The worst possible question in economic theory – where will the money come from?

I went along to hear Joe Hockey talk about tax and the world in 2055, and while I understood the problem, I was underwhelmed by the analysis. It is one of the legacies of modern macroeconomic analysis, one of the absolute worst, to continually think in terms of money and not in terms of value added. This is one of the consequences of thinking in terms of aggregates which can only be denominated in money values. But once you sink into money as your mode of thought, you are almost never going to get your head around the problem, which is where will the capital stock come from, and how can we be sure that the capital we are building today is actually going to strengthen our economy over the longer term.

Money is all right as a means of thinking about accounting, which a budget basically is. It’s a balance sheet writ large. It is also why the central concern of those who don’t know any better is merely to try to balance the budget, as if money-in equals money-out is the issue.

The issue is resource use. All forms of production use up resources. Only some forms of production create more value than is used up. The only source of value adding production is the private sector. Governments virtually never create value, other than when they have a monopoly in the production of something, and even then it could inevitably be done better by the private sector. But if a government has a monopoly, they can create value, but the outcome is still far from being as productive as it might have been.

You need to divide all forms of production into three categories: wealth creating, welfare and waste. Only wealth creation makes you better off, and that is almost entirely the province of business. Welfare and waste are the province of government. And while I have no in-principle objection to welfare expenditure that doesn’t eat too deeply into the wealth-creation process, I have a large objection to welfare spending that does. Waste, of course, should be eliminated to the greatest extent possible. But if you are looking for a greater ability to spend on welfare, it is value creation that must come first.

As it happens, the only economics text in the entire world that truly examines and explains value added, outside of the typically useless discussions sometimes found in looking at the national accounts, is my Free Market Economics. If you know of another, feel free to let me know. If you don’t know of another, then you should read my book. It is only if policy makers understand value added properly, and are not muddling themselves up by thinking in terms of money, is there even a ghost of a chance they will get their policies right.

And if you don’t want to take my word for it, here is John Stuart Mill trying to say exactly the same, in Book I, Chapter V, Paragraph XVI of his Principles of Political Economy, the greatest book on economic theory ever written.

It is the intervention of money which obscures, to an unpractised apprehension, the true character of these phenomena. Almost all expenditure being carried on by means of money, the money comes to be looked upon as the main feature in the transaction; and since that does not perish, but only changes hands, people overlook the destruction which takes place in the case of unproductive expenditure. The money being merely transferred, they think the wealth also has only been handed over from the spendthrift to other people. But this is simply confounding money with wealth. The wealth which has been destroyed was not the money, but the wines, equipages, and furniture which the money purchased; and these having been destroyed without return, society collectively is poorer by the amount. It may be said, perhaps, that wines, equipages, and furniture, are not subsistence, tools, and materials, and could not in any case have been applied to the support of labour; that they are adapted for no other than unproductive consumption, and that the detriment to the wealth of the community was when they were produced, not when they were consumed. I am willing to allow this, as far as is necessary for the argument, and the remark would be very pertinent if these expensive luxuries were drawn from an existing stock, never to be replenished. But since, on the contrary, they continue to be produced as long as there are consumers for them, and are produced in increased quantity to meet an increased demand; the choice made by a consumer to expend five thousand a year in luxuries, keeps a corresponding number of labourers employed from year to year in producing things which can be of no use to production; their services being lost so far as regards the increase of the national wealth, and the tools, materials, and food which they annually consume being so much subtracted from the general stock of the community applicable to productive purposes. In proportion as any class is improvident or luxurious, the industry of the country takes the direction of producing luxuries for their use; while not only the employment for productive labourers is diminished, but the subsistence and instruments which are the means of such employment do actually exist in smaller quantity. [Bolding added.

I think my version is easier to understand, but this confusion of money with wealth causes endless damage. You may, of course, disagree with Mill and think that following the money is all there is to it. But it’s not, and if you wish to understand why, read Mill, or again let me suggest, the second edition of my Free Market Economics, especially Chapters 3 and 5.

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