The Bankruptcy of the Keynesian Welfare State

For forty years the domestic policies of the developed countries have been dominated by two sets of beliefs, each considered self-evident:

• One is the Keynesian (or Neo-Keynesian) belief in the “Deficit State.” It rested on three economic assertions: Consumption automatically creates capital formation and capital investment (the Keynesian “multiplier”). Savings are dangerous to economic health (Keynes’ “over-saving”). Government deficits stimulate the economy.
• The other set, the belief in the Welfare State, rested on two social assertions: Government can and should redistribute income so as to promote greater income equality—an assertion which when first pronounced as government policy (by David Lloyd George when he became England’s Chancellor of the Exchequer in the Liberal Cabinet of 1908), was considered the most radical of heresies but which became orthodoxy in the Great Depression. The second assertion: the only thing the poor need is money—what might be called the Social Worker’s creed.

Both beliefs have been decisively disproven.

In the West all Democracies came to accept these beliefs—though West Germany accepted the Keynesian propositions only with great reservations. Japan—with its habitual preference for ambiguity in policies—never completely accepted nor completely rejected these beliefs and followed their prescriptions only intermittently.

Originally the two beliefs were opposed to each other. Keynes was outspoken in his contempt for the Welfare State. He claimed that his economics would make unnecessary large-scale social spending. And he considered futile any governmental attempt to redistribute income. The proponents of the Welfare Theorem in turn had little use for the Free Market in which Keynes passionately believed. After World War II the two found however that they needed each other. Keynes’ putting consumption over thrift and his advocacy of deficits, converted “charity” into “economic stimulus” and thereby enabled the middle class to accept welfare spending on the poor. In turn, Keynesian economics, despite their middle-class and free-market bias, needed the political support of Progressives and Socialists. And so the two embraced each other, thus forming the Keynesian Welfare State.

The Keynesian Welfare State has ruled for forty years. Whatever differences there have been in the Democracies on economic and fiscal policies—between Republicans and Democrats in the United States, between Tories and Labour in the United Kingdom, between Christians and Socialists in West Germany—were mainly differences in degree. Reagan’s “supply siders” fully subscribed to the basic tenets of the Keynesian Welfare State for all their being considered arch-conservatives. Each side, the Right as well as the Left, boasted that it was better at building and running the Keynesian Welfare State—which, by the way, largely explains why government deficits grew the fastest under supposedly Conservative governments, for example, under Reagan in the United States, under Thatcher in the United Kingdom, under Kohl in Germany.

There actually was never any evidence to support the Keynesian propositions—as was pointed out by such eminent economists as Lionel Robbins in England and Joseph Schumpeter in America when Keynes first published his theses in the mid-thirties. By now these propositions are so completely discredited that economists hardly mention them. Nowhere has increased consumption led to capital formation and investment. On the contrary, the United States and the United Kingdom which have been pushing consumption most consistently and most thoroughly, have the lowest rates of capital formation. In the United States it has long been hovering around a dismal 4 percent of disposable income. In the United Kingdom it plunged from 8 or 9 percent to 5 percent of disposable income in 1989 when Mrs. Thatcher tried (unsuccessfully) to stimulate an ailing economy by (successfully) pushing up consumption. Conversely as long as Japan discouraged consumption, it had a capital-formation rate of almost 25 percent of disposable income. But when in the mid-eighties, Japan tried to fight a sudden recession by revving up consumption (with disastrous results, by the way), the capital-formation rate plunged at once to 16 percent of disposable income, and has stayed there ever since.

Oversaving has proven to be pure myth. No one believes anymore Keynes’ assertion that it had anything to do with the Great Depression, let alone that it caused it. And far from oversaving having caused depression in Japan—as the theory would have had do it most assuredly—Japan’s high rate of capital formation is universally considered a key factor in her economic success. The abundant supply of savings pushed interest rates so low that Japanese big business could obtain capital at almost zero cost while the Americans and the Europeans had to pay up to 15 percent or more for their money. Japan thus had a 10 percent cost advantage over its world-market competitors—and even a 5 percent cost advantage is usually decisive.

There also has not been one single case of government spending stimulating the economy, let alone one of government spending turning around a recession or depression. The one instance usually cited to the contrary, the so-called Kennedy tax cut of 1962, is a phony. The economy did indeed recover in 1962–1963. Only there was no Kennedy tax cut. On the contrary, the U.S. tax burden went up in 1962 and 1963—in part because President Kennedy did not get through Congress his key proposal for a cut in the capital-gains tax, in part because states and cities raised their taxes faster and further than the Federal Government lowered its take.

Contrary to the promises of Keynesian economics, business cycles have not been eliminated. There is no difference either in frequency or severity between the recessions of the period since World War II (that is the period of the Keynesian Welfare State), and those of the nineteenth and early twentieth centuries.

Had there been any validity to the basic theories of the Keynesian Welfare State the Democracies would be rolling in money. Government spending would have so stimulated the economy that both capital formation and tax revenues would have skyrocketed. In short order there would then have been huge budget surpluses. President Reagan’s supply-siders still promised that. Instead, the Democracies—excepting only Japan—are so deeply in debt that they can pay their daily bills only if their creditors lend ever more and more money. The proper term for this condition is insolvency.

