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The Roots of Governments' Budget Crises

November 24, 2003

Budget crises—at the federal, state, county and municipal levels of government—are routine these days. Although there may be one or two years of surpluses, in most regions they are followed by many years of deficits. If governments were judged by the standards of private firms, most of them would be bankrupt.


However, because they can use the tax collector to obtain funds, or in the case of the federal governments, to print money, governments are nearly immune to the serious adverse consequences of financial mismanagement.


Why do governments get into bad situations so often?  The real problem is not usually out and out corruption. The problem is systemic. Essentially, governments lack the needed basis for assessing the relationship between their resources and their expenses. They are unavoidably ill informed because the means by which that relationship is best understood is plainly unavailable for governments.

The calculation problem

Ludwig von Mises, the leading economist of the "Austrian School," established as long ago as 1920 that for there to be meaningful and useful economic calculation, there must be a free marketplace where people—for whom governments work—can allocate their resources for whatever they deem worthwhile. When they do this, their millions of purchasing decisions communicate to producers in the marketplace what is in demand, what customers will buy, and the relative priorities of various lines of production. Prices provide essential data for assessing the successes and failures of past production decisions, making wise choices during current production schedules, and speculating with sound judgment about future needs.


The system that best communicates this information between buyers and sellers is capitalism. What makes that possible is that people in a capitalist system have a reasonably clear idea of what belongs to them, through the institution of private property rights. So, they know what they can spend and what would break their budgets. Even buying on credit is adjusted to their capacity to carry debts. So, they have a very clear signal warning them about overspending.


When an economic system has this advantage, it is less likely to experience major inefficiencies and vacillations because, on average, people will balance their economic purchases with their available resources. Put that in terms of several hundred million transactions in the marketplace, and you get a very complicated yet smoothly functioning system.


Mises, and his most famous student, Nobel Laureate F.A. Hayek, presented these ideas in the great debate about whether socialist economies can function. As one of the most famous American socialist economists put it: "Ludwig von Mises . . . had written of the 'impossibility' of socialism, arguing that no Central Planning Board could ever gather the enormous amount of information needed to create a workable economic system. . . . It turns out, of course, that Mises was right. . . ." 


That admission by Heilbroner, made in the pages of The New Yorker, came, however, only after the collapse of Soviet style socialism. And the fact that the point applies also to welfare states—the system of government where the state assumes many production and distribution functions that under capitalism would remain in the private sector—was not noticed even by those who saw its relevance to socialist systems. Yet Mises himself, as well as many of his students, realized that any attempt at top down calculation of economic relations would be futile.


The bottom line, then, is that governments have no ability to gauge what they need and what they must deliver, certainly not when it comes to such essentially private sector goods and services as insurance, housing, medical care, transportation, schooling and the like. Whatever reasons might be given for why governments ought to provide such goods and services, there is one that will never be convincing, namely, that they will deal with the economic issues successfully. They just cannot.


The reason is relatively simple: When you deal with funds that aren't yours but rather are collected at gunpoint from others, you never really know what there is for you to spend, on what you should spend it, or what the best means is to do so. This is, essentially, both an economic and moral problem. Those who do not own the resources, and have no access to the signals of profit and loss, have no clear way to know what they ought to do with the resources even if they are in their legal possession. For example, a reporter for the New York Times recently asked a manager for a nationalized Iraqi shoe plant whether the plant was profitable. His answer was that he had no idea. Precisely. Government is in that position all the time.


That isn't all. Another group of economists, lead by Nobel Laureate Jim Buchanan who teaches at George Mason University in Virginia, and his colleague Gordon Tullock, produced a theory know by the name "public choice." The purpose of this theory is to gain a clear understanding of the economic elements of government bureaucracies. Buchanan and Tullock, in their book The Calculus of Consent (University of Michigan Press, 1962), argued that bureaucrats are not unlike agents in a capitalist marketplace, in that they seek to advance their economic objectives.

However, because they do not have the feedback mechanism of the market, nor the budget constraints of market agents, their "profit maximization" procedures are far more unruly than are those of private market agents. Accordingly, government bureaucracies are nearly always mismanaged.  People always spend more than they have, lacking the natural constraints that most of us face as we go shopping.

Perhaps both of these theories will leave many wondering just what impact they have in real life. A couple of examples from my own experience in government service will help answer them.

When I was in the U.S. Air Force, I worked as a civil engineering draftsman. After Christmas each year I suddenly had to work overtime.  There was not an increase in the amount of work and most people just sat around during the day but then went to work from 6–9 p.m., when the overtime would have to be put in. I just didn't understand this—soldiers didn't receive any money from this extra work, so perhaps my curiosity was understandable.


So I asked one of the civilian engineers—some G-14 or such—what's up and got the low-down rather candidly. They needed the overtime income to pay for their Christmas purchases.

There was another thing I noticed. Each time a new budget had to be submitted, suddenly we had to do several rush jobs. Let's build a little flower garden by the main gate or some such thing—never anything very important. Upon inquiring I was told that we needed to spend all the money in our budget so that we could ask for more money for the next fiscal period.


When the issue of state fiscal mismanagement comes up, many look for bits and pieces of evidence of wrongdoing and even corruption. But that is not what makes sense of this recurrent phenomenon. It is the fact that governments as a rule are very bad at economic calculation. They are ill composed for that purpose. All the incentives are wrong and there are no constraints that guide people to be rational about how to spend their resources.


This is why so many countries around the globe are experimenting with privatization—which is the shifting of these kinds of responsibilities from the public sector, which is blind to public needs, to the private sector, which actually possesses the means to be attentive to public needs.


Tibor Machan, adjunct scholar of the Mises Institute, teaches at the Argyros School of Business and Economics at Chapman University. You may send him MAIL and view his Mises.org  Daily Articles Archive

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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