When government stimulates economic activity it can turn sheep into chickens

If credit extension to, and funding of bankrupt and failing financial institutions and private corporations by government were the solution to the global financial crisis and a means to invigorate the world economy, within a short space of time, the world would be rid of all economic problems and unemployment and poverty would be gone forever. But, contrary to the current popular remedy, government stimulus of the economy does not promote economic growth. Instead, it destabilises the economy and leaves everybody worse off.

The only money that government has to spend is what it takes from its citizens by means of taxation, or borrows, or creates by increasing the money supply. To the extent that citizens and businesses are taxed, spending and investment by those citizens and businesses is curtailed. When government borrows money, it is the taxpayers who have to repay the loans. When government inflates the money supply, the greater amount of money in the economy relative to goods and services causes prices to rise and everyone ends up poorer.

Imagine a simple economy that is based only on direct exchange and assume a tax rate of 10 percent. A sheep farmer raising an additional hundred sheep in a year would pay tax in the form of ten sheep. Some of those ten sheep would be used to pay government officials, and the remaining sheep would be used to pay anyone else who provided a public service, say, someone contracted to build a bridge over a river.

Assume that government decides to stimulate struggling sectors of the economy. To do so it increases the tax rate to 15%. In our example the successful sheep farmer now has to pay 15 sheep, instead of 10, in taxes. Government redistributes the additional tax (sheep) to struggling sectors of the economy that it believes need stimulation. The effect of the increased tax rate is to reduce meat and wool production.

While some of the recipients may actually try to farm with the sheep, others may choose to consume them or trade them for something else, such as chickens. The additional demand for chickens causes poultry prices to rise, makes the production of poultry more profitable, and encourages poultry farmers to increase the production of chickens and eggs. So all the government will have achieved is to turn sheep into chickens, and reduce the stock of sheep held by efficient sheep farmers with deleterious consequences for the long-term productive capacity of the economy.

To see what happens when money enters the equation, it helps to go back to the origin of money. For thousands of years, small groups of hunter-gatherers lived off whatever nature provided. With the emergence of exchange, existence above the subsistence level became possible. But, direct exchange works only as long as it is possible to exchange whole things, say a cow for two sheep. But what to do when you have a valuable cow and you need only a pair of shoes?

The solution stumbled upon was to exchange the cow for a product which could be divided into smaller pieces, one or more of which could be exchanged for the pair of shoes and the leftover pieces then exchanged for other things. Throughout history many products fulfilled this function: seashells, salt, tobacco, tea, beads, iron, copper, silver and gold. Eventually gold and silver became the preferred media of exchange, or money. Governments have long since severed the link between gold and money, and it is paper money that now functions as a medium of exchange, facilitating the exchange of goods and services. When a baker buys a pair of shoes, although he exchanges money for the shoes, it is the bread that he baked and exchanged for money that pays for the shoes. On his part, the shoemaker exchanges shoes for bread. With the help of money, something is exchanged for something else.

When a counterfeiter enters the economy, he purchases bread without having produced something of value in return. A counterfeiter exchanges nothing for something. When a government inflates the money supply, money not backed by the production of goods and services enters the economy. The effect is identical to counterfeiting. It involves the exchange of nothing for something, and causes malinvestment.

Government stimulus of the economy, or an industry, whether by using taxpayers’ money or increasing the money supply, results in a misallocation of resources, which is never sustainable. Eventually an economic correction has to follow and the greater the extent of misallocation of resources the greater the ensuing correction or crisis.

When the government of a small economy such as Zimbabwe manipulates its monetary system, it makes hardly a dent in the world economy. The citizens of Zimbabwe suffer the consequences. When the US Federal Reserve mismanages the monetary system, the entire global economy is affected.

Economic recovery and a stable and growing economy require that governments refrain from redistributing the income of successful and responsible businesses and desist from manipulating the monetary system.

Author: Johan Biermann is a planning consultant and policy researcher. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author’s and are not necessarily shared by the members of the Free Market Foundation.

FMF Feature Article / 14 April 2009
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