The Return of the Panic

A few academic Keynesians—Robert Eisner at Northwestern University is an example—still argue that government deficits do not matter. But even they do not claim anymore that they are beneficial. Outside of the Economics Departments everybody now knows: businessmen, labor leaders, bankers, investors, the stock market, the bond market, that damage is all that deficits can do. At the first sign of an increase in the government deficit, stock markets drop, money flees the country and business investment dries up, and employment with it. Above all there is no longer the slightest doubt that government deficits destroy capital-formation. But this then means that to pay their bills governments which run continuous deficits cannot borrow at home to finance themselves. They become increasingly dependent on foreign money borrowed for shorter and shorter terms. This is extremely volatile money, easily scared, and prone to panic.

Financial panics were the bane of the nineteenth century. Keynes’ claim that his economics would once and for all put an end to them, was therefore a major factor in their acceptance. But panics have returned with a vengeance. They are as plentiful now as they ever were a century ago, and as destructive. A three-day flight of capital in 1981 devastated France’s financial markets and threatened to turn into a run on the banks. It forced President Mitterand to jettison all the social promises on which he had won election only a few months earlier. A few years later panic forced Sweden to raise interest rates overnight to a disastrous 30 percent. Two years ago another panic caused by the flight of foreign money all but destroyed the Italian lira. And only last December panic brought on a run on Mexico’s peso, devalued it overnight by 50 percent, and in one fell swoop wiped out years of hard, painful work that had raised the economy to the threshold of being “developed” (or at least “emerging”).

No country that practices Keynesian Welfare Economics can be considered immune to panic. Indeed, the list of countries that are on the brink is steadily growing—in Europe the worst cases are Italy (government deficit 9.7 percent of disposable income; government debt 125 percent of disposable income; rate of capital formation: zero, if not negative); and Sweden (government deficit 10 percent of disposable income; government debt 100 percent of disposable income; capital-formation rate no more than 2 percent.) Belgium, Holland, Spain, Denmark are not much better off; Britain and France only marginally so—and Canada is almost as close to bankruptcy as Sweden. The United States actually has a fairly low deficit in terms of its disposable income—around 2 percent, or no more than Japan. But because its rate of capital formation is totally inadequate, it is as dependent on short-term money from abroad as any of the Europeans—and thus equally vulnerable to panic. In fact the United States has already suffered two “mini-panics.” The 1987 stock market crash was caused by the Japanese panicking and dumping huge quantities of U.S. Treasury Bonds. And the 1993 crash of the bond market—also caused primarily by a sudden flight of foreign capital—forced President Clinton to scuttle his plans for stimulating the economy and to accept instead the priority of the Federal Reserve Board—led by a Republican Chairman!—to placate the foreign lenders, that is to fight inflation even at the risk of domestic slump.

The worst consequences of the failure of the Keynesian Welfare State are not economic. The increasing dependence on short-term and volatile foreign money impairs the ability of governments to set and to pursue policies. It increasingly subordinates sovereignty to the whims of an erratic world money market, driven by rumors, and with the next “deal” as its long-term horizon. One recent example: to attract and keep the short-term money needed to finance Chancellor Kohl’s (ultra-Keynesian) unification policy, Germany in 1993–1994 had to raise interest rates and keep them sky-high. This severely hurt Germany’s neighbors in Europe who were already suffering from massive unemployment. They in turn had to push up their already high interest rates to prevent the flight of short-term money to high-interest Germany. Throughout Europe the Germans were berated for their “selfishness.” Yet they had no choice. The global short-term money market was in control rather than the German government. The greatest damage was probably the blow the German policy inflicted on the support for political and currency union throughout Europe—Dr. Kohl’s own most cherished goals during his entire political life.

The Keynesian Welfare State also did not deliver on its social promise to redistribute income and thereby to promote equality of income. There is on the contrary an almost perfect correlation among major Democracies between Welfare State spending and income inequality. The country with the lowest inequality of incomes is also the country with the lowest deficit, the lowest rate of social spending (only 12 percent of disposable income), and the highest rate of capital formation: Japan. In the United States, in the United Kingdom, even in Germany (with social-spending rates of 15 percent, 23 percent and 27 percent respectively) income inequality has become greater rather than smaller the more social spending has grown.

The Entitlement Crisis

Liquidating the Deficit State can no longer be avoided. It cannot even be postponed much longer. It is clearly the number one political task faced by the Democracies, and will be their political reality for the next decade. And it means the end of ever-increasing middle-class entitlements. A little over a hundred years old—they were invented in Bismarck’s Germany in the 1880s—entitlements have now become a threat to the very survival of democracy, if not of the modern state altogether. The only way the Democracies can regain control of their finances—and with them of economic, social and foreign policy—is to cut back sharply on entitlements, whether that be health care (spending on which is racing out of control in all developed countries rather than in the United States alone); on social security; on pensions; or, in Europe, on unemployment benefits.

That middle-class entitlements threaten the Democracies’ prosperity, health—and indeed their very survival—has been known for quite some time now. As early as 1988 it was proven with mathematical rigor by Peter G. Peterson (President Nixon’s erstwhile Secretary of Commerce) in a book entitled On Borrowed Time: How the Growth in Entitlement Spending Threatens America’s Future. But nobody was yet willing to listen.

