Saturday, February 17, 2007

Understanding Economics: Growth

One of the most important questions that people have about economics is how to promote economic growth.

The size of the economy is measured by the total value of everything produced in a year. This is called the Gross Domestic Product (GDP) or Gross National Product (GNP) depending or whether everything produced within America or by American companies is being measured.

How can economic output be increased? More people could work, and people could work longer and harder. But there are definite limits to how many people can work, and how long and hard they can work. Besides, people want to work less hard and for less time. This is exactly what has happened as our economy has grown.

Another possibility is to increase the population. But this can only be done slowly. In any case, people are generally more concerned with economic output per capita, which is what affects the average lifestyle.

The only way to increase economic output significantly is to work more efficiently. That is, to be more productive.

All else being equal, people can only do so much to increase productivity. The real gains in productivity come from the adoption of new technologies. But new technologies do not invent and employ themselves. Money must be spent up front to try to develop them. This is called investment.

A common economic myth is that economic prosperity depends on cheap low-skilled labor by legal and illegal immigrants. This ignores the productivity of that labor. If having lots of cheap unskilled labor were the key to economic success, then the immigrants' native countries would be rich. Technology and the investment that creates it are what make us prosperous. Immigrant labor does very little to improve the economy and may actually hurt it in the long run by discouraging the need for investment in more efficient technologies.

One of the myths of Keynesian economics is that spending is what improves the economy. One version of this argument promotes government spending. It states that government spending pumps more money into the economy. This creates jobs, and people have more money to spend and improve their lives. They spend their money and the cycle repeats, improving the whole economy.

This argument is a variation of the classic economic fallacy called the "broken window fallacy." In brief, the broken window fallacy states that breaking a window improves the economy because money must be spent to fix it and this benefits the window-maker and others. The problem with this argument is that it ignores the cost of fixing the window. That is, the money used to fix the window could have spent on something else that would have created the same overall benefit for the economy. Breaking the window does not make the economy better off than not breaking the window, and it destroys a window in the process.

The problem with the argument that government spending improves the economy is that it also has a cost. Government can only get money by taking it away from other people. Those people would have spent the money in other ways. Thus government spending provides no net economic benefit.

Another version of the argument that spending improves the economy is that private spending improves the economy. Sometimes this argument comes with appeals to spend more. Other times, this argument is used to support "targeted tax cuts" or "tax rebates," which are one-time cuts in tax rates, sometimes retroactively.

Private spending is certainly better for satisfying people's desires than government spending, since people know their own situations better. But it will not provide a net economic benefit since government is just as capable of spending money.

Increasing spending may improve the economy in the short run, but it must correspondingly depress the economy in the long run, since money that is spent now cannot be spent later.

The real alternative is between spending and saving. Money that is saved can be invested. People can buy stocks directly or through mutual funds. Money that is saved in a bank is invested by the bank, which is how they can afford to pay interest on savings. Individual retirement accounts and pension plans both invest money that has been saved. Insurance companies do the same with money that is paid by policyholders.

Investment is the only real way to increase production and grow the economy. Increasing spending must decrease saving, and hence damage economic growth in the long run.

What about government investments? Government investments do not perform well because government does not face the same incentives as private individuals and companies. Government can fund itself by taking money by force. It does not have the same incentive to use money wisely as do private investors, who will suffer losses from making bad choices. Government has a tendency to continue to pump money into obviously insolvent investments rather than admit that it made a mistake and suffer embarrassment. Investment decisions are often made for political reasons rather than to maximize profit.

These days, it has become fashionable for politicians to talk about "investment," when what they are advocating is simply spending.

Government policies damage economic growth. Taxation necessarily reduces the incentive to make money, which reduces efforts to produce more goods and services. Penalizing profit reduces the value of investments that increase production and improve people's lives. Capital gains taxes are particularly destructive since they specifically penalize investment. Government policies that threaten property rights increase the risk associated with investments and hence discourage them.

The best thing that government can do to improve the economy is to stop hurting it.

3 comments:

The Blogger formally known as Anonymous said...

Please see the posting regarding money for a prime example of the inconsistencies in Allan's economic logic.

Matthew said...

I agree completely, Allan.

ilanit said...

Los Angeles private equity is clearly an industry in a hurry – on just about everything except in admitting its own failings.But their were encouraging signs of humility yesterday from the new "masters of the universe", as committee chair John McFall dubbed private equity witnesses at the committee's first session.