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Archive for the ‘Deficit’ Category

I’ve warned that the budgetary impact of the coronavirus may trigger another fiscal crisis in Europe.

Especially Italy.

But what about the United States? Will we reach a point, as Margaret Thatcher famously warned, of running out of other people’s money?

We probably still have a couple of decades before that happens, as I speculated at the end of a recent interview, but that doesn’t mean we should continue down our current path.

The Wall Street Journal opined on this topic yesterday, citing newly released estimates from the Congressional Budget Office.

Friday’s Congressional Budget Office report on the federal fisc for April…usually a surplus month as tax payments roll in, but the Treasury postponed tax day this year until July 15. We are grateful for such small government favors. Spending more than doubled in April from the year before and revenue fell by 55%. …we are all apparently supposed to be converts to Modern Monetary Theory. This is the view that governments can spend whatever they like because the Federal Reserve can monetize it without economic harm. We may get to test this proposition. …the damage from so much spending will come in two ways. First, in resources misallocated to government rather than into private hands to invest. Second, in the tax increases that the political class will eventually impose, perhaps starting as early as 2021.

As is so often the case, the WSJ is correct in its analysis.

The fiscal crisis won’t be too much red ink. That’s merely the symptom of the real disease, which is that government is getting far too big.

As the editorial warns, this undermines prosperity because resources get diverted from the economy’s productive sector.

And as that spending burden increases, it means more and more pressure for tax increases, which further penalize growth. I’ve already noted that politicians will try to exploit the crisis by imposing a wealth tax, but I think the real prize – in the mind of statists – is a money-gobbling value-added tax.

I’ll close by sharing a chart from Brian Riedl of the Manhattan Institute, which estimates the per-capita burden of inflation-adjusted federal spending in the United States.

The red portion of the chart is coronavirus-related spending, plus future interest payments on the additional borrowing for all that spending, and the blue portion is spending in prior years plus estimates of future spending (already on an upward trajectory because of poorly designed entitlement programs).

That chart does not paint a pretty picture, but Brian’s numbers may be too optimistic. He assumes that the coronavirus-related emergency spending is just temporary and that additional interest on a bigger debt is the only long-run impact.

But if politicians make some of that spending permanent (which will be in their self-interest), then we’ll be traveling even faster in the wrong direction.

All the more reason to impose a spending cap, which is the only major fiscal reform with a track record of success.

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When I put forth the “The Case for Social Security Personal Accounts” in early 2011, I pointed out that the program’s long-run fiscal shortfall was more than $27 trillion.

We should be so lucky to have that problem today.

The Social Security Administration just released the annual report on the program’s finances, so I went to to Table VI.G9 of the “Supplemental Single-Year Tables” to peruse the yearly projections for future revenue and spending (which are adjusted for inflation so we have a more accurate method for comparisons).

The bad news is that an ever-increasing amount of our income is going to be grabbed by payroll taxes. The worse news is that Social Security’s spending burden will climb at an even-faster rate (historical data to the left of the red line, future projections to the right of the red line).

For those who focus on the less-important issue of red ink, the gap between revenue and spending over the next 75 years is projected to reach $44.7 trillion.

The gap in this year’s report is not directly comparable to the number I cited in 2011, but there’s no question the program’s finances are heading in the wrong direction.

This is partly because Social Security – as a “pay-as-you-go” program – is very vulnerable to demographic changes.

Like other types of Ponzi Schemes, it can work so long as there are always more and more new people entering the system.

But America’s demographic profile is changing. We’re living longer and having fewer kids.

In a column for the Foundation for Economic Education, Daniel Kowalski has a summary of how the program works and why it has a grim future.

Social Security recipients are not paid with the money that the government deducted directly from them and their past employers. Instead that money was used to pay the benefits for past retirees, while current retired recipients are getting their money through Americans who are currently working and contributing to the system. …the first recipients of the Social Security program took out far more than they put in with the difference being made up by the fact that active workers then greatly outnumbered beneficiaries. In 1940 this was not an issue as there were 159 workers supporting one beneficiary. …By 1960, 15 years after President Roosevelt’s death, that ratio was reduced to 5 workers for every beneficiary. In 1980, the ratio dropped to just above three and in 2010 it dropped below that. …there is one thing that Millennials and Generation Z can do to prepare themselves for that day. Start saving and planning for retirement now and make a plan that does not count on a government-issued Social Security check.

He’s right, and his column doesn’t even address the other problem for young people, which is the fact that they get a rotten deal from the program, paying in record amounts of money in exchange for hollow promises of a meager monthly benefit.

By the way, the numbers in the two charts above are based on the Social Security Administration’s “intermediate” assumptions.

I’ve never had any reason to question the reasonableness of those numbers. But in a world with coronavirus, which is causing crippling short-run economic damage and could cause significant long-run harm, it may be more prudent to look at SSA’s “high-cost” assumptions.

The bottom line is that the program’s long-run shortfall could be more than $20 trillion higher.

And remember, these numbers are in 2020 dollars. In other words, adjusted for inflation.

So how do we solve this mess? How do we avoid a grim fiscal future?

Shifting to a system of personal retirement accounts would be the most prudent approach. Yes, there would be an enormous transition cost since we would need to pay benefits to current retirees and many older workers, but that transition cost would be less than the $44.7 trillion unfunded liability (or even more!) of the current system.

I’ve written many times about the benefits of personal accounts for the United States, but I find most people are more interested in real-world evidence. Here are just a few of the several dozen nations that either fully or partially utilize private savings instead of political promises.

P.S. Some folks in Washington want to exacerbate Social Security’s fiscal burden by expanding the program.

P.P.S. I hate to add to the bad news, but the long-run finances for Medicare and Medicaid are an even-bigger problem.

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Back in 2012, when America had a budget deficit above $1 trillion, Investor’s Business Daily opined that America’s fiscal mess could have been avoided if politicians had simply adopted a TABOR-style spending cap starting in 1998.

As illustrated by the accompanying chart, IBD showed how a giant deficit would have become very manageable if politicians simply limited spending so it grew no faster than population plus inflation.

What makes this alternative history so bittersweet is that there are places – such as Switzerland and Hong Kong – that already have successful spending caps that deliver positive results.

Indeed, spending caps have such a good track record that even left-leaning international bureaucracies like the International Monetary Fund and the Organization for Economic Cooperation and Development have acknowledged that they are the most effective fiscal rule.

To understand the benefits of spending caps, especially since we’re now back in an environment of $1 trillion-plus deficits, let’s replicate the IBD exercise.

Here’s a chart showing actual spending (orange line) and revenue (blue line) over the past 20 years, along with what would have happened to spending with a 3-percent cap on annual spending increases (grey line).

The net result is that today’s $1 trillion surplus would be a budget surplus of nearly $500 billion.

More important, the burden of spending today would be much lower, which means more resources being allocated by the productive sector of the economy. And that would mean more jobs and more prosperity.

P.S. While a spending cap is simple and effective, that doesn’t mean it’s easy. Abiding by a cap would force politicians to set priorities, which is a constraint they don’t like. In the long run, complying with a cap also would require some much-need entitlement reform, which also won’t be popular with the interest groups that control Washington.

P.P.S. We would need a spending cap of 1.7 percent to balance the budget over the next 10 years.

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About 10 years ago, the Center for Freedom and Prosperity released this video to explain that America’s real fiscal problem is too much spending and that red ink is best viewed as a symptom of that problem.

I wrote a primer on this issue two years ago, but I want to revisit the topic because I’m increasingly irked when I see people – over and over again – mistakenly assume that “deficit neutrality” or “budget neutrality” is the same thing as good fiscal policy.

  • For instance, advocates of a carbon tax want to use the new revenues to finance bigger government. Their approach (at least in theory) would not increase the deficit. Regardless, that’s a plan to increase to overall burden of government, which is not sound fiscal policy.
  • Just two days ago, I noted that Mayor Buttigieg wants the federal government to spend more money on health programs and is proposing an even-greater amount of new taxes. That’s a plan to increase the overall burden of government, which is not sound fiscal policy.
  • Back in 2016, a columnist for the Washington Post argued Hillary Clinton was a fiscal conservative because her proposals for new taxes were larger than her proposals for new spending. That was a plan to increase the overall burden of government, which is not sound fiscal policy.
  • And in 2011, Bruce Bartlett argued that Obama was a “moderate conservative” because his didn’t raises taxes and spending as much as some on the left wanted him to. Regardless, he still increased the overall burden of government, which is not sound fiscal policy.

To help make this point clear, I’ve created a simple 2×2 matrix and inserted some examples for purposes of illustration.

At the risk of stating the obvious, good fiscal policy is in the top-left quadrant and bad fiscal policy is in the bottom-two quadrants.

Because of “public choice,” there are no real-world examples in the top-right quadrant. Why would politicians collect extra taxes, after all, if they weren’t planning to use the money to buy votes?

P.S. In 2012, I created a table showing the differences on fiscal policy between supply-siders, Keynesians, the IMF, and libertarians.

P.P.S. I also recommend Milton Friedman’s 2×2 matrix on spending and incentives.

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I gave a speech this past weekend about the economy and fiscal policy, and I made my usual points about government being too big and warned that the problem would get much worse in the future because of demographic change and poorly designed entitlement programs.

Which is probably what the audience expected me to say.

But then I told the crowd that a balanced budget requirement is neither necessary nor sufficient for good fiscal policy.

Which may have been a surprise.

