5.3. Loans and Subsidies

Government loans and subsidies to businesses distort production.  A subsidy or grant directly penalizes taxpayers and distorts the structure of production away from where it maximizes consumers’ satisfaction, and towards the chosen industry.  It tends to prevent inefficient producers in that industry from going bankrupt, thus they continue to waste resources.

A government loan to a business, so long as it is paid back and the borrower increases his profits as a result of the loan, while it will still distort the economy towards the tastes of the government bureaucrat, will not be wasted resources and the structure of production will indeed have been improved.  However, government loans are far less likely to be paid back than private loans.

If, say, a farmer, would like a loan to buy a tractor and increase his productivity, but he is unable to get a loan in the market, perhaps because he has bad credit, it is argued that a loan from government can help him get started and all will benefit from his increased productivity.  This overlooks the fact that the reason he could not get a loan on the market was because he was considered too great a risk.  More than likely, he will make inefficient use of the tractor and will not be able to pay back the loan, and therefore the loan by the government would have been a waste of resources and destructive to the structure of production. 

Capital is scarce, and the private sector tends to allocate capital in the most productive (profitable) way possible.  If a loan is not granted by the private sector, then it has been judged to be not the best use of capital or resources.

Investors are cautious about what to do with their own money (capital).  Government, on the other hand, is “investing” other people’s money and this makes them willing to take risks they would not take with their own money.  It leads to favoritism, as governments can pick and choose which industries, and which corporations and individuals, they want to lend money to.  They are not restrained by the risk of not getting a favorable return on their investment.  Government loans will waste far more capital and resources than private loans, and will hence lower productivity.

While the inefficient farmer may be able to improve his individual productivity, what is not seen is what might have been produced if the loan had been a private one, and hence given to someone more likely to make better use of the capital.