Just as the Eurocrats thought they had managed to talk down the euro crisis and save their beloved currency union, a little Danish boy steps out of the crowd and points out that the emperor still has no clothes. From Bloomberg.com (via Zerohedge):
Lars Seier Christensen, co-chief executive officer of Danish bank Saxo Bank A/S, said the euro’s recent rally is illusory and the shared currency is set to fail because the continent hasn’t supported it with a fiscal union.
I spent six years in Denmark. Danes are serious professionals, they are upfront, free-spirited and they have no problem speaking the truth. Culturally, When you hear this from a man in this position within the private sector in Denmark, you better listen.
“The whole thing is doomed,” Christensen said yesterday in an interview at the bank’s Dubai office. “Right now we’re in one of those fake solutions where people think that the problem is contained or being addressed, which it isn’t at all.”
Exactly. The main reason why the euro appears to be stable at this point is that the European Central Bank has put a cooler on the bonfire-like debt crisis by promising to buy any euro-denominated treasury bond, anywhere, any time. Technically, the promise was limited to the most troubled eurozone countries, but by implication it extends to all member states.
This uncapped promise has allowed international investors to go back into high-yield euro-denominated treasuries from primarily Greece, Portugal, Spain and Italy. Secondarily, they can also invest with similar confidence in French treasuries, which are next on the troubled-bonds list. Thereby the ECB removed a major reason for investor flight out of the euro, temporarily strengthened the currency and created the false impression that the crisis is over.
It is not. Bloomberg.com again, which paints a picture of declining GDP and a new phase in the debt crisis:
The European Central Bank forecasts the euro-area economy will shrink 0.3 percent this year … [and while] the euro has strengthened, the economies of Germany, France and Italy all shrank more than estimated in the fourth quarter. Ministers from the 17-member euro area met during the week to discuss aid to Cyprus and Greece as a tightening election contest in Italy and a political scandal in Spain threaten to reignite the region’s debt crisis.
Greece has suffered from a shrinking GDP for years now. Since the recession-turned-depression started they have lost roughly a quarter of their economy. That is extreme, but it shows the devastating consequences of combining austerity with an entirely artificial currency union. Furthermore, it should be a warning sign to the Eurocrats as well as other member states to not adopt the same kind of fiscal policy in their countries. Yet that is precisely what seems to be in the making: the “aid” to Cyprus and – again – to Greece will consist of a buyout of treasury bonds combined with austerity requirements.
There can be only one outcome: more of the same crisis.
As Bloomberg.com continues, it illustrates the dire situation of the European economy, a situation that according to Danish banker Christensen is going to be the undoing of the euro:
France is grappling with shrinking investment, job cuts by companies such as Renault SA and pressure from European partners to speed budget cuts. While Germany expanded 0.7 percent last year…
That’s a pathetic “growth” rate for an economy like the German.
…France posted no growth and Italy probably contracted more than 2 percent, the weakest in the euro area after Greece and Portugal, according to the European Commission. The economy is on the brink of its third recession in four years and the highest joblessness since 1998. Prime Minister Jean-Marc Ayrault said Feb. 13 the country won’t make its budget-deficit target of 3 percent of gross domestic product this year as the economy fails to generate growth and taxes.
The pursuit of a balanced budget is the enemy of growth. So long as the political leaders of Europe’s big welfare states do not want to concede that their countries can no longer afford their big, onerous, sloth-encouraging entitlement programs, there will be no change in the course of the European economy. The welfare states will continue to drive up deficits and drive down growth. The EU will continue to demand austerity, which will further drive down growth and widen the deficit gaps in government budgets. Europe will stagger and stumble, but there is no chance it will ever recover under its current big, redistributive goernment.
In a nutshell, all you Europeans: this is as good as it gets.
And just to add some more salt in Europe’s self-inflicted wounds, Bloomberg. com tops off with a stark reminder of the economic reality the Europe is stuck in:
“People have been dramatically underestimating the problems the French are going to get from this. Once the French get into a full- scale crisis, it’s over. Even the Germans cannot pay for that one and probably will not.” … Spain, which plans to sell three- and nine-month bills tomorrow and bonds maturing in 2015, 2019 and 2023 on Feb. 21, faces a sixth year of slump. Output is forecast to contract for a second year in 2013 with unemployment at 27 percent amid the deepest budget cuts in the nation’s democratic history. Public-sector debt is at record levels, having more than doubled from 40 percent of gross domestic product in 2008. The European Commission, which is due to update its forecasts this week, sees it rising to 97.1 percent of GDP next year.
This is the crisis that the ECB is trying to cover with an endless monetary commitment to defend the euro. But the deficits do not go away, and economic growth does not return. In its desperate fight to save the euro and the welfare state, Europe’s political leaders will bleed the former dry and deplete the latter of any money to honor its entitlement commitments.
I stand by my verdict: Europe is in permanent decline, it is turning itself into an economic wasteland of industrial poverty that over time will be left behind by North America and Asia.
The vastly unsuccessful French hate tax has driven scores of highly productive French professionals and entrepreneurs into financial diaspora. As things look right now, the French government can be happy of the 75-percent marginal income tax bracket does not lead to a net loss of revenue.
You would expect politicians in other countries to pay close attention to what the French are doing – and learn. However, since the advocates of hate taxes on high-income earners are socialists almost by definition, it would be illogical to expect them to take a logical look at the consequences of hate-taxing the rich. To them, the confiscatory principle behind the tax is an ideological motivator that has nothing to do with economic results.
There is, however, a large segment of people in the middle of the political spectrum who are not ideologically married to hate taxes, who are open to economic arguments but who may be swayed in favor of such taxes just because they are concerned about the government’s budget. Those people are the make-or-breakers of already highly taxed economies: on the one hand, a hate tax will break the back of the last segment of productive citizens; on the other hand, avoiding the hate tax opens for reforms that can actually improve an economy and put it back on its right track again.