To bolster my argument, I pointed to states such as IllinoisCalifornia, and New Jersey. They all have provisions to limit red ink, yet there is more spending (and more debt) every year. I also explained that there are also anti-deficit rules in nations such as GreeceFrance, and Italy, yet those countries are not exactly paragons of fiscal discipline.

To help explain why balanced budget requirements are not effective, I shared this chart showing annual changes in revenue over the past two decades for the federal government (Table 1.1 of OMB’s Historical Tables).

It shows that receipts are very volatile, primarily because they grow rapidly when the economy is expanding and they contract – sometimes sharply – when there’s an economic downturn.

I pointed out that volatile revenue flows make it very difficult to enforce a balanced budget requirement.

Most important, it’s extremely difficult to convince politicians to reduce spending during a recession since that’s when they feel extra pressure to spend more money (whether for Keynesian reasons of public-choice reasons).

Moreover, a balanced budget requirement doesn’t impose any discipline when the economy is growing. If revenues are growing by 8%, 10%, or 12% per year, politicians use that as an excuse for big increases in the spending burden.

Needless to say, those new spending commitments then create an even bigger fiscal problem when there’s a future downturn (as I’ve noted when writing about budgetary problems in jurisdictions such as Cyprus, Alaska, Ireland, Alberta, Greece, Puerto Rico, California, etc).

So what, then, is the right way of encouraging or enforcing prudent fiscal policy?

I told the audience we need a federal spending cap, akin to what exists in Switzerland, Hong Kong, and Colorado. Allow politicians to increase spending each year, preferably at a modest rate so that there’s a gradual reduction in the fiscal burden relative to economic output.

I’ve modified the above chart to show how a 2% spending cap would work. Politicians could increase spending when revenues are falling, but they wouldn’t be allowed to embark on a spending spree when revenues are rising.

Spending caps create a predictable fiscal environment. And limiting spending growth produces good outcomes.

If you’re still not convinced, this video hopefully will make a difference.

P.S. Spending caps work so well that even left-leaning international bureaucracies such as the OECD and IMF have acknowledged that they are the only effective fiscal rule.

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I want lower taxes. I want to reform taxes. And I want to abolish existing taxes and block new taxes.

But I also recognize that the biggest fiscal problem, both in America and elsewhere in the world, is that there’s too much government spending.

This creates a bit of a quandary. Given the various pressures and trade-offs in the world of fiscal policy, should supporters of limited government embrace additional tax relief?

Steve Moore opines in the Washington Times that it’s time for further tax cuts.

Every single plausible Democratic candidate for president has endorsed tax increases as centerpieces of their economic agenda. …Meanwhile, Mr. Trump and the Republicans in Congress have the 2017 tax cut to trumpet… Middle class incomes have hit an all-time high as has the stock market and employment. …Mr. Trump and the Republicans need a new tax cut plan… Mr. Trump has said he wants any new tax cut to be aimed at the middle class. …Let the liberals spend the next 11 months trying to explain why higher taxes and lower take home pay is better for families than lower taxes and MORE take home pay.  That should be fascinating to watch.

Steve specifically mentions some good ideas, such as lower marginal tax rates, a lower tax burden on capital gains, protecting more savings from double taxation, and allowing workers to shift some of their payroll taxes to personal retirement accounts.

But are these ideas smart policy?

Robert Verbruggen of National Review is very skeptical.

…it’s shocking that anyone is even thinking about tax cuts as a smart policy right now. …Our deficit has grown by a quarter since the 2018 fiscal year to hit nearly a trillion dollars in 2019, Baby Boomers are retiring, and the president has consistently said he has no intention of cutting the old-age entitlements that drive our spending. …tax cuts at this point would just add to the debt and hasten the day of our fiscal reckoning. We have a bunch of bills piling up. Let’s start paying them. …We need some mix of spending cuts and tax hikes to survive this. …Politicians almost certainly don’t have the guts to get serious about all this until a true crisis forces them to. But at very least, they should stop making matters worse.

So who is right?

The answer may depend on the goal.

If the objective is to simply get more votes in 2020, I’m not the right person to judge the effectiveness of that approach. After all, I’m a policy wonk, not a political strategist.

So let’s focus on the narrower issue of whether further tax relief would be good policy. Here are five things to consider, starting with two points about taxes and the economy.

1. Will tax cuts improve long-run economic performance? It’s impossible to answer this question without knowing what kind of tax cut. Increasing child credits may or may not be desirable, but that kind of tax relief doesn’t boost incentives for additional economic activity. Other types of tax reforms, by contrast, can have a very positive effect on incentives for work, saving, investment, and entrepreneurship.

2. Will tax cuts improve short-run economic performance? This is actually the wrong way to analyze fiscal policy. Advocates of Keynesian economics are fixated on trying to tinker with the economy’s short-run performance. That being said, some types of tax cuts – particularly reforms designed to attract global capital – may generate quicker positive effects.

Now let’s broaden our scope and consider tax cuts as part of overall fiscal policy.

3. Should policy makers focus on deficit reduction? Excessive government borrowing is undesirable, but it’s important to understand that red ink is the symptom and government spending is the underlying disease. Treat the disease and the symptoms automatically begin to go away.

4. Will tax cuts interfere with a bipartisan deal? Some people imagine that America’s fiscal problems can be addressed only if there’s a package deal of tax increases and spending cuts (dishonestly defined). Such an outcome is theoretically possible, but entirely unrealistic. Tax increases almost surely would be a recipe for additional spending.

5. Is there a starve-the-beast constraint on spending? There’s a theory, known as “starve the beast,” that suggests lower taxes can help constrain government spending. Given that Trump has simultaneously lowered the tax burden and increased the spending burden, that’s obviously not true in the short run. But the evidence suggests a firm commitment to lower taxes can inhibit long-run spending.

Based on these five points, I side with Steve Moore. It’s always a good idea to push for lower taxes.

And I definitely disagree with Robert Verbruggen’s willingness to put tax increases on the table. A huge mistake.

That being said, the Trump Administration’s reckless approach to discretionary spending and feckless approach to entitlement spending makes any discussion of further tax relief completely pointless.

So, at the risk of sounding like a politician, I also disagree with Steve. Instead of writing a column discussing additional tax cuts, he should have used the opportunity to condemn big-spending GOPers.

P.S. For what it’s worth, more than 100 percent (yes, that’s mathematically possible) of America’s long-run fiscal problem is excessive spending.

P.P.S. If you doubt my assertion that higher taxes will lead to more spending, I invite you to come up with another explanation for what’s happened in Europe.

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This week featured lots of angst-ridden headlines about the annual budget deficit for the 2019 fiscal year (which ended on September 30) jumping to $984 billion, an increase of more than $200 billion.

For reasons I’ve previously outlined, I don’t lose too much sleep about the level of government borrowing. What’s far more important is the burden of government spending.

Whether the budget is financed by taxes or borrowing, the level of spending is what really matters. Simply stated, that number measures the amount of money that politicians divert from the economy’s productive sector.

That being said, it’s sometimes very illuminating to look at why red ink goes up and down.

So I went to the Treasury Department’s most-recent Monthly Treasury Statement and looked at the raw numbers. What did I find?

Lo and behold, the deficit jumped to $984 billion because outlays are increasing twice as fast as revenue.

Perhaps even more discouraging, the burden of spending is rising more than four times faster than needed to keep pace with inflation.

These are very discouraging numbers, especially when you keep in mind that this is the calm before the storm. Because of poorly designed entitlement programs and an ageing population, our fiscal situation will deteriorate even faster in the future.

Unless there’s much-needed reform.

But I’m not holding out much hope. Trump is a big spender and Congress is filled with big spenders.

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The Congressional Budget Office (CBO) just released its new 10-year forecast. Unsurprisingly, it shows that Trump’s reckless spending policy is accelerating America’s descent to Greek-style fiscal profligacy.

Most people are focusing on the estimates of additional red ink, but I point out in this interview that the real problem is spending.

Some folks also are highlighting the fact that CBO isn’t projecting a recession, but I don’t think that’s important for the simple fact that all economists are bad at making short-run economic predictions.

That being said, I think CBO’s long-run fiscal forecasts are worthy of close attention (unfortunately, I didn’t state this very clearly in the interview).

And what worries me is that the numbers show that government spending will be consuming an ever-larger share of the nation’s economic output.

However, it’s not time to give up.

Modest spending restraint (i.e., obeying the Golden Rule of fiscal policy) generates very good results in a remarkably short period of time.

What matters most is reducing the burden of spending. But when you address the problem of government spending (as the chart shows), you also solve the symptom of red ink.

The challenge, of course, is convincing politicians that spending should be frozen. Or, at the very least, that it should only grow at a modest pace.

We have enjoyed periods of spending restraint, including a five-year spending freeze under Obama, as well as some fiscal discipline under both Reagan and Clinton.

But if we want long-run spending discipline, we need a comprehensive spending cap, sort of like the very successful systems in Hong Kong and Switzerland.

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The Congressional Budget Office just released its new long-run fiscal forecast.

Most observers immediately looked at the estimates for deficits and debt. Those numbers are important, especially since America has an aging population, but they should be viewed as secondary.

What really matters are the trends for both taxes and spending.

Here are the three things that you need to know.

First, America’s tax burden is increasing. Immediately below are two charts. The first one shows that revenues will consume an addition three percentage points of GDP over the next three decades. As I’ve repeatedly pointed out, our long-run problem is not caused by inadequate revenue.

