Whenever someone proposes spending money on a new government program, critics will say that we should balance out the effect on the budget with a matching tax increase. That would be great if it worked, but it’s a mistake to think that we can make up for increased government spending by increasing taxes.
Economist Steven Landsburg tries to illustrate the problem with an analogy about personal spending [1], pointing out that if you spend too much on your lifestyle, you can’t make up for it by going to the ATM more often. His point is that the American taxpayer is kind of like an ATM: Keep taking more money, and eventually you’ll run out. Sooner or later, you will have to stop spending.
I’m sure he’s right, but I think there’s another way to look at the problem. When the government spends money, it spends money on stuff — roads, tanks, buildings, research, gasoline, airplanes, ammunition, computers — but when the government collects taxes, all it gets is money.
The problem is that money has no intrinsic value. It’s just ink on paper (or magnetic fields in some bank’s data center). You can’t eat it, you can’t wear it, you can’t pave a four-lane highway with it. Just having money doesn’t get you anywhere.
This is where you’d probably like to call my bluff by asking me to give you all my money. Don’t hold your breath. Although having money is intrinsically useless, there’s immense value to be had in trading money for other stuff. I can walk into a restaurant, give them some paper money (or allow them to make an entry in a credit card computer), and they will give me food. Elsewhere I can get housing, clothing, transportation, medical care, education, and entertainment.
Unlike money, these goods and services directly make our lives better, and it’s the production, distribution, consumption of these goods that constitute what economists call the real economy. The money is just a tool to help it all run smoother.
The goal of an efficient economy is using available resources to produce and distribute goods and services as efficiently as possible. It’s a complex problem, but our free markets solve it surprisingly well: Consumers buy what they need most, at the best price they can get, and producers try to earn a profit by providing those goods and services as cheaply as possible. Thus, our economy uses the least amount of resources to produce the most goods and services, in the best combination, and distribute them where they will do the most good. The free market has its problems, but it’s brought us pretty far.
Now suppose the government spends a billion dollars on a new highway. This giant construction project will use resources — building materials, construction tools, and labor — and once those resources are scarfed up for the highway, they can’t be used for anything else. Concrete that would have been used to build housing foundations gets used to build a roadbed. Trucks that would have hauled groceries to market are now hauling construction supplies. Construction workers who could have been building homes or packing groceries are now working on the government’s highway. This is the effect of government spending on the real economy: Resources that would have been used to produce other goods and services are sidelined into the government project.
That’s not to say the free market won’t provide all kinds of substitutions and adjustments. Food wholesalers probably found replacements for most of the trucks that were taken for the construction project, although the replacements are probably not as good. Or maybe the trucking companies bought additional trucks so they could continue hauling groceries during the construction project. Those trucks are now unavailable to whoever would have used them instead. Maybe someone will build new trucks to make up the difference, but then the extra materials and labor for the new trucks have to come out of something else that won’t get built.
You get the idea. The change in demand ripples through the economy in a series of trade offs that are complex, far-reaching, and sometimes hard to predict. But there’s only so much stuff we can produce, so whenever we decide to produce something, we consume scarce resources that could been used to produce something else.
Economists call this the opportunity cost because whatever that something else was, we’ve lost the opportunity to have it. When it comes to the real economy, every decision has an opportunity cost. So when the government runs a billion-dollar highway construction project, it does so at the oppornutiy cost of not producing about a billion dollars worth of something else. This is the real cost of government spending.
Of course, the government has to pay for its billion dollars worth of construction with money, and the money has a story of its own. Perhaps the government takes the money as taxes, in which case the affected taxpayers will be a billion dollars poorer, and thus have to reduce their consumption of goods and services by roughly a billion dollars. This works out okay, because the government has taken a billion dollars worth of goods and services out of the economy for its new highway construction. In a free market system, all those trade offs I described earlier will eventually end up taking goods and services away from the taxpayers who couldn’t afford them anyway.
Putting it that way makes it sound kind of magical, but what happens is that the taxpayers have less money to spend so they buy less stuff. This frees up resources which help make other stuff easier to produce, freeing up more resources for still other stuff. These ripples eventually collide with ripples of increased demand coming from the highway project and it all balances out. The process is helped along by traders who understand the system well enough to get ahead of the ripples and take steps to fill shortages and siphon off gluts before anyone feels them.
But what happens if the government doesn’t raise taxes and borrows the money instead? Well, if the government borrows the billion dollars, it has to come from people who are willing to give up spending the money now in exchange for having more to spend later. This reduces their spending by roughly a billion dollars, and has the same short-term effect as if the money had been taxed away.
The point is that however the government gets the money, the goods and services consumed by the highway project are removed from the economy. Once the government spends money, it doesn’t matter where it came from. It’s the spending that does the real damage.
One last thing: Just because the government consumes a billion dollars worth of resources doesn’t mean the economy takes a loss worth a billion dollars. The highway project used up a billion dollars worth of resources, but it created a new highway, and that’s got to be worth something to the economy. The question is whether it’s worth enough.
Highways are a notorious example of something the free market is very bad at providing, so there’s a real possibility that a billion-dollar highway project could reduce travel times and congestion to allow the economy to produce far more than a billion dollars worth of extra goods and services. It could make us all better off.
So before all the politicians and pundits debate the mechanics of paying for a government program, we need to find out if the program is going to be worth the opportunity cost of whatever the free market would have done with an equal amount of resources. In other words, before we figure out how to pay for it, we need to make sure it’s worth buying.
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[4]Mark Draughn [5]
[4]Latest posts by Mark Draughn (Posts [7])
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