Why Government Spending Matters More than the Size of the Deficit
Budget deficits are often in the media spotlight. The budget deficit is defined as the difference between what the government spends and what the government collects. When the government spends more than it collects, a budget deficit exists. When the government collects more than it spends, a budget surplus emerges.
The conventional view is that one can show that budget deficits reduce national saving. National saving is typically defined as the sum of private saving (the after-tax income that households save rather than consume) and public saving. When the government runs a budget deficit, public saving is negative, which reduces national saving below private saving.
By generating surpluses, so it would appear, the government creates real wealth, thereby strengthening the economy’s fundamentals. This argument would be correct if government activities were of a wealth-generating nature.
Government Spending Doesn't Create Wealth
This is, however, not the case. Government activities are confined to the redistribution of real wealth from wealth generators to wealth consumers. Government activities result in taking wealth from one person and channeling it to another.
Various impressive projects that the government undertakes also fall into the category of wealth redistribution. The fact that the private sector didn’t undertake these projects indicates that they are low on the priority list of consumers.
Given the state of the pool of real wealth the implementation of these projects will undermine the well-being of individuals since they will be introduced at the expense of projects that are higher on the priority list of consumers.
Let us assume that the government decides to build a pyramid that most people regard as low priority. The people who will be employed on this project must be given access to various goods and services to sustain their life and well-beings.
Since the government is not a wealth producer it would have to impose taxes on wealth producers (those individuals who produce goods and services in accordance with consumers’ most important priorities) in order to support the building of a pyramid.
Whenever wealth producers exchange their products with each other, the exchange is voluntary. Every producer exchanges goods in his possession for goods that he believes will raise his living standard.
The crux therefore is that the exchange or the trade must be free and thus reflective of individual’s priorities. Government taxes are, however, of a coercive nature: they force producers to part with their wealth in exchange for an unwanted pyramid. This implies that producers are forced to exchange more for less, and obviously this impairs their well-being.
The more that pyramid-building that is undertaken by the government the more real wealth is taken away from wealth producers. We can thus infer that the level of tax, i.e. real wealth, taken from the private sector is directly determined by the size of government activities.
Observe that by being a wealth consumer, the government cannot contribute to savings and to the pool of real wealth. Moreover, if government activities could have generated wealth then they would have been self-funded and would not have required any support from other wealth generators. If this were otherwise then the issue of taxes would never arise.
The Effects of Surpluses on Inflation and the Money Supply
The essence of our previous analysis is not altered by the introduction of money. In the money economy the government will tax (take money from wealth generators) and disburse the received money to various individuals that are employed directly or indirectly by the government.
This money will give these individuals access to the pool of real wealth that is the total stock of goods and services. Government-employed individuals are now able to exchange the taxed money for various goods and services that are required to improve their lives.
What then is the meaning of a budget surplus in a money economy? It basically means that the government’s inflow of money exceeds its expenditure of money. The budget surplus here is just a monetary surplus. The emergence of a surplus produces the same effect as any tight monetary policy.
On this Ludwig von Mises wrote,
Now, restriction of government expenditure may be certainly a good thing. But it does not provide the funds a government needs for a later expansion of its expenditure. An individual may conduct his affairs in this way. He may accumulate savings when his income is high and spend them later when his income drops. But it is different with a nation or all nations together. The treasury may hoard a part of the lavish revenue from taxes, which flows into the public exchequer as a result of the boom. As far and as long as it withholds these funds from circulation, its policy is really deflationary and contra-cyclical and may to this extent weaken the boom created by credit expansion. But when these funds are spent again, they alter the money relation and create a cash-induced tendency toward a drop in the monetary unit's purchasing power. By no means can these funds provide the capital goods required for the execution of the shelved public works.1
Government Spending — Not Surpluses and Deficits — Is What Matters Most
Thinking that government spending is a wealth generator in itself, some will argue that the proper response to a government surplus shows there is no need to reduce spending, and that taxes should simply be reduced. But, a budget surplus — i.e. a monetary surplus — does not "make room" for lower taxes. Only if real government outlays are curtailed (i.e. only when the government cuts the number of pyramids it plans to build) can tax effectively be lowered. Lower government outlays imply that wealth generators will now have a larger portion of the pool of real wealth at their disposal.
On the other hand, if government outlays continue to increase, notwithstanding budget surpluses, no effective tax reduction is possible; the share of the pool of real wealth at the disposal of wealth producers will diminish.
For example, if government outlays are $3 trillion and the government revenue is $2 trillion then the government will have a deficit of $1 trillion. Since government outlays have to be funded this means that the government would have to secure some other sources of funding such as borrowing, printing money or new forms of taxes. The government will employ all sorts of means to obtain resources from wealth generators to support its activities.
What matters here is that government outlays are $3 trillion, not that the deficit is $1 trillion. For instance, if government revenue on account of higher taxes were $3 trillion then we would have a balanced budget. But would this alter the fact that the government still takes $3 trillion of resources from wealth generators?
We Must Build Wealth Before We Can Spend It
The critics of a smaller government will react that the private sector cannot be trusted to build up and enhance the nation’s infrastructure. For instance, the US urgently requires the building and upgrading of bridges and roads.
There is no doubt that this is the case. However, can Americans afford the improvement of the infrastructure? The arbiter here should be the free market where individuals, by buying or abstaining from buying, decide on the type of infrastructure that is going to emerge.
If the size of the pool of real wealth is not adequate to afford better infrastructure then time is needed to accumulate real wealth to be able to secure better infrastructure. The build-up of the pool of real wealth cannot be made faster by raising government outlays. As we have seen, an increase in government spending will only weaken the pool of real wealth.
The government can force various non-market chosen projects. The government, however, cannot make these projects viable. As time goes by the burden that these projects will impose on the economy through higher ongoing levels of taxes is going to undermine the well-being of individuals and will make these projects even more of a burden.
Spending Reductions Must Come With Tax Cuts
What about the lowering of taxes on businesses – surely this will give a boost to capital investment and strengthen the process of real wealth formation? This is what President Trump is being rumored to be considering. As long as this lowering of taxes is not matched by a reduction in government spending this will encourage a misallocation of capital.
The emerging budget deficit is going to be funded either by borrowings or by monetary pumping. Obviously, this amounts to the diversion of real wealth from wealth generating activities to non-wealth generating activities. Various capital projects that emerge on the back of such government policy are likely to be the equivalent of useless pyramids.
We have seen that one of the ways of securing the necessary funds by the government is by means of borrowing. But how can this be?
A borrower must be a wealth generator in order to be able to repay the principal loan plus interest. This is, however, not the case as far as the government is concerned, for government is not a wealth generator – it only consumes wealth.
So how then can the government as a borrower, producing no real wealth, ever repay its debt? The only way it can do this is by borrowing again from the same lender – the wealth-generating private sector. It amounts to a process whereby government borrows from you in order to repay you.
We can conclude that the only meaningful contribution the government can make to the pool of real wealth, and hence people’s living standards, is by focusing on a reduction in real outlays – not whether there is a surplus or a deficit. This in turn means the government must remove itself from business activities and permit wealth generators to get on with the business of wealth generation.
- 1. Ludwig von Mises, Human Action, Scholars edition, chapter 31, p. 793.