‘Government is overhead’ follow-up

Last August, I wrote this post about how I think we should view government as an overhead expense. Yesterday, Edward wrote the following response to that post:

A very interesting post. I agree with your premise that government is overhead. However, if you look at government expenditures relative to GDP, they are lower than the average overhead rates of successful companies. Currently this rate is 19 percent or so (gov/gdp) and for companies this number is in the high twenties. Why is it that anti-tax folks presume that the correct level for our national enterprise is even lower than the faultless private sector can achieve?

This is my response to Edward.

The Federal government is not the only overhead in the economy. It’s a piece of it. Comparing Federal government spending to all business overhead is an apples-to-oranges comparison.

For example, all government — Federal, state and local — is part of overhead. According to this graph, all government spending makes up nearly 40% of GDP, which is more than ten percentage points higher than Edward’s ‘high twenties’ benchmark.

And still, all government is only a part of the economic overhead. For example, all the overhead tied to successful companies that Edward mentions, is also economic overhead.

Also, anything we do to comply with the government is overhead. For example, the time and money you and the companies you deal with spend to keep records and prepare your taxes — at all levels — is economic overhead that does not show up in government spending.  That’s time or money that we could have spent doing something productive, like cleaning our toilets.

Edward then asked a question that I’m really glad he asked:

Why is it that anti-tax folks presume that the correct level for our national enterprise is even lower than the faultless private sector can achieve?

First, as I pointed out above, economic overhead is higher than the ‘faultless private sector’.

Second, and more important, folks of my political persuasion don’t believe the private sector is faultless, as Edward suggests. Far from it. I’d guess the failure rate of government and private sector is about the same. Why wouldn’t it be? Both are run by humans after all.  Are the humans in government less fallible than the humans in the private sector, or vice versa? No.

One reason we favor the private sector is the difference in how it and government naturally respond to failure. The private sector is better in this regard, though not perfect.

The private sector — you, Edward and I — reward organizations that provide us with stuff we value by buying that stuff and we punish the others by not buying their stuff.

When it comes to government, that success/fail feedback isn’t quite as strong, and sometimes it’s the opposite of what it should be.

For example, for years the answer to “Public schools are failing!” was “Public schools need more money!”

This sounded reasonable to a lot of folks. I bet those same folks would scoff if “Public schools” was  replaced in those two sentences with “Enron”.

We realize that giving more money to the corrupt leaders of Enron so it could try to “fix its problems” and save some jobs would have made no sense.  Those corrupt leaders would have blown that money on themselves.

The market clobbered Enron’s stock and put it out of business long before the government even figured out what was going on.

We realized that the best thing was for Enron to go out of business. The market naturally stripped the fraudsters running Enron of their power. Its failure caused some painful collateral damage to people down the totem pole, but it also taught a generation of people valuable lessons in prudence, investment diversification and ‘if it sounds too good to be true…”  And, all this happened without taking the whole economy with it. Markets naturally isolated the disturbance.

This wouldn’t be the case a few years later when government actually encouraged fraudulent practices in home lending.

I also believe that the success/feedback loop is weak in overhead functions, whether those functions are in private companies or government.

I’ve been a part of overhead of private organizations most of my career. I’ve witnessed this from the inside. Strong underlying businesses can feed crony, corrupt and political bureaucracies in the overhead departments, precisely because the success/fail feedback loop is weak.

It wasn’t a stretch for me to recognize that government also had this success/fail feedback problem.

Again, that is precisely the reason government tends to grow in good times and bad and is one reason why anti-tax folks would like to minimize government and overhead.

Politicians tell you they can solve your problems if you vote for them and allow them to spend your money (or the rich guy’s money) and too many people believe them.

Do you need another can of green beans in your pantry?

English: Cut Green Beans Español: Habichuelas ...

"Creating" Demand

I enjoyed Arnold Kling’s column (econblogger at EconLog), Government Cannot Create Sustainable Jobs, published in the European edition of The Wall Street Journal.

