules under which they choose to live.  In socialist societies, rulers impose their utopian vision.

The postwar years began with a widely shared belief that socialism would be the arrangement chosen in most countries.   Even Joseph Schumpeter drew that conclusion.  The founders of the Mont Pelerin Society dissented.  They were a small minority, but they understood that freedom was valuable to people in a way that rigid socialist orthodoxies never could duplicate.  And they understood that free men and women could achieve sustained growth.

The attraction socialism once had weakened as the Soviet Union failed to achieve either growth or freedom.   With the decision by authoritarian China and domestic India to expand private ownership and adopt liberalizing measures, all but a few, small countries abandoned socialist orthodoxy.

This defeat or rejection of socialism should not be misunderstood.  One of the main appeals of socialism was its advocacy of an egalitarian distribution of wealth, income and influence.  Hostility toward capitalism always highlights inequality and recessions or business cycles.  As many could see, and a few like Djilas wrote, socialism did not eliminate income differences.  It transferred power influence and high income to a “new class.”  And to the extent that measures of income inequality showed less dispersion, the price paid in income levels and freedom was high.  People in East Germany, North Korea, and China compared their fate to residents of West Germany, South Korea, and the Chinese Diaspora including Hong Kong, Singapore, and Taiwan.  The famous German wall restricted emigration not immigration.  No one chose to move east.

Political pressure for redistribution remained.  The social democratic welfare state offered grants and subsidies that redistributed wealth and income and increased the reported unemployment rate.  After climbing to within 80 percent of the per capita income in the United States, on average, Germany, France and Italy began to pay some costs of the welfare state.  From 1980 to 2005, these countries averaged one percent slower growth than the U.S.  After 25 years, a gap of 25 percent was almost entered explained by lower employment rates.

No country, democratic or authoritarian, accepts the distribution of income ground out by the market.  All modify the market outcome, most of them by taxing and transferring from high incomes to low.  The politics of the social democratic, welfare states can only reduce transfers and costly redistribution in a crisis.

You may be wondering how this introduction to the failed policies for recovery in the EU and the U.S.  I contend that failure reflects the dominant influence of social welfare redistribution over recoveries.  In the United States, President Obama’s principal economic adviser, Lawrence Summers, said in 2009 that policy actions should be “timely, targeted, and temporary.”  The so-called stimulus policies that the U.S. adopted gave temporary relief to public employees, teachers and police and subsidized investment in solar power, batteries, electric automobiles, and insulation.

The results show that the subsidized autos did not sell well, that the main subsidized producers of solar panels failed, and error, corruption, and political favoritism reduced effectiveness.  A detailed study of the nearly $900 billion called stimulus offers some examples.  (Grabell, 2012)

In Illinois, inspectors failed to detect a gas leak from a newly installed furnace that could have seriously injured the home’s residents.  Contractors billed for labor that wasn’t done and materials that weren’t installed.  Fourteen of fifteen homes visited failed inspection.  In New Jersey, auditors identified twelve households that were approved for free repairs despite having income of more than $100,000.  Agencies bought $1,500 GPS systems and underpaid their workers.  The state’s system of eligible applicants contained the Social Security numbers of 168 dead people.  A nonprofit in Waukesha, Wisconsin got stimulus money despite having spent weatherization funds on Christmas decorations, gift cards for employees, and a parking ticket.  An audit found that one employee’s husband received new windows from the agency, charging it $10,000—more than ten times the average cost.  West Virginia had to take over one agency’s weatherization program after finding “shoddy work, falsified reports, credit car abuses, and missing inventory.”  An inspection of a Houston nonprofit found that work was so sloppy that contractors had to go back and repair thirty-three of the fifty-three homes reviewed.  Investigators in California found untrained workers.  And Delaware suspended its entire program for nearly a year after a scathing report documented problems with nearly every aspect of the program, leading the Department of Energy to freeze its funds.

The most successful fiscal policies in postwar United States were the Kennedy-Johnson and Reagan tax cuts for households and businesses.  These programs marshaled profit incentives to guide investment choices.  The Obama program, like most political decisions were less concerned about gaining economic efficiency.  Their primary interest was to choose who paid and who received.  One of the major flaws in what are called Keynesian policies is that the designers act on the premise that what matters is the amount spent, not the way spending is allocated.  Keynes did not make that mistake.

In the European Union and the ECB, the daily discussion is about getting Germany and a few other fiscally responsible countries to bail out welfare state spending in the debtor countries.  I am frankly appalled by the pressure from bankers and their friends to get Germany to subsidize foreign welfare states.  The Financial Times is particularly outrageous.