Any attempt at cutting entitlements—or even at slowing their growth—is still bitterly resisted. Last year the voters in Sweden tossed out the incumbent Liberal government for proposing to cap a few entitlement programs that had clearly gotten out of control. Shortly thereafter, Italy’s Prime Minister, Silvio Berlusconi, was kicked out of office for the same offense. A few months earlier he had been elected on the promise of reforming entitlements. But when he actually proposed taking a close look at the outrageous abuses of the country’s pension system, his coalition partners deserted him. Everybody in Italy knows that hundreds of thousands of able-bodied men—some estimates say millions—are fraudulently receiving life-long disability pensions while still under 50 and often under 40 even. Everybody also knows that the pensions are the main cause of Italy’s financial troubles; they account for half of Italy’s social spending, that is, for a full eighth of the country’s disposable income and for all of its horrendous deficit. Cutting entitlements—even fraudulent ones—was, however, still not “politically correct.”

That both Republicans and Democrats in the United States now agree that Medicare—long the most sacred of sacred cows—needs to be pruned back is thus a major change. It still remains to be seen however whether the Congress can get itself to do anything so unpopular. Actually, the middle class has no choice. Entitlements will be cut in all developed countries. The only question is by what method. The least painful way is to do it openly—for instance, by raising to 75 the age at which Americans get full Social Security benefits. If this is not accepted, middle-class entitlements will be cut by inflation, that is, by destroying the purchasing power of middle-class incomes. Or there will be draconic increases in taxation—in the United States most probably through substantial consumption taxes on top of already high income taxes.

And as soon as one major country cuts middle-class entitlements—for example, if the United States were to accept more than token cuts in Medicare benefits—it will be the signal for entitlement reform in all the other Democracies. This would herald the end of the Keynesian Welfare State as surely as Mr. Gorbachev’s perestroika heralded the end of Communism.

To restore government to solvency—and with it restore its control of policy—requires that it be forced to make again priority decisions. It will again have to be forced to say “No.” The first step might be a return to the way budgets were made before the advent of the Keynesian Deficit State: by beginning with the available revenues, that is, with how much money can be spent. This forces government to decide what can and should be financed within the limits set by the availability of money. What exceeds these limits has to be said “no” to. Since World War II, however—or at least since Western Europe and Japan returned to prosperity in the late fifties—all Democracies start budgetmaking with the question: What do we want to spend money on? Spending beyond the available revenues, that is deficit spending, was easy to finance. Above all, it was deemed beneficial. Indeed the Keynesian postulates made saying no appear heartless and almost immoral. Saying no is indeed painful. For a politician it is risky. It is only necessary.

But that would only be the first step. The decisions on priorities would then still be ahead. They are likely—I would say, certain—to explode all existing parties everywhere. In fact, both “Right” and “Left” have already lost much of their meaning in the Democracies. Who is on the “Right,” for instance? People who want the pension age set according to life expectancies, that is to be pushed up to 75 (sixty years ago when the United States embraced 65 as the Social Security age, it was actually a good deal higher than average life expectancies at the time and chosen for that reason)? Or people who argue a duty of the young to support their elders? Traditionally both are “Conservative” positions. What is “Liberal”? The argument that university education be free for all? Or the counterargument that its recipients should repay from their greatly increased post-graduation earnings the cost of their schooling so that the next generation can have free access? These are new issues. They do not fit the existing mold of politics; they are neither economic nor ideological. In the Democracies therefore more than political issues can be expected to be in transition; political structure will be in transition too.

Turning Poverty into Degradation

The social axioms of the Keynesian Welfare State have worn no better than its economic axioms. Welfare has not ended poverty. It has instead turned it into degradation and dependence. It has done so in the domestic as well as the international society, that is as much through domestic “welfare” as through “foreign aid.”

In the United States it is now generally accepted that neither of the two big welfare programs works. Both Aid to Families with Dependent Children, and Disability Aid are disasters. It is still widely denied however that they do damage. Rather, the dependence and degradation of long-term welfare dependents, and the dreary squalor of their lives is being explained away.

In terms of income America’s welfare recipients are doing quite well. If non-cash benefits (e.g., food stamps or housing allowances) are included, the incomes of most are above the “poverty line.” Yet they live in a squalor and degradation as bad as that of yesterday’s worst slums, if not worse. The most common explanation asserts that the American “Welfare Mess” is part of our racial problem. There are indeed proportionally many more Black unwed “welfare mothers” who are permanently on Aid to Families with Dependent Children (37 percent of the Welfare population is Black, where Blacks are only 13 percent of the population). And so one explanation is racial inferiority (no longer expressed publicly, as a rule, but surely held by a great many Non-Blacks, whether Whites, Latinos, or Asians). The other one is the legacy of discrimination and slavery. Both are equally racist and equally despicable. And both are patently wrong. There is the same “welfare mess”—that is the same turning of poverty into degradation where the welfare recipients are purely white and indeed where they were competent, self-supporting members of the middle class until they became welfare recipients.

