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.
In his illuminating The Triumph of Politics: Why the Reagan Revolution Failed, perennial fiscal truth teller David Stockman summarized hyperinflation as (p.65):
the deliberate debauching of the nation’s money in a futile effort by politicians to compensate for the shortfalls of capitalist growth that their own misbegotten bureaucratic enterprises had caused.
In plain English: politicians compensate for welfare-state overspending by printing money. I have pointed repeatedly to the signs of inflation pressure building in our economy, and how it is traceable back to the excessive money printing that has fueled recent government spending.
As I previously reported, money supply is now at such a level that the velocity of money in the second quarter fell below one. This means, plainly, that there is money idling in the economy that is not being used; wherever there is idle money, there will be inflation.
A review of third-quarter data on money supply shows that money velocity remains below one:
The fact that money supply has continued to outpace GDP means that it has also outpaced the transactions demand for money. Some of it will be absorbed by equity markets and contribute to a speculative bubble, but part of it will also find its way back into the real sector of the economy.
That transmission mechanism is known as deficit monetization, or government spending money fresh off the Federal Reserve printer. This transmission mechanism between the monetary and the real sectors is a dangerous source of inflation. So far, in the American fiscal-policy debate, it has been widely under-appreciated.
We have only had a velocity this low at one point previously in recorded monetary history. That was in the early 1960s:
Back then, the velocity was low because the Federal Reserve had just started implementing new policy instruments and was attempting to shift from classic to accommodating monetary policy. That policy, in turn, was incompatible with the gold standard, the formal remains of which evaporated during the 1960s.
Since then, monetary policy has been focused on providing liquidity for the U.S. economy. Up until the late 1970s there was little focus on monetizing budget deficits, but as the gaping hole in the federal finances grew bigger in the ’80s, monetization slowly became an accepted practice. In the 2000s that policy became systematic under the label of Quantitative Easing; in reality, QE was more of an excuse to turn an ad-hoc approach to deficit funding into a formal, open practice.
Today, as Figures 1 and 2 demonstrate, deficit monetization is as established as the budget deficit itself. This is deeply worrisome, and it does not get better if we break down the money printing on a monthly basis. As Figure 3 explains, not only is money supply vastly bigger than it was only a year ago, but the difference is still increasing:
There is a bit of an oddity in the difference between M1 and M2 in 2020. It is not unheard of that the two expand at different rates, but it is unusual. We will examine that in greater detail in a later article; for now, the main point is that the money supply keeps expanding, our monetary velocity remains negative and that the transmission mechanisms that cause inflation remain active.
The Republicans in the House of Representatives have put together a task force to study U.S. and Chinese military capabilities. In reporting on their findings, Representative Liz Cheney (R-WY) explains that Congress needs to increase defense spending by 3-5 percent per year – in real terms – to keep our military on top of the game.
This is a tall order, but a necessary one: national defense is the first priority of government, one that we should fund in full before any other functions are considered. That, of course, is not the case today, which reduces defense spending to an item in the budget like any other: less than 15 percent of federal spending goes to defense today, compared to half of the budget 60 years ago.
In other words, by promising to do almost everything under the sun, Congress has already made it harder for itself to fund defense. However, there is another problem that Representative Cheney and the others in the Republican leadership need to consider if they want to reach their necessary but difficult funding goal: inflation.
As I explained recently, there are forces at work in our economy that point to higher inflation going forward. It is entirely possible that we will see four percent inflation next year; higher numbers are unlikely this side of 2022, but over the long term, higher inflation is more likely than lower inflation.
An inflation rate of four percent would of course make real increases in defense spending very hard. For every percentage point of inflation, Congress needs to add approximately $7.5 billion to the defense budget just to protect the military’s purchasing power. At two percent inflation – which is basically where we are today – that means $15 billion more for defense, without even adding any new real money into their budget.
Currently, Congress is giving $45-55 billion more per year to the Department of Defense, which means about four percent in real terms. However, the increase in appropriations is scheduled to taper off as we go forward, falling below two percent beyond 2022. In real terms, this means that defense spending is actually going to go backward.
And that is at the current inflation rate.
The problem is, as mentioned, that there are forces at work in the economy that are driving the inflation rate higher. To make matters worse: Congress is responsible for both of them:
- Cost-push inflation. As I explained recently, the cost of labor is going up at rates we have not seen in at least ten years. This increase is not caused by high growth or rapid gains in productivity, but by the wage toll that the federal government has placed on the labor market. That toll, of course, is the bonus that Congress is paying out to the unemployed: the $600 weekly compensation on top of regular unemployment has dropped to $300, but it is still there. To motivate workers to come out of idleness, employers therefore need to pay their workers more than what is motivated by the value they add to the business. The only way employers can make up the balance is by raising prices.
- Deficit monetization. Congress is borrowing money at rates we have not seen in peacetime, and the Federal Reserve is printing money faster than it has ever done on record – and everything suggests that they will keep the monetary printing presses working overtime for the foreseeable future. Even if the money-supply growth rate tapers off, it will nevertheless keep growing for as long as Congress maintains its enormous budget deficit. Money printing eventually leads to monetary inflation – the most dangerous form of inflation.
To add yet another warning signal of pending inflation, the Federal Reserve has “modified” its inflation goal. It is no longer looking to maintain a two-percent cap on inflation: the goal is now to keep inflation at an average of two percent, without any specification of the period of time over which that average will be calculated.
In plain English, the Federal Reserve has decided to prioritize the funding of the budget deficit over low inflation. This will have serious consequences for the economy over time; for now, it is a major problem for Congress itself – where the monetized inflation originates. Looking again specifically at the defense budget, to protect the real value of DoD procurement and employment checks, at four percent inflation our elected officials will have to add $30 billion per year to the defense budget.
If we get bad monetary inflation, in other words prices go up around ten percent per year, that $30 billion becomes $75 billion. And those numbers are calculated solely based on current spending; compound inflation is not considered. Then comes the fight to actually increase the defense budget by 3-5 percent in real terms.
Common sense – and a dollop of political cynicism – suggests that with the defense appropriations being less than 15 percent of the federal budget, and the welfare state consuming more than two thirds, it is fairly simple to see where the Congressional priorities will be – especially if inflation starts eroding entitlement checks. Therefore, the message to Republicans in Congress is clear, cold and unmistakable:
Entitlement reform – now. Roll back your promises of economic redistribution.
Otherwise, your only choices will be from the list of three bad options I discussed earlier. Not one of them will benefit our national defense.
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:
- 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.
- 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.
- 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.