Prime Minister Thatcher said that welfare states would shrink when they ran out of other people’s money.  We are there.  But instead of adjusting down, the bankrupt governments propose institutional changes that, if adopted, would sustain profligate redistributive policies.

High unemployment and prolonged recession or slow recovery are serious problems that require rational policy action.  Most welfare states are so large that rational policies are politically unpopular, perhaps unacceptable.

We are reaching the point at which welfare state promises of redistribution will shrink.  Or we will lose democratic capitalism.  Voters will not end the welfare state and redistribution, but promises in many countries greatly exceed resources available for payment.  Sweden, once the envied model welfare state has made a start by reducing some transfers.

The crisis is here now in the European Union and the United States.  Even those who favor programs and policies that transfer responsibility and decisions from the market to the bureaucracy must see how difficult it is for government to develop meaningful reforms.  No one believes that the unfunded promises that drive future U.S. debt and deficits will be paid if nothing is done.  On the contrary, everyone who seriously discusses the future welfare state debt and deficits uses the word “unsustainable.”

Many in the European Union point their finger at the “rich” Germans requesting even demanding transfers of one kind or another.  The German government points back saying “we have given ample support.  You, the debtors, must reduce domestic transfers and become more competitive by reducing real wages.  Another continuing stalemate.  Reluctance to recognize the problems of welfare states prevents a solution.

I find it appalling that almost all the daily discussion of the European crisis is about the debt incurred by Greece, Italy, Spain, and Portugal.  Almost daily the Financial Times publishes pieces that urge Germany to accept more inflation to bail out the banks and other lenders.  Do the writers and the editor think that the problem is entirely monetary, to be solved by lowering interest rates and printing money?

Germany recognizes that the problem is real, not just monetary or debt related.  Cost of production are 25 to 30 percent greater in Greece, Italy, Spain and Portugal.  Without lowering costs in these countries, growth cannot resume, or remain even if some stimulus gives temporary relief.  Germany wants real reform of labor, commodity markets, and government policy.

There are two ways to reduce real wages.  The so-called austerity favored by Germany would both reform the economies and force reductions in real wages.  After three years of economic decline, getting an additional 25 to 30 percent reduction in real wages in this way seems to me to be politically impossible.  Voters will not retain in office a government that adopts that policy; political opportunists oppose “austerity.”

Devaluation is an alternative way to reduce real wages.  The ECB should permit the indebted southern countries to form a weak euro temporarily.  The strong euro countries would adopt the fiscal restrictions to which their own representatives have agreed.  The weak euro countries would float down against the strong euro.  Once devaluation reduced real wages, countries in the weak euro would rejoin the strong euro by agreeing to the fiscal rules.

Devaluation would work quickly.  It is not without cost.  Two are of particular importance.  First, the devaluing countries must limit bank runs or currency runs by enforcing temporary exchange controls.  And they must avoid subsequent inflation.  Second, German and French banks would suffer losses on their holdings of foreign bonds.  The French and German governments should require their banks to raise half of their capital shortfall.  Government would supply the other half.  If a bank failed to raise its half in the market, it would be declared insolvent and taken over by regulators.  That gives the bank an incentive to raise its share of the capital infusion.

Social welfare state governments in Europe cannot agree on a solution to their major problem.  They resist imposing the requisite costs on their voters.  Often they fail to carry out the pledges they make.  They cannot agree to change who pays and who receives, the main point of the welfare state.  Most common is a demand for Germany to be more generous.  The German public refuses to pay more transfers to foreigners.

The euro problems are common problems for fixed exchange rate systems.  Governments must limit their budget deficits, the size of outstanding debt, and must keep their terms of trade close to their exchange rate.  Like many other fixed exchange rate systems, the euro failed to meet these requirements.  And it has not been able to agree on a program to restore stability and growth.  These failures will restrict the welfare state and egalitarianism.  It will not end pressures for redistribution.


The United States

The United States also fails to act to reduce or moderate future budget deficits.  Again, the problem is failure of the political system to reduce spending or agree on a comprehensive program to achieve budget balance.

The problem is not new.  From 1930 to 2012, the federal government approved a balanced budget or a budget with a surplus of revenues over spending in successive years only twice.  President Eisenhower was a fiscal conservative.  He favored balanced budgets in all years without a recession, and he gave many speeches about fiscally responsible spending.  President Clinton raised marginal tax rates early in his term.  But he also slowed spending growth enough to run budget surpluses for several years.  Budget surpluses raise expectations that future tax rates will be reduced.  Investment and growth increase.