In the United Kingdom the “welfare underclass” (what British statisticians classify as members of “Class V”) is now growing as fast as the same group in America. It suffers from the same social anomie, the same destruction of personality and competence and self-respect. Before 1950 illegitimacy in the British working class was no higher than it had been for centuries, that is, around 4 or 5 percent of births. It has now passed 25 percent; and among chronic welfare recipients it is well past 30 percent and already higher than among White welfare recipients in America. And it is climbing as fast as among America’s Blacks. Unlike the United States, the British system also supports men on welfare through very high and long-term unemployment benefits. The dependency rate among young British males is climbing as fast as the welfaredependency rate among American young women in the “underclass.” The British on welfare and long-term unemployment payments are financially even better off than their U.S. counterparts. Their pre-tax income is equal to that of the average employed blue-collar family but is tax exempt so that their net income on welfare is actually a good deal higher. Yet they display the same social pathology: dropping out of school; increasing illegitimacy rates; more and more fatherless families; increasing addiction—in Britain still primarily on alcohol though hard-drug use is growing fast. Britain’s inner-cities—only thirty years ago among the safest in the world—are becoming jungles; the urban burglary rate is already higher in Britain than it is in America. Yet this British welfare underclass is almost totally white.

Across the Channel, in Germany, the welfare underclass consists of people—entirely white and predominantly male—who stay permanently idle because Germany pays unemployment compensation of 80 percent of the employees’ former wages for the rest of their lives. The recipients are graduates of the famed German apprentice training system and have grown up with the equally famous German work ethic. But welfare, within no time at all, converts growing numbers of them into what Germans call “welfare cripples,” with all the pathology of social disintegration and anomie: rising numbers of families headed by single, unwed mothers; sharp increases in alcoholism; and the young “skinheads” and Neo-Nazis who “for kicks” set fire to tenement houses inhabited by Turks or other foreign workers. As a result, Germany now has one of the highest unemployment rates—even when the economy is booming—with an intractably high permanent unemployment.

In Italy, the welfare underclass consists of 40- to 50-year-old males—all white, of course—who go on full or partial “disability pension” and stay on it the rest of their adult lives. Most of them, it is generally known, are able-bodied; their disabilities are quite minor or totally fraudulent. That a great many of these people actually hold a job while claiming to be unable to do so, mitigates the economic impact of their idleness. (In fact it is common knowledge in Italy that a fair number of the recipients of disability pensions actually hold two paid jobs; a patronage job in the public service where they only show up to collect their salary, and a paid job in the “underground” economy.) But this does not mitigate the impact on Italy’s government budget which is crippled by pension payments. And it aggravates the moral and psychological damage to society and individual alike. That Italy has become riddled with corruption from top to bottom is in large measure the result of pension fraud. It has made being on the take the accepted, indeed the proper, thing to do.

The evidence is thus crystal-clear. First, modern welfare destroys. It does not build competence; it creates dependence. It does not alleviate poverty even though it provides middle-class or near-middle-class incomes. And it does so irrespective of who the recipients are: black teenage girls in the United States; young, working-class white males in the United Kingdom; highly-trained adult men in Germany; middle-class, mostly salaried men in Italy. The one thing these corrupted and poisoned people have in common, is that they are being financially rewarded for staying on welfare and financially penalized for getting off it.

The Failure of Foreign Aid

Internationally the failure of welfare has been just as great.

Development aid was surely one of the most important political inventions of this century. The first attempt: the Marshall Plan, was successful beyond all expectations. There was thus every reason to expect great results from its two successors: President Truman’s Point Four (1950) and President Kennedy’s Alliance for Progress (1962). (No one expected greater things from both than I did; indeed I worked enthusiastically for both.) At best neither plan did much damage. But neither did much good. The forty years since President Truman’s proclamation have indeed brought more, and more widely spread, economic development than any earlier period in history. But the development was mainly in areas that received little or no aid—especially the countries of Southeast Asia. Indeed there is a near-perfect negative correlation between receiving development aid and development. The areas that received the most such aid either did not develop at all—India and Egypt are the prime examples—or actually lost ground as did most of Tropical Africa. Just as with domestic welfare, the recipients of international welfare (we call it “development aid”) have little in common with each other except their developing the less, the more aid they get. Nor do such popular explanations as the “population explosion” hold water. Populations grew just as much in some of the fastest-developing countries in Southeast Asia, for example, Thailand, Malaysia, Indonesia, Turkey, or coastal China. The one factor that the non-developing countries share is their having received massive development aid. The one factor the fast-developing countries share is that they received little or no development aid.

Welfare and international aid which increases dependence or inhibits development—that is a good many of the welfare and aid programs of the last forty years—will be discontinued or, at least, be cut back sharply. But it is surely wrong to conclude—as a good many people now do—that the welfare concept, both domestic and international, was a mistake and best to be forgotten. What is needed is to re-focus welfare on creating independence, competence, responsibility.

The need for help—at least for temporary help—is surely going to grow. Developed and developing countries alike are undergoing major transformations of economy and society. There will therefore be massive dislocations in which well-established, competent, responsible people will find themselves uprooted. They may not need much—in many cases their main need is the assurance that help is available. But a society and economy in transition are a dangerous environment. There is need for what welfare was supposed to be: a “safety net.” It must only be prevented from becoming instead a “couch and a permanent resting place.

A second reason for constructing an effective welfare system is that it would be total defeat for the Democracies, and a denial of the very idea on which they are based, for affluence to lead to an erosion of compassion.

