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Posts Tagged ‘Debt’

We can learn a lot of economic lessons from Europe.

Today, we’re going to focus on another lesson, which is that higher taxes lead to more red ink. And let’s hope Hillary Clinton is paying attention.

I’ve already made the argument, using European fiscal data to show that big increases in the tax burden over the past several decades have resulted in much higher levels of government debt.

But let’s now augment that argument by considering what’s happened in recent years.

There’s been a big fiscal crisis in Europe, which has forced governments to engage in austerity.

But the type of austerity matters. A lot.

Here’s some of what I wrote back in 2014.

…austerity is a catch-all phrase that includes bad policy (higher taxes) and good policy (spending restraint). But with a few notable exceptions, European nations have been choosing the wrong kind of austerity (even though Paul Krugman doesn’t seem to know the difference).

And when I claim politicians in Europe have chosen the wrong kind of austerity, that’s not hyperbole.

As of 2012, there were €9 of tax hikes for every €1 of supposed spending cuts according to one estimate. That’s even worse than some of the terrible budget deals we’ve seen in Washington.

At this point, a clever statist will accuse me of sour grapes and state that I’m simply unhappy that politicians opted for policies I don’t like.

I’ll admit to being unhappy, but my real complaint is that higher tax burdens don’t work.

And you don’t have to believe me. We have some new evidence from an international bureaucracy based in Europe.

In a working paper for the European Central Bank, Maria Grazia Attinasi and Luca Metelli crunch the numbers to determine if and when “austerity” works in Europe.

…many Euro area countries have adopted fiscal consolidation measures in an attempt to reduce fiscal imbalances…in most cases, fiscal consolidation did not result, at least in the short run, in a reduction in the debt-to-GDP ratio…calls for a more temperate approach to fiscal consolidation have increased on the ground that the drag of fiscal restraint on economic growth could lead to an increase rather than a decrease in the debt-to-GDP ratio, as such fiscal consolidation may turn out to be self-defeating. …The aim of this paper is to investigate the effects of fiscal consolidation on the general government debt-to-GDP ratio in order to assess whether and under which conditions self defeating effects are likely to materialise and whether they tend to be short-lived or more persistent over time.

Now let’s look at the results of their research.

It turns out that austerity does work, but only if it’s the right kind. The authors find that spending cuts are successful and higher tax burdens backfire.

The main finding of our analysis is that…In the case of revenue-based consolidations the increase in the debt-to-GDP ratio tends to be larger and to last longer than in the case of spending-based consolidations. The composition also matters for the long term effects of fiscal consolidations. Spending-based consolidations tend to generate a durable reduction of the debt-to-GDP ratio compared to the pre-shock level, whereas revenue-based consolidations do not produce any lasting improvement in the sustainability prospects as the debt-to-GDP ratio tends to revert to the pre-shock level. …strategy is more likely to succeed when the consolidation strategy relies on a durable reduction of spending, whereas revenue-based consolidations do not appear to bring about a durable improvement in debt sustainability.

Unfortunately, European politicians generally have chosen the wrong approach.

This is an important policy lesson also in view of the fact that revenue-based consolidations tend to be the preferred form of austerity, at least in the short run, given also the political costs that a durable reduction in government spending entail.

Here are a few important observations from the study’s conclusion.

…the findings of our analysis are in line with those of the literature on successful consolidation, namely that the composition of fiscal consolidation matters and that a durable reduction in the debt-to-GDP ratio is more likely to be achieved if consolidation is implemented on the expenditure side, rather than on the revenue side. In particular, when fiscal consolidation is implemented via an increase in taxation, the debt-to-GDP ratio reverts back to its pre-shock level only in the long run, thus failing to generate an improvement in the debt ratio, and producing what we call a self-defeating fiscal consolidation. …fiscally stressed countries benefit from an immediate reduction in the level of debt when reducing spending.

In other words, restraining the growth of spending is the best way to reduce red ink. Heck, it’s the only way.

When debating my leftists friends, I frequently share this table showing nations that have obtained very good results with multi-year periods of spending restraint.

My examples are from all over the world and cover all sorts of economic conditions. And the results repetitively show that when you deal with the underlying problem of too much government, you automatically improve the symptom of red ink.

I then ask my statist pals to show me a similar table of data for countries that have achieved good results with higher taxes.

I’m still waiting for an answer.

Which is why the only good austerity is spending restraint.

P.S. Paul Krugman is remarkably sloppy and inaccurate when writing about austerity. Check out his errors when commenting on the United Kingdom, Germany, and Estonia.

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As a general rule, I’m not overly concerned about debt, even when looking at government red ink.

I don’t like deficit and debt, to be sure, but government borrowing should be seen as the symptom. The real problem is excessive government spending.

This is one of the reasons I’m not a fan of a balanced budget amendment, Based on the experiences of American states and European countries, I fear politicians in Washington would use any deficit-limiting requirement as an excuse to raise taxes.

I much prefer spending caps, such as those found in Hong Kong, Switzerland, and Colorado. If you cure the disease of excessive government, you automatically ameliorate the symptom of too much borrowing.

