I will not go into a discussion on this. Suffice to say, the conservative argument is only part of the story. There is another dimension to the debate that is nowadays much less discussed and which poses a greater threat to economic growth than government per se. In fact, a more nuanced appreciation will lead us to the conclusion that government excesses may only be a symptom of the malaise, but not its underlying cause.
I am inclined to believe that the biggest danger facing societies and economies is the gradual sub-ordination of the institutional framework - social, economic, and political - that governs economic and political activities to the vested interests of those holding the reins of economic power. The power exterted by those at the top of the economic ladder inevitably permeates the institutional framework which determines the allocation of resources. Marx, after all, had a point.
This has several manifestations. A recent book by Charles Murray has sparked off an intense debate in the US about the divergence between the professional and working classes in white America over the last half century. In particular, it highlights how the various institutional elements in the society and economy favor the children of more well-off parents "to move seamlessly from their privileged upbringings to privileged careers" without a struggle. This stands in sharp contrast to the stiff entry-barriers and massive struggles that others face in even acessing their opportunities.
The biggest danger with such trends is the strong potential for elite capture of this institutional framework. As historians have documented, this would also involve using the government to protect and further their interests. An excellent recent illustration of this struggle is the attempt by the Koch Brothers to gain greater control in the activities of the libertarian Cato Institute in the face of strong opposition from the Cato Board.
The irony in this cannot be missed. At the back of Cato publications is written, "In order to maintain its independence, the Cato Institute accepts no government funding." However, now, reflective of the dangers posed by the power-elite, the biggest danger facing Cato is not government, but its own private benefactors. The Koch Brothers, who are major share holders in Cato Institute, want to increase their financial stake and thereby exert greater control in its activities. It is obvious that they want Cato to become unabashed promoters of their personal ideological prejudices, even at the cost of the institution's professional integrity.
In this context, Rajeev points to a brilliant old op-ed by Michael Young, who succinctly puts the issue in perspective,
It is good sense to appoint individual people to jobs on their merit. It is the opposite when those who are judged to have merit of a particular kind harden into a new social class without room in it for others. Ability of a conventional kind, which used to be distributed between the classes more or less at random, has become much more highly concentrated by the engine of education. The new class has the means at hand, and largely under its control, by which it reproduces itself...
So assured have the elite become that there is almost no block on the rewards they arrogate to themselves. The old restraints of the business world have been lifted and... all manner of new ways for people to feather their own nests have been invented and exploited.
Government and state machinery cuts both ways. They can be instruments to promote economic growth, enable access to opportunities, and reduce poverty. But they can also become the hand maiden of vested interests. Unfortunately, the dynamics of forces that drive the modern economy and governments are increasingly gravitating towards the latter. Most worryingly, the institutional checks and balances that existed to pre-empt such trends are being slowly chipped away.
I haven't yet read the recently released book, Why Nations Fail. But one of the central insights of Daron Acemoglu and James Robinson is that nations succeed, among other things, when their institutions of power are inclusive. In other words, they should not become "extractive institutions", where they become instruments to serve the interests of the elite. If this is happening in societies across the world, and there are compelling evidence, then aforementioned trends do not bode well.
Update 1 (22/3/2012)
Daron Acemoglu and James Robinson argue that the biggest concern with economic ienquality is that it brings along with it a reduction in equality of opportunity and generates political inequality,
Economic inequality will lead to greater political inequality, and those who are further empowered politically will use this to gain a greater economic advantage by stacking the cards in their favor and increasing economic inequality yet further -- a quintessential vicious circle... The wealthy have greater access to politicians and to media, and can communicate their point of view and interests - often masquerading as "national interest" - much more effectively than the rest of us. How else can we explain that what is on the political agenda for the last several decades has been cutting taxes on the wealthy while almost no attention is paid to problems afflicting the poor, such as our dysfunctional penal system condemning a huge number of Americans to languish in prisons for minor crimes?