In the not-so-long run, rising affluence does indeed most benefit those at the bottom of the income pyramid. It cannot be said too often that—contrary to everything Marx predicted—the “proletarians” were the main beneficiaries of the enormous increase in wealth-producing capacity in the developed countries during the last hundred years. Their real income has risen at least three times as fast as those of the “capitalists.” Contrary to the predictions of Marx’s successors and disciples—Lenin and the other theoreticians of “Imperialism”—the greatest increase in national prosperity and wealth in these hundred years were among “colonial” and “exploited” countries that have become developed countries. Japan’s total national product has risen a good deal faster than that of the United States—but so also has that of Korea and of the “Tigers” of Southeast Asia: Taiwan, Singapore and Hong Kong—all former colonies—and of such other ex-colonies as Malaysia and Indonesia.

But that the great majority in the developed and emerging countries is now so much better off only makes more visible and more painful the plight of the minorities who are left behind because of lack of competence or lack of opportunity. And this is just as true for the international society as for the domestic society. For their own self-respect the rich therefore need to help. But for the good of the poor it must be help that helps, help that creates competence, health, self-respect, rather than the help of the Welfare State that creates dependence, destitution, incompetence, self-loathing.

Encouraging the competence of the poor and promoting their capacity to develop themselves is clearly in the self-interest of the affluent, that is of the democracies. For their stability and social cohesion is increasingly threatened by the anomie, the degradation, the despair of the incompetent and dependent poor.

A hundred and sixty years ago an epidemic in London’s poor East End made the wealthy in the West End realize for the first time that typhoid among the poor threatened them too. This was the beginning of Public Health—till then there had been only private health—and with it the beginning of the revolution in health and longevity that has benefited the rich surely as much as it has benefited the poor.

The anomie, the degradation, the lawlessness, the corruption caused among the incompetent poor by the failure of welfare—domestically and internationally—equally threatens the cities, the suburbs, the schools, the streets of the healthy, the competent, the affluent. It threatens to infect their children, above all. Surely, spreading contagion from the welfare underclass is heavily to blame for much of the coarsening and proletarization of middle-class life, middle-class culture, and middle-class values. The anomie, the degradation, the lawlessness of the non-developing “Third World” equally threatens the safety, the peace, the affluence of the wealthy countries—if only through the increasing immigration pressure of desperate and incompetent people seeing to the developed world. The final—and most compelling—reason why giving up on development—whether at home or internationally—is the wrong thing to do: there are enough successes to show that development out of poverty and into competence is possible, and also what it requires.

We know what made the Marshall Plan succeed—the world’s biggest welfare program ever, and its most successful one. Another —and equally impressive—success was the “Green Revolution” in which new seeds and improved farming methods (financed and promoted by the Rockefeller and Ford foundations, that is, by two non-governmental organizations) changed India in the 1960s. From a country in which large-scale famines occurred every few years it has become one that in most years has an export surplus of cereal grains. Domestically there is the success of the Salvation Army in the United States in rehabilitating a large proportion of the worst losers: prostitutes; ex-convicts; alcoholics; hard-drug addicts, and turning them into competent, self-sustaining, and self-respecting citizens. It is arguably the most successful social program in any developed country today with, for instance, a 30 percent rehabilitation rate for alcoholics and hard-drug addicts.

There is also the tremendous difference in results between two superficially very similar programs: the European (both British and German) programs of unemployment benefits and the one in the United States. The programs in the United Kingdom and Germany turn self-respecting workers into permanent welfare dependents. In the United States there has been little chronic unemployment despite upheavals in the labor force which were considerably more drastic than anything the United Kingdom and Germany have experienced so far.

The Marshall Plan spent very, very little money by the standards of the 1990s; and it spent it sparingly. It liberally gave technical support and consulting help. But it gave money only as “seed money” to businesses that had a convincing track record, and submitted a realistic plan with clear performance goals. And both, support and money, were withdrawn the moment a business—whether private or government-owned—either diverted money from the agreed-upon plan or failed to meet agreed-upon performance goals. The Green Revolution spent even less money. Its agents—C.A.R.E., the American international relief organization, and others—searched out competent Indian farmers and worked closely with them on trying out new seeds and new farming methods. The main use of money was as an insurance against the risk of crop failure during the first two or three critical years. The Salvation Army spends practically no money at all. It explains its success as being based on discipline; hard work; minimum subsistence pay; a demanding program of skill teaching, and unlimited compassion. And anyone who breaks the Salvation Army’s draconian rules is out, no matter how needy. Unemployment compensation in the United States in the first weeks or months of unemployment is as high as it is in Europe—and for some workers, e.g., those in unionized automobile plants, even higher. It provides ample support for the period during which the newly unemployed is likely to be in state of shock. But the money soon tapers off; and it stops altogether after two years. There is thus a powerful incentive to look for work. Even in cities or regions that have been heavily dependent on a single plant or a single industry which totally shut down, unemployment within two years or so drops to the national average. And national average in the United States, even in times of labor-market upheavals, rarely stays very long above the “natural” rate of unemployment, that is, above the rate which expresses the normal in-between jobs turnover of the American Economy.

Welfare can work, in other words. But only if the axiom is changed from “All the poor need is money” to “All the poor need is competence.” Of course there is need for money. But by itself alone money encourages incompetence and irresponsibility. Today’s welfare focuses on needs. There will be true “welfare,” however, only if the focus is on results.

