Hyperinflation: Still A Threat

With the outcome of the 2020 election still in limbo, so is the fiscal future of our country. On the one hand, it looks like the Democrats may be down to a slim nine-seat majority in the House, a majority that could easily fracture with continued ideological battles within that party. On the other hand, the outcome of the presidential election remains unclear, with investigations continuing of what role the Dominion election software played in the vote count.

Then, of course, there is the Senate majority, which hinges on the outcome of runoffs in Georgia.

If the Democrats secure both chamber in Congress and the presidency, we are likely going to see a tidal wave of new spending, funded in part by much higher taxes, in part by the application of Mad Monetary Theory. If the Republicans hold on to the Senate and the White House (assuming that there is substance to the Dominion-related accusations), there will be some measures taken to dampen excessive deficit spending. It is also possible that if the Republicans prevail, the moderates in the Democrat party will be emboldened, enough so to start working with Republicans on spending containment measures.

That is what America needs. It will, however, require Congress to be on quick feet in order to contain our fiscal crisis, primarily because doing so will help us reduce the threat of high, monetarily driven inflation.

I have written about this threat in the past, pointing to monetization as one of three bad ways to deal with a runaway debt crisis. I have also pointed to the threat that excessive money printing poses to our very free-market capitalist economic system, and to how exorbitant money-printing helps inflation the stock market.

This last point is crucial. Vastly inflated equity markets is the first step that an over-monetized economy takes on its route to hyperinflation. The next step is that the money flows into the real sector of the economy and ends up being spent by government and by households. When that happens, the transmission mechanisms of hyperinflation go to work.*

We are not there yet, but the stage is set for it. All we need to do is continue down the current path of completely irresponsible, monetized entitlement spending. (If we really want to fuel the inflation fire, we add tax increases to the mix, as MMT proponents want.) In fact, this transmission mechanism is nothing new: we have seen glimpses of it in the past, partly – curiously – in relation to two supply-side driven tax reforms. This tells us that it is a bad idea to continue down the same path; if we want to get our current fiscal crisis under control, we need to address the spending side of the equation.

Figure 1 reports the velocity of money in the U.S. economy. This metric, which is the ratio of GDP to money supply, shows how “often” we use the same money in order to pay for all our economic transactions in a given time period (usually a year; here the data is reported quarterly). The higher the velocity, the smaller the money supply relative GDP, and vice versa.

A decline in monetary velocity means that more money is idling in the economy. The real problem occurs when the velocity falls below 1, as it means that part of the money supply is not being used at all for the purposes of economic transactions. That money is not going to just lay idle in some bank account somewhere, but will find its way to profits. If there is no transactions demand for it, banks and investors will put it to speculative use. And, as mentioned, in a monetized welfare state, where a big chunk of government spending is paid for with printed money, inflated equity markets are the preamble to high inflation in consumer prices.

Figure 1

Sources of raw data:
Federal Reserve (Money); Bureau of Economic Analysis (GDP)
  1. The Reagan tax reform, which was necessary to end the punitive taxation of personal income, did not come with the necessary spending reforms. Furthermore, as David Stockman so pointedly explains in his book The Triumph of Politics, the Laffer Effect upon which the tax cuts relied, was in turn dependent on high inflation to yield the surge in tax revenue needed to close the budget gap. That inflation did not materialize; since spending continued to grow uninhibitedly, the budget deficit prevailed. In response, America had her first encounter with money printing for the purposes of covering up Congressional fiscal excesses.
  2. In sharp contrast to the 1980s, the ’90s offered fiscal restraint on the spending side, but not on the tax side. Presidents Bush Sr. and Clinton both signed into law new tax brackets, thus destroying the clear, transparent federal personal-income tax code that Reagan put in place. Clinton’s spending restraint worked to his and to America’s advantage, conspiring with a long growth period to close the federal budget gap entirely. Hence, the fiscal demand for newly minted dollars went away and monetary velocity increased again.
  3. The Bush Jr. tax cuts adjusted some of the errors that his father and Clinton had made. At the same time, the 9/11 attacks injected a big chunk of uncertainty into the economy, causing Congress and the White House to run over to the Federal Reserve and ask for help. The decline in velocity was brief, though, and to Bush Jr.’s credit the economy grew reasonably well during his White House tenure. In fact, if the Great Recession had not happened, we would likely have seen a balanced budget in 2009.
  4. Then came the Obama years, with the most ridiculously tepid economic recovery in recent memory. That was only partly Obama’s fault – by this time the welfare state had begun permanently suppressing U.S. economic growth – but his administration’s regulatory spree and onerous Obamacare reform certainly did not help. Thanks to the slow growth, the Treasury again started tapping into the Federal Reserve to plug its budget hole: for Congress and the President, Quantitative Easing became a way of life. And monetary velocity started plummeting.

