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Government Spending Is Bad Economics

Economics / Government Spending Mar 31, 2011 - 09:28 AM GMT

By: J_M_Finegold_Catalan


Best Financial Markets Analysis ArticleThe debate about whether or not government spending is a useful countercyclical tool has been revived by the continuing economic crisis. Today, the discussion has been politicized and deals almost exclusively with the size of government debt, focusing on the tax burden this debt represents for future generations and whether or not further debt will help stimulate the economy. Politically, the result has been a middle-of-the-road fiscal policy that has left no economist satisfied. Academically, the debate is generally split between free-market and Keynesian schools of thought, with each side arguing for a policy very different from those already implemented.

Most economists — except the Austrians, for reasons discussed below — believe the dramatic fall in expenditure (both investment and consumption) is the problem. Usually, they suggest fiscal or monetary stimulus as a solution. Both solutions aim at repairing the so-called income gap (usually represented by the fall in adjusted gross domestic product) either by creating more money or by stimulating expenditure of already-existing money through wealth redistribution. The point of both forms of stimuli is not the spending itself, but the employment of currently idle resources.

The case for fiscal stimulus is based on two assumptions: that private investment has collapsed and that the effects of monetary stimulus are hindered by some kind of barrier. The barrier is usually believed to be the so-called zero bound. To John Maynard Keynes, a depression results from a fall in investment, in turn caused by a fall in consumer spending (this fall being a byproduct of saving). He considered this a major natural weakness in the capitalist system, thus justifying the "socialization" of investment.

Whether modern prointervention economists accept Keynes's full argument is irrelevant. They agree insofar as they see government spending as the most effective method of recuperating the economy's predepression level of wealth creation.

If a healthy economy could be modeled by a simple expenditure-flow diagram, where economic growth was just a function of the level of investment, then the debate would end here. Taking the concept to the extreme, this premise would be grounds for a completely socialized economy: after all, economic growth is just a function of investing in processes of production.

We know, though, that the market economy is nowhere near as neat and simple as this model suggests. The market is a tangled web of economic relationships, and it is a process characterized by various coordinating and discoordinating forces. We live in a society beset by scarcity, and it is this market-coordination process that aids the individual in allotting the correct resources toward the preferred ends. It follows that economic growth, or wealth creation, is not just a function of investment. The vague term "investment" must be incorporated into this realm of scarcity, preference, and coordination.

When government spending is integrated into the broader picture of the market process, it becomes clear that the issue evolves beyond the simplistic notion of spending and output. It is no longer a question of some straightforward relationship between investment and wealth creation. It becomes a question of whether or not government can effectively participate in the coordination process of the market.

Upon further inspection, there are convincing reasons to believe that government spending is actually a discoordinating force, and that as a result such spending is not an effective countercyclical policy. In fact, it is not a question of efficacy; rather, it is a comment on the harmful consequences of "socialized investment."

Scarcity, Preference, and Coordination

Commonly, critics of government spending argue that at best this type of spending only replaces the spending that would have otherwise occurred in the private sector — it is like taking money out of your right pocket and putting it in your left. At worst, it is said, government spending brings about the negative side effect of discouraging production through taxation (or the threat of taxation in the case of debt-financed spending, assuming that the concept of Ricardian equivalence holds some merit).

These are accurate and powerful critiques of government spending, but they ultimately fall short of explaining the fundamental problem. Government spending is inherently inferior to private spending and does not operate within the coordinating forces of the market.

One of the Austrian School's unique contributions to economic science has been the provision of a framework that approaches economic questions from precisely this angle of scarcity and coordination. It was with this vision that Ludwig von Mises originally disproved the viability of a socialist economy. It was with the same vision that he and Friedrich Hayek, and later Murray Rothbard, built a detailed description of the architecture of the coordinative forces, namely the pricing process.

The idiom of "forces," when describing trends of coordination and discoordination, is a bit misleading, because it may imply some form of mysticism. But the market processes that coordinate activity between savers and investors, consumers and producers, and so on, are very real. I have described and explained these macroeconomic processes at length elsewhere.

