Archive for the ‘Deficit’ Category

Back in January, I wrote about the $42 trillion price tag of Alexandria Ocasio-Cortez’s Green New Deal.

To pay for this massive expansion in the burden of government spending, some advocates have embraced “Modern Monetary Theory,” which basically assumes the Federal Reserve can finance new boondoggles by printing money.

I debated this issue yesterday on CNBC. Here’s a clip from that interview.

Wow, this Modern Monetary Theory (MMT) reminds me of the old joke about “I can’t be out of money. I still have checks in my checkbook.”

I don’t know how far Ms. Kelton would go with this approach. I know from previous encounters that she’s a genuine Keynesian and thus willing to borrow lots of money to finance a larger public sector. But her answer at 2:45 of the interview also suggests she’s okay with using the Federal Reserve to finance bigger government.

In either case, our debate is really about the size of government.

And anybody who wants a bigger burden of government is at least semi-obliged to say how it would be financed. The MMT crowd stands out because they basically say the Federal Reserve can print money.

To help understand the various options, I’ve created a helpful flowchart.

It’s possible, of course, for my statist friends to say “all of the above,” so these are not mutually exclusive categories.

Though the MMT people who select “Print money!” are probably the craziest.

And I hope that they are not successful. After all, nations that have used the printing press to finance big government (most recently, Venezuela and Zimbabwe) are not exactly good role models.

I noted in the interview that MMT is so radical that it is opposed by conventional economists on the right and left.

For instance, Michael Strain of the right-leaning American Enterprise Institute opines that the theory is preposterous and nonsensical.

…modern monetary theory…freshman Democratic Representative Alexandria Ocasio-Cortez spoke favorably about it earlier this month. …MMT is…sometimes a theory of money. MMT is also being discussed in the context of a political program to justify huge increases in social spending. Finally, there is its role as a prescription for macroeconomic policy. …The bedrock observation of MMT is correct: Any government that issues its own currency can always pay its bills. …this is about all that can be said favorably regarding modern monetary theory. …it is in its ideas about macroeconomic policy that MMT fully earns its place on the fringe. …what does MMT have to say about inflation when it does materialize? …it falls to the institution with authority over tax and budget policy — the U.S. Congress — to make sure prices are stable by raising taxes… MMT seems to call for tax increases in order to restrain inflation. …Modern monetary theory…if enacted it could cause great harm to the U.S. economy.

From the left side of the spectrum, here’s some of what Joseph Minarik wrote on the topic.

MMT rests on simplistic observations that have just enough truth to take in those who need to believe. Believers in MMT see crying societal needs… By common reckoning, government lacks the resources to address all of those needs immediately. MMT solves that problem with a simple and (literally) true observation: The federal government can just print the money. …And that is what willing policymakers choose to hear: Anything. Without limit. It is so convenient —  “too good to check.” …to MMT adherents, the Federal Reserve and all other inflation “Chicken Littles” are and forever have been totally wrong. There has not been rapid inflation for 20 years or so. Therefore, there never will be inflation again. …Yes, inflation is low. But it always is before it rises. And once inflation begins, slowing it is hard and painful. MMT is the perfect theory for the video game generation, which never saw the 1960s economic miscalculations so much like what MMT advocates today, and apparently believes that such mistakes can be reversed painlessly by just hitting the reset button. …the consequences could be catastrophic.

Catastrophic indeed.

Letting the inflation genie out of the bottle is not a good idea. And the policies of the MMT crowd presumably would lead to something far worse than what America experienced in the 1970s.

Rescuing the economy from that inflation was painful, so it’s not pleasant to imagine what would be needed to salvage the country if the MMT people ever got their hands on the levers of power.

Let’s wrap this up. Earlier this week, I presented a guide to fiscal policy based on six core principles.

If Modern Monetary Theory gains more traction, I may have to add a postscript.

P.S. If ever imposed, I suspect MMT would be very good news for people with a lot of gold and/or a lot of Bitcoin.

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When I’m asked for a basic tutorial on fiscal policy, I normally share my four videos on the economics of government spending and my primer on fundamental tax reform.

But this six-minute interview may be a quicker introduction to spending issues since I had the opportunity to touch on almost every key principle.

Culled from the discussion, here is what everyone should understand about the spending side of the fiscal ledger.

