DRI-345 for week of 9-9-12: Other People’s Money

An Access Advertising EconBrief:


Other People’s Money

The elephant in the room in any political discussion is the ongoing debt crisis in Europe and the impending one in the U.S. Turn over the debt coin to reveal spending; the two go together like dissipation and death.

We strive to understand the complex and unfamiliar by likening it to the familiar. It is commonplace to read explications of government spending and debt that treat the government as one great big corporation or, worse, as the head of our national household. In fact, it is just those differences between the behavior of government and our own daily lives that give rise to misunderstanding.

In their immortal bestselling text Free to Choose (companion piece to a hit 1980 PBS series), Milton and Rose Friedman developed a beautifully concise matrix to illustrate the differences between government and private spending. Herein lies the key to the avalanche of debt poised to engulf the world.

The Spending Matrix

In a modern economy, money serves as a lubricant to the exchange of goods and services between individuals and businesses. The income received by households for supplying input services to businesses and government forms the basis for expenditure on consumption goods and services. Income not consumed is saved and invested; an excess of current consumption spending over income constitutes dissaving and is financed by borrowing to incur debt. Government “income” is derived from tax revenue and expenditure is undertaken to provide consumption and investment benefits to citizens. Once again, any excess of expenditure over income must be financed, either by money creation or borrowing to incur debt.

The Friedmans explain why the efficiency of the expenditure process depends crucially on the origin of the money being spent and the identity of the spending beneficiaries. First, they identify the four basic categories of spending. Money is the vehicle for spending. Either the money is yours (originating via income you earned) or it is supplied by somebody else via the intermediation of government, which levies taxes and gives you the proceeds. Either you are spending the money on yourself or you are spending it on somebody else. The possibilities reduce to four spending categories.

Category I denotes the case in which you are spending your own money on yourself. In this situation, spending is at its most efficient. The word “efficient” has two everyday meanings, both of which are germane here. First, you spend your own money efficiently because you have the strongest possible incentive not to spend any more than necessary for a given quantity and quality of good or service. This is so because there is nobody whose welfare means more to you than yours. (For our purposes, we can stipulate the content of “you” to include members of your household.) Second, you want to get the most value for your expenditure – that is, for a given expenditure you want to get the best quality and most appropriate items. Again, this makes sense because nobody means more to you than you.

In Category II spending, you are spending your money on somebody else. Your spending will be efficient in the first sense – you will still strive to minimize the cost of a given quality of purchases – but not the second sense. You are not obsessively concerned with value-maximization because you yourself are not consuming the goods your purchase – somebody else is. Any doubt about the truth of this observation will yield to a study of the yearly gift-return statistics during the Christmas season.

In Category III spending, you are spending somebody else’s money on yourself. Now you will strive to get the best possible value for your money, but you will not be rigorously concerned with cost-minimization because you are not spending your own money – you are spending somebody else’s money. Your utility or satisfaction depends on the goods and services you consume, so you have every incentive to acquire goods and maximize their value, but your utility in unaffected by the efficiency with which other people’s money is spent. Thus, you have no incentive to waste time worrying about it.

Category IV spending is the kind undertaken by government. Legislators spend somebody else’s money on somebody else. Consequently, they have no incentive to spend efficiently in either sense. They are not spending their own money and they do not themselves benefit from the expenditures, so their consumption is not dependent on the expenditures. Thus, legislators do not minimize the cost of purchasing a given quality of goods using somebody else’s money, nor to they maximize the value of the goods they purchase for others to consume.

Government Spending

During the 20th century, political economy saw a worldwide trend toward increase in the size and activity of government. The duties of government came to include not merely tasks that private business and individuals were unable to perform, such as national defense, but activities that had heretofore been confined to the private sector, such as the provision and regulation of medical care.

Proponents of bigger government hailed this trend while devotees of limited government deplored it. In terms of our model of spending, the substitution of government for the private sector means a change in spending category and in the relative efficiency with which money is spent. Evaluating this change is one of the best ways of deciding whether more and bigger government is good or bad.

Most government spending is Category IV spending. Legislators appropriate large sums of money from the Treasury and spend it for the benefit of large groups of people or the nation at large. Sometimes the money being spent has a traceable relationship to money raised from the public; sometimes it does not. Sometimes the legislators actually contribute to the funds from which the spending is drawn; sometimes they don’t. (For years, Federal employees were exempt from Social Security and had their own retirement plan. Likewise, state employees hired before 1986 do not contribute to Medicare.) But an individual legislator’s percentage share of the spending and benefits is so minute as to be imperceptible; other incentives swamp the cost and value considerations cited above for legislators.

