Updated Cato Budget Plan
Over at Downsizing the Federal Government, Chris Edwards has released an updated version of his “Plan to Cut Spending and Balance the Federal Budget.” The plan proposes spending cuts of more than $1 trillion annually by 2021, which would balance the budget without resorting to damaging tax increases. Federal spending would be reduced to 18 percent of gross domestic product by 2021 under the plan, which compares to President Obama’s projected spending that year of 24.2 percent of GDP.
Some key points:
- No sacred cows are spared. Defense, domestic, and so-called entitlement programs are all cut.
- The plan recognizes that the scope of federal activities must be curtailed. It would begin the reversal of decades of federal expansion into hundreds of areas that should be left to state and local governments, businesses, charities, and individuals.
- Instead of viewing federal spending cuts as a necessary evil, the plan recognizes that the cuts would shift resources from often mismanaged and damaging government programs to the more productive private sector, thus increasing overall GDP.
- The plan doesn’t achieve budget balance by increasing taxes. Under current tax policy, federal revenues as a share of GDP will gradually return to levels considered normal in recent decades. It is federal spending that has reached abnormally high levels. It must be reduced in order to get the government’s spiraling debt under control.
New Era of Big Government
The George W. Bush administration ushered in a new era of big government. The Obama administration has built on Bush’s profligacy, and the president’s new fiscal 2012 budget proposal would further cement the trend.
Spending as a percentage of GDP has increased dramatically since the surplus years of the late 1990s. As the chart shows, the president’s budget once again seeks a permanently high level of federal spending as a share of the economy:
While the numbers drop from their stimulus- and recession-induced highs, it is not because the president has suddenly decided that he desires a less active government. Rather, optimistic economic assumptions largely account for the slight retrenchment.
Tax increases and optimistic economic assumptions explain the projected rise in revenue as a share of the economy. While the president would like us to believe he’s found religion on spending cuts, he’s actually relying on a rosy economic forecast and sucking more money out of the private sector to reduce annual deficits.
Taking more money from the productive private economy to maintain destructively high levels of federal spending is not a recipe for economic growth. Therefore, this budget proposal is as dangerous as it is disingenuous. Fortunately, it’s also dead on arrival in the Republican-controlled House.
Which Nation Will Be the Next European Debt Domino…or Will It Be the United States?
Thanks to decades of reckless spending by European welfare states, the newspapers are filled with headlines about debt, default, contagion, and bankruptcy.
We know that Greece and Ireland already have received direct bailouts, and other European welfare states are getting indirect bailouts from the European Central Bank, which is vying with the Federal Reserve in a contest to see which central bank can win the “Most Likely to Appease the Political Class” Award.
But which nation will be the next domino to fall? Who will get the next direct bailout?
Some people think total government debt is the key variable, and there’s been a lot of talk that debt levels of 90 percent of GDP represent some sort of fiscal Maginot Line. Once nations get above that level, there’s a risk of some sort of crisis.
But that’s not necessarily a good rule of thumb. This chart, based on 2010 data from the Economist Intelligence Unit (which can be viewed with a very user-friendly map), shows that Japan’s debt is nearly 200 percent of GDP, yet Japanese debt is considered very safe, based on the market for credit default swaps, which measures the cost of insuring debt. Indeed, only U.S. debt is seen as a better bet.
On Happiness
The financial crisis and global warming have reinforced an age-old criticism of our traditional ways of measuring wealth, and a number of alternative indexes have been proposed that would instead measure people’s well-being and environmental sustainability.
There are problems with using GDP. It involves an incredible amount of guesswork; and even if it were perfect, it would be bizarre to use production of goods and services as the only yardstick to evaluate our societies. But finding problems is one thing; it is something completely different to find an alternative that is better. Any sort of well-being index would require agreement on what well-being is, and there is a risk that governments would be tempted to find a one-size-fits-all standard and try to make us all wear it.
In a new paper I examine some of the proposed alternatives and they all beg the question about well-being by defining it as the result of the particular kinds of policies that they happen to prefer. Bhutan’s famous National Happiness Index, for example, defines it partly as a strong, traditional culture, and has used it to oppress minorities. And the Commission on the Measurement of Economic Performance and Social Progress, created by French president Nicolas Sarkozy and led by economist Joseph Stiglitz, selectively chooses measures to show that France is richer in relation to the United States than it would otherwise be.
