Inflation Is Caused by Bad Government Policy

Milton Friedman wisely observed that inflation is always the result of bad monetary policy by central banks. And I echoed that point last month in remarks to the European Resource Bank meeting in Stockholm.

This topic deserves more attention, particularly given the depressing inflation numbers just released this morning by the Bureau of Labor Statistics.

Some of our friends on the left want to downplay these bad numbers. In large part, they are motivated by a desire to shield President Biden from political damage. And I sympathize with them since Biden was not in the White House when the Federal Reserve decided to dump lots of liquidity into the U.S. economy.

Here’s a chart showing the Federal Reserve’s balance sheet over the past decade. It’s easy to see the Fed’s panicked response to the pandemic in early 2020.

But I don’t sympathize with folks who claim that inflation is just something random.

Some of them want to blame Putin. Or the pandemic. Or “corporate greed.” Or maybe even space aliens.

I also wonder about this tweet from Ian Bremmer. He points out that inflation is showing up everywhere, regardless of which political party (or coalition) is running a government.

But I can’t tell what he means by his final line (“wild guess it’s not the govt”).

Is he saying that we should focus on the actions of central banks, not the partisan composition of a nation’s government? If so, I agree.

Or is he saying that we should not blame any part of government? If so, I completely disagree.

Central banks may have varying levels of day-to-day independence, but they are government entities. They were created by politicians and run by people appointed by politicians.

And inflation is happening in many nations because various central banks all made similar mistakes.

For instance, Bremmer mentions Germany and Italy. Those are euro countries and you can see that the European Central Bank made the same mistake as the Fed. It panicked at the start of the pandemic and then never fixed its mistake.

Bremmer also mentioned the United Kingdom. Well, here’s the balance sheet data from the Bank of England.

Once again, you can see a big spike in the amount of liquidity created when the BoE expanded its balance sheet.

And, just as was the case with the Fed and the ECB, the BoE did not fix its mistake once it became apparent than the pandemic was not going to cause a global economic collapse.

P.S. I suggested in the video that the ECB is partly motivated by a desire to prop up decrepit welfare states in nations such as Italy and Greece. This is a point I’ve been warning about for many, many years.

P.P.S. While Biden is not to blame for the outbreak of inflation, it’s also true that he is not part of the solution and has not used his appointment power to push the Fed in a more sensible direction.

P.P.P.S. If you have the time and interest, here’s a 40-minute video explaining the Federal Reserve’s track record of bad monetary policy.

P.P.P.P.S. If you’re constrained for time, I recommend this five-minute video on alternatives to the Federal Reserve and this six-minute video on how people can protect themselves from bad monetary policy.

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The Economic Consequences of Expanding Pay-as-You-Go Social Security Systems

Despite the fact that Social Security is an ever-increasing fiscal burden with a 75-year cash-flow deficit of nearly $45 trillion, many politicians in Washington have been trying to buy votes with proposals to expand the program (Barack Obama, Hillary Clinton, Bernie Sanders, Elizabeth Warren, etc).

A new working paper from the European Central Bank gives us some insights on what will happen if they succeed.

Authored by Daniel Baksa, Zsuzsa Munkacsi, and Carolin Nerlich, the study look at the long-run impact of related policies in Europe, using Germany and Slovakia as examples.

Here’s their description of the study.

In view of the adverse macroeconomic and fiscal implications of ageing, many European countries have implemented significant pension reforms… More recently, however, the reform progress has stalled, and despite an unchanged demographic outlook, several European countries reversed, or plan to do so, parts of their previously adopted pension reforms. In this paper we offer a framework that allows us to evaluate the macroeconomic and fiscal costs of pension reform reversals. …By using a general equilibrium model with overlapping generations we can account for feedback effects between changes in pension parameters, pension expenditures and macroeconomic variables. …The model is calibrated for Germany and Slovakia.

Before sharing their findings, here’s a look at how demographics are a ticking time bomb for Europe.

The yellow dots are the 2016 numbers for the old-age dependency ratio (the number of people over 65 compared to the 15-64 working-age population) and the red dots show how that ratio will deteriorate by 2070 (the numbers for the United States are similarly grim).

These bad numbers mean that Europe’s economic outlook will worsen over time.

…population ageing has adverse macroeconomic and fiscal implications. …the results show an increase in the public debt-to-GDP ratio by around 100 percentage points until 2070, compared to the initial period, for both Germany and Slovakia. Moreover, real GDP per capita is projected to decline by almost 14% in Germany and 9% in Slovakia, compared to the initial period.

But it’s possible for the numbers to get better or worse, depending on changes to public policy.

…similar to other studies we find evidence that pension reforms help to contain the adverse implications of ageing… In particular, increases in the retirement age appear to help to alleviate ageing pressures most. …we find strong evidence for the presumption that reversals of pension reforms are potentially very costly. In fact, reform reversals would not only result in higher aggregate pension expenditure and public debt-to-GDP ratios, but would in most cases also exacerbate the adverse macroeconomic impact of ageing.

Unfortunately, public policy is now trending in the wrong direction. Here’s what’s been happening in Germany and Slovakia.

