Note to American capitalists: don’t emulate Scandinavia (or Canada)

It is commonplace for the chatting classes to view Scandinavian (and, to some degree, Canadian) social democracy through rose tinted lenses.

The usual refrain goes roughly as follows. Across a wide range of socio-economic indicators, outcomes are far more egalitarian in Canada, Norway, Sweden and Denmark than in the United States. Yet, in terms of economic growth, the U.S. does not dramatically outperform its more egalitarian peers. So, if the U.S. embraced a more generous social safety net (Scandinavian-style), would it reduce inequality and still enjoy a high and growing standard of living?

According to economists Daron Acemoglu, James Robinson and Terry Verdier (henceforth, AJV), the answer to this question may be “no.” In a recent working paper, AJV develop the theoretical implications of a world with two types of capitalism. The first type, dubbed “cutthroat capitalism,” is one in which entrepreneurial effort and innovation is rewarded but outcomes are unequal because the state does not engage in much redistribution of income (think of the U.S. or Hong Kong). The second type, called “cuddly capitalism,” is one in which incentives for innovation are weaker but outcomes more equal due to more extensive government redistribution (think Sweden or, to a lesser extent, Canada).

In AJV’s model, each country chooses whether to adopt the cutthroat or cuddly model, which in turn, determines the degree of innovation undertaken within each country. As expected, countries that choose the cutthroat model have high domestic levels of innovation but unequal outcomes while those that chose the cuddly model have lower domestic levels of innovation but more egalitarian outcomes. However, because innovation in the AJV model diffuses across countries, the cuddly countries can costlessly reach the technological frontier and, hence, enjoy the same growth rates as the cutthroat countries. In other words, technological interconnectedness—which seems a plausible assumption, at least among advanced countries—allows the cuddly capitalists to free ride off the innovation that occurs in the backyard of the cutthroat capitalists.

Accordingly, if we are to believe the AJV model, Canada and Scandinavia get to enjoy the enviable combination of generous social safety nets and high living standards precisely because other countries like the U.S. do not. Additionally, the model suggests that if cutthroat capitalist countries like the U.S. adopted more cuddly Scandinavian or Canadian institutions, innovation and growth would slow down everywhere.

Now, it’s important to emphasize that AJV’s contribution is theoretical, not empirical (i.e. they do not test the model directly against the data). As with any theoretical model, the results are to some degree driven by assumptions. One might quibble, for instance, with the assumption that innovation is entirely a function of individual effort, which in turn depends on the extent of redistribution (i.e. tax rates). Clearly, other factors apart from the tax and transfer system affect the incentive to innovate. If higher public investment in education improves a society’s capacity to innovate, then it’s possible that cuddly capitalism might generate larger technological spillovers than cutthroat capitalism. Or if innovation is risky, then risk averse agents may have a stronger incentive to innovate in places with more generous social insurance, which would also generate more innovation in cuddly than cutthroat countries.

Additionally, one might argue that, given the well-known inefficiencies of the U.S. tax and regulatory systems, there is still scope for the U.S. to improve incentives to innovate in ways that would allow it to redistribute more efficiently. If the U.S. were to embark on fundamental tax and regulatory reform, it could potentially improve not only economic growth and equity in the U.S., but, also, via spillovers generated by technological interconnectedness, help other countries grow even faster. This is perhaps the most important lesson that Scandinavian countries—whose tax systems are, arguably, among the most efficient in the developed world—can offer the U.S.

Nevertheless, AJV’s work should give social democrats in Europe and Canada something different to chat about. Additionally, it should give pause to U.S. politicians like Democratic presidential hopeful Senator Bernie Sanders, who want to implement Scandinavian-style social benefit levels in the U.S.

If AJV are correct, a more generous social safety net in the U.S. could make cuddly capitalism less attractive everywhere because growth would be slower worldwide. Social democrats would therefore no longer be able to have their cake and eat it too.