That being said, the fiscal chaos plaguing European welfare states is proof that there is a point when a spending problem can also become a debt problem. Simply stated, the people and institutions that buy government bonds at some point will decide that they no longer trust a government’s ability to repay because the public sector is too big and the economy is too weak.

And even though the European fiscal crisis no longer is dominating the headlines, I fear this is just the calm before the storm.

For instance, the data in a report from Citi about the looming Social Security-style crisis are downright scary.

…the total value of unfunded or underfunded government pension liabilities for twenty OECD countries is a staggering $78 trillion, or almost double the $44 trillion published national debt number.

And the accompanying chart is rather appropriate since it portrays this giant pile of future spending promises as an iceberg.

And when you look at projections for ever-rising spending (and therefore big increases in red ink) in America, it’s easy to see why I’m such a strong advocate of genuine entitlement reform.

But it’s also important to realize that government policies also can encourage excessive debt in the private sector.

Before digging into the issue, let’s first make clear that debt is not necessarily bad. Households often borrow to buy big-ticket items like homes, cars, and education. And businesses borrow all the time to finance expansion and job creation.

But if there’s too much borrowing, particularly when encouraged by misguided government policies, then households and businesses are very vulnerable if there’s some sort of economic disruption and they no longer have enough income to finance debt payments. This is when debt becomes excessive.

Yet this is what the crowd in Washington is encouraging.

Writing for the Wall Street Journal, George Melloan warns that misguided “stimulus” and “QE” policies have created a debt bubble.

…while Mr. Bernanke and Ms. Yellen were trying to prevent deflation, the federal government was engineering its cause, excessive debt. And the Fed abetted the process by purchasing trillions of dollars of government paper, aka quantitative easing. Near-zero interest rates also have encouraged consumers and business to releverage. Cars are now financed with low or no-interest five-year loans. With the 2008 housing debacle forgotten, easier mortgage terms have made a comeback. Corporations also couldn’t let cheap money go to waste, so they have piled up debts to buy back their own stock. Such “investment” produces no economic growth, but it has to be paid back nonetheless. Amid the Great Recession, many worried that the entire economy of the U.S., or even the world, would be “deleveraged.” Instead, we have a new world-wide debt bubble.

The numbers he shares are sobering.

Global debt of all types grew by $57 trillion from 2007 to 2014 to a total of $199 trillion, the McKinsey Global Institute reported in February last year. That’s 286% of global GDP compared with 269% in 2007. The current ratio is above 300%.

Professor Noah Smith writes in Bloomberg about research showing that debt-fueled bubbles are especially worrisome.

…since debt bubbles damage the financial system, they endanger the economy more than equity bubbles, which transmit their losses directly to households. Financial institutions lend people money, and if people can’t pay it back — because the value of their house has gone down — it could cause bank failures. …Economists Oscar Jorda, Moritz Schularick, and Alan Taylor recently did a historical study of asset price crashes, and they found that, in fact, debt seems to matter a lot. …To make a long story short, they look at what happened to the economy of each country after each large drop in asset prices. …bubbles make recessions longer, and credit worsens the effect. …the message is clear: Bubbles and debt are a dangerous combination.

To elaborate, equity and bubbles aren’t a good combination, but there’s far less damage when an equity bubble pops because the only person who is directly hurt is the person who owns the asset (such as shares of a stock). But when a debt bubble pops, the person who owes the money is hurt, along with the person (or institution) to whom the money is owed.

Desmond Lachman of the American Enterprise Institute adds his two cents to the issue.

…the world is presently drowning in debt. Indeed, as a result of the world’s major central banks for many years having encouraged markets to take on more risk by expanding their own balance sheets in an unprecedented manner, the level of overall public and private sector indebtedness in the global economy is very much higher today than it was in 2008 at the start of the Great Economic Recession. Particularly troublesome is the very high level of corporate debt in the emerging market economies and the still very high public sector debt levels in the European economic periphery. …the Federal Reserve’s past policies of aggressive quantitative easing have set up the stage for considerable global financial market turbulence. They have done so by artificially boosting asset prices and by encouraging borrowing at artificially low interest rates that do not reflect the likelihood of the borrower eventually defaulting on the loan.

In other words, artificially low interest rates are distorting economic decisions by making something (debt) seem cheaper than it really is. Sort of financial market version of the government-caused third-party payer problem in health care and higher education.

And Holman Jenkins of the Wall Street Journal makes the very important point that debt is encouraged by bailouts and subsidies.

Big banks aren’t automatically bad or badly managed because they are big, but it’s hard to believe big banks would exist without an explicit and implicit government safety net underneath them. …None of this has changed since Dodd-Frank, none of it is likely to change. …we know where the crisis will come from and how it will be transmitted to the financial system. The Richmond Fed’s “bailout barometer” shows that, since the 2008 crisis, 61% of all liabilities in the U.S. financial system are now implicitly or explicitly guaranteed by government, up from 45% in 1999. …Six years after a crisis caused by excessive borrowing, McKinsey estimates that even visible global debt has increased by $57 trillion, while in the U.S., Europe, Japan and China growth to pay back these liabilities has been slowing or absent.

The bottom line is that government spending programs directly cause debt, but we should be just as worried about the private debt that is being encouraged and subsidized by other misguided government policies.