However, all of that pales in comparison to what the coronavirus packages have done to our money supply. The velocity free-fall during the QE years, which was brought to an end by Janet Yellen, has been concentrated into a free-fall this year. For two quarters in a row our velocity has been below one. While the plummet seems to have tapered off, it does not take much to cause it to decline again. Another artificial economic shutdown would certainly do the trick, but even without that we are at great risk if Congress decides to do more “stimulus” spending.

We need a new fiscal doctrine in Washington: structural spending reform.

*) In my soon-to-be-published Socialism or Democracy: The Fateful Question for 2024, I point to this very mechanism: excessive, monetized welfare-state expansion causes hyperinflation.

Structure of the U.S. Economy: Government

I have been working in economic policy most of my adult life. Even as a college professor, I taught classes that emphasized how economics can be used – and not used – to inform policy decisions. If there is one thing I have learned throughout these years, it is that people who do what I do tend to be ill informed and shallow in their analytical work.

The consequences of bad analysis are formidable. Our economy is in the shape it is – struggling to grow and staggering under an unsustainable government debt burden – in large part because economists have derelicted on their duties to provide clear, concise and well-researched information to policy makers. That, of course, is not to say politicians are innocent: there is a widespread tendency among our political leaders to let the interests of their constituents be overrun by the interests of their benefactors.

While we economists can’t do anything about the intellectual honesty (such as it is) of our politicians, we can do something about the integrity of our own discipline and profession. Sadly, in the past 30 years economics has descended into a dungeon of econometric masturbation, where increasingly technical analysis produces increasingly irrelevant outcomes. The standard for good research among academic economists today is to crank out eclectic flea-killing standardized under the template “The influence of X on Y given Z”.

The art of political economy has been almost completely wiped from the collective conscience of the economics profession. Thanks to this, about 80 percent of all economics research today is useless in public policy. The remaining 20 percent have varying degrees of usefulness, most of it being applicable in isolated policy fields like education reform or health care.

Those applications are not to be under-estimated, but they tend to focus on efficiency gains and other forms of deck-chair rearrangement schemes for a slowly sinking welfare state.

What is truly missing in the economics profession is the ability to analyze the economy as a system. I find practically no trace of it among my academic peers, and the reason is – again – their universal lack of training in political economy.

I have devoted my career to the latter, to the point where I make sure to always introduce myself not as an economist, but a political economist. It is my job and my career – my mission – to explain the real-world economy and how it works under the influence of various political theories and ideologies. This blog is one small effort of mine along that line, which is why I prefer to write about the economy as a system, and always bring in a political perspective. I do this, of course, again with “political” being understood not as the daily jib-jab of party politics – far from it – but the interaction between the economy and political theory.

There are many systemic aspects of the economy that econometricians ignore, and therefore fail to bring to the table whenever they do get a chance to inform our legislative class on good economic policy. The central systemic aspect, of course, is the welfare state, but beyond the immediacy of that structure itself lies the need to understand the composition of our economy. There is a body of knowledge that economists should have, and that our politicians need, that does not inform them directly of what policy decisions are best at any given moment; instead, this body of knowledge builds a set of reference points, a system of intuitive signals that give the economist and, ideally, the politician a gut feeling in critical policy-making situations.

The gut feeling is important. It is a shortcut for anyone who wants to make informed decisions. If you know what the woods behind your house sound like on a normal day, you will not need instrumented evidence to know when to get out; you will hear the Sasquatch coming.

One of the most important pieces of intuitive knowledge is to have a good idea of how our economy is composed: the size of government relative the private sector; the composition of private industries; long-term trends in productivity, jobs growth and absorption. To give some examples of this type of knowledge, I will write a couple of articles giving an overview of the structure of the American economy.

We start today with a look at government. This over-bloated, resource-sucking, productivity-stifling behemoth is centered around the welfare state, which I have already written plenty about (and will continue to do). Today, however, we will take a step back and look at some hard data that tell us a bit more about how our government is actually structured. This, in turn, helps us understand where to concentrate reform efforts, and what types of reforms to go for, should we as a country ever be inclined to downsize government.

Following the current public-policy debate, you can easily get the impression that reforms to limit government should be done by Congress. This is true to some degree, but you can also miss important needs for reform by spending too much resources on rocking Capitol Hill out of its inherent inertia.

To see this point in numbers, let’s start with Figure 1, which reports the distribution of government employment across the federal, state and local levels. Local governments dominate, and their share has grown over time:

Figure 1

Source of raw data: Bureau of Labor Statistics

The fact that almost two thirds of all government employees work in municipalities is easily explained by our public school system. However, Figure 1 also raises another question: does this distribution of the government workforce also mean that local governments spend most of our tax money?

