Our Government, or Lack There Of

Some of you thought my recent complaints against uncompromising Republicans toward the fiscal cliff were somewhat one sided. It takes two to tango in the compromise game, of course. I would like to suggest a structural change in the U.S. budgetary rules that I think will help reduce our deficits and our debt while at the same time making government more effective. It shifts the focus of the debt reduction discussion from taxation to expenditures, which is the side of the equation on which the Democrats have been irresponsible and uncompromising. The Democrat controlled Senate has not even passed our government’s budget for the last three years.

The subject of taxation divides into its structure (what is taxed and how the burden is shared among the population—these are issues of fairness and the economic consequences), and its level (how much revenue is raised). Getting the structure right is very important for economic growth and for public acceptance of and cooperation with paying the taxes chosen. My views on taxation were reviewed four years ago: https://wcoats.wordpress.com/2008/09/06/how-to-measure-the-size-of-government/ and more extensively almost 40 years ago: http://works.bepress.com/warren_coats/29/.

My proposal, which is really a bit of left over unfinished business from the Reagan administration, is that the level of tax revenue should be set to pay for all of government’s expenditures over the business cycle. Deficits would be allowed during recessions (the so called automatic stabilizers), which would have to be paid for with surpluses during booms. I would like to see a constitutional amendment that imposes this requirement in place of legislated debt ceilings. If the public really wants more government spending, taxes will need to be raised to pay for it.

The focus on taxation, and the refusal of many Republicans to raise them, has been very counterproductive. The Republicans have done a terrible job of making the case for smaller government and I blame a lot of that on their emphasis on taxes rather than spending. If we insist that Obama’s spending programs must be financed by tax revenue rather than borrowing (except for automatic stabilizers during recessions – e.g., increases in unemployment insurance and the natural fall in tax revenue when incomes fall), people would start focusing on the fact that they will have to pay for these expenditures. It would make fighting for more restrained spending easier.

The government (federal, state and local) should be involved in some areas of our lives, but we should make the case for such involvements carefully because the nature of government, if not firmly and continuously resisted, is to keep growing. The defense industry in the United States is large and powerful. It has an obvious profit interest in seeing the government’s defense expenditures increase and it has the economic means to help influence such an outcome. The taxpayers’ representatives in government need the counter pressure those taxpayers can provide to evaluate defense spending and all other government programs carefully and to apply rigorous cost benefit analysis to every proposal.

Even then, it is well known in public choice literature that it is difficult for the diverse and defused public interest of taxpayers to dominate over the individual special interests of bankers, pharmaceuticals, farmers, teachers unions, etc. If these special interests are able to gain special favors from the government (e.g., farm subsidies) they benefit greatly but the cost is spread widely over all taxpayers. These forces push government to grow into activities that can harm the economic efficiency and growth that benefits us all. But they also invariably push and ultimately cross the boundaries of honest advocacy into blatant corruption. I expounded on this dangers in (at least) two earlier blogs:

https://wcoats.wordpress.com/2009/12/23/keep-it-lean/ and http://dailycaller.com/2011/01/17/ikes-farewell-address-fifty-years-on/

Liberal (in the classical meaning defined by John Stewart Mill) and democratic societies are the exception in history. They are not easily defended.

“The price of liberty is eternal vigilance.”

Happy New Year.

Republicans and the Fiscal Cliff: What are they thinking?

Our government, whether headed by a Republican or a Democrat, governs for all of us. The Republicans lost this time around, though they still control the House of Representatives. They are in the minority. The Democrats, who control the Senate and the Executive branch, rightly expect to introduce and oversee policies that are more aligned with their view of what is best for the country than the views of the party that lost. But if they are wise and have the best interests of the country at heart they will take into account the views of the rest of the country as well. Compromise is part of the art of governing a diverse people successfully. Limiting the scope of government is another. See my comments on this theme over four years ago: “The Death of the Right?”

