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Posts Tagged ‘Debt’

I’ve identified seven reasons to oppose tax increases, but explain in this interview that the biggest reason is that it would be a mistake to give politicians more money to finance an ever-larger burden of government spending.

I had two goals when responding this question (part of a longer interview).

First, I wanted to help viewers understand that America’s fiscal problem is too much government spending and that red ink is simply a symptom of that problem.

Over the years, I’ve concocted all sorts of visuals to make this point. Like this one.

And this one.

And this one.

Second, I wanted viewers to understand that higher taxes will simply make a bad situation even worse.

From my perspective, the biggest problem with tax increases is that they will enable a bigger burden of government spending.

But even the folks who fixate on red ink should adopt a no-tax increase position.

Why? Because politicians who want big tax increases want even bigger spending increases.

Joe Biden is pushing for a massive tax increase, for instance, but his proposed spending increase is far larger.

We also have decades of evidence from Europe. There’s been a huge increase in the tax burden in Western Europe since the 1960s (largely enabled by the enactment of value-added taxes).

Did that massive increase in revenue lead to less red ink?

Nope, just the opposite, as I showed in both 2012 and 2016.

If you don’t agree with me on this issue, maybe you should heed the words of these four former presidents.

P.S. Some people warn that endlessly increasing debt is a recipe for an eventual crisis. They’re probably right. Which is why it is important to oppose tax-increase deals that wind up saddling us with more red ink. Besides, the long-run damage of tax-financed spending is very similar to the long-run damage of debt-financed spending.

P.P.S. As I mention in the interview, the only real solution is spending restraint. And a spending cap is the best way of enforcing that approach.

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As part of a panel discussion with the Texas Public Policy Foundation, I explained (with a frozen look) why spending caps (such as Switzerland’s “debt brake“) are better than balanced budget requirements.

This is a topic I’ve written about many times, noting that even left-leaning international bureaucracies like the IMF and OECD have reached the same conclusion.

For today’s discussion, I want to focus on a wonky but important observation. I mentioned in the presentation that the European Union’s “Maastricht Criteria” – which focus on controlling red ink – have not worked.

Those interested can click here for further background on these rules, but the key thing to understand is that eurozone nations agreed back in 1992 to limit deficits to 3 percent of economic output and to limit debt to 60 percent of GDP.

Has this approach worked?

Here’s the data, from a 2019 European Parliament report, on government debt for eurozone nations. Incidentally, the euro currency officially began in 2002, though nations were supposed to comply with the Maastricht Criteria starting back in 1993.

As you can see, debt has increased in most European nations. In may cases, debt is more than twice as high as the supposed maximum specified in the Maastricht Criteria.

And these are the “good” numbers. I deliberately chose data from a few years ago to make clear that the failure to comply with the Maastricht Criteria has nothing to do with the coronavirus pandemic.

In other words, debt in Europe is now far worse.

What went wrong? Why did anti-red ink rules produce more red ink?

A big part of the answer is that politicians use anti-deficit and anti-debt rules as an excuse to raise taxes (which is what happened during Europe’s prior debt crisis).

And we know that tax increases generally backfire, both because they undermine economic growth and because they give politicians leeway to spend even more money.

By contrast, spending restraint has a very good track record of reducing red ink.

P.S. To learn more about Switzerland’s spending cap, click here. To learn more about Colorado’s spending cap, click here.

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The title of this column is an exaggeration. What we’re really going to do today is explain the main things you need to know about government debt.

We’ll start with this video from Kite and Key Media, which correctly observes that entitlement programs are the main cause of red ink.

I like that the video pointed out how tax-the-rich schemes wouldn’t work, though it would have been nice if they added some information on how genuine entitlement reform could solve the problem  (as you can see here and here, I’ve also nit-picked other debt-themed videos).

Which is why I humbly think this is the best video ever produced on the topic.

As you can see, I’m not an anti-debt fanatic. It was perfectly okay, for instance, to incur debt to win World War II.

But I’m very skeptical of running up the nation’s credit card for routine pork and fake stimulus.

But my main message, which I’ve shared over and over again, is that deficits and debt are merely a symptom. The underlying disease is excessive government spending.

And that spending hurts our economy whether it is financed by taxing or borrowing (or, heaven forbid, by printing money).

Now let’s look at some recent articles on the topic.

We’ll start with Eric Boehm’s column for Reason, which explains how red ink has exploded in recent years.

America’s national debt exceeded $10 trillion for the first time ever in October 2008. By mid-September 2017 the national debt had doubled to $20 trillion. …data released by the U.S. Treasury confirmed that the national debt reached a new milestone: $30 trillion. …Entitlements like Social Security and Medicare are in dire fiscal straits and will become even more costly as the average American gets older. Even without another unexpected crisis, deficits will exceed $1 trillion annually, which means the debt will continue growing, both in real terms and as a percentage of the economy. The Congressional Budget Office estimates that the federal government will add another $12.2 trillion to the debt by 2031.

As already stated, I think the real problem is the spending and the debt is the symptom.

But it is possible, of course, that debt rises so high that investors (the people who buy government bonds) begin to lose faith that they will get repaid.

At that point, governments have to pay higher interest rates to compensate for perceived risk of default, which exacerbates the fiscal burden.

And if there’s not a credible plan to fix the problem, a country can go into a downward spiral. In other words, a debt crisis.

This is what happened to Greece. And I think it’s just a matter of time before it happens to Italy.

Heck, many European nations are vulnerable to a debt crisis. As are many developing countries. And don’t forget Japan.

Could the United States also be hit by a debt crisis? Will we reach a “tipping point” that leads to the aforementioned loss of faith?

That’s one of the possibilities mentioned in the New York Times column by Peter Coy.

It’s hard to know how much to worry about the federal debt of the United States. …Either the United States can continue to run big deficits and skate along with no harm done or it’s at risk of losing investors’ confidence and having to pay higher interest rates on its debt, which would suppress economic growth. …the huge increase in federal debt incurred during and after the past two recessions — those of 2007-09 and 2020 — has used up a lot of the “fiscal space” the United States once had. In other words, the federal government is closer to the tipping point where big increases in debt finally start to become a real problem. …any given amount of debt becomes easier to sustain as long as the growth rate of the economy (and thus the growth rate of tax revenue) is higher than the interest rate on the debt. In that scenario, interest payments gradually shrink relative to tax revenue. …but it doesn’t explain how much more the debt can grow. …Past a certain point, there’s a double whammy of more dollars of debt plus higher interest costs on each dollar. …sovereign debt crises tend to be self-fulfilling prophecies: Investors get nervous about a government’s ability to pay, so they demand higher interest rates, which raise borrowing costs and produce the bad outcome they feared. It’s a dynamic that Argentines are familiar with — and that Americans had better hope they never experience.

For what it’s worth, I think other major nations will suffer fiscal crisis before the problem becomes acute in the United States.

I realize this will make me sound uncharacteristically optimistic, but I’m keeping my fingers crossed that this will finally lead politicians to adopt a spending cap so we don’t become Argentina.

P.S. The Wall Street Journal recently editorialized on the issue of government debt and made a very important point about the difference between the $30 trillion “gross debt” and the “debt held by the public,” which is about $6 trillion lower.

…the debt really isn’t $30 trillion. About $6 trillion of that is debt the government owes to itself in Social Security and other IOUs. …The debt held by the public is some $24 trillion, which is bad enough.

As I’ve noted when writing about Social Security, the IOUs in government trust funds are not real.

They’re just bookkeeping entries, as even Bill Clinton’s budget freely admitted.

Indeed, if you want to know whether some is both honest and knowledgeable about budget matters, ask them which measure of the national debt really matters.

As you can see from this exchange of tweets, competent and careful budget people (regardless of whether they favor big government or small government) focus on “debt held by the public,” which is the term for the money government actually borrows from credit markets.

If you want to know the difference between the various types of government debt – including “unfunded liabilities” – watch this video.

P.P.S. This column explains how and when debt matters. If you’re interested in how to reduce the debt, there’s very good evidence that spending restraint is the only effective approach. Even in cases where debt is enormous.

P.P.P.S. By contrast, the evidence is very clear that higher taxes actually make debt problems worse.

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Back in 2017, the Center for Freedom and Prosperity released this video to help explain why spending caps are the most sensible and sustainable fiscal rule.

Switzerland actually has a spending cap in its constitution, and similar fiscal rules also exist in Hong Kong and the state of Colorado.

These policies have produced very good results.

There are many reasons to support a spending cap, including the obvious observation that an expenditure limit (as it is sometimes called) directly addresses the actual problem of excessive government.

And addressing the underlying disease works better than rules that focus on symptoms, such as balanced budget requirements or anti-deficit mandates.

You’ll notice toward the end of the video that the narrator cites pro-spending cap research from international bureaucracies, which is remarkable since those institutions normally have a bias for bigger government.

I’ve also written about that research, citing studies by the International Monetary Fund (here and here), the Organization for Economic Cooperation and Development (here and here) and the European Central Bank (here).

Today, let’s look at more evidence from these bureaucracies.

We’ll start with a new study from the European Central Bank. Here’s some of what the authors (Nicholai Benalal, Maximilian Freier, Wim Melyn, Stefan Van Parys, and Lukas Reiss) found when comparing spending limits and anti-deficit rules.

this paper provides an in-depth assessment of two alternative measures of fiscal consolidation and expansion: the change in the structural balance (dSB) and the expenditure benchmark (EB). Both the dSB and the EB are currently used to assess compliance with the fiscal rules under the Stability and Growth Pact (SGP).The EB was introduced as an indicator in 2011, and has gained in importance relative to the dSB since the European Commission began to put more emphasis on it in 2016.A comparison of the fiscal performance of euro area countries reveals significant differences depending on whether the assessment is based on the dSB or the EB. this paper finds that the EB has advantages over the dSB as a fiscal performance indicator. …expenditure rules…provide more predictability in fiscal requirements. …Even more importantly, the EB can be shown to be less procyclical as a fiscal rule than the dSB. 

Let’s also review some 2019 research from the International Monetary Fund.

This study (authored by Kodjovi Eklou and Marcelin Joanis) looks at whether fiscal rules can constrain vote-buying politicians.

In order to increase their chances of reelection, politicians are known to undertake fiscal manipulations, especially in election years. These fiscal manipulations typically take the form of increased public expenditure… Many countries, both developed and developing, have adopted fiscal rules in recent decades as an attempt to enforce fiscal discipline. …In this paper, we employ a cross-country panel dataset in order to test whether fiscal rules adopted in developing countries have been effective in constraining political budget cycles. The dataset covers 67 developing countries over the period 1985-2007. …Our dependent variable is the general government’s final consumption expenditure as a share of GDP.