I think the following two paragraphs contain the most concise and understandable contrast of two competing visions on how the economy works (emphasis mine):

For Keynesians, job creation is simple. Entrepreneurs have knowledge of how and what to produce. All that is required is more demand, in order to induce them to undertake more hiring.

n contrast, in our [Adam] Smith-Ricardo story, the knowledge of how and what to produce has to be discovered. Entrepreneurs have to figure out ways to utilize resources that satisfy wants in an efficient way. The market mechanism first must undertake trial and error to create production processes that exploit comparative advantage. Until these new patterns of sustainable specialization and trade are discovered, there are no job slots.

I bolded the key phrases.  Do you believe that progress comes from stimulating evermore demand or from trial and error experimentation?

I believe the latter.  Progress, wealth, improvements in the standard of living, GDP per capita growth — whatever you call it — comes from experimentation and trial and error and a process that allows the valued to survive and multiply and the least valued to die off (i.e. evolution).  This trial-and-error market process is driven by the ultimate democracy of individuals voting with their own value store on the the things they value and vote against those things they don’t value.

The problem for me with the former explanation, creating more demand, is where this new demand comes from.

The theory says that more government spending will put more money into some folks pockets, which they then spend.  So, then the businesses that benefit from that extra spending will spend more too.  And so on.  This is a chained spending effect.  By the time the that extra dollar of government spending has worked its way through the economy, it’s spawned more than a dollar of economic activity.

This seems reasonable on the surface.  But pry deeper.  Where did that extra dollar of government spending come in from in the first place?  It either came from current or future spending.

If it came from current spending, then all we’ve done is take a dollar from someone to get the spending chain started.  That someone may have started their own chain by spending it themselves.

Defenders of this theory will say, yes, but that someone wasn’t going to spend it any time soon so it’s best for everyone that the government took it and spent it.

I believe the miss in this line of thinking is that someone was waiting to discover something of value to spend it on, while spending it now does not help him find that value.

What’s really happened is that demand was pulled forward from the future and we’ve spent it on something that doesn’t add value.

Companies see this when they run ineffective limited time promotion.  The sale will produce a sales spike during the offer period and a lull afterwards.  The sale encouraged people who were going to buy the product anyway to buy it sooner, and buy less later.

But, in the case of the government pulling forward demand, it makes things worse.

That someone with the original dollar was waiting to spend that dollar on something he valued — maybe a new pill that will reduce his sick days and make him more productive.

Instead, the government takes it and spends it on another can of green beans.  So, instead of having four cans of green beans in the pantry (that he’s never going to eat), he has five now — something that doesn’t bring as much value as that new pill.  But, hey, the green bean growers and canners are better off.  Except, we find that since there’s a glut of canned green beans now, green bean makers will sell fewer cans in the coming months.

So, creating demand through government spending is a myth.  There is no creation.  Just moving demand from one place to another or from the future to now — and in either case, we replace careful spending with careless.

Related articles

Bill Gates: Treating symptoms rather than causes

While reading a November Forbes interview with Bill Gates about his philanthropic activities, I had a few thoughts I wish he would consider.

In the interview, Gates explains his charitable efforts in public health and elimination of disease:

The logic was crisp and Bill Gates-friendly. Health = resources ÷ people. And since resources, as Gates noted, are relatively fixed, the answer lay in population control. Thus, vaccines made no sense to him: Why save kids only to consign them to life in overcrowded countries where they risked starving to death or being killed in civil war?

Gates is wrong on two accounts here.  Population control is not the answer and resources are not “relatively fixed.”

The western world enjoys the best standards of living ever on this planet not through population control, but by an abundance of resources that were developed and allocated through innovation and trade.  We’ve discovered how to use resources more effectively to sustain larger populations with a grand standard of living.

The true equation is:  Health = Freedom, innovation and trade.  Seeking ways to improve this equation is THE answer.

More from the interview:

In society after society, he saw, when the mortality rate falls—specifically, below 10 deaths per 1,000 people—the birth rate follows, and population growth stabilizes. “It goes against common sense,” Gates says. Most parents don’t choose to have eight children because they want to have big families, it turns out, but because they know many of their children will die.