Principle #1 – America’s fiscal problem is a government that is too big and growing too fast. Government spending diverts resources from the productive sector of the economy, regardless of how it is financed. There is real-world evidence that large public sectors sap the private sector’s vitality, augmented by lots of academic research on the negative relationship between government spending and economic performance.

Principle #2 – Entitlements programs are the main drivers of excessive spending. All the long-run forecasts show that the burden of spending is rising because of the so-called mandatory spending programs. Social Security, Medicare, and Medicaid were not designed to keep pace with demographic changes (falling birthrates, increasing longevity), so spending for these program will consume ever-larger shares of economic output.

Principle #3 – Deficits and debt are symptoms of the underlying problem. Government borrowing is not a good idea, but it’s primarily bad because it is a way of financing a larger burden of spending. The appropriate analogy is that, just as a person with a brain tumor shouldn’t fixate on the accompanying headache, taxpayers paying for a bloated government should pay excessive attention to the portion financed by red ink.

Principle #4 – Existing red ink is small compared to the federal government’s unfunded liabilities. People fixate on current levels of deficits and debt, which are a measure of all the additional spending financed by red ink. But today’s amount of red ink is relatively small compared to unfunded liabilities (i.e., measures of how much future spending will exceed projected revenues).

Principle #5 – A spending cap is the best way to solve America’s fiscal problems. Balanced budget rules are better than nothing, but they have a don’t control the size and growth of government. Spending caps are the only fiscal rules that have a strong track record, even confirmed by research from the International Monetary Fund and Organization for Economic Cooperation and Development.

Here’s one final principle, though I didn’t mention it in the interview.

Principle #6 – Increasing taxes will make a bad situation worse. Since government spending is the real fiscal problem, higher taxes, at best, replace debt-financed spending with tax-financed spending. In reality, higher taxes loosen political constraints on policy makers and “feed the beast,” so the most likely outcome – as seen in Europe – is that overall spending levels increase and long-term debt actually increases.

In an ideal world, these six principles would be put in a frame and nailed above the desk of every politician, government official, and bureaucrat who deals with fiscal policy.

Not that it would make much difference since their decisions are guided by “public choice” no matter what principles they see at their desk, but it’s nice to fantasize.

Here are a few other observations from the interview.

P.S. Needless to say, I wish limits on enumerated powers were still a guiding principle for fiscal policy. Sadly, the days of Madisonian constitutionalism are long gone.

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The Congressional Budget Office just released it’s annual Budget and Economic Outlook, and that means I’m going to do something that I first did in 2010 and most recently did last year.

I’m going to show that it’s actually rather simple to balance the budget with modest spending restraint.

This statement shocks many people because they’ve read about out-of-control entitlement spending, pork-filled appropriations bills, big tax cuts, and trillion-dollar deficits.

But  the first thing to understand when contemplating how to fix America’s fiscal problems is that tax revenues, according to the new CBO numbers, are going to increase by an average of nearly 5 percent annually over the next 10 years. And that means receipts will be more than $2.1 trillion higher in 2029 than they are in 2019.

And since this year’s deficit is projected to be “only” $897 billion, that presumably means that it shouldn’t be that difficult to balance the budget.

By the way, I don’t even think balance should be the goal. It’s far more important to focus on reducing the burden of government spending. After all, the economy is adversely affected if wasteful outlays are financed by taxes, just as the economy is hurt when wasteful outlays are financed by borrowing.

In other words, too much government spending is the disease. Deficits are best understood as a symptom of the disease.

But I’m digressing. The point for today is simply that the symptom of borrowing can be addressed if a good chunk of that additional $2.1 trillion of new revenue is used to get rid of the $897 billion of red ink.

Unfortunately, the CBO report projects that the burden of government spending also is on an upward trajectory. As you can see from our next chart, outlays will jump by about $2.6 trillion by 2029 if the budget is left on autopilot.

The solution to this problem is very straightforward.

All that’s needed is a bit of spending restraint to put the budget on a glide path to balance.

I’m a big fan of spending caps, so this next chart shows the 10-year fiscal outlook if annual spending increases are limited to 1% growth, 2% growth, or 2.5% growth.

As you can see, modest spending discipline is a very good recipe for fiscal balance.

