When I first became involved with economics, especially when I started to write for Mises.org and get involved with the online community there, it was a common belief amongst us amateur economists that the government does not produce wealth. It’s a good thing that it didn’t take me too long to realize that this is wrong. Unfortunately, there are many other people who still believe this to be true. I suspect, though, that there is a nugget of truth in what people actually believe, but that they’re confusing two separate ideas. This post is a bit rushed, but hopefully it gets my thoughts across.
In early 2011, I wrote “Government Spending is Bad Economics,” which I mostly still agree with (although my understanding of the role of public goods has changed [improved] over time). The argument is that the market enjoys certain institutions that give it an advantage over alternative frameworks of exchange. Specifically, profit and loss is a disciplining process that constrains the damage of error, since those who plan poorly will suffer a loss and those who plan well will earn a profit. This allows for a continuous redistribution of wealth that follows success. In other words, profit and loss allow for superior plan coordination.
The are other, related, advantages that I don’t discuss in the article. For example, the market is typically more competitive than government. If we look at the economy from the perspective of planning — whether planning by part of the individual with no power or planning by part of some central agency, or somewhere in between —, a competitive planning process, competition allows for a broader set of plans to be tested, and it improves (through profit and loss) the ability for the market to reject bad plans and reward the good ones. There are theories of government competition, but real world political institutions do not approach this ideal (e.g. there is hardly real freedom of movement between countries). Planning doesn’t include just productive plans, but even how firms regulate themselves or regulate their peers (e.g. it would impact the rules a clearinghouse would enforce on member banks).
In short, there are many reasons to believe that the market, on average, does a better job at allocating resources than the state. Where we would look at alternative forms of resource allocation is when there is a market failure, but this is a totally separate topic and we don’t need to assume there are such things as public goods to see the merit in my argument below (of course, the existence of public goods doesn’t necessarily justify government provision of these goods, either). But, most economists, for the most part, accept the fact that the market is generally a better allocator than governments. The debate is over the range of public goods that the government is justified in providing.
None of this implies, however, that governments cannot produce wealth. It only means that, on average, there will be an opportunity cost that is higher than that of alternatives. A simple example might clarify my point. Assume we start off with $100 of real wealth (for the sake of simplicity, forget about whatever difficulty there is in translating nominal values to real values). We can invest a total of $60. If the market allocates the investment the result will be a return of $100, implying an increase in total wealth to $200. If the government allocates the investment the return will be $80, pushing total wealth up to $180. There is a clear $20 loss from government allocation, but society is still better off than it was originally — it’s just not as well off as it could have been. Had the government consumed those $20, total wealth would then be $80.
To make it even clearer, let’s define consumption and production in terms of real resources (actually, I borrow these, more-or-less, from George Reisman — IIRC, he refers to production as “productive consumption,” or something similar),
- Consumption: The use of a real resource for direct satisfaction, such that at the end of that resource’s use it will no longer exist. Consumption lowers the real stock of wealth;
- Production: The use of a real resource towards the production of new resources. Production is indirect consumption, and it can increase the real stock of wealth (assuming a successful plan).
There is probably a lot of government spending that can be categorized as consumption. But, it doesn’t follow that all government spending must necessarily be consumption. Investing in infrastructure is clearly production. Paying out subsidies to firms is clearly a subsidization of production. Again, none of this means that these investments pass a cost-benefit test — whether government spending does should always be open to debate, and skepticism here is very healthy —, but this is a very different statement to “government spending is always consumption.”
I figure that when most people claim all government activity is consumption they have the much more accurate belief that alternative investments could have lower opportunity costs in the back of their mind. But, once you look at it closely, these are two very different concepts, the latter of which is wrong and the former of which can be right.