Opinion & Commentary
Making things worse
There is an ongoing debate about whether the government’s spending spree is going to work or whether it is a waste of money.
In the red corner are the Keynesians, who argue that during a recession the government should be pumping money into the economy to compensate for falling private consumption and investment.
And in the blue corner are those who believe Keynes has been discredited, and argue that government spending will have little to no effect while sending the country billions of dollars into debt.
The truth is actually much worse.
The debate about the various ‘stimulus’ packages and deficit spending has concentrated on short-term analysis of whether government spending will boost aggregate demand.
Maybe. Maybe not. But this demand-centric approach misses the point.
Ultimately, an economy does not grow because demand grows. Australia does not get richer because people want more things; we get richer because people create more things.
It is the supply side of the economy that matters most. And yet our current policies actually harm the productive capacity of our economy. The main consequences from current policies will be bigger government, less efficient government, and more political risk. All of these things are a constraint on the supply-side of the economy.
That the government is getting bigger is beyond doubt. In less than a year the Commonwealth government has increased its share of the economy from 24% to 28% and added new layers of government control.
Both in theory and reality, government involvement in the economy is linked to poorer economic performance.
The Heritage Foundation measures economic freedom (small government, free trade, private property, low regulation) and finds that it is correlated with prosperity, democracy, human development, and a clean environment. Countries classified as ‘free’ or ‘mostly free’ have a GDP/capita over US$30,000; while ‘moderately free’ countries have a GDP/capita of around US$15,000; and ‘unfree’ countries are around US$4,000 GDP/capita.
It is not hard to understand why economic freedom and small government are linked to prosperity. Despite the loud protestations from the left, the free market is simply more efficient than the bureaucracy. Sure, businessmen and women make mistakes. But then they will also learn, innovate, adjust to changing circumstances, and respond to the diverse and changing needs of the public. Economic growth comes from the private sector, not from politicians and bureaucrats.
Not only are we seeing bigger government, we’re also seeing worse government. In their haste to throw around billions of dollars, the government has been forced to lower its standards and pursue projects that are even less efficient than usual.
Perhaps one of the biggest costs from the current policy approach is one that is the least well understood. Erratic government behaviour, policy on the run, and large (and growing) budget deficits create political uncertainty. Investors must now be worried that their projects will see excessive government regulation, or perhaps a government competitor. And growing government debt must lead to either inflation, higher taxes, cuts in government programs, or debt default.
A 2006 study by Michael Ferguson and Hugh Witte found that when the US Congress is in session, the US stock market returns are lower and volatility is higher.
There is no doubting that government policy impacts on the perception of political risk, and it is equally certain that a high ‘political risk premium’ will lead to lower investment and lower growth. Unfortunately, it is much more difficult to actually measure the exact impact of government policy on the risk premium, and so this issue is overlooked for less sensible but simpler explanations.
American author Amity Shlaes suggests that one of the reasons that the United States failed to recover from the Great Depression during the 1930s despite a decade of Keynesian policies was that the higher political risk premium prevented the private sector from investing. We are potentially facing the same risk today.
The sad thing about this story of failed government policy is that it was entirely unnecessary. While the political pressure to ‘do something’ was strong, the truth is that the economy would have recovered fine by itself, as it has throughout the world and throughout history. Some businesses will fail, but then prices will adjust, new investments will be made, and new jobs created.
The idea that the economy can only recover if a politician is spending billions of our dollars is not supported by any theory or evidence. The economy will recover from the current recession. However, the recovery will happen despite the government, not because of it.
John Humphreys is a Research Fellow at The Centre for Independent Studies.
