Time to Constrain Government
Michael Boskin
PALO ALTO –The current financial crisis in Europe provides a unique update to Lenin’s dictum that nothing so destabilizes a country as a run on its currency. In today’s EU, nothing so destabilizes a currency union as a flight from a member’s sovereign debt.
The turmoil from the Greek debt crisis and concern over analogous problems in Ireland, Portugal, Spain, and Italy have spread fears about the stability of European banks, the global financial system, the eurozone, and the global economy. German Chancellor Angela Merkel recently echoed these fears in public and added worries over whether the euro will survive the crisis.
The €750 billion (almost $1 trillion) bailout package from the EU, the European Central Bank, and the International Monetary Fund provided only a brief respite in international markets. This has now given way to a more sober analysis of the crisis and the efficacy of the response.
The bailout is no solution to the fundamental problems that the eurozone confronts; at best, it buys time to spread the inevitable wrenching adjustments over time and across people. And it carries its own serious risks of moral hazard and the loss of the ECB’s credibility and independence.
The fundamental problem for Greece is its bloated fiscal commitments, enabled by lower borrowing costs when it joined the euro. But the problems are not limited to Greece – or even to the other countries on the eurozone’s periphery. Fiscal folly is widespread throughout Europe and much of the rest of the world. If Greece paid no interest on its debt and regained full employment, its fiscal deficit would still be an astounding 6% of GDP, but the corresponding figures elsewhere are similar, if not worse: 8% for Ireland, 5.6% for Spain, 6.8% for Great Britain, and 7.5% for the United States.
Some argue that the only way to save the euro is for monetary union to be followed by fiscal union. Their recipe is for the high-tax, high-social-spending (and not-so-small deficit) policies of the large northern European economies, Germany and France. But that would be a big mistake. What is needed are constraints on fiscal policy by each country, not a supranational fiscal authority.
The problem plaguing many advanced democracies, in Europe and elsewhere, is rising government spending, taxes, and public debt, all of which gravely threaten economic growth. In response to this trend, the IMF urges a return to pre-crisis debt-to-GDP ratios. Otherwise, the vast explosion of public debt will permanently depress per-capita growth by one-third or more in most advanced economies – a stunning permanent stagnation – and would hamstring governments’ ability to combat the next recession.
But to return to the pre-crisis safety zone will require a decade of large primary budget surpluses (excluding interest payments) of roughly 4% of GDP for the US, 3% for the eurozone (higher for higher-debt countries), and 7% for Japan.
The fundamental lessons of the Greek debt fiasco are not new: 1) elected officials systematically ignore long-run costs to achieve short-run benefits; 2) they wait to act until they are forced; 3) government policies cannot circumvent the laws of economics; 4) governments cannot revoke the laws of arithmetic; and 5) budget policy is not merely accounting.
When a government borrows a euro (or a dollar, pound, peso, or yuan), it commits itself to pay a euro in present value of future interest payments and eventual repayment of principal. That money must come from higher taxes, from eroding the real value of money balances and government debt through inflation, or from outright default and debt restructuring. The eventual costs of any of these actions are severe.
Moreover, the problem is not just one of public debt. A much higher ratio of taxes to GDP only trades a deficit problem for more sluggish economic growth. In recent decades, the large advanced economies with the highest taxes have grown most slowly. And the higher-tax economies did not even have smaller budget deficits than the lower-tax US; rather, higher taxes merely enabled higher spending.
Will a new Stability and Growth Pact, with eurozone members assessing the fiscal policies of their peers, solve these problems? IMF consultations and evaluations have had little impact outside of economies that are heavily dependent on IMF programs. Citizens and local politicians will not outsource their policies to neighbors or international organizations unless forced to do so by strict bond covenants.
So it would be far better for each country to enact serious legal constraints on its legislators’ budget authority. Restrictions on budget deficits are a start, but are not sufficient. The immense growth of the welfare state and soaring public deficits and debt have become the major source of systemic economic risk at both the national and global level. Simultaneous restrictions on spending, taxes, and debt are thus required to avert future economic and financial crises.
Analogous rules for federal budgeting were somewhat helpful in the US in the 1980’s and 1990’s, but were abandoned in 1998. Future legislatures cannot be completely bound by such rules unless they are embedded in constitutions. The constitutional balanced-budget rules (for operating budgets, with borrowing allowed for capital spending such as school construction) found in many US states have by and large worked well, and Germany has recently moved in this direction.
These rules include appropriate temporary safety valves for recession, and some have super-majority voting requirements. Sensible rules promise big payoffs, given the current and long-term global crisis in public finances.
The problem is not that governments lack resources to spend, but that higher government spending, taxes, and debt are eroding economic growth and future living standards. Such a future seems to be on the horizon not only in Europe, but everywhere, unless governments rein in their spending.
Michael Boskin, currently Professor of Economics at Stanford University and a senior fellow at the Hoover Institution, was Chairman of President George H. W. Bush’s Council of Economic Advisors, 1989-1993.
Copyright: Project Syndicate, 2010.
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Explorer 03:31 31 May 10
This analysis shows no understanding of the flexibility of sovereign nations which issue their own (fiat) currency, borrow at least mainly in that currency and do not have an exchang rate peg.
Those countries do not have to borrow tax or sell assets to spend. It might be the current political custom, but it is not necessary. Since the abandonment of the gold standard and Bretton Woods fixed exchange rate system, sovereign nations issuing their own fiat currency and not having substantial obligations denominated in other currencies have a great deal more flexibility in the race of high unemployment and low capacity utilisation, even more so it they are not overly dependent on imports of basic comodities.
Countries which don't meet these three requirements have less options. This includes the members of the Eurozone, particularly the PIIGS. It does not include the US, UK, Japan (and China if it is willing if needed to allow exchange rate adjustment).
FT05 01:12 07 Jun 10
It seems to me that the author treats different problems as if they were a single problem.
The problem of the tendencies of growth of public expenditure in the developed world and the problem of the recent jump of the deficit and debt in the developed world are two different things. The first is the outcome of preferences for consuming collective goods vs private ones. The second derives from the contingent necessity to save the financial system and the real economy as a consequence.
In the first case I do not see the purpose of imposing a 2/3 majority to take a decision; this would be more reasonable when a country has to make decisions about other problems, for instance the energy policy, which often implies an advantage of present versus future generations. In the second case, had countries had this sort of constraint, we would very likely be in a much worse recession than the one in which we are plunged now.
The problem of the euro is not so much related to public finance, but to the fact that Europe is not an optimal currency area as far as labor movements. Above all, it is because there is no Federal Treasury. Public finance should be more flexible and more centralized if it has to back a single currency. If every country had a constitutional constraint on the national public finance without a reform at the EU level, the collapse of the system would be certain.
If the problem of the euro was the public finance of the euro area, we would expect a revaluation of the euro vis a vis the dollar and not the opposite, as is the case in recent months. My opinion is simply the opposite: the financial markets do not bother with the long term equilibrium of the public finance (otherwise the dollar would devaluate vs the Euro), but instead with the short term situation of the real economy. Growth forecasts for Europe are much more somber than the ones for the US because there are too many people around Europe (and in Germany) thinking like Boskin.
cheeheongquah 05:23 28 May 10
Absolutely agree but it seems to be a miracle that governments would restrain themselves unless being forced.
Hence, I forsee that governments would continue to expand and spend util a day when people revolutionize and topple the governments and replace them with republic systems in which governments have no power on the private economy other than providing judiciary, legislation, and security.
Quah, Chee Heong