Braking the Federal Debt

As both Europe and America continue to struggle with big government debt, the debate rages on about how to rein in, and eventually reduce, the debt of the U.S. government. In recent years several proposals for balanced-budget constitutional amendments have seen the light of day. Most of them have suffered from serious practical problems, but there is at least one approach that has some merit to it. Simply put, this approach applies a brake to the federal debt, forcing Congress into a gradual change of its fiscal policy to rein in the debt.

This approach is familiar to Europeans but has only recently made it into the American arena. While still not the perfect solution, it adds some tangible policy instruments that could actually help turn our nation’s focus where it needs to be: on runaway government spending.

That said, it is very important that during this debate we never lose track of that very item. All contributors to the issue should be aware that debt is only a macroeconomic symptom, not a disease. A recent article at Reason.com exemplifies the risk of losing focus. The article is good and well worth reading, but only when put in its proper context. Over to Reason.com:

American progressives are fond of gazing across the pond at Europe and wishing the U.S. would emulate it. So as soon as President Obama started announcing from all reaches of the country that Congress “must” eliminate the debt ceiling, progressive cheerleaders echoed his demands, pointing out that most European countries did not have a debt ceiling. But Europe worshippers are drawing the wrong lesson from across the Atlantic. Despite public protests against austerity cuts, many European countries are instituting constitutional reforms requiring balanced budgets in the form of “debt brakes”—a far stronger way to control the national debt than a debt ceiling.

Before we continue, let us note that the EU has been under a technically strong collective debt ceiling since the Maastricht Treaty (later Lisbon Treaty) became the constitution of the EU some two decades ago. That debt ceiling did not primarily cap debt, but focused first and foremost on the budget deficit. The cap limited a member state’s national government deficit to three percent of that state’s GDP.

There were real sanctions built in to this cap, so in a technical sense it was stronger than the American debt ceiling mechanism. However, it became clear pretty soon after the euro was created (a few years after the Lisbon Treaty went into effect) that too many member states ran too large deficits to merit any meaningful enforcement. Back then, the Eurocrats in whose hands the enforcement power had been placed would simply have nothing else to do than to play whack-’em-all with Europe’s deficit-ridden member states. As a result, the three-percent rule was reduced to the “guideline” it is now being thought of.

Herein lies one reason why Greece got off on such a runaway ride with its government budget. But the practical political and administrative problems with enforcing Europe’s deficit cap are ancillary problems: the real culprit is the system of government spending called the welfare state. As soon as government makes promises to its citizens that are unrelated to its ability to pay – the very essence of the welfare state – then government is on an unstoppable path to perpetual budget problems.

Either you let the welfare state run amok (Greece) or you wage war on the private sector to keep the welfare state alive (Sweden). All the debt and deficit control mechanisms in the world won’t solve the underlying problem.

However, that does not mean those mechanisms are useless. They can actually be of some help. Let’s get back to the Reason article and see how:

The [federal debt] ceiling has been raised 68 times since 1960-including 18 times under Ronald Reagan, and by nearly $5 trillion under Barack Obama. Not surprisingly, government spending has gone through the roof along with the size of the public debt. … The debt ceiling didn’t start as a political distraction. Under the Constitution, any government spending or borrowing has to be authorized by Congress. For the first 150 years of America’s existence, that is, most of the republic’s life, Congress authorized debt for specific purposes such as funding wars or building the Panama Canal. In 1939, however, in order to give President Roosevelt flexibility to conduct World War II, Congress gave up its power to approve specific debt issuance but set a maximum aggregate borrowing limit for Treasury. Voila, the debt ceiling was born.

That was about the worst time to make such a reform. FDR was determined to lay the foundations of a European welfare state in America. He did not accomplish much on the health-care front, but when it comes to regulatory restrictions on businesses (for “progressive” purposes) as well as Social Security, he got away with a lot.

A welfare state is defined by its entitlement programs where the amount to be spent is determined by a right. That right is created – invented – by government which gives it to a select group of citizens. The right gives them either in-kind entitlements such as education or health care, or cash entitlements such as welfare or general income security. Either way the cost of the entitlement is determined by variables totally unrelated to the ability of taxpayers to fund those entitlements.

