What is sometimes referred to as the original economic problem is the issue of scarcity – limited resources exist to satisfy essentially unlimited demand for goods and services. Faced with restrictions on inputs, resources should be diverted to the most productive use to maximise output, or wealth. Wealth is created when the end product of any production process has more value than the factors used to produce it. That value is measured by the market price. This represents the amount of alternative spending people (customers) are willing to forgo to obtain the end product and is the only objective way of measuring wealth. It is the often misunderstood mechanism of profit and loss that in the end determines what gets produced (as we discuss here).
Economics as a scientific discipline can be regarded as an attempt to explain what gets produced and why. Most schools of economic thought take one step further, attempting to create a policy rule book for government to intervene in and optimize the economy. No school of thought has been more influential in this respect than the one developed by John Maynard Keynes in response to the Great Depression in the 1930s.
The central tenet of Keynes’s theory is that should economic growth slow, government should intervene to prop up aggregate demand. The theory is that spending by one economic actor is income for another, so should private sector spending drop, government must step in to make up the shortfall until confidence returns and spending by the private sector returns.
But it should be obvious that this theory confuses spending with wealth. The theory asserts that the role of government spending is only to make up for the fall in spending, not the fall in wealth creation. This is why Keynesians see no problem with building the proverbial ‘bridges to nowhere’. Keynesians have no concern about government enterprises losing money – as long as money is being spent. The truth is of course that we do not get richer by spending, but by creating wealth.
It should hardly be surprising that spending resources on building a bridge that nobody intends to use does not make society richer – such behaviour is normally referred to as waste. But government spending affects the economy adversely in other ways too. Resources are scarce and what government uses, the private sector cannot use. Keynesians will claim that when the economy is operating below capacity, putting idle resources to work does not divert resources from the private sector. However, Austrian economics tells us that those idle resources were applied in the wrong sectors of the economy and shouldn’t be put to work, but re-allocated to sectors where production meets real, underlying demand. The textbook example is a boom and bust in the housing sector. After the crash, with an oversupply of housing constructed during the boom, idle house-building resources should not be ‘put to work’, but re-allocated to real, wealth generating activities. Only the private sector can do this re-allocation, guided by profit and loss. Furthermore, Keynesian spending is traditionally undertaken when the economy is slowing, tax receipts are down and social spending (unemployment benefits) are up – hence it is often referred to as deficit spending. Such spending is therefore normally debt financed. After the recovery, resources will continue to be diverted from the productive private sector, in the form of tax, in order to service the debt.
The Keynesian school enjoys great popularity amongst policy makers as it endows them with a theory that places the ability to smooth out the business cycle in the hands of politicians (as we discuss here). The idea of spending your way out of trouble has obvious political appeal. But government spending has a fundamental flaw: the disciplining forces of profit and loss, which in the private sector allocates resources to wealth creating activities, is absent from the public sector. Most would recognise that when someone spends money, the logical question is: ‘On what?’. Keynesians have no answer to that.