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Why Does Government Overspend? Because It Has Too Much Power
John Maynard Keynes is credited with once remarking about fiscal policy: “You cannot make a fat man skinny by tightening his belt.” Such a dilemma is precisely what confronts Europe and the United States at the moment. Government obligations have simply outstripped the fiscal ability of the economies to generate the revenue to pay them. That is, indeed, not a problem of belt tightening. The problem is not so much that the scale of government has gotten out of control, but rather its scope. Yes, government spending is bloated, but that is the symptom, not the cause. The cause is the expansion of the scope of government controls in the economy. Obligations that were once left to private citizens and their local communities (including churches and other institutions of civic association) have been assumed by the governmental authorities. No squeezing and tightening of the belt will make this fat man skinny. The only way to do that, to push Keynes’ analogy, would be for the fat man to become lean through exercise and diet and then the belt will tighten as a natural consequence. The debate over austerity—budgetary political tricks aside—misses the essential point that must be discussed: The challenge is not starving the state of resources, as much as starving the state of responsibility.
But such a reassessment of the state is at odds with the breakdown of the constraints on government spending. Adam Smith pointed out that governments—ancient as well as modern—had consistently engaged in a “juggling trick” of running deficits, accumulating public debt, and then attempting to pay off those debts through debasement of money. The cycle of deficits, debt, and debasement is a governmental habit as old as the exercise of political power itself. Only if the ruler’s hands are effectively tied will this endless juggling cease. Constitutionally constrained government emerges as a result of the effort to limit the scope of governmental power. The effort to constrain the power of the state can be traced from antiquity to today, but the historical record provides only fleeting examples of success.
Unless the state is effectively constrained, fiscal irresponsibility will destroy the long-run viability of the political and economic order. If we take the desire to spend at will as a government habit that exists across time and place, as Adam Smith so urgently warned his readers about, and combine that with both the electoral logic of democratic politics and the vote motive faced by citizens within a modern democracy, then the necessity of effective constraints on the fiscal behavior of government is as true for democracies as it is for kingdoms or even dictatorships. It doesn’t matter if citizens have the right to voice their opinion on fiscal irresponsibility. The bias in democratic decision making is to concentrate benefits in the short run on the well-informed and organized interest groups, and to disperse the costs in the long run on the unorganized and ill informed. In this way, good politics is not necessarily good economics. Or to think about it another way, fiscal irresponsibility may be extremely popular politically and fiscal responsibility may be extremely unpopular, but that doesn’t change the reality that fiscal irresponsibility is irresponsible.
As economist Richard Wagner has so aptly put it, responsible budgeting may very well be a casualty of rational politics. It is a staple of political and economic thought that the persistence of a pattern in human affairs over time reflects some systemic incentive in the institutional framework. “During the first 150 or so years of the American republic,” Wagner writes, “that pattern conformed largely to the budgetary principles of sound finance.” Following Adam Smith’s wisdom that “what is prudence in a private family could scarce be folly in a great kingdom,” the American republic ran deficits during times of war and depression, and surpluses recorded during normal times were used to reduce the debt. This pattern changed in the past 60 years. The principle of responsible budgeting was replaced with functional finance, according to which “the condition of the budget, whether in deficit or surplus, should be whatever is necessary to promote full employment, however this might be defined.”
Keynesian fiscal policy supplanted the “old-time fiscal religion” of classical political economy. Government spending became a goal unto itself in this political-economic mindset as politicians became unconstrained from the heritage of the historical fiscal constitution of budgetary balance. The public debt problems that confront Europe and the United States today did not emerge in the past 10 years. The problem is deeply rooted in the interaction between Keynesian policies and the systemic incentives of democratic politics. “From Roosevelt’s New Deal onward, elected politicians have lived with the demonstrated relationship between favorable election returns and expansion in public spending programs,” write Nobel-prize winning economist James Buchanan and Richard Wagner. Vote-seeking politicians would be acting against their self-interest within this environment by advocating fiscal restraint and responsibility. “Sober assessment,” Buchanan and Wagner conclude, “suggests that, politically, Keynesianism may represent a substantial disease, one that can, over the long run, prove fatal for a functioning democracy.”
