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Posts Tagged ‘Deficits’

With all the fiscal troubles in Greece, Spain, Ireland, Portugal, and Italy, there’s not much attention being paid to Cyprus.

But the Mediterranean island nation is a good case study illustrating the economic dangers of big government.

For all intents and purposes, Cyprus is now bankrupt, and the only question that remains to be answered is whether it will get handouts from the IMF-ECB-EC troika, handouts from Russia, or both. Here’s some of what has been reported by AP.

Cyprus’ president on Thursday defended his government’s decision to seek financial aid from the island nation’s eurozone partners while at the same time asking for a loan from Russia, insisting that the two are perfectly compatible. …Cyprus, with a population of 862,000 people, last week became the fifth country that uses the euro currency to seek a European bailout… The country is currently in talks with the so-called ‘troika’ — the body made up of officials from the European Commission, the European Central Bank and the International Monetary Fund — on how much bailout money it will need and the conditions that will come attached. Locked out of international markets because of its junk credit rating status, Cyprus is paying its bills thanks to a €2.5 billion ($3.14 billion) Russian loan that it clinched last year. But that money is expected to run out by the end of the year.

So what caused this mess? Is Cyprus merely the helpless and innocent victim of economic turmoil in nearby Greece?

That’s certainly the spin from Cypriot politicians, but the budget data shows that Cyprus is in trouble because of excessive spending. This chart, based on data from the International Monetary Fund, shows that the burden of government spending has jumped by an average of 8.3 percent annually since the mid-1990s.

My Golden Rule of fiscal policy is that government spending should grow slower than economic output. Nations that follow that rule generally enjoy good results, while nations that violate that rule inevitably get in trouble.

Interestingly, if Cypriot politicians had engaged in a very modest amount of spending restraint and limited annual budgetary increases to 3 percent, there would be a giant budget surplus today and the burden of government spending would be down to 21.4 percent of GDP, very close to the levels in the hyper-prosperous jurisdictions of Hong Kong and Singapore.

Actually, that’s not true. If the burden of government spending had grown as 3 percent instead of 8.3 percent, economic growth would have been much stronger, so GDP would have been much larger and the public sector would be an ever smaller share of economic output.

Speaking of GDP, the burden of government spending in Cyprus, measured as a share of GDP, has climbed dramatically since 1995.

A simple way to look at this data is that Cyprus used to have a Swiss-sized government and now it has a Greek-sized government. Government spending is just one of many policies that impact economic performance, but is anyone surprised that this huge increase in the size of the public sector has had a big negative impact on Cyprus?

Interestingly, if government spending had remained at 33.9 percent of GDP in Cyprus, the nation would have a big budget surplus today. Would that have required huge and savage budget cuts? Perhaps in the fantasy world of Paul Krugman, but politicians could have achieved that modest goal if they had simply limited annual spending increases to 6 percent.

But that was too “draconian” for Cypriot politicians, so they increased spending by an average of more than 8 percent each year.

What’s the moral of the story? Simply stated, the fiscal policy variable that matters most is the growth of government. Cyprus got in trouble because the burden of government grew faster than the productive sector of the economy.

That’s the disease, and deficits and debt are the symptoms of that underlying problem.

Europe’s political elite doubtlessly will push for higher taxes, but that approach – at best – simply masks the symptoms in the short run and usually exacerbates the disease in the long run.

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I’ve argued, ad nauseam, that the single most important goal of fiscal policy is (or should be) to make sure the private sector grows faster than the government. This “golden rule” is the best way of enabling growth and avoiding fiscal crises, and I’ve cited nations that have made progress by restraining government spending.

But what’s the best way of actually imposing such a rule, particularly since politicians like using taxpayer money as a slush fund?

Well, the Swiss voters took matters into their own hands, as I describe in today’s Wall Street Journal.

Americans looking for a way to tame government profligacy should look to Switzerland. In 2001, 85% of its voters approved an initiative that effectively requires its central government spending to grow no faster than trendline revenue. The reform, called a “debt brake” in Switzerland, has been very successful. Before the law went into effect in 2003, government spending was expanding by an average of 4.3% per year. Since then it’s increased by only 2.6% annually.

So how does this system work?