No, it doesn’t. Figure 2 compares the federal share of the government workforce with the federal share of total government spending:

Figure 2

Sources of raw data:
Bureau of Labor Statistics (Employment); Bureau of Economic Analysis (Spending)

The federal government and its 12.5 percent of the government workforce spends two thirds of all government money.

There is an important piece of information to extract from this: the primary purpose of the federal government is to spend money on cash entitlements. In 2019, the average federal employee administered outlays of $1,679,000. This, of course, is in good part due to Social Security, which means that most federal employees were responsible for a lot less spending. That said, the average number gives us a good indication of the purpose of government – in this case, again, to spend money on cash entitlements.

Each state and local government employee administered only $149,000 worth of spending. The contrast is stark visavi the federal government, and it gives us an important piece of information regarding the nature of states and municipal governments: their primary purpose is to produce services. The per-employee spending at these levels of government is reasonably close to what employee compensation, facilities and administrative overhead would add up to (in a non-competitive setting).

Since the federal government is predominantly preoccupied with doling out cash to people, the way to bring down its costs is to reform those cash-benefit programs. If we want to reduce the cost of state and local governments, we have to reform the services they produce. Emphasis, of course, will be on school choice reform.

Next up will be a review of the private sector and its industrial composition. Stay tuned, and do click the Follow button to be informed as soon as new articles are published!

Structural Spending Reform, Part 6

In this the last installment of our series on structural spending reform, we will take a look at how a reform of the poverty concept would affect income-security spending. This analysis is theoretical in the sense that it focuses on the fiscal mechanics of these programs; it does not take into account the specific reforms needed to adjust the operations of each program.

However, the conclusion from this analysis is entirely applicable in policy reform: what matters in reforming entitlements is to change their purpose.

Here is what we said about this change-of-purpose reform back in Part 3 of this series:

Before the War on Poverty, the federal government used an absolute definition of poverty. It constituted the foundation for the welfare-program reforms under the Social Security Act of 1934. Figure 1a sketches the idea behind a return to this reform. The present trajectory in government spending (1) will continue unchanged (2) if no reform is made. If the definition of poverty is changed from relative to absolute (A) the trajectory of entitlement spending will change radically (3):

Figure 1a

This image has an empty alt attribute; its file name is proact1.png

In Part 4 we saw what kind of policy thought needs to go into health-care reform in order to create the “kink” at (A) above. In Part 5 we learned how this can be done in Social Security. Here, we apply the same principle to programs that provide income security for the poor.

The idea behind the reform is to change the definition of poverty, from the relative definition we have today where the poverty limit is supposed to track median income, to a definition that defines a basket of benefits that remains unchanged over time. In practice, this means changing the method by which the poverty limit is calculated from year to year; technically, the poverty limit is no longer calculated with reference to overall income growth, but solely with reference to consumer prices.

This may seem to be a largely inconsequential difference, but it is not. When we upgrade the threshold for poverty with median income growth, we also take into account the qualitative rise in the standard of living that comes with a growing economy in general. When we use this relative definition of poverty, the purpose of income-security spending is no longer to provide for the poor. It is to redistribute the rising standard of living from households with higher incomes to those with lower incomes.

In order to remove the redistributive component, we – again – concentrate the calculation of the poverty limit strictly to inflation in consumer goods prices. This means that we keep constant the ability of the poor to buy a basic set of goods and services while on poverty relief. When the standard of living rises among the population in general, the poverty limit remains unchanged, thus keeping poverty relief programs confined to what they were originally meant to be: a dignified last-resort safety net for those who fall on hard times for no fault of their own.

Figure 2 applies this calculation method in a simulation over the period from 2002 to 2017. The poverty limit still rises each year, but at a lower trajectory:

Figure 2

Sources of raw data:
Census Bureau (Poverty threshold); Bureau of Economic Analysis (Inflation)

The impact of this new poverty-limit calculation method would be significant. First, it would show up in the growth of benefits per poor person:

Figure 3

Sources of raw data:
Census Bureau (Poverty threshold); Bureau of Economic Analysis (Inflation)

It is important to note that the change in benefits growth simulated in Figure 3 does not translate literally into a change in benefits for every poor person. Some of the difference would materialize when some programs deny benefits for those who earn more than the poverty limit.

With that said, since the poverty limit itself is changed, so will the number of poor. It is a bit dicey to estimate by how much, but Figure 4 presents a possible scenario. The technical difficulty lies in knowing where the poor are clustered: do most of them have an income just a hair below the poverty limit, or do they cluster far below the limit? Since we cannot say this for certain without highly sophisticated income data, the rational approach is to assume that they are evenly spread across the income spectrum below the poverty limit.