The second of the two charts shows that most of the increase is due to “real bracket creep,” which is what happens when people earn more income and wind up having to pay higher tax rates.

So even if Congress extends the “Cadillac tax” on health premiums and extends all the temporary provisions of the 2017 Tax Act, the aggregate tax burden will increase.

Second, the spending burden is growing even faster than the tax burden.

And if you look closely at the top section of Figure 1-7, you’ll see that the big problems are the entitlements for health care (i.e., Medicare, Medicaid, and Obamacare).

By the way, the lower section of Figure 1-7 shows that corporate tax revenues are projected to average about 1.3 percent of GDP, which is not that much lower than what CBO projected (about 1.7 percent of GDP) before the rate was reduced by 40 percent.

Interesting.

Third, we have our most important chart.

It shows that the United States is on a very bad trajectory because the burden of government spending is growing faster than the private economy.

In other words, Washington is violating my Golden Rule.

And this leads to all sorts of negative consequences.

  • Government consumes a greater share of the economy over time.
  • Politicians will want to respond by raising taxes.
  • Politicians will allow red ink to increase.

The key thing to understand is that more taxes and more debt are the natural and inevitable symptoms of the underlying disease of too much spending.

We know the solution, and we have real world evidence that it works (especially when part of a nation’s constitution), but don’t hold your breath waiting for Washington to do the right thing.

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The folks at USA Today invited me to opine on fiscal policy, specifically whether the 2017 tax cut was a mistake because of rising levels of red ink.

Here’s some of what I wrote on the topic, including the all-important point that deficits and debt are best understood as symptoms of the real problem of too much spending.

Now that there’s some much needed tax reform to boost American competitiveness, we’re supposed to suddenly believe that red ink is a national crisis. What’s ironic about all this pearl clutching is that the 2017 tax bill actually increases revenue beginning in 2027, according to the Joint Committee on Taxation. …This isn’t to say that America’s fiscal house is in good shape, or that President Donald Trump should be immune from criticism. Indeed, the White House should be condemned for repeatedly busting the spending caps as part of bipartisan deals where Republicans get more defense spending, Democrats get more domestic spending and the American people get stuck with the bill. …The real lesson is that red ink is bad, but it’s only the symptom of the real problem of a federal budget that is too big and growing too fast.

I also pointed out that the only good solution for our fiscal problems is some sort of spending cap, similar to the successful systems in Hong Kong and Switzerland.

Heck, even left-leaning international bureaucracies such as the OECD and IMF have pointed out that spending caps are the only successful fiscal rule.

Now let’s look at a different perspective. USA Today also opined on the same topic (I was invited to provide a differing view). Here are excerpts from their editorial.

…more than anyone else, Laffer gave intellectual cover to the proposition that politicians can have their cake and eat it, too. …Laffer argued — on a cocktail napkin, according to economic lore, and elsewhere — that tax reductions would pay for themselves. These “supply side” cuts would stimulate growth so much, revenue would rise even as tax rates declined. This is, of course, rubbish. In the wake of the massive 2017 tax cuts, …the budget deficit is projected to run a little shy of $1 trillion… To run such large deficits a decade into a record economy recovery, is a massive problem because they will soar to dangerous heights the next time a recession strikes.

I think the column misrepresents the Laffer Curve, but let’s set that issue aside for another day.

The editorial also goes overboard in describing the 2017 tax cut as “massive.” As I noted in my column, that legislation actually raises revenue starting in 2027.

That being said, the main shortcoming of the USA Today editorial is that it doesn’t acknowledge that America’s long-run fiscal challenge (even for those who fixate on deficits and debt) is entirely driven by excessive spending growth.

Indeed, all you need to know is that nominal GDP is projected to grow by an average of about 4.0 percent annually over the next 30 years while the federal budget is projected to grow 5.2 percent per year.

This violates the Golden Rule of sensible fiscal policy.

And raising taxes almost certainly would make this bad outlook even worse since the economy would be weaker and politicians would jack up spending even further.

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Earlier this year, I reviewed new fiscal projections from the Congressional Budget Office (CBO) and showed that balancing the budget would be relatively easy if politicians simply limited spending so that it didn’t grow faster than inflation.

Though I made sure to point out that the primary goal should be to limit the burden of spending. That’s because government spending, regardless of whether it’s financed by taxes or financed by borrowing, undermines prosperity by diverting resources from the productive sector of the economy.

We now have some new numbers from CBO. The number-crunching bureaucrats have put together their estimates of the latest Trump budget and that’s generated some predictable squabbling between Republicans and Democrats.

Most of the finger-pointing has focused on the (relatively trivial) fiscal impact of the Trump tax cuts.

The Wall Street Journal wisely put the focus instead on the growth of government.

You wouldn’t know it from the press coverage, but there’s some modest good news about the federal budget. The deficit is rising, but not as much as feared because tax revenues are increasing due to faster economic growth. …So why has the federal deficit increased by $145 billion this fiscal year to $531 billion? Because federal spending continued to rise rapidly—7% in the first seven months to $2.571 trillion. That’s $178 billion more than in the same period a year ago. …The media blame deficits on tax reform, but the facts show the main culprit is spending. No one in the political class wants to talk about entitlements but that’s where the money is.

The WSJ’s editorial focused on short-run data.

I want to augment that analysis by looking at medium-run and long-run numbers.

We’ll start with this chart looking at what will happen over the next 10 years. As you can see, Washington is violating my Golden Rule by allowing spending to grow faster than the private economy.

As a result, the burden of federal spending, measured as a share of gross domestic product, is projected to climb over the next decade.

That’s not good news.

(For what it’s worth, since tax revenues will be growing at the same pace as spending, there won’t be any meaningful change in the deficit as a share of GDP.)

Now let’s look at the most-recent long-run data from CBO. These numbers are even more depressing because the spending burden continues to grow faster than the private sector. A lot faster.

Which is why the burden of federal spending is projected to increase from less than 21 percent of GDP today to nearly 29 percent of GDP by 2049.

That’s terrible news.

And if you include spending by state and local governments (which currently consumes more than 11 percent of economic output and also is projected to increase), the terrible news gets even worse.

Moreover, the tax burden is projected to climb as well, and that doesn’t even include any estimate of what will happen if politicians manage to impose a value-added tax, an energy tax, a wealth tax, a financial transactions tax, or any of the other revenue-raising schemes under consideration in Washington.

In other words, the U.S. is on track to become just like GreeceFrance, and Italy.

P.S. There is an alternative to this dismal future. But can we convince politicians to adopt a spending cap and then make it work with genuine entitlement reform? I’m not holding my breath for any of that to happen.

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Every year, the Social Security Administration issues a “Trustees Report” that summarizes the program’s financing. So every year (see 2018, 2017, 2016, 2015, etc) I cut through all the verbiage and focus the numbers that really matter.

First, here’s the data from Table VI.G9 showing annual spending and annual revenue, and the numbers are adjusted for inflation. Everything to the left of the vertical red line is historical data. Everything to the right is an estimate based on “intermediate” economic and demographic projections.

The bad news is that there’s a never-ending increase in the program’s fiscal burden.

The only good news is that country presumably will be much richer in the future, so we’ll have more income to pay all those taxes and finance all that spending.

That being said, the fiscal burden is projected to increase faster than our income, so the economic burden of Social Security will increase over time.

But there’s also a wild card to consider. Simply stated, we have more data from Table VI.G9 that shows the program has a giant, ever-expanding deficit.

Here are the grim numbers (though not quite as grim as last year when the cumulative shortfall was $43.7 trillion). Once again, everything to the left of the line is historical data and everything to the right is a projection.

The obvious takeaway is that the program is bankrupt.

Indeed, a private pension fund with these numbers would have been shut down a long time ago. And its executives would be in prison for running a Ponzi Scheme.

Politicians won’t put themselves in prison, of course, but they eventually will be forced to address Social Security’s huge shortfall. If nothing else, the so-called Trust Fund (which isn’t a real Trust Fund since it is filled with IOUs) runs out of money in 2035.

The interesting question is what sort of “solution” they choose when the crisis occurs.

Sadly, many politicians are gravitating to a plan to impose ever-higher taxes to prop up the system.

A far better approach is personal retirement accounts. I’ve written favorably about the Australian system, the Chilean system, the Hong Kong system, the Swiss system, the Dutch system, the Swedish system. Heck, I even like the system in the Faroe Islands.

The bottom line is that there’s been a worldwide revolution in favor of private savings and the United States is falling behind.

P.S. If you have some statist friends and family who get confused by numbers, here’s a set of cartoons that shows the need for Social Security reform.

P.P.S. As I explain in this video, reform does not mean reducing benefits for current retirees, or even older workers.

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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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Way back in early 2011, I wrote about the likelihood of various nations suffering a Greek-style meltdown. After speculating on the importance of debt burdens and interest payments, I concluded that

…which nation will be the next domino to fall? …Some people think total government debt is the key variable…that’s not necessarily a good rule of thumb. …Japan’s debt is nearly 200 percent of GDP, yet Japanese debt is considered very safe… The moral of the story is that there is no magic point where deficit spending leads to a fiscal crisis, but we do know that it is a bad idea for governments to engage in reckless spending over a long period of time. That’s a recipe for stifling taxes and large deficits. And when investors see the resulting combination of sluggish growth and rising debt, eventually they will run out of patience.

