With the Third Ashes test match finishing early our guest economist and cricketer John Hearn found himself starting on another blog. Read them all here and follow John here
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Government spending does not cause the economy to grow
In the current round of tweeting I noticed how many economists and people who write about the economy make a really big mistake when they say that the only way an economy can grow is if government spends more money. Statements like this are used to justify yearly budget deficits and burgeoning national debts.
It has been my observation over too many years that while economic growth is about using the same number of resources to produce more, government spending, almost without exception, is about using the same number of resources to produce less. There are examples galore of government waste whether it be IT networks in the public sector, energy (in)efficient schemes, high speed rail networks, saving the planet, foreign aid and many others.
The best example of government trying to spend its way to growth was in the 1970`s when it targeted raising the yearly 2.5% growth rate of the 1960`s to 5% in the 1970`s. The government boosted spending, cut taxes, ran a growing budget deficit and for the whole decade the average yearly growth rate fell to 0.6% p.a.
Why is it that so many economists not only support government spending as the way to grow the economy, but some even refer to it as the only way to grow the economy? Supporters of this argument state in a simplistic way that if the government, for sake of argument, employs an additional 100,000 people then this expands the economy almost in a self-financing way because these people may have been taken off benefits and now be contributing taxes to the Exchequer. This they claim is a win-win situation.
However there are a number of unanswered questions the most obvious of which is where does the money come from to employ these people? If it is taken from another area of taxation then job losses may equal job gains. If it is borrowed from real people then funds are just being redirected from one part of the economy to another. If money is printed (QE) then inflation may result and this may lead to a damaging redistribution of resources away from the private sector to the public sector.
At this point a number of economists may jump up and say "but what about the output gap?" I remind them that I have explained elsewhere that there is no such thing as an "output gap" that can be closed by manipulating aggregate demand and I ask them to trust me as I have probably been an economist for many more years than them.
I now move on to answer another common question and that is what if government directly spend their money buying resources from the private sector? My reply to this is that it is unlikely government will be spending this money efficiently as they have no real incentive to spend effectively. This is because they probably lack the knowledge and skills as well as the single-mindedness to drive a hard bargain. After all there is an endless stream of taxpayer`s money and no requirement to be profitable.
There is a rough rule of thumb that may explain why increases in spending and deficits are never associated with net increases in employment and it is that for every job created inefficiently in the public sector there is more than one job lost somewhere in the private sector. The problem has always been marrying up these two events to produce a coherent argument supporting a net loss of jobs when government increase their spending through deficit budgeting. All I can suggest is that you need to look at the evidence.
I know of no economist who will disagree that there are some products that government must buy. These are products that we all want but are not prepared to purchase as we cannot exclude other people from getting a free ride and consuming these products at no personal cost. They are "public goods" such as street lighting, internal law and order and external defence to mention a few. These cannot be supplied in a market place and can only be demanded by a third party e.g. government. Therefore there is a role for government spending, but we should not jump to the conclusion that, even in this situation, government spend this money efficiently. It is just that no-one else will demand these products for us so it is a sound economic reason for taxation and spending. Beyond a limited role for government there is no evidence that increased spending benefits the economy in terms of a net increase in employment and economic growth
What is being said is that government have no magic wand that can link their spending to a growing economy. In fact evidence tends to support the very opposite point of view once government has completed those tasks that only it can do.
So is there an alternative that can bring about higher levels of employment and faster rates of economic growth? The answer is yes and it is the opposite of what has been said so far. It is necessary for current governments to spend less money, borrow less money, be required by law to balance their budgets and in turn require their Central Bank to achieve its 2% inflation target without interfering with market rates of interest. Government needs to create and enforce a level playing field for free market capitalism where firms can compete fairly with each other to produce the products we need, want and desire.
After a lot of painstaking research and a few simple theories, made to seem more difficult as they are hidden in mathematical models and jargon, many economists have concluded that only with government intervention and more government spending can we seek economic Nirvana. This is wrong and debates like this must convince some and may have to encourage others to take a leap of faith and see solutions in a free market capitalist system.
John Hearn August 2015