Unfortunately, it seems as though the French hate tax initiative could have planted the seed of a global trend. South Africa is considering following in the French footsteps, and there are now voices in Britain in favor of similar policies. From the Daily Express:
Calvin Coolidge, the far-sighted American President of the 1920s, once said that “collecting more taxes than is absolutely necessary is legalised robbery.” Tragically, his wise words appear to have been lost on our political class, whose members spend much of their time dreaming up new ways to grab our cash. As the appetite of the state machine becomes ever more ravenous, so the tax system grows ever more oppressive. Now the Liberal Democrats want to expand the scope of this confiscatory regime even further.
The British Liberal Democrat party has long claimed that its reason to exist is that British politics needs a strong middle-of-the-road party, a compromise between conservative Tories and social-democrat Labor. That has changed over time, of course, as the Tories have drifted in toward the middle and the Liberal Democrats have become an increasingly clone-like copy of the main stream of the Labor party.
Nevertheless, it is noteworthy that this is the party that now proposes a hate tax. It verifies the theory that there is a critical mass in the center of politics that can be swayed by socialists into supporting anti-rich taxation, typically in the name of fiscal responsibility.
QED, as the Daily Express reports:
A plan drawn up by the party’s Federal Policy Committee proposes a wide-ranging new so-called “wealth tax”, targeted at anyone with assets estimated to be worth more than £2 million in total. The sum would include not just property but all possessions, including shares, paintings, jewellery, cars, and furniture, on which the owners have probably already paid tax.
Imagine the bureaucracy needed to assess the values of all these various kinds of property. Of course, the Liberal Democrats have already thought of this, as they suggest that “tax inspectors would be given unprecedented new powers to go into homes and check the valuations of personal effects.” So much for personal integrity, something European liberals typically claim to be staunch supporters of.
Daily Express again:
This is not the first time the Lib Dems, always eager to differentiate themselves from the Tories, have demanded an attack on the affluent. The party has long been wedded to the idea of a “mansion tax”, focused on houses worth more than £2million, while last autumn the Deputy Prime Minister [Liberal Democrat] Nick Clegg urged the introduction of “an emergency wealth tax on Britain’s richest” as part of the “economic war” against the deficit.
Just wait for that term to make it Stateside. It almost sounds like the campaign slogan of an Andrew Cuomo or a Martin O’Malley running for the Democrat ticket in 2016. Especially Governor O’Malley would be ready to validate virtually any tax policy under the guise of a “war against the deficit”. During his tenure as chief executive of Maryland, O’Malley has raised a tax on average every ten weeks.
Back to Britain, where the Daily Express makes a formidable point about hate taxes:
Enthusiasts for this sort of aggressive taxation like to pretend that only the very richest will be hit. But the lesson from history is that, once a new tax is established, ever larger numbers are sucked within its destructive embrace. That is certainly true of the upper rate of income tax. Only 30 years ago, just 3 per cent of taxpayers fell into this category. Now, through the cynical process of failing to raise thresholds in line with inflation, more than 15 per cent of earners are upper rate taxpayers. Soon, more than five million people, including ordinary middle- class people, will be paying income tax at 40 per cent. The same is true of so many other taxes, such as inheritance duties, which were once aimed at the only the wealthiest but now catch huge swathes of the population in their net.
Americans should take note and remember the Alternative Minimum Tax. The problems caused by the AMT will be absolutely nothing compared to what a “war on the deficit” and its hate-the-rich taxes would do to our economy.
The Daily Express concludes, aptly:
If state control and hatred of the rich really worked, then North Korea would be the most prosperous nation on earth, not a land of misery.
This is a very important point – there is no better place in the world to study the contrast between statism and capitalism than on the Korean peninsula. We should not have to go to such extremes to explain why statism does not work, but on the other hand, if friends of freedom do not take the incrementalist strategy of the left seriously, the only question remaining to answer is how small the difference will be between our society and North Korea before the left is satisfied.
That, in turn, is like asking an American liberal or a European social democrat: when is government big enough? So far I have not heard even a shred of an answer to that question. What I do hear, though, is a cacophony of new ideas for how to expand government, ideas that are produced increasingly by mainstream “moderates” in European as well as American politics.
The fact that hate taxes on the “rich” are back in vogue, despite their abysmal failure in the ’70s, is a testament to how uninterested in reality statists are. It is also a testament to the seductive power of socialist rhetoric, in particular in bad economic times. It is easy to tell someone who is just out of school and has no opportunities on the job market that “the rich took the money you never had and ran with it”. If wrapped in slick rhetoric and sold with the right kind of ad campaign, this kind of hateful politics can easily win the day.
It is the responsibility of every friend of liberty to fight the growth of government, to resist the advancement of hate taxes – and to offer a credible, reliable and realistic path to limited government.
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.
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.
Sadly, the world is full of failing welfare states. One of them is Argentina, where the out-of-control welfare state is causing runaway inflation. This, together with bad GDP growth numbers, has led to a credit downgrade that expels Argentina’s treasury bonds from the reliable end of the market, confining it to shady backstreets together with other C- and CC-rated bonds.
As if this was not bad enough, the government of Argentina is engaging in a macroeconomic form of accounting fraud byt trying to conceal its 30-percent annual price increases in manipulated data. This has rightfully caused a confrontation between Argentina and the IMF, whose credit line is in part dependent on the debtor country complying with certain statistical standards.
Aside some real yelling and screaming from Buenos Aires, the IMF demands seem to have a little bit of an impact on the Argentine government. It is not all for the better, but at least the Fund has caught president PMS Kirchner’s attention. From MyFoxNY:
Argentina announced a two-month price freeze on supermarket products Monday in an effort to break spiraling inflation. The price freeze applies to every product in all of the nation’s largest supermarkets — a group including Walmart, Carrefour, Coto, Jumbo, Disco and other large chains. The companies’ trade group, representing 70 percent of the Argentine market, reached the accord with Commerce Secretary Guillermo Moreno, the government’s news agency Telam reported.