As I noted earlier this year, it’s not easy to predict the point at which “investors no longer trust that they will receive payments on government bonds.”

Though that would be useful information, which is why a new study from the International Monetary Fund could be very helpful. The researchers look at how to measure fiscal crisis.

The literature on fiscal crises and on early warning indicators is limited, although it has expanded in recent years. Most of the past literature focused on sovereign external debt defaults alone …the canonical fiscal crisis is a debt crisis, when the government is unable to service the interest and or principle as scheduled. … It is important to note, however, that fiscal crises may not necessarily be associated with external debt defaults. They can be associated with other forms of expropriation, including domestic arrears and high inflation that erodes the value of some types of debt. …a fiscal crisis is identified when one or more of the following distinct criteria are satisfied: …Credit events associated with sovereign debt (e.g., outright defaults and restructuring). …Recourse to large-scale IMF financial support. …Implicit domestic public default (e.g., via high inflation rates). …Loss of market confidence in the sovereign.

The goal is to figure out the conditions that precipitate problems.

…The objective of this paper is to better understand the structural weaknesses that make countries prone to entering a fiscal crisis. …We use two of the more common approaches to build early warning systems (EWS) for fiscal crises: the signal approach and logit model. …event studies indicate that a fiscal crisis tends to be preceded by loose fiscal policy (Figure 3.1). In the run-up to a crisis, there is robust real expenditure growth.

Some of the obvious variables, as noted above and also in Figure 3.1 (the dashed vertical line is the year a crisis occurs), are whether there’s a rising burden of government spending and whether the economy is growing.

For readers who like wonky material, the authors explain the two approaches they use.

In order to construct early warning systems for fiscal crises, we adopt two alternative approaches that have been used in the literature. We first use the signal approach, followed by multivariate logit models. …The signals approach involves monitoring the developments of economic variables that tend to behave differently prior to a crisis. Once they cross a specific threshold this gives a warning signal for a possible fiscal crisis in the next 1-2 years. …Logit model…early warning systems…draw on standard panel regression…with a binary dependent variable equal to one when a crisis begins (or when there is a crisis). …The main advantage of this approach is that it allows testing for the statistical significance of the different leading indicators and takes into account their correlation.

Then they crunch a bunch of numbers.

Here’s what they find using the signal approach.

…current account deficit, degree of openness, use of central bank credit to finance the deficit, size of the fiscal (overall or primary) deficit and pace of expansion in public expenditures—all these increase the probability of a future crisis.

And here’s what they conclude using the logit approach.

The results, by and large, highlight similar leading indicators as the signals approach… The probability of entering a crisis increases with growing macroeconomic imbalances due to large output gaps and deteriorating external imbalances. The results also indicate a role for fiscal policy, via public expenditures growth. … high expenditure growth could contribute to a deterioration in the current account and a large output gap, making the fiscal position vulnerable to changes in the economic cycle.

The bottom line is that both approaches yield very similar conclusions.

Our results show that there is a small set of robust leading indicators (both fiscal and non-fiscal) that help assess the probability of a fiscal crisis. This is especially the case for advanced and emerging markets. For these countries, we find that domestic imbalances (large output or credit gaps), external imbalances (current account deficit), and rising public expenditures increase the probability of a crisis. …Our results suggest that indeed fiscal variables matter. Strong expenditure growth and financing pressures (e.g., need for central bank financing) can help predict crises.

Some of this data is reflected in Figure 5.2.

And here’s the bottom line, starting with the claim that governments are being semi-responsible because we don’t actually see many fiscal crises.

…we find that some types of vulnerabilities are consistently relevant to explain fiscal crises. This raises the question why governments do not act as they see signals. In large measure they do, as crises among advanced economies are rare. Still, the occurrence of crises may reflect overly optimistic projections about the future… Our results show that a relatively small set of robust leading indicators can help assess the probability of a fiscal crisis in advanced and emerging markets with high accuracy. …countries can reduce the frequency of fiscal crises by adopting prudent policies and strengthening risk management. Fiscal crises are more likely when economies build domestic and external imbalances. This calls for avoiding excessively loose polices when domestic growth is above average. For fiscal policy, this means avoiding procyclical increases in expenditures.

The key takeaway is that spending restraint is a very important tool for avoiding a fiscal crisis.

Yes, a few other factors also are important (central bankers should avoid irresponsible monetary policy, for instance), but some of these are outside the direct control of politicians.

Which is why this new research underscores the importance of some sort of spending cap, preferably enshrined in a jurisdiction’s constitution like in Hong Kong and Switzerland.

P.S. While there haven’t been many fiscal crises in developed nations, that may change thanks to very unfavorable demographics and poorly designed entitlement programs.

P.P.S. I hope the political decision makers at the IMF read this study (as well as prior IMF studies on the efficacy of spending caps) and no longer will agitate for tax increases on nations that get into fiscal trouble.

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Writing a column every day can sometimes be a challenge, in part because of logistics (I have to travel a lot, which can make things complicated), but also because I want to make sure I’m sharing interesting and relevant information.

My task, however, is very easy on certain days. When Economic Freedom of the World is published in the autumn, I know that will be my topic (as it was in 2017, 2016, 2015, etc). My only challenge is to figure out how to keep the column to a manageable size since there’s always so much fascinating data.

Likewise, I know that I have a very easy column about this time of year (2017, 2016, 2015, etc) since that’s when the Social Security Administration releases the annual Trustees Report.

It’s an easy column to write, but it’s also depressing since my main goal is to explain that the program already consumes an enormous pile of money and that it will become an every bigger burden in the future.

Here are the 1970-2095 budgetary outlays from the latest report, adjusted for inflation. As you can see, the forecast shows a huge increase in spending.

The good news, as least relatively speaking, is that we’ll also have inflation-adjusted growth between now and 2095, so the numbers aren’t quite as horrifying as they appear. That being said, Social Security inexorably will consume a larger share of the private economy over time.

Now let’s examine a second issue. Most news reports incorrectly focus on the year the Social Security Trust Fund runs out of money.

But since that “Trust Fund” is filled with nothing but IOUs, I think that’s an utterly pointless piece of data. So every year I show the cumulative $43.7 trillion cash-flow deficit in the system. Using inflation-adjusted dollars, of course.

Assuming we don’t reform the program, think of these numbers as a reflection of a built-in future tax hike.

You won’t be surprised to learn, by the way, that politicians such as Barack Obama and Hillary Clinton already have identified their preferred tax hikes to fill this gap.

Let’s wrap up.

Veronique de Rugy of Mercatus accurately summarizes both the problem and the solution.

The single largest government program in the United States will soon have an annual budget of $1 trillion a year. …The program is Social Security, and our national pastime seems to be turning a blind eye to its dysfunctions. …Since 2010, it has been running a cash-flow deficit—meaning that the Social Security payroll taxes the government collects aren’t enough to cover the benefits it’s obliged to pay out. …

Veronique punctures the myth that there’s a “Trust Fund” that can be used to magically pay benefits.

Prior to 2010, the program collected more in payroll taxes than was needed to pay the benefits due at the time. The leftovers were “invested” into Treasury bonds through the so-called Old Age Trust Fund, which is now being drawn down. …In fact, the Treasury bonds are nothing but IOUs. …Treasury…doesn’t have the money: It has already spent it on wars, roads, education, domestic spying, and much more. So when Social Security shows up with its IOUs, Treasury has to borrow to pay the bonds back. …Did you catch that? Past generations of workers paid extra payroll taxes to bulk up the Social Security system. But the government spent that additional revenue on non-retirement activities, so now your children and grandchildren will also have to pay more in taxes to reimburse the program.

So what’s the solution?

Veronique explains we need to reform the system by allowing personal retirement accounts. She was even kind enough to quote me cheerleading for the Australian system.

Congress should shift away from Social Security into a “funded” system based on real savings, much as Australia and others have done. The libertarian economist Daniel J. Mitchell notes that, starting in the ’80s and ’90s, that country has required workers to put 9.5 percent of their income into a personal retirement account. As a safety net—but not as a default—Australians with limited savings are guaranteed a basic pension. That program has generated big increases in wealth. Meanwhile, Social Security has generated big deficits and discouraged private saving. Who would you have emulate the other?

Though I’m ecumenical. I also have written favorably about the Chilean system, the Hong Kong system, the Swiss system, the Dutch system, the Swedish system. Heck, I even like the system in the Faroe Islands.

The bottom line is that there’s been a worldwide revolution in favor of private savings and the United States is falling behind.

P.S. If you have some statist friends and family who get confused by numbers, here’s a set of cartoons that shows the need for Social Security reform.

P.P.S. As I explain in this video, reform does not mean reducing benefits for current retirees, or even older workers.

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As a general rule, we worry too much about deficits and debt. Yes, red ink matters, but we should pay more attention to variables such as the overall burden of government spending and the structure of the tax system.

That being said, Greece shows that a nation can experience a crisis if investors no longer trust that a government is capable of “servicing” its debt (i.e., paying interest and principal to people and institutions that hold government bonds).

This doesn’t change the fact that Greece’s main fiscal problem is too much spending. It simply shows that it’s also important to recognize the side-effects of too much spending (if you have a brain tumor, that’s your main problem, even if crippling headaches are a side-effect of the tumor).

Anyhow, it’s quite likely that Italy will be the next nation to travel down this path.

This in in part because the Italian economy is moribund, as noted by the Wall Street Journal.