Switzerland’s debt brake limits spending growth to average revenue increases over a multiyear period (as calculated by the Swiss Federal Department of Finance). This feature appeals to Keynesians, who like deficit spending when the economy stumbles and tax revenues dip. But it appeals to proponents of good fiscal policy, because politicians aren’t able to boost spending when the economy is doing well and the Treasury is flush with cash. Equally important, it is very difficult for politicians to increase the spending cap by raising taxes. Maximum rates for most national taxes in Switzerland are constitutionally set (such as by an 11.5% income tax, an 8% value-added tax and an 8.5% corporate tax). The rates can only be changed by a double-majority referendum, which means a majority of voters in a majority of cantons would have to agree.

In other words, the debt brake isn’t a de jure spending cap, but it is a de facto spending cap. And capping the growth of spending (which is the underlying disease) is the best way of controlling red ink (the symptom of excessive government).

Switzerland’s spending cap has helped the country avoid the fiscal crisis affecting so many other European nations. Annual central government spending today is less than 20% of gross domestic product, and total spending by all levels of government is about 34% of GDP. That’s a decline from 36% when the debt brake took effect. This may not sound impressive, but it’s remarkable considering how the burden of government has jumped in most other developed nations. In the U.S., total government spending has jumped to 41% of GDP from 36% during the same time period.

Switzerland is moving in the right direction and the United States is going in the wrong direction. The obvious lesson (to normal people) is that America should copy the Swiss. Congressman Kevin Brady has a proposal to do something similar to the debt brake.

Rep. Kevin Brady (R., Texas), vice chairman of the Joint Economic Committee, has introduced legislation that is akin to the Swiss debt brake. Called the Maximizing America’s Prosperity Act, his bill would impose direct spending caps, but tied to “potential GDP.” …Since potential GDP is a reasonably stable variable (like average revenue growth in the Swiss system), this approach creates a sustainable glide path for spending restraint.

In some sense, Brady’s MAP Act is akin to Sen. Corker’s CAP Act, but the use of “potential GDP” makes the reform more sustainable because economic fluctuations don’t enable big deviations in the amount of allowable spending.

To conclude, we know the right policy. It is spending restraint. We also know a policy that will achieve spending restraint. A binding spending cap. The problem, as I note in my oped, is that “politicians don’t want any type of constraint on their ability to buy votes with other people’s money.”

Overcoming that obstacle is the real challenge.

P.S. A special thanks to Pierre Bessard, the President of Switzerland’s Liberales Institut. He is a superb public intellectual and his willingness to share his knowledge of the Swiss debt brake was invaluable in helping me write my column.

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A couple of weeks ago, I offered some guarded praise for Paul Ryan’s budget, pointing out that it satisfies the most important requirement of fiscal policy by restraining spending – to an average of 3.1 percent per year over the next 10 years – so that government grows slower than the productive sector of the economy (I call this my Golden Rule).

I was more effusive in my comments about Senator Rand Paul’s budget, which limited the growth of the federal budget over the next 10 years to an average of 2.2 percent each year.

Now the Republican Study Committee from the House of Representatives has put forth a plan that also deserves considerable applause. Like Senator Paul, the RSC plan would impose immediate significant fiscal discipline such that spending in 2017 would be about the same level as it is this year.

Think of this as being similar to the very successful fiscal reforms of New Zealand and Canada in the 1990s.

After the initial period of spending restraint, the budget would be allowed to grow, but only about as fast as the private economy. This chart shows spending levels for the Obama budget, the Paul Ryan budget, the Rand Paul budget, and the RSC budget.

A couple of final points.

1. For all the whining and complaining from the pro-spending lobbies, the RSC budget is hardly draconian. Federal spending, measured as a share of GDP, would only drop to where it was when Bill Clinton left office.

2. One preferable feature of the Rand Paul budget is that the Kentucky Senator eliminates four needless and wasteful federal departments – Commerce, Education, Energy, and Housing and Urban Development. As far as I can tell, no departments are eliminated in the RSC plan. Also, Senator Paul’s plan is bolder on tax reform, scrapping the corrupt internal revenue code and replacing it with a simple and fair flat tax.

3. The RSC comes perilously close to winning a Bob Dole Award. The first chapter of their proposal fixates on symptoms of debt and deficits rather than the real problem of excessive government spending. Indeed, the first six charts all relate to deficits and debt, creating an easy opening for leftists to say they can solve the mis-defined problem with higher taxes.