The advantage of GDP is precisely what it has often been criticized for — that it is a narrow and value-free measure. It does not even try to define well-being, and so fits liberal, pluralistic societies in which people have different interests, preferences and attitudes toward well-being. It tells us what we can do, but not what we should do; and since it measures what we can do, it also correlates with most of the things most people want from life: better health, longer lives, less poverty and even happiness. The latest research shows not only that people in rich countries are happier but also that countries grow happier as they become richer.
Read the paper here. Read Will Wilkinson’s Policy Analysis on happiness research here.
The Consumer Spending Fallacy behind Keynesian Economics
I’m understandably fond of my video exposing the flaws of Keynesian stimulus theory, but I think my former intern has an excellent contribution to the debate with this new 5-minute mini-documentary.
The main insight of the mini-documentary is that Gross Domestic Product (GDP) only measures how national output is allocated between consumption, investment, and government. That’s useful information in many ways, but if we want more output, we should focus on Gross Domestic Income (GDI), which measures how national income is earned.
Focusing on GDI hopefully would lead lawmakers to consider ways of boosting employee compensation, corporate profits, small business income, and other components of national income. Focusing on GDP, by contrast, is misguided since any effort to boost consumption generally leads to less investment. This is why Keynesian policies only redistribute national income, but don’t boost overall output.
You may recognize Hiwa. She narrated a very popular video earlier this year on the nightmare of income-tax complexity.
WaPo’s Fiscal Truths
A Washington Post editorial today discusses the National Academy of Sciences “Fiscal Future” study. The NAS report modeled four possible tax and spending paths for the nation over the next 70 years. I was one of the NAS report’s co-authors.
The Post focuses on the “low spending and revenue” path, which would keep federal revenues below about 19 percent GDP and keep spending below about 21 percent of GDP. The Post argues that both tax hikes and spending cuts will be needed to fix the government’s budget problem because the “pain and sacrifice” would be too large if we just cut spending, as under this “low” path. But the Post’s conclusion is based on faulty one-sided accounting, only considering the recipients of government largesse.
The reality is that every dollar the government spends imposes ”pain and sacrifice” on current or future taxpayers. Thus, spending cuts may impose temporary pain on people whose benefits are withdrawn, but they create equal or greater pain on the taxpayers who foot the bill. Indeed, standard economic theory suggests that the economy gets a “free lunch” when spending and taxes are reduced in tandem because the deadweight losses caused by government coercive actions are reduced.
Note that I say “temporary” pain because to a substantial degree, benefit recipients will adjust their lives as subsidies are withdrawn, and most people will prosper without government help, as we saw following welfare reform in 1996. Misguided government spending programs–like welfare–cause damage to society and the economy, so that reducing spending doesn’t increase pain, it ultimately reduces it. Consider how government housing subsidies ended up causing widespread damage, including for many people who initially benefited. For a guide to damaging federal programs, see www.downsizinggovernment.org.
The Post is right that the NAS study’s “low spending” path would require “broad areas” of federal spending to be cut, such as K-12 school subsidies and other state aid programs. But that would be a good thing for citizens, the economy, and for responsible government. Federal spending on properly state and local activities has been a giant failure, and it should be ended whether or not there is a budget deficit.
The Post is on sounder footing with its observation that many Republicans do not seem to grasp the magnitude of spending reforms that are needed in the years ahead. The GOP does need to “get specific” and push for particular cuts. Let’s have national debates on federal involvement in K-12 schools, raising the Social Security retirement age, and cutting the corporate welfare programs mentioned by the Post. Let’s start that “adult conversation” right now, because as the NAS report warns, the longer we wait, the more the federal debt monster grows.
For the record, the NAS report did not endorse tax hikes or any other particular fiscal solution. It simply provided four possible combos of future tax and spending levels as starting points for discussion. It also usefully described how to overhaul the income tax and replace it with a much simpler and flatter tax system, as I’ve described here.
Is the Trade Gap to Blame for Slowing GDP Growth?
What had been a recurring story line buried in the business pages has now burst onto the front page: “Economic growth slowed by trade gap,” the Washington Post reports this morning in an above-the-fold headline.
The lead sets the stage for a story long on generalizations: “A widening U.S. trade deficit has become a substantial drag on economic growth as the country’s exports struggle to keep pace with the swelling sums that Americans are again spending on imported goods.”