Here’s what the authors concluded about the effectiveness of spending caps.

Our empirical evidence in a sample of 67 developing countries over the period 1985-2007, shows that fiscal rules cause fiscal discipline over the electoral cycle. More specifically, in election years with fiscal rules in place, public consumption is reduced by 1.65% point of GDP as compared to election years without these rules. Furthermore, the effectiveness of these rules depends on their type… In particular, expenditure rules, rules covering the general government and rules characterized by a monitoring body outside the government dampen political budget cycles in government consumption.

Indeed, footnote 12 of the paper specifically notes the superiority of expenditure limits.

…the results show that public consumption is reduced by 2.44% points during election years with expenditure rules in place. The findings on expenditure rules are consistent with Cordes et al. (2015) who show that the compliance rate for these rules are high.

Last but not least, the fiscal experts at the Office of Management and Budget included in Trump’s final budget some very encouraging language at the end of Chapter 10 of the Analytical Perspectives.

…additional efforts to control spending are needed. Several budget process reforms should be considered, including setting spending caps… Outlay caps that are consistent with the historical average as a share of gross domestic product (GDP), post-World War II levels could be enforced with sequestration across programs similar to other budget enforcement regimes. An outlay cap on mandatory spending would complement discretionary caps, which have been in place since 2013. The Budget proposes to continue discretionary caps through 2025 at declining levels and declining levels through 2030.

Trump was a big spender, of course, but at least there were people in his administration who realized there was a problem.

And they recognized the right solution.

P.S. It’s also interesting that the authors of the IMF study found that fiscal rules work better in democracies.

…estimates focusing on the subsample of democratic elections. The effect of fiscal rules on the political budget cycle is larger… More specifically, public consumption is reduced by 2.46% point of GDP (while it is 1.65% point in the baseline).

This may not bode well for the durability of Hong Kong’s spending cap.

The authors also found that foreign aid makes it less likely that a government will follow sensible policy.

Foreign aid, which relaxes the budget constraint of the government, is negatively correlated with the probability of having fiscal rules.

Needless to say, nobody should be surprised to learn that foreign aid undermines good policy.

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As part of a recent discussion with Gene Tunny in Australia, I explained why I support “Starve the Beast,” which means keeping taxes as low as possible to help achieve the goal of spending restraint.

The premise of Starve the Beast is very simple.

Politicians like to spend money and they don’t particularly care whether that spending is financed by taxes or financed by borrowing (both bad options).

As Milton Friedman sagely observed, that means they will spend every penny they collect in taxes plus as much additional spending financed by borrowing that the political system will allow.

The IMF published a study on this issue about 10 years ago. The authors (Michael Kumhof, Douglas Laxton, and Daniel Leigh) assert that there’s no way of knowing whether Starve the Beast will lead to good or bad results.

…there is no consensus regarding the macroeconomic and welfare consequences of implementing a starve-the-beast approach, henceforth referred to as STB. …it could be beneficial in the ideal case in which it results in cuts in entirely wasteful government spending. In particular, lower spending frees up resources for private consumption, and the associated lower tax rates reduce distortions in the economy. On the other hand, …lower government spending may itself entail welfare losses…if it augments the productivity of private factors of production. …the paper examines whether the principal macroeconomic variables such as GDP and consumption, both in the United States and in the rest of the world, respond positively to this policy. …In addition, the paper assesses how the welfare effects depend on the degree to which government spending directly contributes to household welfare or to productivity.

The authors don’t really push any particular conclusion. Instead, they show various economic outcomes depending on with assumptions one adopts.

Since plenty of research shows that government spending is not a net plus for the economy (even IMF economists agree on that point), and because I think a less-punitive tax system is possible (and desirable) if there’s a smaller burden of government spending, I think the findings shown in Figure 4 make the most sense.

Now let’s shift from academic analysis to policy analysis.

In a piece for National Review back in July 2020, Jim Geraghty notes that Starve the Beast has an impact on government finances at the state level.

…we’re probably not going to see a massive expansion of government at the state level in the coming year or two. …Thanks to the pandemic lockdown bringing vast swaths of the economy to a halt, state tax revenues are plummeting. …So states will have much less tax revenue, constitutional balanced-budget requirements that are not easily repealed, and a limited amount of budgetary tricks to work around it. State governments could attempt to raise taxes, but that’s going to be unpopular and hurt state economies when they’re already struggling. Add it all up and it’s a tough set of circumstances for a dramatic expansion of government, no matter how ardently progressive the governor and state legislatures are.

For what it’s worth, Geraghty warned in the article that fiscal restraint by state governments wouldn’t happen if the federal government turned on the spending spigot.

And that, of course, is exactly what happened.

Now let’s look at the most unintentional endorsement of Stave the Beast.

A couple of years ago, Paul Krugman sort of admitted that cutting taxes was a potentially effective strategy for spending restraint.

…the same Republicans now wringing their hands over budget deficits…blew up that same deficit by enacting a huge tax cut for corporations and the wealthy. …this has been the G.O.P.’s budget strategy for decades. First, cut taxes. Then, bemoan the deficit created by those tax cuts and demand cuts in social spending. Lather, rinse, repeat. This strategy, known as “starve the beast,” has been around since the 1970s, when Republican economists like Alan Greenspan and Milton Friedman began declaring that the role of tax cuts in worsening budget deficits was a feature, not a bug. As Greenspan openly put it in 1978, the goal was to rein in spending with tax cuts that reduce revenue, then “trust that there is a political limit to deficit spending.” …voters should realize that the threat to programs… Social Security and Medicare as we know them will be very much in danger.

In other words, Krugman doesn’t like Starve the Beast because he fears it is effective (just like he also acknowledges the Laffer Curve, even though he’s opposed to tax cuts).

Let’s close by looking at some very powerful real-world evidence. Over the past 50 years, there’s been a massive increase in the tax burden in Western Europe.

Did all that additional tax revenue lead to lower deficits and less debt?

Nope, the opposite happened. European politicians spent every penny of the new tax revenue (much of it from value-added taxes). And then they added even more spending financed by additional borrowing.

To be fair, one could argue that this was an argument for the view of “Don’t Feed the Beast” rather than “Starve the Beast,” but it nonetheless shows that more money in the hands of politicians simply means more spending. And more red ink.

P.S. I had a discussion last year with Gene Tunny about the issue of “state capacity libertarianism.”

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Regarding fiscal policy, almost everyone’s attention is focused on Biden’s growth-sapping plan to increase the burden of taxes and spending.

People are right to be concerned. If the President’s plan is approved, the already-grim fiscal outlook for United States will get even worse.

This battle will be decided in next 12 months, hopefully with a defeat for Biden’s dependency agenda.

Regardless of how that fight is resolved, though, we’re eventually going to get to a point where sensible people are back in charge. And when that happens, we’ll have to figure out how to restore the nation’s finances.

That requires figuring out the appropriate goal. Here are two options:

  • Keeping taxes low.
  • Controlling debt.

These are both worthy objectives.

But, as a logic teacher might say, they are necessary but not sufficient conditions.

Here’s a chart showing how a policy of low taxes (the orange line) presumably enables faster growth, but also creates the risk of an eventual economic crisis if nothing is done to control spending and debt climbs too high (think Greece).

By contrast, the chart also shows that it’s theoretically possible to avoid an economic crisis with higher taxes (the blue line), but it means less growth on a year-to-year basis.

The moral of the story is that the economy winds up in the same place with either tax-financed spending or debt-financed spending.

Which is why we should consider a third goal.

  • Limiting spending.

The economic benefits of this approach are illustrated in this second chart. We enjoy faster year-to-year growth. And, because spending restraint is the best way of controlling debt, the risk of a Greek-style economic crisis is averted.

Now for some caveats.

I made a handful of assumptions in the above charts.

  • The economy grows 2.0 percent annually for the next 31 years with tax-financed spending
  • The economy grows 2.5 percent annually with debt-financed spending, but suffers a 10 percent decline in Year 31.
  • The economy grows 3.0 percent annually for the next 31 years with smaller government (thus enabling low taxes and less debt).

Anyone can create their own spreadsheet and make different assumptions.

That being said, there’s a lot of evidence that higher tax burdens hinder growth, that ever-rising debt burdens can lead to crisis, and that less government spending produces stronger growth.

So feel free to make your own assumptions about the strength of these effects, but let’s never lose sight of the fact that spending restraint should be the main goal for post-Biden fiscal policy.

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I’ve periodically warned the European nations such as France, Italy, Greece, and Spain almost surely are doomed to suffer a fiscal crisis.

This is because governments in Europe didn’t respond to the 2010 crisis by actually solving the problem of excessive spending.

Instead, I pointed out about five years ago that they have allowed the spending burden to rise, as measured by outlays as a share of economic output.

Well, things have since gone even further in the wrong direction, exacerbated by long-run factors such as demographic decline and short-run factors such as the coronavirus pandemic.

So what’s the net result?

Writing for the Hill, Desmond Lachman of the American Enterprise Institute is concerned about the possibility of a new round of fiscal chaos in Europe.

In 2010, the Eurozone experienced a sovereign debt crisis that shook the world economy. Today…, it appears that the Eurozone could be well on the way to another such debt crisis. It is not only that the public finances of several key countries in the Eurozone periphery are considerably worse than they were on the eve of the 2010 sovereign debt crisis. It is also that inflation has risen to a level that will make it difficult for the European Central Bank (ECB) to continue to keep the Eurozone periphery governments afloat by a continuation of bond purchases on the massive scale that it has been doing to date. …Over the past 18 months, in response to the pandemic and with a view to stimulating the European economy, the ECB increased the size of its balance sheet by more than $4 trillion. …The fly in the ointment for countries such as Italy and Spain is that they cannot expect that the ECB will continue to buy their bonds on a large scale forever. …Another reason to fear an early end to the ECB’s massive bond-buying program is the strong resistance to such bond buying by the Eurozone’s northern member countries in general and by Germany in particular. These countries view the ECB’s bond-buying activities as a move to a fiscal union through the backdoor.

Excellent points, particularly with regard to the malignant role of the European Central Bank, which has created the conditions for a much bigger crisis by enabling bigger government and more debt.

If you want to understand how much worse the debt problem is today, here’s a chart based on OECD data for European nations (with the U.S. and Japan added for purposes of comparison.

