Rachel Reeves, the UK's Shadow Chancellor, has declared that Labour's economic plan is simple: "invest, invest, invest." The goal is to boost living standards and drive economic growth. But this raises a fundamental question: Does government spending lead to prosperity?

Keynesian economics suggests that government-led investment spurs demand and stimulates the economy. Yet, from an Austrian perspective, this approach overlooks the essential structure of economic growth—the production process itself. Austrian economists argue that real prosperity emerges not from increasing government expenditure but from private sector investment in the entrepreneurial and risky generation of capital goods.

This article challenges the notion that state-led investment is the key to economic growth. Instead, it demonstrates how government spending distorts market signals, misallocates resources, and creates an illusion of short-term growth at the expense of long-term stability.

The Fallacy of Government-Led Investment

Keynesians assert that increased government spending fuels economic activity. They even argue that unproductive activities—such as ”digging holes only to fill them again”—can contribute to GDP through the so-called multiplier effect. But this fundamentally misunderstands the nature of economic growth.

Government spending is divided into current and capital expenditure, primarily stimulating short-term consumption. This focus stems from the short mandates of democratic governments, which prioritise re-election over long-term economic sustainability. Capital spending typically involves investment in infrastructure projects driven by social objectives, with the initial goal of job creation to boost consumption. However, such projects often proceed without a clear understanding of their sustainability or alignment with market demand, which is determined by individuals' subjective preferences and willingness to pay. For example, despite the government's plan to build 1.5 million homes over five years to address housing affordability, approximately 700,000 homes in England remain empty and unfurnished. This highlights a fundamental issue of economic calculation. Due to the decentralised nature of information in modern economic systems, precise assessments are impossible. Governments may identify "what is needed" politically but cannot determine "how much," "when," or "by whom" in concrete terms.

Carl Menger, the founder of Austrian Economics, argued that production occurs in complex stages: from capital goods (factories, equipment, research) to consumer goods (food, electronics, services). These complex stages vary by the nature of products and services. When the government intervenes, given its inability to understand the nature of these stages relative to the product or service it tries to intervene, it focuses simplistically on boosting the consumption of final goods—that essentially neglects the complicated early stages where the real value is created to generate the final good.

Politicians push infrastructure and welfare spending as solutions, despite their imperfect economic calculation and incomplete information guiding their decisions. But these pushes misalign with market demand, losing value. Funded by taxation and borrowing, these artificial stimuli create a justified and unsustainable cycle of government intervention led by the increase of prices in consumption goods, distorting economic efficiency and proving that top-down planning can't replace market-driven solutions, particularly in a dynamic environment guided by millions of people's subjective preferences and contexts. This ultimately results in the fallacy of government-led investment in cross-roads with the natural complexity of production stages.

​​The Stages of Production – Where Real Growth Happens

To understand how government spending is inefficient, let's take a simple example: coffee production.

1. The farmer plants and harvests the coffee beans (earliest stage of production).

2. The roaster processes the beans, adding value.

3. The distributor transports the product to retailers.

4. Finally, the barista serves a cup of coffee to consumers (latest stage of production).

Each production stage represents an opportunity cost, increasing the value of coffee relative to demand at the final stage, where consumption occurs. These stages involve complex market decisions shaped by tacit knowledge and entrepreneurial foresight that require time. However, governments often intervene at the lastest stage, foregoing time-constraints, prioritising short-term consumption over the foundational production of capital goods at earlier stages. Politicians focus on making goods and services more affordable rather than fostering investment in early-stage production, which drives long-term prosperity through innovation and lower prices. This is the fundamental flaw of government intervention—it prioritises immediate gratification within short political cycles rather than supporting the entrepreneurial and investment processes necessary for sustainable wealth creation.

The Fiscal Illusion – How Governments Hide the True Cost of Spending

The fallacy of government-led investment and the nature of the complex stages of production in the modern economy, leads us to Amilcare Puviani's theory of fiscal illusion. This theory explains how governments obscure the actual cost of their policies. By financing spending through borrowing, taxation, and inflation. The state creates the illusion that the economy is growing while burdening future generations with debt. Consider the UK's rising debt-to-GDP ratio, which is approaching 100%. In the private sector, a company with this level of debt relative to its assets would likely face bankruptcy. 

Source: ONS

Yet, politicians continue to promote expansive spending, justified by the flawed assumption that government debt is not like household debt. But this assumption ignores the critical reality of the nature of government financing:

1. Raising taxes reduces disposable income and business investment.

2. Printing money (via the central bank) devalues currency and causes inflation.

3. Borrowing more pushes debt repayment onto future taxpayers.

Instead of recognising these consequences, policymakers employ expansionary and complex fiscal policies to mask the long-term damage—creating temporary booms at the cost of future busts.

Why Government Spending is Inefficient

Milton Friedman famously described four ways to spend money:

1. Spending your own money on yourself → Maximum efficiency (you want the best value for your money).

2. Spending your money on someone else → Moderate efficiency (you still care, but not as much).

3. Spending someone else's money on yourself → Inefficient (you're less cautious because it's not your money).

4. Spending someone else's money on someone else → Most inefficient (little accountability or incentive to economise).

Government spending falls into Category 4—where politicians allocate taxpayers' money with minimal accountability, often prioritising political considerations over real economic demands. For example:

• Private investors risk their own money accounting that projects are efficient and necessary (1 and 2)

• Government projects are funded through taxation and debt, reducing incentives for cost control and leading to wasteful spending such as White Elephant infrastructure projects. (3 and 4).

This is why market-driven economies tend to be more productive in real terms than government-controlled ones—the incentive and profit motive ensures that only valuable projects are pursued.

Conclusion – The Case for Market-Driven Growth

Government spending does not create wealth; it merely redistributes it. Real economic growth occurs when wealth is created and individuals and businesses invest in earliest stages of production, not when governments spend recklessly to boost short-term consumption artificially. With rising debt and inflation, the UK's current fiscal trajectory highlights the dangers of ignoring these fundamental economic fundamental for growth.  A better approach inspired by Austrian Economics-policy Solutions are:

1. Stricter Fiscal Rules – Limit government borrowing to ensure long-term financial sustainability.

2. Incentivise Private Investment – Reduce taxes and regulations to encourage entrepreneurship.

3. Decentralise Economic Decision-Making – Allow local governments and individuals greater control over economic policies.

The illusion of growth fueled by government spending is just that—an illusion. Sustainable economic progress requires entrepreneurship, hard work, private investment, and market-driven innovation. The sooner policymakers recognise this, the better the future will be for the UK economy.

 

Card Image: Time series graph of trade balances in Denmark and Norway from 1700 to 1780. Image in the Public Domain.
Banner Image: West Street, Scunthorpe. Image in the Public Domain.