Entitlement Collapse and Demographic Change

In my recent interview with John Stossel, I explained that America’s entitlement programs are unsustainable because of demographic change.

Our population pyramid is turning into a population cylinder, so there will not be enough working-age taxpayers in the future to finance all the benefits promised to the elderly. Not even close.

This inevitably and unavoidably means one or more of the following options.

• Massive tax increases.
• Massive benefits cuts.
• Massive borrowing.
• Massive money printing.
• Genuine entitlement reform.

Given those choices, entitlement reform is the only sensible path. Both for the United States and for other nations.

Some readers may think I’m exaggerating in order to push a libertarian agenda. So let’s look at some analysis from non-libertarian sources.

We’ll start with some excerpts from a recent report by the St Louse Federal Reserve Bank. Authored by Amy Smaldone and Mark L.J. Wright, it warns that the collapse in fertility is going to be a major problem for tax-and-transfer welfare states.

…the era of rapid population growth is coming to an end. …the world’s population will peak at around 10.5 billion people later this century before beginning to decline. …China’s population is expected to rapidly decline, ending the century around 800 million. Europe’s population has plateaued at approximately three-quarters of a billion people and will decline below 600 million by the end of the century, while the U.S. population is expected to level off at around 400 million. …The slowdown in population growth is due to a collapse in childbirth around the world. …the total fertility rate (TFR)—which represents the expected number of births over a woman’s life…for the world as a whole has fallen from about 5 in 1950 to around 2.3 today. Current TFRs are well below the “replacement rate” (or level needed to keep the population constant) of 2.1 in European countries (where they average 1.5), as well as in China (1.2), South Korea (0.9) and Japan (1.3)… Declining fertility and increased lifespans have resulted in a rapidly aging population. The figure below plots the median age of the population—the age at which half of the people are younger and half are older—around the world. As recently as 1973, half of the world’s inhabitants were under age 21. By the end of the 21st century, more than half will be middle-aged or elderly (40 or older). …the world as a whole will need to contend with a declining share of young workers. It is likely that pension and health care benefits will come under pressure with a shrinking tax base to pay for them.

I’ll add an editorial comment. It’s not “likely” that pension and health care benefits will come under pressure. That’s a given.

To understand why it’s a given, here’s a chart from the report.

As you can see, the average age is going to dramatically increase in all parts of the world.

The U.K.-based Economist also wrote about this topic in its latest issue. It also concludes that changing demographics could lead to fiscal crises.

Across much of the world the fertility rate, the average number of births per woman, is collapsing. Although the trend may be familiar, its extent and its consequences are not. …The largest 15 countries by GDP all have a fertility rate below the replacement rate. That includes America and much of the rich world, but also China and India… a shrinking population creates problems. …The obvious one is that it is getting harder to support the world’s pensioners. …whereas the rich world currently has around three people between 20 and 64 years old for everyone over 65, by 2050 it will have less than two. The implications are higher taxes, later retirements, …and, possibly, government budget crises.

Once again, I’ll add an editorial comment. It’s not that budget crises will “possibly” happen. They will happen.

However, I’ll conclude with a bit of optimism for the United States.

Greece’s fiscal crisis (starting in 2009) was a teachable moment. Republicans actually realized it was a warning sign and took a more-serious approach to the entitlement issue, supporting budgets with genuine Medicaid reform and Medicare reform.

Unfortunately, that reformist energy was blunted by Obama and it then largely evaporated under Trump.

But something similar may happen again. Other nations (probably led by Italy) are going to suffer a fiscal crisis in the not-too-distant future. And when that happens, I hope it will be another learning experience for American lawmakers.

Maybe, just maybe, they’ll then decide to do what’s best for the country.

P.S. For more information about the demographic change and entitlement crisis, click here and here.

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Another European Fiscal Crisis?

Why did many European nations, most notably Greece, suffer fiscal crises about a dozen years ago?

Because the burden of government spending, which already was excessive, increased even further.

And with taxes already very onerous in those countries, much of that new spending was financed with borrowing.

Investors then realized it was very risky to finance the various spending sprees. And when they stopped buying bonds from these governments (or started demanding higher interest rates to compensate for risk), that triggered the crises.

One would think that the nations most affected – Portugal, Italy, Greece, and Spain (the PIGS) – would have learned a lesson.

Nope.

As you can see from this IMF data, those governments did not use the post-crisis recovery as an opportunity to get debt under control. Instead, every nation has more debt today than it did when the crisis occurred.

And why do these nations have higher debt levels?

For the simple (and predictable) reason that they have not reduced the burden of government spending.

Instead, as you can see from this next chart, governments are now consuming even greater shares of national economic output. Which means a greater chance of more crises.

To make a bad situation even worse, the European Central Bank cranked up the figurative printing press starting in 2020 by massively expanding its balance sheet.

Dumping all that money into the system quite predictably caused prices to soar. And now that the ECB is belatedly trying to undo its mistake.

That puts the PIGS under more pressure, as Desmond Lachman explained for National Review.

Christine Lagarde, the president of the European Central Bank (ECB)…has to raise interest rates at a time when governments in the euro zone’s economic periphery are more indebted today than they were at the time of the 2010 euro zone sovereign-debt crisis. This more hawkish interest-rate policy, coupled with a shift to quantitative tightening, now risks triggering another round of the euro zone debt crisis. …One of the ECB’s problems in having to raise interest rates aggressively to contain inflation is that such a course risks exacerbating the cracks that are now emerging in the European banking system. …if current trends continue, then another round of euro zone sovereign-debt crisis, where investors lose faith in the government’s ability to repay its debt, could be just around the corner. …This is especially true for Italy, where until recently the ECB had been buying Italian government bonds equivalent to that government’s net borrowing needs.

By the way, Lachman seems to think the Fed should allow continued inflation in order to help bail out Italy and the other PIGS.

That would be a big mistake. The long-run damage of that approach would be much greater than the long-run damage (actually, long-run benefits) of letting Italy and the others go bankrupt.

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

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

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

P.P.P.P.S. From the archives, here’s some comedy (and more comedy) about Europe’s fiscal mess.

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Bad Math Leads to Bad Economics

The combination of demographic change and poorly designed entitlement programs is producing an ever-increasing burden of federal spending.

In my Twelfth Theorem of Government, I pointed out that this inevitably will mean big tax increases on lower-income and middle-class households.

As stated in the Theorem, if there was a way of financing big government by only taxing the rich, other nations already would have made that choice.

Some of them have tried, but there simply are not enough rich people to finance large welfare states.

But I don’t want any tax increases. Class-warfare tax increases are a bad idea, and so are tax increases on regular people.

It would be much better for the country to reform entitlement programs.

But many politicians (both Democrats and Republicans) disagree.

However, that means they want big tax increases on lower-income and middle-class household.

To emphasize this point, I unveiled my Fifteenth Theorem of Government, which drives home the point that you can’t have big government without pillaging ordinary people.

I pontificated on this issue today in a MoneyShow presentation.

There were lots of charts to justify my two theorems, but these six points hopefully are a good summary of my argument.

For what it’s worth, the first five points are basic math.

Indeed, there are some honest folks on the left (including Paul Krugman) who have made similar observations.

My final point is where the honest leftists and I have a big disagreement. They think it would be a good thing to copy Europe. But I think that would be crazy since European living standards are much lower because of bloated welfare states.

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France and Fiscal Suicide

Which European nation has the costliest welfare state?

Greece would be a good guess, but it’s only in second place.

At the top of the list, according to OECD data, is France, where government spending consumes nearly 60 percent of the nation’s economic output.

These numbers are very depressing, but they are going to get worse over time.

Like most nations in Europe, France is dealing with demographic decline. People are living longer, and also having fewer children.

And that means fewer people pulling the wagon and more people riding in the wagon.

The net result is that the burden of government spending is going to climb by another 12 percentage points of GDP over the next four decades.

Looking at the two charts, it’s obvious that France has a massive fiscal problem.

If it stays on its current course, a Greek-style fiscal collapse is inevitable.

Which explains why President Macron has proposed to take a small step in the right direction by raising the retirement age from 62 to 64.

But even this modest reform is an outrage to some French leftists. In a column for the Washington Post, Rokhaya Diallo denounces the proposed change as an assault on “the French welfare model.”

Like tens of thousands of others, I was proud to be on the Place de la République recently to defend the legacy of the French welfare state. …Across the country, millions have gathered in periodic protests to defend one of the crown jewels of the French welfare model: the pension system. President Emmanuel Macron is determined to reform the pension system and to increase the retirement age from 62 to 64 (he first intended to push it to 65). …According to Macron, the calculus is simple: The French system cannot sustain itself financially, and because life expectancy is increasing, people have to work longer. …Big companies, however, have far more resources at their disposal than individual citizens, and raising corporate taxes would be a fairer way of increasing government revenue. …The fact that we live longer does not mean that we should spend our lives working for companies. Why should we subordinate our lives to the needs of capitalism?

At the risk of being snarky, Ms. Diallo is complaining about the reality of math rather than “the needs of capitalism.”