Our final chart adds a bit of commentary to illustrate how quickly we could move from deficit to surplus based on different spending trajectories.

I’ll close with a video from 2010 that explains why spending restraint is the best way to achieve fiscal balance. Especially when compared to tax increases.

The numbers are different today, but the analysis hasn’t changed.

As I noted at the end of the video, balancing the budget with spending restraint may be simple, but it won’t be easy.

If we want spending to grow, say, 2% annually rather than 5% annually, that will require some degree of genuine entitlement reform. And it means finally enforcing some limits on annual appropriations.

Those policies will cause lots of squealing in Washington. But we saw during the Reagan and Carter years, as well as more recently, that spending discipline is possible.

P.S. The video also exposed the dishonest way that budgets are presented in Washington.

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I don’t like writing about deficits and debt because I don’t want to deflect attention from the more important underlying problem of excessive government spending.

Indeed, I constantly explain that spending is what diverts resources from the productive sector of the economy, regardless of whether outlays are financed by taxes or borrowing. This is why a spending cap is far and away the best rule for fiscal policy.

That being said, red ink does matter when politicians incur so much debt that investors (i.e., the folks in the private sector who buy government debt) decide that a government no longer is trustworthy. And when that happens, interest rates climb because investors insist on getting a higher return to compensate for the risk of default.

And if things really deteriorate, a government may default (i.e., no longer make promised payments) and investors obviously will refuse to lend any more money. That’s basically what happened in Greece.

Sadly, most governments have not learned from Greece’s mistakes. Indeed, government debt in Europe is now significantly higher than it was before the 2008 recession.

This suggests that there will be another fiscal crisis when the next recession occurs. Italy presumably will be the big domino to fall, though there are many other nations in Europe that could get in trouble.

But the problems of excessive spending and excessive debt are not limited to Europe. Or Japan.

The World Bank has a new report that shows that red ink is a growing problem in the rest of the world. More specifically, the report is about “fiscal space,” which some see as a measure of budgetary flexibility but I interpret as an indicator of budgetary vulnerability. Here’s how it is defined in the report.

…fiscal space is simply defined as the availability of budgetary resources to conduct effective fiscal policy. …some studies define it as the budgetary room to create and allocate funding for a certain purpose without threatening a sovereign’s financial position. …Debt service capacity is a critical component of fiscal space. It has multiple dimensions, including financing needs that are related to budget positions and debt rollover, access to liquid markets, resilience to changes in market valuations of debt, and the coverage of contingent liabilities. …Market participants’ perceptions of sovereign risk reflect and, in turn, influence an economy’s ability to tap markets and service its obligations. Thus, fiscal space can function as an essential instrument of macroeconomic risk management.

And what is “effective fiscal policy”?

From the World Bank’s misguided perspective, it’s the ability to engage in Keynesian spending.

Countries with ample fiscal space can use stimulus measures more extensively.

But let’s set aside that anti-empirical assertion.

I found the report useful (though depressing) because it had data showing how debt levels have increased, especially in emerging market and developing economies (EMDEs).

Fiscal space improved during 2000−07, but has shrunk around the world since the global financial crisis. …debt sustainability indicators, including government debt and fiscal sustainability gaps, have deteriorated in at least three-quarters of countries in the world. …and perceptions of market participants on sovereign credit risks have worsened. …Since 2011, fiscal space has shrunk in EMDEs. …fiscal deficits widened to 3 to 5 percent of GDP in 2016, on average… Government debt has risen to 54 percent of GDP, on average, in 2017. …EMDEs need to shore up fiscal positions to prevent sudden spikes in financing costs… Fiscal space has been shrinking in EMDEs since the global financial crisis. It needs to be strengthened.

Here is a set of charts from the report, showing both developed nations (red lines) and developing nations (yellow lines). The top-left chart shows debt climbing for EMDEs and the bottom-right chart shows debt ratings dropping for EMDEs.

The EMDEs have lower debt levels, but their debt is rated as more risky because poorer nations don’t have a very good track record of dealing with recessions and fiscal crises (would you lend money to Argentina?).

In any event, the yellow lines in the top-left chart and bottom-right chart are both headed in the wrong directions.

The bottom line? It won’t just be European welfare states that get in trouble when there’s another recession.