Germany recently decided to cap the decline in the benefit ratio and the increase in the contribution rate until 2025 at certain levels, and is considering whether to extend this cap even until 2040. Slovakia decided to break the automatic link between changes in life expectancy and retirement age, by capping the retirement age at 64 years. …in the reversal scenario for Germany we freeze the benefit ratio at its current level of 48% and assume that the contribution rate would not exceed the threshold of 20% until 2040. With this reform reversal scenario we assume that the agreed freeze of the benefits ratio and contribution rate until 2025 will be ex-tended until 2040. In Slovakia, we assume the retirement age to stop increasing from the year 2045 onwards.

And what do they find when countries backtrack on reform?

Here’s what they estimated in Germany.

For Germany, we find that the reform reversal would imply sizeable costs (see Table 6, column “reform reversal”). Specifically, by 2070, the increase in the public debt-to-GDP ratio can be expected to be ceteris paribus almost 60 percentage points higher than under the baseline scenario, as a result of higher pension expenditures, adverse feedback effects and lower contribution rates.

For those interested, here’s Table 6, which I’ve augmented by highlighting in red the most relevant changes. Yes, the debt increases compared to the baseline, but I think it’s equally important (if not more important) to see how young people are hurt and how the burden of government spending goes up.

Now let’s see what the authors found for Slovakia.

…we quantify the fiscal costs of the reform reversal in Slovakia by comparing the debt impact under the reform reversal scenario with that under the baseline scenario. Our results show that such a reform reversal would be very costly. In fact, the increase in the public debt-to-GDP ratio would be more than 50 percentage points higher than the estimated increase of around 100 percentage points of GDP under the baseline scenario (see Table 7).

Here’s Table 7, and again I have highlighted in red the increase in debt as well as the data showing additional harm to young people and a much bigger increase in the burden of government spending.

So what do these findings mean for the United States?

Let’s explain using a homemade infographic. I’ve put four options for Social Security on a spectrum. Here’s what they mean.

• “Expand Social Security” means more taxes and spending in pay-as-you-go systems that are already costly and out of balance.
• The “Status Quo” is a typical pay-as-you-go-system (where the United States is now and where Germany and Slovakia were before their reforms).
• “Conventional Reform” means trying to stabilize a pay-as-you-go system by demanding that workers pay more while promising to give them less (what Germany and Slovakia did).
• The most market-friendly position is “Personal Retirement Accounts,” which transforms creaky pay-as-you-go systems into real individual savings.

Here’s the infographic, including arrows to indicate that some options mean more government and others mean more prosperity.

What Germany and Slovakia did was move from “Status Quo” to “Conventional Reform.” But now they’re backtracking on those reforms and shifting back to the old version of the “Status Quo.”

In other words, a move in the direction of “More Government” and the European Central Bank’s study shows such a step will have negative consequences.

In the United States, by contrast, some folks on the left want America to move from “Status Quo” to “Expand Social Security.”

Like Germany and Slovakia, we’d be moving in the wrong direction. But the damage for the U.S. presumably would be worse because we didn’t first take a step in the right direction.

P.S. If you want to learn more about the best option, Australia, Denmark, Chile, Switzerland, Hong Kong, Netherlands, Faroe Islands, and Sweden are a few of the many jurisdictions that have fully or partially shifted to systems based on real savings.

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Help Workers and the Economy with Lower Employment Taxes

One of the core principles of economics is that prices are determined by supply and demand. That includes the price of labor – i.e., the wages received by workers.

Another core principle is that taxes create distortions by reducing demand and supply. Which is why it’s not a good idea to impose high tax rates on behaviors that contribute to prosperity, such as work, saving, investment, and entrepreneurship.

That’s the theory. Now let’s consider some real-world implications of taxes on work.

Here are some excerpts from new research by the European Central Bank.

Several reforms can be enacted to reduce the unemployment rate in the euro area. Among them is a permanent reduction in the labour tax. Typically, a decrease in labour taxes reduces labour costs to employers and increases the net take-home pay of employees, positively impacting both labour demand and labour supply. Reducing taxes on labour can contribute to increase employment and activity rates in the EA, by increasing incentives to hire, to look for, and take up, work. …In this paper we contribute to the debate on those issues by evaluating the macroeconomic effects of a fiscal reform in the EA countries.

The study look at what happens with employment-related taxes are lowered at either the employer level or the employee level.

Permanently reducing labour tax rates paid by Home firms would have stimulating effects on economic activity and employment, and would permanently reduce the unemployment rate. The same is true when tax rates paid by Home households are reduced.

Here are some of the specific estimates of the positive impact of lower labor taxes at the firm level.

The tax rate is reduced by almost 2 p.p. (trough level). The reduction of labour taxes paid by firms reduces the gross wage bill of firms and hence increases the value of having a worker. Workers are able to obtain part of the increase in firms’ surplus in the bargaining process, which results in a real wage increase. Nevertheless, the wage increase is not sufficient to undo the increase in the value of having a worker for firms, which leads to an increase in labour demand through vacancy posting. The number of matches increases as well and, consistently, the probability of finding a job and that of filling a vacancy increases and decreases, respectively. Employment increases (and unemployment rate decreases) by roughly 0.3 p.p. after two years and 0.4 p.p. in the medium and in the long run, respectively. …Home GDP increases by 0.5% after two years. Both consumption and investment increase. Consumption increases because of households’ larger permanent income, associated with the increase in employment, hours and production. Investment increases because firms augment physical capital to accompany the rising employment.