Keep in mind, of course, that the debt is basically a symptom of the real problem of excessive spending.

Though debt becomes its own problem when investors no longer trust a government’s ability to pay bondholders.

P.S. Notice Switzerland’s good numbers, which is an argument for that nation’s spending cap.

P.P.S. The problem in Europe is too much government spending, not the euro currency.

P.P.P.S. Eurobonds will make things worse in the long run.

P.P.P.P.S. It is possible to reduce large debt burdens, so long as governments simply restrain spending.

P.P.P.P.P.S. Here’s some comedy (and more comedy) about Europe’s fiscal mess.

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In an ideal world, Americans would have personal retirement accounts, just like workers in Australia, Sweden, Chile, Hong Kong, Israel, Switzerland, and a few dozen other nations.

But we’re not in that ideal world. We are forced to participate in a Ponzi Scheme known as Social Security.

By the way, that’s not necessarily a disparaging description. A Ponzi Scheme can work if there are always enough new people in the system to pay off the old people.

But because of demographic changes (increasing lifespans and decreasing birthrates), that’s not what we have in the United States.

And this is why Social Security faces serious long-run problems.

How serious? The Social Security Administration finally released the annual Trustees Report. This document has a wealth of data on the program’s financial condition, and Table VI.G9 is where the rubber meets the road.

As you can see from this chart, there will be an ever-increasing burden of Social Security taxes and spending over the next 75 years. And these numbers are adjusted for inflation!

The good news (relatively speaking) is that the economy also will be growing over the next 75 years, both in nominal terms and inflation-adjusted terms.

The bad news is that spending on Social Security will grow at a faster rate, so the program will consume a larger share of the economy’s output.

And because Social Security spending is growing faster than the economy (and also faster than tax revenue), this next chart shows there is going to be more and more red ink in the future. Once again, you’re looking at inflation-adjusted data.

As indicated by the chart’s title, the cumulative shortfall over the next 75 years is nearly $48 trillion. That’s a lot of money, even by Washington standards.

And with each passing year, the problem seems to worsen. The 75-year shortfall was $44.7 trillion according to the 2020 report and $42.1 trillion according to the 2019 report.

I’ll conclude by observing that today’s column focuses on the big-picture fiscal problems with Social Security.

But let’s not forget the program’s second crisis, which is the fact that Americans are deprived of the ability to enjoy much higher levels of retirement income.

Certain groups are particularly harmed by this aspect of the current program, including minorities, women, older workers, and low-income workers.

P.S. Our friends on the left argue that the program’s fiscal problems (the first crisis) can be solved with tax increases. Perhaps that is true, but it will mean a weaker economy and it will exacerbate the second crisis by forcing workers to pay more to get less.

P.P.S. I once made a $16 trillion dollar mistake on national TV when discussing Social Security’s shaky finances.

P.P.P.S. Much of the news coverage about the Trustees Report has focused on the year the Social Security Trust Fund supposedly runs out of money. But this is sloppy journalism since the Trust Fund has nothing but IOUs (as illustrated by this joke).

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Back in 2019, I listed “Six Principles to Guide Policy on Government Spending.”

If I was required to put it all in one sentence (sort of), here’s the most important thing to understand about fiscal policy.

This does not mean, by the way, that we should be anarcho-capitalists and oppose all government spending.

But it does mean that all government spending imposes a burden on the economy and that politicians should only spend money to finance “public goods” that generate offsetting benefits.

Assuming, of course, that the goal is greater prosperity.

I’m motivated to address this topic because Philip Klein wrote a column for National Review about Biden’s new spending. He points out that this new spending is bad, regardless of whether it is debt-financed or tax-financed.

As Democrats race toward squandering another $4.1 trillion — perhaps with some Republican help — we are being told over and over how the biggest stumbling block is figuring out how the new spending will be “paid for.” …Senator Joe Manchin (D., W.Va.), who is trying to maintain his image as a moderate, insisted that he doesn’t believe the spending should be passed if it isn’t fully financed. “Everything should be paid for,” Manchin has told reporters. …Republican members of the bipartisan group have also made similar comments. …But it is folly to consider massive amounts of new spending to be “responsible” as long as members of Congress come up with enough taxes to raise… At some point in the next few weeks, Democrats (and possibly Republicans) will announce that they have reached a deal on some sort of major spending compromise. They will claim that it is fully paid for, and assert that it is fiscally responsible. But there is nothing responsible about adding trillions in new obligations at a time when the nation is already heading for fiscal catastrophe.

Klein is correct.

Biden’s spending binge will be just as damaging to prosperity if it is financed with taxes rather than financed by debt.

The key thing to realize is that we’ll have less growth if more of the economy’s output is consumed by government spending.

Giving politicians and bureaucrats more control over the allocation of resources is a very bad idea (as even the World Bank, OECD, and IMF have admitted).

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Two days ago, the Congressional Budget Office released its latest long-run fiscal forecast. The report focuses – incorrectly – on the growth of red ink.

And most of the people who have written about the report also have focused – incorrectly – on the rising levels of debt.

That’s the bad news.

The good news is that the report also contains lots of data on the variables – the spending burden and the tax burden – that should command our attention.

Here are four visuals from the report. We’ll start with Figure 7, which shows what will happen to spending and taxes over the next three decades. I’ve highlighted in red the most important numbers.

The right-most column gives you the big picture. The main takeaway (and it’s been this way for a while) is that more than 100 percent of America’s long-run fiscal problem is driven by the fact that government spending (“total outlays”) will consume a much greater share of our economic output.

The top-left of Figure 7 shows the growth of entitlement programs (which captures the fiscal problems of Social Security, Medicare, and Medicaid).

So lot’s look at Figure 9, which presents the same data in a different way.

The moral of the story is that America desperately needs genuine entitlement reform.

Why did I write above that government spending is responsible for “more than 100 percent of America’s long-run fiscal problem”?

Because, as depicted in Figure 11, there’s a built-in tax increase over the next three decades.

In other words, the fiscal mess in Washington is not the result of inadequate tax revenue.

Last but not least, Figure 13 is worth sharing because it shows how small differences in some variables can make a big difference over time. I’m especially interested in the top chart, which shows how slight differences in productivity (which determines the all-important variable of per-capita growth) have a big impact on long-run debt.

It would be preferable, of course, if the CBO report showed how greater productivity impacts both revenue and spending. We would see that faster growth generates more tax revenue (without raising tax rates) and reduces spending (people with good jobs are less likely to be dependent on government redistribution programs).

P.S. Yes, government debt matters. It matters in the short run because it’s a measure of how much private saving is being diverted to finance government. And it matters in the long run because excessive red ink can trigger a fiscal crisis when investors decide that a government no longer can be trusted to pay back lenders (see Greece, for instance). But we should never forget that it is excessive spending that drives the debt. Cure the disease of excessive spending and it is all but certain that you eliminate the symptom of red ink.

P.P.S. For what it’s worth, the United States is not Greece. At least not yet.

P.P.P.S. But we will be if there’s not some long-run spending restraint (an approach that worked in the 1800s), which almost certainly would require a spending cap.

P.P.P.P.S. There is zero evidence that tax increases would be successful. Indeed, that approach would make matters worse if history is any guide.

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The 21st century has been bad news for proponents of limited government. Bush was a big spender, Obama was a big spender, Trump was a big spender, and now Biden also wants to buy votes with other people’s money.

That’s the bad news.

The good news is that there is still a simple solution to America’s fiscal problems. According to the just-released Budget and Economic Outlook from the Congressional Budget Office, tax revenues will grow by an average of 4.2 percent over the next decade. So we can make progress, as illustrated by this chart, if there’s some sort of spending cap so that outlays grow at a slower pace.

The ideal fiscal goal should be reducing the size of government, ideally down to the level envisioned by America’s Founders.

But even if we have more modest aspirations (avoiding future tax increases, avoiding a future debt crisis), it’s worth noting how modest spending restraint generates powerful results in a short period of time. And the figures in the chart assume the spending restraint doesn’t even start until the 2023 fiscal year.

The main takeaway is that the budget could be balanced by 2031 if spending grows by 1.5 percent per year.

But progress is possible so long as the cap limits spending so that it grows by less than 4.2 percent annually. The greater the restraint, of course, the quicker the progress.

In other words, there’s no need to capitulate to tax increases (which, in any event, almost certainly would make a bad situation worse).

P.S. The solution to our fiscal problem is simple, but that doesn’t mean it will be easy. Long-run spending restraint inevitably will require genuine reform to deal with the entitlement crisis. Given the insights of “public choice” theory, it will be a challenge to find politicians willing to save the nation.

P.P.S. Here are real-world examples of nations that made rapid progress with spending restraint.

P.P.P.S. Switzerland and Hong Kong (as well as Colorado) have constitutional spending caps, which would be the ideal approach.

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I have repeatedly warned that nations get in fiscal trouble when government is too big and growing too fast.

In such countries, it’s very common to find high levels of government debt as one of the symptoms of excessive spending.

This can create the conditions for a fiscal crisis, particularly during an economic downturn. Simply stated, investors (the people who buy government bonds) begin to worry that governments may renege on their promises (i.e., default).

There’s a must-read story on this issue in today’s Washington Post suggesting that the economic fallout from coronavirus has created conditions for new fiscal crises in nations across the globe.

Authored by Alexander VillegasAnthony Faiola Lesley Wroughton, the report explains that the downturn has produced record levels of debt.

Around the globe, the pandemic is racking up a mind-blowing bill: trillions of dollars in lost tax revenue, ramped-up spending and new borrowing set to burden the next generation with record levels of debt. In the direst cases — low- and middle-income countries, mostly in Africa and Latin America, that are already saddled with backbreaking debt — covering the rising costs is transforming into a high-stakes test of national solvency. …By the end of 2020, total government debt worldwide was projected to soar by $9 trillion and top 103 percent of global GDP, according to the Institute of International Finance — a historic jump of more than 10 percentage points in just one year. Countries have maxed out their figurative credit cards.

Keep in mind, by the way, that spending burdens were climbing in most nations, leading to more red ink, even before the pandemic.

That was true in developed nations (the U.S., Europe, Japan), but also in developing nations.

And, the story explains that developed nations are far more vulnerable to fiscal crisis.

