Monday, 22 December 2008

The Green Road to Nowhere

History is repeating itself, though whether as tragedy or farce awaits to be seen. As our economy enters another of its periodic recessions, caused as ever by government meddling in the economy, politicians race to solve the problem with further doses of the same poison.

Sadly, in an age where politicians fear differentiating themselves from one another and parties squabble over a consensus they disingenuously call the middle ground, there seems to be no real debate over how best to ensure that the recession that we are now in is as brief as possible. Just as President Hoover’s failed interventions were succeeded by President Roosevelt’s even greater interventions, so today politicians seem to be in a bidding war to intervene in the economy.

The latest dose comes from the Liberal Democrats, who have joined the chorus with their latest call for action. Nick Clegg has announced a Green Road Out of the Recession that is built on the same errors that underpin Labour’s proposals and the $4.61 trillion US bailout.

It is a simple error, summed up by Henry Hazlitt when he notes that “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.” It is the error of looking at the immediate results of what one does but not the damage that doing it causes; specifically, of believing that one can utilize a resource (in this case, money) for one purposes without denying it to another.

So let us be utterly clear: when the Lib Dems say “Now is the time for big investment to get the wheels of the economy turning again”, any rational observer should immediately ask “From where is the money coming, and what will be sacrificed so that this investment can be achieved?”

It is an impressive list the Lib Dems have compiled: new trains; new railways; new track; social homes; insulated lofts; smart meters. It will “create jobs and ensure that once this recession is over, we have something to show for the money we borrowed.” All of which is true, but what it does not show is all the jobs that will not be created because the money that would have been spent creating those jobs has been siphoned off by government to pay for its own projects.

There is absolutely no reason why government spending of £12.5 billion (as the Lib Dems propose) should create more jobs than private spending of £12.5 billion. On the contrary: while markets operate specifically to maximise economic efficiency – by, for example, allowing people to spend money on projects that will maximise their own utility – government’s have no such built-in discipline and no means of weighing the efficiency or efficacy of different projects. In fact (as the sorry litany of failed government projects demonstrates) governments all too often blow vast sums of taxpayers’ money on projects that promise big benefits but deliver dubious or disappointing outcomes.

I should add that this is not a criticism of any individual project and certainly not of the environmental (“green”) thrust of the proposals. That the “road out of recession” is “green” is irrelevant. We could as easily talk about the white heat of technology or indulge in some blue-skies thinking. The point is that this is being sold on economic, not environmental, grounds; if the Lib Dems were as keen on agriculture as we are on environmentalism, we could as easily advocate policies akin to President Hoover’s New Deal farm programme, and the proposals would be no less flawed. Government cannot spend the country out of recession.

The reason for this is that government money must come from somewhere, and not matter what its source, it merely transfers money from one use to another. If we spend £12.5 billion on new trains to “create jobs” and “stimulate industry” then the money, workers and materials that are diverted to those ends are no longer available to make shoes, televisions, meals or whatever else we might buy. The net effect in jobs created, wages spent and economic activity stimulated is zero.

Indeed, while we may scoff at the 2.5% cut in VAT and say that the £12.5 billion could be better spent insulating lofts, it ignores the fact that the £12.5 billion would otherwise have been spent by consumers on (for example) carpets. The criticism that the VAT cut would not in fact encourage people to buy is valid in as far as an individual price reduction of 2.13% is not going to make a product hugely more attractive to buy. But the fact that the money remains in people’s pockets means that it will eventually be spent somewhere. It will still represent an increase in consumer demand and so will stimulate growth.

Thus the one part of the Green Road Out of the Recession which is sound is the bit that promises “big, permanent tax cuts”. It is the bit that has been policy for over a year and upon which conference voted. It would transfer spending from inefficient governments to efficient consumers and so allocate resources in the marketplace (that is to say you and me and our respective savings) most efficiently.

A couple of additional points need to be made, to head off possible comments (welcome though all comments are, of course!). Firstly, it makes no difference if the government gets the money through taxation, inflation or borrowing. Borrowing has exactly the same effect as taxation in as much as it diverts savings from being invested in industry and instead invests it in public services; there is still no net gain. It also lands future taxpayers with a bill, so diverting money from future generations to the present. Inflation is effectively a flat tax: if we “print” an additional 1% of money, we are reducing the value of everybody’s savings and wages by 1% - an “inflation tax” that falls as heavily on the poor as it does on the rich (except that rich people are more likely to own commodities or foreign assets that are inflation proof, so inflation may actually be regressive). It also creates imbalances in the economy that will lead to further crises in the future.