And surely we shouldn’t forget to include the pernicious role of the tax code, which further tilts the playing field in favor or debt.

P.S. Let’s briefly divert to another issue. I wrote last Christmas that President Obama may have given the American people a present.

But the Washington Examiner reports that gift has turned into a lump of coal.

The Department of Justice announced this week that it is resuming its Equitable Sharing program…that allows state and local police to get around tough state laws that limit how much property can be taken from citizens without being charged with wrongdoing, let alone convicted of a crime. …money-hungry police departments can exploit these lax federal rules about confiscating people’s property. The feds like this because they get a cut of the loot. …there is no presumption of innocence. …civil forfeitures by the feds amounted to $4.5 billion in 2014, which is more than the $3.9 billion that all of America’s burglars stole that year. It’s hard to imagine more compelling evidence of gross wrong.

Wow, so the government steals more money than burglars. I guess I’m not surprised.

But if you really want to get upset, check out real-world examples of asset forfeiture by clicking here, here, here, here, and here.

Thankfully, some states are seeking to curtail this evil practice.

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The most depressing data about America’s economy is not the top tax rate, the regulatory burden, or the level of wasteful of government spending.

Those numbers certainly are grim, but I think they’re not nearly as depressing as America’s demographic outlook.

As you can see from this sobering image, America’s population pyramid is turning into a population cylinder.

There’s nothing a priori wrong with an aging population and a falling birthrate, of course, but those factors create a poisonous outlook when mixed with poorly designed entitlement programs.

The lesson is that a modest-sized welfare state is sustainable (even if not advisable) when a nation has a population pyramid. But even a small welfare state becomes a problem when a nation has a population cylinder. Simply stated, there aren’t enough people to pull the wagon and there are too many people riding in the wagon.

But if America’s numbers are depressing, the data from Europe should lead to mass suicide.

The Wall Street Journal has a new story on the utterly dismal fiscal and demographic data from the other side of the Atlantic Ocean.

State-funded pensions are at the heart of Europe’s social-welfare model, insulating people from extreme poverty in old age. Most European countries have set aside almost nothing to pay these benefits, simply funding them each year out of tax revenue. Now, European countries face a demographic tsunami, in the form of a growing mismatch between low birthrates and high longevity, for which few are prepared. …Looking at Europeans 65 or older who aren’t working, there are 42 for every 100 workers, and this will rise to 65 per 100 by 2060, the European Union’s data agency says. …Though its situation is unusually dire, Greece isn’t the only European government being forced to acknowledge it has made pension promises it can ill afford. …Across Europe, the birthrate has fallen 40% since the 1960s to around 1.5 children per woman, according to the United Nations. In that time, life expectancies have risen to roughly 80 from 69. …Only a few countries estimate the total debt burden of the pension promises they have made.

The various nations is Europe may not produce the data, but one of the few good aspects of international bureaucracies is that they generate such numbers.

I’ve previously shared projections from the IMF, BIS, and OECD, all of which show the vast majority of developed nations will face serious fiscal crises in the absence of reforms to restrain the burden of government spending.

New we can add some data from the European Commission, which has an Ageing Report that is filled with some horrifying demographic and fiscal information.

First, here are the numbers showing that most parts of the world (and especially Europe) will have many more old people but a lot fewer working-age people.

Looking specifically at the European Union, here’s what will happen to the population pyramid between 2013 and 2060. As you can see, the pyramid no longer exists today and will become an upside-down pyramid in the future.

Now let’s look at data on the ratio between old people and working-age people in various EU nations.

Dark blue shows the recent data, medium blue is the dependency ratio in 2030, and the light blue shows the dependency ration in 2060.

The bottom line is that it won’t be long before any two working-age people in the EU will be expected to support themselves plus one old person. That necessarily implies a very onerous tax burden.

But the numbers actually are even more depressing than what is shown in the above chart.

In the European Commission’s Ageing Report, there’s an estimate of the “economic dependency ratio,” which compares the number of workers with the number of people supported by those workers.

The total economic dependency ratio is a more comprehensive indicator, which is calculated as the ratio between the total inactive population and employment (either 20-64 or 20-74). It gives a measure of the average number of individuals that each employed “supports”.

And here are the jaw-dropping numbers.

These numbers are basically a death knell for an economy. The tax burden necessary for this kind of society would be ruinous to an  economy. A huge share of productive people in these nations would decide not to work or to migrate where they would have a chance to keep a decent share of their earnings.

So now you understand why I wrote a column identifying safe havens that might remain stable while other nations are suffering Greek-style fiscal collapse.

Having shared all this depressing data, allow me to close with some semi-optimistic data.

I recently wrote that Hong Kong’s demographic outlook is far worse than what you find in Europe, but I explained that this won’t cause a crisis because Hong Kong wisely has chosen not to adopt a welfare state. People basically save for their own retirement.

Well, a handful of European nations have taken some steps to restrain spending. Here’s a table from the EC report on countries which have rules designed to adjust outlays as the population gets older.

These reforms are better than nothing, but the far better approach is a shift to a system of private retirement savings.