“If a mother and father know their child is going to live to adulthood, they start to naturally reduce their population size,” says Melinda.

This doesn’t go against common sense.   It is common sense.  Too bad it took that long for him to figure that out and more unfortunate that he states it as if it’s some unique finding of his.  This is well-known from anyone who have given any thought to their own ancestry.  There are reasons why two to three generations ago the birth rate in my family was much higher than it is today.  One of those reasons is that there was a greater likelihood of death, so parents had more kids to improve their chances of keeping the family going.

What’s especially frustrating here is that the Gates’ only see part of the picture.  Low mortality rate is a result (or output) of something bigger than the availability of vaccines, it’s not an input to it.

Low mortality rates are a result of a wealthy society that derives from freedom, innovation and trading.

It’s no accident that free societies grow wealthy enough where vaccines and other things that save lives, like nourishment, shelter, low crime rates, drug stores, paved roads to get to the drug stores, indoor plumbing, hand soap, sanitary conditions, disinfectants, antibiotics, bandages and clean water aren’t that difficult to come by.

In the U.S., vaccines are usually cheap and plentiful.  Even the poorest families here don’t need a billionaire to give them a vaccine.

Would Bill Gates rather have societies that are dependent on his benevolence for addressing a part of the problem, or societies that could become self-sufficient in that regard and not only would he save lives from disease, but also make available all the other advances that help make our lives better?

I don’t fault the guy for wanting to make a visible impact.  Giving a vaccine to a child that otherwise wouldn’t have had it is good.

But, I think it’s important to recognize that this doesn’t address the root cause of why a child in a third world country has such a difficult time getting medical treatment that is plentiful and basic to children in first world countries.

And, think about what happens when Bill Gates’ money runs out.  Either more philanthropy will have to take its place or the conditions will return, because the root cause has not been addressed.  He’s creating a dependency.

So, what is this root cause?  It’s concentration of political power.

At a young age, I crossed the border into Mexico at Laredo, Texas and was befuddled by the drastic difference in the standards of living on the north and south side of that river.

This was an eye-opening test-and-control.  The difference in the standard of living didn’t derive from the richness of the soil, or the availability of natural resources or differences in climate.  Folks on the north and south side of the Rio Grande have all of this in common.

The only difference between the two was how political power was distributed.  Period.

If Bill Gates wants to make a lasting impact for third world countries, he could do no better than to find ways to de-concentrate political power in those areas.

That is THE answer to improve public health.  It also happens to be the answer to improving education.

This is from the same interview:

It wasn’t dissimilar from the formula that he was developing behind a multibillion-dollar push into education reform. In that case, he based his giving on this formula: Success = teachers ÷ students. Smaller class sizes would result in more attention per student and smarter kids.

But much as Gates loves elegant solutions, his greatest achievements have resulted from perseverance and adaptability. It took three versions to get Windows right, and the Xbox originally lost billions. He’s not afraid to challenge assumptions when they don’t work. And in education he’s had a clear reversal: Class size, it turns out, is not the best determinant of student outcome. Teacher quality is. So after spending a fortune, Gates shifted course.

Here again, Gates stops short of the root cause.  Teacher quality is important.  But, it’s an output, rather than an input.

High teacher quality is an output of a system that decentralizes political power and allows the users of the system to choose the best teachers.

In third world countries, political power is concentrated in the hands of the dictators and warlords who run those countries.  Similarly, in public education, political power is concentrated in the hands of teacher unions, school boards and the so-called “education experts” whose often incorrect preferences for how things should work subjugate the preferences of the people who directly use the system — the parents.

In both health and education, he would do well to look for ways to decentralize the political power bases, instead of reinforcing them.