Given this assumption, an application of the new poverty limit reduces the number of poor as follows:

Figure 4

Sources of raw data:
Census Bureau (Poverty threshold); Bureau of Economic Analysis (Inflation)

And now for the grand finale. Let us multiply the new, lower benefits levels with the new poverty population. Figure 5 reports the results as the dashed line that slowly bends downwards; for comparison, the lower benefits levels are also multiplied by the actual number of poor (the dotted line). Compare these two functions to the solid line, which represents the actual cost trajectory, and then compare Figure 5 to Figure 1a above:

Figure 5

Sources of raw data:
Census Bureau (Poverty threshold); Bureau of Economic Analysis (Inflation)

Structural spending reform is not easy, but if it were easy it would have been done already. It takes courage, persistence and commitment to do reforms like these. Whoever steps up to the plate and does it, will save this country from fiscal ruin.

Whoever doesn’t, will keep rearranging the deck chairs on M/S Debt Crisis as she steams toward the iceberg.

There are a few more loose ends to tie up. The Addendum will follow in just a day or two.

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Structural Spending Reform, Part 5

The big item in the federal budget is, of course, Social Security. Slated for bankruptcy in a little bit over a decade, Social Security is an ominous symbol for the entire American welfare state. Despite 20 tax hikes in 40 year, taking the Social Security tax from two to over 12 percent, the program is rapidly running out of money.

The same is true for the entire American welfare state. I explained in great detail already in 2012 when I wrote Ending the Welfare State: A Path to Limited Government That Won’t Leave the Poor Behind. In that book I gave five examples of comprehensive reforms to entitlement programs, all of which would:

  • Eliminate the threat of a fiscal cliff,
  • Advance economic freedom, and
  • Protect the poorest among us.

One of the reforms in the book explains how we can save Social Security from bankruptcy. This article is a summary of that chapter; for the sake of brevity I will not explain the details of the algorithm for introducing private accounts. The full technical outline is in the book.

The biggest problem with Social Security is that it has made promises to low-income workers. Thanks to these promises, they have refrained from seeking other retirement security options and therefore become entirely dependent on government. To reinforce this promise profile, the Social Security system allows you to accrue future benefits with a slant in favor of low incomes. In a three-tier formula, taxpayers qualify for benefits equal to 90, 32 and 15 percent, respectively, of their income, depending on how much money they earn.

By contrast, the tax funding Social Security is a flat rate, which means that the program redistributes money on an on-going basis, from higher-earning taxpayers to those with lower incomes.

Herein lies one of the two key design flaws in Social Security: it works if and only if

  1. Overall household income grows at a certain minimum rate per year, and
  2. Income differences remain big enough for a solid transfer of money from those with higher incomes to those with lower incomes.

The second condition depends on the first. Social Security is funded out of work-based income; in a slow-growing economy, work-based income grows more slowly across the board – not just for low- and middle-income families. As a result, tax revenue slows down and the “surplus” tax base, i.e., the higher incomes that fund the benefits redistribution, shrinks.

Since GDP growth has slowed down markedly in the past 20 years, so has growth in personal income – and especially work-based income. Therefore, Social Security is structurally under-funded.

However, there is another design flaw: income migration. This flaw is independent of the rate at which the economy grows over time. At the heart of Social Security lies a discrepancy between the growth rate in benefits and the growth rate in funding. The benefits that each person accrues over his or her working life will, by necessity, grow faster than the incomes out of which those benefits are paid.

Here is how it works. You enter the workforce at a young age, with a wage or salary at the bottom of what is common for your profession. As your career advances, your income increases primarily in three ways: annual raises and seniority; promotions and job changes; and career-advancing training and education. When you approach retirement, you earn a top salary for your profession.

Over the years, your income migrates upward, but it doesn’t just migrate upward with average household income. Thanks to your progress through your career, your earnings outpace the average. But here is also where the problem starts for Social Security: your benefits are accrued based not on average, national household income, but on your individual income path.

Taxes, by contrast, grow with average household income.

To take an example, suppose you enter the workforce at 22. You start out with a salary of $25,000.* Average personal income is $40,000, placing you at 62.5 percent of the average. Over time, average income grows by three percent – new, younger workers enter the workforce at entry-level wages – but due to the three factors behind individual income growth, your income rises faster, say at five percent per year.

By 47, your income will equal the national average; when you retire, you earn 42 percent more than the average.

This example is based on a modest assumption of how individual income outgrows average income. If the growth difference is 2.5 percent per year instead of two percent, in the example above the individual will retire with an income 75 percent above average, instead of 42 percent.

When your individual income grows at five percent per year (with average income growing at three percent) you retire with an individual funding deficit. You have, bluntly, underfunded your own retirement by $216,600.

Over the decades, this underfunding makes the system structurally underfunded. Every retiring generation adds to the funding deficit. I include a calculation in my book, simulating a benefits cap at average income growth (p. 120). Over the 50 years from 1960 to 2010, the benefits cap would have eliminated half the benefits paid out.

The root cause is that Social Security is a pay-as-you-go system. Cash that goes into the system from current tax payments fund cash going out of the system, i.e., current benefits. The individual earns IOUs as he goes, relying on future taxpayers to fund it for him.