Though, by proposing higher taxes on French companies, she sort of acknowledges that the status quo is untenable.

So is Ms. Diallo’s proposed policy of higher taxes on workers, consumers, and shareholders a feasible solution to France’s ever-growing fiscal burden? Could all the built-in new spending (12 percentage points of GDP) be financed by a higher corporate tax rate?

No. Not even close. The French corporate tax rate currently is 25.8 percent and it collects about 2.3 percent of GDP according to OECD data.

Given her economic naivete, Ms. Diallo might support a very radical approach, such as doubling the corporate rate to more than 50 percent. And she might think that change would boost receipts from 2.3 percent of GDP to 4.6 percent of GDP.

But she would be wrong. Wildly wrong. As shown by this map from the Tax Foundation, France already has the fourth-highest corporate tax rate in Europe. Any increase (especially a big increase) will simply cause more business activity to leave France and go to nations with less-onerous tax policy.

In other words, a higher rate would not lead to a big increase in revenue. Indeed, it might do so much damage to the business climate that the government would collect less revenue.

And don’t forget that an additional 2.3 percent of GDP in revenue (assuming it magically materialized) is still far less than the built-in spending increase of 12 percent of GDP. So her math is wrong in two ways.

The bottom line is that France has two choices.

1. Stick with the status quo and eventually suffer a horrific fiscal crisis.
2. Enact reforms to prevent an ever-growing spending burden.

Macron’s reforms are grossly inadequate, but at least he wants to take a small step in the right direction. Ms. Diallo wants to put her head in the sand.

P.S. In her column, Ms Diallo notes that lower-income workers don’t live as long.

…mortality numbers vary among social classes. Nurses live seven years less than other women: 20 percent of them and 30 percent of nursing assistants retire with disabilities. Blue-collar workers live six years less than executives, so that one-quarter of the poorest men die by age 62, while 94 percent of the rich are still alive at 64. Only 40 percent of the poorest survive to 80, whereas 75 percent of the wealthiest do.

I want to congratulate her. She accidentally has provided a very good argument for why folks on the left should support personal retirement accounts.

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Biden and Trump Should Learn from Sweden’s Social Security Reform

Some American politicians, such as Joe Biden and Donald Trump, are very much opposed to dealing with Social Security, even though the current system has a massive $56 trillion cash-flow deficit.

For all intents and purposes, both the current president and his predecessor want to kick the can down the road, which surely is a recipe for massive future tax increases and may cause drastic changes to promised benefits.

Given their advanced ages, they probably won’t be around next decade when the you-know-what hits the fan.

But the rest of us will have to deal with a terrible situation thanks to their selfish approach.

Other nations are more fortunate, with leaders who put the national interest above personal political ambition.

Johan Norberg has a new column in the Wall Street Journal about how Swedish lawmakers adopted personal retirement accounts and undertook other reforms to strengthen their pension system.

President Biden refuses to consider any reforms, and so do many Republicans. But that won’t save the program; it’ll doom it. …Sweden faced the same problem in the early 1990s. The old pay-as-you-go pension system had promised too much. With fewer births and longer lives, projections showed the system would be insolvent a decade later. …Its politicians chose not to deceive the voters. …In 1994 the Social Democrats agreed with the four center-right parties to create an entirely new system based on the principle that pensions should correspond to what the beneficiary pays into the system—a system in which the contribution, not the benefits, is defined. …Sweden introduced partial privatization of the kind the American left derides as a Republican plot… The Swedish government withholds roughly 2.3% of wages and puts it into individual pension accounts. Workers are allowed to choose up to five different funds in which to invest this money…the average Swede has made an impressive average return of roughly 10% a year since its inception in 1995, despite the dot-com crash, the financial crisis and the pandemic. …Sweden’s pension system was recently described as the world’s best by the insurance group Allianz, based on a combination of sustainability and adequacy.

Back in 2018, I wrote about Sweden’s pension reforms, and I cited a study I co-authored back in 2000 for the Heritage Foundation.

Readers who want to learn more about the details of the Swedish system should read those publications.

For purposes of today’s column, though, let’s zoom out and see how Sweden’s system compares to other nations.

We’ll start by looking at a report by Mercer and the Chartered Financial Analyst Institute, which compared retirement systems in 43 developed countries. You can click here to view the full report and full rankings, but let’s focus on the United States and Sweden.

As you can see, Sweden beats America in every category, including a giant lead for integrity.

It’s also worth noting that Sweden is above average in every category while the United States is below average in two of the three categories.

Based on the Mercer/CFA report, we know Sweden’s system is good for workers.

But what about taxpayers?

Here’s a table showing the fiscal burden of old-age programs in European nations, taken from a report by the International Monetary Fund.

As you can see for both the present and the future, Swedish taxpayers face one of the lowest burdens, with old-age spending consuming significantly less than 10 percent of economic output.

I’ll close with a couple of very important observations about the international data.

• Sweden is not the top nation in the Mercer/CFA report. It trails Australia, Denmark, Iceland, Israel, Netherlands, and Norway – all of which have systems that are fully or partly based on mandatory private savings.
• Sweden does have the lowest spending burden in the IMF. The Baltic nations all do better – and all of those countries have systems that are partly based on mandatory private savings.

It’s almost as if there’s a lesson to be learned, even if Biden and Trump want to bury their heads in the sand.

P.S. Here’s my short video making the case for personal retirement accounts.

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“Prioritization” and Debt Limit Nonsense

Back in 2016, here’s what I said about the debt limit during some congressional testimony (and I made very similar points in some 2013 testimony).

Near the end of my testimony (about 4:55) I discuss “prioritization,” which is what would happen if the debt limit is not raised and the Treasury Department has to decide which payments are made (and which payments are delayed).

I then pointed out that federal tax revenues in 2017 were expected to be 11 times greater than annual interest payments.

As such, there obviously would have been plenty of cash available to make interest payments, as well as to finance other economically or politically sensitive items (I assume, for instance, that Treasury would have prioritized monthly Social Security benefits as well).

Would this have been messy? Yes. Would it have been uncharted territory not covered by the law? Yes. But would it have been better than default, which would have caused turmoil in financial markets? Another yes.

Which now brings us to the present day. We’re now in another debt limit fight, so I decided to look at the most-recent data from the Congressional Budget Office to see whether the federal government will still have plenty of cash so that interest payments on the debt can be prioritized.

Lo and behold, annual tax revenue this fiscal year is going to be more than 11 times greater than annual interest payments. Just like in 2017.

In other words, we presumably can sleep easy. There’s plenty of money to pay interest on the debt.

There would only be a default if Joe Biden or Janet Yellen (the Treasury Secretary) deliberately chose not to prioritize. And the odds of that happening presumably are way below 1 percent.

Some people may wonder why we should accept even that small risk? Why not simply increase the debt limit so that the odds of a default are 0 percent?

That’s a fair point, but it must be balanced by the recognition that the United States is on a path to long-run economic and fiscal chaos. So I can also understand why some lawmaker say the debt limit should only be raised if accompanied by some much-need spending restraint.

And, for those who care about real-world evidence, that’s what has happened in the past. Indeed, Brian Riedl notes that it’s the only plausible vehicle for altering the nation’s fiscal trajectory.

I’ll close by expressing pessimism that House Republicans will achieve anything in the current fight over the debt limit.

We won’t get something really good, like a spending cap. But I start with very low expectations, so I guess I’m happy that Republicans are at least pretending to care once again about excessive government spending.

A journey of a thousand miles begins with a first step!

P.S. I partially disagree with Brian Riedl’s list. The 1990 Bush tax increase was not a “deficit-reduction law.” And it was post-1994 spending restraint that produced a balanced budget, not Clinton’s 1993 tax increase.

P.P.S. Remember that debt is bad, but it should be viewed as a symptom. The underlying disease is excessive government spending.

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America’s Looming Entitlement Crisis

Back in July, I made the case for the right kind of entitlement reform in a discussion with the folks at Live and Let Live.

Today, I want to underscore why it is important to focus on “the right kind” of reform.

On paper, you can save money with “means testing” of benefits, but that creates an indirect penalty on work, saving, and investment.

You can also, on paper, save money by imposing price controls on health care, but that policy has a long track record of failure.

At the risk of understatement, either of those approaches represents “the wrong kind” of entitlement reform. Indeed, those policies are not really reform. Instead, they are tinkering with systems that are fundamentally broken.

For what it is worth, most politicians do not support good reform or bad reform.

As predicted by “public choice,” their preferred approach is kicking the can down the road.

Which is what Greek politicians did for many years.

But they learned in Greece that ignoring a problem does not make it disappear. Instead, it is a recipe for fiscal crisis (and we will probably have to re-learn that lesson in Italy).

So my other goal today is to show why something needs to be done.

We’ll start with a look at Medicare from Brian Riedl’s chartbook.

That’s a very sobering image, so now I’ll share some very sobering words.

James Capretta of the American Enterprise Institute summarizes America’s grim fiscal future.

