What does the cost disease imply about the public sector?

Matt Yglesias has a good post on the recent Steven Pearlstein column.  Here is Matt:

…people need to start paying much more attention to questions of tax efficiency. It’s overwhelmingly likely that we’re going to want the public sector to be a larger share of the economy in 10, 20, 30, 40 years than it is today and we need to find relatively growth-friendly ways to make that happen.

Here is Pearlstein:

    From a political perspective, Baumol’s most important insight is that government spending must grow as a percentage of the economy. Most of the services that are provided by, or financed by government — health care, education, criminal justice, national security, diplomacy, industry regulation, scientific research — are those that suffer most acutely from Baumol’s disease. That’s not because of incompetence or self-interest on the part of public servants or even the socialist instincts of Democratic politicians — it’s in the nature of those activities.

To demand, as Republicans do, that government be held to some historical average as a percentage of the economy stubbornly ignores this reality. It would condemn the country, as John Kenneth Galbraith once put it, to a future of “private affluence and public squalor.”

Let’s for the purposes of discourse take the cost-disease argument, and this classification of sectors, for granted.  I would stress that there are two different ways of measuring the relative size of government in the economy.  The first is as expenditure share, say as a fraction of gdp, and that indeed may well go up because of Baumol’s argument (I’ll return to this).

The second question concerns the real value of outputs from government, as measured from the consumer side.  If government outputs increasingly cost more to produce, should not a substitution effect kick in and lead us to prefer, at the margin, a higher proportion of productivity enhancement-enjoying private sector outputs?  In common parlance, if flat screen TVs become much cheaper, buy more of them.

This implication often receives less stress from cost-disease advocates and you will note that it militates in favor of substituting away from government outputs.

There is a further implication.  What goes up on the expenditure side is the share of any given governmental output in gdp.  If we substitute out of government outputs enough, the total share of government output, as an expenditure fraction of gdp, could go up or down in an optimum.  If the elasticity of demand is sufficiently high, flat screen TVs can become an increasing share of gdp and government social workers a smaller share.  Right now for instance internet commerce is a growing share of gdp as measured in terms of expenditures.

In any case, moving away from expenditure shares and back toward output: if government responds optimally, we end up with government as a smaller share of real output over time, yet at higher costs.  Surely that is a recipe for cynicism, justified or not.