The problem is not just that the incentives within the democratic process produce shortsightedness in policy and bloated bureaucracies. As responsible public finance was replaced with functional finance aimed at macroeconomic management of aggregate demand, the relationship between the government and the economy shifted drastically. Government was no longer seen as a referee but instead became an active player in the economic game, and in fact became the overlord of the economy. “Functional finance,” Wagner observes, “is the fiscal component of the Progressivist political agenda of a government that is unlimited by any constitutional limit on its scope of activity.” What is expected of government in meeting the demands of citizenry shifted drastically in the wake of the Keynesian erosion of the fiscal constitution. Adam Smith’s “juggling tricks” were no longer avoided, but instead embraced.
The economist Albert Hahn identified the fundamental flaws of Keynesianism in his book The Economics of Illusion. In order for Keynesian remedies to have the force required, argued Hahn, the participants in the economy must remain ignorant of the policy steps being taken and their impact on economic factors. As Hahn put it, Keynesian thinking ignored the potential “compensating reactions” that arise as a response to the manipulation of monetary and fiscal policy. An inflationary theory of employment cannot solve the problem of unemployment any more than government spending can be the source of long-run economic growth and development. The belief that such discretionary and expansionary monetary and fiscal policy can correct flaws in the economy is the “economics of illusion.” Economists trained in this tradition, said Hahn, “seem to have lost the ability to think along classical lines.” They are preoccupied with demand management and thus ignore the long-run costs of these policies.
Hahn was critiquing not merely economic forecasting, but the general exercise of trying to manage demand. “As long as the world is not entirely totalitarian,” he wrote, “neither the objective data of the future nor the subjective reactions of millions of individuals can be predicted.” The economics of control in a real economy, as opposed to an abstract model, is an impossibility and incompatible with any notion of economic freedom. You can fool some of the people some of the time, but you cannot fool all of the people all of the time.
The logic of democratic politics that emerges from the interaction between vote-seeking politicians, and rationally ignorant, rationally abstaining, and specially interested voters is to concentrate benefits on well-organized and well-informed groups (who will provide campaign contributions and votes) in the short run, and disperse the costs on the unorganized and ill-informed (who are either not paying attention or are mistaken in their understanding) in the long run. Deficits and accumulated public debt are perhaps the best illustration of this logic playing out. Who pays for what and when?
The shift in the implicit constraint on fiscal policy that was wrought by the Keynesian revolution (or Keynesian confusion, as Hahn called it) has changed the behavior of politicians and citizens over the past 60 years. As Wagner has stressed: “A recipe for prudent fiscal conduct for an individual within a regime of wholly private property might be revised when society governance proceeds with an admixture of private and collective property.” The expansion of public services since 1950 has been very popular among the electorate, but the costs of those policies have been hidden by economic growth, intergenerational transfers, and budgetary tricks. As economists Laurence Kotlikoff and Scott Burns argue in their recent book The Clash of Generations: “Thanks to six decades of incredibly profligate and irresponsible generational policy, we can declare, The United States is bankrupt.” And, as they add, it is not bankrupt years from now; it is bankrupt right now. By their estimates, the true indebtedness of the United States is $211 trillion—the fiscal gap between the present value of future obligations minus future tax receipts.
Kotlikoff and Burns reach that figure by including various unofficial spending obligations that the government has assumed but kept off the books. In their narrative of our budgetary woes, these are mainly obligations to senior citizens, as political promises have resulted in “turning retirement into a well-paid, long-term occupation.” And these seniors are an extremely powerful interest group and have successfully lobbied to make sure that they get what is “owed” them, including having their benefits fully adjusted for inflation.
The economics of illusion, in other words, has been checkmated in this instance. Adam Smith’s “juggling trick” of deficits, debt, and debasement has been truncated because the ability to inflate away the debt obligations has been limited with inflation adjustments built into the benefits package owed. Putting aside the issue of the costs associated with inflation to erode debt obligations, there is now the need to confront the consequences of the “profligate and irresponsible” fiscal practice. Adam Smith argued that the least dishonorable and least harmful policy a government could pursue in such a situation would be repudiation. But given the cultural situation in Europe and the United States, the rupture of the relationship between the citizens and the state that would result is perhaps too severe for any politician to accept.