I’ve combined some of the key results from Figures 3 and 4, all of which show the benefits over time of lower tax rates on work (the horizontal axis is quarters, so 20 quarters equals five years).

And here are the specific estimates of the good outcomes when labor tax are reduced at the household level.

Qualitatively, results are similarly expansionary as those obtained when reducing labour taxes paid by firms. Hours worked, employment, matches, and the probability of finding a job increase, while the probability of filling a vacancy decreases. …hours worked now increase by 0.4% (0.3% in the previous simulation), employment by almost 0.5% (0.35% in the previous simulation), while the unemployment rate falls by almost 0.5 p.p. (0.4 p.p. in the previous simulation). …Home GDP increases by around 0.7% after two years.

Once again, let’s look at some charts showing the benefits over time of lower tax rates on workers.

Interestingly, it appears that there are slightly better outcomes if labor taxes are reduced for workers rather than employers, but the wage numbers are better if the tax cuts take place at the business level.

I’ll take either approach, for what it’s worth.

Let’s close with one additional excerpt. The study incorporated the impact of government employment, which can have a very distorting effect on private employment given the excessive size of the bureaucracy and above-market compensation for bureaucrats.

…we allow for public sector employment and for the possibility of directed search between the private and public sector labour market… In fact, a proper assessment of the impact of the labour market reforms on private-sector employment should take into account that a common characteristic of the EA labour market is the important share of the public employment in total employment, which is, according to OECD (2015), around 20% in France, 15% in Spain, Italy and Portugal, and 13% in Germany. Thus, this component is important to understand the labour market dynamics in the EA, given also that, during a crisis period, public and private labour markets tend to be more inter-related (when the unemployment rate is high, the number of applicants to the public sector is larger).

P.S. I’m periodically asked whether I’m exaggerating when I assert that something (such as taxes distorting the supply and demand for labor) is a “core principle” in economics. But I don’t think left-leaning economists (and there are plenty) would disagree about taxes impacting supply and demand. But they presumably would quibble about the “elasticity” of supply and demand curves (in other words, how sensitive are people to changes in tax rates). Moreover, they surely would claim in some instances that any “deadweight loss” would be offset by supposed economic benefits of government spending (and pro-market people acknowledge that’s possible, at least when government is small). And, when push comes to shove, some folks on the left would openly argue that it’s okay to have less prosperity if there’s more equality.

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ECB Research: Pro-Market Reforms Generate Very Positive Results, but not Overnight Miracles

I wrote three days ago about the worst-international-bureaucracy contest between the International Monetary Fund and the Organization for Economic Cooperation and Development.

A reader emailed to ask me whether I had a favorite international bureaucracy. I confess I’ve never given that matter any thought. My gut-instinct answer would be the World Trade Organization since its mission is to discourage protectionism.

But I’m also somewhat fond of the European Central Bank, both because the euro has been better than many of the currencies it replaced and because the ECB often publishes good research.

• Two studies (here and here) on the benefits of spending caps.
• Two studies (here and here) showing small government is more efficient.
• Two studies (here and here) on how large public sectors retard growth.
• And also studies on the adverse impact of regulation, bureaucracy, and welfare.

And here’s a study on regulation to add to the collection. The European Central Bank published a working paper that looks at the effect of selected pro-market reforms. Here’s their methodology.

In this paper, we investigate the relationship between a wide range of structural reforms and economic performance over a ten-year time horizon. …we identify 23 episodes of wide-reaching structural reform implementation (so-called “reform waves”). These are based on a database…which provides detailed information on both real and financial sector reforms in 156 advanced and developing countries over a 40 year period. Indicators considered specifically cover trade-, product market-, agriculture-, and capital-account liberalisation, together with financial and banking sector reform. Then, we track top-reforming countries over the 10 years following adoption and estimate the dynamic impact of reforms.

And here’s an excerpt that describes the theoretical assumptions.

…orthodox economic theory has made a strong case for structural reforms, identified as measures aimed at removing supply-side constraints in an economy. This in turn would favour efficient factor allocation and contribute to medium- to long-term growth. Such measures include, but are not limited to, product and labour market liberalisations, current and capital account openness, and financial liberalisation. For a long time, a collection of these policies has fallen under the name of Washington Consensus.

I agree with this theory, though allow me to elaborate.

The Fraser Institute’s Economic Freedom of the World is the gold standard when looking at overall economic policy. It considers five major factors – fiscal policy, trade policy, regulatory policy, monetary policy, and governance policy (indicators such as rule of law and property rights).

The “Washington Consensus” also is based on good policy, but it undervalues the importance of a small burden of government spending.

But I’m digressing. Let’s return to the ECB study, which basically looks at the impact of trade liberalization and deregulation. Here’s what the authors found.

Our main findings are as follows: on average, reforms had a negative but statistically insignificant impact in the short term. This slowdown seems to be connected to the economic cycle, and the tendency to implement reforms during a downturn, rather than an effect of reforms per se. Reforming countries however experienced a growth acceleration in the medium-term. As a result, ten years after the reform wave started, GDP per capita was roughly 6 percentage points higher than the synthetic counterfactual scenario.

Here’s a chart from the study illustrating the positive effect of reform.

And here’s another chart from the ECB report looking at the results from another perspective.

The obvious good news from this research is that we have new evidence about the benefits of pro-market reforms. Boosting economic output by an extra 6.3 percent is nothing to sneeze at. And it reinforces my oft-made point that even small improvements in growth – if sustained over time – can lead to dramatic improvements in living standards.