In 2001, the Treasury estimated the government’s net unfunded liabilities, in present value terms, at $6.5 trillion, or 61 percent of GDP, with federal debt accounting for $3.3 trillion of the measured obligations. …By 2021, the government’s net position had deteriorated to minus $29.9 trillion, or 128 percent of GDP, with federal debt accounting for $22.3 trillion of the liabilities. The government’s unfunded commitments beyond public debt had grown by $2.9 trillion over ten years. …The financial hole is actually deeper than these numbers reveal because they exclude the dramatic effects of Social Security and Medicare. …with Social Security and Medicare included in the assessment, the federal government’s unfunded liabilities in 2021 are $93.1 trillion, or nearly 400 percent of annual GDP. That compares with $11.1 trillion as calculated in the 2001 Treasury report, which was 105 percent of GDP. …The problem posed by unfunded public liabilities is a relatively new one in U.S. history. It has only been over the past half century that the combination of an aging population and the modern entitlement system has pushed the federal government toward a financial crisis.

Having shared all this depressing data, I’ll now close with a couple of observations.

• First, doing nothing almost surely guarantees massive future tax increases. Including European-style levies like a value-added tax that will be very bad news for lower- income and middle-class taxpayers.
• Second, “funded liabilities” are hardly an improvement over “unfunded liabilities” since that simply means debt-financed spending becomes tax-financed spending. From the frying pan to the fire, or vice-versa.

As I said in the above video, we need the right kind of entitlement reform so that we save money and have better policy for old people and poor people.

P.S. Entitlements are a ubiquitous problem in developed nations.

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European Fiscal Policy Week, Part III: A Continent-Wide Spending Problem

I discussed Italy’s looming fiscal crisis on Monday and then argued against a potential bailout on Tuesday.

Today, let’s focus on the rest of Europe.

I gave a presentation yesterday in Brussels about “Public Finances in the Eurozone” and used the opportunity to explain that governments are too big in Europe and to warn that demographic changes were going to lead to an even-bigger burden of government in the future.

My assessment is very mainstream, at least with regards to what will happen to national budgets in European nations.

A study from the Organization for Economic Cooperation and Development, authored by Yvan Guillemette and David Turner, examines the long-run fiscal position of member nations.

It warns that government debt levels will increase dramatically if they don’t change current policies.

… secular trends such as population ageing and the rising relative price of services will keep adding pressure on government budgets. Without policy changes, maintaining current public service standards and benefits while keeping public debt ratios stable at current levels would increase fiscal pressure in the median OECD country by nearly 8 percentage points of GDP between 2021 and 2060, and much more in some countries. …governments will need to re-assess long-run fiscal sustainability in the context of higher initial government debt levels…when considering expenditure pressures associated with ageing…, the OECD structural primary balance would deteriorate rapidly and net government debt would more than double as a share of GDP by 2050 (Figure 12).

Here is the aforementioned Figure 12. As you can see, both deficits (left chart) and debt (right chart) are driven by the cost of age-related entitlement programs.

The report also explains that the increase in red ink is being caused by a bigger burden of government spending.

Under a ‘business-as-usual’ hypothesis, in which no major reforms to government programmes are undertaken, public expenditure is projected to rise substantially in most countries… Public health and long-term care expenditure is projected to increase by 2.2 percentage points of GDP in the median country between 2021 and 2060… Public pension expenditure is projected to increase by 2.8 percentage points of GDP in the median country between 2021 and 2060… Other primary expenditures are projected to rise by 1½ percentage points of GDP in the median country between 2021 and 2060 (Figure 13, Panel A). This projection excludes potential new sources of expenditure pressure, such as climate change adaptation.

Here’s Figure 13, mentioned above. Notice the projected increases in spending in most European nations.

So what’s the best response to this slow-motion fiscal disaster?

Since more government spending is the problem, you might think the OECD would recommend ways to restrain budgetary expansion.

But that would be a mistake. As is so often the case, OECD bureaucrats think giving politicians more money is the best approach.

The present study…uses an indicator of long-run fiscal pressure that is premised on the idea that governments would seek to stabilise public debt ratios at projected 2022 levels by adjusting structural primary revenue from 2023 onward. … all OECD governments would need to raise taxes in this scenario to prevent gross government debt ratios from rising over time… The median country would need to increase structural primary revenue by nearly 8 percentage points of GDP between 2021 and 2060, but the effort would exceed 10 percentage points in 11 countries.

To be fair, the authors acknowledge that there might be some complications.

Raising taxes…appears feasible in some countries…, in other countries it may present a substantial challenge. In Belgium, Denmark, Finland and France, for instance, structural primary revenue is already around 50% of GDP… Pushing mainstream taxes on incomes or consumption further up, even by only a few percentage points of GDP, may be politically difficult and fiscally counter-productive if it means reaching the downward-sloping segment of the Laffer curve… Lundberg…identifies five OECD countries where top effective marginal tax rates (accounting for income, payroll and consumption taxes) are already beyond revenue-maximizing levels (Austria, Belgium, Denmark, Finland and Sweden). Thus, if taxes are to rise, it might be necessary to look to other bases, such as housing, capital gains, inheritance or wealth. Recent international efforts to establish a minimum global corporate tax could also enable more revenue to be raised from corporate taxes.

I’m happy that the study acknowledges the Laffer Curve, though that is not much of a concession since even Paul Krugman agrees that it exists.

And even when OECD bureaucrats admit that it may be unwise to increase some taxes, their response is to suggest that other taxes can be increased.

Sigh.

Now you understand why I’ve argued that the OECD may be the world’s worst international bureaucracy. Especially since OECD bureaucrats get tax-free salaries while urging higher taxes on the rest of us.

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European Fiscal Policy Week, Part II: The Right Response to Italy’s Fiscal Crisis

I wrote yesterday to speculate about a possible fiscal crisis in Italy.

Today, here are my thoughts on why there should not be a bailout if/when a crisis occurs.

I have moral objections to bailouts, but let’s focus in this column on the practical impact.

And let’s start with this chart, which shows debt levels in Portugal, Italy, Greece, and Spain (the so-called PIGS) ever since the misguided bailout of Greece about a dozen years ago.

As you can see, OECD data reveals that there’s been no change in these poorly governed nations. They have continued to over-spend and accumulate ever-higher levels of debt.

This certainly seems like evidence of failure, in part because of Greece’s continued bad policy.

But I’m equally concerned about how other Mediterranean nations did not change their behavior.

So why did those nations accumulate more debt, even though they had an up-close look at Greece’s fiscal collapse?

I suspect they figured they could get bailouts, just like Greece. In other words, the IMF and others created a system corrupted by moral hazard.

Defenders of bailouts assert that Greece was forced to engage in “austerity” as a condition of getting a bailout.

I have two problems with that argument.

• First, notice how Greece’s debt has continued to go up. If that’s a success, I would hate to see an example of failure.
• Second, the main effect of the so-called austerity is a much higher tax burden and a somewhat higher spending burden.

If there’s a bailout of Italy (or any other nation), I suspect we’ll see the same thing happen. Higher taxes, higher spending, and higher debt.

I’ll close by acknowledging that there are costs to my approach. If Italy is not given a bailout, the country may have a “disorderly default,” meaning the government simply stops honoring its commitments to pay bondholders.

That is bad for individual bondholders, but it also could hurt – or even bankrupt – financial institutions that foolishly decided to buy a lot of Italian government bonds.

But there should be consequences for imprudent choices. Especially if the alternative is bailouts that misallocate global capital and encourage further bad behavior.

The bottom line is that the long-run damage of bailouts is much greater than the long-run damage of defaults.

P.S. Just like it’s a bad idea to provide bailouts to national governments, it’s also a bad idea to provide bailouts to state governments. Or banks. Or student loan recipients.

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European Fiscal Policy Week, Part I: Italy’s Looming Fiscal Crisis

I’m in Europe to give a couple of speeches about fiscal policy, so I’m going to spend all week commenting on the continent’s (mostly miserable) fiscal policy.

Let’s start with comments about Italy, the nation most likely to suffer a crisis.

Normally, I tell people to focus on government spending rather than red ink. After all, the economy is hurt whether spending is financed by taxes or borrowing (or printing money).

But I’ve also noted that governments sometimes spend so much money and incur so much debt that investors decide it is very risky to buy or hold debt from those governments. In other words, they begin to fear default.

When investors (sometimes known as “bond vigilantes”) reach that stage, they probably try to get rid of their holdings and definitely refuse to buy more debt. The net result is that profligate governments have to offer much higher interest rates to compensate for the risk of a possible default.

That happened earlier this century in Greece.

And if peruse this data from the OECD, you find that Italian government debt has jumped to levels that may be unsustainable.

So why has Italy avoided a crisis?

As noted in this article by Desmond Lachman, published by Inside Sources, the nation is being propped up by the European Central Bank.