Secondly, it makes no difference that this is supposedly “investment” rather than mere “spending”. It is certainly true that this sort of government spending will ensure that “once this recession is over, we [will] have something to show for the money we borrowed.” I have a house to show for the money I borrowed in December, but it does not follow that I made a sound “investment”. Had my internal chancellor not borrowed and spent, my internal taxpayer would not now be saddled with debt.

As Adam Smith noted over two centuries ago, “What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom”. What is more, the fact that we can see what the borrowing has financed should not blind us to the fact that we cannot see the things that the borrowing has denied us: other investments will have been sacrificed. And finally, even spending on consumer fripperies stimulates long-term investment: if demand for MP3 players and trainers increases, so does investment in the production and retailing of these (so creating jobs) and in the infrastructure needed to move them about. Indeed, as taxes/inflation/borrowing tend to make it particularly hard for new businesses to arise, because capital formation (i.e. saving) is harder and credit is absorbed by government, new start-up businesses such as those marketing new solutions to environmental problems struggle to get off the ground. Big government spending may therefore be counter-productive even environmentally!

I also ought to add that members of other parties shouldn’t’ take too much pleasure in seeing me demolish my own party’s latest policy initiative. Neither Labour nor the Conservatives have exactly covered themselves in glory during the present economic crisis and both are participating in the flawed concensus politics outlined above. This article focuses on Liberal Democrat policy only because errors are doubly galling when they come from within one’s own camp and I would like to see the Lib Dems taking a braver, more distinctive and more honest approach to the current crisis that did not argue that more government can get us out of a problem that government made in the first place. The alternative norm of passing money through the hands of politicians instead of citizens has been Labour and Conservative policy for the last century and it has been a tragic disappointment.

7 comments:

Tristan said...

There's an awful lot of bad thinking on this issue, largely 'Something must be done - this is something, lets do it'.
Frankly I think doing nothing is better than most of the somethings being proposed, but that is anathema for politicians...

There's also the ludicrous claim that this is an injection of cash into the economy - it isn't, its a rearrangement of money flow - as Douglas Adams might have put it, we're moving little bits of green paper around.

I think there's also a lot of that hubris which the political classes possess, that they know best how money should be spent.
For LibDems its on green things, for Labour its on the database state and ever mroe complex benefits systems, for the Tories - I'm not sure, although probably on their friends and some sort of 'law and order' nonsense.

Tristan said...

Actually, the Tories will spend money on what they think will win votes, ie whatever the latest focus groups say is important to people...

Tom Papworth said...

"I think there's also a lot of that hubris which the political classes possess, that they know best how money should be spent"

...and yet all the evidence is against them. There is almost no serious economic thinking that argues that politicians spend money in a more economically-efficient manner than consumers.

There is a separate argument that economic efficiency is not the be-all-and-end-all and that governments must intervene to spend the money on things that are "inefficient" but nonetheless socially desirable; this is called Social Democracy.

However, the Green Road and other economic recovery plans of the moment are explicitly about economic efficiency and as such are utterly without foundation.

MatGB said...

"Government cannot spend the country out of recession.

The reason for this is that government money must come from somewhere, and not matter what its source, it merely transfers money from one use to another. If we spend £12.5 billion on new trains to “create jobs” and “stimulate industry” then the money, workers and materials that are diverted to those ends are no longer available to make shoes, televisions, meals or whatever else we might buy.
"

I partially disagree—I'm not sold one way or t'other on this one, I do recall reading some Friedman that said spending in a recession was a good thing for Govts to do, but it was in a book I don't own.

But the problem with the analysis is that you're assuming that the money could be raised, and spent, by others. This isn't demonstrably true. In the normal state of affairs, I'd agree, but at this stage in a cycle I don't think I do.

I'te been demonstrated that Govts can raise money both more easily and cheaper than non-state actors (please don't make me go dig through the papers on this). In addition, Govts can raise money from overseas that wouldn't necessarily come into the UK in other means.

At the moment, those with money are looking for 'secure' investments, that's a result of the banking sector disgrace, etc. Govt bonds are a lot more popular when the overall economic situation is looking bad.

Investors don't always act rationally, and sometimes run scared. Now would be a good time to invest in some sectors that require property, for example, as property is cheap. Areas of the hospitality sector have been failing for some time predating the current issue, because they've failed to adapt.

If I had money to invest, I'd be buying a lot of the vacant pubs that Enterprise and Punch have, and turning them into pubs that people actually want to go to—people are less likely to spend on massive holidays or similar, but a night out in a decent pub is a lot cheaper, do it right and you'd do well.

