Government And The Economy

August 8, 2014

What are governments capable of doing?  I ask this question since for many, it seems as if government is an omnipotent force capable of providing anything for its citizens and supporting its empire abroad.  It is important to understand the role government occupies within the context of the broader economy. 

In order for government to do anything, it must have funding.  Article I, Section 8 of the U.S. Constitution assigns the following powers to Congress:

  • The Congress shall have power to lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defense and general welfare of the United States; but all duties, imposts and excises shall be uniform throughout the United States.
  • To borrow money on the credit of the United States.
  • To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures.

At one point in US history, the majority of funding came from tariffs.  Then government expanded to do more things for more people.  With that expansion came additional funding needs.  As the Constitution indicates, Congress can collect taxes and borrow money.  When the Constitution was drafted, however, money meant something very different than it does today.  Money was understood to represent gold or silver coin.  The Founding Fathers understood that governments can easily debase currencies by creating money by fiat.  In fact, the Revolutionary War government created their own money with something known as a Continental.  This was a paper certificate that was supposed to be as good as gold, except that it wasn’t.  By war’s end, nobody wanted a Continental.

Today, the federal government’s funding primarily comes via taxes and tariffs.  In fiscal 2014, the federal budget was roughly $3.8 trillion but it was only funded for $3 trillion.  Since the federal government historically has a reputation as the best credit risk, investors (foreign and domestic) are willing to lend money through Treasury sales of bonds, notes, and bills. Since the financial crisis of 2008, the market absorbed trillions in federal debt albeit with major assistance from the Fed.

The financing capacity of government is expanded through a unique link to the Federal Reserve, which allows purchases of US Treasury debt.  The Fed loans money to the Treasury by creating bookkeeping entries.  The money from these bookkeeping entries emerges from thin air.  The Fed does not need to have any money on hand to expand the debt of the country.  With fiat based money, the government can create more debt since our money has no intrinsic value. 

 At the state and local level, funding originates with taxes, federal government funds, and extensions of credit (bond issues).  Unlike the federal government, states do not have the luxury of spending more than they have.  When they do spend more than they have, they have to cut back on the services they provide, raise taxes, travel to Washington to ask for more, or all of the above.  At the depths of the 2008-2009 recession, 46 of 50 states experienced budget shortfalls.  

So how do governments interact with the economy?  Economies are expressions of what people do.  Participants in an economy act on their own behalf in a manner that meets the satisfaction of others acting on their own behalf.    Therefore, the economy is a collection of many people acting on their own behalf for the benefit of others. 

The economy needs an authority to ensure its participants can act freely.  Government protects the market and its citizens by enacting laws or regulations along two main principles:

  1. Do onto others as they would do onto you – the basis of criminal law.
  2. Do what you said you would do – the basis of contract law.

If you lived in a society where you had to worry about Principle #1 or Principle #2, it would be hard to have a smoothly functioning economy.  There would be constant fear that someone was trying to inflict physical harm (Principle #1) or that you could not trust your market transactions with others (Principle #2).  Government is responsible for creating an environment in which an economy can operate safely. 

As one can imagine, the economy is in a continual state of change.  The economy changes due to differences in judgment on the part of its individual participants.   A snapshot of the economy at any point in time reveals the price or exchange rate for something.  The price is simply an agreement between two parties - nothing more, nothing less. 

Economies tell producers what to produce and in what quantities.  The economy also tells consumers what to consume and in what quantities.  If the price of filet mignon were $0.10 per pound, how would consumers react?  Similarly, imagine the price of filet going to $1,000 per pound.  How would consumers react then?  In both cases, the economy dictates behavior.

In order for government to protect the economy, it has to be a participant.  Government inserts itself in the economy buying raw materials, equipment, and labor.   But we live in an age where government is borrowing in order to expand its role beyond being the economy’s protector.  In the recession of 2008-2009 government ran historic budget deficits that continued after the recession’s official end.  This borrowing occurs alongside anyone else needing to borrow.  Government is not a supernatural or mystical being orbiting earth sprinkling magic dust on its inhabitants.  It is out there like other businesses asking for money albeit with great taxing power and help from the Fed.  Think of government as another business competing for capital and resources. 

The economic crisis provided government an opportunity to expand its role further.  Some call this expansion socialism.  Socialism, in fact is a more comprehensive control of the economy.  The Austrian economist Von Mises argued in Human Action that an economy is either socialist or capitalist.  If the economy is socialist, then government plans everything.  If the economy is capitalist, then the market dictates what happens.  As large as government has become, it remains a minority player in comparison to the rest of the economy.  I make this assertion with a US economy of $17 trillion versus a government budget of $3.8 trillion.  Though the budget is large, I am placing it in context.

That said, government has become a larger part of the economy.  During the economic crisis, it decided to take on a larger role.  Unlike private enterprise who enacts austerity measures during times of greatly reduced revenue, the government actually spent more.  Economic participants are marginalized when government expands beyond its economic boundaries.  The government utilizes resources that private individuals would perhaps engage otherwise.  Government may also do things that the economy does not want. 

One of government’s economic boundaries are investors desiring to be its creditors.  The other boundary is its ability to tax.  These boundaries do have limits but those limits are far more malleable when fiat money is part of the picture.  Ultimately the economy will decide if it can live with fiat money.  This will be a seminal point in our history when government (politics) and economics intersect.

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Jim Mosquera is the author of E$caping Oz: Navigatingthe crisis.  This is a successor to his previous book, E$caping Oz: Protecting your wealth during the financial crisis. Jim is a Principal at Sentinel Consulting a business restructuring and capital acquisition firm geared towards small to mid-sized businesses. He operates the financial and economic site The Sentinel. You can email him here: jim@thesentinel.biz

With gold stolen by Conquistador Francisco Pizarro from the Inca Empire in 1532, Spain financed its conquest of Europe.