Is government spending effective?

Let us start by asserting that the money the government holds is not its own. In general the government does not produce anything, nor create wealth, nor even create jobs. If we are lucky, the government only reshuffles capital from place to place. If we are not, which is the most common occurrence by the way, it will waste some of the capital in the process. The government competes for capital with the market. By the way, these remarks are not directed at one particular government. It is the nature of taxes and government spending in general.

Our story begins with a discussion of the quite-often-mentioned Laffer curve. The point of the Laffer curve is to maximize governmental budget revenue. The economist Arthur Laffer has developed it to illustrate the fact that when the government raises taxes up to a point its revenue rises as well, but after that raising taxes actually causes revenue to fall, as citizens either leave the country or try to avoid taxes by shifting their businesses to the informal sector. True, the Laffer curve often serves as an argument for tax cuts because, apparently, very high taxes can result in a decrease in government revenue. But is increasing the government revenue, and in consequence the government spending, really a good way to develop the economy and satisfy people’s needs?

In order to fund its spending, the government must confiscate money from the private sector by means of taxation, or borrow the money from the private sector by issuing bonds. Assuming that the government will pay back for the bonds in the future, it will do so by raising future taxes. The third way the government can get money is the so-called debt monetization. The government monetizes its debt directly or indirectly by using central bank’s power to issue new money and then using this money to finance the budget deficit. The government issues bonds that are purchased indirectly or directly by the central bank for newly created money. In effect the deficit is being financed by an increase in money supply. This means that the government acquires its money at the expense of declining purchasing power of the money people hold. Some countries only use a combination of these methods, but each of them does siphon out capital from its most productive use elsewhere in the economy, and thus impoverishes society. No government expenditure can be made without the private sector paying for it one way or the other. Moreover, the government can ignore economic calculation and in fact more than often does so. Government needs not to be profitable; all that it takes is for some bureaucrat to regard a given policy as needed by the public or by himself as serving his own political interests. Consequently, the government can always crowd out private capital from acquiring resources, because the private sector must mind its profits as an indication of the economic effectiveness of its ventures. As for the government, it can always use its power to tax the society for more money or make the public its creditor, and consequently it can regard market prices as merely a meaningless formality.

The market is extremely complex. It is made up of millions of everyday decisions made by people to meet their individual needs. These needs may vary depending on the individual, but together all people are doing their best to use limited resources to improve their situation. The whole economy is an intricate web of such human actions and choices. These processes are coordinated at the macroeconomic level by the division of labor and the system of market price formation. The individuals most effective in managing their capital are rewarded with profits and can continue to do what they do best. At the other hand, those least effective are discouraged by losses, thus forcing them to either seek out other activities, or to change the way they use their resources. The very act of government raising its money is thus tantamount to depriving individuals of their ability to choose a most preferred use of their own resources. Even in a rare case when a government program is actually profitable, such foregone individual opportunities actually constitute a loss for society. To put it simply, profits could be larger had people been given an opportunity to act freely. Market processes tend to allocate capital in the most productive uses. On the other hand, the government misallocates capital by wasting it in sectors previously bypassed by the market due to its expectations of profit opportunities existing elsewhere. If such government expenditures were profitable, private capital would be there already.

Moreover, incentives and motives of market actors and those of the government differ drastically. An entrepreneur investing his own money is a risk-taker who counts on making profit later. He has no other option to receive profits but to satisfy the needs of his clients, therefore improving their standard of living. If he makes a good choice, he enjoys the increased profits. If he makes a wrong choice, he suffers losses and loses some or all of his capital. That is why it is in the interest of the entrepreneurs to invest their capital with care. The government, as we have mentioned, is not driven by profit. It is driven by political goals. Often, instead of profit, the government sets a goal such as a supposed public service, or job creation. The government can also engage in bribing the public by use of redistributive measures. This is because the ultimate political goal of government in a democracy is future reelection. When a government makes a mistake the society suffers losses in its stead, being the government’s ultimate taxpayer and creditor. More than often, unprofitable projects are allowed to exist, and continue to bleed public money. This is obviously because from the conception their goal is a public service or job creation, not the money. Thus it is irrelevant whether such a project continues to siphon money out of your pocket or not.

Finally, two things about government spending should be noted. First of all, all government spending at its core is consumption. Investments are based on savings, and savings are created by abstaining from present consumption in return for the increased productivity and consumption in the future. The state has no savings, and its spending serves present political purposes, so it cannot be treated as an investment. Second of all (and this is slightly unintuitive, but true nevertheless), if we want our economy to grow rapidly, we need to try for a smaller, rather than balanced budget. In most cases a $1 million budget with a 50% deficit is much better than a balanced budget of $5 billion. Why? Because government spending is more important than the way it is financed. Of course, a small balanced budget would be an improvement.

Government spending is always a cost for the society. Sometimes a society may agree, that some of this cost is necessary and we should pay such a price for something important. Reasonable defense expenditures seems to be such an example. However, you should never consider government spending as an investment. True, the market is not perfect, and people sometimes take wrong turns. The market, however, tends to quickly correct bad choices and eliminate bad investments. What is more, instead of everyone, only the individual who made the mistakes bears the brunt for them. Unfortunately, it is not the same with government, as its revenues are effectively unlimited because it always has the 3 methods of raising funds we have mentioned earlier. The government, unlike the private sector, is oblivious to profit and loss incentives. Thusly, it should be obvious that the private sector will always be more effective than the public sector in managing capital. If we want our needs to be met with utmost effectiveness, we need to stop pushing the government to crowd out as much capital from productive undertakings as possible, and start to do the opposite!