Who's Managing the Economy?

Paul A. Cleveland

Paul A. Cleveland is Assistant Professor of Economics and Business Administration at Birmingham-Southern College

What should the government do to improve our economy? How many times each year is this question raised? Everyone seems to be interested in finding a solution to our economic woes. As a result, our interest in the government's role in the economy is a hot topic especially during political campaigns. During these times we often hear about surveys and polls aimed at assessing the managerial effectiveness of current bureaucrats. Pollsters typically ask the question this way. Do you think the president, or congressman, or senator, or whichever politician we care to name is effective in his or her management of the economy? To this question the respondent is merely to answer yes or no.

But this kind of question is highly misleading because it presupposes that it is the government's role to somehow manage the economy. What if the reality of the situation were that no government could effectively accomplish this undertaking? Further, what if in reality any governmental action aimed at economic management was sure to cause economic distortions which would have to be overcome later? If this is the case, to ask the question of whether old so and so is doing a good job at something that cannot be done is superfluous. The real question then becomes, has this particular politician's policies and actions been more or less damaging to the operation of the economy?

This should be the real focus of debate and yet it rarely is. Somewhere along the way Americans have forgotten not only how economies work, but also the proper role of government. Economy is a natural part of life. As we all know, there simply are not enough resources and products available in the world for us all to have all we want at a zero price. The reality is that resources are scarce relative to our wants and desires; therefore we are forced to make choices as we seek to satisfy our wants. Choosing one alternative generally means giving up a host of other options. In our choices we first satisfy those desires that we find most pressing.

The development of free markets offers one means by which individuals seek to satisfy their wants and desires. Their rise allows individuals to produce and trade amongst themselves those things that they individually find most valuable. When left unrestricted, prices of goods and services reflect those values and send signals to all individuals about what is profitable and what is not. As a result of this voluntary interaction, the wants and needs of individuals are satisfied (though not perfectly satisfied) with greater and increasing regularity than could be achieved under any other alternative including either self-sufficiency or central planning. Furthermore, in unrestricted, voluntary exchange, the imperfections of the market really provide opportunities for entrepreneurs to meet the frustrated desires of individuals. This is the basis for pursuing greater prosperity and for economic growth.

What then is the government's role? Some people argue that it is the government's role to stabilize the economy and ensure full employment. However, I do not think that governments will ever be able to successfully eliminate all unemployment in any real sense, nor do I think that governments need to target some level of aggregate expenditures for such purposes. Instead, I think the government's role with respect to the economy is merely to protect the property rights of its citizenry. It is not the state's role to guarantee employment, or to control the nation's money supply, or to attempt to plan some aggregate level of national consumption. Rather, as it relates to the economy, government is merely an agency set up to protect the rights of those who have property against the desires of those who do not have property to steal it from them and to serve as a final mediator in disputes which cannot otherwise be resolved. Any government meddling beyond this will lead to distorted market signals, malinvestment, and ultimately a period of hardship when resources must be reallocated from the poor investments individuals undertook due to their misperceptions of actual market conditions. If this is the real situation, then calls for better governmental management of the economy are fundamentally flawed if by management we mean the active intervention of government in private exchange and meddling aimed at targeting some economic aggregates.

Let us reason together about my assertion. First consider why governments exist.{1} They exist because of human nature. Regardless of what some may say, people are not predisposed to doing the right thing. A simple walk through history reveals the horrors that humans have inflicted upon one another. Since people are prone to do violence to others, to injure others and their property, governments have arisen as a source of protection. Governments therefore use the threat of force to protect the lives and property of its people from those who would do them harm.

It is this necessity which illuminates the nature of government to us. Specifically, government is an agency of force seeking to deter certain types of behavior so as to maintain the public peace and promote justice. The very concept of justice has traditionally been interpreted as the occasion when people are able to receive their due. On the basis of this concept the founders of our country laid the principles for our nation. Thus they specifically advocated the protection of our lives, our liberty, and our property rather than a bureaucratic array of entitlement programs. Within this context we can then consider the question of the government's impact on the economy.

Government actions and policies use resources. These resources must be paid for and the money to pay for them is either raised through taxation or borrowed from private lenders. As such, government spending poses a burden upon the economy for someone must pay for the expenditures. Suppose you were in business for yourself. If your rate of taxation increased wouldn't you be more hard pressed to make ends meet in your business? Or, alternatively, wouldn't your business find it more difficult to survive if market rates of interest rose as a result of increased government borrowing? The obvious answer to both of these questions is yes. At the margin then, increased governmental expenditures come with a price of destroying marginal business operations. Those marginal businesses are the very ones which provide viable incomes for the poorest segment of the nation's population. Therefore, the key to good government, from the standpoint of promoting economic success, is to minimize the need for and size of government. It is not good government to expand its operations to ever more and more areas of control and thus destroy the opportunities of its citizenry to ever greater degrees.