This is pure cosmetics. You don’t do away with inflation by banning the last agent in the chain from compensating himself for price increases further back in the process. Wal-Mart and the other supermarket chains are still going to have to compensate their suppliers for higher costs of production and transportation.
There are only two possible results from this: empty shelves in the stores or product reconfiguration. The former is the Soviet solution, the latter the Venezuelan version. After Hugo Chavez caused 30-percent inflation in Venezuela he went after the retailers and food producers when they reconfigured their products. His aggressive policies actually escalated the crisis to the Soviet level, causing food shortage in Venezuela.
It remains to be seen what the outcome will be in Argentina. But one thing is clear: you cannot escape the devastating consequences of inflation by banning people from raising prices.
Polls show Argentines worry most about inflation, which private economists estimate could reach 30 percent this year. The government says it’s trying to hold the next union wage hikes to 20 percent, a figure that suggests how little anyone believes the official index that pegs annual inflation at just 10 percent.
The underlying problem is that the government has been flooding the economy with borrowed funds and printed money, paying for all sorts of work-free entitlements. When more and more spending in the economy is based on work-free income, you open up an imbalance between production and consumption.
This is one of three transmission mechanisms from reckless monetary and fiscal policies to consumer prices spiraling out of control. The second has to do with banks being flooded with cheap liquidity. This can encourage banks to start lending without due attention to the credit strength of their borrowers, simply because they are faced with tempting interest margins, ultimately created by a reckless government.
A third transmission mechanism involves the exchange rate, where a surge in domestic money supply causes a depreciation of the currency.
Which one of these transmission mechanisms has had the strongest influence thus far is yet to be determined. Preliminarily, it looks as though the first one is a major culprit, simply because of the perpetually bad government finances and the lavish nature of Argentina’s entitlement systems.
Argentina offers yet another example of how a runaway welfare state can bring devastation and destitution to a country. It is about time that policy makers in Europe and America pay attention – and start working on Ending the Welfare State.
After last year’s battle to save the euro, little has been heard lately about the threat of a break-up of the currency. It is undoubtedly true that the European Central Bank and the EU together with the IMF managed to save the euro. But at what price? Here is an article on that topic from an interesting blog called Testosterone Pit – Where the Truth Comes Home to Roost:
The state-sponsored chorus about the end of the debt crisis in the Eurozone has been deafening. It even has feel-good metrics: the Euro Breakup Index for January fell to 17.2%—the percentage of investors who thought that at least one country would leave the Eurozone within twelve months. In July, it stood at 73%. For Cyprus, the fifth Eurozone country to ask for a bailout, the index fell to 7.5%. “A euro breakup is almost no issue anymore among investors,” the statement said.
In other words, the euro shines brightly over Europe, reflecting its golden glance in the eyes of millions upon millions who have lost their jobs and their livelihood to euro-saving austerity programs.
But there is more, as the Testosterone Pit reports. It has to do with Cyprus, next in line for a bailout from the EU:
Just then, in a fight over whether or not to bail out Cyprus, top Eurocrats exposed what a taxpayer-funded con game they thought these bailouts really were—and how fragile the Eurozone was. A debate has been raging in Germany about Cyprus. Not that the German parliament, which has a say in this, wouldn’t rubberstamp an eventual bailout, as it rubberstamped others before, but right now they’re not in the mood. Cyprus is too much of a mess. Bailing out uninsured depositors of Cypriot banks would set a costly precedent for other countries.
It gets better:
And bailing out Russian “black money,” which makes up a large portion of the deposits, would be, well, distasteful in Germany, a few months before the federal elections. For the tiny country whose economy is barely a rounding error in the Eurozone, it would be an enormous bailout. At €17.5 billion, it would amount to about 100% of GDP: €10 billion for the banks, €6 billion for holders of existing debt, and €1.5 billion to cover budget deficits through 2016.
If the Cypriots were left to fend for themselves, their banking industry would learn the lesson. But note also the budget deficit number that the TP reports. I have not confirmed it independently, but if GDP is as they say 17.5 billion euro, and the deficit coverage would amount to 1.5 billion euro, then the Cypriot government is running a budget deficit at 8.6 percent of GDP!
This is where the truly big questions are hidden. It is not far fetched to assume that this is about a welfare state gone haywire. We will have to get back to that.
The TP again, with a very good point about how the Eurocrats always prefer to save the euro over defending the prosperity of Europe’s citizens:
As always, there is never an alternative to a bailout. “It’s essential that everybody realizes that a disorderly default of Cyprus could lead to an exit of Cyprus from the Eurozone,” said Olli Rehn, European Commissioner for Economic and Monetary Affairs. “It would be extremely stupid to take any risk of that nature.”
So instead of doing the right thing and allowing Cyprus to exit, the Eurocracy wants to pour yet more taxpayers’ money into yet another black fiscal hole.
At least this time, the Germans seem a bit skeptical, which is delaying the Cypriot bailout:
German Finance Minister Wolfgang Schäuble … [has been] saying publicly that it wasn’t certain yet that a default would put the Eurozone at risk—”one of the requirements that any bailout money can flow at all,” he said. Cyprus simply wasn’t “systemically important.” … at the meeting of Eurozone finance ministers a week ago … Cyprus was also on the agenda, but not much was accomplished, other than an agreement to delay the bailout decision until after the Cypriot general elections in February.
But the fight for more tax money to another bailout is not over:
ECB President Mario Draghi, bailout-fund tsar Klaus Regling, and Olli Rehn, all three unelected officials, had formed a triumvirate to gang up on Schäuble. … If Cyprus went bust, they contended, it would annihilate the flow of positive news that has been responsible recently for calming down the Eurozone. For weeks, all signs have pointed towards an improvement, they argued. Risk premiums for Spanish and Italian government debt have dropped significantly, and balances between central banks, which had risen to dangerous levels, have been edging down.