The pandemic is hurtling heavily leveraged nations into an economic danger zone, threatening to bankrupt the worst-affected. Costa Rica, a country known for zip-lining tourists and American retirees, is scrambling to stave off a full-blown debt crisis, imposing emergency cuts and proposing harsher measures that touched off rare violent protests last fall. …Angola, in contrast, effectively shut out of global markets, is racing to strike a deal with the Chinese, but even that might not be enough to prevent a painful debt crisis. Sri Lanka, locked in recession, needs to make $4 billion in debt payments this year with only $6 billion in the bank. Brazil’s debt, worsened by a yawning budget deficit, has surged to a crippling 95 percent of GDP — raising alarm over the medium-term ability of the Latin American giant to stay afloat. …Zambia, once a shining example of Africa’s economic renaissance, is now the Ghost of Crises Future for debt-burdened countries slammed by the pandemic. The sub-Saharan nation fell into default in November.

Here’s a visual from the report.

To simplify, it’s good to be in a lighter-colored nation and bad to be in a darker-colored country. At least in terms of national debt burdens.

All this grim data understandably raises the very important question of what choices governments should now make.

Sadly, some self-styled experts are actually urging even more spending, mostly because of a dogmatic belief in the supposed elixir of Keynesian economics. In other words, they want governments to dig a deeper hole.

Analysts argue that the need for stimulus to keep economies running during this historically challenging period still outweighs the need to balance budgets. …the IMF…is telling countries that now is not the time to scrimp, lest they jeopardize still-fragile economic recoveries.

Politicians will want to follow that advice because it tells them that their vice (buying votes with other people’s money) is a virtue (more spending magically can boost growth).

In the real world, there are two big lessons we should learn.

  • First, it’s profoundly reckless to further increase tax and spending burdens when nations are already in trouble because of previous bouts of fiscal profligacy.
  • Second, countries should focus on spending restraint in both the short run and long run, ideally by enacting caps to limit annual spending increases.

For what it’s worth, the U.S. would be in great shape today if, back in 2000, lawmakers had adopted a Swiss-style spending cap.

P.S. One reason that spending caps work so well is that there’s built-in flexibility when dealing with economic volatility.

P.P.S. Financing government with the printing press won’t work any better than financing it with taxes and debt.

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At the risk of oversimplification and exaggeration, these six principles tell you everything you need to know about fiscal policy.

For purposes of today’s column, let’s focus on Principle #3, which is that “Deficits and debt are symptoms of the underlying problem” of excessive spending.

I’ve been making that point over and over and over and over and over again, but I feel motivated to address the issue again after reading two columns about government debt.

First, here’s some of what Paul Krugman wrote on the topic for his column in the New York Times.

…we’ve learned a lot about the economics of government debt over the past few years — enough so that Olivier Blanchard, the eminent former chief economist of the International Monetary Fund, is talking about a “shift in fiscal paradigm.” And the new paradigm suggests both that public debt isn’t a major problem and that government borrowing for the right purposes is actually the responsible thing to do. …It made some sense, nine or 10 years ago, to worry that the financial crisis in Greece was a harbinger of potential debt crises in other countries. …What briefly seemed like a spread of Greek-style problems across southern Europe turned out to be a temporary investor panic, quickly ended by a promise from the European Central Bank that it would lend money to cash-short governments if necessary. …We weren’t and aren’t anywhere close to that kind of crisis, and probably never will be. …But what about the longer term? …The important point for current discussion is that government borrowing costs are now very low and likely to stay low for a long time. …given what we’ve learned and where we are, it’s clear that the U.S. government should be investing heavily in the nation’s future, and that it’s OK, indeed desirable, to borrow the money we need to make those investments.

Second, Brian Riedl of the Manhattan Institute provides a different perspective in a column for today’s Washington Post, .

The election of Joe Biden to the presidency has prompted liberal calls to set aside pesky budget deficit concerns and go deeper into debt to finance large new spending initiatives… All these writers share the view that the persistence of low interest rates — currently about 1 percent for a 10-year Treasury bill — means the rules of the fiscal game have fundamentally changed. …But…deficit advocates must face two fundamental realities: First, the debt is already set to soar in the absence of any new spending. And second, these bloated debt levels will mean that any future rise in interest rates could bring a full-scale debt crisis. …Deficit doves are essentially gambling the future of the U.S. economy on the expectation that interest rates never again exceed 4 percent or 5 percent. …they are wrong to assume that state of affairs will continue. …Exceeding the projections by two or three points would mean annual interest costs consuming all projected tax revenue, leaving no taxes to finance normal federal programs. These debt spirals become nearly impossible to escape, as rising interest costs necessitate more borrowing, which in turn brings higher interest costs… Deficit doves would gamble America’s economic future on the hope that interest rates will never again top 4 or 5 percent. Are you feeling lucky?

At the risk of sounding like a muddle-headed, finger-in-the-wind moderate, I’m going to disagree with both of them (I’m like Goldilocks, who doesn’t want the porridge too hot or too cold).

I have a fundamental disagreement with Krugman because he’s overtly arguing for a bigger burden of government. Based on his past writings, he is willing to use higher taxes to finance some additional spending.

But the aforementioned column confirms that he’s in favor of a big amount of additional debt-financed spending as well.

He presumably wants to move the country into the lower-right quadrant of this 2×2 matrix, but doesn’t mind getting there by detouring through the lower-left quadrant.

My disagreement with Brian is probably more a matter of rhetoric. Based on his past writings, I think he wants to be in the upper-left quadrant, but he has an unfortunate tendency to fixate on the symptom of debt and deficits when he should be focusing on the underlying disease of excessive government spending.

My bottom line if that bigger government is a bad idea when it’s financed by debt, but it’s an equally bad idea if it’s financed by taxes.

Moreover, I worry when well-meaning people grouse about red ink because that creates an opening for not-so-well-meaning people to say, “I agree with you, so let’s raise taxes.”

P.S. In the real world of Washington (as opposed to blackboard theorizing), higher taxes lead to higher deficits and more debt.

P.P.S. Assuming they’re both sincere and guided by empiricism, people who care about red ink should support a spending cap.

P.P.P.S. Maintained for a sufficient period of time, spending restraint can even eliminate huge debt burdens.

 

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For a land-locked nation without many natural resources, Switzerland is remarkably successful.

One reason for the country’s success is pro-market policy. Switzerland routinely scores in the top 5 according to both Economic Freedom of the World and Index of Economic Freedom.

More specifically, I’m a big fan of the country’s fiscal policy, especially the “Debt Brake,” which was imposed when voters overwhelmingly adopted the provision (84.7 percent approval) early this century.

There’s always been a debate, however, whether Switzerland’s good outcomes are because of the debt brake, or because of some random reason, such as the sensibility of Swiss voters.

Three academic economists, Michele Salvi, Christoph Schaltegger, and Lukas Schmid, investigated this issue in a study for Kyklos, a scholarly journal published by the University of Basel.

A prominent means to prevent excess debt accumulation is the use of fiscal rules. In fact,fiscal rules focus on securing solvency of governments by concentrating on the intertemporal budget constraint. …there is a strong positive association between constrained fiscal discretion and improved fiscal performance. …Our paper presents evidence on the effect of a fiscal rule with a strict enforcement mechanism… We analyze the consequences of the centrally imposed balanced budget rule on public debt in Switzerland. …the Swiss debt containment rule stands out as a clearly defined fiscal rule with a constitutional basis that constrains deviating from a balanced budget in the long-term. …The rule consists of a simple mechanism stating that expenditure may not exceed revenues over the course of an economic cycle. …The debt containment rule brings a“top-down”element into the budgeting process, which has a strong disciplinary appeal and leads to more accurate budgeting. …one key aspect is the fact that the debt containment rule sets a clear expenditure ceiling.

The key parts from the above excerpt are “expenditure may not exceed” and “clear expenditure ceiling.”

Those statements ratify my oft-made point that the debt brake is really a spending cap. And spending caps are far and away the only effective macro-fiscal rule.

The policy certainly has generated good results for Switzerland. Here’s what the authors found when thy crunched numbers to compare the country’s current fiscal trajectory with what would have happened without a spending cap.

To construct the counterfactual outcome of the debt ratio for Switzerland without a debt containment rule, we select a control group…countries expected to be driven by a similar structural process as Switzerland. …Due to the availability of comprehensive debt data, the observation period is restricted to last from 1980 until 2010. …we divide the time period into a pre-treatment period from 1980 to 2002 and a postintervention period from 2003 to 2010. …Figure 2 displays the central government debt ratio for Switzerland and its synthetic counterpart during the study period. …In 2003, the two debt ratio curves start to diverge. …it appears that the introduction of the debt containment rule led to a substantial and persistent decrease in the debt ratio in Switzerland.

And here’s the relevant set of charts from the study.

Here’s one more sentence I want to cite since it echoes the argument I’ve made to my Keynesian friends about how they also should support a Swiss-style spending cap.

The debt containment rule has made a significant contribution to switching from a procyclical to a cyclically appropriate fiscal policy.

Simply stated, the political tradeoff embedded in the debt brake is that politicians get to modestly increase spending during a downturn, even though revenues are falling, but they also can only enact modest spending increases during growth years, even if revenue is growing much faster.

By the way, you will have noticed that the study focused on how the debt brake helped to reduce red ink.

Regular readers know that I’m far more interested in focusing on the real fiscal problem, which is excessive government spending.

So I’ll close by looking at some additional evidence from Switzerland. Here’s a chart, based on IMF data, showing that the growth rate of spending fell sharply after the debt brake was adopted.

I looked at the 2003-2010 period, since it matched the years in the study discussed above.

But I also calculated the spending growth rate for 2003-2019 and confirmed that the debt brake’s success hasn’t just been a temporary phenomenon.

P.S. Click here for a short presentation on the debt brake, as well as similar presentations on Hong Kong’s spending cap and Colorado’s TABOR spending cap.

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The Congressional Budget Office released it’s 2020 Long-Term Budget Outlook yesterday.

Almost everybody has focused on CBO’s projections for record levels of red ink. And it is worrisome that debt is heading to Greek/Japanese levels (especially if the folks who buy government bonds think American politicians are more like Greek politicians rather than Japanese politicians).

But what should really have us worried, both in the short run and the long run, is that the burden of government spending is on an upward trajectory.

CBO has some charts showing that federal government spending will consume more than 30 percent of GDP by 2050, assuming the budget is left on autopilot.

But I dug into CBO’s database and created my own chart because I think it does a much better job of illustrating our problem.

As you can see, the problem is that government spending is projected to grow too fast, violating the Golden Rule of fiscal policy.

The solution to this problem is very simple.