What might be most noteworthy in this study, however, is the finding that pro-market reforms are associated with a short-run dip in economic performance. The authors suggested that it might be a statistical quirk related to the fact that governments have a “tendency to implement reforms during a downturn”.

That’s certainly plausible, but I’m also open to the notion that good reforms sometimes may have short-run costs. Simply stated, if bad policy has produced a misallocation of labor and capital, then pro-growth reforms are going to cause some temporary disruption.

But unless you’re planning on dying very soon and also don’t care about your heirs, that’s not an argument against reform. For example, I think the housing lobby’s opposition to the flat tax is misguided since every sector will enjoy long-run benefits from faster growth, but it’s certainly possible that residential real estate will endure some short-run weakness as some resources shift to business investment.

Unfortunately, politicians tend to have very short time horizons (i.e., the next election), so they fixate on short-run costs and under-value long-run benefits.

But I’m digressing again. Let’s look at one final passage from the ECB study. For those interested in additional research, there’s a section citing some of the other literature on liberalization and growth.

Post-Soviet countries moving towards a market economy have received considerable attention in this respect. Fischer et al. (1996) looked at 26 transition economies over the period 1989-1994. They conclude that structural reforms played a vital role in reviving economic growth. This finding for transition economies was echoed by de Melo et al. (1996), and more recently by Havrylyshyn and van Rooden (2003) and Eicher and Schreiber (2010). Focussing more broadly on countries implementing wide reform packages covering domestic finance, trade, and the capital account, Christiansen et al. (2013) find a strong impact of the former two on growth in middle-income countries. Moreover, they show how well-developed property rights are a precondition in order to reap fully the benefits of structural reforms. The importance of institutions in explaining cross-country heterogeneity is further remarked by Prati et al. (2013), who illustrate how the positive relationship between structural reforms and growth depends on a country’s constraints on the authority of the executive power. Distance from the technological frontier seems also to play a role.

If you’re not familiar with technological jargon, “distance from the technological frontier” is basically a way of saying that nations with lots of bad policy – and thus lots of misallocated and/or underutilized labor and capital – probably have more ability to enjoy fast growth. Sort of a version of convergence theory.

I also like the reference to “constraints on the authority of the executive power,” which presumably a recognition of the importance of the rule of law.

The bottom line is that the ECB study reconfirms that free enterprise is the answer if the goal is reducing poverty and increasing prosperity.

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The Negative Macroeconomic Impact of Overpaid Bureaucrats

Last year, I shared some remarkable research from the Organization for Economic Cooperation and Development about the negative relationship between government spending and economic performance.

The economists at the Paris-based bureaucracy looked at data from its member nations (primarily Europe, North America, and the Pacific Rim), discovered that the countries with bigger government experienced less growth, and concluded that there would be much more prosperity if those nations merely reduced government modestly.

So you can imagine what sort of numbers that study would have generated if a few jurisdictions with genuinely modest-sized government, such as Hong Kong and Singapore, were part of the data.

But that’s a separate issue. Today’s topic is about a study from another international bureaucracy. The European Central Bank has new research looking at the impact specifically of excessive pay for government bureaucrats. Here are the key findings from the nontechnical summary at the beginning of the paper.

…there are benefits from government wage bill reform that go beyond the objective of fiscal consolidation. …a rationalisation of government wages and employment policies can generate favourable labour market effects in the medium to longer term through competitiveness and efficiency gains. Competitiveness gains materialise through the spillovers effects of public wage moderation on the determination of private sector wages. …An important aspect of the debate on public wage bill restraint concerns how long such policies can be sustained over time. …Additional margins of short-term adjustment include the moderation of still high public-to-private wages gaps, or a possible continuation of the downsizing trend in public employment, depending on the country-specific situation. …Finally, the paper argues that reforms affecting public sector personnel are most effective and have more sustained effects when the measures implemented are of a structural nature… Some examples are…measures to streamline the size and scope of government.

Wow, an international bureaucracy writing about the economic benefits that accrue if policy makers “streamline the size and scope of government.” Be still, my beating heart!

If you’re a policy wonk, you’ll like the fact that the study is filled with lots of interesting data and charts.

…aggregate data show that the euro area government wage differential with respect to the private sector increased from 20% in 2007 to 25% in 2009, and subsequently fell to 23% in 2014.

Here’s the relevant chart. The blue line, which links to the left axis, shows the degree to which bureaucrats are overpaid compared to the private sector. For the past 10 years, the “pay premium” has been in the 20 percent-25 percent range.

This problem of excessive pay for the bureaucracy has been a growing problem.

…general government compensation of employees grew faster than nominal GDP over the whole 2007-2014 crisis period

Though once the “austerity” era began about 2010, there was a bit of reform to bureaucrat compensation (in Europe, “fiscal consolidation” mostly meant higher taxes, but some spending restraint), particularly in nations that were forced to make changes because investors were becoming increasingly reluctant to lend them more money..

Here’s a chart showing bureaucrat pay as a share of GDP, with the blue bar showing the amount of economic output consumed by government workers in 2010 and the yellow dots showing the level in 2014. Some countries increased the relative burden of bureaucrat compensation and others reduced it, but what strikes me as noteworthy is that Germany and the Czech Republic deserve praise for keeping the burden low (honorable mention for Luxembourg and Slovakia) while Denmark stands out for being absurdly extravagant.

