Understanding Economics in One Hour, Part Seven

Small Government [and its counterpart, low taxation]

Emile Woolf, Going Postal

When Keynes was asked, “Why pay them to dig and fill holes? Why not pay them to build roads and schools?” he replied: “Fine, pay them to build schools. The point is it doesn’t matter what they do – as long as the government is creating jobs.”

That, however, is not the role of government.

In essence, the proper role of government is to protect the lives, property and civil freedoms of its subjects, and few would resent paying taxes to cover those essentials. Moreover, sound money and free trade automatically reduce the role of government to those natural limits.

Note these basic truths:

(i) Whatever government spends has to be paid for in taxes raised from the private sector. The public sector cannot be taxed, as it is paid out of taxes.

(ii) In a sound-money economy government cannot print fiat money. For every pound it wishes to spend it must either tax or borrow honestly – bearing in mind that there is a natural limit to public tolerance for taxes; and increased borrowing drives up the interest rate, increasing the burden on the productive economy.

(iii) An economy running on unsound money creates an appearance of unlimited resources. This, of course, is the progenitor of the “entitlement culture”. To pay for the state’s unfunded promises and good works, all it has to do is print more money.

(iv) Political animals with power to set priorities, and make spending decisions, forget all too easily that their own remuneration comes out of taxes and that they are public servants, not masters.

(v) Government expenditure is simply not susceptible to the kind of economic analysis that citizens apply when spending their own money. There is no incentive to raise productivity in the public sector. Only half of NHS employees are doctors or nurses; only one-third of the state education sector’s employees are teachers.

(vi) Politicians with unbridled power to spend their citizens’ money are the worst culprits. The more grandiose the project, the greater the potential for unchecked extravagance – whether it relates to new power generators, runways, high-tech university labs, bridges or tunnels.

The reason that no consideration is given to the questions that arise when private capital is involved (such as whether the project’s returns are likely to exceed its origination and operating costs) is that such questions are meaningless when the mindset is “bounty unlimited”.

This key question is rarely asked: “How will the nation suffer if this project is abandoned right now?”

Wherever tax-funded infrastructure spending is let loose on the basis of little more than political whim, the result is a pure gamble with taxpayers’ money:

  • How else is it possible to close a hospital operating theatre in Barcelona, yet keep open an airport with 40 employees, at which no plane has landed?
  • Or Portuguese electronic toll-roads that drivers avoid like the plague? [They have no tollbooths, and require drivers to buy transponders and variable-priced pre-paid cards!]
  • Or the World Bank aid project that diverted fresh water from Lesotha Highlands into South Africa at a cost of $3.5 billion to produce electricity that proved (a) too expensive for consumers; and (b) created environmental havoc downstream?
  • Or the Norwegian government’s $22 million development aid-funding of a fish processing plant on Lake Turkana to “create jobs” in Kenya? Did no one tell them that the Turkana people are nomads with no history of ever catching or eating fish? And the cost of operating freezers was prohibitive anyway! The empty plant stands as a monument in the “museum of well-meaning cock-ups”.

Nor is there an end to the government’s “social engineering” meddling, as if it has an electoral mandate to apply our taxes according to its totally uncosted, unmeasured, political vote-catching agenda – whether imposing a sugar tax, printing health warnings on every surface in sight or building more lethal cycle lanes.


[Allowing private sector entities to get in on the act can, in some instances, be an unmitigated disaster! Just look at the hellish chaos into which Britain’s railway systems have descended! The understandable response, especially from those beleaguered rail travellers directly affected, is that re-nationalisation is the answer.

Again, while it appears to commuters and others that almost anything would be preferable, the real fault lies with the business model, the brainless planning of the ministers charged with delivering a decent service, and their inept management supervision. Even running a railroad can allow for competition that raises standards and delivers a profit – but while the present batch of useless entrepreneurs are allowed to hold franchises that they should have lost years ago, all the time profiteering by manipulating prices ever-upwards, even nationalisation with its own brand of chaos is a preferred interim option until the right business operators materialise.]


What it all comes down to is this. Provided that the principles of free trade and sound money are properly understood, and applied, government would be left with little to do beyond its primary raison d’etre of protecting the lives, property, liberty and civil rights of its citizens.

Limiting the role of government is difficult to visualize. But if we allow the subtle world of what is unseen to enter our consciousness, we’ll find it far more powerful than the chimera now frustrating our search for economic justice.

