Is Government Part of the Economy?

The question posed in the title of this post is key to understanding the relationship of governmental policies to individuals and the economy.

Traditionally, governments are considered as agents outside the system (in technical terms, exogenous).  For example, the following comes from Jack Hirshleifer’s 1970 textbook Investment, Interest, and Capital (page 11):

Following the standard tradition of economic analysis…government will be treated as an agency outside the social-exchange relationship, purportedly acting in the interests of society as a whole rather than the interests of the particular social grouping who happen to constitute the government.

A lot of welfare economics, from Pigou to modern, tend to treat government the way Hirshleifer describes. It’s an impartial spectator that can, with proper knowledge, set things right. Government can just come in and, with some perfectly crafted policies, fix any “market failure.”

But one of the things Public Choice teaches us (and this goes back to Bastiat) is that government is not separate from the system, but indeed part of it (in technical terms, government is endogenous). It is populated by the same people as those who make economic decisions. Governments are populated by people, and those people have hopes, dreams, desires, senses of right and wrong, just like the rest of us. They’re self-interested (which is not the same as selfish or self-centered), just like the rest of us. They respond to incentives, just like the rest of us.  Once we incorporate this simple fact, then the expectation of government “serving the public interest” becomes problematic.  Even if we assume away the knowledge problem, to expect government to be “molded from finer clay”, so to speak, and to be able to adjust the system from afar without any impact on the government itself is the height of foolishness.

So yes, in theory, with extremely strong assumptions, one can construct a tariff or tariff system “free” from cronyism. But if we weaken those assumptions, if we take government as endogenous (internal) rather than exogenous (external), then simple welfare economics like Pigou goes right out the window.