There are lots of other details worth exploring, but the main lesson is that restraining spending is the key to good fiscal policy.

And that’s what’s happening.  Indeed, the good news is that policymakers have proposed several budget plans that would shrink the burden of spending as a share of GDP. It’s refreshing to debate the features of several good plans (rather than comparing the warts in the competing plans during the big-government Bush years).

The bad news is that Harry Reid and Barack Obama will succeed in blocking any progress this year, so America will move ever closer to becoming another Greece.

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Last year, while lounging on the beach in the Caribbean…oops, I mean while doing off-site research, I developed the first iteration of a rule to describe how fiscal policy should operate.

Good fiscal policy exists when the private sector grows faster than the public sector, while fiscal ruin is inevitable if government spending grows faster than the productive part of the economy.

My motivation was to help people understand that America’s fiscal problem is excessive government spending, not red ink. Deficits and debt are undesirable, of course, but they are best understood as symptoms. The underlying disease is a bloated federal budget that diverts resources from the productive sector of the economy and subsidizes dependency.

But after getting feedback, I realized that the rule was too wordy. So, after a bit of tweaking and market testing, I came up with “Mitchell’s Golden Rule.”

The purpose of this rule isn’t to make me famous, like Art Laffer with the Laffer Curve. Instead, I’m hoping that this simple construct will help policymakers focus on the most important variable.

Countries that follow the Golden Rule, such as Hong Kong and Singapore, enjoy long-run prosperity. But the Golden Rule also shows how nations in fiscal trouble can get back on the right track with periods of spending restraint, as shown in this video featuring Canada, Slovakia, New Zealand, and Ireland. And this video shows how the United States made progress during both the Reagan years and the Clinton years.

Governments that take the opposite approach, however, eventually wind up in fiscal chaos. Just look at the data from Greece. Or other crumbling welfare states.

All this discussion about how to measure good fiscal policy may seem esoteric, but it provides the foundation to understand why Senator Rand Paul’s new budget proposal is so admirable. Joined by Senators Jim DeMint and Mike Lee, Senator Paul has a comprehensive proposal to curtail big government.

1. An immediate cut of $500 billion of wasteful spending.

2. A five-year freeze on total government spending.

3. Limiting average annual spending growth to 2.2 percent over the next ten years.

Last but not least, taxpayers get a big reward from Senator Paul’s budget with a simple and fair 17 percent flat tax. This pro-growth policy is desperately needed to boost the economy and improve competitiveness. And while a flat tax theoretically could be enacted without accompanying spending restraint, it’s far more likely to happen if lawmakers show they’re serious about restraining the federal behemoth.

The accompany chart shows the 10-year projections for spending and revenue if Senator Paul’s budget is enacted.

A few additional thoughts. Senator Paul and his colleagues are highlighting the fact that the plan generates a balanced budget in just five years. That’s a good outcome, but it should be a secondary selling point. All the good results in the plan – including the reduction in red ink and the flat tax – are made possible because the overall burden of federal spending is lowered. That should be the main selling point.

This doesn’t mean that Senator Paul is in any danger of winning a Bob Dole Award, but it’s nonetheless unfortunate since a focus on deficits gives an opening for leftists to claim that they can achieve the same outcome with tax increases. This is why sponsors should focus on the importance of spending restraint, and then add explanations of how this eliminates red ink. This is the approach I took in this video showing how limits on the growth of spending would lead to a balanced budget.

Also, I have two minor disagreements with Senator Paul’s budget proposal.

1. He does not modernize Social Security system with personal retirement accounts. He does have reforms to rein in the program’s long-run outlays, thus addressing the system’s fiscal crisis. But this generally means workers will pay more and get less, thus exacerbating the system’s other crisis, which is the anemic ratio of benefits received compared to taxes paid.

2. He retains the home mortgage interest deduction in the flat tax plan. This may sound like nit-picking since I should be happy to get 99 percent of what I want, but I worry that allowing one deduction will pave the way for more deductions. Remember the old advertisement by Lay’s potato chips (at least I think) with the saying that “I bet you can’t eat just one”? Well, that’s how politicians would be with a flat tax. Once they allowed one horse out of the barn (I realize I’m mixing my metaphors here, but you get the point), it would be just a matter of time before the entire herd escaped.

