Fiscal Cliff: Cato’s Missed Opportunity

Acclaimed author Astrid Lindgren wrote a whole series of books about Pippi Longstocking, the red-head little orphan girl has a horse live in the kitchen, sleeps upside down in her bed and keeps a suitcase full of gold coins in her bedroom.

She also sets her own rules about bedtime. Each night she tells herself to go to bed. A friend asks: “So what do you do if you don’t listen to yourself?” whereupon Pippi replies: “Then I yell at myself to go to bed right now!”

Sometimes, Pippi Longstocking follows her own rules. Sometimes she doesn’t.

Much like Congress with their fiscal rules.

One of the enduring enigmas in American politics is the unending failure of Congress to follow its own Pippi rules. Even if it tells itself to balance its budget, and even if it does not listen to itself, Congress just keeps yelling at itself in the feeble hope of getting its own attention.

In their new book A Fiscal Cliff: New Perspectives on the U.S. Federal Debt Crisis, the Cato Institute sets out to solve this enigma. The book, edited by John Merrifield and Barry Poulson, offers 20 essays of varying levels and focus, all with rules-based fiscal policy in focus. The work, which appears to have been more than two years in the making, has undoubtedly consumed considerable effort (at least for a think tank that otherwise does not pay more than passing interest to this issue) and was, rightly, widely anticipated.

After all, when almost two dozen experts sit down around the proverbial table to solve the nation’s fiscal debt crisis, should we not all expect a major breakthrough?

Of course we should. Sadly, the book – worthwhile as it is – falls flat to the ground. While carefully accounting for the problem – the unsustainable federal debt and the chronic failure of Congressional Pippi rules – the book does not even attempt to explain why we have. a debt crisis in the first place.

Since this question is left unanswered, the book also fails to tackle the inevitable follow-up question: “How do we avoid the fiscal cliff?”

All the spotlight is on the Pippi rule: if Congress doesn’t enforce its own fiscal rules, then it should try again and yell those rules a bit louder at itself. But the problem is not explaining how Congress can enforce the Pippi rule differently; the problem is that the rule cannot work even if Congress actually were to listen to itself.

Before we get to the reason why fiscal rules cannot work over time, a review is in place of what fiscal rules are all about.

As I explained in my 2016 article in Journal of Governance and Regulation (Vol. 5, Issue 4), since the 1970s Congress has considered at least a dozen different Pippi rules. While few have passed, over the past four decades Congress has, one way or the other, operated under some form of a Pippi rule (see Romina Boccia’s essay in A Fiscal Cliff for a good summary).

With 40 years of experience with failed self-enforcement, the first question on the Cato table should have been: why have fiscal rules failed?

This question lurks in the background throughout the book, but that appears to be entirely unintentional. The strength of the book is in its historic review, accounting for the failure of American fiscal rule-making and examples of mixed international experience.

However, true to the book’s evasive action around the “why debt” question, the international outlook stays clear of such egregious failures of fiscal rule-making as Greece in the past ten years and Sweden in the 1990s. For sure, two essays discuss Sweden (Romina Boccia and Ryan Bourne), but neither goes back to the horrific enforcement of austerity rules after the 1992 collapse of the Swedish economy. Nor do they account for the relaxing of the fiscal rules in Sweden in recent years.

Ryan Bourne offers a review of fiscal rules in Chile and the UK, and he and Romina Boccia discuss the Swiss debt brake. Doing so, they echo my conditionally positive conclusions from 2016.

Unfortunately, the essays remain shallow and avoid in-depth problems related to fiscal rule making. This, again, leaves them void of answers as to why the rules keep failing, both in the United States and in Europe. A discussion of the Greek example would have shed copious light on this question (Greece is not even mentioned in the book!) and led the authors to far more informed conclusions.

To work your way toward an answer to why fiscal rules fail, you first need to distinguish between two types of fiscal rules. The first type concentrates on deficit elimination, typically by demanding annual budget balancing. This is the most common type of fiscal rule. It is also the type that was imposed on Greece in 2009-2014, with catastrophic results. By enforcing annual budget-balancing, the deficit-elimination rule amplifies the swings in the business cycle. This causes deeper recessions, more radical losses of tax revenue – and an aggravation of the very problem the rule was supposed to solve.