In Europe, when the European Central Bank (ECB) soon dials back its bond-buying program, we are likely to find out that it is the Italian economy that has been swimming naked. This should be of deep concern for the Eurozone and world economies. While the Italian economy might be too large for its Eurozone partners to allow it to fail, it also might prove to be too large for them to bail it out. …The main factor that has allowed the Italian government to finance its ballooning budget deficit on favorable terms has been the ECB’s massive government bond-buying…the ECB used its emergency bond-buying program to more than fully finance the Italian government’s borrowing needs. …it must be only a matter of time before we have another round of the Italian sovereign debt crisis. …no longer being able to count on ECB bond-buying, the Italian government will have to increasingly finance itself in the market. It will have to do so with its public finances in a worse state than they were in during the 2012 debt crisis.

In the article, Lachman thinks a crisis is all but inevitable because the ECB is unwinding its pandemic-era money creation.

I agree about the ECB’s harmful role, but I fear the central bankers in Frankfurt will continue to do the wrong thing.

P.S. I mentioned demographics at the start of the video. Here’s some more information about how aging populations are contributing to fiscal meltdown.

P.P.S. Italy can solve its problems, but I doubt it will choose the only effective solution.

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Learning a Lesson about Big Government from Barbados

I realize few readers are interested in small, faraway countries. But I periodically write about nations such as Jordan, Cyprus, Latvia, Vanuatu, Panama, and Pakistan because they offer important lessons – mostly negative, but sometimes positive – about fiscal policy.

Today, let’s see what we can learn from Barbados.

That island nation in the Caribbean wound up in fiscal trouble a few years ago and Abrahm Lustgarten of the New York Times wrote a lengthy article last week about that experience.

Here’s the situation as of 2018.

Barbados was out of money. It was so broke that it was taking out new loans just to pay the interest on the old ones, even as its infrastructure was coming undone. Soon the nation would have no choice but to declare itself insolvent, instigating a battle with the dozens of banks and creditors that held its $8 billion in debt and triggering austerity measures that would spiral the island into further poverty. …Mottley, the first woman to lead Barbados, had been working…to develop a plan that would restructure the country’s soaring debts in a way that would free up money to invest in Barbados’s economy.

While the preceding excerpts are mostly to illustrate what was happening, I can’t resist two editorial comments.

• First, the right kind of austerity produces growth rather than poverty.
• Second, government spending rarely acts as productive investment.

Now let’s get back to the story.

Prime Minister Mottley’s plan involved going to the International Monetary Fund, then headed by Christine Lagarde, for a bailout.

Mottley knew that banks and investors would work with her only if Barbados were participating in a formal I.M.F. program… Mottley wanted Lagarde to endorse an economic program that would still allow her to raise salaries of civil servants, build schools and improve piping and wiring for water and power. …No one was sure how Lagarde would respond. Would she trust Mottley to spend on Barbados first? …the director’s surprising reply: She was extremely supportive of what Mottley was proposing.

Needless to say, I don’t like bailouts. And a bailout that enables more government spending seems especially foolish.

But I like to check the numbers before making sweeping pronouncements.

And while I am very skeptical of IMF bailouts, I like that the international bureaucracy has an extensive database with economic and fiscal numbers. Including fiscal data for Barbados going back to 1994.

So let’s see whether Barbados somehow was being hurt by inadequate levels of government spending.

But it turns out that total government spending today is more than four times greater than it was in 1994.

And if we look at government spending as a share of gross domestic product, we can see that government has nearly doubled in size.

To be fair to Ms. Mottley, the politicians in office from 1994-2008 were the most profligate.

But none of that changes the fact that government is far bigger today than it was in the recent past. So the notion that Barbados needs a bigger government budget is nonsense.

Sadly, the reporter did not bother to share any of these numbers. Indeed, in a story that ran more than 10,000 words, there were only 50 words that even hinted at the real problem.

…a mixture of poor management and corruption had eroded the country’s economy. …the country had developed a “dysfunctional” fiscal culture in which government agencies and departments took loans and negotiated deals without consulting the central bank, accumulating sprawling debt… The country’s response was to print more money and borrow more.

I’ll close by observing that Barbados never would have gotten into trouble if it had a Swiss-style spending cap. If government spending had been allowed to grow only 3 percent each year starting in 1994, Barbados would be enjoyed a huge budget surplus today.

P.S. Ironically, economists at the IMF have written in favor of spending caps on multiple occasions. Too bad the political hacks in charge of the bureaucracy don’t pay attention to that research.

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The Case for Entitlement Reform

If Joe Biden’s bungled economic policy is any indication, the GOP may wind up controlling Washington in the not-too-distant future.

If so, I hope Republicans rekindle their interest in the kind of genuine entitlement reform discussed in this interview.

But I’m not sure whether to be optimistic or pessimistic.

On the plus side, the GOP supported pro-growth entitlement reform during the Obama years.

On the minus side, the party largely punted on the issue once Trump took over.

To be sure, punting is the easy route from a “public choice” perspective. Politicians like offering freebies to voters and many voters like getting handouts.

However, that approach means America’s economy is weakened by an ever-growing burden of federal spending and eventually is plunged into fiscal crisis.

And that’s based on the programs that already exist. Joe Biden wants to expand the welfare state with even more entitlements!

The Wall Street Journal editorialized about the downside of making America more like Europe last October.

The result of…expanded entitlements is likely to be reduced incentives to work and invest, slower economic growth, lower living standards, and less fiscal space for essential public goods like national defense. That’s the lesson from Europe’s cradle-to-grave welfare states… Europe’s little-discussed secret is that its cradle-to-grave welfare states are financed by the middle class via value-added and payroll taxes. The combined employer-employee social security tax rate is 36% in Spain, 40% in Italy and 65% in France. Value-added taxes in most European economies are around 20%. There simply aren’t enough rich to finance their entitlements.

Amen. I’ve repeatedly warned that a European-sized welfare state would mean European-sized taxes on lower-income and middle-class Americans.

And what’s remarkable (and discouraging) is that some politicians in the U.S. want to expand entitlements even though many European governments now realize they made big mistakes and need to scale back.

The irony is that some European governments have tried to reform their tax and welfare systems to become more competitive. Germany and Sweden over two decades reformed their welfare and labor policies. …Other European governments are also pushing welfare-state reforms. French President Emmanuel Macron has passed pension reform and cut the corporate tax rate to 26.5% from 33% in 2017… Greece is pulling out of its debt trap with Prime Minister Kyriakos Mitsotakis’s tax, pension and regulatory reforms.

For what it’s worth, I’m happy about these reforms, but I fear many European nations are in the too-little-too-late category.

Why? Because the demographic outlook is deteriorating faster than reform is happening. In other words, most of them are probably destined to suffer Greek-style fiscal crises.

But if (or when) that happens, maybe American politicians will finally wake up and realize we need good reforms to prevent Social Security, Medicare, and Medicaid from causing a similar collapse on this side of the Atlantic Ocean..

Hopefully that epiphany will take place before it is too late for the United States.

P.S. For those who are interested in the history of fiscal policy, John Cogan of the Hoover Institution wrote about pre-20th-century entitlements earlier this year.

Here are excerpts from his column in the Wall Street Journal.

The history of U.S. entitlements is a 230-year record of continuous expansion… The first major entitlement, Revolutionary War disability benefits, was initially restricted to members of the Continental Army and Navy who were injured in battle and survivors of those killed in wartime. Eligibility was then expanded, first to state militia soldiers, then to veterans whose disabilities were unrelated to wartime service, and eventually to virtually all people who served during the war regardless of disability. Civil War disability pensions followed the same…process, except on a far grander scale. Pensions were initially confined to U.S servicemen who suffered wartime injuries and survivors of those killed in battle. Eventually they were extended to virtually all union Civil War veterans regardless of disability. …Congress followed the same liberalizing process with 20th-century entitlements.

If this excerpt doesn’t satisfy your curiosity, here’s Cogan discussing the topic for 46 minutes.

P.P.S. Not all entitlement reform is created equal.

P.P.P.S. Here an informative chart if you want to know whether to blame defense spending or entitlement spending.

P.P.P.P.S. I always argue in favor of a Swiss-style spending cap, which presumably would force politicians to address America’s entitlement problem.

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Which Nation Will Be the Next to Go Bankrupt?

Last month, I shared a chart from a study published by the European Central Bank.

It showed which European nations were in the unfortunate position of facing big future spending increases (the vertical axis) combined with already-high levels of government debt (the horizontal axis).

The bottom line is that Italy, Portugal, France and Belgium face a very difficult fiscal future.

And Estonia (at least relatively speaking) is in the best shape.

Today we are going to augment those ECB numbers by looking at some data from the OECD’s recent report on Estonia.

Here’s a chart showing how the burden of government spending is going to increase in various nations between now and 2060.

Slovakia, Spain, Norway, and the Czech Republic have the biggest problem.

Lithuania is in the best shape, surprisingly followed by Greece (I assume because that nation already hit rock bottom, not because of good policy).

I also highlight the United States, which will have to face the challenge of above-average spending increases.

But if you want to know which nation will be the next to suffer fiscal collapse, you also need to know whether (or the degree to which) it has the capacity – or “fiscal space” – to endure a bigger burden of government spending.

James Capretta addressed that topic in an article for the Bulwark.