We need spending restraint, ideally enforced by some sort of spending cap.

And if we control the growth of spending (preferably so that it grows no more than the rate of inflation), the projections for ever-rising levels of red ink will disappear.

In other words, you can get rid of symptoms (red ink) when you cure the underlying disease (big government).

P.S. Given all the profligacy over the past year, you won’t be surprised to learn that this year’s long-run forecast from CBO is more depressing than last year’s forecast.

P.P.S. While the solution is simple, it’s not easy. Restraining the growth of spending – especially in the long run – will require entitlement reforms, especially for Medicare and Medicaid.

P.P.P.S. Tax increases almost certainly would make a bad situation even worse by weakening the economy and encouraging more spending.

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There are two reasons why I generally don’t write much about government debt.

  • First, red ink is not desirable, but it’s mostly just the symptom of the far more important problem of excessive government spending.
  • Second, our friends on the left periodically try to push through big tax increases by hypocritically exploiting anxiety about red ink.

The one thing I can state with full certainty, however, is that tax increases are guaranteed to make a bad situation worse.

We’ll get a weaker economy (perhaps much weaker since the left is now fixated on pushing for the kinds of tax increases that do the most damage).

Equally worrisome, the biggest impact of a tax increase is that politicians won’t feel any need to control spending or reform entitlements. Indeed, it’s quite likely that they’ll respond to the expectation of higher revenue by increasing the spending burden.

To complicate matters further, any tax increase probably won’t generate that much additional revenue because of the Laffer Curve.

All of which explains why budget deals that include tax increases usually lead to even higher budget deficits.

This analysis is very timely and relevant since advocates of bigger government somehow claim that the new fiscal forecast from the Congressional Budget Office is proof that we need new taxes.

So I’m doing the same thing today I did back in January (and last August, and in January 2019, and many times before that starting back in 2010). I’ve crunched the numbers to see what sort of policies would be needed to balance the budget without tax increases.

Lo and behold, you can see from this chart that we wouldn’t need draconian spending cuts. All that’s needed for fiscal balance is to limit spending so that it grows slightly less than 1 percent per year (and this analysis even assumes that they get to wait until 2022 before imposing a cap on annual spending increases).

To be sure, politicians would not want to live with that kind of limit on their spending. So I’m not optimistic that we’ll get this type of policy in the near future.

Especially since the major parties are giving voters a choice between big-spender Trump and big-spender Biden.

But the last thing that we should do is worsen the nation’s fiscal outlook by acquiescing to higher taxes.

P.S. It’s worth noting that there was a five-year nominal spending freeze between 2009 and 2014 (back when the Tea Party was influential), so it is possible to achieve multi-year spending restraint in Washington.

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Yesterday, the Congressional Budget Office released updated budget projections. The most important numbers in that report show what’s happening with the overall fiscal burden of government – measured by both taxes and spending.

As you can see, there’s a big one-time spike in coronavirus-related spending this year. That’s not good news, but more worrisome is the the longer-run trend of government spending gradually climbing as a share of economic output (and the numbers are significantly worse if you look at CBO’s 30-year projection).

Most reporters and fiscal wonks overlooked the spending data, however, and instead focused on the CBO’s projection for government debt.

Since government spending is the problem and borrowing is merely a symptom of that problem, I think it’s a mistake to fixate on red ink.

That being said, Figure 3 from the CBO report shows that there’s also an upward-spike in federal debt.

And it is true (remember Greece) that high levels of debt can, by themselves, produce a crisis. This happens when investors suddenly stop buying government bonds because they think there’s a risk of default (which happens when a government is incapable or unwilling to make promised payments to lenders).

I think some nations are on the verge of having that kind of crisis, most notably Italy.

But what about the United States? Or Japan? And how’s the outlook for Europe’s welfare states?

In other words, what nations are approaching a tipping point?

A new study from the European Central Bank may help answer these questions. Authored by Pablo Burriel, Cristina Checherita-Westphal, Pascal Jacquinot, Matthias Schön, and Nikolai Stähler, it uses several economic models to measure the downside risks of excessive debt.

The 2009 global financial and economic crisis left a legacy of historically high levels of public debt in advanced economies, at a scale unseen during modern peace time. …The coronavirus (COVID-19) pandemic is a different type of shock that has dramatically affected global economic activity… Fiscal positions are projected to be strongly hit by the crisis…once the crisis is over and the recovery firmly sets in, keeping public debt at high levels over the medium term is a source of vulnerability… The main objective of this paper is to contribute to the stabilisation vs. sustainability debate in the euro area by reviewing through the lens of large scale DSGE models the economic risks associated with regimes of high public debt.

Here’s what they found, none of which should be a surprise.

…we evaluate the economic consequences of high public debt using simulations with three DSGE models… Our DSGE simulations also suggest that high-debt economies…can lose more output in a crisis…have less scope for counter-cyclical fiscal policy and…are adversely affected in terms of potential (long-term) output, with a significant impairment in case of large sovereign risk premia reaction and use of most distortionary type of taxation to finance the additional public debt burden in the future.

Here’s a useful chart from the study. It shows some sort of shock on the left (2008 financial crisis or coronavirus being obvious examples), which then produces a recession (lower GDP) and rising debt.

That outcome isn’t good for nations with “low” levels of debt, but it can be really bad for nations with “high” debt burdens because they have to deal with much higher interest payments, much bigger tax increases, and much bigger reductions in economic output.

For what it’s worth, I don’t think the study actually gives us any way of determining which nations are near the tipping point. That’s because “low” and “high” are subjective. Japan has an enormous amount of debt, yet investors don’t think there’s any meaningful risk that Japan’s government will default, so it is a “low” debt nation for purposes of the above illustration.

By contrast, there’s a much lower level of debt in Argentina, but investors have almost no trust in that nation’s especially venal politicians, so it’s a “high” debt nation for purposes of this analysis.

The United States, in my humble opinion, is more like Japan. As I wrote last year, “We probably won’t even have a crisis in the next 10 years or 20 years.” And that’s still my view, even after all the spending and debt for coronavirus.

The study concludes with some common-sense advice about using spending restraint and pro-market reforms to create buffers (some people refer to this as “fiscal space“).

Overall, once the COVID-19 crisis is over and the economic recovery firmly re-established, further efforts to build fiscal buffers in good times and mitigate fiscal risks over the medium term are needed at the national level. Such efforts should be guided by risks to debt sustainability. High debt countries, in particular, should implement a mix of fiscal discipline and wide-ranging growth-enhancing reforms.

Needless to say, there’s an obvious and successful way of achieving this goal.

P.S. Here’s another chart from the ECB study that is worth sharing because it confirms that not all tax increases do the same amount of economic damage.

We see that consumption taxes (red line) are bad, but income taxes on workers (green line) are even worse.

And if the study included an estimate of what would happen if there were higher income taxes on saving and investment, there would be another line showing even more economic damage.

P.P.S. History shows that nations can reduce very large debt burdens if they follow my Golden Rule.

P.P.P.S. There’s a related study from the IMF that shows how excessive spending is a major warning sign that nations will be vulnerable to fiscal crisis.

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Last week, I shared some data showing how the economy enjoyed a strong recovery from recession in the early 1920s when President Warren Harding cut government spending.

(And these were genuine cuts, not the nonsense we get from today’s politicians, who claim they’ve cut spending simply because the budget increases by 5 percent rather than 7 percent.)

What happened nearly 100 years ago is very relevant today since we still have advocates of Keynesian economics who claim that more spending (especially debt-financed spending) is a recipe for more growth.

To show why this view is misguided, let’s now look at what happened in the 1940s after World War II came to an end.

In a column for today’s Wall Street Journal, Professor Richard Vedder explains that the Keynesians predicted economic disaster because of big reductions in government spending.

…many Americans assumed the end of the war would mean a resumption of the Depression, which was cut off by the World War II military buildup. In the middle of the fighting, America’s leading Keynesian economist, Alvin Hansen of Harvard, said: “When the war is over, the government cannot just disband the Army, close down munitions factories, stop building ships, and remove economic controls.” …When the sudden end of combat became apparent in late August 1945, economist Everett Hagen predicted that the unemployment rate in the first quarter of 1946 would be 14.8%.

So what actually happened?

Vedder points out that the Keynesian predictions of massive unemployment were wildly inaccurate.

Millions of military personnel did become jobless within months and defense spending plummeted, putting more out of work. In June 1946 federal employment was almost precisely 10 million less than a year earlier. Yet the sharp rise in overall unemployment didn’t occur. The total unemployment rate for 1946 was 3.9%… Perhaps most interesting for today, all this occurred as the U.S. moved from an extremely expansionary fiscal policy—with budget deficits equal to almost 25% of gross domestic product in 1944 (the equivalent of more than $5 trillion today)—to an extremely contractionary one. The U.S. by 1947 was running a budget surplus exceeding 5% of output—the equivalent of more than $1 trillion today. …This was the complete reverse of the expectation of the newly dominant Keynesian economists.

In the following chart, you can see the numbers from the Office of Management and Budget’s Historical Tables (Table 1.2), which show that fiscal policy between 1945 and 1948 was very contractionary, at least as defined by the Keynesians.

There definitely were huge spending cuts (the real kind, not the fake kind) during those years, and big deficits also became big surpluses.

Professor Vedder’s column explained that this anti-Keynesian policy didn’t produce mass unemployment.

But what about economic growth?

Well, you’ll see in the chart below the data from the Bureau of Economic Analysis for the 1945-48 period. There was a recession in 1946, which could be interpreted as evidence for Keynesianism.

But then look what happened in the next couple of years. There were more budget cuts, deficits became surpluses, and the economy enjoyed a strong rebound.

According to Keynesian theory, these two charts can’t exist. There can’t be an economic recovery when spending and deficits are falling.

Yet that’s exactly what happened after World War II (just as it happened under Harding, as Thomas Sowell observed).

Maybe, just maybe, Keynesianism is simply wrong. Maybe it’s nothing more than the economic version of a perpetual motion machine?

P.S. It’s also worth noting that huge increases in spending and debt under Hoover and Roosevelt didn’t produce good results in the 1930s.

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Because of changing demographics and poorly designed entitlement programs, the burden of government spending in the United States (in the absence of genuine reform) is going to increase dramatically over the next few decades.

That bad outlook will get even worse thanks to all the coronavirus-related spending from Washington.

This is bad news for America since more of the economy’s output will be consumed by government, leaving fewer resources for the private sector. And that problem would exist even if all the spending was magically offset by trillions of dollars of unexpected tax revenue.