Because of the lack of spending caps in the welfare state’s entitlement programs, government needs more than just taxes to fund them. Enter government debt. In other words, the real problem here is not the debt, but the welfare state.

Reason explains:

However, what began as wartime “necessity” evolved into peacetime political cover that no longer required Congress to justify increasing specific borrowing. It simply authorized spending and let the Treasury Department sort out the necessary borrowing. The results of this bargain speak for themselves. Since 1940 Congress has run a deficit nearly every year (62 of 72 years). The federal budget has grown from roughly 15 percent of GDP in 1950 to about 25 percent today. And America has now borrowed over $16.4 trillion-roughly equal to the size of the entire U.S. economy!

However, once again: let’s not be seduced into focusing all our attention on the debt. When we do, it is easy to make the following mistake, which Reason cannot avoid:

America has not been alone in racking up such a large credit card bill. Greece—the land with debt-to-GDP above 150 percent—leads the way among her Eurozone peers. And countries like Italy (127 percent), Portugal (120 percent), Ireland (117 percent), and Spain (77 percent), followed a similar pattern of unfettered debt accumulation. Even the uber-responsible Germans let their debt rise to 80 percent of GDP. These debts have crippled the European economy in recent years.

No. Debts do not cripple the economy. Sure, debts cost money for taxpayers in the form of interest payments. However, those interest payments go back into the economy by entering the pockets of creditors, most of whom are actually domestic.

In fact, one could make a credible argument that it is better if government borrows to fund its spending than taxes us, because we can choose whether or not we want to lend government our money. We cannot choose whether or not to pay taxes.

The reason why Europe’s economies are struggling is that they have allowed government to take control over far too many of people’s needs. In addition to the assortment of government “services” that we get here in America, Europeans also typically get universal child care; tuition free, government-only universities; heavily subsidized pharmaceutical products; single-payer health care; massively inefficient mass transit systems; and general income security for working adults.

In all these areas, government has crowded out the private sector and seized a destructive monopoly. This has dramatically reduced efficiency both in producing and delivering the services. That slows down GDP growth, which in turn reduces job creation and earnings among those who actually can find a job. More people depend on government entitlements, either as unemployed or as employed with low earnings, low enough to make them eligible for – you guessed it – government entitlements.

This raises the cost of government, which goes up even more as government scrambles to find all the tax revenues it needs to pay for all its spending programs. Stifling taxes add to the growth-hampering effects of government and the economy enters a vicious downward spiral of low growth, gradually increasing dependency on government, an eroded tax base, higher taxes… and eventually austerity.

Debt, again, is only a symptom of the underlying problem. Which, again, does not mean we should not try to put a cap on it – so long as the efforts do not take our focus off the fiscal virus that made the patient sick in the first place.

Back to Reason:

One method for debt control that has gained popular support is the Swiss “debt brake.” Adopted into Switzerland’s constitution in 2001, the debt brake requires a balanced budget, but measured over a multiyear period. In technical terms, it requires the nation’s “structural deficit” to be nil over the course of a business cycle so that surpluses generated during boom periods can defray the deficits during bust periods to keep the overall debt manageable. Implicit in the debt brake idea is the recognition that constraining debt is important to honorably meet national debt obligations and avoid default—whose very prospect American liberals raise to justify their calls for scrapping the debt ceiling. Germany, for example, has now adopted the Schuldenbremse (debt brake) concept as well, specifying that its structural deficit cannot exceed 0.35 percent of GDP in any given year. This does not cap aggregate debt, but the idea is that if the federal government is not running huge deficits every year, the national debt won’t grow.

Sweden used this debt-brake model back in the ’80s. It did not prevent the enormous deficits in the early ’90s. That said, the idea has some merits that, if put to work properly, could actually help us rein in government spending. It is possible, even probable, that a debt brake could shift the fiscal policy debate in our country away from what we can do to increase government spending to what we can do to reduce it.

The best American approach to the debt-brake mechanism is the one proposed by Compact for America. It is worth a serious look.