Italy’s national elections…featured populist promises of largess but neglected what economists have long said is the real Italian disease: The country has forgotten how to grow. …The Italian economy contracted deeply in Europe’s debt crisis earlier this decade. A belated recovery now under way yielded 1.5% growth in 2017—a full percentage point less than the eurozone as a whole and not enough to dispel Italians’ pervasive sense of national decline. Many European policy makers view Italy’s stasis as the likeliest cause of a future eurozone crisis.

Why would Italy be the cause of a future crisis?

For the simple reason that it is only the 4th-largest economy in Europe, but this chart from the Financial Times shows it has the most nominal debt.

So what’s the solution?

The obvious answer is to dramatically reduce the burden of government.

Interestingly, even the International Monetary Fund put forth a half-decent proposal based on revenue-neutral tax reform and modest spending restraint.

The scenario modeled assumes a permanent fiscal consolidation of about 2 percent of GDP (in the structural primary balance) over four years…, supported by a pro-growth mix of revenue and expenditure reforms… Two types of growth-friendly revenue and spending measures are considered along the envisaged fiscal consolidation path: shifting taxation from direct to indirect taxes, and lowering expenditure and shifting its composition from transfers to investment. On the revenue side, a lower labor tax wedge (1.5 percent of GDP) is offset by higher VAT collections (1 percent of GDP) and introducing a modern property tax (0.5 percent of GDP). On the expenditure side, spending on public consumption is lowered by 1.25 percent of GDP, while productive public investment spending is increased by 0.5 percent of GDP. The remaining portion of the fiscal consolidation, 1.25 percent of GDP, is implemented via reduced social transfers.

Not overly bold, to be sure, but I suppose I should be delighted that the IMF didn’t follow its usual approach and recommend big tax increases.

So are Italians ready to take my good advice, or even the so-so advice of the IMF?

Nope. They just had an election and the result is a government that wants more red ink.

The Wall Street Journal‘s editorial page is not impressed by the economic agenda of Italy’s putative new government.

Five-Star wants expansive welfare payments for poor Italians, revenues to pay for it not included. Italy’s public debt to GDP, at 132%, is already second-highest in the eurozone behind Greece. Poor Italians need more economic growth to generate job opportunities, not public handouts that discourage work. The League’s promise of a pro-growth 15% flat tax is a far better idea, especially in a country where tax avoidance is rife. The two parties would also reverse the 2011 Monti government pension reforms, which raised the retirement age and moved Italy toward a contribution-based benefit system. …Recent labor-market reforms may also be on the block.

Simply stated, Italy elected free-lunch politicians who promised big tax cuts and big spending increases. I like the first part of that lunch, but the overall meal doesn’t add up in a nation that has a very high debt level.

And I don’t think the government has a very sensible plan to make the numbers work.

…problematic for the rest of Europe are the two parties’ demand for an exemption from the European Union’s 3% GDP cap on annual budget deficits. …the two parties want the European Central Bank to cancel some €250 billion in Italian debt.

Demond Lachman of the American Enterprise Institute suggests this will lead to a fiscal crisis because of two factors. First, the economy is weak.

Anyone who thought that the Eurozone debt crisis was resolved has not been paying attention to economic and political developments in Italy…the recent Italian parliamentary election…saw a surge in support for populist political parties not known for their commitment to economic orthodoxy or to real economic reform. …To say that the Italian economy is in a very poor state would be a gross understatement. Over the past decade, Italy has managed to experience a triple-dip economic recession that has left the level of its economy today 5 percent below its pre-2008 peak. Meanwhile, Italy’s current unemployment level is around double that of its northern neighbors, while its youth unemployment continues to exceed 25 percent. …the country’s public debt to GDP ratio continued to rise to 133 percent, making the country the most indebted country in the Eurozone after Greece. …its banking system remains clogged with non-performing loans that still amount to 15 percent of its balance sheet…

Second, existing debt is high.

…having the world’s third-largest government bond market after Japan and the United States, with $2.5 trillion in bonds outstanding, Italy is simply too large a country for even Germany to save. …global policymakers…, it would seem not too early for them to start making contingency plans for a full blown Italian economic crisis.

Since he writes on issues I care about, I always enjoy reading Lachman’s work. Though I don’t always agree with his analysis.

Why, for instance, does he think an Italian fiscal crisis threatens the European currency?

…the Italian economy is far too large an economy to fail if the Euro is to survive in anything like its present form.

Would the dollar be threatened if (when?) Illinois goes bankrupt?

But let’s not get sidetracked.3

To give you an idea of the fairy-tale thinking of Italian politicians, I’ll close with this chart from L’Osservatorio on the fiscal impact of the government’s agenda. It’s in Italian, but all you need to know is that the promised tax cuts and spending increases are on the left side and the compensating savings (what we would call “pay-fors”) are on the right side.

Wow, makes me wonder if Italy has passed the point of no return.

By the way, Italy may be the next domino, but it’s not the only European nation with fiscal problems.

P.S. No wonder some people want Sardinia to secede from Italy and become part of “sensible” Switzerland.

P.P.S. Some leftists genuinely think the United States should emulate Italy.

P.P.P.S. As a fan of spending caps, I can’t resist pointing out that anti-deficit rules in Europe have not stopped politicians from expanding government.

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The Congressional Budget Office just released its annual Economic and Budget Outlook, and almost everyone in Washington is agitated (or pretending to be agitated) about annual deficits exceeding $1 trillion starting in the 2020 fiscal year.

All that red ink isn’t good news, but I’m much more concerned (and genuinely so) about this line from CBO’s forecast. In just 10 years, the burden of federal spending is going to jump from 20.6 percent of GDP to 23.6 percent!

Simply stated, we’ve entered the era of baby boomer retirement. And because we have some very poorly designed entitlement programs, that means the federal budget – assuming we leave it on autopilot – is going to consume an ever-growing share of our national economic output.

The bottom line is that Washington is violating my Golden Rule.

Let’s look at the underlying numbers. Federal spending is projected by CBO to grow by an average of about 5.5 percent per year over the next decade while nominal GDP is estimated to grow by just 4.0  percent annually.

And that unfortunate trend isn’t limited to the nest 10 years. CBO’s latest long-run forecast, which I discussed last year, shows a never-ending deterioration of America’s fiscal position.

Hello Greece.

Fortunately, there is a solution to this mess.

A modest amount of spending restraint can quickly reverse our fiscal troubles and put us on a path to a balanced budget. More importantly, limits on the growth of spending can slowly reduce the size of the federal government relative to the private sector.

Here’s a chart, based on CBO’s numbers, that shows how much Uncle Sam is spending this year (a bit over $4.1 trillion), along with a blue line showing projected tax revenues over the next 10 years (blue line). And I’ve shown what happens if spending is “only” allowed to increase by either 2 percent annually (orange line) or 3 percent annually (grey line) over the next decade.

This chart is basically everything you need to know. It shows that our fiscal situation is not hopeless. All we have to do is make sure government is growing slower than the productive sector of the economy.

A good rule of thumb, as suggested in the chart title, is that government shouldn’t grow faster than the rate of inflation.

And we’ve done it before.

  • During the Clinton years, the United States enjoyed a multi-year period of spending restraint. We got a balanced budget because of that frugality. More important, spending fell as a share of GDP.
  • During the Obama years, we benefited from a five-year de facto spending freeze. Deficits dropped dramatically and the nation experienced the biggest drop in the relative burden of spending since the end of World War II.

And many other nations also have also managed multi-year periods of spending restraint.

Let’s close with a video I narrated which illustrates how modest spending discipline generates good outcomes.

It’s from 2010, so the numbers are no longer relevant, but otherwise the analysis applies just as strongly today.

P.S. I’m not overly optimistic that President Trump is serious about solving this problem. His proposed a semi-decent amount of spending restraint in last year’s budget, but then he signed into law a grotesque budget-busting appropriations bill.

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Five former Democratic appointees to the Council of Economic Advisers have a column in today’s Washington Post asserting that we should not blame entitlements for America’s future fiscal problems.

The good news is that they at least recognize that there’s a future problem.

The bad news is that their analysis is sloppy, inaccurate, and deceptive.

They start with an observation about red ink that is generally true, though I think the link between government borrowing and interest rates is rather weak (at least until a government – like Greece – gets to the point where investors no longer trust its ability to repay).

The federal budget deficit is on track to exceed $1 trillion next year and get worse over time. Eventually, ever-rising debt and deficits will cause interest rates to rise. …the growing debt will take an increasing toll.

But the authors don’t want us to blame entitlements for ever-rising levels of red ink.

It is dishonest to single out entitlements for blame.

That’s a remarkable claim since the Congressional Budget Office (which is not a small government-oriented bureaucracy, to put it mildly) unambiguously shows that rising levels of so-called mandatory spending are driving our long-run fiscal problems.

CBO’s own charts make this abundantly clear (click on the image to see the original column with the full-size chart).

So how do the authors get around this problem?

First, they try to confuse the issue by myopically focusing on the short run.

The primary reason the deficit in coming years will now be higher than had been expected is the reduction in tax revenue from last year’s tax cuts, not an increase in spending.

Okay, fair enough. There will be a short-run tax cut because of the recent tax legislation. But the column is supposed to be about the future debt crisis. And that’s a medium-term and long-term issue.

Well, it turns out that they have to focus on the short run because their arguments become very weak – or completely false – when we look at the overall fiscal situation.

For instance, they make an inaccurate observation about the recent tax reform legislation.