Many people, however, think the nation’s future fiscal problem is that politicians will borrow to finance  that new spending. I think that’s a mistaken view, since it focuses on a symptom (red ink) rather than the underlying disease (excessive spending).

But regardless of one’s views on that issue, fiscal policy is on an unsustainable path. And that means there will soon be a fight between twho different ways of addressing the nation’s grim fiscal outlook.

  • Restrain the growth of government spending.
  • Divert more money from taxpayers to the IRS.

Fortunately, we now have some new evidence to help guide policy.

A new study from the Mercatus Center, authored by Veronique de Rugy and Jack Salmon, examines what actually happens when politicians try to control debt with spending restraint or tax increases.

Here’s what the authors wanted to investigate.

Fiscal consolidation can take two forms: (1) adopting a debt-reduction package driven primarily by tax increases or (2) adopting a package mostly consisting of spending restraint. …What policymakers might not know is which of these two forms of consolidation tend to be more effective at reining in debt levels and which are less harmful to economic performance: tax-based (TB) fiscal consolidation or expenditure-based (EB) fiscal consolidation.

Here’s their methodology.

Our analysis focuses on large fiscal consolidations, or consolidations in which the fiscal deficit as a share of GDP improves by at least 1.5 percentage points over two years and does not decrease in either of those two years. …A successful consolidation is defined as one in which the debt-to-GDP ratio declines by at least 5 percentage points three years after the adjustment takes places or by at least 3 percentage points two years after the adjustment. …Episodes in which the consolidation is at least 60 percent revenue increases are labeled TB, and episodes in which the consolidation is at least 60 percent spending decreases are labeled EB.

And here are their results.

…of the 45 EB episodes, more than half were successful, while of the 67 TB episodes, less than 4 in 10 were successful. …The results in table 2 show that while in unsuccessful adjustments most (74 percent) of the changes are on the revenue side, in successful adjustments most (60 percent) of the changes are on the expenditure side. In successful adjustments, for every 1.00 percent of GDP increase in revenues, expenditures are cut by 1.50 percent. By contrast, in unsuccessful adjustments, for every 1.00 percent of GDP increase in revenues, expenditures are cut by less than 0.35 percent. From these findings we conclude that successful fiscal adjustments are those that involve significant spending reductions with only modest increases in taxation. Unsuccessful fiscal adjustments, however, typically involve significant increases in taxation and very modest spending reductions.

Table 2 summarizes the findings.

As you can see, tax increases are the least effective way of dealing with the problem. Which makes sense when you realize that the nation’s fiscal problem is too much spending, not inadequate revenue.

In my not-so-humble opinion, I think the table I prepared back in 2014 is even more compelling.

Based on IMF data, it shows nations that imposed mutli-year spending restraint and how that fiscally prudent policy generated very good results – both in terms of reducing the spending burden and lowering red ink.

When I do debates at conferences with my left-wing friends, I almost always ask them to show me a similar table of countries that achieved good results with tax increases.

Needless to say, none of them have ever even attempted to prepare such a list.

That’s because nations that repeatedly raise taxes – as we’ve seen in Europe – wind up with more spending and more debt.

In other words, politicians pull a bait-and-switch. They claim more revenue is needed to reduce debt, but they use any additional money to buy votes.

Which is why advocates of good fiscal policy should adamantly oppose any and all tax increases.

Let’s close by looking at two more charts from the Mercatus study.

Here’s a look at how Irish politicians have mostly chose to restrain spending.

And here’s a look at how Greek politicians have mostly opted for tax increases.

It goes without saying (but I’ll say it anyhow) that the Greek approach has been very unsuccessful.

P.S. For fiscal wonks, one of the best parts of the Mercatus study is that it cites a lot of academic research on the issue of fiscal consolidation.

Scholars who have conducted research find – over and over again – that spending restraint works.

In a 1995 working paper, Alberto Alesina and Roberto Perotti observe 52 efforts to reduce debt in 20 Organisation for Economic Co-operation and Development (OECD) countries between 1960 and 1992. The authors define a successful fiscal adjustment as one in which the debt-to-GDP ratio declines by at least 5 percentage points three years after the adjustment takes place. In successful adjustments, government spending is reduced by almost 2.2 percent of gross national product (GNP) and taxes are increased by less than 0.5 percent of GNP. For unsuccessful adjustments, government expenditure is reduced by less than 0.5 percent of GNP and taxes are increased by almost 1.3 percent of GNP. These results suggest that successful fiscal adjustments are those that cut spending and include very modest increases in taxation.

International Monetary Fund (IMF) economists John McDermott and Robert Wescott, in a 1996 paper, examine 74 episodes of fiscal adjustment in which countries attempted to address their budget gaps. The authors define a successful fiscal adjustment as a reduction of at least 3 percentage points in the ratio of gross public debt to GDP by the second year after the end of an adjustment. The authors then divide episodes of fiscal consolidation into two categories: those in which the deficit was cut primarily (by at least 60 percent) through revenue increases, and those in which it was reduced primarily (by at least 60 percent) through expenditure cuts. Of the expenditure-based episodes of fiscal consolidation, almost half were successful, while of the tax-based episodes, less than one out of six met the criteria for success.

Jürgen von Hagen and Rolf Strauch observe 65 episodes in 20 OECD countries from 1960 to 1998 and define a successful adjustment as one in which the budget balance stands at no more than 75 percent of the initial balance two years after the adjustment period. …it does find that successful consolidations consist of expenditure cuts averaging more than 1.2 percent of GDP, while expenditure cuts in unsuccessful adjustments are smaller than 0.3 percent of GDP. The opposite pattern is true for revenue-based adjustments: successful consolidations consist of increases in revenue averaging around 1.1 percent, while unsuccessful adjustments consist of revenue increases exceeding 1.9 percent.

American Enterprise Institute economists Andrew Biggs, Kevin Hassett, and Matthew Jensen examine over 100 episodes of fiscal consolidation in a 2010 study. The authors define a successful fiscal adjustment as one in which the debt-to-GDP ratio declines by at least 4.5 percentage points three years after the first year of consolidation. Their study finds that countries that addressed their budget shortfalls through reduced spending burdens were far more likely to reduce their debt than countries whose budget-balancing strategies depended upon higher taxes. …the typical successful adjustment consists of 85 percent spending cuts and just 15 percent tax increases.

In a 1998 Brookings Institution paper, Alberto Alesina and coauthors reexamined the research on the economic effects of fiscal adjustments. Using data drawn from 19 OECD countries, the authors assess whether the composition of fiscal adjustments results in different economic outcomes… Contrary to the Keynesian view that fiscal adjustments are contractionary, the results of this study suggest that consolidation achieved primarily through spending reductions often has expansionary effects.

Another study that observes which features of fiscal adjustments are more or less likely to predict whether the fiscal adjustment is contractionary or expansionary is by Alesina and Silvia Ardagna. Using data from 20 OECD countries during 1960 to 1994, the authors label an adjustment expansionary if the average GDP growth rate in the period of adjustment and in the two years after is greater than the average value (of G7 countries) in all episodes of adjustment. …The authors conclude, “The composition of the adjustment appears as the strongest predictor of the growth effect: all the non-expansionary adjustments were tax-based and all the expansionary ones were expenditure-based.”

French economists Boris Cournède and Frédéric Gonand adopt a dynamic general equilibrium model to compare the macroeconomic impacts of four debt reduction scenarios. Results from the model suggest that TB adjustments are much more costly than spending restraint when policymakers are attempting to achieve fiscal sustainability. Annual consumption per capita would be 15 percent higher in 2050 if consolidation were achieved through spending reductions rather than broad tax increases.

In a review of every major fiscal adjustment in the OECD since 1975, Bank of England economist Ben Broadbent and Goldman Sachs economist Kevin Daly found that “decisive budgetary adjustments that have focused on reducing government expenditure have (i) been successful in correcting fiscal imbalances; (ii) typically boosted growth; and (iii) resulted in significant bond and equity market outperformance. Tax-driven fiscal adjustments, by contrast, typically fail to correct fiscal imbalances and are damaging for growth.”

Economists Christina and David Romer investigated the impact of tax changes on economic activity in the United States from 1945 to 2007. The authors find that an exogenous tax increase of 1 percent of GDP lowers real GDP by almost 3 percent, suggesting that TB adjustments are highly contractionary.

…the IMF released its annual World Economic Outlook in 2010 and included a study on the effects of fiscal consolidation on economic activity. The results of studying episodes of fiscal consolidation for 15 OECD countries over three decades…reveals that EB fiscal adjustments tend to have smaller contractionary effects than TB adjustments. For TB adjustments, the effect of a consolidation of 1 percent of GDP on GDP is −1.3 percent after two years, while for EB adjustments the effect is just −0.3 percent after two years and is not statistically significant. Interestingly, TB adjustments also raise unemployment levels by about 0.6 percentage points, while EB adjustments raise the unemployment rate by only 0.2 percentage points.

…a 2014 IMF study…estimates the short-term effect of fiscal consolidation on economic activity among 17 OECD countries. The authors of the IMF study find that the fall in GDP associated with EB consolidations is 0.82 percentage points smaller than the one associated with TB adjustments in the first year and 2.31 percentage points smaller in the second year after the adjustment.

Focusing on the fiscal consolidations that followed the Great Recession, Alesina and coauthors…find that EB consolidations are far less costly for economic output than TB adjustments. They also find that TB adjustments result in a cumulative contraction of 2 percent of GDP in the following three years, while EB adjustments generate very small contractions with an impact on output not significantly different from zero.

A study by the European Central Bank in 2018…finds that macroeconomic responses are largely caused by differences in the composition of the adjustment plans. The authors find large and negative multipliers for TB adjustment plans and positive, but close to zero, multipliers for EB plans. The composition of adjustment plans is found to be the largest contributor to the differences in economic performance under the two types of consolidation plans.

The bottom line is that nations enjoy success when they obey fiscal policy’s Golden Rule. Sadly, that doesn’t happen very often because politicians focus mostly on buying votes in the short run rather than increasing national prosperity in the long run.

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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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Motivated in part by a sensible desire for free trade, six nations from Western Europe signed the Treaty of Rome in 1957, thus creating the European Economic Community (EEC). Sort of a European version of the North American Free Trade Agreement (now known as USMCA).

Some supporters of the EEC also were motivated by a desire for some form of political unification and their efforts eventually led to the 1992 Maastricht Treaty, which created the European Union – along with increased powers for a Brussels-based bureaucracy (the European Commission).