It is thanks primarily to 20 tax hikes over a period of 40 years, 1950 to 1990, that the bankruptcy of the system has been delayed.

There have been attempts to solve this problem. President Bush Jr. and then-Congressman Paul Ryan (R-WI) introduced a model for static private accounts where a fixed share of a person’s Social Security taxes would be diverted into a private account. This model delays but does not solve the problem with the structural budget deficit.

Only a model for dynamic private accounts can do this. Referring again to my book for the details, here is the dynamic model in a nutshell.

Instead of diverting a fixed income share, over time the dynamic reform diverts a growing share of a person’s income. The increase in the share is faster for low incomes: they will be the first to get control over their own retirement. Since a private-account model means that retirement is pre-paid, and since individualized retirement builds a more solid structure of benefits upon retirement, this feature of the model guarantees that low-income workers are taken care of before anyone else.

There is another feature of the model that protects low-income taxpayers. The private accounts are phased in, meaning that the accounts slowly, gradually replace Social Security as a national retirement plan. The phase-in period is very long – the algorithm developed in my book is based on a 40-year transition period – which means that the current Social Security system will continue to receive funding for a long time to come. Since current benefits are structured to prioritize low-income workers, this means that those who are too old to benefit substantially from the private accounts, are guaranteed funding of their Social Security benefits.

The phase-in follows a formula (p. 127) where private accounts are rolled in by income quintile. The transition from Social Security taxes to private-account contributions migrates upward through the income layers; the share of the tax that is diverted increases annually.

It takes five years before the highest income quintile is introduced to private accounts. This, again, helps guarantee the solvency of the gradually out-phased Social Security system.

To further guarantee a solvent transition, the expansion of the private accounts takes place in three stages:

  1. The introduction period is 6-8 years long. During this period the share of Social Security taxes that go into private accounts will increase steadily until 30 percent of all Social Security tax revenue goes into those accounts. At that point the transition tapers off and comes to a halt at a 45-percent private account share.
  2. A stabilization period lasts for 10-12 years, during which the private-accounts share remains unchanged. This is to allow for solvent funding of retirement benefits for those who are too old to participate to any substantial degree in the transition.
  3. The final phase, the completion period, is about ten years long. During this phase, the transition is completed into a fully private model for retirement security.

Again, the algorithm developed for this transition (pp. 129-131) is based on a total transition period of 40 years. If GDP growth picks up during that period of time, the transition can move faster and be completed sooner.

The main point with the privatization is, again, to liberate America from one of its most bone-headed government promises – one that was based on embarrassing design flaws from the get-go – and to do so while protecting the poor, the vulnerable and those who have been lured into believing that they can trust government with their own financial future.

We have one more reform model to talk about: income security. Click here and see what happens when we toss out the socialist, relative definition of poverty and replace it with the socially conservative, absolute definition.

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*) The numbers here are hypothetical, but please keep in mind that the statistics used for this privatization model are almost a decade old by now. However, the Social-Security structural problems identified here have not changed. They remain regardless of what actual numbers we plug in.

Structural Spending Reform, Part 3

In Part 2 we discussed reactive spending cuts, which include the Penny Plan and traditional European austerity. We concluded that this type of spending reform defeats its own purpose: it does not solve the underlying problems causing a structural budget deficit. The reform type does not incentivize economic growth, but instead contradicts it by keeping government expensive over time, while eroding its benefits.

Today we will dive into the alternative reform type: proactive spending cuts. This type is almost unheard of in reality, and there is scant literature – if any – explaining either its theory or its practice. The closest real-world example is the Dutch health-insurance reform: in 2005, the year before the reform went into effect, government paid for two thirds of all health care in the Netherlands; in 2007, the year after the reform went into effect, the proportions were reversed.

As of 2017, the latest year with available data, the private share was three quarters. This is higher than in America.

A coming article will examine the Dutch reform in detail; for now, let us lay out the principles for proactive spending reform. Before we do, though, let us notice that this reform type is associated with some significant political and policy challenges. We can overcome those – in fact, we must. Proactive reform is the only way to secure the fiscal sustainability of our government. However, the challenges are not be under-estimated, and will be discussed in articles on specific reform proposals: health insurance, Social Security and income security.

In Part 2 we noted that entitlement spending, which accounts for two thirds of all federal government spending and more than half of state and local government spending, is defined in principle by a simple equation. Spending, GE, is determined by the share of the population, e, that is eligible for the entitlement program, and the amount they get in benefits, B:

Benefits, in turn, are determined by the value of those benefits, b, as share of household income, Y:

The problem with these two equations is that they define a trajectory of perpetual increase in government spending. The key element of proactive spending reform is to break this trajectory and point government spending in a new, fiscally sustainable direction.