Bureaucrats and innovators, part two

This is from Peggy Noonan’s column in the Wall Street Journal today:

Then he turned to the rise and fall of various businesses. He has a theory about “why decline happens” at great companies: “The company does a great job, innovates and becomes a monopoly or close to it in some field, and then the quality of the product becomes less important. The company starts valuing the great salesman, because they’re the ones who can move the needle on revenues.” So salesmen are put in charge, and product engineers and designers feel demoted: Their efforts are no longer at the white-hot center of the company’s daily life. They “turn off.” IBM and Xerox, Jobs said, faltered in precisely this way. The salesmen who led the companies were smart and eloquent, but “they didn’t know anything about the product.” In the end this can doom a great company, because what consumers want is good products.

I agree.  This reminds me of a few of my previous posts where I write about the secret of good business, bureaucrats vs. innovators and bureaucrats and innovators.

Jobs just uses the term salesman in place of bureaucrat and product engineers in place of innovator.

Salesmen stifle innovation by favoring their own projects and restricting other projects.  That lowers the chance that the company will discover something truly valuable for customers.

I’ve witnessed projects that showed early promise get nixed because they weren’t the saleman’s project.  I’ve also seen projects that show no signs of promise continue to get resources, because it is the salesman’s project.  The salesman can sell others (for awhile) that the project is working, even when all measures suggest it is not.

Good innovation model at Coke

In a September 22 HBR Ideacast (Harvard Business Review’s podcast), Coca-Cola CEO, Muhtar Kent, says this as a side note about innovation at Coke:

…for us, innovation is not only inside the four walls of the company.  We have incubation projects [in] many parts of the world, because we think that the Coca-Cola company and system is too big to have embryonic ides flourish.

So, we have outside [projects], in parts of the world, innovation/incubation projects.

I’ve seen my share of embryonic ideas die.  Some even showed promise.  With some adaptive business folks in charge, they may have grown into something.

But, inside a big company, there are many reasons to say no.  Arnold Kling and Nick Schulz wrote about this in their book, From Poverty to Prosperity, which I wrote about here:

Corporate decisions are made by committees.  In a typical committee, no individual has the power to say “yes” to a new project.  On the other hand, almost every member of a committee has the power to veto a new project.

Observers of organizational behavior have noted that in committees one is more likely to be regarded as intelligent and a good team player by one’s peers by arguing against a new idea than by arguing in favor of it.  Middle managers who fight for new ideas are regarded as troublemakers, even if they succeed in convincing corporations to undertake the projects they propose.

I’ve seen this in action.  For example, I’ve seen projects killed that threatened a powerful leader’s turf (of course, that’s not the reason they made passionate pleas against the project).  Or because the project was a pet idea of previous leadership.  Or, the project didn’t fit into some arbitrary slogan the leader had for running the company (e.g. “We’re in the widget business, not the gidget business”).  I’ve also seen these shutdown just due to impatience.

Because of this, I recommend that companies do just as Coke does, separate innovation from the bureaucratic organization.  In reality, it’s hard to put any new project out of the reach of meddling bureaucrats.

Ultimately, it takes the realization by leadership that few of these projects will succeed, that none will add significantly to next quarter’s earnings (think more like 5 to 10 years) and, most importantly, leadership needs to protect these external projects from the meddling bureaucrats.

What is wealth and where does it come from?

David Mamet corroborates my previous post on pp. 42 and 43 of his book, The Secret Knowledge:

The Left (as Thomas Sowell points out in Intellectuals and Society) believing in what it calls “social justice,” believes that wealth should be “shared,” but enters the discussion in its middle.  For wealth may or may not be shared (in fact, it is shared, as efficiently as possible, through trade), but the a priori question, to the Left, is unasked and unanswered: Where did it come from?

Where does wealth come from?  Great question.  So rarely is it asked and even more rare it answered.  Get ready.  Here’s the answer (in bold):

It was not, again, quoting from Professor Sowell, descended from heaven, like manna, and spread evenly over the ground.  It was created by individual expenditure of effort and individual willingness to undertake risk.