The half truth in the story line is that exports fell by $2 billion in June compared to the month before, and that this has a negative effect on overall GDP growth. In our more globalized world, the rising wealth of our trading partners translates into more production in our own economy, and vice versa.
The fatal flaw of the story line (as I tackled recently here and at greater length here) is that it assumes that rising imports slow economic growth. That assumption, in turn, rests on a simplistic Keynesian view that if a portion of domestic demand is satisfied by spending on imports, that means less demand for domestically produced goods, thus less output and lower employment.
That view neglects the supply-side role of imports. More than half of what we import consists of goods consumed by producers—capital machinery, raw materials, parts and other intermediate inputs. Those imports help us produce more, not less. The Keynesian view also confuses cause and effect: Imports usually grow in response to RISING domestic demand. Consumers more eager to spend “swelling sums” on imports typically buy more domestically produced goods as well.
The bean counters at the Commerce Department “subtract” imports from GDP, not because those imports are a drag on growth, but to avoid double counting. If we want to count the number of widgets and other goods added to the economy in a quarter, we would obviously not count those that have been imported. But this does not mean the economy would have been that much larger if the widgets had not been imported.
Even Keynesian Accounting Can’t Find All That ‘Stimulus’
From January 2009 to the present, President Obama and his team have repeatedly made grandiose claims about the economic benefits of shoveling money at shovel-ready projects or green jobs. “It is largely thanks to the Recovery Act that a second Depression is no longer a possibility,” said the President. He also claimed that lavish spending alone (not Federal Reserve actions or bank bailouts) is what prevented the unemployment rate from “getting up to . . . 15%.”
If any of that were remotely close to being true then, as a matter of simple accounting, rising federal spending would have shown up as a huge offset to falling GDP in 2009, and also as a major component of the modest increase in GDP growth in early 2010. On the contrary, the table below shows that the increase in federal nondefense spending contributed only two-tenths of one percent (0.2) to the change in GDP in 2009. That was no better than 2008 when the Recovery Act did not exist. If nondefense spending had not increased at all in 2009 (unlike 2008) then GDP would have fallen 2.8% rather than 2.6% — scarcely the difference between a recession and a “second Depression.” If nondefense federal spending had not increased at all in 2010, the economy still would have grown at a 3.6% pace in the first quarter, 2.1% in the second. Cutbacks in state and local spending were a trivial damper on GDP growth last year, contrary to recent speculation, and real state and local spending rose significantly in this year’s second quarter (unlike the first).
This is just an exercise in crude Keynesian accounting, not economics. Yet it nonetheless makes the stimulus bill look like a huge waste of money. The reason Keynesian accounting is no substitute for economics is that governments can only spend other peoples’ money. To claim that such spending is a net addition to “aggregate demand” is to ignore those other people — namely, current and future taxpayers.
Nobel Laureate Robert Lucas put it this way:
If the government builds a bridge . . . by taking tax money away from somebody else, and using that to pay the bridge builder — the guys who work on the bridge — then it’s just a wash. It has no first-starter effect. There’s no reason to expect any stimulation. And, in some sense, there’s nothing to apply a multiplier to. You apply a multiplier to the bridge builders, then you’ve got to apply the same multiplier with a minus sign to the people you taxed to build the bridge. And then taxing them later isn’t going to help, we know that.
The Greek Model
It was a good idea to get science and democracy from the ancient Greeks. It’s not such a good idea to get fiscal policy from the modern Greeks.
But that’s the way we’re headed.
Greece has a budget deficit of 13.6 percent. We’re not in that league — ours is only 10.6 percent, the highest level since 1945.
Greece has a public debt of 113 percent of GDP. We’re not there yet. But the 2009 Social Security and Medicare Trustees Reports show the combined unfunded liability of these two programs has reached nearly $107 trillion.
Under President Obama’s budget, debt held by the public would grow from $7.5 trillion (53 percent of GDP) at the end of 2009 to $20.3 trillion (90 percent of GDP) at the end of 2020. It could rise to 215 percent of GDP in 30 years. Welcome to Greece.
Here’s a graphic presentation of the official debt and real net liabilities of various countries, including the United States and Greece at the right. (From the Telegraph, apparently based on Jagadeesh Gokhale’s report.)
