Tagged: DEBT DEFAULT

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 GreeceĀ 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.

Basel III: The Path to A Debt Crisis

Have you heard of Basel III? If not, you are probably doing OK anyway. For now.

The problem is that we all need to start educating ourselves on it. The so-called Basel III regulations for international banking make it easy for governments to go into excessive debt without credit risk.

Back in 2013 the world’s leading governments got together to revamp banking credit-risk standards. The goal was to protect banks around the globe against another crisis like the one we now know as the Great Recession. Banks would become better at weighing risk and therefore steer clear of excessive exposure to bad debt.

This all sounds fine and dandy. There is just one caveat.

Today, the biggest problems with credit rating is not with the private sector. The free market has pretty much got that one covered. The problem is instead sovereign debt.

Governments borrowing exorbitant amounts of money.

You would think that when the world’s brightest minds get together to prevent another bank meltdown, they would take into account all forms of credit and all forms of risk that banks are faced with. But no: when the Basel III package of regulations was complete, government had been exempt from risk evaluation.

That’s right. When banks report their risk exposure to government regulators they are not supposed to grade sovereign debt based on risk. If a bank owns $1bn worth of Greek government debt and $1bn worth of Swiss government debt, it is supposed to weigh the two equally in terms of default risk.

The fact that the Greek government defaulted on 25 percent of its debt back in 2012 and keeps running deficits is supposed to be of no consequence.

It is not rocket science – or economics – to see what this means in practice. A government that borrows excessively to pay for its big welfare state does not have to worry about being downgraded. It can keep borrowing. At least in theory, it can even default on some of its debt without risking its credit rating.

Viewed from the other side of the table: a bank that has bought Greek debt and receives an offer from the Greek government to buy more, should have no reason to refuse that offer. While no government can force its banks to buy its debt, there are plenty of ways it can make the banks an offer they can’t refuse. The central bank, for example, can collude with the treasury by offering banks extremely cheap loans, hinting between the lines that if the money is used to buy treasuries, there is a lot more coming.

Then there is the fallout of the risk-assessment mechanics of Basel III. Regulations force banks to strike a “prudent” risk balance in their portfolios. To do so they will always need to hold sovereign debt. And here is where it gets interesting: since fiscally conservative governments do not borrow much but high-risk governments can dole out treasuries like free candy without risk (pun intended), the international banking system is simply forced to buy high-risk sovereign bonds in order to comply with risk-balance regulations.

All this is, of course, by design. The negotiators at the table in Basel came from assorted governments around the world, many of which are very generous to themselves in terms of going into debt. Those with the most serious debt addiction simply weren’t going to accept that they were called out for being fiscally irresponsible. Instead of taking responsibility for the long-term future of their countries, those governments pouted and threw political temper tantrums until they got a set of regulations that allows the children on the block to ride on the coattails of the adults.

We cannot underestimate the gravity of this outcome of Basel III. Long before the coronavirus artificial economic shutdown, governments around the world had made budget deficits a permanent form of paying for spending. Consider this table, courtesy of the latest IMF Fiscal Monitor:

Table 1: Government deficits as percent of current-price GDP

Source: IMF Fiscal Monitor

Some of the projections beyond 2020 are purely fantasmagorical. Sweden, for example, will not be able to balance its government finances without breaking the back of the country. (They are already hard at work doing just that.) Greece will slide deeper into debt as their economy continues to stall from heavy taxes. The German figures are irresponsibly optimistic, given that Germany is no longer the leading industrial investment magnet in Europe (that title is now shared between Hungary and Poland). Ireland is under a purely totalitarian economic shutdown and – like all totalitarian run countries – will not recover economically until the tyrannical rule has ended.

But even if we disregard these points and assume that the IMF is largely correct, the picture is chilling, not to say outright frightful. In 2025, 22 or the 35 jurisdictions listed will run deficits. Basically, the forecast is that by 2022 the world’s leading governments will be back to deficits as usual, as they were before the 2020 artificial economic shutdown.

This, again, is optimistic. It is more than likely that many governments will expand their welfare states in response to the economic crisis they themselves created. Since the shutdown has crippled private-sector activity – albeit temporarily – the tax base has been disrupted at the same time as governments are going to spend more money.

Since governments, thanks to Basel III, can borrow as much money as they want with impunity, our banking industry will increasingly become the source for funding of much of this government debt. Those banks, of course, need money to buy that debt.

Whose money? Ours.