As you can see from this chart, Denmark, Sweden, and the Netherlands already have a large degree of mandatory private retirement savings, and a handful of other countries have recently adopted private Social Security systems that will help the long-run outlook.

I’ve already written about the sensible “pre-funded” system in The Netherlands, and there are many other nations (ranging from Australia to Chile to the Faroe Islands) that have implemented this type of reform.

Given all the other types of government spending across the Atlantic, Social Security reform surely won’t be a sufficient condition to save Europe, but it surely is a necessary condition.

Here’s my video explaining why such reform is a good idea, both in America and every other place in the world.

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With both Hillary Clinton and Bernie Sanders agitating for higher taxes (and with more than a few Republicans also favoring more revenue because they don’t want to do any heavy lifting to restrain a growing burden of government), it’s time to examine the real-world evidence on what happens when politicians actually do get their hands on more money.

Is it true, as we are constantly told by the establishment, that higher tax burdens a necessary and practical way to reduce budget deficits and lower debt levels?

This is an empirical question rather than an ideological one, and the numbers from Europe (especially when looking at the data from the advanced nations that are most similar to the US) are especially persuasive.

I examined the European fiscal data back in 2012 to see whether the big increase in tax revenue starting in the late 1960s led to more red ink or less red ink.

You won’t be surprised to learn that giving more money to politicians didn’t lead to fiscal probity. The burden of taxation climbed by about 10-percentage points of economic output over four decades, but governments spent every single penny of the additional revenue.

They actually spent more than 100 percent of the additional revenue. The average debt burden in these Western European nations jumped from 45 percent of GDP to 60 percent of GDP.

I often share this data when giving speeches since it is powerful evidence that tax increases are not a practical way of dealing with debt and deficits.

But in recent years, audiences have begun to ask why I compare numbers from the late 1960s (1965-1969) with the data from the last half of last decade (2006-2010). What would the data show, they’ve asked, if I used more up-to-date numbers.

So it’s time to re-calculate the numbers using the latest data and share some new charts about what happened in Europe. Here’s the first chart, which shows on the left that there’s been a big increase in the tax burden over the past 45 years and shows on the right average debt levels at the beginning of the period. And I ask the rhetorical question about whether higher taxes led to less red ink.

Now here’s the updated answer.

What we find is that debt levels have soared. Not just from 45 percent of GDP to 60 percent of GDP, as shown by the 2012 numbers, but now to more than 80 percent of economic output.

In other words, we can confirm that the giant increase in the tax burden over the past few decades has backfired. And we can also confirm that the big income tax hikes and increases in value-added taxes in more recent years have made matters worse rather than better.

I can’t imagine that anyone needs any additional evidence that tax increases are misguided.

But just in case, let’s look at the findings in some newly released research from the European Central Bank.

Since the start of the sovereign debt crisis, in early 2010, many Euro area countries have adopted fiscal consolidation measures in an attempt to reduce fiscal imbalances and preserve their sovereign creditworthiness. Nonetheless, in most cases, fiscal consolidation did not result.

That doesn’t sound like good news.

I wonder whether it has anything to do with the fact that “fiscal consolidation” in Europe almost always means higher taxes? And, indeed, the ECB number crunchers have confirmed that the tax-hike approach is bad news.

The aim of this paper is to investigate the effects of fiscal consolidation on the general government debt-to-GDP ratio in order to assess whether and under which conditions self-defeating effects are likely to materialise… In the case of revenue-based consolidations the increase in the debt-to-GDP ratio tends to be larger and to last longer than in the case of spending-based consolidations. The composition also matters for the long term effects of fiscal consolidations. Spending-based consolidations tend to generate a durable reduction of the debt-to-GDP ratio compared to the pre-shock level, whereas revenue-based consolidations do not produce any lasting improvement in the sustainability prospects as the debt-to-GDP ratio tends to revert to the pre-shock level.

The two scholars at the ECB then highlight the lessons to be learned.

…strategy is more likely to succeed when the consolidation strategy relies on a durable reduction of spending, whereas revenue-based consolidations do not appear to bring about a durable improvement in debt sustainability. Moreover, delaying fiscal consolidation until financial markets pressures threaten a country’s ability to issue debt, may have a cost in terms of a less sizeable reduction in the debt-to-GDP ratio for given consolidation effort, even if it is undertaken on the spending side. This is an important policy lesson also in view of the fact that revenue-based consolidations tend to be the preferred form of austerity, at least in the short run, given also the political costs that a durable reduction in government spending entail.

In other words, the bottom line is a) that tax hikes don’t work, b) reform is harder if you wait until a crisis has begun, and c) the real challenge is convincing politicians to do the right thing when they instinctively prefer tax hikes.

P.S. It’s worth pointing out that the value-added tax has generated much of the additional tax revenue (and therefore enabled much of the added burden of government spending) in Europe.

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Whenever there’s a fight over raising the debt limit, the political establishment gets hysterical and makes apocalyptic claims about default and economic crisis.

For years, I’ve been arguing that this Chicken-Little rhetoric is absurd. And earlier this week I testified about this issue before the Oversight and Investigations Subcommittee of the House Financial Services Committee.

By the way, when I first showed up, my placard identified me as Ms. Mitchell.