Many Republicans, however, are behaving as if they think they should force their views on the majority.  Not only is this unwillingness to compromise unacceptable in our democracy, it is producing worse outcomes for those of us who would like to keep government smaller. These republicans rejected a deal last year tentatively agreed between House Speaker John A. Boehner (R-Ohio) and President Obama that would have increased tax revenue by $800 billion over the next ten years in exchange for spending cuts three times that.  Without some sort of agreement by the end of this week, falling over the “fiscal cliff” will increase tax revenue by around $5,000 billion over the same period. That won’t happen, of course, as both parties want to restore the existing income tax rates for all but the wealthy. The Democrat controlled Senate has already passed such a bill, which would increase tax revenue by $700 billion over the next ten years. That would become the base line from which Obama would bargain for more tax revenue in exchange for budget cuts.

I assume that some minimalist agreement will be reached in the next week that will eliminate the worst tax effects from going over the cliff, but that will only perpetuate and prolong uncertainty over how our currently unsustainable future spending commitments will be rained in and/or financed. This uncertainty is a major factor contributing to the slow recovery of investment and the economy in general. The current impasse will continue to do great damage to the county.

According to Ezra Klein: “If Boehner had taken the White House’s deal in 2011, he could’ve stopped the tax increase at $800 billion. If he took their most recent deal, he could stop it at $1.2 trillion. But if he insists on adding another round to the negotiations — one that will likely come after the White House pockets $700 billion in tax increases — then any deal in which he gets the entitlement cuts he wants is going to mean a deal in which he accepts even more tax increases than the White House is currently demanding.

“Today, Boehner wishes he’d taken the deal the president offered him in 2011. A year from now, he might wish he’d taken the deal the president offered him in 2012.”[1] See also: “The GOPs worst cliff myth”[2]

For the sake of the country and for the sake of the principles in which many Republicans believe, they must recover (with the cooperation of Democrats) the art of governing.


[1] Ezra Klein, “Obamas small deal could lead to bigger tax increases” The Washington Post, Dec 22, 2012

[2] Ezra Klein, The Washington Post, Dec 24, 2012.

Our Unsupportable Empire

Most of you are grudgingly aware that the U.S. government has promised us more than we want to or can easily pay for.  China is no longer willing to fill the gap knowing that we will not be capable of repaying it.  This is on top of the existing national debt from past borrowing to cover the government’s current and past spending in excess of its revenue of $16 trillion, about the same as the United States’ total annual output.  These numbers pale in comparison with the government’s unfunded commitments (those not covered by the revenue expected from existing tax laws and user charges) to future retirees and recipients of medical care (social security, medicare and Medicaid). The present value of the revenue short fall to pay for these future commitments (the government’s unfunded liabilities) is currently around $50 trillion for an astonishing total debt of around $66 trillion, which is larger than the total annual output of the world per year.

Naturally, these promises must be pared back because they can’t be paid for. To some extent a healthy, growing economy will also increase our capacity (lighten the burden) to pay for them but by itself growth will not be enough. This is one, but only one, of the reasons that we also need to reconsider our military promises around the world, while reducing and reorienting our military budget and modestly increasing our diplomatic (State Department) expenditures.

Our promise to provide security to most of the world suffers from the same moral hazard as does an overly generous welfare state.  Incentives matter. When access to welfare is easy and the level of support is generous, more people will choose it over taking a job that doesn’t interest them much.  When President Bill Clinton signed “The Personal Responsibility and Work Opportunity Reconciliation Act of 1996” (PRWORA) on August 22, 1996 (with strong Republican support), he fulfilled his campaign pledge to “end welfare as we have come to know it.” The law ended welfare as an entitlement by introducing tighter conditions for receiving it. Welfare costs dropped following adoption of the law. “A broad consensus now holds that welfare reform was certainly not a disaster–and that it may, in fact, have worked much as its designers had hoped.”[1] While some people remain skeptical, Sweden’s welfare reforms of the last two decades have demonstrated very similar results.[2]