Which governments have exercised budgetary restraint in recent years, even while confronting sequential global crises? Which have been more profligate? And what do the differences portend for their differing abilities to handle an era when servicing debt may be more expensive than it has been in many years? …Accuracy…requires assessing both assets and liabilities. …The Organization for Economic Cooperation and Development…’s most comprehensive measure of fiscal resilience is the “financial net worth” of the reporting countries, which includes the main sources of accumulated liabilities (especially public debt) along with financial assets owned by governments.

And here’s a chart showing how developed nations (with the exception of oil-rich Norway) have been spending themselves into a fiscal ditch.

Here are some of Capretta’s observations.

Among the twenty-seven OECD countries that reported data every year from 1995 to 2020, the average deterioration in their net financial position, weighted by population size, was equal to 48 percent of GDP. …Several countries stand out for the steepness of their declines. Japan’s net financial position was -20 percent of GDP in 1995, and in 2020 it was -129 percent of GDP—in other words, in just 25 years it worsened by over 100 percent of the country’s annual GDP. Similarly, the United Kingdom experienced a serious deterioration, with a net financial position in 2020 equal to -109 percent of GDP. In 1995, it was -26 percent. …France, Greece, Italy, and Spain are regularly criticized for their uneven approaches to fiscal discipline. The OECD data showing a substantial deterioration of their net financial positions over the last quarter century provides more evidence that each of these countries needs to take further steps to lower the risk of a fiscal crisis in future years.

The United States obviously is not in good shape, though I think the OECD’s methodology is imperfect.

Yes, America will have to deal with a fiscal crisis if we don’t figure out a way of controlling spending, but I suspect many other countries will reach that point before the U.S. (with Italy quite likely being the next to go belly up).

P.S. At the risk of repeating advice from previous columns, genuine entitlement reform is the only solution to America’s long-run spending problem, ideally enforced by a Swiss-style, TABOR-style spending cap.

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The European Central Bank: Subsidizing Profligacy, Creating Bubbles

Earlier this year, I pointed out that President Biden should not be blamed for rising prices.

There has been inflation, of course, but the Federal Reserve deserves the blame. More specifically, America’s central bank responded to the coronavirus pandemic by dumping a lot of money into the economy beginning in early 2020.

Nearly a year before Biden took office.

The Federal Reserve is not the only central bank to make this mistake.

Here’s the balance sheet for the Eurosystem (the European Central Bank and the various national central banks that are in charge of the euro currency). As you can see, there’s also been a dramatic increase in liquidity on the other side of the Atlantic Ocean.

Why should American readers care about what’s happening with the euro?

In part, this is simply a lesson about the downsides of bad monetary policy. For years, I’ve been explaining that politicians like easy-money policies because they create “sugar highs” for an economy.

That’s the good news.

The bad news is that false booms almost always are followed by real busts.

But this is more than a lesson about monetary policy. What’s happened with the euro may have created the conditions for another European fiscal crisis (for background on Europe’s previous fiscal crisis, click here, here, and here).

In an article for Project Syndicate, Willem Buiter warns that the European Central Bank sacrificed sensible monetary policy by buying up the debt of profligate governments.

…major central banks have engaged in aggressive low-interest-rate and asset-purchase policies to support their governments’ expansionary fiscal policies, even though they knew such policies were likely to run counter to their price-stability mandates and were not necessary to preserve financial stability. The “fiscal capture” interpretation is particularly convincing for the ECB, which must deal with several sovereigns that are facing debt-sustainability issues. Greece, Italy, Portugal, and Spain are all fiscally fragile. And France, Belgium, and Cyprus could also face sovereign-funding problems when the next cyclical downturn hits.

Mr. Buiter shares some sobering data.

All told, the Eurosystem’s holdings of public-sector securities under the PEPP at the end of March 2022 amounted to more than €1.6 trillion ($1.7 trillion), or 13.4% of 2021 eurozone GDP, and cumulative net purchases of Greek sovereign debt under the PEPP were €38.5 billion (21.1% of Greece’s 2021 GDP). For Portugal, Italy, and Spain, the corresponding GDP shares of net PEPP purchases were 16.4%, 16%, and 15.7%, respectively. The Eurosystem’s Public Sector Purchase Program (PSPP) also made net purchases of investment-grade sovereign debt. From November 2019 until the end of March 2022, these totaled €503.6 billion, or 4.1% of eurozone GDP. In total, the Eurosystem bought more than 120% of net eurozone sovereign debt issuances in 2020 and 2021.

Other experts also fear Europe’s central bank has created more risk.

Two weeks ago, Desmond Lachman of the American Enterprise Institute expressed concern that Italy had become dependent on the ECB.

…the European Central Bank (ECB) is signaling that soon it will be turning off its monetary policy spigot to fight the inflation beast. Over the past two years, that spigot has flooded the European economy with around $4 trillion in liquidity through an unprecedented pace of government bond buying. The end to ECB money printing could come as a particular shock to the Italian economy, which has grown accustomed to having the ECB scoop up all of its government’s debt issuance as part of its Pandemic Emergency Purchase Program. …the country’s economy has stalled, its budget deficit has ballooned, and its public debt has skyrocketed to 150 percent of GDP. …Italy has had the dubious distinction of being a country whose per capita income has actually declined over the past 20 years. …All of this is of considerable importance to the world economic outlook. In 2010, the Greek sovereign debt crisis shook world financial markets. Now that the global economy is already slowing, the last thing that it needs is a sovereign debt crisis in Italy, a country whose economy is some 10 times the size of Greece’s.

Mr. Lachman also warned about this in April.

Over the past two years, the ECB’s bond-buying programs have kept countries in the eurozone’s periphery, including most notably Italy, afloat. In particular, under its €1.85 trillion ($2 trillion) pandemic emergency purchase program, the ECB has bought most of these countries’ government-debt issuance. That has saved them from having to face the test of the markets.

And he said the same thing in March.

The ECB engaged in a large-scale bond-buying program over the past two years…, as did the U.S. Federal Reserve. The size of the ECB’s balance sheet increased by a staggering four trillion euros (equivalent to $4.4 billion), including €1.85 trillion under its Pandemic Emergency Purchasing Program. …The ECB’s massive bond buying activity has been successful in keeping countries in the eurozone’s periphery afloat despite the marked deterioration in their public finances in the wake of the pandemic.

Let’s conclude with several observations.

• First, many European countries are at risk because politicians, year after year, have spent too much money (Italy is just the tip of the iceberg).
• Second, the ECB has enabled much of that spending by buying a lot of the government debt issued by Europe’s profligate nations.
• Third, there’s now a bubble thanks to the combination of bad fiscal policy by national governments and bad monetary policy by the ECB.
• Fourth, some economic misery is unavoidable, but the damage can be limited if governments impose Swiss-style spending caps.
• Fifth, the political elite in Europe do not want spending restraint and instead prefer very bad policies such as “debt mutualization.”

So if politicians won’t adopt good policies and their bad policies won’t work, what’s going to happen?

At some point, national governments will probably default.

That’s an unpleasant outcome, but at least it will stop the bleeding.

Unlike bailouts and easy money, which exacerbate the underlying problems.

P.S. For what it is worth, I do not think a common currency is necessarily a bad idea. That being said, I wonder if the euro can survive Europe’s awful politicians.

P.P.S. While I think Mr. Buiter’s article in Project Syndicate was very reasonable, I’ve had good reason to criticize some of his past analysis.

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Everything You Need to Know about the National Debt

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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The Economics of Tax-Financed Spending vs. Debt-Financed Spending

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

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

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

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

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

• Keeping taxes low.
• Controlling debt.

These are both worthy objectives.

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

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

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

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

Which is why we should consider a third goal.

• Limiting spending.

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

Now for some caveats.

I made a handful of assumptions in the above charts.

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

Anyone can create their own spreadsheet and make different assumptions.

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

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

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Will Excessive Government Spending Cause another European Debt Crisis?

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

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

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

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

So what’s the net result?

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

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

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

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

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

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

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

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

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

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

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

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Demography + Entitlements = Fiscal Crisis

It’s impossible to predict when another pandemic will strike.

But there’s one future crisis that we already know about, and I recently spoke about that issue to the Liberty International World Conference in Medellin.

At first, I wasn’t planning to share this video, particularly since I covered much of the same material in a speech back in January.

But then I saw a story in Yahoo Finance that includes this very sobering chart about how the burden of government spending will climb in G-7 nations over the next four decades.

The main takeaway is that aging populations and poorly designed tax-and-transfer programs (entitlements) are a recipe for long-run fiscal crisis in almost all developed nations.

That includes the United States. The four-decade outlook for America isn’t as bad as it is in nations such as France and Japan, but government will grow more than the fiscal burdens in Canada, Germany, and the United Kingdom.

And here are some details from the story.

The Covid-19 pandemic may have bloated public debt…, but that’s nothing compared to the fiscal difficulties brewing in the coming decades, the OECD said. …states will face rising costs, particular from pensions and health care. To maintain public services and benefits while stabilizing debt in that environment, governments would have to raise revenues by nearly 8% of gross domestic product, the OECD said. In some countries, including France and Japan, the size of the challenge would amount to more than 10% of output, and the economists didn’t even account for new expenditures such as climate change adaptation.