All macroeconomic forces refer back to a fundamental "microfoundation" — the economization of scarce resources. We know that the common denominator of all economic activity is the fact that man acts — that individual market agents employ certain means to attain preferred ends. Individuals, holding subjective, ordinal utility scales, employ scarce means of production toward chosen ends on the basis of their preferences. Individuals do so in attempting to remove "uneasiness," that is, in order to reach a more preferred situation.

The continuous process of allocating resources throughout society is simply an aggregate of the ongoing calculation that takes place on an individual basis. These individual actions coordinate on a macroeconomic scale through the pricing process and through the division of labor. Producers are rewarded or punished through profit and loss, creating a tendency for capital to flow to those who use it the best (those who satisfy the consumer the most). This is the market method of rewarding "efficiency."

The consequences of government spending can only be properly assessed within the framework of market coordination. If socialized investment is truly warranted, then the results of the investment must be better than the result that would have occurred had those same resources been economized by individuals on the market.

In other words, the government's method of deciding on investments would either have to enjoy the same characteristics as the market's, and the government a better entrepreneur, or the government's method would itself have to be in some way superior. We can rule out the latter option on the grounds that we know that the only method of economic calculation is by individuals through the pricing process. Therefore, government investment is inherently inferior to free-market investment.

Individuals economize resources based on their own preferences and their own ends and based on the expected preferences of others, which are partly reflected through the price mechanism and oftentimes predicted through other means of information as well. Even producers of capital goods removed from the final consumer by one or more phases derive their profits from consumer satisfaction, since the demand for their products is decided by the entrepreneurs who are directly supplying the consumer.

The ability for one individual to acquire the means necessary to accomplish a certain end is influenced by the abilities of others competing for the same means, and in this fashion too does the market reinforce the tendency of efficiently economizing the means toward the most important ends.

Government does not face the same constraints or the same motivations when it spends. In fact, if government were subject to market constraints and motivations, then it could not provide society with that which the market fails to produce (for better or for worse).

Since the state is not constrained by revenue, it can effectively outbid potential competitors for whatever resources are necessary to complete the spending program. There is no need to economize dollars, because the state can borrow, tax, and simply create more in order to finance its purchases. Ultimately, this distorts the entire notion of scarcity, because government can acquire any economic good at any cost. The role of prices in aiding individuals in making their decisions when economizing means is effectively nullified, because, to the government, prices are almost irrelevant.

Similarly, the constraint of profit and loss is not applicable to government operations. Governments operate on the money of others — the source of government revenue is not profit but taxation — so there is no need to run a profit. Furthermore, the type of investments governments make tend to require large initial costs, even if the program reaps profit over the long run — an example is General Motors, assuming that at some point the company will become a profitable competitor in the automobile market. If individual market agents invest toward ends that they consider to be highest on their utility scale, then it follows that government tends to invest toward the ends that are neglected (because they are less economical).

The consequences of government spending are best understood when laid against the backdrop of market activity. We live under the specter of scarcity — a corollary of human action and the fundamental scarcity of labor — and thus all economic goods, which are defined as scarce to begin with, are economized on the market through the processes mentioned above. Government spending, whether done directly or through subsidies, redistributes resources from the individuals who would have economized them and instead allots them toward less-preferred ends. Thus, even if a government program ultimately turns a profit, the opportunity cost represented by the foregone production represents a net loss to society.

Idle Resources

We know that if economization of resources is taking place government spending will disrupt this economization and redistribute the resources toward the attainment of ends considered less important. It may seem, though, that this argument fails to properly tackle the issue of countercyclical fiscal policy during a recessionary period, since it is during this period that, it is said, that there is an excess of "idle resources."

Idle resources are means of production that are seemingly being left unused — an obvious example is an unemployed laborer. If these means of production are "idle", what harm is there in government employing these resources?

