Wednesday, March 21, 2007

Other people's money

I’ve been thinking about the role of government in environmental policy. And in economic, social, health and education policy. When should governments provide services? When should they regulate activities? When should they just leave things alone?

There’s the environmental questions: Should they ban incandescent light gloves? Should they fund clean coal research? Should they restrict household water use? Should they impose a carbon tax or increase the price of water and let individuals decide whether to use incandescents or limit their water use and let energy companies decide whether they invest in clean coal or in renewable energy? And there’s others: To what extent should the government provide education and health and to what extent should the private sector do so? How should the government regulate smoking, alcohol and other drugs? Should the government get involved in the fast food / obesity debate?

I think economic ideas can help us think about some of these issues. One of the reasons that markets tend to work effectively is that they efficiently communicate information (Should I plant wheat or grape vines? Well, how much will they cost me to grow? How much will I get for them?) and they provide incentives for people to respond to that information (planting vines will be a lot of bother, but it should make me enough in a few years to buy that car I want).

The disdain that some have for governments providing services is that the information and incentives are less obvious. Should we invest more in mental health care or cancer care? Hm , hard to know. We can survey people and we can look at health stats but it’s hard to know where we’ll get more value for our money. And the people who make the decisions, while interested in the health outcomes, might also be interested in the publicity generated by opening a new cancer wing at a regional hospital.

Libertarian economist Milton Friedman talked about four ways you can spend money and I think it’s an interesting way to look at some of these issues:

There are four ways in which you can spend money. You can spend your own money on yourself. When you do that, why then you really watch out what you’re doing, and you try to get the most for your money. Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I’m not so careful about the content of the present, but I’m very careful about the cost. Then, I can spend somebody else’s money on myself. And if I spend somebody else’s money on myself, then I’m sure going to have a good lunch! Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get. And that’s government. And that’s close to 40% of our national income.

This observation is often used to suggest that things are always better left to markets than to government. But real life much more complicated than that.

There are other constraints on governments. Taxpayers are acutely aware of the taxes they’re paying and proposals to reduce them will be popular and proposals to increase them unpopular. So it’s not true to say that governments don’t care about how much they spend. They have incentives to care quite a bit. Voters are also very aware of the services they’re receiving, another accountability. But these accountabilities are generally less direct than in a market. If I don’t like the service or price of my doctor’s service, I can go elsewhere. But if I don’t like the service provided by public healthcare or the taxes I pay for it, I can only exercise my one vote among thousands every three or four years and there’s generally only one other real competitor.

But these problems also apply to the private sector. Economists call them agency problems. Have a think about a superannuation fund or a managed share fund, for example. When they choose to invest, they’re spending other people’s money on other people. They, not you, are making the decisions about what companies to invest in to benefit you. Where’s the incentive to make the best decision? Well, incentives are there, but again they’re indirect. After a few years of bad performance, people may start to switch funds. But this incentive is also distorted. They have an incentive not to perform much worse than anyone else – in other words, an incentive to make conservative investment decisions.

Have a think about a law firm acting for you in a court case and advising you about whether to accept a compromise. What should they advise you? Again, they’re decision in how to advise you involves their assessment of how someone else’s money should be spent. And possibly creeping into that assessment is a confidence of a positive outcome that might not be there if they were spending their own money or if your money wasn’t being spent on their fees.

Or think about the Board of Directors of a company deciding whether to award themselves a substantial pay rise. Here, they’re making a decision about how to spend other people’s (shareholders’) money on things that will benefit the company. Will a big pay rise for directors benefit the company? Of course, you’ll attract the best talent, the people who will boost the company’s performance, right? Again, people spending other people’s money on other people. And again, there’s incentives to do the right thing, but they’re indirect and conflict with the direct incentive to benefit themselves. (The incentives are that if they go too far, they’ll be removed by angry shareholders, and if they channel too much money that could be better spent on other things, the company will suffer, leading to pressure on them to resign and/or damaging the value of their own shares and options in the company).

