By Don Cooper
Production
Production means creating market value. Consumption means destroying market value.
Production is the act of taking factors of production (inputs to production) and combining them in such a way that the market value of the outcome is greater than the market value of the inputs separately. If the market value of the outcome is less, then it’s consumption.
For example, take a 2×4 that has a market value of $10 and cut it into smaller pieces to make a chair. Ignoring other costs like nails and glue and time, the builder of the chair will ask at least $10 for the chair. If he can sell it for $15 then he will have produced $5 of market value. If he cannot sell it for at least $10 but he can sell it for firewood at $5, then he’s consumed $5 of market value.
Production is not the act of just doing something. All costs, including opportunity costs, must be considered to determine if the activity was productive or consuming. Any activity that consumes but is claimed to be productive is an economic fallacy known as the broken window fallacy.
To be productive requires certain economic incentives and risks. First of all, the inputs to production must be obtained—and that comes with a cost. Having incurred that cost, the producer now has an incentive to use his inputs as efficiently as possible in order to sell the outcome for a profit. Further incentive comes from the fact that there’s a risk he’s producing something that the market simply doesn’t value so production decisions are made carefully. The market will not tolerate waste.
Since, for a business, everything comes with a cost, producers are careful to ensure that the benefits associated with those costs are at least equal to, if not greater than, the costs. If not, they go out of business and lose all their investment. Even then, more times than not, businesses still fail to be productive. It’s not easy and the market is a harsh regulator.
So, given the costs and risks, why would anyone engage in productive endeavors at all? Because the market value created is their income, their wealth, their productivity to use to trade with others for the things they need like rent, food, electric, etc. It’s basic economic activity that people have engaged in since the beginning of civilization. Each produces what they’re good at producing, consumes some of it themselves, and trades some of it for the other things they need.
Productive activities are only undertaken, however, by those who need to earn their income. This is borne out, for example, by lottery winners who quit their jobs. They no longer have to earn their income, so they no longer have to incur the costs and risks of being productive. This holds true for anyone who has alternative means of acquiring wealth rather than through productivity.
Given this definition of production and consumption, consider that the government doesn’t produce anything, it directly consumes. It is not subject to economic market forces, but rather political forces. It’s in fact economically impossible for the government to be productive and its consumption should be accounted for in any national income equation.
Government obtains its inputs via legislation: taxes, fees, licenses, fines, unlimited borrowing from the FED, asset seizure, etc. In other words, it takes the inputs to what it does, it doesn’t earn them or have to pay for them. Therefore, they have no incentive to use their inputs efficiently. They can always get more by simply raising taxes, creating new taxes, borrowing more, increasing fees, creating new fees, seizing more, etc.They don’t have to earn anything.
There is also no risk in what the government does since risk is shifted onto society via legislation. When the government does something nobody wants and when resources are wasted, there are no consequences. The government doesn’t go out of business and the resources aren’t freed up for other productive endeavors. They are protected by law. When the government borrows absurdly irresponsible amounts of money, society is taxed to pay it back, not the government.
Nor are economic decisions made by bureaucrats based on market demand, risk, or economic benefit analysis but rather by a vote based on political analysis and political expedience.
Given then that the government has alternative means of acquiring wealth, it serves them no economic purpose to incur the costs and risks of engaging in productive activity, similar to lottery winners. They simply take what they want. The United States Postal Service, for example, is $50 billion in the red even though it has a legal monopoly on delivering first class mail, but continues to operate because the government simply takes more money from society and gives it to the USPS, rewarding economic failure and wasting resources.
The government also indirectly consumes in the form of dead weight losses caused by regulation. Taxes, price floors, price ceilings, trade barriers etc. all create an inefficient allocation of resources resulting in economic costs with no economic gains.
National Income Revised
There are a number of different economic measures for the production of a society. There is GDP, GNP, NNP, NI, NNI, and others. This analysis applies equally to all of them, so let’s use national income.
Classically, national income (a measure of national production) is equal to the sum of consumer spending C, investment spending I, government spending G, and net exports NX.
Y = C + G + I + NX
Government spending is included in the equation as a contributing factor to national income, but the government doesn’t have any wealth of its own. As we saw, it doesn’t produce anything. Any money it spends it has to first take from someone who did produce something in the form of taxes, licensing, fees, regulatory fines, or other methods. It’s just a wealth transfer and government spending is just a redistribution of that wealth.
This classic equation for national income assumes that this redistribution is frictionless, that it’s a wash. What the government takes from C, I and NX, re-enters the equation in G, but that ignores the opportunity costs of government redistribution of wealth.
Government redistribution of wealth leads to malinvestment and the misallocation of resources.
When the government builds the bridge to nowhere that nobody wants and which will sit idle after construction, resources are taken away from market productivity and reallocated to the government make work program. It’s tantamount to hiring people to dig a hole and then fill it back up. There’s an opportunity cost associated with those wasted resources.
The government also imposes domestic and foreign trade restrictions on markets such as taxes, licensing, fees, fines, regulatory compliance, barriers to entry etc. all sending erroneous signals to the markets resulting in the misallocation of resources.
The government redistributes domestic productivity to foreign governments like Israel and Saudi Arabia so that wealth leaves the economy.
The government manipulates wages and prices which skew market signals and decisions.
The government spends hundreds of millions on inputs to war which, by their nature, are meant to be destroyed and destroy other resources in the process with no benefit to the economy. They are the epitome of the broken window fallacy of government.
So there’s a qualified opportunity cost of government redistribution of wealth, OC, that deducts from national income that should be included in the equation.