What Welfare Has to Be

Major countries are now tackling welfare spending. In the United States, Aid to Families with Dependent Children is being sharply cut by some states (for instance, New York, California, and Massachusetts); and for the United States altogether by the new, Republican-dominated Congress. Italy, as already mentioned, is at least talking about pension reform. The United Kingdom is about to enact cuts in the rewards for remaining permanently unemployed, as is Germany. These proposals penalize staying on welfare. This may do the trick where, as with German unemployment compensation and Italian disability pensions, the recipients are largely competent and healthy people whose main incapacity is welfare itself.

But for people who lack competence—the welfare recipients in the United States and largely in the United Kingdom—there may be need also for positive incentives for not going on welfare in the first place, and for not staying on it. Governments will surely have to pay for this at least in part (though, as in the Salvation Army programs, rehabilitated recipients should routinely be required to become themselves donors or volunteers). We are unlikely to be able to depend for helping the less competent entirely on philanthropy, as the Victorians believed. But the delivery of welfare programs should be contracted out to non-governmental, community organizations as much as possible. This is what the example of the Salvation Army teaches (but also many smaller and less conspicuous programs in the United States—especially a good many churchrun ones). What is primarily needed by the less competent and the wounded is not money—whether less of money or more of it. It is what makes the Salvation Army successful: discipline; commitment; hard work; self-respect and a great deal of individual attention. And such intangibles a government bureaucracy, however well-intentioned, cannot deliver.

In the present discussion of “welfare reform” the emphasis in all countries is on money. It is the wrong emphasis. In the first place welfare is a big budget item only if it is “entitlement” to the middle class as are German unemployment compensation and Italian disability benefits. Welfare to the truly less competent—the U.S. and U.K. programs—is a minor budget item in comparison to the entitlements to the competent middle class such as Medicare, Social Security, or the British National Health Service. Secondly, that welfare wastes money—and it does—is its least offense. It wastes lives. If welfare had results it would be cheap even if it cost twice as much. And the reason for welfare should not be, as the Welfare State asserted, that the less fortunate and less competent deserve to be financially supported. The reason must be that they deserve to be restored to competence, self-respect, and self-support—and those are the results welfare needs to aim for and to pay for.

Internationally too, welfare—that is, foreign aid—is being pruned drastically. It should, however, in all probability be stopped altogether—except as disaster aid in an earthquake or to house and feed the refugees from civil war. What is needed internationally—as the next section discusses—is Civil Society; and that money cannot buy.

But to develop policies that truly promote domestic welfare rather than create dependence and destitution will be the major social challenge for the Democracies in the next decade, and a crucial test for them as functioning societies.

The Free Market’s Power and Its Limitations

Keynesian economics still underlie the domestic policies of the Democracies. But only in the first half of the period since World War II did they reign unchallenged. In the second half, i.e. since the seventies, Keynesian economics have come under increasingly heavy attack from what in the United States is known as “Neo-Conservatism” (elsewhere called “Neo-Classic Economics,” the term I shall use). And in international economics, Neo-Classics has come to reign supreme. It is the economics on which the international agencies: World Bank and International Monetary Fund, base themselves. And the same governments that are Keynesian at home—especially the U.S. Government—have also been turning Neo-Classics in their international economics. Whenever a foreign country gets into trouble, the United States advises it to accept, and fast, the Neo-Classic prescription.

Neo-Classic economists, like their forebears in the nineteenth century, preach the superiority of the Free Market over any other system of economic organization. But they go far beyond their mentors. They claim that the Free Market by itself will create a functioning society and, indeed, even a stable democratic political system.

Neo-Classicism goes back to Friedrich von Hayek’s 1944 book The Road to Serfdom. Hayek asserted that any tampering with the Free Market soon leads to destruction of political freedom and to tyranny. He also claimed—and that has proven eventually his most important thesis—that an economy based on the Free Market and unencumbered by government controls, regulations and interventions, creates, by itself, an optimally free, just, and equal society. What to the nineteenth century had primarily been economic theory Hayek converted into social and political doctrine.

Hayek’s book was an immediate sensation: though, for a long time, without much impact on government policy or on academia. But as the failure of Keynesian economics became more and more apparent, Neo-Classicism became increasingly respectable. It is still not domestic government policy—deficit spending is much too attractive for governments to embrace the Neo-Classics’ austerity and self-discipline—and not only in the Anglo-American countries. But in the universities Keynesians are now a minority and found mainly among the older economists. The younger ones have predominantly become “Neo-Classics,” even in such Keynesian strongholds as Harvard, M.I.T., or Cambridge University. Until the late seventies and early eighties the Nobel Prize in Economics went regularly to Keynesians: Paul Samuelson (1970) or Kenneth Arrow (1972). In the last twenty years it has gone increasingly to Neo-Classics (examples are George J. Stigler in 1982, James M. Buchanan in 1986, and Gary S. Becker in 1992). Neo-Classic economics have become the standard prescription for turning around an economy after it had floundered under the Statist or Neo-Keynesian economics of the 1950s and 1960s (e.g., the economies of Latin America); when it embarks on systematic economic development (e.g., the economies of Southeast Asia, beginning with South Korea); and to bring back to life economies asphyxiated by Communism (e.g., the countries of the former Soviet Empire and post-Maoist China).There can be no doubt anymore that Neo-Classics work as economics. In fact, they work like a wonder drug. As soon as an economy moves toward Free-Market policies—that is, cuts government spending and balances the budget; privatizes government-owned businesses; cuts back or eliminates government regulations and government controls of economic activity; opens its borders to imports and thereby allows competition; eliminates (or at least cuts back) government restrictions on the movement of money and capital—an economic boom gets going. At first it is accompanied by—often severe—dislocation. Inefficient enterprises go bankrupt as they are no longer kept alive by tariff walls or government subsidies. There is a drastic jump in unemployment. But this transition period should not last very long, as a rule no more than two years. Then unemployment, for instance, goes down again, and fast.