For a longer-term perspective, at least with regards to the size of the bureaucracy, here’s a table showing the share of the population getting a paycheck from government. Fascinating data. I especially like the columns on the right, which show that Ireland, the Netherlands, and the United Kingdom deserve credit for reducing over time the amount of bureaucrats relative to the private sector. The nations that have moved farthest in the wrong direction, by contrast, are Greece (gee, what a surprise), Spain, Portugal, and Finland.

Now let’s get to the meat of the study, which looks at the economic impact of less bureaucracy.

The authors cite some of the existing academic research, much of which focuses on the degree to which excessive pay for the public sector causes economy-wide distortions that make nations less competitive and result in slower growth. Basically, excessive pay for bureaucrats forces private employers to increase pay as well, but in ways that aren’t sustainable based on underlying levels of productivity.

A seminal work Alesina et al. (2002) found that reducing public wage expenditure generates reductions in private wages per employee, which improves competitiveness, increasing profits, investment, and economic growth. …A key argument is that public wage restraint may set in motion a labour market adjustment through the inter-linkages with private wages. …The literature has found robust evidence of significant interrelations between public and private sector wages per employee. A wealth of recent empirical papers provides evidence of a direct causal relationship between these variables. …The empirical literature tends to find that public employment crowds-out private sector employment.

But when fiscal pressures force politicians to cut back on the excessive pay for government employees, this enables the private sector to have pay levels that are consistent with sustainable long-run growth.

The authors share some of their new findings.

…the recent consolidation period has contributed to some competitiveness gains in the euro area, in view of the evidence provided on the partial correction of the public-private wage premium. …Overall, the restraint in public wages directly reduced unit labour cost (ULC) growth in the euro area during the 2010-2014 period. …The existence of distortions in public-private wage gaps…can be particularly harmful for competitiveness given that public sector activities are concentrated in non-tradable sectors, which are less exposed to international competition. …There is evidence that the recent public wage restraint has driven the partial correction of the existing positive public-private wage premium in the euro area.

The authors close by discussing some policy implications.

Well-designed government wages and employment policies and reforms may generate overall economy competitiveness gains and increase the efficiency of the labour market. …public employment adjustments can affect GDP and total economy employment positively if there are large inefficiencies in the government sector… In addition, if a public pay gap exists, the latter positive effect of public wage restraint becomes amplified as labour market inefficiencies are also reduced.

This is helpful research. It’s not often that a government bureaucracy releases a study showing that overpaid bureaucrats hinder overall economic performance.

Though I hasten to add that the study only looked at the macroeconomic effect of excessive pay. As I argue near the end of this video I narrated for the Center for Freedom and Prosperity, the additional problem is that various bureaucracies are engaging in activities that are economically harmful. In the case of the United States, the Department of Agriculture, Department of Education, and Department of Housing and Urban Development would be just a few examples of agencies where programmatic spending surely is more damaging that bureaucrat compensation.

The good news is that the ECB study also recognizes the need for structural reform. That’s why there was a reference to the need to “streamline the size and scope of government.”

The bad news is that politicians don’t care about this consensus.

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Scholarly Evidence against the Welfare State

I repeatedly try to convince people that the welfare state is bad for both taxpayers and poor people.

Sometimes I’ll add some more detailed economic analysis and explain that redistribution programs undermine growth by reducing labor supply (with Obamacare being the latest example).

And I’ve even explained that the welfare state has a negative impact on savings and wealth accumulation (these dramatic charts show Social Security debt in America compared to ever-growing nest eggs in Australia’s private pension system).

But if new research from the European Central Bank (ECB) is any indication, I should be giving more emphasis to this final point.

Culling from the abstract, here’s the key finding from the working paper by Pirmin Fessler and Martin Schürz.

…multilevel cross-country regressions show that the degree of welfare state spending across countries is negatively correlated with household net wealth. These findings suggest that social services provided by the state are substitutes for private wealth accumulation and partly explain observed differences in levels of household net wealth across European countries.

Here are details from the study.

We regress net wealth on income…and add welfare state country level variables. …The main result of these hierarchical linear models is that pension and social security expenditure measured as shares of GDP show significant and negative correlation with household net wealth levels. …We regard this as evidence that welfare state expenditures indeed act as substitutes for private wealth accumulation and explain partly observed differences in household net wealth among euro area countries. A larger and more active welfare state leads to less need for private households to accumulate private wealth.

Here’s a pair of graphs from the study, showing the negative relationship between government-provided pensions and private wealth.

Now here’s the part that should make honest leftists more open to entitlement reform.

The data show that the welfare state increases inequality!

The effect of a 1 percentage point increase in state pension expenditure as a share of GDP on net wealth is a decrease about 20% less wealth for households around the 10th net wealth percentile. The size of the negative impact is smaller for wealthier households, but remains at above 10% of net wealth. Social security expenditure shows a similar but somewhat weaker effect, ranging at around 10% at the 10th net wealth percentile and coming close to zero for the wealthiest. …we see a decrease in net wealth of 47% for the low wealth household, of 16% for the middle wealth household, and 8% for the high wealth household. These numbers are roughly in line with our results… Additional welfare state spending is negatively associated with all wealth levels but decreasing in size relative to wealth across the full net wealth distribution. …this mechanism would lead to increased observed inequality of private net wealth given an increase of welfare state activity.

