Below is an extract from a commentary originally posted at www.speculative-investor.com on 3rd July, 2008.

Increased government spending: always the proposed solution, never the right solution

There is almost universal agreement that as the economy continues to deteriorate the government should "do something" to help, with "something" being increase its own borrowing/spending to make up for the reduction in the borrowing/spending of the private sector. Even analysts and commentators who claim to understand the problems wrought by inflation and who consider themselves to be pro-free-market are, in some cases, advocating increased government spending on the basis that things are getting so bad that there is no longer any viable alternative. It is clear that these people haven't thought things through in sufficient detail and/or are unaware of the dismal history of government attempts to mitigate economic downturns via deficit spending.

The government is like a giant parasite that attaches itself to the economy and grows by sucking the economy's blood (wealth). During times when the host (the economy) becomes weak it would appear to be prudent for the parasite to suck blood at a reduced rate, yet whenever the economy weakens the call goes out for the government to borrow and spend at a FASTER pace. The popular line of thinking therefore seems to be that the host will get healthier if only the parasite is allowed to become even bigger and to suck even more blood.

The "sucking blood" analogy is apt because the government does not produce any wealth. Rather, it re-distributes wealth and, in the process, takes a cut in order to pay its own large and ever-increasing expenses. The total cost of government will therefore be the cut that it takes to fund its own existence plus the impossible-to-measure effect of using scarce resources far less efficiently than a free market would use them.

The government funds itself in three ways: by direct taxation, by borrowing, and by inflation (creating money out of thin air), although at a time of economic distress the only politically acceptable funding options will be borrowing and inflation. But regardless of whether the government funds its operations by directly taking money from one segment of the population or by increasing the supply of money and thus taking a bite out of all existing currency units, the end result of increased government spending MUST be reduced wealth within the economy due to the direct cost of the bigger government and the more-difficult-to-quantify costs of resource misallocation and less freedom. Therefore, those who claim that an increase in government spending is needed are, in effect, claiming that the economy will benefit from a reduction in wealth.

Logic aside, the historical record clearly shows the inadvisability of ramping up government spending in response to an economic slowdown. For example, when the great US credit expansion of the 1920s inevitably went bust, the Republican Hoover Administration responded with a substantial increase in government spending. However, things continued to get worse. The presidential nominee of the Democratic party at the time, F.D.Roosevelt, was vehemently critical of the Hoover Administration's excessive spending and labeled Hoover a "spendthrift", but the budget deficit racked up during just the first three months of the subsequent FDR presidency turned out to be greater than the deficit racked up by Hoover over the preceding two years. And still, FDR's unprecedented government spending binge failed to catalyse a sustained recovery. Instead, depression-like economic conditions prevailed for more than a decade. Rather than helping to alleviate the economic distress it is readily apparent that the increase in government spending during the 1930s helped to prolong it.

1990s Japan is another good example of how increased government spending will tend to prolong, rather than mitigate, an economic downturn. The debt of the Japanese Government ballooned during the 1990s as it poured massive amounts of money into public works projects in an effort to stimulate a moribund economy, but the strategy proved to be an abject failure.

But hey, even though increased government deficit-spending has never worked in the past and logically can only make things worse, let's give it another go anyway.

More inflation to come

If you want to develop a better understanding of what inflation is and how it operates within the economy then we suggest that you read THIS short article.

As we've noted in previous commentaries, when measured properly the rate of US inflation (money-supply growth) has been fairly slow over the past couple of years, particularly relative to the rampant inflation of the first half of this decade. The prices of many things are now rising swiftly, but this is an effect of what happened to the money supply years ago rather than an effect of what is currently happening to the money supply.

That being said, the seeds are being sown for the next round of monetary expansion. Those seeds are the frenetic calls for increased government spending and other "stimulus packages" to address the economic downturn, and the virtual certainty that politicians of all stripes will heed these calls. The bonds issued by the government to finance the additional deficit-spending will lead to more inflation because they will be purchased by the central bank or private banks with newly-created money.

As noted above, an increase in government spending cannot possibly help. Its likely effect will be to PROLONG the downturn, but the longer it takes for a sustained recovery to begin the greater the opportunity for the government to 'fight' the downturn via even more inflation-financed spending.

The way these things usually go, the economic problems caused by one set of government interventions are used to justify more interventions. Therefore, when the situation continues to deteriorate following the first round of "economic stimulus", a bigger stimulus package will undoubtedly be proposed. And when that doesn't have the desired effect, an even bigger one. We'd like to think that reason will eventually prevail and that before it's too late a critical mass of people will come to the realisation that, far from being part of the solution, government intervention in the economy and massive government deficit-spending are integral parts of the problem. However, hope is not inspired by the fact that FDR's disastrous presidency is widely considered to be a great success.

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