One recent afternoon I took my daughter to a movie. The tickets cost a total of $5 and to pay for them, I pulled a $10 bill from my wallet. As any economics professor could have told me, I held $10 of purchasing power. Since I could not resell the tickets once I had bought them, my purchasing power was reduced to $5.
A trip to the concessions stand further reduced my purchasing power to slightly above $2, which might be used for buying more snacks. When that money is spent, providing my coffers are not replenished, my purchasing power will be zero.
And so the cycle continues. I receive a paycheck, save some of it, and spend the rest. The size of that paycheck determines what I may purchase and what quantities I can buy. It would seem, then, that my purchasing power is derived from the amount of money printed on my paycheck. So it seems, but like so many other popular notions of economics, this idea is based on fallacy.
Henry Hazlitt writes in his classic Economics in One Lesson that “economics is haunted by more fallacies than any other study known to man.” This is not due simply to a lack of education, but is caused primarily by the presence of many conflicting special interest groups.
Consider a common fallacy—“the blessings of destruction.” We encounter this, in one form or another, following every war or natural disaster. For example, after Hurricane Alicia struck Galveston, Texas, in 1983, one news reporter declared that the cloud of destruction had a silver lining: the cleanup after the storm would create many jobs. Furthermore, the newly hired workers would then spend their paychecks, bringing untold benefits to the community.
If this sounds familiar to students of liberty, it is: Frederic Bastiat exposed this fallacy in his brilliant satire of the broken window. In Bastiat’s example, a hoodlum who threw a brick through a shop window was hailed as an economic benefactor because he created work for the local glazier. In the case of Hurricane Alicia, many glaziers, tree surgeons, electricians, carpenters, and others were hired to clean and restore businesses and homes. In each case, workers received purchasing power, a large part of which was then spent.
But in each situation, we must remember that the principal spenders (property owners and insurance companies) before the incidents had not intended to spend their money on glaziers and electricians. They had other plans for their money—plans which would have involved their own spending, saving, and investment decisions. The money which was spent on repairs would have been used elsewhere. Spending money on repairs creates no net gain in wealth or employment.
Both the news reporter and the crowd gathered outside the shop’s window saw only a part of the economic picture. More importantly, they failed to understand the source of purchasing power. And while the reporter’s economic illiteracy may border on the humorous, we must bear in mind that many government economic policies are based on such false assumptions.
Government spends money which goes into someone’s hands. The money is then spent, and jobs are supposedly created. Few people pay attention to where the money comes from, or what the money would have done if it hadn’t been taxed and spent by government.
Of course, government, in its attempt to create “purchasing power,” doesn’t blow a hurricane onto our shores or heave bricks through our windows. But it brings economic destruction all the same.
Wealth The Government Way
Ever since the Great Depression of the 1930s and the New Deal, it has been assumed that government is a net creator of wealth and employment. From the Civilian Conservation Corps to the Works Progress Administration to the Tennessee Valley Authority, Federal officials set up “Alphabet Soup” agencies to hire unemployed workers and, supposedly, “prime the pump” of the national economy through increased spending.
It was commonly assumed by economists of the day that the Great Depression was caused by “underconsumption” or “over-saving.” According to John Maynard Keynes and others, the U.S. economy in the 1920s grew faster than workers’ wages. Thus, the Keynesians believed, workers were unable to “buy back the products” they had manufactured.
The solution to this problem seemed simple: place more money in the hands of ordinary workers, who would then buy the products they had originally created. In other words, the answer was to give the workers more “purchasing power.” The means to pay for such largess was to come in one or more of three ways. The first was to tax those with “excessive” incomes and transfer that money to those with lower incomes. The theory was that those in upper-income brackets would save too much; by transferring that “excessive” amount of money that would have been saved to poorer persons who would spend those funds, the economy supposedly would be given a shot in the arm.
The second way to boost spending was by simply creating new money through the Federal Reserve System and funneling it to individuals deemed most in need. Their increased spending would then force up prices, decreasing the value of existing money and discouraging savings. Thus the rich would be kept from “oversaving” either by direct confiscation of their wealth or by eroding it through inflation. In this way, it was alleged, the overall economy would receive a net benefit.
The third way involved unionization of the American work force. It was believed during the 1930s that increasing wage rates through unionization of American workers would increase their purchasing power. Thus, Congress passed a series of laws in the 1930s that encouraged the formation of labor unions, and by 1953, more than a third of the U.S. work force was organized. On top of this, Congress enacted minimum wage legislation as well as laws that shortened the work week.
Results of the Experiment
For four decades after the New Deal, transferring wealth was the soul of national economic policy. Income tax rates rose as high as 94 per cent, while inflation came on in waves, climaxing in 1980 at nearly 14 per cent. It would seem that the Keynesian experiment, given these statistics, would have proven successful.
But real increases in personal income (adjusting for inflation), which were at significant levels before the start of the Great Depression, were tailing off badly by the end of the 1960s, as the United States began a decade of economic chaos. And even counting the latest economic recovery, which began at the end of 1982, the average American has barely been able to keep pace with inflation, while many of those in low-income brackets have lost ground.
In the past, a seven per cent unemployment rate would have been cause for alarm; today, seven per cent unemployment is considered to be close to “full employment.” in economics, as in American social mores, what was once considered scandalous has now become acceptable. At the same time, the once-vaunted industrial base in this country has deteriorated, and production facilities that once employed thousands of people and supported whole communities now are idle.
At present, there seem almost to be two Americas, one in which people are happily employed and looking forward to the future, the other where there reside large numbers of the poor and unemployed. What makes this situation even more tragic is that so much of the damage was done in the name of giving the poor more “purchasing power.” The ironic truth is that real purchasing power—the ability to produce and be productive—has been torn from the hands of those who most need it; the ones who have deprived the poor of that power have been a combination of intellectuals, politicians, and union leaders, all of whom claim that their actions were done to benefit the needy.