This has happened in quite a few countries. It happened in desperately poor Bolivia in the eighties; in Chile a little later; in Argentina after 1989; in the Czech Republic in 1991–1992 and, most spectacularly, in the “Tigers” of mainland Asia: Hong Kong, Taiwan, Singapore and, a few years later, in their neighbors, Malaysia, Thailand, and Indonesia.

But it did not happen in all countries. Except for the Czech Republic it has not happened so far in any of the countries of the former Soviet Empire, whether they had been incorporated in the Soviet Union or had been nominally independent. Free-Market economics did not turn around the East German economy. To keep East Germany from dying, West Germany had to pour in larger amounts of government aid than has ever been poured into any area. Freeing the economy did indeed produce economic boom in China. But in Inland China where most of the people live, the boom soon collapsed. And even coastal China has wild inflation rather than a stable economy. Mexico experienced tremendous economic growth as soon as it adopted Free-Market economics in 1987–1988. But this did not produce social and political stability. On the contrary, economic growth only activated the profound cultural, economic, social and political seismic faults which economic backwardness had kept from producing earthquakes.

Economically Neo-Classicism has been fully proven. But its claims that it would also generate a functioning society and a stable polity—the claim that made it Neo-Classicism—has been fully disproven. The Free Market works only where there are effective institutional guarantees of property rights and, especially, effective protection of property rights against the powerful whether kings, nobles, bishops, generals, or parliaments—as shown by the American economic historian Douglass C. North, especially in his 1990 book Institutions, Institutional Change and Economic Performance (Cambridge University Press), for which he received the 1993 Nobel Prize in Economics. For the Free Market to work also requires a reliable legal system, an infrastructure of financial institutions and an adequate educational system. The free market does not create a functioning society—it presupposes it. Without such functioning civil society a few speculators may get very rich. But the economy will remain poor. There may be tremendous economic excitement as there is in Mr. Yeltsin’s Russia, or in today’s Shanghai. But unless there is the social infrastructure of a civil society this apparent economic turn-around is likely to be short-lived. It will either collapse right away or swell into a speculative bubble and burst. Sustained economic development does indeed require the Neo-Classic economics. But there first have to be the legal, financial, educational institutions of a functioning society, and the human resources such a society produces, educates, develops, tests—and respects.

Before Hitler the Czech core of Czechoslovakia was one of the most stables, most solid, most bourgeois—and most productive societies in the world—next to Switzerland the stablest and most solid society on the continent of Europe. It was first brutally persecuted by Hitler and then totally suppressed by Stalin. But the foundations were still there; the traditions were there; the memories were there—and the people remained resolutely bourgeois in their values and commitments. In the Czech Republic the Free Market could and did indeed perform economically almost as soon as the Stalinist shackles were struck off. Hong Kong, Taiwan, Singapore—even South Korea—all inherited legal, financial, educational institutions from their former colonial rulers, as did Malaysia and Indonesia. For a century or longer Chile—with a stable society and stable politics—was considered “the Switzerland of Latin America”; and thus the Free Market could produce a functioning economy despite a few years of Communist incompetence followed by a brutally repressive military dictatorship. But where no such tradition of civil society exists: in Tropical Africa; in the former lands of the Tsar; in China which never knew Civil Law, the Free Market by itself is unlikely to create a functioning economy, let alone a functioning society.

Democracy—as the term is commonly understood—that is free elections and a parliament or Congress—is by itself not the answer. Hong Kong knows neither. Neither does Singapore. Taiwan was a military dictatorship until fairly recently. Chile started her spectacular turnaround under a repressive military dictatorship. In fact, there is considerable evidence for the claim made by the authoritarian rulers of the rapidly developing economies of Southeast Asia: political freedom and democracy follow economic development rather than precede it as U.S. political dogma preaches. Indeed, except in the United States, political development has everywhere followed economic development. The enormous social, economic and cultural development of major continental-European countries during the nineteenth century for instance: Imperial Germany; the Austro-Hungary of Francis Joseph; France under Napoleon III, all took place under authoritarian political regimes. The Japan of the “economic miracle” of the last forty years is in its political reality (e.g., in the supremacy of a politically uncontrolled bureaucracy) much closer to the authoritarian nineteenth-century continental-European countries than to Anglo-American “democracy.” That the United States—alone of all countries in the world—achieved political development before it achieved economic development may thus be only another case of “American exceptionalism.”

But what is absolutely essential—or otherwise the Free Market will not function even as an economic institution—is what nineteenth-century political theorists called by a German word: the Rechtsstaat (the Justice State), and what we now call Human Rights: a social and political order which effectively protects the person and the property of citizens against arbitrary interference from above. Human Rights equally guarantee the citizens’ freedom to choose their religion; to choose their professions or their vocations; to form autonomous social institutions and to read, speak, write and think, free of dictation by any power whether party, church, or state.

