Government Spending: Y Oh Y?

GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X - M).

Y = C + I + G + (X − M)

This is the basic economic equation that appears in every debate over private and public economic activity. Consumption (and exports) are a proxy for production. One can see the inherent relationship between consumption and production; if a society consumes more than it produces, imports (M) increase, net exports (X) decrease and the GDP drops. Thus consumption, itself, cannot keep a society going. Savings, here, could be seen as a threat if it is removed from the economy and goes under the mattress but is a boon if it goes into investment. But investment itself might fail, produce nothing to consume or export, take that money from consumption and be a negative. So consumption could be a negative, investment could be a negative and the import-export balance could be a negative. For some reason we never look at the government spending in the same light.

The key point is, unlike the other factors, government spending (G) is not a proxy for production. The government might build a school for 600 kids grade 1 through 4. That seems like a good place for money to go. But what if the school has only 30 kids show up, or what if each floor has a their own electron accelerator? That will still show up as a positive contribution towards GDP. If the government builds the school for 1200 kids, the contribution to GDP will be double, even though there will be no more use for it than for the school built for 600. If the government realizes its mistake and tears the school down, that expense is more government spending and more contribution to GDP. So the building and then the destruction of a school are both positive contributors to GDP; that is clearly unreasonable. Had a private school made the same investment it would report losses that would accurately reflect the circumstances. It might even go out of business and become fertilizer for the next economic planting. More, the government takes money in taxes to pay for the useless school that could have gone elsewhere, consumption or investment, that would have also contributes to the GDP and might have had the additional advantage of stimulating further investment.

The unused school will never show up in the equation accurately. Government always takes money that might be used otherwise as a real contributor to the economic community and puts that money in areas that are open-ended, that are never judged economically. Moreover, as government spending always counts towards GDP, it is--by definition--productive regardless of how inefficient or costly. Wars are always "productive" but terribly inefficient and inflationary because the government pays for things that blow up on purpose. It would be like building refrigerators that automatically stopped working in 3 months--or building schools to tear them down.

The TARP program is winding down; it is a temporary economic stimulus and its time is up. However, there is an infrastructure of 17,000 employees and they will not be going away. So the purpose of the bureaucracy has ended but the bureaucracy has not. That expense will be counted as a positive for the GDP. There is no negative for government spending. Ever.

Until we are able to look at government spending clearly, not as an absolute number but as a contributor or a threat to GDP, we will never make progress with our economic problems.