But I’m not here to make the perfect the enemy of the very, very good. I wrote a lot last year about the Ryan budget, which was quite an achievement (particularly since it actually passed the House).

The Paul budget is the Ryan budget, but even better.

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President Obama’s budget proposal was unveiled today, generating all sorts of conflicting statements from both parties.

Some of the assertions wrongly focus on red ink rather than the size of government. Others rely on dishonest Washington budget math, which means spending increases magically become budget cuts simply because outlays are growing at a slower rate than previously planned.

When you strip away all the misleading and inaccurate rhetoric, here’s the one set of numbers that really matters. If we believe the President’s forecasts (which may be a best-case scenario), the burden of federal spending will grow by $2 trillion between this year and 2022.

In all likelihood, the actual numbers will be worse than this forecast.

The President’s budget, for instance, projects that the burden of federal spending will expand by less than 1 percent next year. That sounds like good news since it would satisfy Mitchell’s Golden Rule.

But don’t believe it. If we look at the budget Obama proposed last year, federal spending was supposed to fall this year. Yet the Obama Administration now projects that outlays in 2012 will be more than 5 percent higher than they were in 2011.

The most honest assessment of the budget came from the President’s Chief of Staff, who openly stated that, “the time for austerity is not today.”

With $2 trillion of additional spending (and probably more), that’s the understatement of the century.

What makes this such a debacle is that other nations have managed to impose real restraints on government budgets. The Baltic nations have made actual cuts to spending. And governments in Canada, New Zealand, Slovakia, and Ireland generated big improvements by either freezing budgets or letting them grow very slowly.

I’ve already pointed out that the budget could be balanced in about 10 years if the Congress and the President displayed a modest bit of fiscal discipline and allowed spending to grow by no more than 2 percent annually.

But the goal shouldn’t be to balance the budget. We want faster growth, more freedom, and constitutional government. All of these goals (as well as balancing the budget) are made possible by reducing the burden of federal spending.

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I’m getting very frustrated. I  spend too much time reminding my supposed allies that America’s fiscal problem is too much government. Deficits and debt, I constantly explain, are best understood as symptoms, whereas a bloated public sector is the underlying disease.

Even people who are very solid on fiscal policy make the mistake of sometimes focusing too much on red ink rather than the size of government, including Senator Jim DeMint, Mark Steyn of National Review, Representative Paul Ryan, and my old friends at the Heritage Foundation.

So I’ve decided to create a new award. But unlike my other awards, which are exercises in narcissism (Mitchell’s Law, Mitchell’s Golden Rule), I’m naming this award after former Senator Bob Dole.

The message is very simple. Whenever people complain about red ink, even if they are genuine advocates of small government, they give leftists an opportunity to say that higher taxes are a solution.

That’s bad politics and bad policy. And since Bob Dole excelled in both those ways, you can understand why his name is linked to the award.

Naming the award after Bob Dole also is appropriate since he was never a sincere advocate of limited government. The Kansas lawmaker was a career politician who said in his farewell speech that his three greatest achievements were a) creating the food stamp program, b) increasing payroll taxes, and c) imposing the Americans with Disabilities Act (no wonder I wanted Clinton to win in 1996).

For all of these reasons, and more, no real conservative should want to win an award linked to Bob Dole.

So I’m putting the policy world on notice. If you say the wrong thing – even if your heart is in the right place, you may win this booby prize.

This video has further information on why the real fiscal problem is excessive government spending. Deficits also are bad, the video explains, but they are best understood as a bad consequence of big government (with high taxes being the other bad consequence).

One last point, for those who are still fixated on red ink, is that nations that do the right thing on spending also tend to be the ones who reduce deficits and debt.

Not that this should come as a surprise. The best way to get rid of symptoms is to cure the disease that causes them.

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…Well, I’m not sure what it means. But it sure doesn’t make sense when you look at the big picture. A credit card company wouldn’t increase a deadbeat’s credit limit, so why is it a sign of fiscal prudence to give Uncle Sam more borrowing authority?

That being said, I never thought it was realistic to block a debt limit increase. Indeed, I fully expected an unsatisfactory result.

But this cartoon is a pretty good summary of how Washington thinks.

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