Infernal Ramblings
A Malaysian Perspective on Politics, Society and Economics

Why Government Economic Planning Fails: An Economic Parable

Written by johnleemk on 3:26:49 am Jun 27, 2008.

Economists often caution against excessive and direct government intervention in the economy. Government micromanagement is bad for the economy, they say. Unfortunately the public and politicians usually fail to grasp the reasoning behind this. We may intuitively sense that only private and individual enterprise can serve as the backbone of economic growth, but our first impulse is to usually turn to the government to set the economic agenda. It is too bad, because the economists' reasoning is simple: individuals left to their own devices adapt to economic progress better than they would under a government tempted to intervene on their behalf.

What drives economic development? Economists have long puzzled over what is the crucial component for economic growth — free markets and strong institutions such as the rule of law are favourite picks, but they do not seem to explain the big picture. Fortunately, we can confine ourselves to thinking about what constitutes economic growth; about how growth takes place.

The answer is simple: the economy grows when people have more options immediately available to them. This becomes clear when you think about it in terms of a parable — a little story. I can't do much with a tree. I can, however, sit on a log after I fell the tree. If I make a chair and table out of the lumber, I can sit down more comfortably, and put something on the table. If I were an enterprising type, I could trade with a forager to serve food on the table for both of us: I get food, he gets a nice place to sit and relax while eating. My wellbeing fundamentally improves when I can do more things; the economy in essence is about making the most out of the scarce little we have.

Thus, the more opportunities we have, the better off we are. There are some caveats to this, of course, but in general, this is a good rule of thumb. In this parable, we see some possible ways to grow the economy: to grow the opportunities available to us.

One way is to harvest natural resources: fell a tree. This works as long as there are trees to chop down; without natural resources to start with, there would be no economy.

Another is to manufacture something out of those natural resources: hew a chair and table out of the felled timber. Again, this relies on natural resources being available, and on other things too: labour and capital (capital is basically economic jargon for things like tools, machinery, etc. — I can't carve a table without a sharp implement).

Finally, we can provide a service using manufactured products: set up a dining establishment. In addition to all the earlier conditions mentioned, we need human ingenuity.

In all three cases, of course, we need smarts: we need to see the opportunities a tree represents. If we cannot be forward-thinking, the economy cannot grow. But just as importantly, we need to cooperate and trade.

Oh, yes, we could all individually chop down trees, carve our own furniture, and serve food ourselves. But that would be inefficient; it would not be effective. If we all specialise in something, then we can have more for less work; this is how trade arises.

Let's introduce technology to our economic model. Say we discover an incredible machine which, when we feed one log into it, can produce enough furniture for everyone. Overnight, the whole furniture industry collapses. The inventor of the machine is rewarded immensely for his discovery. Technology on the whole seems to have made us worse off: now the unemployed carpenters cannot afford to buy any furniture, while the inventor can buy much more than he really needs.

This shock to the economy does not have to be technological progress; it can be simply trade (maybe we find out that if we send one log down the river, someone sends us back enough chairs and tables for everyone), or the discovery of a new raw material which makes timber obsolete — anything. But now human ingenuity re-enters the picture. The carpenters can choose to take up a new occupation: with all this surplus furniture around, surely there will be things we can do with them. We have to adjust to the shock to the economy, no doubt, and adjustment is tough; in the long run, we nevertheless become much better off.

How, you ask? Simple: we no longer have to expend labour carving tables and chairs out of raw lumber. We can expand the service industry, or focus on refining the machine-produced furniture, or any number of things. We still have as much capacity to produce furniture as we did before, but we can now produce other things as well.

You might be wondering what this has to do with government intervention in the economy. The answer is simple: the government is often too short-sighted to ably plan.

Returning to our parable, if they could, the carpenters would complain about this new horrible machine putting them out of business. A responsive government would take action, perhaps banning or regulating the use of the machine so the carpenters could still produce some furniture and maintain some business. Or it might subsidise the carpentry industry so furniture made the old-fashioned way would be sold at competitive prices with the new machine-made products. The most obvious solutions would, alas, be harmful to the economy, stunting economic growth: rather than devoting their energy to coming up with new ideas, the carpenters would be happily following their old way of life, oblivious to the lost economic potential.

Worse still would be a government that planned ahead, setting the economic agenda. Assuming that the carpentry industry would follow its old path, humming along fine, the government would be taken aback by the sudden economic shock — whether the increased efficiency came from technological advance or trade. It would not know what to do next; if its policies were all aligned with funding the carpenters as the only source of furniture, then the economy would be severely distorted right until the government figured that it would be more beneficial to follow the more efficient path — and considering the carpenters' activism, that could be a long time to wait. We might never even get a chance at enjoying the machine-made furniture of our parable.

You may think this parable sounds ridiculous, that such things could never happen in real life. I wish that were so. The Luddites of the 19th century have gone down in history for smashing industrial machinery which put them out of work. In the modern day, we have people arguing that countries which produce goods more efficiently than others should not be allowed to sell their goods at "excessively cheap" prices in less efficient countries. Governments often duly concede; the economy may not reach its full potential, but vocal short-sighted interest groups are pacified.

But what this really means is that when the government makes economic policy, chances are it will actually be bad for the economy! In our little parable, if there were no government to turn to, the carpenters would have no choice but to accept the obsolescence of their industry, and find new things to do. At the very least, they would have a lot more leisure time, which is, if not good, at least not a very bad thing to have. Having a government, at least in this case, is detrimental to economic growth.

Of course, that is not to say that government is on the whole bad. On the contrary, without a government to enforce contracts and ensure people pay up when they promise to pay up, it would be all but impossible to have a functioning economy. Government serves a variety of purposes, many of them economic.

If the government must intervene in the economy, it ought to err on the side of making opportunities available to people who have lost them, at least in the short term. It is hard to think about possibilities for entrepreneurship when you are starving, your children are sick, and you don't have a roof over your head, all because you lost your job when it turned out someone in another country or a new robot can do the job better than you. The government can directly transfer money to those in need in this case; what it should avoid is the temptation to retard progress by "protecting" people from more efficient ways of producing goods and services.

The more you think about it, the more you realise this maxim holds true in a surprising variety of situations. People complain about rising fuel prices; the government could subsidise petroleum-based fuels, but at what cost? The rising price clearly indicates oil production is becoming more inefficient relative to alternative energy sources; to "protect" us from this change will only serve to dampen the market for these alternative energies. At the same time, subsidising "alternative energy" cannot work because we have no way to tell what form of alternative energy is most promising. It is far better if we just give people cash directly and let them decide what to do; they will not be protected from the hidden costs of using petroleum-based fuels, and their range of opportunities will remain the same. In almost any situation where we hear calls for "protection" of the defenceless, we can apply the principles we learn from our little parable — to truly protect those affected by economic change, we must maintain their range of opportunities to the best of our ability, but not insulate them from the altered economic situation.

This whole exercise might strike you as a little simplistic. But this is how economic models work: they tell stories about aspects of the economy. They help us think about the economy in a structured and systematic manner. And once we have derived some fundamental principles from the model, we can apply them to the real world and see if our reasoning holds up. If the model's system of thinking accords with a reasonable approach to the real world, we can proceed on the basis of the principles we derived.

Therefore, a government which attempts to directly intervene in the economy, to stop the winds of change, will in most cases wind up harming the economy. Governments cannot set the agenda for a country's economy; they are no substitute for the judgement of individuals responding positively to economic change. Governments should serve as facilitators of opportunity, rather than protectors of inefficiency; in the long run, the economy will thank them for it.

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