When I came home from my golf game last Tuesday I found my 13 year-old grandson Michael sprawled on my office carpet reading an article I had written in “Accountancy” Magazine. He said “Grandpa, I agree with everything you write, but I just don’t understand this sentence.”

“Which sentence is that, Michael? Read it, and I’ll try to explain.”
“ ‘Government expenditure is not susceptible to economic calculation.’ What does that mean, grandpa?”

I find that of my six grandchildren, Michael in particular has the knack of providing me with a unique opportunity to sort out my own thinking on economic postulates, even my own formulations, that require further exploration, simplification and intelligible reassembly.

He is also a good listener and quick to grasp a point if clearly explained. He has the additional advantage of having a mind that is free from entrenched preconception or dogma, – which makes my job as his economics mentor so much easier. Of course, being the patriarch of a family, most of whose members are blighted with a distinctly left-wing bias, has its own problems – but whenever Michael is warned “Don’t let him brainwash you!” he responds in like fashion, and insists that he is merely reasoning things out for himself, with grandpa’s assistance!

What follows is the gist of my further elaboration.

How government gets, and spends, its money

1 – Take the first two words, “Government expenditure”. Government, or the state, has no money other than its tax receipts. Taxation is borne by the productive sector of the community, mainly out of people’s earnings and the profits of industrial and commercial enterprise (otherwise known by the short-hand “private sector”). Government expenditure therefore consumes, rather than produces, wealth.

2 – Government faces innumerable demands for a share of the tax receipts garnered from the private sector. These demands are made by a host of worthy supplicants, usually administered by public sector bodies, notably town and borough councils and their myriad departmental committees that control the budgets of every centralised community activity such as care homes, hospices, nursing homes, hospitals, schools, libraries, parks, highways, and the rest – not to mention the impenetrable maze known as the “benefits system”. The list is without discernible limit, since there can be no satisfaction when “needs proliferate like weeds”.

3 – The chief characteristic of this system is the manner in which so-called benefits elide into entitlements. Public outrage greets every attempt by central or local government to scale back on its munificent “commitments” when it runs out of funds. One South London borough recently had the temerity to withdraw its programme of IVF (in vitro fertilisation) treatment for women who have difficulty conceiving in the normal way, thereby saving the council £6 million a year. From ‘free’ IVF to ‘free’ cataract removal, the list of entitlements just goes on and on, without rational limit. Of course, none of it is ‘free’. This word glibly masks the fact that someone else is paying. But rational thinking is rare these days!

4 – How government chooses to dispense the tax revenue it has collected lies in the realm of politics rather than economics, but the political animals with power to set priorities, and make spending decisions, all too easily forget, for all their heady self-importance, that their own remuneration comes out of taxes and that they are public servants, not masters.

Blind spending, and borrowing

5 – The process of reaching spending decisions is complicated by the fact no one in government knows how much tax revenue will find its way into the public coffers each year, and consequently no one knows how much is available to meet the multitude of uncosted demands. Even for the Chancellor, when he sets income tax rates, the only certainty is that a tax rate of 100% will raise nothing at all because it will leave taxpayers with no incentive to work. (They can’t all go on the dole because there will be no money to pay them.) On the other hand a tax rate of 0% will similarly (and equally obviously) raise nothing at all. As noted, the political juggling act known as the annual “Budget”, the Chancellor’s attempt to find a judicious medium between these extremes, is a pure gamble.

6 – One final point on the consequences of fiscal miscalculation on the part of government. If the taxes raised by the exchequer prove insufficient to meet the promised benefits, the chancellor always has another trick up his sleeve called Quantitative Easing (QE). He asks the Governor of the Bank of England to co-operate by simply generating (printing) Treasury Bills and other assorted bonds (government debt) that the Bank then puts into wider circulation via the commercial banks and other City institutions. The new money is called “fiat” money. Just as “fiat lux” is Latin for “let there be light”, fiat money arises because the chancellor waves his magic wand and says “let there be money”. It has no more substance than that.

7 – Of course, this is just government borrowing by sleight of hand, and it has a double purpose – (i) to assist government to fulfill its promises by handing the chancellor more money; and (ii) to stimulate demand in the economy by, again, injecting money. The first objective simply covers up the chancellor’s failure to balance his spending promises with his resources; and the second objective (referred to demand stimulation) overlooks the obvious fact that all the demand in the world is completely useless if the supply side produces nothing to satisfy that demand. Indeed, eight years of stimulation have failed to move the sluggish economy.