Since I work at a libertarian think tank, I reckon nobody would object if I wanted to change my identity. But since I’m the boring rather than adventurous kind of libertarian, I guess it’s good that I wound up being Dr. Mitchell.

More important, here’s some elaboration and background links to some of the information from my testimony.

America’s long-run fiscal problem isn’t debt. That’s just a symptom. The real challenge is a rising burden of government spending, largely because of demographic change and poorly designed entitlement programs.

Measured as a share of economic output, the tax burden already is above historical levels. Moreover, taxes are projected to rise even further, so there is zero plausible evidence for the notion that America’s future fiscal crisis is the result of inadequate tax revenue.

International bureaucracies such as the IMF, BIS, and OECD show America in worse long-run shape than Europe, but the U.S. is actually in a better position since a spending cap easily would prevent the compounding levels of debt that are driving the terrible long-run outlook in the United States.

It’s good to have debt limit fights today if such battles enhance the possibility of averting a future Greek-style economic calamity.

Arguments against using the debt limit as an action-forcing event usually are based on the bizarre claim that an inability to borrow more money would cause a default and wreck the “full faith and credit” of the United States. Nonsense. Treasury would be able to avoid default in the absence of a higher debt limit for the simple reason that tax receipts are far greater than what’s needed to pay interest on the debt.

This last point is worth some extra attention. I’ve been arguing for years that debt limit fights are harmless since there’s no risk of default. I even explained to the Senate Budget Committee a few years ago that it would be easy for the Treasury Department to “prioritize” payments to ensure that bondholders would never be adversely impacted.

The Obama Administration routinely denied that it was sufficiently competent to engage in “prioritization” and even enlisted the then-Fed Chairman Ben Bernanke to dishonestly fan the flames of economic uncertainty.

Well, thanks to the good work of the Subcommittee on Oversight and Investigations, we now have a report outlining how the White House was prevaricating. Simply stated, of course there were and are contingency plans to prioritize in the event of a standoff on the debt limit.

By the way, I didn’t get the chance to mention it in my oral testimony, but my full written testimony addressed the silly assertion that any delay in a government payment is somehow a “default.”

I will close by noting the utterly disingenuous Administration tactic of trying to…make it seem as if delaying payments of things like crop subsidies and Medicaid reimbursements is somehow equivalent to default on interest payments.

One final point. Let’s imagine that we’re four years in the future and political events somehow have given us a Republican president and a Democratic Congress. Don’t be surprised if the political parties then reverse their positions and the GOPers argue for “clean” debt limits and make silly claims about default and Democrats argue the opposite.

That’s why I’m glad I’m at the Cato Institute. I can simply tell the truth without worrying about partisanship.

P.S. Here are some jokes about the debt limit, and you can find some additional humor on the topic here and here.

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I have a very mixed view of the Committee for a Responsible Federal Budget, which is an organization representing self-styled deficit hawks in Washington.

They do careful work and I always feel confident about citing their numbers.

Yet I frequently get frustrated because they seem to think that tax increases have to be part of any budget deal, regardless of the evidence that such an approach will backfire.

So when CRFB published a “Fiscal FactChecker” to debunk 16 supposed budget myths that they expect during this campaign season, I knew I’d find lots of stuff I would like…and lots of stuff I wouldn’t like.

Let’s look at what they said were myths, along with my two cents on CRFB’s analysis.

Myth #1: We Can Continue Borrowing without Consequences

Reality check: CRFB’s view is largely correct. If we leave policy on autopilot, demographic changes and poorly structured entitlement programs  will lead to an ever-rising burden of government spending, which almost surely will mean ever-rising levels of government debt (as well as ever-rising tax burdens). At some point, this will lead to serious consequences, presumably bad monetary policy (i.e., printing money to finance the budget) and/or Greek-style crisis (investors no longer buying bonds because they don’t trust the government will pay them back).

The only reason I don’t fully agree with CRFB is that we could permanently borrow without consequence if the debt grew 1 percent per year while the economy grew 3 percent per year. Unfortunately, given the “new normal” of weak growth, that’s not a realistic scenario.

Myth #2: With Deficits Falling, Our Debt Problems are Behind Us

Reality check: The folks at CRFB are right. Annual deficits have dropped to about $500 billion after peaking above $1 trillion during Obama’s first term, but that’s just the calm before the storm. As already noted, demographics and entitlements are a baked-into-the-cake recipe for a bigger burden of government and more red ink.

That being said, I think that CRFB’s focus is misplaced. They fixate on debt, which is the symptom, when they should be more concerned with reducing excessive government, which is the underlying disease.

Myth #3: There is No Harm in Waiting to Solve Our Debt Problems

Reality check: We have a spending problem. Deficits and debt are merely symptoms of that problem. But other than this chronic mistake, CRFB is right that it is far better to address our fiscal challenges sooner rather than later.

CRFB offers some good analysis of why it’s easier to solve the problem by acting quickly, but this isn’t just about math. Welfare State Wagon CartoonsIt’s also important to impose some sort of spending restraint before a majority of the voting-age population has been lured into some form of government dependency. Once you get to the point when more people are riding in the wagon than pulling the wagon (think Greece), reform becomes almost impossible.