In contrast, from the beginning of the presidency of George Washington in 1789 to 1930, the federal budget had a surplus in two-thirds of the non-war years.   Wartime deficits did not continue after wars.  Peacetime governments reduced debt.  As late as the 1920s, Secretary Andrew Mellon was able to reduce tax rates and wartime debt by running budget surpluses.

After 1930, the Great Depression followed by several wars brought increased government spending.  The size of government, measured by the ratio of federal government spending to GNP or GDP rose from three percent in 1930 to about 18 percent average for recent decades.  The current administration increased spending to 25 percent of GDP.  Its budgets are rejected unanimously by Congress.  Unlike the early postwar budgets that included a heavy component for defense, social spending is by far the largest share of federal spending.  Most of social spending is labeled “entitlement spending” suggesting (falsely) that it cannot be reduced without depriving recipients of something that is their due.

So-called “entitlements” put future budgets on an unsustainable path in the United States and many other countries.  For the United States, future spending for healthcare and retirement has a present value of $70 trillion dollars or more.  There is no combination of tax rates, expected growth, and reductions of other spending that permit the promised entitlements to be paid.

Why was the modest size of government in the 19th and early 20th century maintained and accepted almost everywhere?  I credit two main, but related, reasons.  One was the international gold standard.  The other was the widespread belief that governments, like households, should balance their budget.  Persistent peacetime budget deficits were a cause for concern that a country would have to devalue against gold.  The currency would move to the gold export point, requiring intervention.  Intervention could succeed in stabilizing the gold exchange rate only if the market expected fiscal discipline to improve.

I have never advocated a return to the gold standard.  The principal reason is that the public prefers stable domestic prices and employment to a stable exchange rate.  A second reason is that a single country that fixed its exchange rate to gold would buffer shocks for all other countries by inflating and deflating when others demanded to buy or sell gold.  An effective gold standard must be universal or, at least, multi-lateral.

The enduring lesson from the gold standard years is that a publicly accepted a monetary rule that maintains a stable domestic price level (or low rate of inflation) also restrains budget deficits, just as fiscal restraint supports the monetary rule.


Collapse of the Welfare State

            After John Maynard Keynes read Hayek’s Road to Serfdom, he wrote to Hayek praising the book but disagreeing with its conclusion.  Keynes claimed that if well-intentioned people made the decisions, outcome would be beneficial and desirable.  This is a major flaw in the organization and operation of social democratic governments and welfare states.  They presume most often that they are selfless and know better than the public what is right.

The great German philosopher, Immanuel Kant, had a better understanding of human character.  He wrote: “Out of timbers so crooked as that from which man is made, nothing entirely straight can be carved.”  Christian theology at the time saw humans as morally imperfect.  Some exceptions can be found in all eras, but it is a mistake to rely on goodwill and good intentions.  Twentieth century experience in authoritarian states and the democracies of Western Europe and India alike reminds us that “power corrupts.”

Kant’s judgment warns us that we should not expect benevolent government regulation.  The rule of law directs government to treat all citizens as equal before the law.  This is an ideal that guides regulation toward desirable outcomes.

Detailed regulation often proclaims that it is done “in the public interest.”  Most often it brings special privileges, crony capitalism, corruption, and circumventions.  Powerful Soviet or Chinese officials had access to better opportunities, better food and healthcare than ordinary citizens.  Democratic India became known for bribery and corruption of officials to obtain special privileges.

After writing the Constitution of the United States, James Madison contributed to the Federalist papers to promote ratification.  He insisted that the Constitution limited the power of the federal government, and in Federalist 10, he warned about the threat posed by “factions.”  Today we replace factions with interest groups.  As Madison warned, interest groups protect their interests at the expense of others.

Interest group politics make it difficult to reform the welfare state or the pressure for egalitarian outcomes.  Here are some examples.  In the 1980s, it became clear that many savings and loan associations would fail.  Deposit guarantees protected depositors, but failure imposed losses on taxpayers.  The U.S. Congress acted to hide the problem, but managements knew that delay created opportunities to take risky gambles that would restore the value of equity if the investment paid off.  Since equity was low or negative, the cost of additional losses would be borne by taxpayers.  Some took the gamble.  Taxpayers’ losses reached $150 billion.

A few years later, President Clinton appointed Jim Johnson to head the Federal National Mortgage Association, FNMA.  FNMA began in 1937 as a purchaser and occasional seller of outstanding mortgages to smooth fluctuations in mortgage rates and create a more liquid market.  Later, the Federal Home Loan Bank Board created a separate organization (Freddie Mac) to buy and sell mortgages also.