Those are some damning results.

And the numbers might be even worse in the United States since many minorities already are screwed by Social Security because they have shorter lifespans.

P.S. Since we’re on the topic of inequality, regular readers know that I think the issue as a complete red herring. Simply stated, the goal should be faster growth and it doesn’t matter if some people get richer faster than others get richer (assuming, of course, that the rich are earning their money and not getting subsidies, bailouts, and other forms of unearned wealth).

That being said, if somebody had asked me whether there had been a significant increase in inequality over the past couple of decades, I would have guessed – based on all the feverish rhetoric from our statist friends – that the answer is yes. So I was very surprised to see this chart from Mark Perry at the American Enterprise Institute.

In other words, the politicians who are talking about a supposed crisis of growing inequality are spouting nonsense. And I’m ashamed I didn’t know their rhetoric is a bunch of you-know-what.

That being said, if their concern about inequality is legitimate and not just for purposes of demagoguery, I expect them to read the ECB working paper discussed above and add their voice in support of a smaller welfare state and in favor of Social Security reform.

P.P.S. If the New York Times can support private retirement savings (albeit by accident), then other leftists should be able to do the same thing.

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Easy Money Is Creating the Conditions for a Bigger European Economic Crisis

At the beginning of the year, I was asked whether Europe’s fiscal crisis was over. Showing deep thought and characteristic maturity, my response was “HAHAHAHAHAHAHAHAHA, are you ;@($&^#’% kidding me?”

But I then shared specific reasons for pessimism, including the fact that many European nations had the wrong response to the fiscal crisis. With a few exceptions (such as the Baltic nations), European governments used the crisis to impose big tax hikes, including higher income tax rates and harsher VAT rates.

Combined with the fact that Europe’s demographic outlook is rather grim, you can understand why I’m not brimming with hope for the continent. And I’ve shared specific dismal data for nations such as Portugal, France, Greece, Italy, Poland, Spain, Ireland, and the United Kingdom.

But one thing I’ve largely overlooked is the degree to which the European Central Bank may be creating an unsustainable bubble in Europe’s financial markets. I warned about using bad monetary policy to subsidize bad fiscal policy, but only once in 2011 and once in 2012.

Check out this entertaining – but worrisome – video from David McWilliams and you’ll understand why this issue demands more attention.

I’ve openly argued that the euro is not the reason that many European nations got in trouble, but it appears that Europe’s political elite may be using the euro to make a bad situation even worse.

And to add insult to injury, the narrator is probably right that we’ll get the wrong outcome when this house of cards comes tumbling down. Instead of decentralization and smaller government, we’ll get an expanded layer of government at the European level.

Or, as I call it, Germany’s dark vision for Europe.

That’s Mitchell’s Law on steroids.

P.S. Here’s a video on the five lessons America should learn from the European crisis.

P.P.S. On a lighter note, the mess in Europe has generated some amusing videos (here, here, and here), as well as a very funny set of maps.

P.P.P.S. If all this sounds familiar, that may be because the Federal Reserve in the United States could be making the same mistakes as the European Central Bank. I don’t pretend to know when and how the Fed’s easy-money policy will turn out, but I’m not overly optimistic about the final outcome. As Thomas Sowell has sagely observed, “We all make mistakes. But we don’t all have the enormous and growing power of the Federal Reserve System… In the hundred years before there was a Federal Reserve System, inflation was less than half of what it became in the hundred years after the Fed was founded.”

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European Central Bank Research Shows that Government Spending Undermines Economic Performance

Europe is in the midst of a fiscal crisis caused by too much government spending, yet many of the continent’s politicians want the European Central Bank to purchase the dodgy debt of reckless welfare states such as Spain, Italy, Greece, and Portugal in order to prop up these big government policies.

So it’s especially noteworthy that economists at the European Central Bank have just produced a study showing that government spending is unambiguously harmful to economic performance. Here is a brief description of the key findings.

…we analyse a wide set of 108 countries composed of both developed and emerging and developing countries, using a long time span running from 1970-2008, and employing different proxies for government size… Our results show a significant negative effect of the size of government on growth. …Interestingly, government consumption is consistently detrimental to output growth irrespective of the country sample considered (OECD, emerging and developing countries).

There are two very interesting takeaways from this new research. First, the evidence shows that the problem is government spending, and that problem exists regardless of whether the budget is financed by taxes or borrowing. Unfortunately, too many supposedly conservative policy makers fail to grasp this key distinction and mistakenly focus on the symptom (deficits) rather than the underlying disease (big government).

The second key takeaway is that Europe’s corrupt political elite is engaging in a classic case of Mitchell’s Law, which is when one bad government policy is used to justify another bad government policy. In this case, they undermined prosperity by recklessly increasing the burden of government spending, and they’re now using the resulting fiscal crisis as an excuse to promote inflationary monetary policy by the European Central Bank.

The ECB study, by contrast, shows that the only good answer is to reduce the burden of the public sector. Moreover, the research also has a discussion of the growth-maximizing size of government.

… economic progress is limited when government is zero percent of the economy (absence of rule of law, property rights, etc.), but also when it is closer to 100 percent (the law of diminishing returns operates in addition to, e.g., increased taxation required to finance the government’s growing burden – which has adverse effects on human economic behaviour, namely on consumption decisions).