By the way, the report from the World Bank offers some policy advice. Some of it potentially good.

Pension reforms could…support fiscal credibility and generate long-term fiscal gains… credible and well-designed institutional mechanisms can help support fiscal discipline and strengthen fiscal space. …Fiscal rules impose numerical constraints on budgetary aggregates—debt, overall balance, expenditures.

But most of it bad.

Fiscal sustainability could be improved by increasing the efficiency of revenue collection… Measures to strengthen revenue collection could include broadening tax bases to remove loopholes for higher-income households or profitable corporates. In countries with high levels of informality, taxing the informal sector—for example, by promoting a change in payment methods to non-cash transaction and facilitating collective action by informal sector associations—could help raise revenues directly, as well as indirectly… In EMDEs, reforms to broaden revenue bases and strengthen tax administration can generate revenue gains.

At the risk of stating the obvious, the problem in developing nations is bad government policy, not insufficient revenue in the hands of politicians.

P.S. I included the caveat that some of the recommendations were “potentially good” since the report didn’t specify the type of pension reform or the type of fiscal rule. I like to think the authors were referring to personal retirement accounts and spending caps, but it’s not clear.

P.P.S. The IMF subsidizes and encourages bad fiscal policy with bailouts. Fortunately, there is a much more sensible approach.

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I’ve warned many times that Italy is the next Greece.

Simply stated, there’s a perfect storm of bad news. Government is far too big, debt is too high, and the economy is too sclerotic.

I’ve always assumed that the country would suffer a full-blown fiscal crisis when the next recession occurs. At that point, tax receipts will fall because of the weak economy and investors will realize that the nation no longer is able to pay its bills.

But it may happen even sooner thanks to a spat between Italy’s left-populist government and the apparatchiks at the European Commission.

Here’s what you need to know. There are (poorly designed) European budget rules, known as the Maastricht Criteria, that supposedly require that nations limit deficits to 3 percent of GDP and debt to 60 percent of GDP.

With cumulative red ink totaling more than 130 percent of GDP, Italy obviously fails the latter requirement. And this means the bureaucrats at the European Commission can veto a budget that doesn’t strive to lower debt levels.

At least that’s the theory.

In reality, the European Commission doesn’t have much direct enforcement power. So if the Italian government tells the bureaucrats in Brussels to go jump in a lake, you wind up with a standoff. As the New York Times reports, that’s exactly what’s happened.

In what is becoming a dangerous game of chicken for the global economy, Italy’s populist government refused to budge on Tuesday after the European Union for the first time sent back a member state’s proposed budget because it violated the bloc’s fiscal laws and posed unacceptable risks. …the commission rejected the plan, saying that it included irresponsible deficit levels that would “suffocate” Italy, the third-largest economy in the eurozone. Investors fear that the collapse of the Italian economy under its enormous debt could sink the entire eurozone and hasten a global economic crisis unseen since 2008, or worse. But Italy’s populists are not scared. They have repeatedly compared their budget, fat with unemployment welfare, pension increases and other benefits, to the New Deal measures of Franklin D. Roosevelt.

Repeating the failures of the New Deal?!? That doesn’t sound like a smart plan.

That seems well understood, at least outside of Italy.

The question for Italy, and all of Europe, is how far Italy’s government is willing to go. Will it be forced into submission by the gravity of economic reality? Or will Italian leaders convince their voters that the country’s financial health is worth risking in order to blow up a political and economic establishment that they say is stripping Italians of their sovereignty? And Brussels must decide how strict it will be. …the major pressure on Italy’s budget has come from outside Italy. Fitch Ratings issued a negative evaluation of the budget, and Moody’s dropped its rating for Italian bonds to one level above “junk” last week.

So now that Brussels has rejected the Italian budget plan, where do things go from here?

According to CNBC, the European Commission will launch an “Excessive Deficit Procedure” against Italy.