But what if governments default on their debt? Don’t worry. Our governments have already taken care of that one. It’s called the Cyprus Bank Heist and means that if government defaults on debt owned by banks, then banks can simply confiscate our deposits to recover the money they lost to government. This was first done – legally – in Cyprus, hence the name. Since then, other governments have followed with legislation allowing their banks to do the same.

It remains to be seen just how bad the fallout will be from Basel III, but the policy message is clear: government will always take care of itself. If you won’t agree to fund it through confiscatory taxes, then government will always find another way to grab your money.

American Debt Default?

A few days ago the Congressional Budget Office released a long-term outlook on government debt. Their dire prediction: by 2050 the share of the federal debt that is held by the public will have risen to 195 percent of GDP.

This is a frightful outlook, but it is only the beginning of the story. First of all, it does not include the debt held by other government institutions – an omission that should give us all pause – and therefore does not tell us the full impact that the debt has on the economy. When creditors look at buying U.S. Treasuries, they assess the debt default risk based on the entire body of debt; to them, it does not matter if the debt is owned by the Social Security Trust Fund or by the general public. Therefore, to not include the entire debt in the CBO calculation is to cushion the story in front of Congress and the American people.

Secondly, the CBO outlook does not take into account the effect on debt costs from a deterioration of U.S. credit worthiness. On the contrary, when CBO Director Phillip Swagel commented on the report at a Senate hearing, he noted that the U.S. economy is the strongest in the world, that our currency is a world reserve currency and that this means we are not in any imminent danger of a debt crisis. This is a mistake, albeit from Swagel’s viewpoint an understandable one: if he would start talking about the United States losing its credit worthiness he would most likely repel a lot of the audience he now had.

There is a third component that was left out from the CBO report, namely a discussion of the policy alternatives that Congress now has. However, it is not that hard to put together a list of what options our legislators have: there are three bad ones and one good. The three bad ones are:

  1. Austerity. This means, plainly, spending cuts and tax increases in order to balance the budget. Contrary to libertarian conventional wisdom, it is not a good option. It means spending cuts without corresponding tax cuts, thus raising the price of government either in absolute terms – spending cuts are accompanied by tax hikes – or in relative terms. This last part is the one that libertarians tend to not grasp: even if taxes are not raised, a spending cut increases the price of government. If you pay $100 in property taxes for your children’s schools and the schools cut their budget from $100 to $90, you get a poorer-quality education for the same money. While it may seem desirable in itself, this change in the price-product relationship means that we get less for the same money, while we could have used the $10 for private-sector spending instead. By choosing austerity, Congress will depress the U.S. economy on a broad scale, with the same detrimental effects as I documented in Europe during the Great Recession and the austerity response there.
  2. Monetization. This is perhaps an even more dangerous path, where Congress relies on the Federal Reserve to purchase large chunks of its new debt by simply printing more money. There is a downward slope of increasingly bad effects from this policy strategy, a slope that the Europeans got on ten years ago but shifted away from when they took to austerity instead. Venezuela, on the other hand, continued printing money at breathtaking rates, eventually causing hyperinflation. As I explained in a recent EconTalk episode of my podcast, we are inching closer to that precipitous point. We are not on the doorstep of hyperinflation – not at all – but the fuse that makes hyperinflation explode is lit, and it is shorter than most people think.
  3. Debt default. Yes, this is now an option that is being floated around in Washington, DC. It is talked about quietly, but when it is mentioned it comes with an inconspicuous moniker known as “debt restructuring”. This means, simply, that the U.S. Treasury unilaterally decides to only pay back cents on every dollar creditors owe them. This is the Greek solution, one that would have epic repercussions on our economy and our ability to function as a country for decades to come.

The third option has been unthinkable in the U.S. debate – until now. The Greeks had the same experience; for those who do not believe that the Greek experience is relevant to the United States, I recommend my paper for the Center for Freedom and Prosperity on the Greek crisis (Part 1 and Part 2). To make matters worse, the debt crisis does not even have to become a real debt crisis to have serious ramifications: the mere suspicion that the federal government would consider “restructuring” its debt could spark a surge in interest rates. At that point the cost of debt rises accordingly, in turn aggravating the debt situation by accelerating current government costs.

When default concerns raise interest rates, Congress has only two options: to take rapid action to curb the worries among lenders, or accelerate monetization. If the latter measure is already being used – as is currently the case – it is already exacerbating default concerns. Therefore, once default concerns raise interest rates, panic-driven spending cuts will dictate the fiscal agenda for Congress.

A coming episode of EconTalk at the Liberty Bullhorn will discuss panic-driven spending cuts in contrast to the kind of structural spending reform that constitutes the only productive path away from our looming debt crisis.