Category IV spending is the least efficient kind of spending in both senses of the word. It is also the kind of spending most conducive to fraud. Fraud is generally thought of as “deceit” or “trickery,” but its legal definition requires that the perpetrator lacked any intention of performing or providing the contracted-for good or service. Intentions are best gauged and fulfilled by their possessor; by definition, one cannot defraud oneself legally, however self-deceptive one’s actions may be psychologically. Thus, Category I spending is proof against fraud. Category II and III spending has at least the safeguard that you are vetting one end of the transaction, although this is not absolute proof against fraud. But Category IV spending is an open invitation to fraud, since nobody has a direct interest in efficient spending on either end of the transaction.

A Case Study in Government Overspending: Medicare

The Medicare program is a classic case of inefficient government spending in general and an invitation to fraud in particular. Medicare’s general inefficiency lies in its Category IV status. The recipients of the Medicare program are (as a first approximation) elderly Americans. But program expenditures are ultimately determined by government, which approves covered procedures and global budgets. Efficient spending requires patients to view doctor visits, tests and medical procedures as expenses, buying them only when their prospective value outweighs their cost. Doctors should aid patients in determining prospective benefits. Instead, the program grossly distorts the true economic costs of medical treatment by understating them. Doctors have no incentive to seek least-cost treatment regimes since they know that patients pay only a relatively small ($140) deductible and 20% of subsequent treatment costs. Patients have little incentive to minimize costs since they pay so little at the margin for additional treatment. This alone is a formula for overspending – which is just what has happened around the world, forcing most countries to ration medical treatment inefficiently by queue and government fiat rather than efficiently through the price system.

Total Medicare expenditures exceed $500 billion annually. Fraud detections of just under $50 billion are probably underestimates, but nobody knows the true extent of Medicare fraud. One of the most prevalent forms is billing fraud, in which providers bill the government for services not performed. In these cases, the government is spending taxpayers’ money for the ostensible benefit of patients but the actual benefit of providers. Since patients do not pay the bill, they have no incentive to detect or object to the fraudulent payments. Sometimes fraudsters will include patients in the scheme, in order to reduce the likelihood of detection. Since patients are not paying the bill, they do not lose from undetected fraud but do gain from kickbacks.

What about the fact that Medicare recipients are also (often still) taxpayers? Since no action taken by Medicare recipients can affect taxes already collected from taxpayers, recipients quite correctly view those taxes are sunk costs. They ignore them and abuse the system just as much as any non-taxpayer. And their behavior is economically rational.

The Limitations of Government

Why are you a more efficient spender of your money than government? The Friedmans accurately pinpointed one key reason: incentives. You have the strongest incentive to achieve both kinds of efficient spending, cost-minimization and value-maximization. But they almost completely overlooked another, equally important reason: information. In order to buy at least cost, You must be able to locate the names and prices of the relevant sellers. In order to maximize value, you must obtain relevant information about quality and potential substitute and complementary goods.

Economists have traditionally taken this ability for granted, which may be why the Friedmans mostly ignored the issue. Even the well-known economic treatments of the subject of information by Nobel laureates George Stigler and Gary Becker have begged key questions by assuming that buyers and sellers would automatically gather information up to the point where it was no longer economically sensible to continue. The missing link in these treatments is that they assume that consumers already know the nature and type of information that needs to be gathered. In other words, they are supposed to already know what they don’t know, and their only problem is how to (and to what extent) to find that out. Or, to borrow a form of expression currently popular, Stigler and Becker have assumed that the problem is one of “known unknowns.”

But the ghastly failures of regulation that led to the housing-market collapse, financial crisis and Great Recession show that the problem of “unknown unknowns” is at least as big. Regulators didn’t know various things – that sovereign debt and mortgage securities were now unsafe asset classes despite their history of safety, for example – and didn’t know that they didn’t know them. Their ignorance was disastrous. It rendered their good intentions useless.

The advantages of leaving most decisions to markets are that markets produce information to which governments have no ready access and markets leave more options open to decisionmakers. Free health-care markets allow doctors and patients to decide upon medical treatment, thereby generating vast quantities of information about how different individuals prefer and react to different regimes and medications. Most of this information is lost to government-dictated panels that formulate so-called “best practices” protocols under government health-care systems.