If you want to dig into the details, you can click here to read the underlying report from the Organization for Economic Cooperation.

I think the following excerpts are particularly relevant. As you can see, the problem is demographics, which leads to more spending for entitlement programs such as health and pensions.

And, assuming politicians decide to address the issue with revenues, this implies massive tax increases.

Public health and long-term care expenditure is projected to increase by 2.2 percentage points of GDP in the median country between 2021 and 2060… These projections are based on a pre-pandemic spending baseline, so any permanent increase in health spending in response to experience with COVID-19…would come in addition. Public pension expenditure is projected to increase by 2.8 percentage points of GDP in the median country between 2021 and 2060… Other primary expenditures are projected to rise by 1½ percentage points of GDP… This projection excludes potential new sources of expenditure pressure, such as climate change adaptation. …OECD governments would need to raise taxes in this scenario to prevent gross government debt ratios from rising over time… The median country would need to increase structural primary revenue by nearly 8 percentage points of GDP between 2021 and 2060, but the effort would exceed 10 percentage points in 11 countries.

Most interesting, the two authors of the OECD study point out that are some major problems with the tax “solution.”

The results of this section do not imply that taxes will, or even should, rise in the future. The fiscal pressure indicator is simply a metric serving to quantify and illustrate the fiscal challenge facing OECD governments. Raising taxes is only one of many possible avenues to meet this challenge. …Pushing mainstream taxes on incomes or consumption further up, even by only a few percentage points of GDP, may be politically difficult and fiscally counter-productive if it means reaching the downward-sloping segment of the Laffer curve.

I’m especially impressed that they acknowledge the Laffer Curve (the nonlinear relationship between tax rates and tax revenue that the Biden Administration wishes away).

P.S. The real solution is entitlement reform, and here’s the explanation for how to do it in the United States.

P.P.S. As I’ve regularly noted, the economists who work at the OECD often produce very solid analysis. The problem with that bureaucracy is that it has very statist leadership, which is why the OECD’s policy agenda includes anti-growth policies such as big tax increases and tax harmonization.

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Demographic Decline = Fiscal Crisis

As a libertarian, I don’t care if couples have zero children or 10 children.

But as an economist, I’m horrified that big changes in demographics are going to lead to fiscal crises thanks to poorly designed entitlement programs.

Simply stated, modest-sized welfare states are sustainable if more and more new taxpayers enter the system to finance benefits for a burgeoning population of old people.

But that’s not happening any more. In most nations, traditional population pyramids are becoming population cylinders because of falling birthrates and increasing longevity.

That’s the bad news.

The good news is that there is growing awareness the demographic changes are happening. Indeed, Damien Cave, Emma Bubola and Choe Sang-Hun have a big article on population decline in the New York Times.

All over the world, countries are confronting population stagnation and a fertility bust, a dizzying reversal unmatched in recorded history that will make first-birthday parties a rarer sight than funerals, and empty homes a common eyesore. Maternity wards are already shutting down in Italy. Ghost cities are appearing in northeastern China. Universities in South Korea can’t find enough students, and in Germany, hundreds of thousands of properties have been razed, with the land turned into parks. …Demographers now predict that by the latter half of the century or possibly earlier, the global population will enter a sustained decline for the first time. …The strain of longer lives and low fertility, leading to fewer workers and more retirees, threatens to upend how societies are organized — around the notion that a surplus of young people will drive economies and help pay for the old. …The change may take decades, but once it starts, decline (just like growth) spirals exponentially. With fewer births, fewer girls grow up to have children, and if they have smaller families than their parents did — which is happening in dozens of countries — the drop starts to look like a rock thrown off a cliff. …according to projections by an international team of scientists published last year in The Lancet, 183 countries and territories — out of 195 — will have fertility rates below replacement level by 2100.

Plenty of interesting data, though remarkably little focus on the fiscal implications. Sort of like writing about 1943 France with almost no reference to World War II.

In any event, the article takes a closer look at the challenges in certain nations., including South Korea.

To goose the birthrate, the government has handed out baby bonuses. It increased child allowances and medical subsidies for fertility treatments and pregnancy. Health officials have showered newborns with gifts of beef, baby clothes and toys. The government is also building kindergartens and day care centers by the hundreds. In Seoul, every bus and subway car has pink seats reserved for pregnant women. But this month, Deputy Prime Minister Hong Nam-ki admitted that the government — which has spent more than $178 billion over the past 15 years encouraging women to have more babies — was not making enough progress.

I was struck by the statement from the Deputy Prime Minister that his nation “was not making enough progress”?

That’s a strange way of describing catastrophic decline in birthrates, as noted in the article.

South Korea’s fertility rate dropped to a record low of 0.92 in 2019 — less than one child per woman, the lowest rate in the developed world. Every month for the past 59 months, the total number of babies born in the country has dropped to a record depth.

Maybe, just maybe, government handouts are not the way to boost birthrates.

I’ll conclude by noting that the real problem is tax-and-transfer entitlement programs, not low birth rates.

Both Singapore and Hong Kong have extremely low birth rates, for instance, but they aren’t facing a huge fiscal crisis because they have very small welfare states and workers are obliged to save for their own retirement.

Other Asian jurisdictions, however, made the mistake of copying Western nations, meaning entitlement programs that become mathematically impossible when populations pyramids become population cylinders (or even upside-down pyramids!).

In addition to South Korea, Japan also faces a major challenge.

And the situation is very grim in Europe, even though birth rates haven’t fallen to the same degree (though the numbers is some Eastern European nations are staggeringly bad).

P.S. The United States isn’t far behind.

P.P.S. We know the answer to this crisis, but far too many politicians are focused on trying to make matters worse rather than better.

P.P.P.S. You can read my two-part series on this topic here and here.

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Preventing Fiscal Meltdowns with a Spending Cap

As part of my recent interview about European economic policy with Gunther Fehlinger, I pontificated on issues such as Convergence and Wagner’s Law.

I also explained why a Swiss-style spending cap could have saved Greece and Italy from fiscal crisis. Here’s that part of the discussion.

For those not familiar with spending caps, this six-minute video tells you everything you need to know.

Simply stated, this policy requires politicians to abide by fiscal policy’s Golden Rule, meaning that – on average – government spending grows slower than the private economy.

And that’s a very effective recipe for a lower burden of spending and falling levels of red ink.

One of the points I made in the video is that spending caps would prevented the fiscal mess in Greece and Italy.

To show what I mean, I went to the International Monetary Funds World Economic Outlook database and downloaded the historical budget data for those two nations. I then created charts showing actual spending starting in 1988 compared to how much spending would have grown if there was a requirement that the budget could only increase by 2 percent each year.

Here are the shocking numbers for Greece.

The obvious takeaway is that there never would have been a fiscal crisis if Greece had a spending cap.

That also would be true even if the spending cap allowed 3-percent budget increases starting in 1998.

And it would be true if the 2-percent spending cap didn’t start until 2000.

There are all sorts of ways of adjusting the numbers. The bottom line is that any reasonable level of spending restraint could have prevented the horrible misery Greece has suffered.

Here are the numbers for Italy.

As you can see, the government budget has not increased nearly as fast in Italy as it did in Greece, but the burden of spending nonetheless has become more onerous – particularly when compared to what would have happened if there was a 2-percent spending cap.

I’ve written many times (here, here, here, and here) about Italy’s looming fiscal crisis. As I said in the interview, I don’t know when the house of cards will collapse, but it won’t be pretty.

And tax reform, while very desirable, is not going to avert that crisis. At least not unless it is combined with very serious spending restraint.

P.S. For those who want information about real-world success stories, I shared three short video presentations back in 2015 about the spending caps in Switzerland, Hong Kong, and Colorado.

P.P.S. It’s also worth noting that the United States would be in a much stronger position today if we had enacted a spending cap a couple of decades ago.

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The Globe’s Looming Fiscal Crisis

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

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

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

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

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

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

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

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

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

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

Here’s a visual from the report.

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

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

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

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

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

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

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

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

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

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

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Is America Approaching the Tipping Point of Too Much Debt?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Tax Increases Will Generate More Spending, More Debt, and Less Prosperity

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

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

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

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

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

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

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

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

Here’s what the authors wanted to investigate.

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

Here’s their methodology.

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

And here are their results.

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

Table 2 summarizes the findings.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Coronavirus Is Worsening America’s Grim Fiscal Outlook

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

Especially Italy.

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

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

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

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

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

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

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

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

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

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

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

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

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

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European Fiscal Crisis, Round 2?

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

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

That’s a very grim combination.

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

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

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

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

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

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

And we may be reaching that point.

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

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

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

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

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

If the latter, Lachman predicts it will be huge.

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

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

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

Simply stated, we should minimize moral hazard.

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

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

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

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

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

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

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

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

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

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

But all of the PIGS are in trouble.

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

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

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Chicago’s Continuing Decline…and Inevitable Fiscal Crisis

Is Greece the international version of New Jersey or is New Jersey the American version of Greece?