But I don't. Those with money are palpably not interested in such things. The Govt can raise money as the finance they raise is guaranteed.

They can then invest that money in projects that have long term benefits for the area they invest in, which would pay off medium to long term. This is especially true of insulating schools and similar, that'll bring bills down and thus save tax money in the future.

Improved rail links, especially for freight, have almost zero chance of being built by private investment (unlike the first time around), but would significantly benefit the areas they improve communication links to.

I want to minimse the overall impact of the state as a vector. But at times, the state is the only agent that can act.

Thus I'm not sold on the argument that this sort of investment is necessarily a bad thing, as I can see many benefits.

Tom Papworth said...

Matt,

The only reason that “Govts can raise money both more easily and cheaper than non-state actors” is that, unlike any other organisation, governments print their way out of bankruptcy. Their monopoly on money-production means that they can always pay their debts at the expense of private owners of capital (you; me; JP Morgan) whose investments are eroded by the inflation they use to ameliorate their own debt.

The irony of this is that – in a credit equivalent of Gresham’s Law – government debt drives out private investment. There are currently plenty of people (individually or through corporations) with money to invest. If the government was not offering investment opportunities backed by the printing presses, this money would find its way to private investment opportunities that (in the absence of government meddling in interest rates) would offer returns that factored in risk.

Friedman certainly advocated inflationary measures to counter deflation. I don’t recall him ever saying that increasing government spending was a good idea but he did believe that when credit became tight central banks should step in and create masses of extra credit and cash. Personally, I think that this simply prevents the errors of the previous inflation being corrected and so stores up trouble for the future. We may be worrying about deflation now, but governments and their central banks are already laying the foundations for the next inflationary spiral. Indeed, they would be investing in corporate bonds, shares, mortgages and so on; all the things that are currently in short supply.

The second part of your argument is different. You say that governments “can invest …in projects that have long term benefits … which would pay off medium to long term. This is especially true of insulating schools and similar, that'll bring bills down and thus save tax money in the future.” Partly this is a moot point. As I noted in the article, the argument behind this kind of spending is not that the investment is valid in itself – this is only of secondary importance and, as Tristan notes, would vary from government to government. The argument is that the investment will have beneficial macro-economic effects. This is palpably false. Investors cannot just sit on their money. Unless government offers guaranteed returns, they will have to invest elsewhere. And as I also noted in the article, markets are inherently superior mechanisms for achieving economically efficient outcomes.

As for private investors building infrastructure projects, a bit of land value taxation, a carbon tax to stop the users of some forms of transport externalising their costs, and allowing private builders to charge market rates for the use of their infrastructure and I’m sure private investment would work just fine. But we digress…

dreamingspire said...

Sadly we use investment with a variety of meanings. In business, investment means creating something that will later bring a financial return. So you direct the spend, rather than wildly throwing it around. In the public sector we build bridges and roads and railways and hospitals and schools and... Social investment can use money to increase the fitness of individuals to be more productive in society (or less dependent). If you believe in the power of people to persuade others to do better (rather than treat all politicians as totally self-serving), then directing public spending rather better can do good. Wealth surely comes from the labours of men and women - better that they contribute than be idle.

Tom Papworth said...

“Wealth surely comes from the labours of men and women - better that they contribute than be idle.”

Absolutely! At least, the labours and capital of men and women: the whole progress of humanity has been built on the ability to accumulate capital and so increase at any point in time the productiveness of labour.

This is why it is important that we allow them to find the most productive outlet for their money and efforts. This is prevented by governments when they depress interest rates and reallocate resources to expenditure that they favour over the expenditures that would emerge by individuals in free association.

“If you believe in the power of people to persuade others to do better (rather than treat all politicians as totally self-serving), then directing public spending rather better can do good.”

It’s not that politicians are “totally self-serving” (though they are somewhat self-serving, to be sure); it is that – to use Tristan’s expression, above – their belief that they know better than the mass of the population is hubris on a grand scale. I actually think that most politicians are well intentioned; sadly, those good intentions pave the road to hell (if by “hell” we mean enormous business losses and mass unemployment).

While it is certainly possible for “people to persuade others to do better” (I don’t write this blog as a historical record of my opinions ;o), it is not possible for a command economy to be run more efficiently or to be more beneficial to society than a market economy, and tax-and-spend (or borrow-and-spend) policies are facets of a command economy (even if the rot has not fully taken hold yet).

“[P]eople [can] persuade others to do better” without becoming politicians; the difference with politics is that they need not persuade as they can compel. That tends to go to their heads, so that they start to think that they can save the world.