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Premier Thoughts: The CSUB Business Blog Abbas P. Grammy Professor of Economics [email protected] Economic Research Center www.csub.edu/kej April 9, 2012 There Ain't No Such Thing As A Free Lunch There ain't no such thing as a free lunch (TANSTAAFL)! You have heard it from a preaching grandparent or an economics professor. It is a cliché implying everything has a cost. It warns you to be suspicious of anything that appears to be free. When given something, you are expected to give something back or to do something in return. In economics, TANSTAAFL came about in response to the libertarian views of Henry Wallace, the United States Vice-President (1941-45). In an article published in The Atlantic Monthly, Wallace suggested a post-war economic regime offering "minimum standards of food, clothing and shelter" for people throughout the world. He asserted, "If we can afford tremendous sums of money to win the war, we can afford to invest whatever amount it takes to win the peace." Paul Mallon, a journalist, responded to Wallace's proposition that "Mr. Wallace neglects the fact that such a thing as a 'free' lunch never existed. Until man acquires the power of creation, someone will always have to pay for a free lunch.” 1 Milton Friedman, a Nobel laureate, popularized the phrase by using it as the title of his 1975 book. Greg Mankiw of Harvard University uses TANSTAAFL to demonstrate opportunity cost, "To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires trading off one goal against another." 2 If an individual or a group gets something at no cost, someone else ends up paying for it. If there appears to be no direct cost to any single individual, there is a social cost. 1 2 Wikipedia, http://en.wikipedia.org/wiki/There_ain%27t_no_such_thing_as_a_free_lunch Ibid. 1 There ain’t no such thing as a free lunch! Of course, it is not exactly true. In the United States, nearly 50 million children attend public schools free. At the average per pupil spending of $9,870 per school year, the foregone tuition payments total $494 billion. 3 In addition, the federal school nutrition programs provide more than five billion meals served to nearly 31 million students. Annual spending on all nutrition programs adds to more than $12 billion. 4 Guess what? We pay for costs of public education and free/reduced lunches with our taxes. I almost break into tears looking at the list of deductions in my monthly paystub: federal income tax withholding, state income tax withholding, Medicare taxes, and Social Security taxes. April 15 is not a day of celebration either; I usually make extra federal and state tax payments, not to mention paying $400-plus to an accountant to prepare and file my tax returns. In addition to on-going disbursement of sales and excise taxes, paying annual property taxes makes me go for a brisk walk to recover from it. Government spending ain’t a free lunch either! Governments are apt to deficit-spend on the assumption that each dollar spent would create additional dollars of income. This concept known as “the multiplier effect” is the rationale for massive government spending to stimulate the economy out of a recession. The government spending multiplier for the United States economy is believed to be 1.4, indicating that an additional dollar spent creates an extra $1.40 of income over a span of 4 to 6 months. Robert Barro of Harvard University has challenged the “multiplier effect” of government spending. 5 If the multiplier were 1.0, an increase of $1.00 in government purchases would lead to an increase of $1.00 in the Gross Domestic Product (GDP). Thus, the added public goods are essentially free to society. When the government buys a new airplane or constructs a bridge, the economy's total output expands by exactly the same amount. He points out, “The explanation for this magic is that idle resources -unemployed labor and capital -- are put to work to produce the added goods and services.” If the multiplier were greater than 1.0, the GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we have more goods and services left over to raise private consumption or investment. In this scenario, the added government spending is a good idea. However, if the multiplier were zero, 3 Professor Mark Perry calculates public school per pupil spending at $9,620 per year in 2004, which I have adjusted for inflation. See ”Private School Tuition 1/3 to 1/2 Less Than Publics,” CARPE DIEM, October 28, 2007, http://mjperry.blogspot.com/2007/10/private-school-tuition-13-to-12-less.html 4 “National School Lunch Program,” United States Department of Agriculture, October 2011 5 Barro, R. J., “Government Spending Is No Free Lunch: Now the Democrats are Peddling Voodoo Economics,” The Wall Street Journal, January 22, 2009, http://online.wsj.com/article/SB123258618204604599.html 2 increased government spending requires an equal fall in consumption or investment. In this case, the social cost of $1.00 of additional government purchases is $1.00. To measure the “multiplier effect,” Barro refers to the shared view that the World War II fiscal expansion provided the needed stimulus that finally got the United States out of the Great Depression. He estimates that the war raised defense expenditures by $540 billion (in 1996 dollars) per year at the peak in 1943-44. He also estimates that war expenditures raised the GDP by $430 billion per year in 1943-44. Thus, the multiplier for defense spending is $430/$540 = 0.80. This number being less than 1.0 asserts that the war lowered the GDP aside from military purchases. The main declines were in private investment, non-military government purchases, and net exports. Accordingly, “Wartime production siphoned off resources from other economic uses -- there was a dampener, rather than a multiplier.” 6 Barro offers three reasons for the wartime multiplier of less than 1.0: • • • Households and firms expected the added wartime outlays to be partly temporary The use of the military draft in wartime had a direct, coercive effect on total employment. The United States economy was already growing rapidly after 1933 (aside from the 1938 recession), and it is probably unfair to ascribe all of the rapid GDP growth from 1941 to 1945 to the added military outlays. Similarly, for other wartime episodes (i.e., World War I, the Korean War, and the Vietnam War), Barro calculates a government spending multiplier close to 0.80. Interestingly, Barro finds that the wartime multiplier overstates the effect of peacetime government purchases. He estimates that the “multiplier effect” of peacetime government purchases is close to zero. Barro’s prescription for economic recovery is to avoid massive government spending based on the notion of the “multiplier effect.” He refers to the fundamentals of marketorientation to illuminate a path to recovery: • • • • 6 Create incentives for households and firms to work, invest, and produce. Avoid programs that throw money at households and firms. Emphasize reductions in the marginal income-tax rates. Undertake public-works projects that pass the test of cost-benefit analysis. Ibid. 3