Myth #4: Deficit Reduction is Code for Austerity, Which Will Harm the Economy

Reality check: The folks at CRFB list this as a myth, but they actually agree with the assertion, stating that deficit reduction policies “have damaged economic performance and increased unemployment.” They even seem sympathetic to “modest increases to near-term deficits by replacing short-term ‘sequester’ cuts”, which would gut this century’s biggest victory for good fiscal policy!

There are two reasons for CRFB’s confusion. First, they seem to accept the Keynesian argument about bigger government and red ink boosting growth, notwithstanding all the evidence to the contrary. Second, they fail to distinguish between good austerity and bad austerity. If austerity means higher taxes, as has been the case so often in Europe, then it is unambiguously bad for growth. But if it means spending restraint (or even actual spending cuts), then it is clearly good for growth. There may be some short-term disruption since resources don’t instantaneously get reallocated, but the long-term benefits are enormous because labor and capital are used more productively in the private economy.

Myth #5: Tax Cuts Pay For Themselves

Reality check: I agree with the folks at CRFB. As a general rule, tax cuts will reduce government revenue, even after measuring possible pro-growth effects that lead to higher levels of taxable income.

But it’s also important to recognize that not all tax cuts are created equal. Some tax cuts have very large “supply-side” effects, particularly once the economy has a chance to adjust in response to better policy. So a lower capital gains tax or a repeal of the death tax, to cite a couple of examples, might increase revenue in the long run. And we definitely saw a huge response when Reagan lowered top tax rates in the 1980s. But other tax cuts, such as expanded child credits, presumably generate almost no pro-growth effects because there’s no change in the relative price of productive behavior.

Myth #6: We Can Fix the Debt Solely by Taxing the Top 1%

Reality check: The CRFB report correctly points out that confiscatory tax rates on upper-income taxpayers would backfire for the simple reason that rich people would simply choose to earn and report less income. And they didn’t even include the indirect economic damage (and reductions in taxable income) caused by less saving, investment, and entrepreneurship.

Ironically, the CRFB folks seem to recognize that tax rates beyond a certain level would result in less revenue for government. Which implies, of course, that it is possible (notwithstanding what they said in Myth #5) for some tax cuts to pay for themselves.

Myth #7: We Can Lower Tax Rates by Closing a Few Egregious Loopholes

Reality check: It depends on the definition of “egregious.” In the CRFB report, they equate “egregious” with “unpopular” in order to justify their argument.

But if we define “egregious” to mean “economically foolish and misguided,” then there are lots of preferences in the tax code that could – and should – be abolished in order to finance much lower tax rates. Including the healthcare exclusion, the mortgage interest deduction, the charitable giving deduction, and (especially) the deduction for state and local taxes.

Myth #8: Any Tax Increases Will Cripple Economic Growth

Reality check: The CRFB folks are right. A small tax increase obviously won’t “cripple” economic growth. Indeed, it’s even possible that a tax increase might lead to more growth if it was combined with pro-growth policies in other areas. Heck, that’s exactly what happened during the Clinton years. But now let’s inject some reality into the conversation. Any non-trivial tax increase on productive behavior will have some negative impact on economic performance and competitiveness. The evidence is overwhelming that higher tax rates hurt growth and the evidence is also overwhelming that more double taxation will harm the economy.

The CRFB report suggests that the harm of tax hikes could be offset by the supposed pro-growth impact of a lower budget deficit, but the evidence for that proposition if very shaky. Moreover, there’s a substantial amount of real-world data showing that tax increases worsen fiscal balance. Simply stated, tax hikes don’t augment spending restraint, they undermine spending restraint. Which may be why the only “bipartisan” budget deal that actually led to a balanced budget was the one that lowered taxes instead of raising them.

Myth #9: Medicare and Social Security Are Earned Benefits and Should Not Be Touched

Reality check: CRFB is completely correct on this one. The theory of age-related “social insurance” programs such as Medicare and Social Security is that people pay into the programs while young and then get benefits when they are old. This is why they are called “earned benefits.”

The problem is that politicians don’t like asking people to pay and they do like giving people benefits, so the programs are poorly designed. The average Medicare recipient, for instance, costs taxpayers $3 for every $1 that recipient paid into the program. Social Security isn’t that lopsided, but the program desperately needs reform because of demographic change. But the reforms shouldn’t be driven solely by budget considerations, which could lead to trapping people in poorly designed entitlement schemes. We need genuine structural reform.

Myth #10: Repealing “Obamacare” Will Fix the Debt

Reality check: Obamacare is a very costly piece of legislation that increased the burden of government spending and made the tax system more onerous. Repealing the law would dramatically improve fiscal policy.

But CRFB, because of the aforementioned misplaced fixation on red ink, doesn’t have a big problem with Obamacare because the increase in taxes and the increase in spending are roughly equivalent. So the organization is technically correct that repealing the law won’t “fix the debt.” But it would help address America’s real fiscal problem, which is a bloated and costly public sector.

Myth #11: The Health Care Cost Problem is Solved

Reality check: CRFB’s analysis is correct, though it would have been nice to see some discussion of how third-party payer is the problem.