There are significant reasons to think that this evolution – from a Europe based on free trade and mutual recognition to a Europe based on supranational governance – was an unfortunate development.

Back in 2015, I warned that this system would “morph over time into a transfer union. And that means more handouts, more subsidies, more harmonization, more bailouts, more centralization, and more bureaucracy.”

A few years earlier, when many of Europe’s welfare states were dealing with a fiscal crisis, I specifically explained why it would be a very bad idea to have “eurobonds,” which would mean – for all intents and purposes – that reasonably well governed nations such as Germany and Sweden would be co-signing loans for poorly governed countries such as Italy and Greece.

Well, this bad idea has resurfaced. Politicians from several European nations are using the coronavirus as an excuse (“never let a crisis go to waste“) to push for a so-called common debt instrument.

Here are the relevant parts of the letter.

…we need to work on a common debt instrument issued by a European institution to raise funds on the market on the same basis and to the benefits of all Member States, thus ensuring stable long term financing… The case for such a common instrument is strong, since we are all facing a symmetric external shock, for which no country bears responsibility, but whose negative consequences are endured by all. And we are collectively accountable for an effective and united European response. This common debt instrument should have sufficient size and long maturity to be fully efficient… The funds collected will be targeted to finance in all Member States the necessary investments in the healthcare system and temporary policies to protect our economies and social model.

Lots of aspirational language, of course, but no flowery words change the fact that “collectively accountable” means European-wide debt and “social model” means welfare state.

I wrote last year that globalization is good whereas global governance is bad. Well, this is the European version.

The Wall Street Journal opined against the concept. Here’s some background information.

Bad crises tend to produce worse policy… We speak of proposals for “corona bonds,” an idea floated as a fiscal solution to Europe’s deepening pandemic. Italian Prime Minister Giuseppe Conte launched the effort, and French President Emmanuel Macron this week joined Mr. Conte and seven other leaders in backing such a bond issue for health-care expenditures and economic recovery. Some 400 economists have joined the chorus. …The bonds would be backed collectively by member governments. The proceeds could be allocated to members such as Italy that otherwise couldn’t borrow from private markets. …Calls for euro bonds last hit a crescendo during the debt crises of 2010-12, when they were pitched to fund bailouts of Greece and others. But the idea has never gone anywhere because it would transform the eurozone into something voters didn’t approve when the currency was created in the 1990s.

And here’s the editorial’s explanation of why eurobonds would be a very bad idea.

Europeans were promised the euro would not become an excuse or vehicle for large fiscal transfers between member states. …Proponents say corona bonds are a special case due to the unfolding economic emergency. But the Italian government that now can’t finance its own recovery was also one of the worst fiscal offenders before Covid-19… Claims that the corona bond would be temporary aren’t credible because European elites have wanted such a facility for years… Voters can assume that if they get these bonds in a crisis, they’ll be stuck with this facility forever. …euro bonds would create profound governance problems. …With corona bonds, German and Dutch taxpayers for the first time are being asked to write a blank check to Italy and perhaps others.

Amen.

Once the camel’s nose is under the tent, it would simply be a matter of time before eurobonds would become a vehicle for bigger government in general and more country-to-country transfers in particular.

Hopefully this terrible idea will be blocked by nations such as Germany, Sweden, and the Netherlands (this satirical video will give you an idea of the tension between the European nations that foot the bills and the ones looking for handouts).

Some advocates for eurobonds say there’s nothing to worry about since the European Commission and related pan-European bureaucracies currently don’t spend much money, at least when measured as a share of overall economic output.

Which is why I sometimes warn my European friends that the United States is an example of why they should be vigilant.

For much of American history, the central government in Washington was very small, as envisioned by the Founders. But beginning with the so-called Progressive Era and then dramatically accelerating under the failed policies of Hoover and Roosevelt, the federal government has expanded dramatically in both size and scope.

The lesson to be learned is that more centralization is a very bad idea, particularly if that centralized form of government gains fiscal power.

That’s especially true for Europe since the burden of government spending at the national level already is excessive. Eurobonds would exacerbate the damage by creating a new European-wide method of spending money.

P.S. While eurobonds are a very bad idea, it would be even worse (akin to the U.S. approving the 16th Amendment) if the European Union somehow got the authority to directly impose taxes.

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I’m not an optimist about Europe’s economic future.

Most nations have excessive welfare states and punitive taxes, which is hardly good news. You then have to consider demographic trends such as aging populations (i.e., more people relying on government) and falling birthrates (i.e., fewer future taxpayers).

That’s a very grim combination.

Indeed, this is a big reason why I favored Brexit. Yes, it was largely about escaping an increasingly dirigiste European bureaucracy in Brussels, but it was also about not being chained to a continent with a dismal long-run outlook.

More than one year ago, before there were any concerns about a coronavirus-instigated economic crisis, Vijay Victor, an economist from Szent Istvan University in Hungary, expressed concern about Europe’s fiscal future in a column for the Foundation for Economic Education.

The debt crisis in the Eurozone is getting no better, even in the wake of the new year. The five countries in the Eurozone with the highest debt-to-GDP ratio in the third quarter of 2018 were Greece, Italy, Portugal, Belgium, and Spain. The total debt of Greece is around 182.2 percent of its GDP and that of Italy is 133 percent… Dawdling economic growth coupled with low-yield investment options are dragging these indebted economies toward insolvency… Unemployment rates, for example, are still very high in most of these highly indebted European economies. Despite the recurrent monetary assistance and policy support, job creation is weak, which might imply that the debt financing is channelized in a nonproductive direction.

By the way, I can’t resist taking this opportunity to remind people that debt is a problem, but it also should be viewed as a symptom of en even-bigger problem, which is an excessive burden of government spending.

A bloated welfare state is a drag on economic performance, whether it’s financed by borrowing or taxes.

Though nations that try to finance big government with red ink eventually spend their way into crisis (as defined by potential default).

And we may be reaching that point.

Desmond Lachman of the American Enterprise has authored a very grim assessment, focusing primarily on Italy, for the National Interest.

Today, with Italy at the epicenter of the world coronavirus epidemic, it would seem to be only a matter of time before the durability of the Euro is again tested by another full-blown Italian sovereign debt crisis. …even before the coronavirus epidemic struck its economy was weak while its public finances and banking system were in a state of poor health. After having experienced virtually no economic growth over the past decade, the Italian economy again entered into a recession by end-2019. At the same time, at 135 percent its public debt to GDP ratio was higher than it was in 2012 while its banks’ balance sheets remained clogged with non-performing loans and Italian government bonds. …the coronavirus epidemic will seriously damage both Italy’s public finances and its banking system…by throwing the country into its deepest economic recession in the post-war period. That in turn is bound to cause Italy’s budget deficit to balloon and its banking system’s non-performing loans to skyrocket as more of its households and companies file for bankruptcy. …all too likely that the Italian economy will shrink by at least 10 percent in 2020.

All this matters because the people and institutions that purchase government debt may decide that Italy’s outlook is so grim that they will be very reluctant to buy the country’s bonds (i.e., they’ll be very hesitant about lending money to the Italian government because of a concern that they won’t get paid back).

This means that the Italian government will have to pay much higher interest rates in order to compensate lenders for the risk of a potential default.

So what are the implications? Will Italy default, or will there be some sort of bailout?

If the latter, Lachman predicts it will be huge.

One way to gauge the amount of public money that might be needed to prop up Italy is to consider that over the past decade it took around US$300 billion in official support to keep Greece in the Euro. Given that the Italian economy is around ten times the size of that of Greece, this would suggest that Italy might very well need around $3 trillion in official support to keep Italy in the Euro. …Meanwhile, Italy’s US$4 trillion banking system could very well need at least US$1 trillion in official support to counter the capital flight and the spike in non-performing loans that are all too likely to occur in the event of a deep Italian recession.

For what it’s worth, Lachman thinks a bailout would be desirable.

I disagree. Default is a better choice because it will discipline the Italian government (it would mean an overnight balanced budget requirement since nobody will lend money to the government) and also discipline foolish lenders who thought Italian politicians were a good bet.

Simply stated, we should minimize moral hazard.

I also think it’s worth noting that Italy isn’t the only government at risk of fiscal crisis. Here’s the OECD data for major nations, including a few non-European examples.

Japan wins the prize for the most red ink, though this doesn’t mean Japan is most vulnerable to a default, at least in the short run.

A fiscal crisis is driven by investor sentiment (i.e., when will people and institutions decide they no longer trust a government to pay back loans). And that depends on a range of factors, including trust.

The bottom line is that investors trust the Japanese government and they don’t trust the Italian government.

That being said, I think all of the PIGS (Portugal, Italy, Greece, and Spain) are very vulnerable.

And politicians in Ireland, Belgium, and France should be nervous as well.

I’ll close by sharing some calculations, based on the aforementioned OECD data, showing which nations used last decade’s economic recovery to improve their balance sheets.

Congratulations to Germany and Switzerland for fiscal responsibility, and mild applause for the Netherlands and Sweden.

I’ve highlighted (in red) the nations that were most reckless.

Though keep in mind that you want to look at both the trend for debt (far-right column) and the existing level of debt (the next-to-far-right column). So I’m not overly worried about Australia. Debt is still comparatively low, even though it almost doubled last decade.

But all of the PIGS are in trouble.

So if economic conditions deteriorate in Europe, the fallout could be significant.

P.S. The United Kingdom, like Japan, benefits from a high level of trust – presumably in part because the country paid off enormous debts from the Napoleonic wars and World War II. That being said, the numbers for the U.K. are worrisome, which hopefully will lead to a renewed commitment to spending restraint by Boris Johnson’s government.

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There will be many lessons that we hopefully learn from the current crisis, most notably that it’s foolish to give so much regulatory power to sloth-like bureaucracies such as the FDA and CDC.

Today, I want to focus on a longer-run lesson, which is how tax policy (a bias for debt over equity) and monetary policy (artificially low interest rates) encourage excessive private debt.

Are current debt levels excessive? Let’s look at some excerpts from a column in the Washington Post, which was written by David Lynch last November – before coronavirus started wreaking havoc with the economy.

