‘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.

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Government is still overhead

Given the President’s job speech, I thought I’d link to this post of mine, Government is overhead.

To sum that post up, individuals working in the private sector produce all the wealth that results in the standard of living we enjoy.  Individuals working in the public sector  consume some of that wealth.

The public sector would not exist if not for the private sector.

They should co-exist in a beneficial parasite (public sector)/host (private sector) relationship.  However, the parasite can get too big and and significantly weaken or kill off its host.

A wise vampire once said:

We like to talk big… vampires do. “I’m going to destroy the world.” That’s just tough-guy talk. Strutting around with your friends over a pint of blood. The truth is, I like this world. You’ve got…dog racing, Manchester United. And you’ve got people. Billions of people walking around like Happy Meals with legs. It’s all right here. But then someone comes along with a vision. With a real… passion for destruction.  He could pull it off.  Good-bye, Picadilly. Farewell, Leicester-bloody-Square.

This vampire understood he was the parasite and knew where his food came from.  He didn’t think there was much sense in killing off his host (bonus points if you can name that vampire).

Those in the government seem to have a tough time figuring out where their food comes from.

Government’s weakness: It doesn’t have to add value

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.

Government is overhead

In this post, I quoted from a Reagan radio address where I thought he created a good mental image of how the private sector and government work together.  Here’s the key point from his address:

To sum it up roughly 70 million Americans [working in the private sector] provide a living for themselves and 143.4 [million] additional people.

Those 143.4 million people included the non-working family members of the 70 million Americans and the folks who receive a check from government — be it through a government job or transfer payment.  (Though, come to think of it, I think Reagan neglected the private sector jobs that are paid by taxes, like with government contractors.  But, perhaps he was simplifying.)

Reagan’s analysis came up in a conversation with an old friend when we discussed the political theater that has been going on in Washington DC.  Specifically, how liberals are hostile to the private sector and business, even though the private sector and business pay for government. Or put another way, without the private sector, government wouldn’t exist.  And, therefore growing government faster than the private sector is not sustainable.

It then occurred to me that few people seem to understand the value creation process that goes on in the private sector and how that pays for government.  They don’t recognize that this value creation process is the very source of our standard of living, which provides for government and that government is just the overhead.

As a rough analogy for economy, let’s consider a business that makes burritos.

The burrito business has two types of costs — direct and overhead.

Direct costs pay for the materials to make the burritos like flour, meat, seasonings, tomatoes, labor and the cost of the space to make the burritos (I’m getting hungry).  This might also include the sales force and advertising used to sell the burritos and the cost of the trucks to deliver them.

Overhead are the indirect costs like accountants, lawyers, and HR and IT people and the resources these folks use like space and utilities.  These folks aren’t necessarily needed to make the burritos.  Their jobs wouldn’t exist without the value created from the burrito making operation.

Now, overhead does perform some useful functions for the business, just as government performs some useful functions for society.  It’s much better that the business has an accurate accounting of its financials and pays its bills on time.  These sorts of things helps the business remain in good standing with the folks they do business with.

But most people intuitively understand that there’s a limit to the overhead costs the business can support.  It’s not an exact number, but they understand that if a business grows it’s overhead costs faster than profits from making and selling burritos, it would not last long.  And everyone who depends on the business for a living and for good burritos would be in trouble.

They also understand that if the company’s burrito sales declined, the best strategy to fight this probably is not to expand overhead costs.  The best strategy is probably to focus on producing and selling burritos folks will buy.

Yet, when the economy declined, increasing overhead was the idea to save it.  Not surprising that it didn’t work.

This is one reason I dislike the equation for economic output or GDP.  It treats overhead costs, or government spending, as if it were interchangeable with direct costs, like buying more flour to sell more burritos.  And this leads politicians to do crazy things, like increase overhead when what really need to do is make a better burrito.