Sweden had the same experience in the 1990s. As I reported in my book Industrial Poverty, when the Swedish government used its deficit-elimination fiscal rule after the collapse in 1992, the crisis was prolonged through the decade. The eventual success that the government had in balancing the budget came at a big cost to the economy – a cost that the country still has not recovered from.

It is worth repeating that the praise for the Swedish experience that both Boccia and Bourne give voice to, pale in view of the most recent changes in fiscal policy in Sweden. Already a year ago (i.e., before the coronavirus crisis), when the Swedish parliament was faced with the prospect of a new deficit, the response was to gradually drift away from enforcement of the fiscal rule.

In short: when enforcing the Pippi rule becomes politically problematic, government chose not to listen to itself. A few of the essays in the Cato volume note this, but not in an international context.

The second type of fiscal rules imposes a debt cap. The Swiss debt brake appears to be the only formal example of this rule type currently in effect. The European Union has one in its constitution, but as the austerity crisis of 2009-2014 demonstrated, it is not enforced; only the deficit-elimination component has been put to work.

As I explained back in 2016, the Swiss debt brake has been somewhat successful. That, however, does not mean it can be imported to the United States. It has an architecture that does not easily lend itself to applications in elaborate welfare states such as ours. It is built around the dynamics between cyclical and structural GDP (the latter also referred to as “trend” GDP), but in reality the mechanism that is supposed to cap government debt is nothing more than a conventional-wisdom Keynesian debt cycle. I explain (Larson 2016, 103):

In recessions, Y falls short of Y*; if the output gap ratio is in the right proportion to tax revenues, then the decline in tax revenue, inevitable during a recession, will still allo0w for the structural spending to continue,. Likewise, in a growth period when actual output exceeds trend output, and tax revenue is higher than trend, spending is maintained so long as the growth rate balances excess revenue.

This is the gist of the Swiss debt brake. If long-term GDP growth falls below what the debt brake needs in order to keep debt constant, then government is forced into a somewhat less destructive version of the Greek and Swedish austerity policies. Once it goes down that path, there will be both political and macroeconomic costs associated with debt-brake enforcement.

These costs are inevitable. A closer examination of Swedish fiscal policy over the past 20 years would have shown this in abundance. The welfare state has been subject to a fiscal war of attrition, with constant cuts in spending, starvation of resources and rationing. What Greece, Italy, Spain and other European countries went through in five short years, Sweden has experienced in small doses over an extended period of time.

In other words, the success of a fiscal rule is the failure of the welfare state.

If the editors of the Cato book had taken the configuration of welfare-state spending into account, they could eventually have seen that the bigger the welfare state is, the harder it is to maintain a fiscal rule. It can still be done, but only if government continuously deteriorates its services while keeping its taxes high. Both Sweden and Greece are the most compelling examples of this, but they are far from the only examples. Europe offers a plethora of other examples to be studied.

There is only one way to balance a government budget and thus avoid a debt crisis: privatize government promises. Give both spending and funding of what are now government-run entitlements back to the private sector. Lay out a transition path from today’s welfare state to a minimal state where free-market capitalism solves the problems that government takes responsibility for under the welfare state.

There is no other option. The welfare state is structurally unaffordable, a conclusion that the Cato essayists try but fail to grasp. There are numerous references in the book to the need for higher GDP growth to fund the welfare state. The message is simple: if growth is high enough, tax revenue will be high enough; if tax revenue is high enough, government can balance its budget.

The only problem with this reasoning – which is loudly echoed in the book Trumponomics by Steve Moore and Art Laffer – is that it treats GDP growth as an exogenous variable. It is not. The welfare state depresses growth; the bigger the welfare state gets, the more slowly the economy grows.

What does this mean for the fiscal rule-making that Cato celebrates? The bigger the welfare state, the harder it is to enforce the Pippi rule.

What do we do instead? How does structural spending reform work? Stay tuned. Starting tomorrow I will roll out an entire series of articles that will answer these questions.

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