Or think about any manager in any large company. They’re spending the company’s money on themselves, their staff and their projects with the aim of benefiting the company. Again you can make the claim that they won’t be as careful as if it was their own money. Once again, there are incentives to spend it wisely: they want to generate good results and be seen to be doing a good job. But there are also conflicting incentives to spend it on themselves, their staff, a team retreat in the Hunter Valley, etc.

Looking at who is spending whose money on whom is a useful way of looking at things and generally you’ll get the best decisions if people can spend their own money on themselves. But it doesn’t simply follow that the private sector does everything better than the public sector. A lot of private sector decisions involve how to spend other people’s money on other people too.

Taken to its logical extent, this argument would suggest that all goods and services should be provided by sole traders. The baker is disciplined because she depends on her customers for her livelihood. So she’ll spend her money in ways that best benefits her customers and hence her business. But the bakery staff-member who buys the flour is spending his boss’s money on his boss’s customers: he doesn’t care too much about either. But in reality, there are other incentives on the staff member to get flour that’s good value for money. And if the baker wants to expand her business, she has to put some trust in other people.

Large companies exist because the problems of people spending other people’s money is more than compensated for by economies of scale. And that’s one of the reasons that governments do things too. We could each build our own little private roads going only where we want them to go: spending our own money on ourselves. But maybe we get better value by governments doing it, even if they do sometimes decide that a marginal seat needs a brand new one to be opened at a photo opportunity just before an election.


Trinifar said...

It's so nice to read a post that isn't about one extreme versus the other. We need the ability to make judgments along the spectrum of choices which is much of what I take away from what you've written above. Good work.

David said...

Thanks Trinifar.

Bianca Nogrady said...

We've been having lots of discussions about how we think governments should be encouraging more sustainable water and electricity use. We know that we can afford to pay extra for green power, rainwater tanks etc, but there are so many people who can't afford the extra cost, so is that a case for low-income subsidies to encourage lower income families to take up green power? But then again, we've met so many middle-class, well-educated types who could easily afford green energy, and know enough to know that things have to change, yet they still throw up barriers such as "Oh, I don't know if those green energy plans are really giving you 100% green power". Which also points to an overwhelming need for more education and promotion about green power among all socioeconomic levels. After all, if people start voting with their wallets, energy companies will have no choice but to invest more in green energy, and decommission fossil fuel - maybe?

Paul Clieu said...

In his explanation of the four ways you can spend money Milton Friedman is stating that goods and services are most efficiently purchased when the buyer who needs the good is spending his or her own money to acquire the good.

When a company is owned by the founder or the founder's family, they try to spend and invest their money as efficiently as possible. Every cent wasted costs them one cent. At a Public company, every cent wasted merely costs the shareholders one cent and they don't have much power so much more is wasted. Of course competition is an incentive to avoid excessive waste. In government, every cent wasted is easily replaced by yet another tax, the voters have almost no power to reduce waste and the fear of competition is missing because governments give their agencies statutory monopolies. Thus Government spending is the most inefficient.

In Europe, Germany has by far the most powerful manufacturing economy. Germany also has the largest proportion of SMEs owned by the founding families. This suggests that Dr Friedman's observations have a huge practical effect on real economies.

While Germany has excessive taxes and excessive Government spending, it is the formidable economic power of the mittlestand SMEs that provide the economic efficiency that funds government spending.

In the UK in contrast, the private sector has been shrinking for years, the excess government spending is provided by raiding the capital of the private sector. This policy is stupid in the extreme and recent history confirms this.

If the USA adopts Socialism, and the consequent economic inefficiency then all bets are off. The USA will slip continually down the world league table just like the UK.

It must also be said, that if government spending was efficient, then the Soviet Union would have been a roaring success, but in fact they dared not provide exit visas for their citizens because when they saw prosperity in the West they either did not return or if they did then there was the danger that they might tell their close friends that the daily propaganda was 100% false.

The fact that the Berlin wall had to be built to detain East German and other Soviet block citizens against their will is direct proof of Dr Friedman's observations.