Friday, November 13, 2009

The Irrelevance of Bang per Buck.

Economists spend millions every year trying work out how many jobs are created by different forms of spending. They are wasting their time and your money. This subject is of particular relevance just now because according to the Wall Street Journal (as pointed out in the 26th Oct post below) “the Obama administration is searching for ways to boost job growth without adding to the federal budget deficit.” In short, they’ll be looking for bang per buck.

And here is a laborious attempt to calculate bang per buck from a couple of years ago (thanks to George Washington for this link).

In an economy where those in charge understood economics, bang per buck would be irrelevant. Of course the reality is that we live in a world where leading politicians do not understand some of the basic ideas in economics, like the difference between macro and micro economics. That is, we live in a world where leading politicians think that government budgets work the same way as household budgets.

Given this ignorance, it is probably inevitable that bang per buck will have to be considered. However, assuming an ideal world where politicians understood economics, bang per buck is irrelevant for the following reasons.

There is only ONE ultimate cost: a labour. To illustrate, the cost of any product is made up of labour, machinery, materials, etc. But the latter machinery and material costs themselves break down into - yes, you guessed it - labour, machinery, materials, etc. Work your way back far enough and there is only one cost: labour.

Thus it makes little difference how a given amount of money is spent - the number of jobs created will ultimately be much the same.

Counting entrepreneurs as “labour”.

Having said all that, I have to confess to using the word “labour” in a broader sense than normal. It is widely recognised in economics that GDP can be broken down into three elements: labour, interest and profits. Labour normally takes about 75% of the cake. In saying above that there is only ONE ultimate cost, labour, I am counting the “wage” of entrepreneurs (i.e. profits) as a form of labour. And I’m counting the rewards for money lenders, i.e. interest, as the “wage” of money lenders, or banks. In short I am using the word “labour” in a broader sense than is normal.

However, the vast majority of entrepreneurs don’t just sit around all day letting the profits roll in. Most are hard working “labourers” much like their employees. As to money lending, the bulk of the cost here again does not involve rich individuals sitting around while the interest rolls in. The bulk of the cost is made up of very mundane items like maintaining bank buildings, and employing people to check up on the credit worthiness of potential borrowers.

And finally, for those who don’t like the idea of counting profit and interest as labour, this objection won’t get you anywhere because there is no reason to assume that the profit and interest content of what seem to be “good bang per buck” areas of the economy are any different to poorer bang per buck areas. Put another way, instead of saying, as above, that 100% of the ultimate cost of everything is labour, I just change my argument to saying that about 75% of the ultimate cost of everything is labour.

Back to the main argument.

Getting back to the main argument, I’ve hopefully established that the number of jobs created by a given amount of spending is much the same regardless of what form the spending takes. But even if the number of jobs are NOT the same, bang per buck is still irrelevant. This is because inflation only becomes a problem when unemployed has dropped far enough (dropped to NAIRU to use the technical acronym – Non Accelerating Inflation Rate of Unemployment). And if a particular form of spending does NOT create many jobs, then it is not inflationary, which in turn means the relevant government or central bank can just print more money and spend it so as to create more jobs. Alternatively, if a government does not want to print more money, it can go for the Keynsian “borrow and spend” option.

The important point here is that advocates of bang per buck are attempting to get what they see as “value for money”: i.e. lots of jobs for a given cost or sacrifice. The flaw in this argument is that printing money (or borrowing and spending) are not a REAL cost, assuming the exercise is done responsibly. (Of course when lunatics like Robert Mugabwe gain control of printing presses, then there is a real cost for the country concerned). But printing extra money to lubricate an economy does not cost in real terms when it is done responsibly.

In the words of Edward Lazear, chairman of the President’s Council of Economic Advisers in a recent Wall Street Journal article, “Historically, recoveries have a consistent pattern: productivity grows first, then jobs are created, and finally wages rise.” I.e. wages (and thus inflation) do rise significantly till unemployment has fallen to too low a level.

It can of course be argued that there are factors contributing to inflation other than labour shortages. For example inflation can rise simply because of inflationary expectations, that is inflation can be a self fulfilling prophesy. But governments can only act on the basis that the population will not make silly self fulfilling prophesies. If the population does make such prophesies, then too bad. Government would then have to rein in demand, and force a period of relatively high unemployment until the “prophesy” madness abated. Arguably Paul Volcker spent a fair amount of time doing just this.

It can also be argued that when an economy is near capacity, it is not just labour shortages that cause inflation, but also material and equipment shortages. In answer to this I would cite the fact that the official unemployment figure in Switzerland in the 1960s dropped to zero on two occasions. Thus it looks as though material and equipment shortages do not become serious till unemployment reaches very low levels.

Moreover, material or equipment shortages can be alleviated, often as not, by importing the necessary stuff.


Another area where the “bang per buck is all nonsense” argument might seem to go astray is where a form of spending involves a large import content. In this case many of the jobs created will be abroad. On the other hand, this just depresses the value of the currency of the country concerned relative to other currencies, which in turn brings extra orders for exports, which in turn creates jobs.

Employment subsidies.

Another very different area where “bang per buck” is a nuisance is subsidies. Subsidies can be divided into two types: marginal and intra-marginal. The former subsidise just the additional units produced as a result of a subsidy – an example of this is the “tax credit” idea currently doing the rounds in the US: the idea that firms should be subsidised in proportion to the number of ADDITIONAL jobs they create.

In contrast, intra-marginal subsidies aim at ALL members of a particular category of labour (or ALL units produced, if it is a physical product that is subsidised). For example the UK used to subsidise all labour in high unemployment areas in the UK. And for another example, most agricultural subsidies subsidise ALL wheat, potatoes, etc produced.

Now intra-marginal subsidies appear to involve a large amount of waste in that taxpayer money assists the production of stuff that would have been produced anyway (or employees who would have been employed anyway). However, this is not a waste in REAL TERMS. It is simply money going round in circles.

To illustrate, if a government subsidises all cars produced, this government first has to tax citizens. Then it gives the money to car manufacturers (or dealers), which reduces the price of cars. Which makes cars cheaper for citizens (who funded the subsidy in the first place!).

Of course this exercise does have an element of real cost: bureaucrats are needed to collect the tax, distribute it to car dealers, etc. There is also possibly a real cost in that the relative price of different products have been distorted. But apart from that, there is not much of a real cost involved.

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