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June 18th 2013 print

Peter Smith

A plague of bad economists

How can it be that the dominant voices directing policy in Australia, the US and almost everywhere else do not grasp the difference between producing chocolate and eating it?


Personal circumstances of an unfortunate kind have me temporarily without Foxtel and thrown to the mercy of free-to-air TV. Oh ,the ads; please stop the ads! Anyway, some investment bank or other (no names, no pack drill) was hawking its wares the other night and thought fit to have its economist, in an introductory gravitas-adding segment, give his learned views on the latest GDP numbers. Having told us that GDP grew by 0.6% in the March quarter and 2.5% over the year, he said that higher growth would depend on increases in business investment and consumer spending.


He didn’t miss a beat in going from business investment to consumer spending. Thankfully he didn’t mention government spending as needing to rise. To that extent he displayed, I think, a little more economic sense than the IMF.

Before getting to the IMF’s latest attempt to subvert economic growth, it is instructive to understand the profound difference between business investment and consumer spending. They are not the same. One is the wellspring of producing more goods and services; the other eats them up. Eating fish is nutritious and pleasurable but it is not the same as constructing boats and weaving fishing nets (business investment) to catch them. The latter comes before the former.

I am sorry to do this again, and put down a famous man who can’t defend himself, but it’s Keynes’ aggregate demand that is responsible for churning out plagues of idiot economists year after year. If you think aggregate demand (loosely speaking, total spending) drives economic growth then the content of the spending doesn’t matter. As Paul Krugman has told us, don’t worry about what government spends money on so long as it is spent.

Let me appeal to common sense. Do you think you would be contributing to economic growth if you were to eat a giant box of chocolates? Certainly your stomach might grow, but would the economy? Leave aside the possibility that the chocolates were made in Belgium and consider this: in buying the chocolates you would be using money that you might otherwise save. If you were to save the money it would provide the wherewithal for businesses to borrow and invest and grow the economy.

Now there are two essential sides to an economy: the producing side and the buying side. Both are necessary. But, once we understand that our wants are boundless (hands up those who couldn’t spend an extra few thousand a year), we are inevitably led to putting emphasise and primacy onto business investing and producing not onto willy-nilly spending; particularly not onto consumer spending; nor onto government spending. Consumer spending and most government spending eat up production; they don’t add to it.

The IMF, staffed with “brilliant” (i.e., they got top marks at uni) Keynesian economists, is apparently oblivious to the distinction between production and aggregate demand. This allowed Christine Lagarde and her IMF economists to claim last week that the United States government’s deficit reduction in 2013 has been excessively rapid and ill-designed. In particular, the automatic spending cuts (“sequester”) not only exert a heavy toll on growth in the short term, but the indiscriminate reductions in education, science, and infrastructure spending could also reduce medium-term potential growth”.

Every dollar government spends uses resources that could be better used by the private sector. Why is this? It is because business is punished if it produces things that don’t create more value than the resources used in their production. Government on the other hand faces no such sanction. It can destroy value with impunity, for example, by installing pink batts and building redundant school halls.

Of course, it is not wholly true that government always destroys value but it is, nevertheless, a pretty good approximation of the truth. So exactly what is the IMF on about? What causes it to arrive at the conclusion that a government, spending each year more than a trillion dollars more than it raises in revenue, is remiss if it cuts growth in expenditure by a small fraction of this. In this case by 1.2 trillion, evenly spread over nine years from 2013 to 2021.

Well, first, its macroeconomic model tells it that each dollar reduction in government expenditure cuts GDP; and, moreover, by more than the dollar. Second, it is besotted by the immediate future.

The first is simply based on statistical error. Correlation is mistaken for causation. A relatively synchronous path of government expenditure and GDP is interpreted as causation. If you doubt the existence of such naivety you haven’t been keeping up with the climate debate. In the case of economics, interpretation of the data in this way is axiomatic; it follows from the Keynesian paradigm.

As to the second, being besotted by the immediate future may be a product of our impatient age. It is obvious that the withdrawal of wasteful government expenditure will be disruptive. The IMF was apparently surprised at the extent of the effect on economic growth of austerity measures in Europe. The process can be likened to withdrawing alcohol from an alcoholic. The initial effect is not pretty. It has to be given time. Equally, withdrawing government expenditure is painful but it is a prerequisite for the resumption of healthy and robust economic growth.

While we have economics dominated by individuals, and organizations like the IMF, that seem not to understand the primacy of business investment and production in generating economic prosperity, the emphasis of economic policy will continually be misdirected to the demand side of the economic equation. Economic salvation lies on the supply side. The keys are to give business the scope and freedom to invest by cutting the government’s claim on resources and by reducing regulatory obstacles to hiring labour, developing and using resources, and exploiting opportunities. Demand can be left to take care of itself.

Peter Smith, a frequent Quadrant Online contributor, is the author of Bad Economics

Peter Smith, a frequent Quadrant Online contributor, is the author of Bad Economics