Myth #12: Social Security’s Shortfall Can be Closed Simply by Raising Taxes on or Means-Testing Benefits for the Wealthy

Reality check: To their credit, CRFB is basically arguing against President Obama’s scheme to impose Social Security payroll taxes on all labor income, which would turn the program from a social-insurance system into a pure income-redistribution scheme.

On paper, such a system actually could eliminate the vast majority of Social Security’s giant unfunded liability. In reality, this would mean a huge increase in marginal tax rates on investors, entrepreneurs, and small business owners, which would have a serious adverse economic impact.

Myth #13: We Can Solve Our Debt Situation by Cutting Waste, Fraud, Abuse, Earmarks, and/or Foreign Aid

Reality check: Earmarks (which have been substantially curtailed already) and foreign aid are a relatively small share of the budget, so CRFB is right that getting rid of that spending won’t have a big impact. But what about the larger question. Could our fiscal mess (which is a spending problem, not a “debt situation”) be fixed by eliminating waste, fraud, and abuse?

It depends on how one defines “waste, fraud, and abuse.” If one uses a very narrow definition, such as technical malfeasance, then waste, fraud, and abuse might “only” amount to a couple of hundred billions dollars per year. But from an economic perspective (i.e., grossly inefficient misallocation of resources), then entire federal departments such as HUD, Education, Transportation, Agriculture, etc, should be classified as waste, fraud, and abuse.

Myth #14: We Can Grow Our Way Out of Debt

Reality check: CRFB is correct that faster growth won’t solve all of our fiscal problems. Unless one makes an untenable assumption that economic growth will be faster than the projected growth of entitlement spending. And even that kind of heroic assumption would be untenable since faster growth generally obligates the government to pay higher benefits in the future.

Myth #15: A Balanced Budget Amendment is All We Need to Fix the Debt

Reality check: CRFB accurately explains that a BBA is simply an obstacle to additional debt. Politicians still would be obliged to change laws to fulfill that requirement. But that analysis misses the point. A BBA focuses on red ink, whereas the real problem is that government is too big and growing too fast. State balanced-budget requirement haven’t stopped states like California and Illinois from serious fiscal imbalances and eroding competitiveness. The so-called Maastricht anti-deficit and anti-debt rules in the European Union haven’t stopped nations such as France and Greece from fiscal chaos.

This is why the real solution is to have some sort of enforceable cap on government spending. That approach has worked well in jurisdictions such as Switzerland, Hong Kong, and Colorado. And even research from the IMF (a bureaucracy that shares CRFB’s misplaced fixation on debt) has concluded that expenditure limits are the only effective fiscal rules.

Myth #16: We Can Fix the Debt Solely by Cutting Welfare Spending

Reality check: The federal government is spending about $1 trillion this year on means-tested (i.e., anti-poverty) programs, which is about one-fourth of total outlays, so getting Washington out of the business of income redistribution would substantially lower the burden of federal spending (somewhat offset, to be sure, by increases in state and local spending). And for those who fixate on red ink, that would turn today’s $500 billion deficit into a $500 billion surplus.

That being said, there would still be a big long-run problem caused by other federal programs, most notably Social Security and Medicare. So CRFB is correct in that dealing with welfare-related spending doesn’t fully solve the long-run problem, regardless of whether you focus on the problem of spending or the symptom of borrowing.

This has been a lengthy post, so let’s have a very simple summary.

We know that modest spending restraint can quickly balance the budget.

We also know lots of nations that have made rapid progress with modest amounts of spending restraint.

And we know that the tax-hike option simply leads to more spending.

So the only question to answer is why the CRFB crowd can’t put two and two together and get four?

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I wrote last month that the debt burden in Greece doesn’t preclude economic recovery. After all, both the United States and (especially) the United Kingdom had enormous debt burdens after World War II, yet those record levels of red ink didn’t prevent growth.

Climbing out of the debt hole didn’t require anything miraculous. Neither the United States nor the United Kingdom had great economic policy during the post-war decades. They didn’t even comply with Mitchell’s Golden Rule on spending.

But both nations managed to at least shrink the relative burden of debt by having the private sector grow faster than red ink. And the recipe for that is very simple.

…all that’s needed is a semi-sincere effort to avoid big deficits, combined with a semi-decent amount of economic growth. Which is an apt description of…policy between WWII and the 1970s.

Greece could achieve that goal, particularly if politicians would allow faster growth. The government could reduce red tape, which would be a good start since the nation ranks a miserable #114 for regulation in Economic Freedom of the World.

But Greece also should try to reverse some of the economy-stifling tax increases that have been imposed in recent years.

That may seem a challenge considering the level of red ink, but good tax policy would be possible if the Greek government was more aggressive about reducing the burden of government spending.

And if that’s the goal, then the Baltic nations are a good role model, as explained by Anders Aslund in the Berlin Policy Journal. With Latvia being the star pupil.