The True Source of Purchasing Power
To reverse this disturbing trend, we must expose the flawed economic policy that is based on a false conception of “purchasing power.”
So far in this article, I have used the term “purchasing power” in conflicting ways, from simple cash to economic production. Lest this seem confusing, it should be remembered that many people mistakenly assume that money really is the same as production.
To clear up this confusion, we must first show why simple cash does not necessarily equal “purchasing power.” This belief is part of the larger fallacy that “money equals wealth,” which Adam Smith criticized in The Wealth of Nations.
The first rule of money is that it is a medium of exchange. It is not the object of exchange, as many people seem to assume. The role of money is to facilitate the indirect exchange of goods and services, as opposed to barter where exchanges are direct. Within any economy, real exchanges always involve the trading of goods and services.
We gain support for this analysis when we examine economies in which public confidence in the currency has broken down. An excellent example is Chile in 1973 during the hyperinflation brought about by the policies of the Allende government. When the Chilean escudo began to depreciate catastrophically, the Marxist regime began to impose currency restrictions upon its citizens to keep them from buying dollars on the black market.
Faced with prohibitions and price controls, the Chilean people simply resorted to barter (tobacco, the old standby, became a favorite with traders). While barter brought about certain inconveniences such as problems with storage and handling, it was the only sane alternative to holding the near-worthless Chilean money.
The Chilean government’s economic strategy was centered around inflation. First, the Marxist government nationalized numerous businesses. Second, it gave workers in those nationalized enterprises large pay increases and financed the largess with the printing press. Suddenly the Chilean workers whose pay had been far less than that earned by middle-class employees, found themselves at parity with the middle class. The buying spree that followed soon stripped the store shelves; at the same time, production in the nationalized businesses fell drastically. The result was long lines and shortages.
To be sure, the Allende regime had its defenders who claimed that the government’s policies had successfully increased the “purchasing power” of Chileans. But what really happened was a temporary transfer of wealth from wealthier Chileans to the poorer ones. The advantages gained by the poorer workers at the beginning, however, were short-lived. With production falling, the quantity and quality of goods Chileans could purchase fell, and continued to fall as the money supply rose. In the end, the poor were as bad off (or worse) than they had been before, while the middle-class workers were devastated. True, the incomes of the poor had reached parity with those above them, but any advantage gained was merely academic; the economy had stopped producing in any meaningful way, leaving Chileans with money in their hands but no place to spend it. Thus, the Chileans resorted to barter.
What does this have to do with purchasing power? The object of economic exchange is to obtain goods and services; if the object were simply to obtain money, then Chileans in 1973 would have been among the richest people on earth. Instead, they found that their Marxist government’s policies had impoverished them.
As Adam Smith pointed out in The Wealth of Nations, the true source of wealth in any economy is the production of goods and services, not the paper money government can crank off the printing presses nor the income it can transfer from one group to another. Wealth is a function of production, period.
Wealth is what people want, be it houses, cars, food, clothing, televisions, computers, or books. Wealth may be a concert, a play, or a walk by the shore. It is whatever one values as wealth.
An individual’s so-called purchasing power is measured in the kinds and quantities of wealth he or she can obtain. Yet, one can only accumulate wealth on the basis of production, be it by that person or by someone else. For example, a child may buy candy at a store with allowance money provided by her dad; while the child did not actually produce to earn that money, her father probably did, and his productivity is the source of her purchasing power.
The point is that our ability to purchase goods and services is the direct result of either our own productivity or the productivity of someone else who contributes—either voluntarily or involuntarily—to us. And what is true for individuals is also true for a nation. Our nation enjoys a high standard of living only because we—not to mention our parents and grandparents—are a productive people. Take away our ability to produce, and you take away our “purchasing power.”
There is no substitute for production. Printing money only brings inflation, as Chileans found to their sorrow. Taxing one group of persons to give cash to another may transfer abilities to purchase, but fails to produce new goods and services. Raising wages through union activity is just another transfer scheme that takes abilities to purchase from non-unionized workers and gives them to union members.
Yet, our government has transferred wealth for the past 50 years in the name of creating*’purchasing power.” At the same time, government regulators, operating on Federal, state, and local levels, have imposed millions of rules and regulations on wealth-creating enterprises, not allowing them to produce to their full capacities, thus cutting down on the supply of wealth.
For all the talk of government bringing “fairness” into the economy through its policies of taxation and regulation, it is important to note that such activities do not create wealth. At best, they only transfer wealth; at worst, they destroy it. Such policies create “purchasing power” for some only at the expense of others and, in the long term, diminish the capacity of the economy to produce.
Because the real source of exchange is barter, it follows that increased exchanges (or purchases) can come about only when there are more goods and services with which to trade. And that can occur only when production increases. Anything that cuts overall production of goods and services cuts real purchasing power.
In the personal example at the beginning of this article, I gave the impression that my “purchasing power” came from the semi-monthly check given by my employer. The truth is, my “purchasing power” comes from my ability to render a service to my employer, who must, in turn, convince his consumers that he is giving them the best value for their money. Thus, my economic future depends on the productive efforts of others as well as my own.
It is the same with all of us. As long as our society produces acceptable goods and services in large quantities, all of us can consume in large quantities. Take away our abilities to produce, and we are denied opportunities to consume.
At its best, government can protect our rights to produce and consume, thus enhancing the prospects for future growth. At its worst, government can work to deny us the fruits of our labors, it is up to us to make sure that government protects our rights.