Is New Jersey the national version of Chicago, or is Chicago the the local version of New Jersey?

The answer is yes, regardless of how the question is phrased because – in all cases – we’re talking about examples of how politicians (and short-sighted voters) create “Goldfish Government.”

Let’s examine Chicago to see how this process works.

The Washington Post noted early last year that the new mayor was going to face an enormous fiscal challenge because of the reckless choices made by previous generations of politicians.

The city has been underfunding its pensions for decades, with dire results. Chicago’s pension plans collectively have only about a quarter of the assets they’ll need to pay benefits, one of the worst funding ratios in the nation. To put that hole in dollar terms, Chicago is about $28 billion short of what it needs, even under relatively favorable assumptions about future returns, or about $10,000 for every man, woman and child living in the city. …radical surgery still needed. Within a few years, pension contributions are projected to suck up more than 20 percent of the city’s budget. And Chicago can’t count on much help from the state, which is dealing with its own, equally severe case of pension underfunding. …what’s happening in Illinois is merely the earliest and most extreme manifestation of a quandary that will soon be dominating the public conversation in many states: how to pay for retirement promises to public employees without entering a fiscal death spiral. …shoddy accounting allowed generations of politicians all over the country to curry favor with public-sector workers by offering them ever-fatter pension packages, gaining immediate benefit while deferring the political cost of paying for all those benefits until much later. Later is now arriving. …Chicago has been losing lower- and middle-class residents for years, in part because of its heavily regressive tax burden. And when Chicago and Illinois both start raising the rates on upper earners — as they will have to, and soon — they run the risk that those people ,too, will start trickling away, either to smaller cities without the burdensome pension-legacy costs.

Megan McArdle pointed out that Chicago is a mess because of “public choice” – i.e., politicians make short-sighted and irresponsible decisions in order to maximize votes and power.

Throw in a recession sometime in the next couple of years, and Chicago is going to be in a full-blown crisis. …it’s the fault of generations of politicians before them who promised an ever-richer array of benefits to government workers. Particularly, they liked to raise the retirement benefits. …The whole point of giving workers pension benefits instead of cash was that you didn’t have to pay for them; you could promise the benefits now and gather up the votes that the grateful workers tossed at your feet, all without costing current taxpayers a single dime. …Future taxpayers mostly weren’t voting in 1982 municipal elections. …Chicagoans, welcome to “later.” The municipal pensions only have about 25 percent of the assets they’ll need to cover projected benefits, a shortfall of roughly $28 billion. …If you use a more cautious method, you come up with a shortfall of more than $40 billion. …Moody’s Investors Service rates the city’s general obligation debt as junk bonds. …Chicago is now approaching the point where the growth of its obligations will outpace the growth of any possible revenue stream it might use to cover them. It’s a few steps from there to municipal bankruptcy.

Unsurprisingly, Chicago’s relatively new mayor wants to keep the scam going.

As reported by the Chicago Tribune, she wants to extract more money from taxpayers.

Chicago Mayor Lori Lightfoot…said there’s “no question” residents will need to pay more in taxes or fees to plug a looming city budget shortfall… “There’s no question we’re going to have to come to the taxpayers and ask for additional revenue.” …Lightfoot did not specify what sort of revenue she expects to raise — whether it would come in the form of new taxes, a property tax hike or increased fees. …referring to her campaign promise to seek cuts before asking taxpayers for more money, Lightfoot added, “I meant what I said on the course of the campaign: We have a lot of hard choices we’re going to have to make regarding city finances.”

Like previous mayors, she’s buying votes with other people’s money.

The Wall Street Journal opined last year about her surrender to the teacher unions (a Chicago tradition, as illustrated by the adjacent cartoon by Lisa Benson).

Except it wasn’t really a surrender since she was already on their side (as perfectly captured by this Ramirez cartoon).

So the net result is a combination of bad fiscal policy and bad education policy.

Chicago Mayor Lori Lightfoot and the Chicago Teachers Union on Thursday struck an agreement to end an 11-day strike, and by the looks of it the union was bargaining with itself. The mayor is touting the new contract as the most generous in Chicago history, and she’s right. …The new contract includes a 16% raise over five years (not including raises based on longevity), a three-year freeze on health insurance premiums, lower copays, …and more than 450 new social workers and nurses. …you can bet it will be expensive. Last week the mayor proposed a slew of tax increases including levies on ride-hailing services and restaurant meals. This week her staff suggested that property taxes may have to increase . . . again. Michelle Obama the other day complained that white people were leaving the city to escape minorities who are moving in. No, they’re fleeing Chicago’s high taxes and lousy schools—and so are minorities.

This story from Reason is a powerful (and nauseating) example of how a money-hungry city is making life miserable for ordinary people.

Chicago police pulled Spencer Byrd over for a broken turn signal. Byrd says his signal wasn’t broken, but that detail would soon be the least of his worries. …Byrd was giving a client, a man he says he had never met before, a ride… Police pulled both of them out of the car and searched them. Byrd was clean, but in his passenger’s pocket was a bag of heroin… Police released Byrd after a short stint in an interrogation room without charging him with a crime. But when Byrd went to retrieve his car, he found out the Chicago Police Department had seized and impounded it. …The program impounds cars when the owner beats a criminal case or isn’t charged with a crime in the first place. It impounds cars even when the owner isn’t even driving, like when a child is borrowing a parent’s car. …Byrd calls his car his “livelihood,” and he has been fighting for close to two years now to recover it. He says he has $3,500-worth of tools locked in the trunk, and he can’t retrieve them. …Like tens of thousands of other Chicagoans, Byrd was a victim of years of the city’s fiscal negligence. …to try and nickel-and-dime…out of these massive budget gaps. …The result is a uniquely punitive impound system, in which Chicago profits off restricting the ability of its residents to drive.

Amazingly, Chicago’s politicians want to dig an even deeper hole.

The Wall Street Journal has a new editorial examining a scheme to borrow even more money in hopes of keeping the gravy train rolling.

Chicago has been seeking to take advantage of historically low interest rates by refinancing debt—even as its credit rating has deteriorated amid swelling budget deficits and pension payments. …In 2017 state and city politicians contrived a shell scheme to lower the city’s borrowing costs. The city essentially sold off sales-tax revenue that it receives from the state to a corporation specially created to pay creditors. …Voila, Chicago’s financial magicians spun junk into gold. …Chicago’s budget woes are mounting, and financial alchemists are diluting the claims of existing creditors. If the city were to renege on its $8 billion in GO debt, those bondholders would surely demand a slice of the sales-tax revenue now pledged to other creditors. This is what happened in Puerto Rico. …Chicago’s population has declined for each of the past four years, and taxpayers are getting tapped out. On top of a $50 million increase in property taxes this year, Mayor Lori Lightfoot has imposed a new “congestion” fee on Uber and taxi rides, doubled the tax on restaurant meals, and raised a special personal property tax on computer cloud software. Yet a recession would probably blow a gigantic hole in its budget and could cause its pension funds to run dry. Does anyone think that city politicians wouldn’t prioritize public workers over bondholders?

So when will this house of cards collapse?

I have no idea. There’s a famous quote from the late economist Rudiger Dornbusch, who observed that, “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”

The people buying bonds from Chicago are betting that the collapse won’t happen in the near future.

But that was the same mentality of the people who bought Greek bonds in, say, 2005.

I’ll simply observe that what’s happening in Chicago is confirmation of my “First Theorem of Government.”

And I’ll also make an easy prediction that the people buying Chicago bonds will want a bailout when the you-know-what hits the fan.

Needless to say, the answer should be a resounding no.

P.S. If you want to know all my Theorems of Government, click here.

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Trump’s Greek-Style Budget Deal

I point out in this interview that the 2011 Budget Control Act (BCA) was the only big victory for taxpayers this century. It imposed spending caps on discretionary spending and led to a sequester in early 2013, which was Barack Obama’s biggest defeat.

The bad news is that the BCA is merely legislation. That means politicians can conspire to bust the spending caps – which is what they did at the end of 2013, as well as in 2015, 2018, and again this year.

This most recent deal may be the worst of the worst. The Committee for a Responsible Federal Budget (CRFB) shows that it brings discretionary spending almost up to the level we reached during Obama’s pork-filled stimulus.

By the way, the chart also shows that Bush was a big spender and that we actually had a bit of spending restraint after the Tea Party-themed 2010 mid-term elections.

But let’s focus on today.

Here’s one more chart from CRFB. It shows that Trump is doing a good job of impersonating Obama with huge, across-the-board spending increases.

These charts show why I’m so depressed. And let’s not forget that they are only measures of discretionary spending. The outlook for entitlement spending is even worse!

In other words, we’re on the path to fiscal crisis. Is there a solution?

Yes, we could adopt constitutional restraints on the growth of government. I mentioned Colorado’s Taxpayer Bill of Rights in the interview, as well as the “debt brake” in Switzerland.

But there’s zero chance that today’s crop of politicians will enact this kind of sensible reform. We’ll probably have to wait until a crisis occurs. At which point it may be too late.