The United States spends more on its military than the next 14 largest military spenders combined (China, Russia, UK, France, Japan, Saudi Arabia, India, Germany, Brazil, Italy, South Korea, Australia, Canada, and Turkey). We are policing/protecting most of the world. This has two negative effects. The first, similar to chronic welfare recipients, is that other nations spend less on their own defense, taking a free ride on the United States’ ability to keep the world safe for everyone else. The second is that by diverting so much of our productive resources into the military, we reduce the resources available for developing and strengthening our economy. It is our powerful economy that underlies our influence in the world as much, if not more, than our military power. Moreover, our military might is made possible by our economic power. So we need to get the balance right. I urge you to read David Ignatius’ recent discussion of this issue in The Washington Post, (“The foreign policy debate we should be having”, Oct 21, 2012, page A15)

But there are more reasons that our military adventurism and spending should be reduced and more resources given to diplomacy. Our national security and the freedoms America was founded to establish and protect will be strengthened as a result.

American hegemony rests largely on our economic and military power, but also on widespread respect for the American way of life (our respect for human freedom and dignity and our prosperity). Our efforts to promote democracy via military interventions have generally not gone well.  The talents and spirit of enterprise that have served us so well at home have not generally contributed to success in building new democratic nations where we have militarily intervened. Books like Joseph Heller’s, Catch 22 (about WWII) and movies like Robert Altman’s Mash (about Viet Nam) entertainingly introduced us to the bureaucratic problems of fighting and/or governing in foreign lands. We have the best trained and most well equipped military history has ever known, but it has failed for the last ten years to win in Afghanistan, which is now the longest war in American history. Our powerful military is not good at nation building, nor should we expect it to be. The military is not the right tool for promoting the values we believe in around the world. That is a job for diplomacy (with our powerful military well in the background).

We have been more successful at promoting our values and our economic interests through our promotion of and participation in international organizations like the International Monetary Fund, the World Bank, and the World Trade Organization and a wide range of international agreements and cooperation that facilitate free trade, and capital movements, and that extend the protection of property and human rights internationally. These organizations and agreements have developed the international legal frameworks for telecommunications, patents, financial and product standards, etc. that underlie the explosion of globalization that has dramatically raised the standard of living for much of the world’s population.

Rajiv Chandrasekaran, has written an excellent exposition of our military efforts in Afghanistan, which I urge you to read “Afghan security forces rapid expansion comes at a cost as readiness lags” (The Washington Post, Oct 21, 2012, page 1). Every few years America’s military strategy has changed: from counter terrorism, to counter insurgency, to building and training (and equipping) an Afghan National Army and Afghan National Police. As each approach fails, the Joint Chief’s extract the lessons learned and try a new one until it fails. In recent years, our military commanders have correctly emphasized the fact that “success” cannot be achieved by the military alone (it amazes me that anyone could have thought so – no wonder they are so eager to start wars).

But those are far from the only reasons for reducing our military footprint and budget. I believe in keeping government relatively small and encumbered with the organizational and political checks and balances meant to replace the role of competition in the private sector in bending self-interest to the public good. People are influenced by their self-interest whether they are in government or the private sector. However, in the private sector success comes from serving the needs of others in the market. This exerts a strong incentive on individual behavior. (Dishonesty can exist in either sector and can only be addressed by embracing appropriate moral standards and consistent punishment of breaches of those standards) In place of market discipline (acceptance or rejection), government must rely more on checks and balances to ensure that government officials behave as intended and they can only go so far to keep government honest and impartial in serving the public. The power of the government to coerce, and the expenditure of large sums of money by the government create enormous temptations for personal gain by those in positions of power in the government. The bigger government gets the more difficult it is to prevent some in government from yielding to the temptations to direct its power and money to their own good rather than the general good.

