Inefficient government spending

Alasdair Macleod – 19 June 2009
At the end of May, I wrote a note about the damage inflicted by government deficits which referred to the likely deficits in the US over the next four years or so. In that note I suggested that the redistribution of the US’s financial resources from the private sector to the public sector will have a net deflationary effect, arising solely from the less efficient use of the money involved. Since no economists seem to have factored this effect into their expectations, the topic is worth examining further.

The problem arises when the private sector is highly indebted, and unable to generate further economic growth. The public sector is expected to borrow and spend in the private sector’s place to keep the economy going, until such time the private sector can take up the running again. This is the logic behind Keynesian-inspired deficit spending.

In normal recessions, this may work. It is relatively simple to increase the government deficit for a year or two until confidence returns and the private sector returns to normal. The dip in the economy is probably no more than a few percent below trend, so relative to GDP the required government deficit is not significant, and can be corrected over the economic cycle. This time it is different. The recession is very severe at the least, and one suspects the effect on government finances may even be worse than generally expected. The diversion of capital from the private sector to the public sector is now becoming the largest in history, so how well this money is actually deployed is important. Every buck towards economic recovery should be as effective as possible. But as any businessman will confirm, government spending is extremely inefficient, so the question arises, how less efficient is government spending? I put a figure on it of 40% in my note, which felt about right, based on an example I derived from the UK.

In England education is provided by both public and private sectors, so it should be possible to make a simple comparison. Even though government figures are clouded in a thick fog of obfuscation, from various statistical releases it is possible to estimate that the cost of educating one of England’s 3.2 million primary school pupils is about £9,000 per annum, including an apportionment of central costs. In the private sector, school fees for such a pupil average about £6,300, which suggests that the cost of educating a child in the public sector is 43% more than in the private sector. However, this is not like-for-like because education in the private sector is generally better, with lower teacher-to-pupil ratios, better sports facilities, and everything else that comes with a private education. So using simple primary education as our template, we can be confident that what the government does is at least 40% more expensive than the private sector equivalent.

We can now apply this to the division of national resources. In the UK, the Treasury’s borrowing forecasts for this and the following four fiscal years total £703bn, just under 50% of today’s GDP. Taking this money from the private sector therefore implies a net negative effect on GDP of about 20% spread over the forecast period, or 4% per annum – and that is if you agree with the Treasury’s optimistic numbers: if you don’t, the cost could be much more.

The position in the US is at least as bad, as I pointed out in my note at the end of May.

It is interesting to speculate why economists generally miss this point. The most likely reason, besides their seeming ignorance of business, is that they only understand economics in the context of a socialistic or mixed economy, where the fundamental assumption is that economies must be managed. This is so ingrained that the true costs of intervention are never even considered.

Just for fun, ask an economist what he thinks how successful an economy would be if its government’s spending was no more than 15% of GPD. Hopefully he would see the light, but don’t put money on it.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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