There is a technical and a theoretical component to this reform. First, the technical component, which consists of severing the tie between b and Y in the equation above. We replace the bY variable with a fixed B:

Each eligible individual now gets a fixed amount of benefits. That amount is independent of household income; as a ratio of household income, it declines over time.

From a theoretical viewpoint, this reform requires a more substantial change than its technical representation may suggest. The key is to redefine the formula by which we estimate poverty: today our definition of what it means to be poor is relative, with the poverty limit largely tracking median household income. This has absurd consequences, primarily that a thriving economy cannot reduce poverty. On the contrary, the population defined as poor can actually increase, even though employment is high and household income is rising.

The reason is, again, that poverty is defined as a percentage of median household income:

  1. If median income is $50,000 and the poverty limit is 55 percent of that, then you are poor if you make $27,500;
  2. If median income rises to $55,000, then the poverty limit rises to $28,250.

You are now better off being poor than you were before. As a result, the amount of entitlement spending has to rise, as per the definition of B above.

To decouple B from Y, we need to replace the relative definition of poverty with an absolute definition. This is represented by the third equation above, where entitlement benefits are capped and kept constant.

Before the War on Poverty, the federal government used an absolute definition of poverty. It constituted the foundation for the welfare-program reforms under the Social Security Act of 1934. Figure 1a sketches the idea behind a return to this reform. The present trajectory in government spending (1) will continue unchanged (2) if no reform is made. If the definition of poverty is changed from relative to absolute (A) the trajectory of entitlement spending will change radically (3):

Figure 1a

But wait: doesn’t this look a lot like a Penny Plan in practice?

Superficially, yes, it does. However, Figure 1a only tells half the story of a proactive spending reform. There is another side to the equation, namely the funding of the welfare state. However, before we get to the taxes, let us also note that this is just the fiscal schematics of a proactive reform; its execution within each entitlement program will bring far more difference than is laid out here. Those details will come in subsequent articles.

One more point before we get to the tax side: let us not forget the purpose behind proactive spending reform. The reactive type aims to make the welfare state more affordable – it does not seek to eliminate the welfare state. Therefore, government promises remain on the shoulders of the taxpayers, whose duty it is to work harder and harder over time to foot the bill.

A proactive reform seeks to permanently alleviate the burden on taxpayers.

Speaking of which, if the proactive reform is going to work as intended – in other words to roll back the welfare state – it must include reforms that alleviate the burden on taxpayers. In other words, tax cuts, but not just any tax cuts.

Today, the welfare state is paid for with tax revenue that rise and fall with GDP and, more specifically, personal income. Let TE be total tax revenue paying for the welfare state. Let t be the aggregate tax rate – how large a share we all pay in taxes combined – and let Y, again, be household income:

If we leave taxes alone, the burden will rise not only with income, but also relative welfare-state spending after the reform in Figure 1a. In other words, we have to combine the reform that changes the spending trajectory with a reform that caps taxes on par with spending:

Let us now plot the tax-revenue trajectory together with spending from Figure 1a. We assume that we have a structural budget deficit, represented by the vertical difference between the red (spending) and blue (tax revenue) functions.

With points 1, 2, 3 and A being the same as before, we now have tax revenue originally growing parallel to, but numerically below spending (4). If no reform takes place, it continues upward (5). However, suppose we combine spending reform (A) with tax reform (B). Revenue now veers off (6) to eventually catch up with the news spending trajectory:

Figure 1b

What type of tax reform would produce this result? It would take a reform that shifts from a tax that is proportionate to economic activity – be it income or consumption – to a tax that is proportionate to expected spending. Denoting this spending variable with *, we set the tax rate to:

Expected spending, in turn, is determined by spending in the past – say one year – and a forecast for spending in the coming year:

Since economists are notoriously bad at forecasting, it is reasonable to balance the forecast against past experience.

An important consequence of defining the welfare-state funding tax in this way, is that the tax rate will change with spending. Increases in spending will immediately translate into higher taxes, and vice versa. This has one important effect: as incomes grow and entitlement spending remains constant, the tax burden will gradually decrease.

As the tax burden declines, the private sector gradually gets more room to spend, invest, create jobs and build wealth. Over time, this keeps the economy on a path where demand for government entitlements will not only be a lighter burden at a constant rate of eligibility, e, but where the population needing government assistance will gradually decline.

Now: how do we put this proactive type of spending reform to work? The answer begins with Part 4!

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Structural Spending Reform, Part 1

I have drawn some ire from fellow libertarians for my criticism of their fiscal policy priorities. My review of the book Trumponomics by Steve Moore and Art Laffer, which concluded that tax cuts have become ineffective, rendered a couple of surprising comments from fellow libertarian economists. Nevertheless, as I explained in my series Tax Cuts or Spending Cuts, facts are facts; cutting taxes to close the budget gap in a big welfare state is about as futile as ignoring gravity.