This may sound familiar, because it’s a description of the Rahn Curve, which is sort of the spending version of the Laffer Curve. This video explains.

The key lesson in the video is that government is far too big in the United States and other industrialized nations, which is precisely what the scholars found in the European Central Bank study.

Another interesting finding in the study is that the quality and structure of government matters.

Growth in government size has negative effects on economic growth, but the negative effects are three times as great in non-democratic systems as in democratic systems. …the negative effect of government size on GDP per capita is stronger at lower levels of institutional quality, and ii) the positive effect of institutional quality on GDP per capita is stronger at smaller levels of government size.

The simple way of thinking about these results is that government spending doesn’t do as much damage in a nation such as Sweden as it does in a failed state such as Mexico.

Last but not least, the ECB study analyzes various budget process reforms. There’s a bit of jargon in this excerpt, but it basically shows that spending limits (presumably policies similar to Senator Corker’s CAP Act or Congressman Brady’s MAP Act) are far better than balanced budget rules.

…we use three indices constructed by the European Commission (overall rule index, expenditure rule index, and budget balance and debt rule index). …The former incorporates each index individually whereas the latter includes interacted terms between fiscal rules and government size proxies. Particularly under the total government expenditure and government spending specifications…we find statistically significant positive coefficients on the overall rule index and the expenditure rule index, meaning that having these fiscal numerical rules improves GDP growth for these set of EU countries.

This research is important because it shows that rules focusing on deficits and debt (such as requirements to balance the budget) are not as effective because politicians can use them as an excuse to raise taxes.

At the risk of citing myself again, the number one message from this new ECB research is that lawmakers – at the very least – need to follow Mitchell’s Golden Rule and make sure government spending grows slower than the private sector. Fortunately, that can happen, as shown in this video.

But my Golden Rule is just a minimum requirement. If politicians really want to do the right thing, they should copy the Baltic nations and implement genuine spending cuts rather than just reductions in the rate of growth in the burden of government.

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Will Europe’s Feckless Politicians Destroy the Euro?

As demonstrated by the new video from the Center for Freedom and Prosperity, there are five key lessons to learn from the fiscal crisis in Europe.

Unfortunately, Europe’s despicable political class has not learned from their mistakes. They are not taking the simple and obvious steps that are needed to address the problems of spendthrift governments.

Instead, they want to compound bad fiscal policy with bad monetary policy by having the European Central Bank purchase even more bonds issued by the continent’s most decrepit welfare states.

I warned last year that this was a big mistake and I’m glad to see that the issue is now getting more attention. Here’s some of what the Wall Street Journal said in an editorial this morning.

Only weeks into his new job as president of the European Central Bank, the Italian is being portrayed along with German Chancellor Angela Merkel as the main—the only—obstacle to saving the euro zone. If only the ECB would print a few trillion euros to buy the debt of spendthrift European countries, all will be well. Hang in there, Mr. Draghi, and you too, Chancellor. Don’t let the French, the British and the Yanks, the euro-pundits and the other blabbering bullies for bailouts get you down. Someone needs to defend the principle of central bank independence and price stability. The ECB has been by far the most effective part of the euro system since its founding. It shouldn’t squander that legacy now by taking on the debts of spendthrift governments that are the real cause of this crisis. It’s true that the ECB has already become a little bit pregnant in buying sovereign bonds, first taking on Greek, Irish and Portuguese debt, and this summer Spanish and Italian bonds. A week ago Friday, the ECB held €187 billion worth of country bonds. …So far, the ECB’s bond purchases have been limited enough that the central bank has been able to “sterilize” them, meaning they are offset by withdrawing money elsewhere in the banking system and haven’t added to the overall supply of money. But a multitrillion euro program would make sterilization impossible and would become a money-printing exercise. …If the Germans and ECB do write a blank check, then the balance of power within the euro zone will shift markedly, and perhaps irreversibly, in favor of the spenders. Even if this prevented short-term panic, it would merely postpone the day of reckoning and leave Europe worse off in the medium and long term. Without a system that can enforce spending restraint, borrowing discipline and economic reform, all the ECB bond-buying in the world won’t save the euro, and the independence of the ECB itself will become another casualty of the crisis.

The mess in Europe is like a slow-motion train wreck. It’s easy to see it won’t work, but that doesn’t stop the politicians from doing the wrong thing.

Indeed, I predicted most of the bad policies. But it doesn’t require much insight to know that statism won’t work, as I acknowledged in my I-told-you-so post.

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Even Studies from the European Central Bank Show Spending Restraint Is Key to Controlling Red Ink

I’m not a big fan of central banks, and I definitely don’t like multilateral bureaucracies, so I almost feel guilty about publicizing two recent studies published by the European Central Bank. But when such an institution puts out research that unambiguously makes the case for smaller government, it’s time to sit up and take notice. And since these studies largely echo the findings of recent research by the International Monetary Fund, we may have reached a point where even the establishment finally understands that government is too big.

The first study looks at real-world examples of debt reduction in 15 European nations and investigates the fiscal policies that worked and didn’t work. Entitled, “Major Public Debt Reductions: Lessons From The Past, Lessons For The Future,” the report unambiguously concludes that spending restraint is the right way to reduce deficits and debt. Tax increases, by contrast, are not successful. The study doesn’t highlight this result, but the data clearly show that, “revenue increases do not seem to have induced debt reductions, whereas cuts in primary expenditure seem to have contributed significantly in the case of major debt reductions.” Here’s a key excerpt.