Understanding economics leaves us with a profound sense of awe: these simple but irreducible principles hold the key to the ordering of human affairs as they might exist – a vision that is also a lifeline.


Footnote – but would it work in practice?

I am often asked to provide an illustration or example of these fine principles being successfully applied in the real world. There are actually many examples, yet people tend to be distracted by examples of everything going haywire. However, what follows is an example of the application of sound principles –and it is a gem.

People rarely stop to consider the astonishing, unprecedented, economic turnaround that transformed Germany from its immersion in deep and desperate economic ruin in 1945 to become, in record time, one of the world’s most dynamic industrial powerhouses? If ever there was a case of an economic miracle, this was it.

How was such a thing possible? It was neither luck nor magic, though you could be forgiven for thinking so!

No, it happened only because one man, Ludwig Erhard, in the right place at the right time, understood and applied the principles I have outlined above.

Here’s the story, and I am grateful to Alasdair Macleod for the narrative.

By the mid-1940s both the Nazi war machine and allied bombing had destroyed Germany’s post-war economy. The country was in ruins and people were starving. The British and American military solution was to extend and intensify rationing and throw more aid at the problem.

Then Ludwig Erhard was appointed director of economics and in effect became finance minister. He decided, despite British and American misgivings, as well as opposition from the Social Democrats, to do away with price controls and rationing, which he did in 1948. These moves followed his currency reform that June, which contracted the money supply by about 90%, ending the reichsmark hyperinflation and instituting deutschmarks instead. He also slashed income tax from 85% to 18% on annual incomes over Dm2,500 (US$595 equivalent).

Erhard’s reforms went totally against the prevailing bureaucratic grain, and the military governor of the US Zone, General Lucius Clay, to whom he reported, duly upbraided him.

“Herr Erhard, my advisers tell me what you have done is a terrible mistake. What do you say to that?”

Erhard replied, “Herr General, pay no attention to them! My advisers tell me the same thing.”

Then a US Colonel confronted Erhard: “How dare you relax our rationing system when there is a widespread food shortage?”

Erhard replied, “I have not relaxed rationing, I have abolished it. Henceforth the only rationing ticket the people will need will be deutschmarks. And they will work hard to get those deutschmarks, just wait and see.”

The US Colonel did not have to wait long. According to contemporary accounts, within days of Erhard’s currency reform, shops filled with goods as shopkeepers recognized that the money they sold their products for would retain its purchasing power. People no longer needed to forage for the basics in life, so absenteeism from work halved, and industrial output rose more than 50% in the second half of 1948 alone.

Erhard had spent the war years studying free-market economics, planning how to structure Germany’s economy for the post-war years. His free-market approach made him a long-standing and widely recognised opponent of Nazi socialism, a fact that enhanced his credibility with the military authorities tasked with repairing the German economy.

[He became an early member of the Mont Pelarin Society, a grouping of free-market economists inclined towards the Austrian School, founded in 1947, and whose first President was Friedrich von Hayek, mentor to both Reagan and Thatcher.]

Erhard simply understood that ending all price regulation, introducing sound money and slashing the burden of taxation, were the basics required to revive the economy, and that the state must resist the temptation to “help”.

He remained a highly successful finance minister for fourteen years, before succeeding Konrad Adenauer as Chancellor in 1963.

Erhard not only allowed unfettered free markets to rapidly turn Germany around from economic devastation, but being publicly credited with this success he presided over the economy long enough to ensure that bureaucratic meddling was kept at bay. His legacy served Germany well, despite the generally destructive actions of his successors.

The contrast with Britain’s economic performance was stark. Rationing in Britain was not finally lifted until 1954, and her post-war socialist, anti-market government was nationalising key industries. The contrast between Germany’s revival and Britain’s decline could not have been more marked.

The point to note well is that free markets are demonstrably more successful than regulated markets as a means of ensuring economic progress.

The same phenomenon was observed in Hong Kong, where John Cowperthwaite succeeded in stopping his own local officials and London’s Colonial Office from imposing regulations on the island’s economy in the post-war years. Cowperthwaite was roughly contemporary with Erhard, retiring as Hong Kong’s Financial Secretary in 1971. Yet despite this indisputable evidence that free unregulated markets actually work best, both the central and local political classes can never resist the compulsion to regulate, and their efforts invariably have an effect diametrically opposed to what’s needed.

© Emile Woolf May 2018 (website)

Audio file