Bidding for contracts

8 – The process is further complicated by government’s convoluted and ludicrously anti-competitive “procurement” protocols that encourage the formation of supply chain cartels while acting as a disincentive to potential bidders for government contracts. Expenditure of time and resources on a bid to win a lucrative public sector contract is a risky and costly game under the rules. These dictate that once procurement has been awarded additional suppliers cannot be added. Any competing supplier would have to wait until the next relevant tender opportunity arises. The length of an arrangement is usually two to four years, and the procurement process itself takes several months to complete. Obviously only the very largest organizations can afford to undertake these complicated and costly procurement bids, and their pricing necessarily reflects their attempt to recover these costs.

9 – A little economic reasoning would tell us that the services which government dispenses “free of charge” would, in the private sector, be subject to far less wasteful bureaucracy and more open competition. Market forces would compel suppliers of, say, pharmaceutical drugs, surgical gloves, hearing aids, wheelchairs and other products and commodities, to keep their pricing competitive simply to stay in business. This principle would apply throughout every service currently falling within the orbit of the public benefit system and lower prices would be the result.

10 – No economic calculation can be made of the total amount suffered by the exchequer due to the simple fact that the pricing of supplies from private companies to public sector bodies is not subjected to the commercial cut-and-thrust of free market forces. From this it should be apparent that the only certain way to benefit the public by bringing down the costs of services would, in the longer term, be to privatize them – the very idea of which is anathema to a population that has never known an alternative to state-funded dependency.

The infrastructure trap

11 – While there is no doubt that every community actually needs hospitals, schools and all the other services, the same cannot be said of grandiose infrastructure projects that cost the public purse billions of pounds, such as new power stations, new airport runways or new high-speed rail links. These are of a different order entirely. The simple equations that would, in an open market commercial environment, determine whether a project is worth embarking on, are never asked:
(a) Will the monetary returns generated after the project’s completion reliably exceed the costs of (i) original construction; (ii) normal depreciation charges; and (iii) its operational running costs, taking account of market determined interest rates?
(b) Have these calculations been rigorously tested and double-checked to within a tolerable margin of error?
(c) Is the imperative to proceed with the project based on genuine commercial need, publicly expressed, or sheer bravado on the part of government, as revealed by meaningless political slogans such as “demonstrating that Britain is open for business”?
(d) How will the nation suffer if the project is abandoned right now?

12 – Examples abound everywhere. After Spain’s last housing boom government planners believed that the country needed new airports to bring in the visitors and holidaymakers. Result? Fifteen new airports were built. They are all completely empty, several of which have never seen an airplane. As a member of the European Union the Spanish government knew that the European Central Bank would be forthcoming in a crisis. There is a crisis, and a bailout looms, despite it being contrary to EU rules. In the words of an economist at Barcelona University, “it is distressing to close a hospital operating theatre and keep open an airport with 40 people working there and no planes landing.”

13 – In similar fashion the latest Portuguese motorways have been designed to deter any sane motorist from using them. They are toll roads that have no tollbooths, and they are all electronically operated, each vehicle being charged a fixed price depending its class. Each car requires a transponder that registers a charge every time it passes an arch. If it does not have a transponder, a photograph of the number plate will automatically be recorded. Some service stations sell transponders, and some sell pre-paid cards. All the rules are shown on signs along the route, setting out the many options for drivers – in small letters, and in Portuguese. Drivers avoid motorways like the plague. Can you imagine James Dyson marketing an invention as hellish as this?

14 – Even a “successful” project like Eurotunnel fell victim to failure of economic calculation. It was a year behind schedule, £2 billion over budget, and today has traffic utilization levels of only 50% of capacity for passengers and 10% of capacity for freight. So massive were its debts that the French Court had to grant it protection from its creditors. According to the Public Accounts Committee, the Department for Transport “failed to anticipate that airlines and ferry companies would adjust their pricing so as to compete with the tunnel.”

15 – Several development aid projects funded by the World Bank share a similar record. Diverting fresh water from Lesotho Highlands to South Africa at a cost of $3.5 billion produced electricity that was too expensive for consumers, and created environmental havoc downstream, without compensation.

16 – In a plan to provide jobs in Kenya the Norwegian government funded a $22 million fish processing plant on Lake Turkana. The Turkana people, however, are nomads who have no history of fishing or eating fish, and the cost of operating freezers was too great. The plant stands as an empty monument in the “museum of well-meaning cock-ups”.

17 – Young Michael’s eyes were glazing over at this point. He will no doubt think twice before asking me another question – but, if he does, I promise to let you know!