The Spanish and Italian risk premiums have fallen not because of the good news about the euro zone, but because the ECB has pledged to print astronomical amounts of money to guarantee every treasury bond issued in Rome and Madrid. The euro zone has stabilized because of this commitment, in other words the opposite causality compared to what the Eurocrats are suggesting.
It will take probably something similar to keep Cyprus in the euro zone, and since the Eurocrats do not think of anything other than to save the currency – no matter the cost – it is easy to predict that they will wrist all the German arms they need to in order to get the taxes they need for a Cypriot bailout.
Two questions: What austerity measures will come with the bailout to bring down the deficit from 8.6 percent of GDP to the magic three percent the EU considers acceptable? And: What will German taxpayers think of this when they go to the polls in a few weeks?
The Troika has reached a deal with Greece. The deal defuses the imminent risk of an uncontrolled bankruptcy by authorizing the release of emergency cash. The Greek government can now pay its bills for a little while longer. From The Guardian:
European governments and the IMF sought to bury months of feuding over Greek debt levels in a tentative agreement that should see the release of up to €44bn in bailout funds needed to rescue Athens from insolvency. But after almost 12 hours of talks for the third time in a fortnight between eurozone finance ministers, leaders of the IMF, the European central bank and the European commission struggled to reach a consensus, suggesting a lack of confidence that the effort to resurrect the Greek economy will bear fruit or that three years of European bailout policy was working.
Nothing has changed as far as the underlying crisis goes. All the variables that caused the crisis are still in place. The welfare state is structurally intact: it still makes all the same spending promises as it made before the crisis, and it still demands the same taxes as before. The only thing that has changed is that some taxes have gone up, the compensation levels in some entitlement programs are lower and the standard of government-provided services, such as health care, has deteriorated.
It was the welfare state that caused the crisis. Remember: the Greek government debt is nothing but a pile-up of years and years of budget deficits, and the budget deficits are nothing more than years and years of government spending exceeding government revenues. The Greek crisis has nothing to do with any “financial crisis”. The only solution is a structural phase-out of the welfare state.
Somewhere, the parties involved in the debt talks to save Greece know this. They also know that they are all ideologically married to the welfare state and therefore cannot bring themselves to put together a true rescue plan for Greece. The only thing they can muster is a plan that eases the burden of debt and give the country a little bit more time to breathe.
Back to The Guardian:
The meeting agreed to shave projected Greek debt to allow it to level at 124% of GDP by 2020, entailing a 20% cut in Greek debt by the deadline. With the IMF demanding a writedown of Greece’s debt by its official eurozone creditors and Germany leading the resistance to such a move, declaring it illegal, the meeting agreed on a mixture of measures involving debt buybacks, lower interest rates on loans, longer maturity periods on borrowing, and ECB returns to Greece of profits on its holdings of Greek bonds.
Note, again, that the focus of the talks has been entirely on variables related to the government debt, and the plans for how to pay down that debt. Nothing is said about what caused the debt or whether or not those causes are in place for the future. In other words, the Troika’s entire effort is static and frustratingly un-economic in nature.
As an interesting twist, the IMF has forced the euro zone countries to write off part of what Greece owes them. Almost one fifth of the IMF’s money comes from the United States, where Congress and the President are in precipitous negotiations over the federal budget deficit. This is not a good time for the IMF to come to the U.S. Congress and ask for a few more tens of billions of dollars to bail out a failing European welfare state. Better then to force the other failing European welfare states to swallow the bitter pill.
At the end of the day, though, all that this will accomplish is to further raise the tensions between EU member states over an increasingly insoluble crisis. Another article in The Guardian, this one from their Economics Blog, expresses some of the same frustration:
[There] has been an acceptance that Greece needs additional help to make its debt sustainable. The IMF has been making the point that Greece is going through an immense amount of pain for no purpose, since tax increases and spending cuts to reduce the budget deficit are being outweighed by the revenue loss from a country five years into a brutal depression.
If this is indeed what the IMF says, then the IMF is wrong. The brutal depression is caused by excessive government over-spending and has been severely aggravated by years of hard austerity policies.
Since the members of the debt-negotiating Troika completely lacks insight into these fundamental macroeconomic “mechanics”, it is safe to predict that they will continue to demand austerity packages of the Greek government until the full extent of the debt deal has been met. This means, plain and simple, that they will demand a perpetuation of the crisis, which further erodes the country’s tax base, government budget, overall economy – and social and political stability.
As a result, the debt reduction goals negotiated, and reported by the Economics Blog, are little more than fiscal delusions:
European policymakers, after some resistance, have now agreed that there should be a strategy for getting Greek debt down to 124% of GDP by 2020 – almost but not quite the 120% of GDP the IMF was calling for, and substantially below 110% of GDP in 2022.
And let’s once again review what steps they want to take to get there:
A number of measures have been proposed for achieving this objective. Greece could see the interest rate on its borrowings reduced by 100 basis points (a full percentage point). It could pay a smaller guarantee fee on its loans. It could benefit from extra time to pay back its debts. European countries could agree to return any profits they make on their holdings of Greek debt back to Athens.
This is all trickery to ease the cost of the country’s Everest-size debt. But unlike a real mountain, this debt mountain continues to grow as it is fed from the bottom by new deficits and an ever shrinking economy.
What the creditors are trying to do is really very simple. They know that the Greek government is paying interest and principals out of its current tax revenues. If they have any understanding at all of where the Greek economy is heading, they will realize that those tax revenues are not exactly increasing. But even a static understanding of what is currently going on in the Greek economy – a GDP in free-fall, personal income declining, sky high unemployment, depression-level dependency on government – is enough to bring about some insights into the burden that debt service payments place on the Greek government.
Again, though, any alleviation of the debt payment burden will entirely miss the target when it comes to Greece’s long-term macroeconomic outlook. Given the time and political energy that has been spent on stitching together this deal, and given its superficial impact on the Greek crisis, it is next to impossible to imagine how the same power players would be able to do anything that could actually help the country get back on its macroeconomic feet again.