…a three-week negotiation period follows in which a potential agreement could be found on how to lower the deficit (essentially, Italy would have to re-submit an amended draft budget). If that’s not reached, punitive action could be taken against Italy. Lorenzo Codogno, founder and chief economist at LC Macro Advisors, told CNBC…“it’s very likely that the Commission will, without making a big fuss, will move towards making an ‘Excessive Deficit Procedure’…to put additional pressure on Italy…” Although it has the power to sanction governments whose budgets don’t comply with the EU’s fiscal rules (and has threatened to do so in the past), it has stopped short of issuing fines to other member states before. …launching one could increase the already significant antipathy between Brussels and a vociferously euroskeptic government in Italy. Against a backdrop of Brexit and rising populism, the Commission could be wary of antagonizing Italy, the third largest euro zone economy. It could also be wary of financial market nerves surrounding Italy from spreading to its neighbors… Financial markets continue to be rattled over Italy’s political plans. …This essentially means that investors grew more cautious over lending money to the Italian government.

For those who read carefully, you probably noticed that the European Commission doesn’t have any real power. As such, there’s no reason to think this standoff will end.

The populists in Rome almost certainly will move forward with their profligate budget. Bureaucrats in Brussels will complain, but to no avail.

Since I’m a nice guy, I’m going to give the bureaucrats in Brussels a much better approach. Here’s the three-sentence announcement they should make.

  1. The European Commission recognizes that it was a mistake to centralize power in Brussels and henceforth will play no role is overseeing fiscal policy in member nations.
  2. The European Commission (and, more importantly, the European Central Bank) henceforth will have a no-bailout policy for national governments, or for those who lend to national governments.
  3. The European Commission henceforth advises investors to be appropriately prudent when deciding whether to lend money to any government, including the Italian government.

From an economic perspective, this is a far superior approach, mostly because it begins to unwind the “moral hazard“that undermines sound financial decision making in Europe.

To elaborate, investors can be tempted to make unwise choices if they think potential losses can be shifted to taxpayers. They see what happened with the various bailouts in Greece and that tells them it’s probably okay to continue lending money to Italy. To be sure, investors aren’t totally blind. They know there’s some risk, so the Italian government has to promise higher interest payments

But it’s highly likely that the Italian government would have to pay even higher rates if investors were convinced there would be no bailouts. Incidentally that would be a very good outcome since it would make it more costly for Italy’s politicians to continue over-spending.

In other words, a win-win situation, with less debt and more prudence (and maybe even a smaller burden of government!).

My advice seems so sensible that you’re probably wondering if there’s a catch.

There is, sort of.

When I talk to policy makers, they generally agree with everything I say, but then say my advice is impractical because Italy’s debt is so massive. They fret that a default would wipe out Italy’s banks (which imprudently have bought lots of government debt), and might even cause massive problems for banks in other nations (which, as was the case with Greece, also have foolishly purchased lots of Italian government debt).

And if banks are collapsing, that could produce major macroeconomic damage and even lead/force some nations to abandon the euro and go back to their old national currencies.

For all intents and purposes, the Greek bailout was a bank bailout. And the same would be true for an Italian bailout.

In any event, Europeans fear that bursting the “debt bubble” would be potentially catastrophic. Better to somehow browbeat the Italian government in hopes that somehow the air can slowly be released from the bubble.

With this in mind, it’s easy to understand why the bureaucrats in Brussels are pursuing their current approach.

So where do we stand?

  • In an ideal world, the problem will be solved because the Italian government decides to abandon its big-spending agenda and instead caps the growth of spending (as I recommended when speaking in Milan way back in 2011).
  • In an imperfect world, the problem is mitigated (or at least postponed) because the European Commission successfully pressures the Italian government to curtail its profligacy.
  • In the real world, though, I have zero faith in the first option and very little hope for the second option. Consider, for instance, the mess in Greece. For all intents and purposes, the European Commission took control of that nation’s fiscal policy almost 10 years ago. The results have not been pretty.

So this brings me back to my three-sentence prescription. Yes, it almost certainly would be messy. But it’s better to let the air out of bubbles sooner rather than later.

P.S. The so-called Basel Rules contribute to the mess in Europe by directing banks to invest in supposedly safe government debt.

P.P.S. If the European Union is going to impose fiscal rules on member nations, the Maastricht criteria should be jettisoned and replaced with a Swiss-style spending cap.

P.P.P.S. Some of the people in Sardinia have the right approach. They want to secede from Italy and become part of Switzerland. The Sicilians, by contrast, have the wrong mentality.

P.P.P.P.S. Italy is very, very, very well represented in the Bureaucrat Hall of Fame.