The only way to close the budget gap is by means of structural spending reductions. Since such reforms are no longer being discussed in the public discourse, nor being given attention by leading libertarian thinkers, pundits and scholars, starting today I am rolling out a series of articles on how to structurally reform away the welfare state.

In this the first installment we will condense the case for structural spending reform. I find it necessary to do so, partly – again – in response to the conventional wisdom that tax cuts can save us, but partly also in response to another idea being floated around among conservatives and libertarians: fiscal rule making.

Many people with influence have suggested that all Congress needs in order to end our deficits and prevent a debt crisis, is to follow a set of fiscal rules. A new book from the Cato Institute offers a collection of 20 essays centered around this notion; as I explained in my review of the book, for two reasons fiscal rule-making does not work:

  1. The rules are “Pippi rules”, i.e., they are self enforced with impunity for non-compliance;
  2. Without exception, the rules rely on healthy levels of GDP growth in order to work.

The last point applies not only to fiscal rule-making but also to the unending pursuit of tax cuts. In the case of rule-making, the prevailing wisdom is that GDP growth is exogenous to fiscal policy, in other words that it is not affected by the enforcement of a fiscal rule. However, as we will see in a coming article, fiscal rules can actually undermine the very basis for their own enforcement.

In other words, GDP growth is not exogenous, but endogenous to fiscal policy.

Proponents of tax cuts recognize this: in fact, the endogenity of GDP is the very life blood of the tax-cut argument. The problem here, though, is that tax cutters limit the endogenity to taxes; there is no explicit consideration of the effects of government spending on GDP growth. Right there we have the mistake that prevents the tax cutters from seeing how their budget-balancing strategy has run its course and no longer works.

It is essential for any attempt to save us from a debt crisis, that we understand why GDP growth is affected by the size of government spending. Before we get to the analytical explanation, let us start with empirical evidence. Figure 1 summarizes what this evidence says, namely:

  1. When government spending as share of GDP increases, i.e., when G/Y goes up (horizontal axis), initially the growth rates of taxes (t) and government spending (g) are largely similar;
  2. As the size of government passes a certain point, the growth rates of t and g divert, with the former declining and the latter increasing;
  3. when government spending grows faster than tax revenue, we get a structural budget deficit.

Figure 1

Let us review some data that confirm the image in Figure 1. First, Figure 2 reports data from Europe on the relationship between government spending as share of GDP, G/Y, and real GDP. Covering 31 countries, almost all of them over a 25-year period (1995-2019), it paints a stark image of the negative relationship between economic growth and the size of the welfare state:

Figure 2

Source of raw data: Eurostat

Next up: numbers from the U.S. economy, which gives us an opportunity to link the size of government to the root cause of the budget deficit: the welfare state.

Government growth in America can be divided into five distinct phases. The first era runs from 1950 to 1963. This is the first phase of stability (Stability 1 in Figure 3 below). During this phase the welfare state was still ideologically conservative and did not engage in economic redistribution. It was, simply, confined to the provision of a safety net for the poor and needy. This was the welfare state that Congress and the Franklin Roosevelt administration created in response to the Great Depression.

The second phase of government growth begins with President Lyndon Johnson’s State of the Union speech in 1964. There, he declares his War on Poverty and marks the beginning of a fundamental overhaul and expansion of the welfare state. New entitlement programs like Medicare and Medicaid are created, others revamped for much more comprehensive purposes.

At the heart of the War on Poverty is a new, relative definition of poverty. A person is no longer poor because he lives below a certain, fixed standard of living. A person is now poor because he earns below a certain percentage of median income. When median income rises – as it does when the economy is doing well – the poverty limit rises as well. More people qualify for government handouts.

As I explained in my book The Rise of Big Government, the significance of this welfare-state metamorphosis cannot be understated.

After this roll-out phase for the new, socialist welfare state, it was time for the implementation phase: government needed to consolidate its new spending programs. Fiscally, this meant that government grew to the new, larger proportions that all the War-on-Poverty legislation prescribed. During this phase, which essentially coincided with the 1970s, government spending increased significantly.

This is also the phase during which government spending outpaced tax revenue on a permanent basis. The structural budget deficit was born.

Once the new welfare state was consolidated, government went into a new phase of relative stability. It lasted from 1980 to 2007, the year before the Great Recession started. During this Stability 2 phase (again, see Figure 3 below), government spending remained largely constant as share of GDP, but that stability was attainable thanks only to two tax reforms. Government spending was still small enough to let tax cuts work – there was a Laffer effect to be counted on.

If it had not been for the Reagan tax cuts fundamentally overhauling the tax code, there would not have been a long, stable growth period through the 1990s; the Bush tax cuts generated a more limited, yet visible growth spurt that helped carry the economy through most of his presidency.

