No, the state doesn’t create wealth

No, the state doesn’t create wealth / 2018-11-29 / Nick Sallnow-Smith

A good friend of mine recently sent me an article entitled “Yes, Government Creates Wealth”. He did this tongue in cheek because he knew I would object to the idea. But rather than throw the piece in the litter bin, I thought I should have a serious look to the arguments of the “pro-state” folks and assess them.

One reason I did so is that the view of the writer (who had written a book on the subject from which the article was an excerpt) is so common. In fact, her approach appeared to be an earnest attempt not only to legitimise current levels of state spending, but to argue for the need for much more. Shocking as it may seem for those of us who believe the state element in all developed economies is much too large, this author urges states to be more “bold” and increase state investment and intervention in economies. But how did she justify this incredible idea? She does so by not attending at all to the key question of what creates wealth, and the related question, how do you know when wealth has been created? She simply assumes than whenever the State invests or intervenes, wealth is inevitably created.

She refers to three ways in which she claims the state creates value. The first – amazingly enough – is by bailing out banks! This is, to her, self evident creation of value. Yet allowing failed businesses to fail is essential to the creation of wealth. Let’s start from how we can assess whether wealth has been created. If a businessman creates a product or service for an input cost of $100 and finds buyers in a competitive market (without coercion) willing to pay $120, then he has created value of $20. If he cannot find willing buyers above, say, $90 then not only will he make a loss but he has destroyed value. The $100 of resources he has used might have been used productively in other ways. The function of profit and loss accounting is to tell the businessman whether he is using resources effectively or not. Business failures are crucial, so that resources can be redirected to profitable uses where value is being created, not destroyed. For the author of this piece to believe bailing out failed banks creates value is astonishing. No doubt she believes any economic downturn that results from large bank failures must be avoided at all costs. But the opposite is true. Once you prevent failure for the sake of “the market”, you ensure there is no effective market any more; no proper test of value creation. Bailouts subsidise value destruction.

The author’s inability to assess how wealth is created is underlined by her later examples of states creating value. Investing in infrastructure, education and science, and funding technologies, are also claimed to create wealth. Well they might, but how does she know? None of the output is sold in a free market to willing buyers. The value uncoerced buyers would place on these outputs could be less than the cost. Yet the writer never even asks this question, she simply assumes all government spending is valuable. Her complete failure to ask the most basic question is underlined when she complains about the national accounts. She notes that state spending is credited only at the level of government expenditure. Yet state investment, she notes, involves taking risk (true enough) which, she then assumes, must create value in excess of the cost. To calculate this value, she argues that If the private sector on average creates a return of a particular percentage, she can apply that percentage to government spending and thereby calculate how much wealth the state has created. It simply does not seem to occur to her that state spending might be loss making.

Consequently, she argues that because of the “failure” to give credit for the value of Government spending, the “true” importance of Government in the economy is “obscured”. Yet rather than trying to assess this “importance” objectively, she simply assumes it is positive. But since parts of the private sector do actually make losses and destroy wealth, on what basis could you claim that state spending never does.

That an university professor of economics can write an article of this nature is frightening. Not only because it shows the intellectual poverty of some universities today. But because books like hers will be used as “academic” support for more state spending. Governments will claim they are empowered to spend more, because, “academic studies show”, it creates wealth. The writer criticises civil servants for being too unsure, too fearful of making mistakes! Since according to her analysis ANY state spending generates value, states must be bold. And not only states. The private sector is also urged to accept loss making activities urged on them by the state, for similar reasons. The value creation of these loss making activities has been “obscured”, she argues, so that private sector must also be urged to be bold, and invest in more loss making activities.

In a world where the size of the state and the weight of regulation on the private sector has driven down growth, decade by decade ( the EU being a prime example), to have the academic world urging more loss making spending on both the state and private sector is like economic bloodletting. If it’s not working, this must mean the quack has not drained enough blood yet!

I started this piece with a simple outline of how we know value has been created. Will a willing buyer pay more than the product’s cost of production or not? A significant problem today in using this assessment of whether resources are being channeled by the market into productive ends, is the sheer scale and range of state interventions we already face. These interventions corrupt the free market pricing of resources. As a example, what would be the free market wage of a teacher, with no government schools? No one knows.

The writer raised the bank bailouts. But not only banks are bailed out. Remember AIG, General Motors, investors in Lehman minibonds, and many others. Beyond financial interventions, regulations often prevent new businesses from competing with incumbent business which are using resources poorly. (Taxis/Uber?)

It is vital for all of us to remember, not only that the state does not create wealth (or if it does, you cannot tell) but that so many of its activities prevent price signals from working effectively in the so-called private sector. The cost of this is indeed “obscured”. That is where the real failure to create wealth can be found. Not in the lack of “boldness” in the state, holding back from commanding even more of our society’s resources than it does already. But in the corruption of free market signals due to the extensive and ever growing public policy of interference.

Nick Sallnow-Smith


PS If any reader wishes to know more about the article to which I referred above, please contact me and I can provide the link. The amazing absurdities of the claims made in it are even more extensive than I have covered here.


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