Y = C + I + NX – OC
Federal Reserve Banking System
The equation also ignores the effects of the Federal Reserve on national income.
Real money is productivity. You produce something, consume some of it, trade some of it for things you need and save some of it. Those savings can be consumed or traded at a later date or loaned out as credit and interest charged.
Such a loan, plus interest, can be paid back by the borrower with his productivity and that’s the end of the loan.
If there is a form of money that is highly tradeable in all markets such as gold or silver, then the markets will use it as a medium of exchange in order to decrease the transactions costs associated with bartering.
Federal Reserve notes are not real money, they do not come from productivity. All Federal Reserve notes are debt issued by the Federal Reserve Banking System. They are created out of thin air at the time of the loan and must be paid back with interest. Interest that must also be borrowed over time.
Intuitively we can reason that this means that any loan can never be paid off. That more money will constantly have to be borrowed to pay principle and interest. To demonstrate:
Let’s say the first dollar the fed ever loaned was P and it had to be paid back with interest i so the total debt is P + iP. But iP had to be borrowed too, with interest, since the only money in circulation at the time was P. So the total debt became P + i(iP) and so on. This series becomes P + iP + i(iP) + i(i(iP)) … which is P + over an infinite number of times n.
The series can be shown to converge to P / 1 – i. Mathematical convergence means the sum approaches but never reaches a limit. Economically this means the loan has no limit, it never ends. Moreover, it demonstrates that the greater the interest rate, the greater the value of the convergence limit meaning the more the money supply has to be inflated.
Consider $1 loaned at 10% interest. The total amount of money that would be required to pay the $1 loan back with interest over time due to continued borrowing to pay back principle plus interest converges to:
= 1.11111111111111111… The series converges to 1.11 meaning that it never reaches a limit, it never ends. The debt continues into perpetuity, it can never be paid off. This is true at any positive interest rate.
Consider the following:
P / 1 – i = 0 ;
What conditions would need to be met for the debt to decline over time converging to 0? If P = 0 meaning the original loan was never made in the first place. But if it is made, the debt exists forever. Economically this means that in order to have a money supply society must be in debt. No debt, no money.
The federal reserve – and other central banks — manipulates the interest rate by inflating and deflating the money supply.
If i = 0 in P + iP then the total value of the debt is just P which can be paid back just by giving P back to the FED whenever. It implies that at i = 0, the money has no value. It can be paid back, it can be held, doesn’t matter. In which case the money is of no use to anyone.
If i < 0 in P + iP then the debt becomes a fraction of P meaning that if P is borrowed, not only is there no interest charged, but you don’t have to pay back all the principle, just a portion of it. In other words, the central bank is giving money away. This money will be wasted for the same reason lottery winners blow their winnings: there’s no costs associated with obtaining the money so anything it is spent on will be of greater benefit than the cost. Any rational person will want the benefits of his actions to at least equal the costs. When the costs are zero, then anything you like is a greater benefit than the cost.
If the federal reserve loaned $1 the amount of money needed to repay the loan at 10% interest converges toward $1.11, more than the original principle plus interest. If they loaned $100 at 10% it would cost $111 to repay the loan. In other words the nominal interest rate is 10% but the effective interest rate is 11% simply due to the nature of the Federal Reserve banking system being debt. The federal reserve imposes an inflation tax on society.
The higher the nominal rate the higher the effective rate and no matter how small the nominal rate is, the effective rate will still be greater.
At a 15% nominal rate, the effective rate for borrowing $1 would be 17.6% and even as low as .5% the effective rate is .502512%
The effect on the money supply and outstanding debt depends on the principle. The greater the principle, the greater the debt required to pay the effective interest.
This means the fed must create money just to cover the difference between the nominal and effective interest rates that serves no productive purpose. It’s money that is not demanded by the market for productive purposes, but which is required only due to the federal reserve banking system. It’s a dead weight loss.
The inflation tax for every dollar borrowed for any interest rate greater than zero can be calculated as: [(i / 1 – i ) – i].
The Federal Reserve Banking System loans money to private businesses and corporations, foreign governments and corporations, and domestic and foreign banks—again creating the money out of thin air and subsidizing failing businesses when they should be allowed to fail and their resources reallocated by the market. Again, rewarding failure.
The Federal Reserve manipulates financial markets, sending erroneous signals about supply and demand in the money markets, creating more malinvestment.
So there’s also a qualified opportunity cost of the FEDs actions, IT, that deducts from national income that should be included in the equation.
Y = C + I + NX – IT – OC
IT is the opportunity cost of the FED imposed on all markets and OC is the opportunity cost of government imposed on all markets.
So the net effect on production of the FED and government is negative. The FED and G consume, they don’t produce anything so the national income equation should be:
Y = C + I + NX – IT – OC < C + I + NX
Conclusion
National income is qualifiably less than its free market potential with a central bank and centralized government. Both consume productivity from the economy.
The claim that the involvement of the government and the FED in the economy stimulates production is nothing but the broken window fallacy in practice writ large. We can see that’s simply not economically possible.
This simple analysis demonstrates the staggeringly destructive effects of Keynesian economic policies that have been imposed on the US economy since before WWII.
All government programs and policies are an illusion; they produce nothing. They simply consume and “the greater good” is worse off for it. It’s impossible for the government or the FED to do anything to benefit the greater good; only markets can do that.
Furthermore, the Keynesian economics being taught in universities is irresponsibly perpetuating this illusion and should be addressed. It’s simply not true.