As my generation did not live through the Depression, World War II, and the agony of the immigrants who are our grandparents and great-grandparents; as we were raised in the greatest plenty the world has ever known and in the most just of societies, we have grown lazy and entitled (not unlike Marx, who lived as a parasite upon Engels, and never worked a day in his life).  The baby boomer generation, my own, is content, if of the Left, to live out our remaining years upon the work and upon the entitlements created by our parents, and to entail the costs upon our children–to tax industry out of the country, to tax wealth away from its historical role and use as the funder of innovation.

Risk taking and trial-and-error innovation.  That’s where wealth comes from.

It doesn’t come from laws or legislation.  It doesn’t come from taxes.  It doesn’t come government.

And, let me be clear on what wealth is.  Most people view it the state of being a rich person.  Here, I mean it to be our standard of living.

Wealth is what separates us from our hunter-gatherer ancestors.

They had the same 24 hours in the day that we have (plus a few microseconds).  But, they only managed to use those hours to eek out a sustenance standard of living or get just enough calories to keep from starving.

Most of us aren’t worried about starving.  We spend a fraction of the time getting more than enough calories and we spend the rest of the time doing lots of other stuff.  And we have a lot more time to do lots of other stuff, because we live longer than they did.  We survive illnesses that they didn’t.

All that separates us from the hunter-gatherer lifestyle is wealth.

That wealth resulted from innovation that was made sometime between then and now.

Those innovations resulted from encouragement individuals found in trading with each other and discovering that finding better ways to do things would enable them to move even further away from the life of hunter-gatherer grandpa.

Take a look at the products around you right now that make your life better than a hunter-gatherer.  Your carpet, phone, house, furnace, refrigerator, food in the pantry, the pantry, floor joists, electric wire and so on.

Consider that all of those resulted from an experiment — a risk someone took at some point in time.  It may have been an accidental risk.  It may have been planned.  But, it was a risk no less, because nothing is guaranteed to work or to be wanted.  Someone had to think of it and give it a try.  Very few of them came from a government project.  And even the ones that did were usually accidents that found an unintended purpose and what they have become had nothing to do with government.

When I drive around, I like to ask, “where did all these buildings come from?”  Each of those were a risk.  An individual or a group of individuals decided building that building would be a good idea. What things are in this world because you decided it would be a good idea?  How have those things improved your life or the lives of others?

Understanding what wealth is and where it comes from is important if you’re interested in continuing to improve everyone’s standard of living.

Rent seeking on the playground

While watching my kid play hide-n-seek and tag on the playground with other kids, it occurred to me that rent-seeking behavior starts at a very young age.  It seems natural.  It derives from the desire to win, though we tell ourselves it’s about a sense of fairness, and it can get ugly quick.

When kids on the playground are one or two years apart in age, the difference in agility and speed can be big.  The (usually) older kids will dominate the game, if it were not for rent-seeking.

The slower kids, when they realize they are getting beat handily, begin to introduce rules to make the game more fair for them.  For example, they will establish a safe base during a game of tag.  This is rent-seeking.  The slower kids use rules rather than ability to try to get the upper hand on their better competitors.

We see similar things in the business world.  In the 90s, lesser software makers ganged up and got the Department of Justice to go after Microsoft for monopolistic behavior.  The key complaint that the DOJ went after was Microsoft’s inclusion of its own web browser for free on computers that came with Microsoft’s other software.  Giving away something for free hardly seems monopolistic (usually monopolies raise prices).  But, to a competitor (like Netscape) who wanted to charge customers for an Internet browser and didn’t have other products, it hardly seemed fair.

Being fair for the slower kids means being unfair to the faster kids (after all, the faster kids probably have faster opponents at times too). On the playground this seems fair, until the rent-seeking gets out of hand.

A game of tag quickly devolves into a staring contest with most of the kids camping out on base.  Then the faster kids are the ones who claim the game is no fair and they move onto something else.

As a parent who has had the younger kid on the playground, I know it can be rough to watch.  In the short-term (and naturally), it’s easy to welcome the rent-seeking rules.  But, even most parents will protest when their own kids overreach and camp on base (You have to give him a chance to catch you!).