When regulators promulgate a rulemaking, they are betting all chips on their solution being the correct one. When they are wrong, as they were recently in housing and finance, the outcome can be catastrophic. Markets allow for differences of opinion among participants, thereby mitigating the results of mistakes. For example, banks who rigorously followed Basel banking guidelines and held ultra-safe assets like sovereign debt and mortgage securities stood a good chance of going bankrupt, while those who defied regulatory recommendations by diversifying their asset bases fared much better.

The Evolution of Unlimited Government Spending

The severe drawbacks of government spending are so important because the welfare-state model of unlimited government spending has gradually become dominant across the Western world. Starting with the Bismarck administration in Germany in the 1880s, spreading to Scandinavia and to post-World War II Great Britain, and then culminating with the triumph of big government in the U.S. in the 1960s, the trajectory of government spending has pointed skyward at the angle of a launched ballistic missile.

If government spending is so inefficient, why has it overpowered the Western fisc? For that matter, the current issue of The Economist notes that Asia is traveling the same path trod by the West. What Gresham’s Law of sovereign finance has achieved this perverse evolution?

Perhaps the answer can be found in the history of big government in the West. Economics developed as a science partly by exposing the shortcomings of government. These included the propensity to interfere with trade by taxing it or prohibiting it altogether, the futility of hamstringing markets with price ceilings and floors and the downside of printing money as a means of government finance. A conventional wisdom among economists relegated government action to a bare minimum of activities.

Unfortunately, reformers chafed at these restrictions on their ability to improve the lot of humanity. Their discontent coalesced around the idea that the bad effects of government action were a function of its form, not inherent to government itself. Price controls were developed by the Roman emperor Diocletian. Tariffs and quotas in international trade were the residue of the philosophy of mercantilism, followed by Spanish and French kings of the 16th and 17th centuries.

Surely dictatorship and monarchy were to blame for the backwardness of life under the ancien regime, not government per se. In contrast, prosperity and a large measure of peace had followed the advent of constitutional democracy in Europe and the U.S. If democracy could supplant authority in government, the good intentions and institutions of the democrats would overcome any inherent limitations of government and enable government to act more quickly, more surely and more comprehensively than private markets to undo the remaining evils of the world.

Alas, the 20th century taught us that professed good intentions are not nearly a prophylactic against the damage wrought by government unchained. Bismarck’s concessions to 19th-century socialism led to a German welfare state, which led to – Adolf Hitler, of all things. 20th-century liberals scoffed at F.A. Hayek’s warnings against economic planning as the precursor of totalitarianism, but the welfare state has inexorably reduced freedom and free markets as a glacier gradually engulfs all in its path.

The Collapse of the Government-Spending Machine

20th -century liberals in the Franklin Roosevelt administration envisioned a dynasty founded upon government spending. “Tax and tax, spend and spend, elect and elect” was their mantra. The formula has worked for nearly eighty years, not only in the U.S. but around the world.

Now the welfare state is foundering, largely on the issue of spending and its resulting debt. It is at least possible that if government spending were as efficient as private spending, we would tolerate the loss of freedom involved in exchange for the ostensible security provided by the welfare state. But government spending is so wildly inefficient and out of control that even if we were willing to sell our souls to Big Brother, none of us could afford the price tag. A tsunami of debt will drown the world monetary system and end the use of money for indirect exchange unless we make government our servant instead of our master.

Former British Prime Minister Margaret Thatcher once said that “the problem with socialism is that eventually you run out of other people’s money.” Although there are no theoretical limits on the ability of governments to create money, there are practical limits on our ability to absorb created money and government spending. Those limits are now in sight.

Most of the countries in the Eurozone have serious financial problems, either related to structural debt from overspending (Greece, Portugal, Belgium) or debt caused by bank bailouts (Spain, Italy, France, Great Britain, Ireland) or both. Only Germany and Switzerland are relatively problem-free, but they face the grim prospect of bailout out the rest. Banks in the U.S. are closely linked with European banks, particularly those in Great Britain. The need for spending reform is widely recognized, but the overspending has become so culturally entrenched that even a program of austerity, which is hardly thoroughgoing reform, raises the threat of riots and protests in the streets.

Only a few countries in the world have been prescient enough to recognize that the fool’s paradise is no longer inhabitable and must be depopulated via entitlement reform. Ironically, one of these is Sweden, which has passed its own version of Social Security privatization and has eschewed the Keynesian policies and monetary profligacy favored by American policymakers. Few would ever have predicted that Sweden and the U.S. would pass each other on the Road to Serfdom – going in opposite directions.