Little more than a decade after consumers binged on inexpensive mortgages that helped bring on a global financial crisis, a new debt surge — this time by major corporations — threatens to unleash fresh turmoil. A decade of historically low interest rates has allowed companies to sell record amounts of bonds to investors, sending total U.S. corporate debt to nearly $10 trillion… Some of America’s best-known companies…have splurged on borrowed cash. This year, the weakest firms have accounted for most of the growth and are increasingly using debt for “financial risk-taking,”… “We are sitting on the top of an unexploded bomb, and we really don’t know what will trigger the explosion,” said Emre Tiftik, a debt specialist at the Institute of International Finance, an industry association. …The root cause of the debt boom is the decision by the Federal Reserve and other key central banks to cut interest rates to zero in the wake of the financial crisis and to hold them at historic lows for years.

Needless to say, Emre Tiftik didn’t know last November what would “trigger the explosion.”

Now we have coronavirus, and George Melloan explained a few days ago in the Wall Street Journal that the “unexploded bomb” has detonated.

The Covid-19 pandemic…will do further damage to the global economy… The danger is heightened by the heavy load of debt American corporations have piled up as they have taken advantage of low-cost borrowing. …Cheap credit brought on the heavy overload of corporate debt. The Federal Reserve has responded to the virus by—what else?—making credit even cheaper, cutting its fed funds lending rate all the way to 0%-0.25% on Sunday. …Rate cuts in response to crises are programmed into the Fed’s software. There is no compelling evidence that they are a solution or even a remedy. …the low interest rates of the past decade have ballooned all forms of debt: government, consumer, corporate. Corporate debt, the most worrisome type at the moment, stands at about $10 trillion and has made a steady climb to 47% of gross domestic product, a record level… But even cheap borrowing and securitized debt obligations have to be paid back. It becomes harder to make payments when a global health crisis is killing sales and your company is bleeding red ink. …the increased political bias toward easy money remains a problem. The Federal Reserve Act of 1913 was political from the day Woodrow Wilson signed it. It has gotten more political ever since, increasingly becoming an instrument for robbing the poor—savers and pensioners—and giving to often profligate borrowers.

Melloan’s final points deserve emphasis. There are good reasons to reconsider the Federal Reserve, and we definitely should be angry about the perverse redistribution enabled by Fed policies.

But let’s keep our focus on the topic of government-encouraged debt and how it contributes to economic instability.

It’s not just an issue of bad monetary policy. We also have a tax code that encourages companies to disproportionately utilize debt.

But the 2017 tax bill addressed that flaw, as Reihan Salam explained two years ago in an article for National Review.

…one of the TCJA’s good points…limits that the legislation places on corporate interest deductibility, which…could change the way companies in the United States do business and make the U.S. economy more stable. …By stipulating that companies cannot use the interest deduction to reduce their earnings by more than 30 percent, the law made taking on debt somewhat less attractive compared to seeking financing by offering equity to investors. …equity is more flexible in times of crisis than debt, which means that problems are less likely to spiral out of control.

That’s the good news (along with the lower corporate rate and restriction on deductibility of state and local taxes).

The bad news is that the 2017 law only partially addressed the bias for debt over equity. Companies still have a tax-driven incentive to prefer borrowing.

Here’s the Tax Foundation’s depiction of how the pre-TCJA system worked, which I’ve altered to show how the new system operates.

I’ll close with the observation that there’s nothing necessarily wrong with private debt. Families borrow to buy homes, for instance, and companies borrow for reasons such as financing research and building factories.

But debt only makes sense if it’s based on market-driven factors (i.e., will borrowing enable future benefits and will there be enough cash to make payments). And that includes planning for what happens if there’s a recession and income falls.

Unfortunately, government intervention has distorted market signals and the result is excessive debt. And now the economic damage of the coronavirus will be even higher because more companies will become insolvent.

P.S. Even the International Monetary Fund is on the correct side about the downsides of tax-driven debt.

P.P.S. In addition to eliminating the bias for debt over equity, it also would be a very good idea to get rid of the bias for current consumption over future consumption (i.e., double taxation).

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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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One of the few theoretical constraints on Washington is that politicians periodically have to raise a “debt ceiling” or “debt limit” in order to finance additional spending with additional red ink.

I have mixed feelings about this requirement. I like that there is some limit on spending, even if it’s only a potential restraint.

On the other hand, fights over the debt limit are mostly just opportunities for Republicans and Democrats to engage in posturing and finger pointing rather than adopt positive reforms.

Moreover, the scholarly research clearly suggests that spending caps are the only effective fiscal rule, so what’s the point of having a debt limit if potential spending restraint never turns into actual spending restraint?

Catherine Rampell of the Washington Post looks at the current fight and opines that we shouldn’t even have a debt limit.

The government is about to run out of money because of an arbitrary cap on how much it can borrow… Lawmakers and the White House are haggling over  the conditions under which they will, once again, temporarily raise that cap, known as the debt ceiling. But the better solution would be to abolish it entirely… Most recently, the government hit the official debt limit on March 1 . Since then, the Treasury Department has engaged in “extraordinary measures” to shift money around and continue paying its bills… Initially Treasury predicted that its extraordinary measures would get us to October, but more recent forecasts suggest we will hit the wall as soon as early September. Which means the drop-dead deadline before we become global deadbeats could happen while Congress is away on summer vacation.

She worries that a failure to raise the debt ceiling could have very negative consequences.

So what happens if we default on our debt obligations? Well, for one, it would violate the Constitution, which says the “validity of the public debt of the United States . . . shall not be questioned.” No small thing. …U.S. debt instruments are currently considered the safest of safe assets because creditors believe they’ll be paid back on time and in full. …Calling our creditworthiness into question could therefore set off a chain reaction of global financial panic.

I agree.

Defaulting on the debt (i.e., not paying bondholders what they’ve been contractually promised) would be very damaging to financial markets.

In reality, however, what we’re really talking about is potentially a delay in making promised payments. Which would be harmful, though presumably not nearly as bad as long-run default.

And even a delay in payments might not happen if the Treasury Department made sure that tax revenue was set aside to make all promised payments to bondholders.

Though Ms. Rampell doesn’t like this idea, which is sometimes called “prioritization.”

Some right-wingers…have in the past suggested  that defaulting is no big deal, perhaps even desirable. They (mistakenly) think that a debt default would allow those in charge to unilaterally decide which bills deserve payment and which don’t, bypassing the democratic budget process.

I’m not sure why she says prioritization is a “mistaken” view.

I testified to Congress about this issue in 2013 and in 2016. If the debt limit isn’t raised, meaning no ability to issue new debt, that would be the same as an overnight balanced budget requirement (i.e., spending could only equal current tax revenue).

If that happened and Treasury made sure to prioritize interest payments (to avoid the potentially bad results Ms. Rampell and others warn about), who would have the power to stop that from happening?

I’m guessing lawsuits would be filed, but I can’t imagine a judge would issue an injunction to require a default.

Let’s dig deeper into this issue. Back in 2017, when a similar fight occurred, Heather Long of the Washington Post identified five reasons to worry.

Unless Trump and Congress pass a law raising the U.S. debt limit — a legal cap on how much the U.S. government is allowed to borrow — the Treasury Department will soon run out of money to pay its bills, triggering a first-in-modern-U.S.-history default that threatens to turn the world economy on its head. …The danger…is that at some point someone will miscalculate and the government will actually hit the debt limit, sparking a default, intentional or otherwise. Here are five reasons that would cause global panic.

How persuasive are these reasons?

First, it would trigger a wild ride for stocks and bonds. Wall Street doesn’t like bad surprises. …There would probably be an immediate, negative reaction in the markets.

If there’s an actual default, that would be horrible news.

If there’s a temporary default, that also would be bad news, though presumably far less catastrophic than a permanent default (though some will fan the flames of hysteria).

Second, America’s cheap funding source would end. …As soon as the United States actually defaults, investors would start suing the country, and they would almost certainly insist on much higher interest rates in the future.

Interest rates surely would climb because of the perception of added risk for investors.

Though I wonder by how much. I think Italy is heading toward a fiscal/financial crisis, yet investors are buying up plenty of that government’s debt at very low interest rates.

Third, real people won’t get paid. …The Trump administration would have to either stop payments to everyone or they would have to pick who gets paid and who does not. That means deciding between bondholders, Social Security recipients, welfare recipients, …etc.

Interesting, Ms. Long accepts that prioritization would happen.

For what it’s worth, I’m guessing bondholders and Social Security recipients would be at the front of the line.

Fourth, America’s global power would decline. …The U.S. dollar is the world’s reserve currency. People carry dollars and hold U.S. bonds all over the world because they believe America is their best and safest bet. A default would probably cause the value of the dollar to drop and global investors to shift some money out of U.S. assets.

This is an interesting claim.

The U.S. dollar is the world’s reserve currency.

Does drama over the debt limit, or even a temporary default, lead investors to shift, en masse, to another currency?

Perhaps, though I don’t see an alternative. The euro is compromised because the European Central Bank surrendered its independence by engaging in indirect bailouts of some of Europe’s decrepit welfare states.

The Chinese financial system is too debt ridden and too opaque to give investors confidence in that nation’s currency. And other nations are simply too small.

Fifth, a recession is possible. …hitting the debt limit could cause a sharp drop in markets and sentiment around the world as everyone worries that if the United States defaults, who’s next? Investors might start panicking and ditching bonds of other countries in Europe and Asia, too.

These are all reasonable concerns.

It all depends, of course, whether there’s a temporary default and how long it lasts.

And since we may be in the midst of a debt bubble fueled by easy money, any triggering event could lead to very bad outcomes.

Which is why it would make sense for lawmakers to embrace prioritization. There has been legislation to make that happen.

For what it’s worth, it should be quite feasible to prioritize.

Here’s the latest 10-year forecast from the Congressional Budget Office. As you can see from the parts I’ve circled, the government is projected to collect far more revenue than would be needed to fulfill obligations to bondholders.

To be sure, prioritization means that some recipients of federal largesse would have to wait in line. This would be unseemly and unwelcome, but it already happens in profligate states such as Illinois without causing any economic or fiscal disarray.

Who knows, maybe politicians would even decide that it’s time to jettison some federal programs. But since I understand “public choice,” I won’t be holding my breath awaiting that outcome.

I’ll close with two observations.

The first, which I’ve already discussed, is that a failure to increase the debt limit should not result in default. Unless, of course, the Treasury Department wants that to happen. But that’s inconceivable, which is why I fully expect prioritization if we ever get to that point.

The second is that debt limit fights are messy and counterproductive, but I don’t want it abolished since there’s a chance that one of these battles eventually may force politicians to deal with our fiscal mess – thus saving the country from a future Greek-style economic and fiscal meltdown.

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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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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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