…the tax cuts passed last year actually added an amount to America’s long-run fiscal challenge that is roughly the same size as the preexisting shortfalls in Social Security and Medicare.

That’s wrong. The legislation actually increases the long-run tax burden.

And that’s in addition to the long-understood reality that the tax burden already is scheduled to gradually increase, even measured as a share of economic output.

Once again, the CBO has a chart with the relevant data. Note especially the steady rise in the burden of the income tax (once again, feel free to click on the image to see the original column with the full-size chart).

The authors do pay lip service to the notion that there should be some spending restraint.

There is some room for…spending reductions in these programs, but not to an extent large enough to solve the long-run debt problem.

But even that admission is deceptive.

We don’t actually need spending reductions. We simply need to slow down the growth of government. Indeed, our long-run debt problem would be solved if imposed some sort of Swiss-style or Hong Kong-style spending cap so that the budget couldn’t grow faster than 3 percent yearly.

In any event, they wrap up their column by unveiling their main agenda. They want higher taxes.

Additional revenue is critical…responding to the looming fiscal challenge required a balanced approach that combined increased revenue with reduced spending. Two bipartisan commissions, Simpson-Bowles and Domenici-Rivlin, proposed such approaches that called for tax reform to raise revenue as a percent of GDP…set tax policy to realize adequate revenue.

As I already noted, the tax burden already is going to climb as a share of GDP. But the authors want an increase on top of the built-in increase.

And it’s very revealing that they cite Simpson-Bowles, which is basically a left-wing proposal of higher taxes combined with the wrong type of entitlement reform. To be fair, the Domenici-Rivlin plan  has the right kind of entitlement reform, but that proposal is nonetheless bad news since it contains a value-added tax.

The bottom line if that the five Democratic CEA appointees who put together the column (I’m wondering why Austan Goolsbee didn’t add his name) do not make a compelling case for higher taxes.

Unless, of course, the goal is to enable a bigger burden of government.

Which is the message of this very appropriate cartoon.

Needless to say, this belongs in my “Government in Cartoons” collection.

P.S. Entitlement spending is not only to blame for our future spending problems. It’s also the cause of our current spending problems.

P.P.S. In a perverse way, I actually like the column we discussed today. Five top economists on the left put their heads together and tried to figure out the most compelling argument for higher taxes. Yet what they produced is shoddy and deceptive. In other words, they didn’t make a strong argument because they don’t have a strong argument. Reminds me of Robert Rubin’s anemic argument last year against the GOP tax plan.

P.P.P.S. Four former presidents offer good advice on the topic of taxation.

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When I give speeches on Keynesian economics, I usually begin with a theoretical discussion on why consumer spending is a consequence of growth rather than the cause of growth.

I then focus on two reasons to be skeptical about borrow-and-spend schemes to artificially boost growth.

  • In the short run, it makes no sense to “stimulate” an economy by borrowing from one group of people and giving the money to another group of people. It’s like trying to become richer by taking money out of your left pocket and putting it in your right pocket.
  • In the long run, so-called stimulus creates a ratchet effect for larger government since politicians rarely obey Keynes’ admonition to cut back on government spending and run surpluses when the economy is in an expansion phase.

But I oftentimes include a caveat when discussing the first point.

It is possible, I hypothesize, to increase your short-run consumption if you take money out of a foreigner’s left pocket and put it in your right pocket.

I hasten to add that this is probably not be a wise course of action since the money may be squandered and you simply wind up further in debt, but I admit that the short-run consumption data will be better.

Well, there’s a new academic study on exactly this issue from the European Stability Mechanism (sort of an IMF for eurozone countries).

Here’s what the authors decided to investigate.

In this paper, we argue that there is a natural and largely unexplored connection between fiscal multipliers and the foreign holdings of public debt. The intuition is simple….fiscal expansions can…have crowding-out effects on the domestic private sector. Probably the most important among the latter is that the resources used by the domestic private sector to acquire public debt can detract from consumption and investment. This implies that the crowding-out effect of fiscal expansions is likely to be stronger when they are financed by selling public debt to domestic (as opposed to foreign) residents.

Here’s some of the data on foreign holdings of national debt.

Our data on foreign holdings of public debt reveals interesting patterns. First of all, there is significant variation across countries: in some countries, such as Canada and Japan, the share of public debt held by foreigners is consistently low, whereas in others, such as Finland and Austria, foreigners hold more than 75% of public debt towards the end of the sample. Over time, in line with the rise of financial globalization, the general pattern is one of increasing public debt in the hands of foreigners. In the United States, for instance, the share of public debt held by foreigners has increased from less than 5% in the 1950s to close to 50% today.

And here’s a chart from the study showing how foreign holdings of U.S. government debt have increased over time.

And their conclusions, after crunching all the numbers, is that nations can boost short-run consumption if a significant share of new debt is financed by foreigners.

Our main result is that, consistent with the previous argument, the estimated size of fiscal multipliers is increasing in the share of public debt that is in the hands of foreigners. This result holds both for the United States during the postwar period, and for a panel of advanced (OECD) economies over the last few decades. …We find that the average foreign share, i.e., the share of public debt held by foreigners before a fiscal shock, …reflect capital inflows, which help finance fiscal expansions thereby minimizing their crowding-out effects on domestic investment.

Incidentally, the authors acknowledge that this creates a beggar-thy-neighbor effect.

Our findings…point to a potentially negative spillover: to the extent that fiscal expansions are financed via foreign borrowing, their crowding-out effects are exported and consumption and investment are reduced elsewhere.

In other words, any transitory benefit one country experiences will be offset by losses elsewhere.

But politicians barely care about their own voters, much less those who live in other countries, so that certainly would not be an effective argument against Keynesian spending binges.

For what it’s worth, I still think the most persuasive argument is that Keynesian economics has an awful track record, even if there’s some ability to shift part of the short-run cost onto foreigners. After all, ask Keynesians to identify an example of successful government stimulus.

And let’s not forget that the long-run costs are always negative because larger government sectors necessarily lead to smaller productive sectors.

P.S. I feel somewhat guilty for writing a column that acknowledges a potential benefit (albeit transitory and unneighborly) of Keynesian economics, so allow me to expiate my sins by sharing this comparison of Keynesian economics and Austrian economics.

For what it’s worth, I think the Austrians over-emphasize the importance of interest rates. But there’s no question they are much closer to the truth than the Keynesians.

P.P.S. If you want to enjoy some cartoons about Keynesian economics, click here, here, here, and here. Here’s some clever mockery of Keynesianism. And here’s the famous video showing the Keynes v. Hayek rap contest, followed by the equally enjoyable sequel, which features a boxing match between Keynes and Hayek. And even though it’s not the right time of year, here’s the satirical commercial for Keynesian Christmas carols.

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Way back in 2009, I narrated a video explaining that people worry too much about deficits and debt. Red ink isn’t desirable, to be sure, but I pointed out that the real problem is government spending.

And the bottom line is that most types of government spending are bad for an economy, regardless of whether they are financed by taxes or borrowing.

It is possible, of course, for a nation to have a debt crisis. But keep in mind that this simply means a government has accumulated so much debt that investors no longer trust that they will receive payments on government bonds.

That’s not a good outcome, but replacing debt-financed spending with tax-financed spending is like jumping out of the frying pan and into the fire. Or the fire into the frying pan, if you prefer. In either case, politicians are ignoring the real problem.

Greece is a cautionary example. Thanks to a period of overspending, Greek politicians drove the country into a debt crisis. But this dark cloud had a silver lining. The good news (at least relatively speaking) is that the government no longer could borrow from the private sector to finance more spending.

But the bad news is that Greek politicians subsequently hammered the economy with huge tax increases in hopes of propping up the country’s bloated welfare state. And the “troika” made a bad situation worse with bailout funds (mostly to protect big banks that unwisely lent money to Greek politicians, but that’s a separate story).

In other words, Greece got in trouble because of too much government spending and it remains in trouble because of too much government spending. As is the case for many other European nations.

And I fear the United States is slowly but surely heading in that direction. I elaborate about the problem of government spending – and the concomitant symptom of red ink – in this interview with the Mises Institute.

For all intents and purposes, I’m trying to convince people that deficits and debt are bad, but they’re bad mostly because they are a sign that government is too big. Sort of like a brain tumor being the real problem and headaches being a warning sign.

I feel like Goldilocks on this issue. Except instead of porridge that is too hot or too cold, I deal with people on both sides who think red ink is either wonderful or terrible.

For an example of the former group, here’s some of what Stephanie Kelton wrote for the New York Times last October.

…bigger deficits wouldn’t wreck the nation’s finances. …Lawmakers are obsessed with avoiding an increase in the deficit. …It’s also holding us back. Politicians of both parties should stop using the deficit as a guide to public policy. Instead, they should be advancing legislation aimed at raising living standards and delivering…long-term prosperity.

Hard to disagree with the above excerpt.

But here’s the part I don’t like. She’s a believer in the perpetual motion machine of Keynesian economics. She thinks deficits are actually good for the economy and she wants to use debt to finance an ever-larger burden of government spending.

Government spending adds new money to the economy, and taxes take some of that money out again. …we should think of the government’s spending as self-financing since it pays its bills by sending new money into the economy. …the deficit itself could be deployed as a potent weapon in the fights against inequality, poverty and economic stagnation.

Ugh.

Now let’s check out the view of the so-called deficit hawks who think red ink is an abomination.

