Monday, September 13, 2010

Wealth Creation

Matt Yglesias balked at a comment by Eric Schmidt , CEO of Google and somebody whom FLG doesn't have very much respect for when it comes to big philosophical ideas, about how the public sector doesn't create wealth. Matt writes in response:
You would think the CEO of an Internet firm wouldn’t be totally dismissive of the idea that CERN and DARPA are contributing to wealth creation. And of course education is important to wealth-creation, and much of it is state-financed. And transportation infrastructure—typically state-financed—creates wealth. Of course even if the state completely removed itself from education finance, it’s not like nobody would go to school. Presumably the private sector would step in to fill some of the void. But conversely in places where the state steps beyond what we’d consider appropriate in the United States it still creates wealth. State-owned firms like Areva are generating value.

I raise these points not to make the case for a bigger or smaller public sector (I would say bigger than the US but smaller than France is ideal, but both are clearly workable) but simply to underscore the point that the performance of public agencies matters a lot. Even under “small government” the state is still undertaking a lot of important functions, and it matters a great deal whether or not they’re done well. Simply dismissing the whole thing as irrelevant is dumb.

Now, in all my economics education, there are two things that seem most unclear to the field of economics. First, why people want money. We intuitively understand this, but economics has a difficult time formally describing it. Second, how wealth is created exactly. Nevertheless, FLG has tried to address this before.

In your typical private sector transaction, both parties freely agree to engage in it. We then assume that both parties thought they would benefit from the transaction; otherwise, why would they have agree to do it in the first place? Now, there are a lot of reasons why this might not work in practice. These are what we broadly call market failures. But on average if two parties agree to engage in a transaction we can assume both benefit from it. This benefit, or gains from trade, is the root of wealth creation.

The public sector isn't a freely agreed upon transaction between the two parties. One party, the government, takes money. They then spend it. While this can be useful to overcome certain situations where the market fails (tragedy of the commons, etc) and can make people better off, the fundamental nature of the arrangement isn't prone to it. Furthermore, even if there is some sort of market failure that the government can over come in theory, it must also do so in practice, which is a totally different thing altogether.

So, if you look at something like DARPA, the question is not whether its output is valuable, but whether it does so better than the alternative. In cases of R&D, there is a strong argument that if the research was seen to be profitable, then generally speaking private firms would engage in it. Now, there are some conditions where government subsidies to do research may make sense, but generally speaking just like the mutually beneficial arrangement, only government would possibly invest in something that wouldn't pay off. This isn't to say that all private investments don't pay off. That would be idiotic. But the estimated probability that they would pay off times the estimated gain if it does will always be positive for private R&D. Maybe the estimates are wrong. Maybe they roll the dice and they lose. But starting out, it will be higher expected benefits than costs.

The government, on the other hand, has a variety of factors that lead me to believe that many projects can have lower initial benefits than costs. See Pork.

So, while FLG doesn't like the trope of only the private sector creates jobs and wealth, and in this case totally coincides with his opinion of Eric Schmidt as a smart but ultimately small thinking leader, Matt sets the bar far too low in his defense of government creating wealth. It's not just whether the project creates wealth, but also one must realize that the taxes caused distortions and there may have been a more efficient alternative, .i.e. letting the private sector do it.

1 comment:

Anonymous said...

there are two things that seem most unclear to the field of economics... why people want money... [and] how wealth is created exactly.

1) Economics also has a hard time accounting for how intensely different groups want money. Rich investors are seldom satiated at any point, while the lower middle-class (allegedly) finds contentment at $75,000 a year. Because so little is really known, modeling their prospective behavior is a nightmare. (For instance, I don't believe for a minute that the majority of people earning $500K, $750K or even $2M would "save" the money they "gained" as a result of the extension of the Bush tax cuts.)

2) Obviously state and federal agencies occasionally do things that make wealth creation simpler, or allow wealth to be created in entirely new ways. Sometimes that's deliberate and sometimes it's inadvertent. Looking back over the past forty years, I think it would be very hard to make a persuasive case that "deliberate" policies did more than "inadvertent" policies. A majority of state governments have had technology initiatives of some sort; few have accomplished much of anything (the result of unrealistic objectives or poor policy/program tools.) And while everyone likes to point to DARPA, etc. with regard to the internet, no one at all envisioned the commercial consequences. (And I am tempted to say, if they had, federal officials would have found some way to screw it up.)

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