What goes around comes around. This is at least as true in economics as anywhere else. Take the wave of austerity policies in Europe. Germany has been one of the big champions of forcing countries like Greece and Spain into panic-driven combinations of spending cuts and tax hikes. The attitude in Berlin has been that those countries deserves what is coming to them. As an example of that attitude, the EU Observer reports:
“Austerity measures are in the interest of the countries where protests are being held,” [German] Chancellor Angela Merkel’s deputy spokesman said Friday in a reply to a question about the Spanish anti-austerity demonstrations. He added that the German leader was “not concerned” about her image as main promoter of austerity.
Well, according to another report from the EU Observer:
Germany’s economic growth has slowed to a meagre 0.2 percent, as most other eurozone countries are in recession and austerity measures are taking their toll on German exports to southern countries. The eurozone’s overall economy shrank by 0.1 percent compared to the previous three months, the bloc’s statistical office (Eurostat) reported on Thursday (15 November). The 17-nation area had already slipped into recession over the summer, with Greece, Portugal, Spain, Italy, Cyprus and the Netherlands continuing the negative trend.
The euro zone has been suffering from paltry growth for a couple of years now, and the more the austerity policies proliferate, the deeper the recession will get. The big question now is of course what Chancellor Merkel has in mind for the German economy. With the German GDP grinding to a halt it is only a matter of time before the federal German government will run into some urgent budget deficit problems. When they do, is Merkel going to copy the policies she wants other countries to continue with?
The EU Observer goes on to report that the German economy…
…has slowed from 0.5 percent growth in the first quarter to 0.3 percent in the second and 0.2 in the third, with the country’s central bank warning of stagnation and even recession in the months to come
What Germany and other European countries need now is a major boost in economic freedom: lower taxes, structurally reduced government, less regulations and a completely new set of fiscal policy rules: growing employment and growing household income should replace the ridiculous requirements of balanced budgets embedded in the constitution of the EU. However, as the EU Observer explains, there is very little hope for such a turn for the better. Listen to what the German treasury secretary has to say:
Speaking at an economics forum in Berlin on Thursday, German finance minister Wolfgang Schaeuble made the case for “sustainable growth” – meaning modest growth rates not based on real estate bubbles or consumer credit. “We must strive to become a stability union, where fiscal rules are respected” Schaeuble said, one day after massive protests and general strikes took place in Portugal, Italy, Spain, Greece and Belgium against what is seen as a German-led austerity drive. “I have great respect for the demonstrations in these countries,” the German minister said. But he continued to make the case for structural reforms to make an ageing and costly Europe more competitive in relation to China and India.
What those reforms might be is of course held in the dark. Truth is that both China and India have smaller governments, in fiscal terms, than Europe. This keeps operating costs down and allows for a more dynamic evolution of all kinds of entrepreneurship. The only way Europe can compete is by rolling back its ridiculously large welfare state.
That, again, is not going to happen. Schäuble makes clear that he is more interested in a “stability union” than anything resembling a growth union. By “stability union” he means a union that continues to enforce economically harmful balanced-budget criteria at any cost, as has been done in Greece, Spain, Portugal and other countries.
Even more torubling is the point he makes about credit-driven growth. It is true that both the United States and Europe have experienced credit-driven growth periods over the past two decades, and that such growth is not a sustainable path to prosperity. However, there is a very important reason why recent growth periods in Europe, and to some degree the United States, have been credit-driven: high taxes. The more government takes out of private-sector earnings, the less people have left to spend and advance their lives with. As consumers are left with less, there is less of a market for private businesses to sell new, better, more efficiently produced goods and services. With a decline in such markets, the economy is destined to grow less.
Over the past 30-40 years taxes have reached such levels in most of Europe that you hardly feed a family on two incomes any longer. The standard of living that Europeans can attain becomes, essentially, a stagnant standard of living. The only way out for a family who wants to buy a new, safer, better, more efficient car is to do it on credit. This proliferates into more and more areas of consumer spending, from homes and cars to appliances, vacation trips and even computers. With more and more private spending being fueled by credit, credit default becomes a growing problem.
That is where Germany is today, as this blog recently reported.
On a larger scale, the welfare state – the entity that taxed the private sector into credit dependency – becomes the next victim. As private incomes stagnate, the tax base stagnates. But government spending never stagnates, thus pushing the government budget into a deficit.
Which is precisely where virtually all euro-zone member states find themselves today.
The way out is not more government, not stricter “stability unions”. The way out leads through the portal of economic freedom.
The European economy is in trouble. After a few years of slow growth it is now making a turn for the worse. EurActiv reports:
The eurozone economy shows little sign of recovering before the year-end despite an easing of financial market conditions, European Central Bank Mario Draghi said on Thursday (8 November) after interest rates were left at a record low. The ECB held its main rate at 0.75%, … “Economic activity in the euro area is expected to remain weak although it continues to be supported by our monetary policy stance and financial market confidence has visibly improved on the back of our decisions,” Draghi told a news conference.
That monetary policy is basically the open-ended commitment that the ECB has made to print unlimited amounts of money to buy treasury bonds from troubled euro-zone welfare states, from Greece to Portugal. By promising to flood the euro zone with fresh cash, the ECB intends to keep interest rates down, in the hope that their policy will combine two things:
- Low investment financing costs for private businesses, intended to stimulate business growth; and
- Low financing costs for government deficits aiming to keep debt service costs – i.e., current government expenditures – down.
The low interest rates will not help on either front. Businesses do not make major investment decisions based prmarily on their funding opportunities, but instead on the so called marginal efficiency of capital. Simply put, that is their expectations of what they can earn on their investments. The higher their expected earnings, the more inclined they are to invest. Since earnings are defined primarily by sales, a low interest rate won’t help if the economy as a whole is in the tank.
Simple Keynesian macroeconomics.
