Domestic Policy as Prisoner\'s Dilemma?

The recent kerfuffle over the long-term costs of the European-style welfare state got me to thinking about the validity of the central premise: Is it likely that a small difference in growth rates between countries will persist over the several decades required to compound into major differences in standard of living?

My tentative conclusion is that it's probably not likely to happen in a global economy, because global capital markets and the nonrivalrous nature of technology tend to promote reversion to the mean. All else being equal, countries with lower wages are more attractive to foreign investors, so a country can tax its citizens quite heavily and still rely on foreign capital and foreign research to fuel its growth. The viability of this strategy is, of course, contingent on treating foreign capital well and taxing it lightly, but since wages generally account for the lion's share of national income, this is a small price to pay.

Conversely, leading the pack is hard. When wages are high, foreign and domestic investors alike may look elsewhere for better returns, and having to bear a disproportionate share of research costs doesn't help. So it's very hard for a country which already has a high GDP to sustain superior growth decade after decade.

This suggests to me a prisoner's dillemma. If we assume that most countries (or rather, those who ultimately direct policy) would prefer to have an expansive welfare state but not to sacrifice too much growth to pay for it, then the strategy described above is a dominant one. If a country practices fiscal austerity, most of the capital accumulated by its citizens will go to fund other countries' growth anyway, so it makes sense to tax and spend heavily and rely on foreign investors to pick up the slack. But if every country adopts this strategy, relatively sluggish growth ensues.

I'm not entirely sure of the validity of this model, so comments and criticism are welcome.

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