As economist Luigi Zingales described the problem:
Keynesianism has conquered the hearts and minds of politicians and ordinary people alike because it provides a theoretical justification for irresponsible behavior. Medical science has established that one or two glasses of wine per day are good for your long-term health, but no doctor would recommend a recovering alcoholic to follow this prescription. Unfortunately, Keynesian economists do exactly this. They tell politicians, who are addicted to spending our money, that government expenditures are good. And they tell consumers, who are affected by severe spending problems, that consuming is good, while saving is bad. In medicine, such behavior would get you expelled from the medical profession; in economics, it gives you a job in Washington.
Expectations in Western democracies are for government to protect citizens from the vagaries of nature and the market; citizens are expected to be educated when they are young, and protected when they are old. Public sector employment during the past 60 years was transformed through lobbying efforts from a secure though low-paying job to a secure job that paid the going rate on the market and provided a lucrative retirement package.
Blaming public unions for asking for improved benefits for their members or blaming elected officials for responding to those demands in order to win votes is like criticizing a wasp for stinging you when you step on its nest. The problem isn’t the people; it is the institutional regime that produces this pattern of behavior.
A Half Century of Fiscal Irresponsibility and Counting
The economics of control and effective demand management have not only proven to be elusive in the success of their intended practical application, but also possess long-term costs that have not been adequately accounted for in the decision-making process. The economics of illusion in practice results in a perpetual trading off of short-term economic emergency responses for long-term economic health. The cauldron of politics in times of perceived economic crisis is the worst place to expect sound economic policy to emerge. As economist Henry Hazlitt put it: “Emotional economics has given birth to theories that calm examination cannot justify.”
The idea that extraordinary circumstances may require a commitment to ordinary economics simply hasn’t resonated with politicians, the public, or the economics profession as it evolved in the second half of the 20th century and continues to evolve to this day. But a return to the basic teachings of economics from Adam Smith to Friedrich Hayek is what is required. This “mainline” of economic science stressed the role of property, prices, and profit/loss accounting in structuring incentives, mobilizing dispersed knowledge, and providing the required feedback to spur innovation and discipline wishful conjectures. It is within the institutional context of a private property market economy that the striving of individuals to better their own condition is transformed into publicly desirable outcomes. The “invisible hand” is a structure-induced outcome, and it does not require for its realization either perfectly rational actors or perfectly competitive markets. For Smith, as well as Hayek, the invisible hand mechanism operates in a world of very imperfect human beings interacting in a very imperfect world.
This understanding of the “mainline” of economic thought was lost during the Great Depression. A new “mainstream” of economic thought and public policy emerged and announced the end of the classical liberal political economy of Smith, Say, Ricardo, Mill, Bohm-Bawerk, Mises, and Hayek. This “mainstream” held that laissez faire was viable only in a world of perfectly rational individuals interacting in a perfectly competitive market. Laissez faire policies were appropriate only for the simple environment of a perfect world. But the modern world had introduced a new complexity along with the great material progress achieved. The economy was now prone to the abuse of monopoly power, the injustice of income inequality, the inefficiencies of external economies caused by urban living, and the instability of macroeconomics that resulted in the wretched threat of mass unemployment. As a theory, Keynesianism filled an important void because it offered an explanation that unified the greatest resentment of modern capitalist society—the idle rich—with the great fear of capitalist society—mass unemployment. And Keynes’s Cambridge colleagues also provided the theories of microeconomic inefficiency due to monopoly power, including the theory of imperfect competition, and the theory of externalities and market failure. By the mid-1940s, all the pieces of the “New Economics” were in place, and “Orthodox” or “Classical Economics” was held to be in disrepute.