The firms in our large and important military support industry (Lockheed Martin, Boeing, Northrup Grumman, General Dynamics, Raytheon, Halliburton, United Technologies, Computer Sciences, BAE Systems, General Electric, Bechtel, and Honeywell International, to name a few), do not have a disinterested view about the most appropriate and cost-effective military technology the defense budget should provide for. The millions of dollars they spend attempting to influence the choices of the services and congress are, in a sense, “honest” efforts to promote their self-interested view of what best serves our national security. The growing behemoth of the industrial military complex of which Eisenhower warned us over fifty years ago now both defends and threatens our liberties. See my earlier comments on Ike’s famous farewell address: http://dailycaller.com/2011/01/17/ikes-farewell-address-fifty-years-on/

The risks of the misallocation of our resources and waste are directly related to the size of our military (and government more generally). The boundary between honest differences of opinion over the best military equipment and systems and simple cronyism is fuzzy.  Consider, for example, the recent award of a large contract to build 100,000 homes in war-torn Iraq to HillStone International, a newcomer in the business of home building. When its president David Richter was asked how the newcomer swung such a big deal, he replied that it really helps to have “the brother of the vice president as a partner” (James Biden).[3] It would not be fair to disqualify bidders because they are friends or relatives of high government officials (As Afghan President Karzai’s brother Mahmoud said to us with regard to the shares of Kabul Bank given to him by its founders. The Bank is now in receivership as the result of the bank lending 95% of its deposits to its shareholders), but how can you tell what is merit and what is cronyism?

My point is that the defense budget needs to be on the table when our elected officials finally confront the cuts that must be made to the government’s expenditures to save the country. Defense spending needs to be cut not just because we can’t afford it, but also because our oversized military is weakening our economic base on which both our military and our political power in the world rest. And perhaps most important of all, over reliance on military power to the exclusion of diplomacy has actually weakened our security and standing in the world.


[1] The New Republic, editorial September 4, 2006, page 7.

[2] The Economist, “Sweden: The New Model” October 13, 2012.

Has the ECB provided the missing piece to resolve the EU debt crisis?

On September 6, Mario Draghi, president of the European Central Bank (ECB), announced that the ECB would engage in unlimited secondary market purchases of government bonds of member countries adhering to the policy conditions agreed to with the IMF and EU (and thus qualified to borrow from the European Financial Stabilization Fund – EFSF – or the European Stabilization Mechanism – ESM) to the extent needed to promote the efficient transmission of monetary policy throughout the Euro area. The over all liquidity impact of such purchases will be sterilized (offset by the sale of some other ECB assets), as needed, in order to preserve the ECB’s inflation objective of an inflation rate below but near 2% over the next two years. What does this add to the existing European tool kit and is it enough to resolve the EU debt crisis?

All responsible government officials recognize and accept that in the long run nations, like individuals, must live within their means (pay fully for what they consume). Their standard of living will depend on what they are able to produce (productivity).  Eliminating government deficits requires reducing government spending and/or increasing its tax revenue. Increasing the sustainable standard of living of its people (the level of consumption they can fully pay for with what they produce) requires liberalizing restrictions on labor and product markets and investment that will increase the productivity and thus output of workers and businesses. The debate is primarily over the optimal pace of introducing the measures needed to balance budgets and increase productivity and competitiveness.  This matters in that it takes time for the economy to adjust to reforms before it enjoys the benefits of more rapid growth. In the interim continuing but declining deficits must be financed either in the market (if market lenders have confidence in the effectiveness of the measures being taken), or by the IMF/EU/ECB until market confidence can be established.

I have elaborated these points in earlier blogs: “European debt crisis: causes and cures”; “Saving Italy and the euro”;   “Buying time for Italy”; and “Saving Greece-Austerity and/or Growth”.