Here are some passages from a Hill report on the battle over last year’s tax plan.

A handful of GOP deficit hawks are worried that their party’s tax plan could add trillions to the deficit, deepening a debt crisis for future generations. …The tax plan could cost the government $1.5 trillion in revenue over the next decade… Sen. Bob Corker (R-Tenn.), who recently announced his retirement at the end of this Congress, has warned he’ll oppose the tax plan if it adds to the deficit. …In a separate interview, he told The New York Times that the debt is “the greatest threat to our nation,” more dangerous than the Islamic State in Iraq and Syria, or North Korea.

Ugh, again.

The threat isn’t the red ink. The real danger is an ever-increasing burden of government spending, driven by entitlements.

Besides, the GOP tax bill actually is a long-run tax increase!

Let’s close with a video on the topic from Marginal Revolution. It has too much Keynesianism in it for my tastes, but the discussion of Argentina’s default is useful for those who wonder about whether the United States is going to have a debt meltdown at some point.

P.S. I don’t agree with Keynesians and I don’t agree with the self-styled deficit hawks. But I can appreciate that both groups have a consistent approach to public finance. What really galls me are the statist hypocrites who are cheerleaders for debt when there are proposals to increase government spending, but then do a back flip and pretend that debt is terrible and must be reduced when tax increases are being discussed.

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At some point in the next 10 years, there will be a huge fight in the United States over fiscal policy. This battle is inevitable because politicians are violating the Golden Rule of fiscal policy by allowing government spending to grow faster than the private sector (exacerbated by the recent budget deal), leading to ever-larger budget deficits.

I’m more sanguine about red ink than most people. After all, deficits and debt are merely symptoms. The real problem is excessive government spending.

But when peacetime, non-recessionary deficits climb above $1 trillion, the political pressure to adopt some sort of “austerity” package will become enormous. What’s critical to understand, however, is that not all forms of austerity are created equal.

The crowd in Washington reflexively will assert that higher taxes are necessary and desirable. People like me will respond by explaining that the real problem is entitlements and that we need structural reform of programs such as Medicaid and Medicare. Moreover, I will point out that higher taxes most likely will simply trigger and enable additional spending. And I will warn that tax increases will undermine economic performance.

Regarding that last point, three professors, led by Alberto Alesina at Harvard, have unveiled some new research looking at the economic impact of expenditure-based austerity compared to tax-based austerity.

…we started from detailed information on the consolidations implemented by 16 OECD countries between 1978 and 2014. …we group measures in just two broad categories: spending, g, and taxes, t. …We distinguish fiscal plans between those that are expenditure based (EB) and those that are tax based (TB)… Measuring the macroeconomic impact of a plan requires modelling the relationship between plans and macroeconomic variables.

Here are their econometric results.

There is a large and statistically significant difference between the effects on output of EB and TB austerity. EB fiscal consolidations have, on average, been associated with a very small downturn in output growth: a spending based plan worth one percent of GDP implies a loss of about half of a percentage point relative to the average GDP growth of the country, which lasts less than two year. Moreover, if an EB austerity plan is launched when the economy is not in a recession, the output costs are zero on average. …On the other hand TB plans are associated with large and long lasting recessions. A TB plan worth one per cent of GDP is followed, on average, by a two percent fall in GDP relative to its pre-austerity path. This large recessionary effect lasts several years.

Here’s a chart from the study showing that economic performance drops farther and farther to the extent taxes are part of an austerity package.

In addition to the core results, the authors explain why tax-based austerity packages are bad for capital…

…investment growth responds very differently following the introduction of the two types of austerity plans. It responds positively to EB plans and negatively to TB plans. …in their sample of OECD countries, business confidence increases immediately at the start of an EB consolidation plan, much more so that at the beginning of a TB plan.

…and why tax-based austerity packages are bad for labor.

…clearly tax hikes and spending cuts – beyond other effects – have different effects on labor supply. …EB plans are the least recessionary the longer lived is the reduction in government spending. Symmetrically, TB plans are more recessionary the longer lasting is the increase in the tax burden and thus in distortions.

Since capital and labor are the two factors of production, the obvious and inevitable conclusion is that the economy does worse when taxes are higher.

The study also make a critical point about the futility of tax increases when the burden of government spending is rising faster than the private sector. Simply stated, that’s a recipe for ever-increasing taxes, sort of like a dog chasing its tail.

…a TB plan which does not address the automatic growth of entitlements and other spending programs which grow over time if much less like likely to produce a long lasting effect on the budget. If the automatic increase of spending is not addressed, taxes will have to be continually increased to cover the increase in outlays.

That’s why spending restraint is the only way to successfully address red ink.

It doesn’t even require dramatic spending cuts, even though that would be desirable. All that’s needed is some modest fiscal restraint so that spending grows slower than the productive sector of the economy.

Nations that follow this approach for a multi-year period always get good results. But if you want examples of nations that have achieved good outcomes with tax increases, you’ll have to explore a parallel universe because there aren’t any on this planet.

P.S. I need to update the table because both the United States (between 2009-2014) and the United Kingdom (between 2010-2016) enjoyed dramatic improvements in fiscal outcomes in recent years because of spending restraint.

P.P.S. Politicians don’t like spending restraint, which is why most periods of good fiscal policy come to an end. To achieve good long-run outcomes, some sort of constitutional spending cap is probably necessary.

P.P.P.S. The study cited above builds upon research I cited in 2016.

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Since the House has passed a tax cut and the Senate has passed a tax cut, it’s quite likely that there will be a consensus deal that will be signed into law.

Which makes me happy since any agreement presumably will include a lower corporate tax rate and the elimination of the deduction for state and local income taxes.

But some folks don’t think this is good news.

Writing for U.S. News & World Report, Pat Garofalo argues that taxes should be going up.

The entire bill is premised off the belief that taxes are too high and need to go down, when the opposite is actually true. …the U.S. is, by developed country standards, a very low-tax country. It raises about a quarter of its gross domestic product in revenue at all levels of government, compared to about a third in the rest of the developed world, and well more than 40 percent in some countries. For the last several decades, the U.S. at the federal level alone has raised roughly 18 percent of GDP in taxes, while spending around 20 percent. Sorry, but that just doesn’t cut it. …other countries prove there’s plenty of room to raise more revenue without kneecapping economic growth. …America’s concentration of wealth is such that there’s plenty of room to raise taxes on the rich with nary an economic blip… it is possible, as Sen. Bernie Sanders, I-Vt., does all the time, to make a case that, yes, taxes on the middle class will go up, but that the benefits will be more than worth it.

I won’t bother responding to all his inaccurate assertions, but I will give Mr. Garofalo credit for honesty. Unlike a lot of folks on the left, he openly acknowledges that the middle class will have to be pillaged to finance a European-style welfare state. I’ll add him to my list of honest leftists.

But honesty is not the same as accuracy.

Chris Edwards put together a very helpful chart showing federal taxes and revenues as a share of economic output. As you can see, America’s real fiscal problem is government spending. The tax cut being considered on Capitol Hill only causes a small – and completely temporary – drop in revenues.

This is such good information that it deserves a closer look.

I decided to look at the raw year-to-year numbers. I got the latest 10-year budget projections from the Congressional Budget Office, as well as the 10-year projections for the Senate tax bill from the Joint Committee on Taxation (the House bill’s numbers are very similar, so these figures presumably are a very accurate proxy of any final package).

Let’s start with a look at the annual baseline revenues (blue) and annual baseline spending (orange), along with the annual post-tax cut revenues (grey). As you can see, there’s very little difference in the two revenue lines. There’s some short-run aggregate tax relief, but that quickly begins to shrink. And by the 10th year, the federal government actually will be collecting more revenue!

Some people nonetheless will oppose even a tiny and temporary tax cut. They will claim they want to balance the budget (though oftentimes these are the same people who supported the faux stimulus and wanted the new Obamacare entitlement, so judge for yourself whether they are sincere).

Even in the unlikely event that they are sincere, their complaints don’t make sense since revenues will be higher after 10 years. And that’s not even properly considering the impact of additional economic growth, which would cause tax receipts to grow even faster.

But let’s set that aside and consider what would be necessary to balance the budget over the 10-year budget window. Earlier this year, I calculated that it would be possible to balance the budget and enact a $3 trillion tax cut so long as politicians would simply restrain federal spending so that it grew by 1.96 percent per year.

Based on the most recent numbers (and starting the spending restraint in 2019 rather than 2018), the budget can be balanced if federal spending grows by 2.67 percent annually. Since that’s much faster than what would be necessary to keep pace with inflation (projected to average about 2 percent per year), this wouldn’t require any “harsh” austerity.

By the way, if you want an example of successful multi-year spending restraint, we had a five-year de facto spending freeze from 2009-2014 (yes, those fights over debt limits, sequestration, and government shutdowns produced a big payoff).

Heck, when Clinton was in the White House, overall government spending grew by 3.2 percent annually between 1993 and 1999.

Surely Republicans can beat Bill Clinton’s record, right?

I’ll close by observing that we shouldn’t fixate on balancing the budget in any particular year. It’s much more important to shrink the burden of government spending. And that happens when the private sector grows faster than the federal budget.

To be sure, it’s also a good idea to shrink red ink, at least relative to our ability to finance debt. That happens whenever the private economy grows faster than federal borrowing.

The good news is that spending restraint is the one policy that achieves both goals.