Jim Johnson had been a campaign manager in Walter Mondale’s 1984 presidential campaign.  He was well connected politically and wanted to make housing ownership more egalitarian.  He saw an opportunity to expand FNMA’s operations while offering opportunity to low income home buyers.  The political appeal of expanding home ownership was popular.  To facilitate this program, the government agencies lowered down payments and eventually offered to buy sub-prime mortgages that had no down payment to borrowers that had no credit history.

Selling sub-prime mortgages to the two government sponsored buyers, FNMA and FHLMC, was a very profitable business.  Some mortgage lenders actively worked to issue such mortgages that could be resold profitably.  Major banks did the same.  An international agreement required the banks to hold larger reserves behind mortgages in their portfolios.  The banks circumvented the costly regulation by chartering subsidiaries that held the mortgages but evaded the requirement.  Regulators did not object.

A few voices that pointed to the risk of defaults and losses were ignored or dismissed.  Congressman Barney Frank was chairman of the House Committee that had oversight responsibility.  He urged expansion of the program.  President George Bush viewed the programs as part of his “ownership” program.  He did not ask: What did the homebuyers own?  Many made no down payments; they “owned” an option to gain home equity if home prices rose, but they also owned the prospect of loss if home prices fell.

Contrary to repeated forecasts that home prices would not fall throughout the country, the unexpected happened.  The social welfare experiment in expanding home ownership to minorities and low-income families failed in a wave of mortgage defaults and foreclosed houses.

In January 2009, the Obama administration inherited the housing and financial failures.  Their program design called for a massive increase in government spending and temporary tax reductions.  Professor Lawrence Summers, head of the new president’s economic staff, said that the program should be targeted and temporary.  Bad advice!  Decades of economic research showed that temporary tax reduction and spending increases get very little response.

Congress developed the program details.  Their interest as always was in distributing financial support to their political supporters, so the supposed economic stimulus became an example of welfare state redistribution.  For example, money was spent to help states avoid laying off teachers.  When the funding was not renewed, lay offs resumed.  What was achieved?

A principal weakness of the program was its short-term focus.  A large stock of unsold houses and projected defaults on mortgages implied the recession would be deep and long lasting.  Properly designed policy changes would have avoided targeted and temporary changes and offered permanent incentives for investment.

The social welfare state empowers interest groups that demand support from their political allies.   Their main concern is benefits to them and their members.  They oppose efforts to reduce spending on their benefits.  Fire and police unions receive such large pension and health care benefits that state and local governments are forced to reduce spending on such basic functions of government as police or fire protection.  At the federal level, spending for pensions and health care forces reductions in spending for defense against terrorism.

Every knowledgeable observer agrees that projected growth of federal government spending is unsustainable.  Still, the federal government does not propose reductions.  Any solution that reduces spending acts like a tax levied against particular groups – the retired and their families, the teachers union, or some other organized group.  Greece, Italy and Spain waited for the crisis to force sudden changes that could have been phased in gradually and less painfully.  Must the United States repeat their error?

Similar problems threaten the survival of the European Union.  As in the United States, voters agreed to increase spending on redistribution for pensions, health care, and the unemployed, but most do not vote to pay for the benefits.  Budget deficits increase until they are unsustainable and markets are unwilling to finance them.

The political system cannot agree on a program.  Short-term palliatives prevent an immediate crisis, but the problems remain.  Uncertainty rises, so investment falls.  The debtors urge the creditor countries to pay more and to forgive debts.  The creditors demand reforms that open markets, reduce the power of labor monopolies, raise retirement ages, sell state industries, and reduces transfer payments.  Each of these affects a powerful interest group.  And it reduces the welfare states.



            James Madison warned that “factions,” now called “interest groups,” are a threat to democratic governance.  His fears are now reality.  The social welfare state has become the prisoner of interest groups that demand ever increased benefits and resist any changes that lower their benefits.

That puts the social welfare state on an unsustainable path leading to its eventual collapse.  Experience in the European Union and the United States shows these political unions headed for a crisis.  But it will not end the welfare state.  Political pressure for redistribution carried out in the name of equality is always present.  The most we can expect is enough less spending to maintain democratic capitalist governance.  And perhaps we can convince governments that changing incentives, not exhortation and direction, is the effective method for bringing change.




Grabell, Michael, (2012).  Money Well Spent?  New York: Public Affairs.

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