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Two Things to Understand about Debt Limit Hysteria

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

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

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

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

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

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

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

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

I agree.

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

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

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

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

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

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

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

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

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

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

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

How persuasive are these reasons?

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

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

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

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

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

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

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

Interesting, Ms. Long accepts that prioritization would happen.

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

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

This is an interesting claim.

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

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

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

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

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

These are all reasonable concerns.

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

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

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

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

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

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

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

I’ll close with two observations.

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

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

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A Simple Reform to Avert a Future Greek-Style Fiscal Crisis in America

In the absence of genuine entitlement reform, the United States at some point is going to suffer from a debt crisis.

But red ink is merely a symptom. I used numbers from Greece in this interview to underscore the fact that the real problem is government spending.

The discussion was triggered by comments from the Chairman of the Federal Reserve.

Federal Reserve Chairman Jerome Powell said Wednesday that reducing the federal debt needs to return to the forefront of the agenda, warning that the government’s finances are unsustainable. “I do think that deficits matter and do think it’s not really controversial to say our debt can’t grow faster than our economy indefinitely — and that’s what it’s doing right now,” Powell said.

As I noted in my comments, Powell is right, but he’s focusing on the wrong variable.

The real crisis is that spending is growing faster than the private sector (Powell needs to learn the six principles to guide spending policy).

To be more specific, politicians are violating my Golden Rule.

Spending grew too fast under Bush. It grew too fast under Obama (except for a few years when the “Tea Party” was in the ascendancy). And it’s growing too fast under Trump.

Most worrisome, the burden of spending is expected to grow faster than the private sector far into the future according to the long-run forecast from the Congressional Budget Office.

That doesn’t mean we’ll have a crisis this year or next year. We probably won’t even have a crisis in the next 10 years or 20 years.

But I cited Greek data in the interview to point out that excessive spending eventually does create a major problem.

Here’s the data from International Monetary Fund’s World Economic Outlook database. To make matters simple (I should have done this for the interview as well), I adjusted the numbers for inflation.

So how can America avoid a Greek-style fiscal nightmare?

Simple, just impose a spending cap. At the end of the interview, I added a plug for the very successful system in Switzerland, but I’d also be happy if we copied Hong Kong’s spending cap. Or the Taxpayer Bill of Rights from Colorado.

The bottom line is that spending restraint works and a constitutional spending cap is the best way to achieve permanent fiscal discipline.

P.S. By contrast, proponents of “Modern Monetary Theory” argue governments can finance ever-growing government by printing money. For what it’s worth, nations that have used central banks to finance big government (most recently, Venezuela and Zimbabwe) are not exactly good role models.

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Historical Evidence on Reducing Large Debt Burdens

The long-run fiscal outlook for most developed nations is very grim thanks to demographic change and poorly designed entitlement programs.

For all intents and purposes, we’re all destined to become Greece according to long-run projections from the International Monetary Fund, Bank for International Settlements, and Organization for Economic Cooperation and Development.

Are there any solutions to this “most predictable crisis“?

Politicians such as Alexandria Ocasio-Cortez and Bernie Sanders would like us to believe the answer involves never-ending tax increases. But such an approach is a recipe for more debt because the economy will weaken and governments will spend more money (look at what’s been happening in Europe, for instance).

A more sensible approach is a spending cap. I’ve pointed out, for instance, how Swiss government debt has plummeted ever since voters imposed annual limits on budgetary growth.

We also can learn lessons from history according to new research from the International Monetary Fund.

The report contains some very interesting economic history and the evolution of government finance, including the Bank of England being created and given a monopoly so the government would have a vehicle for borrowing money (as I observed in my video on central banking).

But it mostly tells the story of how governments and public finance simultaneously evolved.

Although the written record points to instances of public borrowing as long as two thousand years ago, recent scholarship points to 1000-1400 A.D. as when borrowing agreements with states were concluded with regularity and debt contracts entered into by sovereigns were standardized. …The supply of loans from city-states and territorial monarchies was driven by the need to finance military campaigns and secure borders. …From the 16th century, Europe’s political geography coalesced into the nation states recognized at the Peace of Westphalia in 1648. In parallel, many European states evolved from absolutist regimes to more limited government. …Fiscal states thus evolved in response to the efforts of rulers to secure borders, expand territory and survive. After 1650, larger, more centralized states increasingly possessed the fiscal machinery to raise revenue in uniform ways and had a veto player, such as a parliament, to monitor and discipline public expenditure.

There’s also lots of information in the report about how some governments, primarily outside of Europe, began to borrow money.

In many cases, this produced bad results, with defaults and economic crisis. As the authors wrote, “Debasement and restructuring also have a long history.”

But the part of the report that caught my eye was the description of how three advanced nations – the United Kingdom, the United States, and France – successfully dealt with large debt burdens before World War I.

…we describe three notable debt consolidation episodes before World War I: Great Britain after the Napoleonic Wars, the United States in the last third of the 19th century, and France in the decades leading up to 1913. While the colorful debt crises and defaults of the first era of globalization have been much discussed, less attention has been paid to these successful consolidation episodes. We focus on these three cases because they involved three of the largest economies of the period, but also because their debt burdens were among the heaviest. British public debt as a share of GDP was higher in the aftermath of the Napoleonic Wars, for example, than Greek public debt in 2018. But in all three cases, high public debts were successfully reduced relative to GDP.

In each case, war-time spending was the cause of the debt buildup.

The Napoleonic Wars, Franco-Prussian War and U.S. Civil War were the three most expensive conflicts of the 19th century. …debt accounted for the single largest share of wartime financing.

Here’s a table showing that these nations dramatically reduced their debt burdens.

To be sure, there were differences in the three nations.

The reduction in the British debt-GDP ratio was by far the largest and longest: the debt ratio fell from 194 percent in 1822 to 28 percent nine decades later. …The French public-debt-GDP ratio fell from 96 percent in 1896 to 51 percent in 1913… This case ranks second in size but first in pace. U.S. (federal or union) government debt was not as high at the end of the Civil War, and the subsequent consolidation was more leisurely; however, the process is notable for having reduced the debt-GDP ratio to virtually zero by World War I.

When the authors investigated how these nations reduced their debt burdens, they found that limited government was a common answer.

This was true in the United Kingdom.

Britain achieved the impressive feat of maintaining an average primary surplus of 1.6 percent of GDP for nearly a century (the only deficit in Figure 2 is at the time of the Boer War). One of the political legacies of Peel and Gladstone was a fiscal theory or philosophy of “sound finance” emphasizing budget surpluses, low taxes and minimal government expenditure. …demands for spending on welfare relief from the disenfranchised masses were kept in check. In exchange, the self-taxing class of income-tax-paying electors relieved the non-electors from the burden of direct taxation… Budget surpluses then made feasible further reductions in tariffs and taxes, which reduced the cost of living for the working class

It was true in the United States.

In the U.S., primary surpluses were consistently achieved… Southern states opposed an expansive role for the federal government, while entitlements limited to Civil War pensions contained pressure for public spending.

And it was true even in France.

In France, debt reduction was entirely accounted for by primary surpluses. Those surpluses exceeded British levels, reaching 2.5 percent of GDP on average, albeit over a shorter period.

Remember, this was a period when total government spending only consumed about 10 percent of economic output.

And this was a period when there was no welfare state. Redistribution was virtually nonexistent. Not even in France.

So it shouldn’t be a surprise that debt quickly fell in all three countries.

The common thread was small government.

…in all three of these large-scale debt consolidations, governments and societies went to great lengths to service and repay heavy debts. …it reflected prevailing conceptions of the limited functions of government, and limited popular pressure for public programs, entitlements and transfers.

What’s equally important is to note what didn’t happen.

No default. No inflation. No indirect confiscation.

…there was no restructuring or renegotiation of official or privately-held debts in these cases. Nor was there financial repression, i.e., measures artificially depressing interest rates. …Governments for their part did little to bottle up savings at home or to otherwise use regulation and legislation to artificially depress yields. …None of these three governments undertook involuntary restructurings despite the inheritance of heavy debt.

Now let’s shift from the past to the future

The authors point out how debt is rising today because of the welfare state rather than war.

The end of the last century also saw, for the first time, a secular increase in public-debt-to-GDP ratios in a variety of countries in conjunction not with wars and crises but in response to popular demands on governments for pensions, health care, and other often unfunded social services.

Given the demographic changes I mentioned at the beginning of the column, this does not bode well.

So what are the likely implications? As the authors note, there are two ways of dealing with high debt levels.

Countries have pursued two broad approaches to debt reduction. The orthodox approach relies on growth, primary surpluses, and the privatization of government assets. In turn this encourages long debt duration and non-resident holdings. Heterodox approaches, in contrast, include restructuring debt contracts, generating inflation, taxing wealth and repressing private finance.

At the risk of understatement, I fear Robert Higgs is right and that today’s politicians (and today’s voters!) will choose the latter approach.

Given that those policies will make a bad situation even worse, I’m not overflowing with confidence about the future.

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