There are a number of possible responses to this question. It is worth mentioning that governments tend to exacerbate the degree to which resources are left "idle"; thus, one could make the argument that the problem of idleness is to a large extent artificial. However, this would imply that there could nonetheless be some degree of idleness on the market and that this presents some type of problem. The correct answer to this question is the one that explains why the supposed problem of "idle resources" is actually not a problem at all, because resources are not purposelessly left idle.

Economic goods are constantly economized within the means-end framework of the individual market agent. That some goods may not be applied toward the attainment of a specific end does not mean that these resources are now idle and valueless. It simply suggests that these resources are better saved for the attainment of another end. If economic activity is defined by the attainment of ends and the economization of means toward these ends, and certain means of production are deemed as better off unused, what sense is there in forcibly using these "idle resources" through government spending? The redistribution of allegedly "idle resources" faces the same problem as the redistribution of "non-idle resources" — the opportunity cost of the foregone market activity is higher than the benefit of the actualized government program.

One can reasonably expect an increase in the quantity of "idle resources" during periods succeeding phases of prolonged intertemporal discoordination. During the length of intertemporal discoordination, the structure of production grows around the distorted profit signals caused by monetary expansion. The capital goods developed and produced during this time tend to range in specificity, with some being very unspecific (such as low-skill labor), some being highly specific (such as a machine that is designed to produce only a single type of good), and most falling somewhere in between.

The necessary readjustment of the structure of production that occurs when the distortions are revealed (in what is considered the depressionary, or recessionary, stage) will necessarily cause an increase in the volume of idle resources. Capital goods of higher specificity will sit idle because they may be fully or partially inapplicable toward alternative lines of production. Individual entrepreneurs will have to plan their actions around these remnants of malinvestment, consumer preference, and their own predictions in the face of uncertainty. These "idle" capital goods are not idle at all, but merely being economized during a period of structural readjustment.

During this period of readjustment, wealth redistribution through government spending may employ what are considered to be idle resources. The structure of production may adjust around the various new lines of production revived or funded by government. However, the shape of this structure of production is inferior to that which would have developed without government intervention, and thus there is still a net economic loss.

Government: the Great Disequilibrating Force

Government spending is not a method of improving the market's efficiency, nor is it a method of employing allegedly idle resources. The result of government spending is foregone opportunities; the cost is the gain in wealth that would have occurred had economization been allowed to take place, minus the outcome of government spending. One can easily conclude that the notion of positive countercyclical fiscal stimulus is highly suspect, and that a better alternative would be to allow individual market agents to economize economic goods based on their own utility scales.

This argument does not assume that individual market agents achieve "optimality," or that the market is absolutely efficient. There could be a case in which an individual market agent makes a poor investment decision, and the invested capital is consumed without further wealth production. These cases, however, do not support government spending. On a macroeconomic scale, there are catallactic tendencies and forces, created by acting individuals in a society, that reward those who invest well and punish those who invest poorly. This type of distributional tendency does not affect government spending, because government necessarily operates outside of the scope of the market's coordinative forces — the state is not constrained by a given amount of revenue, nor does it respond to profit and loss. Therefore, there are no corrective measures that realign government spending with consumer preferences.

Government, in fact, is a large disequilibrating force on the market. It forcibly redistributes economic goods, removing them from a process of economization and instead investing them toward the realization of less important, or less preferred, ends. In other words, it distorts the continuous process of coordination.

Whether some degree of government is necessary to allow the market to operate, while being outside the scope of this essay, deserves commentary. The belief that government is necessary to at least guarantee individuals's property rights is not uncommon. However, knowing that property rights are absolutely essential for a working coordination process, it seems difficult to think that individuals themselves would consider the allotment of resources toward the end of securing their property rights as having secondary importance to something else — especially since the attainment of "something else" may require secure property rights.

Overall, we can safely conclude that government spending causes more harm than good; it redistributes the means of production toward the attainment of ends considered inferior by the individuals who make up the society that government is allegedly acting to improve.

Jonathan Finegold Catalán is an economics and political science major at San Diego State University. He blogs at Send him mail. See Jonathan M. Finegold Catalan's article archives.

© 2011 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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