The older orthodox position that maintained that the public debt should follow responsible budgeting principles was overturned in favor of the new theory of functional finance. This “New Orthodoxy” argued that deficits and debt should not be balanced per se, but should be whatever was required to meet the policy objectives established by the government. Government spending became an end unto itself as a tool for maintaining full employment and macroeconomic stability. By 1950, this understanding of the role of government within the economy was deeply embedded in the mindset of politicians, the public, and the economics profession. The new mainstream of economic thought deviated significantly from what had been the mainline of economic teachings for the previous 150 years or so. The culture of government spending unconstrained by any notion of responsible budgeting resulted in a significant expansion of government throughout Europe and the United States.
Toward a Fiscal Constitution for a Free and Prosperous Republic
Thinking through how we might transition from our current situation of fiscal irresponsibility to one of responsible budgeting requires first that we recognize that the problem is not a purely technical one, but ultimately a philosophical, cultural, and institutional one. Philosophically there needs to be a new consensus on a much more limited scope for government. To invoke the earlier analogy Keynes used, you cannot make a fat man skinny by tightening his belt. The challenge is not to starve the state of resources, but to starve it of responsibility. Government must simply be called on to do less, individuals and their communities called on to do more.
Culturally there has to be a renewed appreciation for the self-governing capacity of human beings, and the citizens within the democratic order must embrace, as Tocqueville said so aptly, “the cares of thinking and the troubles of living.” A citizenry capable of self-governance helps democracy work, not by aiding the political process, but by circumventing politics and living a truly democratic life in relation with one to another.
Finally, even in the wake of a philosophical revival of limited government, and a cultural reawakening of democratic self-governance, the institutional structures of the state must be designed to constrain the natural proclivities of politicians. The philosopher David Hume argued long ago that in designing institutions of governance, the analyst must presume that all men are knaves. We must never forget the fundamental problem that government introduces into the question of social order and our ability to live better together—namely, that in our effort to curb private predation, we turn to the creation of the state but in so doing we create the very real threat of public predation. The fundamental paradox of government as recognized by the Founding Fathers was that a constitution must first empower government, and then constrain it.
This institutional puzzle is solved by thinking seriously about countervailing forces. As Alexander Hamilton put it, use ambition to check ambition. The organization of government that James Madison crafted had built-in checks and balances, and sought to limit the ability of political factions to ease those checks on the accumulation of power and favor.
James Buchanan put the puzzle of the paradox of governance in a more modern context: Can we establish a protective and productive state without unleashing the redistributive state to play havoc with our political order? Just as Hayek reluctantly had to conclude that the noble and inspiring project of the U.S. Founding Fathers to limit the rule of factions had failed, we must conclude that Buchanan’s puzzle has not found a successful solution yet in either theory or practice.
The fiscal difficulties faced by the countries in Europe and the United States did not emerge overnight, but are the consequences of decades of public policy. Keynesian economics as a tool for public policy and as an intellectual justification for the existing proclivities of politicians effectively relaxed if not eliminated any of the pre-existing constraints on fiscal policy; the decades of profligate and irresponsible spending have adversely impacted not only public-sector but private-sector behavior.
It’s the culture, stupid! The culture of the Western democracies that emerged in the wake of the Keynesian revolution and the pursuit of the economics of illusion threaten to destroy free market capitalism and with that the long-term prosperity of the Western democracies of Europe and the United States. James Buchanan described himself as an optimist when he looked backwards and a pessimist when he looked forward—an optimist because things hadn’t gotten as bad as he had predicted, but a pessimist because the situation was indeed bleak.
In the second half of the 20th century, technological innovations combined with the opening of new trading opportunities (namely China, but also India) produced economic growth that effectively masked—and thus sustained—the dysfunctions of our fiscal practice. But the dysfunctions are real and the bill is due. We cannot kick the grenade down the road any further. The 60-year exercise in “fiscal child abuse,” as Kotlikoff calls our fiscal practice, must finally come to an end. The demographics don’t line up; the numbers don’t add up.Dr. Boettke is the BB&T Professor for the Study of Capitalism and the Vice-President and Director of the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center, and a professor in the economics department at George Mason University. This article is adapted from a talk he delivered at a meeting of the Mont Pelerin Society in September 2012.