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Left-wing columnists at the Washington Post have hit upon a theme. In late October, Ruth Marcus wrote a column asserting that tax cuts are “dangerous.”

I explained why her argument was nonsensical, but that clearly didn’t have any impact since Robert Rubin has a new column in the same paper with the same theme. He claims to have identified five “dangers” in the Republican tax plan.

It’s a remarkably weak list, but I guess it merits a response, both because Rubin served as Bill Clinton’s Treasury Secretary and because I feel compelled to once again slap down the claim that tax cuts are dangerous.

I debunk each one of Rubin’s points below, but you’ll also notice that I first restate (fairly, I think) what he’s really trying to say since his writing style is so bureaucratically obtuse.

Rubin Claim #1:

…business confidence would likely be negatively affected by creating uncertainty about future policy and heightening concern about our political system’s ability to meet our economic policy challenges.

What he’s really saying: We don’t know what will happen in the future (“uncertainty”) and it would be good if taxes were higher so politicians could spend more (“ability to meet…challenges”).

Why he’s wrong: Since it’s very difficult for today’s politicians to restrict the behavior of future politicians, it is true that there will be policy uncertainty. But that’s just as true if we leave the corporate tax rate at 35 percent as it will be if the rate is reduced the 20 percent. I’m also unimpressed by his desire for government to have more cash to meet challenges since it’s far more likely that government is the cause of problems rather than the solution.

Rubin Claim #2:

…our country’s resilience to deal with inevitable future economic and geopolitical emergencies, including the effects of climate change, would continue to decline.

What he’s really saying: If there’s a tax cut, politicians will have less money, which means it will be harder (a “decline” in “resilience”) to spend money in the future.

Why he’s wrong: Once again, I feel compelled to point out that very few problems can be solved with more government spending. Indeed, that’s usually a recipe for making a problem worse (the welfare state, for example). But the most glaring flaw with Rubin’s argument about “future…emergencies” is that there’s no long-run tax cut. The GOP tax plan is revenue-neutral after 10 years. So how can a plan that doesn’t lower the long-run revenue baseline impact the government’s ability to do anything?

Rubin Claim #3:

…funds available for public investment, national security and defense spending…would continue to decline as debt rises, because of rising interest costs and the increased risk of borrowing to fund government activities.

What he’s really saying: Less tax money going to Washington could mean higher interest payments (“increased risk of borrowing”), which would displace other forms of spending.

Why he’s wrong: There’s actually some truth to this argument, at least in the first 10 years when there actually is a tax cut. If I was being snarky, I could ask why Rubin wasn’t making the same argument when the faux stimulus was being debated. Or when the Obamacare boondoggle was being discussed. Why does he think deficits are only bad when tax cuts are on the agenda (just like CBO), but deficits are “stimulus” when spending goes up? I may sue for whiplash since folks on the other side keep changing their minds on red ink.

Rubin Claim #4:

Treasury bond interest rates would be highly likely to increase over time because of increased demand for the supply of savings and increased concern about future imbalances.

What he’s really saying: A tax cut will lead to higher deficits, which will lead to higher interest rates (“increased demand for the supply of savings”).

Why he’s wrong: I believe in supply-and-demand curves, so it’s theoretically true that interest rates should increase when government competes against private borrowers. That being said, even big shifts in U.S. deficits are just a drop in the bucket in a world where global capital markets amount to tens of trillions of dollars. Here’s a slide from a speech I gave to the Leadership Program of the Rockies earlier this month in Denver. If I had space, I would have added “but in reality the impact is minimal” to the third sentence.

Rubin Claim #5:

…at some unpredictable point, fiscal conditions…would likely be seen as sufficiently serious to cause severe market and economic destabilization.

What he’s really saying: Tax cuts will mean more red ink, which could ultimately lead to a Greek-style fiscal crisis (“severe..destabilization”).

Why he’s wrong: It’s certainly true that America faces very worrisome long-run fiscal problems, but those challenges are entirely due to a rising burden of government spending. And since the GOP plan is only a tax cut in the first 10 years, it’s absurd to say the GOP plan will have any meaningful impact on that dismal outlook. If Rubin really was concerned about America’s fiscal situation, he would be aggressively arguing for genuine entitlement reform.

I could have shortened that entire section by collapsing his five “dangers” into one teenager-type rant: “OMG, the economy will be in danger with tax cuts and the government won’t be able to spend on good things.”

To which I could have replied: “LOL.”

To be fair, there actually is a semi-serious section in Rubin’s column. He summarizes the left’s economic argument against lower tax rates.

…tax cuts will not increase growth and, given their fiscal effects, would likely have a significant and increasingly negative impact. The nonpartisan Tax Policy Center’s latest report estimated that, over 10 years, the average increase in our growth rate would be roughly zero, counting the crowding out of private investment by increasing deficits but not counting other adverse effects of worsening our fiscal outlook. The Penn Wharton Budget Model, using the same approach, estimates virtually no increase in long-term growth. …These estimates reflect three underlying views held by mainstream economists. First, individual tax cuts will not materially induce people to work more. Second, corporate tax cuts will likely have limited effect on investment or decisions about where to locate business activity, given the many other variables at play. Third, deficit-funded tax cuts will have little short-term effect on growth, except perhaps for some temporary overheating, because we are at roughly full employment.

Now allow me to translate: It is quite possible to generate bad numbers if you build models that, 1) assume lower tax rates have very little impact on incentives to engage in productive behavior, and 2) assume larger deficits cause interest rates to increase significantly and therefore measurably reduce investment.

The real question is whether those theoretical models are correct given so much of the empirical evidence on the other side. After all, what are you going to believe, the models or your lying eyes?

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The swamp is pulsating with excitement. For the lobbying community, tax reform is like Christmas. No matter what happens, they win because of lucrative retainers and fat contracts.

And what about libertarian policy wonks? What do we get? Well, we look at the sausage-making process in Washington with disdain, but we hope that the final outcome is a less-destructive tax system.

And there are some interesting debates along the way. Here’s an interview I did a couple of days ago with Maya MacGuineas of the Committee for a Responsible Federal Budget. We touch on several topics relating to tax reform, but pay close attention to the discussion on federal spending and red ink because you’ll see a very interesting mix of agreement and disagreement.

There are big areas of overlap. We both like spending restraint. We both favor getting rid of loopholes (though I fear she may favor the Haig-Simons definition of loopholes rather than the consumption-base definition). And we both seem to agree that lower tax rates can improve economic performance.

But it seems we might diverge on whether a stand-alone tax cut is desirable. My view is that the right kind of tax cut will boost incentives for productive behavior. Yes, that can produce more red ink, but that’s not necessarily a bad thing if it “starves the beast” and creates pressure to restrain the growth of spending. I’m motivated by a desire to limit the overall size of government.

Maya, by contrast, is not happy that Congress is considering a stand-alone tax cut. As a “deficit hawk,” she would prefer that the tax cut be “paid for” with spending restraint or by cutting back on tax preferences. She is motivated by a desire to limit red ink.

For what it’s worth, I think she’s focusing on the symptom or red ink when it would be better to focus on the underlying disease of excessive spending.

I think this 2×2 matrix is a good way of illustrating our areas of agreement and disagreement. Libertarians like me are in the top-left box. Indeed, in the top-left corner of the top-left box. I want less spending and lower taxes. Deficit hawks like Maya, by contrast, are going to be somewhere in the lower-left box since they want less spending but are open to higher taxes.

I also added other groups to the matrix, such as Reaganites (i.e. the Gipper), populists (i.e., Trump), and so-called compassionate conservatives (i.e., Bush). As well as some Democratic politicians such as Bill Clinton, Hillary Clinton, and Crazy Bernie. Since I’m going by gut instinct, I’m not going to claim everybody is in the exact right spot, but I do think this is a decent representation of the real debate in Washington.

But it’s not a perfect representation. For instance, we know the folks in the lower-left box care about red ink. But you can also find people in the top-left box and lower-right box who favor balanced budgets. Perhaps there should be a diagonal line from the top left to the lower right so that we can see who wants balanced budgets and/or budget surpluses.

So here’s a slightly more cluttered version of my fiscal matrix.

And I added Hong Kong and Sweden to the matrix to show that balanced budgets are possible with small government or big government.

Last but not least, I decided to create one more visual. The fiscal matrix is mostly designed to show preferences on spending and taxes, with the obvious implication that people below the diagonal line don’t like deficits.

But if we consider just red ink, here’s a spectrum showing how people view deficits. Maya and her group are in the deficits-are-horrible camp on one end, while the deficits-are-wonderful Keynesians are on the other end. And I put myself in the middle to represent the alleged voice of moderation.

Though even this spectrum isn’t really accurate since Keynes only believed in deficits during a downturn. And I confess I have no idea whether Maya would support red ink in that circumstance.

By the way, I can’t resist commenting on a few other moments in the interview.

  • First, Maya said that tax cuts don’t pay for themselves. That’s true (except in rare circumstances), but it’s still very important to realize that supply-side tax cuts can produce some degree of revenue feedback.
  • Second, modest spending restraint would enable both huge tax cuts and a balanced budget.
  • Third, Republicans in Congress actually approved budgets that restrained spending when Obama was in the White House (hence, my reference in the interview to the Ryan budgets).

I’ll close with a grim prediction. The tax reform battle will be Part II of the Obamacare repeal battle. I fear the effort will come to naught. Those 76,000 pages in the tax code are defended by too many powerful interest groups.

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