In this previous post, I wrote about how government is overhead and that increasing overhead is probably not the way to improve a bad economy.
I compared the economy to a burrito-making business, with the private sector being the burrito-making and selling part of the business and the government being the overhead functions like accounting, legal and IT.
In this post, I’ll explore the limits of that overhead a bit more.
The value creation engine of our society is greatly under appreciated. Without the burrito making part of the business, the overhead jobs for accountants, lawyers and IT folks at the burrito company would not exist.
The value creation engine in the economy is voluntary mutually beneficial trading. When two parties trade voluntarily, they do so because they both come out ahead — otherwise, why would they trade? Since they both come out ahead, value is created.
We each trade with others every day. It’s hard not to. We do it so naturally that we take it for granted.
Try this exercise. The next time you buy something, ask yourself why you bought it. What benefits did it provide you that made it more valuable than whatever it was that you gave up to buy it?
What was your next best use for your money? Could you have spent it on something else? Save it? Why did you buy it instead of your next best use for the money?
Why do you show up to work to trade your time and skills for money? Is that time or skill not worth as much to you as the time you give up?
The reasons you trade (or not) and the value you gain from the trade is Adam Smith’s Invisible Hand. Your actions or inactions send signals through the price system on how much you value or don’t value things so that other individuals will respond and oblige to provide you more of what you do value.
In that sense, the price system was one of the earliest and best communication networks (although it doesn’t send information on why you value the things you buy, which befuddles many company managers).
Taxes paid to government, unlike voluntary trade, is compulsory trading forced by the government.
That’s not to say that some value isn’t created in that forced trade. Government does create value for society, just as the overhead functions create value for the burrito business. Governments provide citizens with security, law enforcement and justice systems, for example, that may benefit all of us.
But, since taxes and government are forced, it does mean that this trade does not have to create value for both sides of the trade. That’s the important distinction that is glossed over by all sides of the debate on taxes and government.
When debating what government should or shouldn’t do, one side tends to provide examples of where they think government is worth the taxes paid. The other side provides examples of where they think government is not worth it.
They never settle their dispute because they both can be right. Neither side sees the full view that government can create value, but it’s not necessary that it does create value since government can force collect on taxes. Government gets money whether it creates value or not.
With voluntary transactions, it is more of a necessary condition that both sides come out ahead. Voluntary trading that does not result in both sides coming out ahead usually dies out quickly because sooner or later the side that’s not coming out ahead voluntarily decides not to trade. That’s a natural check on non-value added trades.
There’s not a natural check on what creates value with government and that’s why government can and does tend to grow far beyond where it adds value, which means it destroys value — or makes us poorer.
This also happens at successful companies. Once a business finds a successful product and reaches a level of sustainable income, its overhead functions tend to grow faster than the value creation side of the business.
Some of this growth is good. More overhead can make the business function more consistently. But, it doesn’t have to all be good. Just like with government, there’s not natural check (like the Invisible Hand) to limit the size of overhead and the “right” size of overhead is not clear cut. Eventually bureaucrats feed off the flesh and muscle of the business and destroy value.
The overall limit on the size of overhead is the business’s income and many successful businesses have failed because management let overhead grow too large.
The overall limit on the size of governments (all of them — local and federal), is the value created by the private sector. We are lucky that capitalism has created such a wealthy private sector. It has allowed us to afford a good sized government.
But we are spending and destroying that wealth faster than the private sector is creating it. Which means we are dipping far into our “rainy day” fund. As Margaret Thatcher said,
The problem with socialism is that you eventually run out of other peoples’ money.
I’ll go a step further. The problem with growing government so large is that you eventually run out of other people.
Don’t mistake this for an argument that essential government functions — especially those listed in the Constitution like defense — should be privatized.
Rather, we should be aware of this weakness of government and understand it has brought us to our current situation. Further, we should keep this mind when evaluating what spending should be cut and consider private alternatives for the areas of government that are destroying value.