And here’s a Heritage Foundation chart on where the national debt is headed in the coming decade:
Paul Krugman wrote, “My prediction is that politicians will eventually be tempted to resolve the [fiscal] crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar.” Now he was writing in 2003, when a different president was in office, but he was also warning about the possibility of a ten-year deficit of $3 trillion. Presumably the same warnings apply to today’s much larger deficit projections. And he was absolutely right to fear that government would turn to inflation as a supposed solution.
Obama Bank Tax Is Misguided
Perhaps I am a little confused, but didn’t the Obama Administration tell the American public only months ago that TARP was turning a profit? But now the same administration is proposing to assess a fee on banks to cover losses from the TARP. Maybe President Obama is coming around to the realization that the TARP has indeed been a loser for the taxpayer. He appears, however, to be missing the critical reason why: the bailouts of the auto companies and AIG, all non-banks. This is to say nothing of the bailout of Fannie Mae and Freddie Mac, whose losses will far exceed those from the TARP. Where is the plan to re-coup losses from Fannie and Freddie? Or a plan to re-coup our rescue of the autos?
If the effort is really about deficit reduction, then it completely misses the mark. Any serious deficit reduction plan has to start with Medicare and Social Security. Assessing bank fees is nothing more than a rounding error in terms of the deficit. Let’s put aside the politics and get serious about both fixing our financial system and bringing our fiscal house into order. The problem driving our deficits is not a lack of revenues, aside from effects of the recession, revenues have remained stable as a percent of GDP, the problem is runaway spending.
The bank tax would also miss what one has to guess is Obama’s target, the bank CEOs. Econ 101 tells us (maybe the President can ask Larry Summers for some tutoring) corporations do not bear the incidence of taxes, their consumers and shareholders do. So the real outcome of this proposed tax would be to increase consumer banking costs while reducing the value of bank equity, all at a time when banks are already under-capitalized.
Another Reason Imports Get a Bad Rap
Why blame only media and politicians for the public’s confusion about imports and trade deficits? Surely economists deserve some scorn. Some of the misunderstanding can be traced to the famous National Income Identity, which expresses gross domestic product, as: Y = C + G + I + (X-M). That is, national output (Y) equals personal consumption (C) plus government spending (G) plus investment (I) plus exports (X) minus imports (M).
The expression clearly lends itself to the wrong interpretation. The minus sign preceding imports suggests a negative relationship with output. It is the reason for the oft-repeated fallacy that imports are a drag on growth. Here’s why that conclusion is wrong.
The expression is an accounting identity, which “accounts” for all of the possible channels for disposing of our national output. That output is either consumed in the private sector, consumed by government, invested by business, or exported. The identity requires subtraction of aggregate imports because consumption, government spending, business investment, and exports all contain, in various amounts, import value. Americans consume domestic and imported products and services, the aggregate of which shows up in Consumption. Likewise, Government purchases include domestic and imported products and services; businesses Invest in domestic and imported machines and inventory; and, eXports often contain some imported intermediate components. Thus, the identity would overstate national output if it didn’t make that adjustment for iMports. After all, imports are not made on U.S. soil with U.S. factors of production, so they shouldn’t be included in an expression of our national output.
Government and GDP
The expansion in government and poor state of the economy got me thinking about how government growth is reflected in measured gross domestic product. So here is a wonky look at the treatment of government in the Bureau of Economic Analysis GDP data.
Data notes: By “government,” I mean total federal, state, and local. For 2009, I’m using the average of second and third quarter data. All data from BEA Tables here.
GDP measures total production. In 2009, government production was 20.7 percent of U.S. GDP. Government production is roughly the sum of government value-added (the stuff it produces itself) and government purchases. The first item, government value-added, was 12.4 percent of GDP and mainly consists of employee compensation. For example, the Pentagon produces output by adding together fighter pilots, which it hires, and fighter jets, which it buys.
A more commonly cited measure of government is total government spending. In 2009, that was 38 percent of GDP. The difference between this number (38 percent) and the production number (20.7 percent) is 17.3 percent, and represents the sum of government interest payments and transfer payments to individuals and businesses.
Figure 1 shows how the three measurements of government size have changed over time. Government production has remained fairly stable as a share of the economy, but total government spending has soared. The growing gap between these two lines mainly represents the massive growth in transfer (or subsidy) programs, such as Social Security.
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