While this behavior appears to be driven by fairness, I believe the true root cause is the desire to win.  Even parents tend to hope that their kids have natural talents that allow them to hang with older kids.

But, maybe we should be more interested in simply having our kids experience more trial-and-error, become accustomed to dealing with and learning from loss and not worry too much about winning.

This reminds me of something Salman Khan, of Khan Academy (educational online videos), said in his TED video:

The traditional model [of education] penalizes you for experimentation and failure, but does not expect mastery [e.g. time to move onto next subject even if you only mastered 90% of the last one].

We encourage you to experiment.  We encourage you to fail.  But we do expect mastery.

Parents and kids both seem to have the traditional model engrained.  We want mastery, but we abhor experimentation and failure.

But the secret to mastery is experimentation and failure.  I’ve heard enough successful people say that one of the secrets to their success was that they weren’t afraid to fail.  They didn’t like it.  But they learned how to deal with it.  To learn from it, brush it off and to not let it keep them from trying again.

So, there could be several benefits to letting our kids play tag with the faster kids, without a safe base.

First, they can learn how to deal with failure. And, as parents we can help them put the failure into perspective and learn from it.  So what?  Who cares?  That kid is two years older than you.  Of course he’s going to win.  But, did you have fun?  Did you learn something?  Even get them to admit that the other guy or gal was really fast and tough to beat.

Second, they might learn other tactics that could be useful.  Instead of trying to beat their opponents with speed, they might try to keep a safe distance, use obstacles to their advantage or stay close to an even slower runner.  Again, we can coach this.

Third, they will get better by being chased down and tagged, much better than just sitting on base.  (However the rent-seeking rule makers also have plenty of career opportunities ahead of them in law and politics.)

Fourth, the older kids might learn a thing or two.  I’ve watched some wise older children deliberately tone their play down.  Most of these kids are older siblings, so they’re use to (and probably have been trained in) playing nice.  Toning the play down has benefits.  If you’re not outright dominating, the other kids will not likely want to create rules to take away your advantages.  Then everybody gets to play, have fun and improve.

Recognizing the reason governments fail

Gary Becker has a piece worth reading today’s Wall Street Journal, The Great Recession and Government Failure.

Becker explains well government failures that contributed to the recession and its prolonged effects.  He also explains well why free markets work better than government (emphasis added):

The traditional case for private competitive markets goes back to Adam Smith (and even earlier writers). It is mainly based on abundant evidence that most of the time competitive markets work quite well, usually much better than government alternatives. The main reason is not that individuals in the private sector are intrinsically better than government bureaucrats and politicians, but rather that competitive pressures discipline market behavior much more effectively than government actions.

Competitive pressures in the private marketplace sort out failure better than in government.  It’s not perfect, just better.

Where do jobs come from?

I recommend listening to Rebooting America’s Job Engine, a podcast from Harvard Business Review Ideacast.  The guest, Henry Nothhaft co-wrote a book entitled, Great Again: Revitalizing America’s Entrepreneurial Leadership.

I look forward to reading the book.

Nothhaft says that he and his co-author tried to take a fact-based look at the connection between innovation and job creation.

He says recessions prior to 1990 had recoveries, in terms of employment, of about four months.  Post 90s, employment recovery has been taking longer.

His answer:  Fewer business start-ups are making it out of gestation to grow and add jobs.  He cites Kaufman Foundation study and Census Bureau data that show that all new job creation comes from business startups and that government regulation is “choking off the ability for small companies to start and succeed and create jobs in the U.S.”

One regulation he points out is the Sarbanes Oxley financial regulations.  He believes the costs of the onerous one-size-fits-all approach can be absorbed by larger organizations, but not by smaller organizations.

Some folks will point out some high profile growth stories that have grown large without adding many jobs, like Facebook.  I don’t necessarily buy that hypothesis. 

I believe cases like Facebook do not counter Nothhaft’s story.  It could be that the Facebooks are the only ones with enough momentum to get past the higher regulatory hurdles.