Unfortunately for the United States, it appears that John M. Keynes has successfully challenged the foundational ideas upon which the country was established, for no one seems to understand that the very structure which made America great economically is being undermined in our day. The Keynesian concept of course is that the government is responsible for stabilizing the economy when aggregate demand falls short of levels which would guarantee full employment. However, this analysis begins with a subtle implicit assumption that the government is "able to fool all of the people all of the time."{2} To understand this let's consider the rise of Keynesian thought.

Keynes was of course hocking his wares during the Great Depression. The Depression in his view was the result of market failure. As such, he promoted a view that government action was necessary if full employment in the economy was to be restored. He arrived at his result by making several key assumptions. He assumed price inflexibility (at least in the downward direction) which could lead to surpluses of products and resources and a aggregated fixed capital stock which was only altered for psychological rather than economic reasons. By aggregating all other spending variables he was then led to conclude that government spending is needed whenever there is a supposed "short fall" in aggregate spending caused by an autonomous decrease in consumption. This action, he assures us, will restore full employment.

The whole concept of the excess supply of products and resources is never sufficiently discussed because they are embedded in the aggregates. However, it seems quite important to ask those questions. Were all products and resources in surplus supply? If not, why not? Also, is it impossible to determine why wages failed to fall or why unemployment continued for such an extended period of time during the Depression? And, was the Depression really just a matter of too little spending? Had all the wants and desires of people during that time really been met to such a degree that they ceased to spend money on goods and services thereby sending the economy into a downward spiral? Finally, why did certain types of capital sit idle while other capital projects continue unabated? The Keynesian explanation is superficial at best. Perhaps the problem of this superficiality is that the real explanation cannot be discerned once it is masked by aggregation.

The works of F.A. Hayek and Ludwig von Mises offer a far superior explanation of the causes of business cycles, especially the events leading to the Great Depression.{3} These writers offer a far more plausible explanation of the economic decline. They argue that economic downturns are most likely to result when individuals have made their plans based on false signals. These false signals arise from the many governmental programs or manipulations of the economy which artificially alter prices. For example, suppose the Federal Reserve System should undertake a process of credit expansion. This activity initially gives the appearance of greater saving activity in the economy. As such, interest rates fall as more credit is available. Business firms respond to this reduction by undertaking long term capital projects which now appear profitable because of the new lower rates of financing for these capital programs. However, the substance (or what we might call the real resources) of saving necessary to sustain these capital projects is simply not present. As a result, at some point in the future it will become clear that the resources to complete these projects simply are not available. The price of borrowing will then be driven up as business firms compete for funds to complete their projects and only those programs which are most profitable will be successful. The remaining failed projects must then be liquidated. However, due to the heterogeneous nature of capital, the process of liquidation will be disruptive to the economy. Furthermore, some of the capital may be so specific as to represent sunk costs which cannot be retrieved.

The point of this explanation is, nevertheless, quite clear. Any attempt by government bureaucrats to manipulate economic activity will at best be successful for only a short period of time. Any artificial boom created by government will necessarily be followed by an economic bust when the essential nature of the underlying elements of the economy are revealed. As Lincoln said, "You can't fool all of the people all of the time."

This brings us back to the original question. Who's managing the economy? The answer is that a market economy is managed by all of its participants through the process of exchange. If the government protects, rather than abuses, the property rights of its citizenry, then the stage is set for economic growth. In protecting these rights, the government's goal must be to minimize its size in order to limit any distortions it may create so that market prices provide true signals to the participants. In this environment, individuals can more effectively plan their productive efforts and coordinate them with the wants and desires of others.


{1} Clarence B. Carson's, Basic Economics, American Textbook Committee: Wadley, Alabama, pp 19-29, provides a good outline for addressing this issue and the presentation here is formulated on the basis of his work.

{2} This analogy is obviously a twist on Abraham Lincoln's statement, "You can't fool all of the people all of the time." I first heard Roger Garrison of Auburn University use this phrase in a presentation he made at the Foundation for Economic Education in the summer of 1992. See D.M. Bellante and R.W. Garrison, "Phillips Curves and Hayekian Triangles: Two Perspectives on Monetary Dynamics", History of Political Economy, 20.2 (Summer), 1988, footnote 11, p.214.

{3} Of particular interest are F.A. Hayek, Prices and Production, (1931; New York, 1967) and Ludwig von Mises, The Theory of Money and Credit, trans. H.E. Batson (New Haven, 1953). An excellent article on the subject is by Roger W. Garrison, "Intertemporal Coordination and the Invisible Hand: An Austrian Perspective on the Keynesian Vision", History of Political Economy, 17.2 (Summer), 1985, pp.309-21.