P.P.P.P.P.S. You’ll think I’m joking, but a columnist for the New York Times actually argued the United States should be more like Italy.

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The Congressional Budget Office just released a Monthly Budget Review showing a $782 billion deficit for the 2018 fiscal year.

My recommendation is to mostly ignore data on red ink. Yes, it is possible that a country can get in trouble because of deficits and debt, but it’s far more important to look at what’s happening with government spending.

This is for two reasons.

  • First, spending is the most accurate way of measuring the fiscal burden of government. Regardless of whether it is financed by taxes or borrowing, spending is what requires resources to be diverted from the economy’s productive sector.
  • Second, the best way of predicting red ink is to look at what’s happening to spending. If the burden of government spending is growing faster than the private sector, that’s a very worrisome trend. In the long run, it leads to fiscal crisis.

With this in mind, I dug into the CBO numbers to see what’s really happening.

Lo and behold, we find that the deficit was falling rapidly when there was a de facto spending freeze between 2009 and 2014. But ever since 2014, spending has been growing more than twice the rate of inflation and the deficit is climbing.

Does tax revenue also play a role? Of course.

I’ve already explained that the Trump plan has a front-loaded tax cut, so that has an effect on short-run deficits. But I also noted that the tax cut gradually disappears because the revenue-raising provisions from last year’s legislation become more important in the long run.

In other words, America’s long-run fiscal challenge is entirely the result of a rising burden of government spending. And that’s very clear in the Congressional Budget Office numbers.

The bottom line is that America has a spending problem, not a red ink problem. Deficits and debt are symptoms, but the underlying disease is that the federal government is too big and that spending is growing too fast.

The solution is to follow my Golden Rule with a spending cap.

P.S. To help them understand this point, Republicans need shock therapy.

P.P.S. Maybe it’s difficult to educate Republicans because they’re part of the problem?

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I’ve been in Lebanon for the past few days, but not because I’m seeking a replacement for the Princess of the Levant.

Instead, I’m here because the Lebanese Institute for Market Studies arranged a briefing in the Parliament on the perilous state of the nation’s finances.

Lebanon is in trouble because policy makers have violated my Golden Rule by allowing spending to grow too fast. As such, even though the overall fiscal burden of government is relatively modest, red ink has climbed to about 150 percent of economic output. That’s higher than Italy today, and higher than Greek debt when that nation’s fiscal crisis occurred.

I’ve pointed out before that there’s not an automatic tipping point when a debt crisis occurs. It happens whenever investors decide that they no longer trust that a government will pay its debt.

I’m not going to predict exactly when Lebanon reaches that point, but I suspect sooner rather than later. Unless, of course, Lebanon changes direction.

And that’s exactly what I’m recommending. I made three points.

First, higher taxes are not a solution. Given the IMF’s awful track record of pushing tax hikes in the region, I repeated my standard joke about arresting any of those bureaucrats who enter the country.

Second, a rule requiring a balanced budget is not the ideal solution. Not because balanced budgets are a bad idea, but because such rules put fiscal policy at the mercy of the business cycle.

This chart showing Lebanon’s revenue makes my point. When there’s strong growth and revenues are increasing rapidly (between 2001-2004 and 2006-2009), big spending increases are possible. But when the economy is weak and revenues are flat (between 2004-2006 and 2009-2016), politicians are very resistant to fiscal discipline during a downturn.

Even the IMF and OECD agree with me that this is a big reason why anti-deficit rules don’t work.

Which leads me to my third point, which is that Lebanon should copy Hong Kong and Switzerland by adopting an annual limit on spending growth.

I didn’t specify a specific number for a spending cap. Instead, I emphasized that the key goal is to make sure spending – over time – grows slower than the private sector.

But I did show what would have happened if lawmakers had limited nominal annual spending increases to 6 percent starting in 1992 (that sounds far too high, but keep in mind that inflation averaged about 4 percent over the past 25 years).

I told the audience that they would have a budget surplus today, and also very little debt, if a spending cap had been in effect (same results would hold for America).

And I also pointed out that lawmakers could avoid boom-bust budgeting with a long-run spending cap. With a fixed limit on annual spending increases, they would not have to cut outlays during a recession, but they also would not be able to have a spending orgy during a boom.

That’s a good recipe for Lebanon. It’s also the right recipe for the United States.

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