Whether democracy then actually emerges—as the nineteenth-century Liberal fervently believed—remains to be seen. But without Human Rights as its foundation there surely will never be political democracy. There can only be chaos or tyranny. Equally, without Human Rights there is unlikely to be lasting economic development, even with market freedom.

“Capitalism” and “Capitalists” we now know—thanks mainly to the work of a great French historian, the late Fernand Braudel—are not modern phenomena. Both have been common throughout the ages and are found in most cultures and countries of which we have any knowledge. What is “modern” is the Free Market as organizing principle of the economy. The Neo-Classics are right: without the Free Market there will be no functioning modern economy and, in fact, no economic growth. But the Free Market is in turn dependent on a functioning civil society. Without it, it is impotent.

The nineteenth-century European Liberal fervently believed that civilization—and that meant a stable government, political order, rapid economic growth, a thriving middle class, and political and religious freedom—would follow automatically upon the establishment of the political institutions of a constitutional monarchy: a hereditary monarch with limited powers; a parliament with political parties and an annual budget; a professional civil service; a small standing army with a professional officer corps; an independent judiciary; a central bank; compulsory public education; a German-style university, and a (substantially) free press. The nineteenth-century American Liberal believed in the same model with only one change: the substitution of an elected president for the hereditary king. And both, the European and the American version of the model were exported to the four corners of the earth.

This nineteenth-century modernization through political institutions does not have a good press today. It did better however than is commonly believed. In two countries: nineteenth-century Japan and early-twentieth-century Turkey—it worked and created a new and modern civilization. Elsewhere—in Romania, Bulgaria, and Poland; in Brazil and Mexico; in Egypt and even in the Tsar’s Russia—it established an ideal to which an educated elite still aspires despite a century’s frustrations and disasters. But the nineteenth-century political model failed overall to create the liberal, enlightened, peaceful civilization it promised. Even in Italy it had impact mainly in the north which had had civilization for many centuries. In the south: in Calabria, for instance, or in Sicily, political modernization brought railroads and hotels but little civilization.

The Neo-Classic economics of today have done somewhat better than the Old-Liberal politics of last century. The Free Market has been changing the lives of many more people. Telephone, movie, television, computer, hit harder than did the steamship, the railroad, and the factory-made goods, which accompanied political modernization and were its most visible symbols. Goods, no matter how greedily desired, change consumption; information changes the imagination. Goods change how we live; information how we dream. Goods change how we see the world; information changes how we see ourselves.

Still, the Free Market of the Neo-Classics no more creates a civil society than did the political institutions in which the Old Liberals of the nineteenth century so firmly believed. The Free Market thus finds itself very much at the same impasse. It will not work unless there is civil society. But it cannot by itself create a civil society—as little as did political Liberalism a hundred years ago. Yet for the democracies truly to win the peace in the post-Cold War world they must bring forth civil societies, especially in the former Communist parts of the world, that is, the successors to the Soviet Empire and the successors to Mao’s (or Deng’s) China.

Can Civil Society Be Exported?

The one public figure in the Democracies who has so far asked this question has answered it with a “yes.” When Jimmy Carter as President of the United States made establishment of Human Rights a goal of American policy and prerequisite to giving American aid, he in effect proclaimed the promotion of civil society to be a goal of American foreign policy on a par with the military and political goal of containing and outliving Communism.

Mr. Carter was ridiculed as a “dreamer.” Viewed twenty years later he may have been the realist, and the dreamers are the believers in the efficacy of the Free Market. But Mr. Carter did not succeed in getting a single country to accept Human Rights nor in convincing the public in the Democracies of the wisdom of his priorities. But that was then still at the height of the Cold War—and in any war, winning it always comes first, and thinking about the peace is brushed aside as dangerous diversion, and subversive. Now the democracies need to reconsider; to win the peace in today’s postwar world they have to establish Civil Society as a policy goal of its own. The resulting failure of the Free Market to deliver on its economic promises, especially in the former Communist countries, may otherwise destroy the credibility of freedom and again endanger world peace.

At the least, governments will have to learn that it is futile, folly and predictably a waste of money, to invest—whether through a World Bank Loan or through a Stabilization Credit—unless the recipient country establishes a truly independent and truly effective legal system. Otherwise the money will only make the wrong people rich: political bosses; generals; con-artists. Instead of enriching the recipient country it will impoverish it. The same lesson needs to be learned by businesses: to invest in a country—like today’s Russia or today’s China—which has not even started on building a legal system means, with near-certainty, to lose one’s money, and in fairly short order. The experience of the last decades is crystal-clear: the Free Market will not produce a functioning and growing economy unless it is embedded in a functioning civil society, with effective Human Rights a minimum requirement.

It is often said today that the democracies have lost their bearings with the collapse of Communism. They no longer have a policy, no longer have priorities, no longer have criteria what to do and what not to do. To be sure: the old policies, priorities, criteria do not make sense now that there is no longer a “public enemy.” But there is a new policy, a new priority, a new necessity: the promotion of civil society as a goal of international policy. A civil society is not a panacea. It is not the “end of history.” It does not by itself guarantee democracy, and not even peace. It is however prerequisite to these, and equally to economic development. Only if civil society worldwide becomes their goal, can the democracies win the peace.

1995