In quantum physics, there is the idea that a single particle can have an effect on a different particle many light years away. Einstein called this ‘spooky action at a distance’. In today’s globalized world, economic activity shows similar ‘spooky’ characteristics, indeed, it is virtually a truism to say that what happens in one industry or segment of an economy will inevitably affect others at great distances. What is often overlooked in ideological debates between the right and the left, however, is the entanglement of the free market economy with the activities of government. They are separate, just like particles separated by great distances, but they are so closely entangled. Action in one sphere will unavoidably affect the other.
Take, for example, the encroaching effects of the ‘fiscal cliff’. An increase in taxes coupled with spending cuts, could potentially cause a drop of as much as 1% of GDP growth in the US. The resulting reduction in economic activity would then impact government revenues, cutting into revenues just as measures to reduce the deficit kick in. This makes these measures, therefore, essentially self-defeating. Even a more measured response to deficit reduction that allows for some spending increase could potentially trigger inflation, since it will unavoidably give the impression that the government will just keep printing money to pay its debt. Inflation could also reduce economic activity and jeopardize growth, although it seems unlikely in the short term, by undermining investor confidence and leading to capital flight. The result, as with the fiscal cliff, is the same: a hit to government revenues and a self-defeating policy.
The first step to breaking the cycle is to recognize that the favoured solutions of both the right and the left are both inappropriate in the present context. Reducing taxes to stimulate the economy without accompanying measures to induce spending and investment just doesn’t work, there is no evidence of it ever having worked, and it does severe damage to the government’s ability to raise revenue. At the same time, government spending does not have the growth-inducing impact as in the past because the implied willingness to spend and borrow undermines investor confidence.
The solution lies in the awareness that government is both an economic actor and an economic hedge. Contrary to the arguments on the right, government cannot just ‘get out of the way’ and let the market grow. For one thing, it might grow somewhere else. For another thing, markets need government to backstop their activities and stop them from imploding on themselves. The sooner that people stop thinking of governments as part of the problem, and realize that free markets require governments to make decisions for the common good, the better off both the economy and the government will be. Governments and markets are not the same thing, their purposes are different and their instruments are different, but they are irrevocably enmeshed together.