…austerity policies have not been attempted most aggressively in Greece: all three Baltic countries pursued more aggressive fiscal adjustments, especially Latvia. The Latvian government faced the global financial crisis head-on. …The Latvian government carried out a fiscal adjustment of 8.8 percent of GDP in 2009 and 5.9 percent of GDP in 2010, amounting to a fiscal adjustment of 14.7 percent of GDP over the course of two years, totaling 17.5 percent of GDP over four years, according to IMF calculations. Greece did the opposite. According to the IMF, its fiscal adjustment in the initial crisis year of 2010 was a paltry 2.5 percent of GDP, and in 2011 only 4.1 percent, a total of only 6.6 percent of GDP over two years. Greece’s total fiscal adjustment over four years was only 11.1 percent of GDP.

In other words, Latvia (like the other Baltic nations) did more reform and did it faster.

And it’s also worth noting that the reforms were generally the right kind of austerity, meaning that expenditure commitments were reduced.

Whereas Greece has implemented some expenditure reforms, but has relied far more on tax increases.

Better policy, not surprisingly, meant better results.

In 2008-10 Latvia suffered an output decline of 24 percent, as much as Greece did in the six-year span from 2009-14. However, thanks to its front-loaded fiscal adjustment, Latvia was able to restore its public finances after two years. The country has shown solid economic growth, averaging 4.3 percent per year from 2011-14, according to Eurostat. …The consequences of tepid Greek fiscal stabilization have been a devastating six years of declining output, even as the Latvian economy has revived. In 2013 Latvia’s GDP at constant prices was 4 percent lower than in 2008, while Greece’s was 23 percent less than in 2008, according to the IMF. A cumulative difference in GDP development of 19 percentage points over six years cannot be a statistical blip – it is real.

The bottom line is that Latvia and the other Baltics were willing to endure more short-term pain in order to achieve a quicker economic rebound.

That was a wise choice, particularly since the alternative, as we see in Greece, is seemingly permanent stagnation.

Anders Paalzow of the Stockholm School of Economics in Riga also suggests, in a recent article in Foreign Affairs, that Latvia is a good role model.

Professor Paalzow starts by explaining that Latvia is now enjoying good growth after enduring a dramatic boom-bust cycle last decade.

In 2008, Europe’s most overheated economy, which had been fuelled by cheap credit and rapidly raising wages and real estate prices, collapsed. GDP dropped by 20 percent and unemployment rose to more than 20 percent. But here’s where things take an unexpected turn. By late 2010, the first glimmers of recovery became apparent. Today, the economy is among Europe’s fastest growing, and its GDP is back at pre-crisis levels. So how did Latvia, the hero of this story, do it?

The first thing to understand is that Latvia was determined to join the eurozone, so that meant it wasn’t going to devalue its currency in hopes of inflating away its problems. Which meant the only other choice was “internal devaluation.”

…the Latvian government’s only real option was fiscal policy adjustment, the details of which it unveiled in its supplementary budget for 2009 and its budget for 2010. Both of these saw substantial reductions in social benefits accompanied by long overdue cuts in public employment with close to 30 percent of civil servants laid off. Those who remained in the public sector saw their salaries cut by 25 percent, on average, whereas salaries in the private sector fell by on average ten percent. …the reductions made during the crisis years amounted to approximately 11 percent of GDP. Most of the fiscal consolidation was done on the expenditure side of the public budget… The fiscal consolidation program continued into 2011 and the years following, even though the economy started to grow again.

Not only did the economy grow, but the government was rewarded for making tough choices.

…in 2010, the government responsible for austerity was reelected.

But here’s the challenge. Professor Paalzow warns that fiscal reforms won’t mean much unless the chronic dysfunction of the Greek government is somehow addressed.

The importance of the institutional framework cannot be overestimated. …it seems like a fool’s errand to try to sell off the public assets of a country riddled with high corruption… Furthermore, with a legal system incapable of enforcing current legislation and characterized by slow judicial processes, inefficient courts, and weak investor protection, legal reform will be a necessary condition for an economic turnaround.

So he suggests that Latvian-type fiscal reforms should be accompanied by Nordic-style institutional reforms.

Greece should look further north to Finland and Sweden, which overcame their own crises in the early 1990s. …The three to four years following the initial economic disaster saw remarkable institutional reform…substantial changes in both welfare systems. …both countries pursued austerity…, a remedy that both nations had frequently tried in the 1970s and 1980s without any success. What made the difference this time was that the institutional, and hence the fundamental roots, of the problems were addressed.

While I like his prescription, I suspect Paalzow is being too optimistic.

You can’t turn the Greeks into Finns or Swedes, at least not without some sort of massive jolt.

Which is why my preferred policy is to end bailouts, even if it means that Greece repudiates its existing debt. If the Greeks no longer got any handouts, that necessarily would mean an immediate end to deficit spending (assuming the government doesn’t ditch the euro in order to finance spending by printing drachmas).

Welfare State Wagon CartoonsAnd that might be a very sobering experience that would teach the Greek people about the dangers of having too many people trying to ride in the wagon of government dependency.

That might not turn the Greeks into Nordics, but it presumably would help them understand that you can’t (at least in the long run) consume more than you produce.

That’s also a lesson that some American politicians need to learn!

P.S. I wonder if Paul Krugman will attack Latvia’s good reforms. When he went after Estonia for adopting similar policies, he wound up with egg on his face.

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