With their growth record, these two tax reforms generated enough growth to essentially keep steady the ratio of government spending to GDP.

It is easy to get the impression from this long phase of stability that America had struck a golden balance between the welfare state and free-market capitalism. That was not the case, as evidenced by the perpetuated deficit. The Reagan and Bush tax reforms were not enough to close the budget gap, and the difference in effect of the two, with the first having stronger effects than the second, remains unrecognized in the literature.

The reason why the two reforms failed to fully fund the welfare state is simply that this structure of government spending grows by its own volition. Government spending is exogenous to economic growth, a fact that originates in the very ideological design of the welfare state.

Phase five, the Stagnation phase in Figure 3, is when the welfare state has grown big enough to permanently depress economic growth. This phase provides ample evidence of how the welfare state overpowers its host economy. During this phase, which begins in 2008 with the Great Recession, total government outlays average more than 37 percent of GDP. Economic growth is so poor that its annual average for the entire period is only 1.7 percent:

Figure 3

Source of raw data: Bureau of Economic Analysis

Predictably, the decline in growth has taken a toll on government revenue. When taxes have not delivered sufficient money to fund the growing welfare state, government – especially states and municipalities – have resorted to non-tax revenue. As Figure 4 explains, the rise of fees, charges and other revenue sources has coincided in time with the transformation, implementation and growth of the socialist welfare state. However, not even the rise of non-tax revenue has been enough: the deficit reported in Figure 4 (red) is mostly federal but also includes overspending by state governments.

De facto, deficits have become a permanent source of government funding:

Figure 4

Source of raw data: Bureau of Economic Analysis

It is worth noting that as taxes become less important as a revenue source for government, the effectiveness of tax cuts also declines.

With declining GDP growth under an increasingly burdensome welfare state, government debt keeps rising. Figure 5 compares the debt-to-GDP ratio to real GDP growth. To highlight trends, the numbers are reported as five-year moving averages:

Figure 5

Sources: Office of Management and Budget (Debt); Bureau of Economic Analysis (GDP)

Let us now add together everything we have learned so far about the interaction between government spending, GDP growth and tax revenue, and add one more twist to the tax-or-spending-cuts debate. Figure 6 reports a total of 262 quarterly observations of annual growth rates in all three variables, from 1954 to Q2 of 2019. The observations are not reported chronologically, but are instead organized by GDP growth, from high to low (blue).

Tax revenue correlates positively with GDP growth (black dashed), which is not surprising. What does stand out, however, is the turn upward of government spending growth (red dashed) when GDP growth falls below three percent per year. As GDP growth gets weaker, government spending accelerates:

Figure 6

Sources of raw data: Bureau of Economic Analysis

We have now learned three important things about the government budget:

  1. As spending grows, GDP growth declines;
  2. As GDP growth declines, spending growth accelerates; and
  3. With declining GDP growth, tax revenue slacks off as well.

There is more to be said about the first two points; for now, let us note the conspicuous divergence between GDP and government spending toward the right end of Figure 6. That gap alone explains our structural budget deficit.

However, first, we need to add one last point about taxes. As Figure 6 tells us, tax revenue fluctuates with GDP growth, but the fluctuation is higher in tax revenue. This means, plainly, that tax revenue is a volatile source of revenue. Figure 7 extracts the equations defining the trend lines in Figure 6 and plots them strictly as analytical representations of how these two variables correlate:

Figure 7

The problem with Figure 7 is that the volatility in tax revenue has increased with each supply-side tax reform. This means, in turn, that tax revenue plunges more violently in recessions, but since the long-term growth trajectory for GDP – and therefore the tax base – is lower than it used to be, this volatility is not symmetrical. We don’t get enough of a compensating “Keynesian” surge in tax revenue at the peak of the business cycle.

In other words, we are left with a structural deficit.

But why, then, do we actually have this structural deficit? This question is of course essential to our discussion of structural spending reform. Figure 8 has the answer. It reports the share of the federal budget that is dedicated to entitlement spending, i.e., the welfare state. The blue function represents the welfare state’s share of the budget in 1964, when the War on Poverty began. Today, two thirds of all federal spending goes toward entitlements, from education to Social Security, from the Earned Income Tax Credit to Medicaid and Medicare:

Figure 8

Source of raw data: Office of Management and Budget

To highlight, Figure 9 divides the 2019 federal budget by major program category. Notice the share that goes to national defense: in 1960 that share was 50 percent.

Figure 9

Source of raw data: Office of Management and Budget

Spending on entitlement programs grows for reasons that are inherent to the programs themselves. This growth causes a depression in GDP growth, which in turn causes a structural budget deficit. The only way we can close the budget deficit is by reforming away the welfare state.

How? Please proceed to Part 2.

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[1] For a more detailed discussion of the ideological character of the American welfare state, see Larson (2018) and Larson (2020f).