…this paper estimates several specifications of a logistic probability model to assess which factors determine the probability of a major debt reduction in the EU-15 during the period 1985-2009. Our results are three-fold. First, major debt reductions are mainly driven by decisive and lasting (rather than timid and short-lived) fiscal consolidation efforts focused on reducing government expenditure, in particular, cuts in social benefits and public wages. Revenue-based consolidations seem to have a tendency to be less successful. Second, robust real GDP growth also increases the likelihood of a major debt reduction because it helps countries to “grow their way out” of indebtedness. Here, the literature also points to a positive feedback effect with decisive expenditure-based fiscal consolidation because this type of consolidation appears to foster growth, in particular in times of severe fiscal imbalances.

The last part of this passage is especially worth highlighting. The authors found that reducing spending promotes faster economic growth. In other words, Obama did exactly the wrong thing with his so-called stimulus. The U.S. economy would have enjoyed much better performance if the burden of spending had been reduced rather than increased. One can only hope the statists at the Congressional Budget Office learn from this research.

Equally interesting, the report notes that reducing social welfare spending and reducing the burden of the bureaucracy are the two most effective ways of lowering red ink.

The estimation results indicate that expenditure-based consolidation which mainly concentrates on cuts in social benefits and government wages is more likely to lead to a major debt reduction. A significant decline in social benefits or public wages vis-a-vis the overall decline in the primary expenditure will increase the probability of a major debt reduction by 31 and 26 percent, respectively.

The other study takes a different approach, looking at the poor fiscal position of European nations and showing what would have happened if governments had imposed some sort of cap on government spending. Entitled, “Towards Expenditure Rules And Fiscal Sanity In The Euro Area,” this report finds that restraining spending (what the study refers to as a “neutral expenditure policy”) would have generated much better results.  Here are the main findings.

…the study assesses the impact of the fiscal stance on primary expenditure ratios and public debt ratios and, thus, provides a measure of prudence or imprudence of past expenditure policies. The study finds that on the basis of real time rules, expenditure and debt ratios in 2009 for the euro area aggregate would not have been much different with neutral expenditure policies than actually experienced. …Primary expenditure ratios would have been 2-3½ pp of GDP lower for the euro area aggregate, 3-5pp of GDP for the euro area without Germany and up to over 10 pp of GDP lower in certain countries if expenditure policies had been neutral.

There’s a bit of academic jargon in that passage, but the authors are basically saying that some sort of annual limit on the growth of government spending is a smart fiscal strategy. And such rules, depending on the country, would have reduced the burden of government spending by as much as 10 percentage points of GDP. To put that figure in context, reducing the burden of government spending by that much in America would balance the budget overnight.

There are several ways of achieving such a goal. The report suggests a rule based on the growth of the overall economy, which is similar to a proposal being developed in the United States by Senator Corker of Tennessee. But it also could mean something akin to the old Gramm-Rudman-Hollings law, but intelligently revised to focus on annual spending rather than annual deficits. Some sort of limit on annual spending, perhaps based on population plus inflation like the old Taxpayer Bill of Rights (TABOR) in Colorado, also could be successful.

There are a couple of ways of skinning this cat. What’s important is that there needs to be a formula that limits how much spending can grow, and this formula should be designed so that the private sector grows faster than the public sector. And to make sure the formula is successful, it should be enforced by automatic spending cuts, similar to the old Gramm-Rudman-Hollings sequester provision.

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Will the Euro Turn into the Argentinian Peso or the Zimbabwean Dollar?

I hope the title to this blog post is completely wrong, but the news out of Europe is very grim. Politicians have been over-spending and going deeper and deeper into debt. This negatively affects the private sector in the usual ways (higher taxes, unproductive allocation of resources, etc), but also creates instability in the financial sector since many banks and other institutions have naively lent lots of money to corrupt and inefficient governments. And as this story from the Telegraph indicates, the European Central Bank has been forced to surrenders its independence and is now monetizing government debt. In theory, the ECB is taking other steps to compensate, but the problem is so large (and the political willingness to solve the problem by radically shrinking government is so small) that it is difficult to see a good ending to this saga.

Fitch Ratings has warned that it may take massive asset purchases by the European Central Bank to prevent Europe’s sovereign debt crisis escalating out of control. …The ECB agreed to start buying Greek, Portuguese, and Irish bonds in April to help buttress the EU’s `shock and awe’ package, known as the European Financial Stability Facility. Total purchases so far have been €47bn (£39bn). It has focused its firepower on Greece, mopping up some €25bn of government bonds. This has prevented a collapse of the Greek debt market but at the high political price of letting banks and funds dump their holdings onto the EU taxpayer. ECB council member Jose Manuel Gonzalez-Paramo said it was “not entirely correct” to assume that the ECB was the sole buyer of the debt. “We will continue buying bonds until the situation has stabilized,” he said. …Fitch said European banks must refinance nearly €2 trillion of long-term debt by the end of 2012 in an unfriendly market. “There’s an awful lot of debt coming due in 2011 and 2012, and that is becoming a concern,” said Bridget Gandy, the agency’s banking expert.

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