Editor’s note: A version of this article first appeared at Forbes.com.
The financial and economic meltdown of 2008 was preceded by large increases in government spending and monetary inflation that artificially lowered interest rates. Those interventionist policies fueled massive capital malinvestment, including housing and credit bubbles, all of which culminated in the greatest economic bust in 80 years. Our rulers’ response has been—you guessed it—large increases in government spending and monetary inflation that artificially lowered interest rates. They think (with apologies to James Carville), “It’s the spending, stupid!” Or, is our problem actually stupid spending?
What gives? Why do so many economists and policy makers think that the solution to our economic woes is the very set of policies that brought on our problem in the first place? Too many believe that the economy is driven merely by aggregate monetary spending as if all such spending is economically equal. E.g., a billion dollars spent on college is the same as a billion dollars spent on cell-phone services, which is the same as a billion dollars spent on farm equipment, which is the same as an equivalent amount spent on government subsidies or on symphony concert tickets.
If total spending is not enough to buy all goods produced at prevailing prices, it is thought the government must step in to prevent recession and unemployment. Keynesians advocate increased government spending and inflationary credit expansion to make up for shortfalls in consumption and investment spending. Monetarists would rely on increases in the money supply to straightforwardly spur consumption and investment.
The trouble is that money per se is not wealth. It matters a great deal how and upon what the money is spent. More spending does not help if, for example, it results in socially destructive consumption and malinvestment. Just ask those in the housing industry.
Prosperity is constituted by consumer and producer goods that people actually desire for use in satisfying their ends. The fundamental economic problem is that all goods are scarce. We cannot satisfy all of our ends with our limited quantity of goods, so we must economize. Scarce land, labor, and capital goods must be used producing those specific goods that are most valued by members of society.
Entrepreneurs discern wise investments from those that are unproductive with the help of economic calculation. They are able to use monetary prices to calculate profit and loss because, in a monetary exchange system, the prices of all goods are denominated in the same good—the monetary unit.
The beauty of the free-market price system is that all prices are the result of voluntary exchange and, hence, reflect the personal preferences of all members of society. If entrepreneurs reap profits, they do so for doing precisely what other people want. If, instead, they make goods for which people are unwilling to pay a price above costs, they reap losses, which serve as a great incentive not to squander scarce resources.
Trying to grow sustainable economic prosperity by resorting to government spending is doomed to failure because bureaucratic spending is not predicated on economic profit-and-loss calculation. During my years at the U.S. Bureau of Labor Statistics, an oft-heard consolation was, “That’s okay. We don’t have to make a profit.” By their very nature, government spending decisions have no regard for profit and loss. For example, Ron Suskind, in his book “Confidence Men,” reveals that President Obama directed stimulus money into infrastructure instead of the health care industry not for economic reasons, but because he thought unemployed men perceived many jobs in health care as “women’s work.” Obama presumed government stimulus had value and decisions were made based on perceived political benefits. That such non-economic investment yields waste and destruction is one of the great lessons of the Soviet experiment.
Monetary inflation is no better at fostering prosperity. When the Federal Reserve encourages monetary inflation via credit expansion, banks artificially lower interest rates. Entrepreneurs are encouraged to undertake many longer-term, more capital-intensive projects than they ought but which appear profitable. Land, labor, and capital goods are squandered in producing things, such as houses, that are valued less than those goods that would have been produced without the monetary manipulation.
Not all monetary spending is equal. Economic prosperity requires wise entrepreneurship. If spending is funded by voluntary saving and invested according to profit and loss considerations, it tends to be productive and hence, add to our prosperity. If spending, however, is funded by coercion and apart from economic calculation, scarce goods are wasted, and the result is relative impoverishment, prolonged recession, and unemployment.