As for government deficits, a low interest rate will only encourage them to borrow more. By making its open-ended bond purchasing promise, the ECB has effectively destroyed the market mechanism for risk management. Governments that will never be able to pay down their debt (hello Greece?) can continue to rake up debt more or less with impunity.
Sadly, it seems like more expansive monetary policy – pushing for lower interest rates – is the only economic-policy instrument that the Europeans are willing to use to revive their economy. EurActiv again:
Gloomy data this week indicated the eurozone economy will shrink in the fourth quarter, which the ECB could eventually respond to by cutting rates. Recent survey evidence gave no sign of improvement towards the end of the year and the risks surrounding the euro area remain on the downside, Draghi said. He signalled the ECB would downgrade its GDP forecasts next month, describing “a picture of weaker economies”, and said inflation would remain above the ECB’s target for the rest of the year, before falling below two percent during in 2013. Before making any decision to cut rates further, the ECB will focus on making sure that its looser policy reaches companies and households across the eurozone, a mechanism that has been broken by the bloc’s debt crisis.
It is not entirely clear what he is saying here, but he is probably referring to where the new money supply is going. It is not replenishing the balance sheets of banks willing to lend to the public, but instead padding the pockets of governments. The mechanics of monetary policy are more complicated than this, but if this is how the ECB thinks, they are essentially correct: government spending, and the credit funding it, is absorbing resources that would otherwise have benefited the private sector. (For those who are familiar with the “crowing out” effect of the IS-LM model, this is somewhat different. But that’s a story for another day.)
Another aspect to the debt crisis is that a long, gloomy recession has weakened the finances of private citizens. In many instances this is leading to a new private-sector debt crisis. Sweden is steaming toward a housing bubble, and in Germany an increasing number of families can no longer afford their mortgages, car loans, credit cards, etc. German Creditreform.de reports (including an informative chart) that “overindebtedness” – defined as more debt than someone can handle – has grown notably since 2009:
Die Zahl der überschuldeten Bürger hat sich in Deutschland wieder erhöht. Gegenüber dem Vorjahr erreicht die Schuldnerquote 9,65 Prozent (2011: 9,38 Prozent). Damit sind 6,59 Millionen erwachsene Bundesbürger überschuldet – im Vorjahr waren es 6,41 Millionen.
This is a small but important sign that the German economy is not going anywhere but down over the next six to nine months. That in turn means less money from German taxpayers to bail out the crumbling welfare states down south of the Alps. And that, in turn, spells even more trouble for politicians in Athens, Rome, Madrid and Lisbon who are trying desperately to keep their sinking welfare states afloat.
So where does this new European recession come from? It’s quite simple: austerity. When governments take more and give less, they drain the private sector of resources while discouraging productive business activity through higher taxes. Businesses and households have less money to spend, which leads to less productive economic activity – and a shrinking tax base. As the tax base shrinks, governments fail in their attempts to balance their budgets. That means more deficits.
And more austerity.
And more recession.
Take note, America. It’s time to change course before it is too late.
We have all heard about the now-infamous video where Governor Romney talks about the 47 percent of Americans who supposedly support Obama as dependent on government. The video made quite a splash in the duck pond that is the GOP establishment. Panic erupted. Republican cocktail-party goers on the Tenderfoot Coast between Times Square and Tyson’s Corner whipped themselves for having even pondered voting for Romney. Jonah Goldberg and his buddies over at National Review are all up in arms. Media “conservatives” like Megyn Kelly at Fox News are trembling with fear. Shoot-from-the-hip columnist Josh Barro over at Bloomberg just can’t jump ship fast enough, declaring to the world that the election is now over.
Leading the scramble away from Romney is of course Bill Kristol, editor of the allegedly conservative Weekly Standard. It is not surprising that Kristol’s coat is turning left: like most people in the mainstream media, Kristol is an ardent Obama supporter (see, e.g., here, here and here).
Unlike these Cocktailers, Mainstreamers and Beltwayers, we at the Liberty Bullhorn don’t have tender feet. We are not addicted to schmoozing with liberals and we are certainly not afraid of either principles or good analysis. Therefore, we don’t panic when Governor Romney says something that is deemed politically incorrect by thin-skinned news pundits and campaign consultants.
What Romney meant is very easy to understand for anyone who cares to spend more time on the issue than it takes to read a tweet. But to make sure that even those with a short political attention span can follow the reasoning, let us sum up what the issue is all about in five easy steps:
1. The federal budget is in deep deficit.
2. About four in ten Americans are net takers of government services and entitlements.
3. About four in ten Americans are net givers of government services and entitlements.
I know these two points can be difficult to grasp for cocktail conservatives, but bear with me. I will explain in a moment.
4. To close the deficit we need to move people from being net takers from government to being net givers to government.
5. (This is the last point – hang in there, tenderfooters!) If you depend on government, you get addicted to the easy money.
From these five points, Romney concludes that:
a) it is likely that those who depend on government will vote to perpetuate their own dependency; and
b) this presents us with a formidable challenge – provided of course that we want to close the budget deficit without killing the American economy.
The best road forward, Romney says, is again to move people from the column of net takers from government to the column of net payers to government. However, the longer people depend on government, the more institutionalized they become (my term, not Romney’s). Even though you can convince people rationally that self determination is better than dependency on government, experience from Europe shows that most of the net takers of government services and entitlements aren’t going to listen to that rational argument. Comfort appeals to a lower level of the human mind than self determination, and therefore has a tendency of prevailing.
Anyone who wants to study the effects of this kind of dependency can look at how Europeans respond when austerity-minded governments try to take away their allowance. They protest wide and loud even though the unsustainability of their welfare state is staring them in the face.
This is the short version of what Romney said – hopefully it is short enough for the cocktail conservatives on the tenderfoot coast to understand. (If you still don’t grasp Romney’s point, and if the following analysis is too complex for you, do feel free to e-mail me and ask for clarifications. I have successfully educated people with little or no high school background on more complex issues than this.) Now, let’s take a more comprehensive look at the problem.
There is a very good way to illustrate the difference between a net taker from government and a net giver to government. It is called the Earned Income Tax Credit (EITC). This welfare program is one of the most obvious candidates for turning people from net taxpayers to net government takers. In fact, it is the single largest welfare program in the country: in 2009, 27.4 million families received a total of $55.1 billion in Earned Income Tax Credit, averaging $2,206 per family.
The EITC is nothing more than a low-income trap. It gives a substantial infusion of cash to eligible taxpayers but combines that infusion with effective marginal tax rates that exceed what people pay who make ten times more.
As for the cash, a taxpayer who qualifies can get up to $5,030 per year. Since the “credit” is refundable, and thus de facto a welfare program, it cancels out and in many instances exceeds what eligible taxpayers pay in federal income taxes. Three out of four EITC recipients got at least as much from the government as they paid in federal income taxes, making them net consumers of government. This is not counting any other government entitlement program; if we add all other cash that government hands out or provides in the form of services, we find – as demonstrated by the Heritage Foundation - that the upper half of all income earners pay virtually all federal income taxes.
It is a big moral problem when people are net takers from government. They are not contributing their fair share – which obviously would be a fixed, equal percent for everyone, as in the Herman Cain 9-9-9 plan – and since they are not paying their fair share it is ethically questionable whether or not they should have the same influence over government as those who actually bankroll government.
However, there as also economic problems that are at least as important as the moral ones. Established economic theory says that steep marginal income taxes discourage increases in labor supply and labor effort. Since the EITC suffers from precisely that – steep marginal tax rates – it discourages self determination and pursuit of prosperity.
To make this point, let us perform a little experiment. Suppose that Jack and Jill are married, have no children and no other deductibles file their taxes jointly. They qualify for the EITC, with an amount determined by the EITC eligibility calculator provided by the Internal Revenue Service. (Federal income tax amounts are taken directly out of the IRS 1040 tax table.) Suppose, also, that their income increases by $10,000 per year, starting at $10,000. Their net between the federal income tax and the EITC will be as follows:
|Taxable Income||Federal Income Tax||EITC||Net||Effective Rate|
|$ 10,000||$ 1,003||$ 5,030||$ (4,027)||-40.3%|
|$ 20,000||$ 2,166||$ 5,030||$ (2,864)||-14.3%|
|$ 30,000||$ 3,666||$ 2,700||$ 966||3.2%|
|$ 40,000||$ 5,166||$ 1,120||$ 4,046||10.1%|
The marginal rates are even more startling than the effective rates reported above. Suppose Jack and Jill make a combined $30,000 per year. Jack is offered a better job which would increase his income by $5,000. Their combined federal income taxes would increase by $750, indicating a 15-percent marginal tax on the new income. But their higher income also reduces their EITC eligibility from $2,700 to $1,640. This loss is now equivalent to a tax on the last $5,000 they make. The actual tax on that income increase is therefore $1,810 – a 36-percent effective marginal tax rate.
This effective marginal rate prevails through a wide income bracket: from $22,500 to $40,000. These numbers are, again, calculated under the assumptions outlined above, which makes them somewhat artificial. Nevertheless, they do highlight the fact that taxpayers who qualify for the EITC are taxed more heavily on the margin than high-income earners.
There is plenty of anecdotal evidence of what happenes to families who go from a low-paying part-time job to full-time employment. I know a family where the breadwinner had endured the recession earning just over $20,000 and was happy to accept a full-time job paying $50,000. He and his wife were amazed to discover that once they had made the transition, they saw no noticeable change in their disposable cash every month. They were penalized by the welfare state who kicked them off income-dependent welfare programs, including but not limited to the EITC. In addition, of course, they had to pay a much higher federal income tax on the last earned dollar.
You work more every day, take on a lot more responsibilities – but you are not better off. Romney’s point is that when faced with this kind of choice, too many people fall for the temptation to remain on welfare.
And just to put another angle on his comment, consider the fact that in 2009 almost 68 million tax returns declared an income of less than $30,000. That was 48 percent of all personal income tax returns. The vast majority of these filers qualify for one tax-funded entitlement or another, transforming them from net taxpayers to net takers of government services and entitlements.
To make this point yet another way: according to individual income tax return data from the IRS, tax filers with an income between zero and $30,000 earned 3.8 percent of the total adjusted gross income – but they paid only 0.1 percent of all federal income taxes.
Put bluntly: their income share is 38 times higher than their share of the taxes.
This imbalance between income and tax payments remains strong as we move up the income ladder. A full 64 percent of all tax filers make less than $50,000 per year. They earn 10.5 percent of all income but pay only 3.9 percent of the federal income taxes. This makes their income share 2.7 times bigger than their share of the total tax burden.
Do you think these people want to increase their share of the taxes? Thought so. And that’s precisely Romney’s point: now that we have placed half of the American people in a tax-and-entitlement comfort zone, how do we get everyone onboard when we try to close the federal budget gap?
This past week we learned that the Chairman of the Federal Reserve, Ben Bernanke, is going to put his money printing presses into overdrive:
The Federal Reserve said it will expand its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt a month in a third round of quantitative easing as it seeks to boost growth and reduce unemployment. “We’re looking for ongoing, sustained improvement in the labor market,” Chairman Ben S. Bernanke said in his press conference today in Washington following the conclusion of a two-day meeting of the Federal Open Market Committee. “There’s not a specific number we have in mind. What we’ve seen in the last six months isn’t it.” Stocks jumped, sending benchmark indexes to the highest levels since 2007, and gold climbed as the Fed said it will continue buying assets, undertake additional purchases and employ other policy tools as appropriate “if the outlook for the labor market does not improve substantially.”
I am not a fan of Austrian economics, and I have my concerns when it comes to monetarism. There is enough evidence out there to suggest that both theories have it wrong, at least generally, when it comes to the destructive consequences of printing money. However, when it comes to the new strategy by the Federal Reserve I am on the side of the monetarists.
My reason, though, is not primarily that I worry about inflation – for reasons I will explain in a moment, you can print a lot of money without causing inflation. My concern is instead that this happens at the same time as the European Central Bank (ECB) has decided to provide an infinite guarantee for the deficits of EU member states.
The Federal Reserve has two policy objects: to keep inflation down and to contribute to the growth of the U.S. economy. The ECB has only one policy object, namely to keep inflation down. Neither of the two central banks has a directive to bankroll a government deficit. That is, however, precisely what is happening: the Federal Reserve has been buying treasury bonds for a very long time, and the ECB has now gotten into the same business.
We could stop here and simply note that both these central banks are breaching their policy boundaries – and probably their charters as well – but that would not be of much consequence. The fact that something is wrong in principle has rarely stopped a politician or a government agency; what matters here is instead that both the Fed and the ECB are getting into policy territory that is very risky from an economic viewpoint.
When a central bank makes an open-ended promises to buy treasury bonds from the fiscal government of that country - which is precisely what the ECB has done for Spain and thus by implication for any other troubled welfare state in the euro zone – it effectively nullifies any effort by that same government to end a budget deficit. From the viewpoint of those who create the deficit, namely the legislators, the money printed by the central bank is the perfect solution: they don’t have to raise taxes to pay for their spending, nor do they have to schmooze foreign investors. As far as they can see, they can keep on spending ad infinitum.
For a while, they can. Short-term, there is no immediate penalty to expansive monetary policy. (There is later on; let’s get back to that in a moment.) On the contrary, the combination of sustained government spending and low interest rates is appealing to many mainstream policy makers. They can continue to run a deficit without having to support politically painful spending cuts or even more politically painful tax increases. Furthermore, they can make the case that private-sector activity is stimulated by low interest rates, from household spending on durable goods to businesses making investments at low cost.
Over time, though, two dark clouds rise on the horizon. The first is a downward macroeconomic spiral, driven by a relentless growth in government spending. Due to what legislators consider to be easy money, government will continue to spend on its entitlement programs, and do it essentially as if the deficit did not exist. Such government spending has negative effects on many fronts, one being that people reduce their workforce participation and live more on entitlements. This reduces the tax base and deprives the welfare state of some of the revenue it needs to pay for that same welfare state. It is this revenue gap that the central bank fills with freshly printed money.
By perpetuating this replacement funding the central bank thus perpetuates the spending that erodes the tax base and perpetuates people’s dependency on entitlements. It perpetuates the need for its own printing presses.
But this situation is not static. Over time, more and more people depend more and more on entitlements, and the increasing demand for taxes that comes with growing entitlement spending falls on fewer and fewer shoulders. Not only do people who are not working depend on government, but in a welfare state more and more working people get at least as much in entitlements from government as they pay in taxes.
When a central bank steps into this situation and makes an open-ended money-printing commitment, it only reinforces the destructive erosion of the tax base and of people’s ability to support themselves through work. A vicious circle becomes a vicious downward macroeconomic spiral. This is where Greece, Spain, Portugal and Italy find themselves today – and it is where America is heading.
The second dark cloud on the horizon is inflation. However, it does not kick in as early as Austrian and monetarist economists claim: the monetary printing presses in America have been running on overtime for years without causing the kind of inflation that those theories foresee. But that does not mean there is no connection whatsoever between an expanding money supply and the general price level in the economy.
The key is a set of so called “transmission mechanisms” between the monetary sector of the economy and the real sector (the one where production, consumption, investment and work take place). During the 1990s there was a lively debate in the academic economics literature about these transmission mechanisms, and one of the front figures in the related research was - you guessed it - Ben Bernanke. He was one of the economists involved who pointed out that there was insufficient research as to how these transmission mechanisms actually work.
This is important because prices are not monetary phenomena: they are real-sector value equivalents that happen to be denominated in a certain currency. When monetarists and others claim that prices rise as a direct consequence of expanding money supply, they assume – implicitly – that prices are monetary phenomena. They claim that a one-percent rise in the supply of money will cause a one-percent rise in prices, all other things equal. But all other things are neither equal nor irrelevant. A price does not rise just because there is more money in the economy.
Austrians and monetarists are missing a mechanism, namely that which makes the increased money supply change the real-sector value equivalents. Prices, for short.
What could possibly change real-sector value equivalents? Well, this is where government-provided entitlements enter the picture. In an economy without entitlements, all products produced are priced relative people’s workforce participation. You buy what you need and want by means of what you earn through work (current or accumulated in the form of investment dividends). When government provides entitlements it allows some people to pay for their goods without working, which increases demand for a given production. Since the entitlements also discourage workforce participation, there will be less labor available to produce in order to meet the extra demand. This has an inflationary effect on consumer prices.
So long as government pay for entitlements through taxes, it somewhat mitigates the imbalance by reducing demand among those who are net taxpayers. That way the inflationary effect on consumer prices is moderated or eliminated. However, when government decides to pay for some of its entitlements with newly printed money, it removes the inflation moderation that comes with taxes. When a sufficiently large share of consumer spending is driven by entitlements, and when a sufficiently large share of those entitlements are funded by money supply, consumer prices will start to rise. And when they do, there will be little in the way to stop them from rising further.
These mechanisms have been at work in many countries at different points in time. Weimar Germany is a classic example; some Latin American countries have a history of hyper inflation, driven by out-of-control entitlements. Zimbabwe has long suffered from a similar problem. Therefore, we know what this problem looks like and we have a good idea of what its causes are. However, what we do not know is just how far you can push a welfare state by funding its entitlements with freshly printed cash, without causing hyper inflation.
I would rather we don’t try to find out. But both the ECB and the Federal Reserve appear all too eager to test the limits of monetary sanity.
Let’s hope someone puts a foot down before these two central banks have caused consumer prices to spiral out of control in the world’s two largest economies.