Throughout the crisis Germany has demanded that Greece and other over indebted and uncompetitive countries undertake the needed corrective measures before being granted the financing needed for the transition back to normal market borrowing.  Events have proven Germany to be right as earlier “bailout” commitments have led to a suspension or slow down in policy reforms thus prolonging recovery.  For the same reason Germany has vigorously opposed (correctly in my view) the adoption of Eurobonds, which would allow Greece and others to borrow at the same interest rate as Germany and all other EU members. The moral hazard of bad fiscal behavior when market discipline of over borrowing is removed is a real and serious issue.

On the other hand, Germany is also pushing for Fiscal Union in order to gain better EU wide control over excessive national deficits. This may or may not be a good idea for Europe (I have my doubts) but it is certainly not, contrary to much opinion, essential for the viability of the Euro. The idea behind the German push for Fiscal Union stems from the markets’ failure to properly price the risk of lending to Greece, Portugal and some other overly indebted countries and Germany’s belief that the only way it can protect its tax payers from supporting inflated living standards to the South is by gaining control over their governments’ expenditures. Until the last few years, the governments of Greece and Portugal could borrow in the market at interest rates very close to the rates paid by the German government, which by the way has borrowed quite a lot itself (the ratio of German government debt to its GDP is currently above 81%). These governments spent and over promised future benefits recklessly on the (temporary) basis of relatively cheap debt financing in the market.

It is certainly a fair question to ask why the market failed in this regard and over lent to a number of governments that now have difficulty repaying. The expectation that Germany and other Northern EU countries would not allow the profligate southern ones to default made such lending seem risk free and the market priced it accordingly.  Fiscal Union and/or EU-wide fiscal rules are one way to limit such excessive borrowing and unfunded future promises. Improved market discipline of borrowing via more accurate risk premiums on market lending is another, and in my opinion, superior approach. Greece’s orderly default (75% haircut) on its publicly held debt and the current crisis have restored a large measure of market discipline to sovereign borrowing. Greece and Portugal do not need to borrow from the market for several more years as long as they implement and adhere to the reforms demanded by the IMF/EU/ECB. However, Spain and Italy closely watch the now far more sensitive interest rates demanded by the market when lending to them. Given the substantial outstanding debt of these countries, those interest rates can make the difference between the success or failure of reform efforts. Ireland, which has successfully, though painfully, implemented all of the conditions of the IMF et al “bailout,” is well on the way to full recovery and is now able to borrow again in the market at reasonable interest rates.

The missing piece in the EU/ECB tool kit to manage the ongoing debt crisis is the availability of sufficient temporary adjustment financing for larger countries such as Spain and Italy should markets loss confidence in one or both of them before their reforms have had time to bear fruit. The resources of the EFSF/ESM, still waiting for the German constitutional court’s approval, are not sufficient to finance stabilization programs with both countries. This leaves markets uneasy and volatile.  Market interest rates on ten-year Spanish government bonds have varied this year between under 5% to 7.6%. German government bond rates have varied between 1.24% and 1.85%.  Mario Draghi’s commitment of ECB funds to buy short-term sovereign debt (with maturities of up to three years) in secondary markets does not augment the resources available to the EFSF/ESM to finance adjustment programs with the IMF, but by buying such bonds in the secondary market should liquidity in a program country dry up, the ECB should be able to significantly reduce the prospects of what it considers unrealistically high risk premiums for such bonds. The ECB would only buy bonds of countries meeting the conditionality of an IMF supported adjustment program. Outright secondary market purchases are a standard and traditional liquidity management tool for central banks. What is unique in the European context is that open market purchases must be for the bonds of individual countries and the choice of countries matters. It is for others to determine whether, as Mr. Draghi claims, the new initiative is consistent with the ECB’s mandate.

This past week I attended a meeting of the Mont Pelerin Society in Prague. Friedrich Hayek, Milton Friedman and a few other free market champions founded the MPS in 1946. Czech President Vaclav Klaus, also an MSP member, hosted this year’s meeting. President Klaus has opposed the Czech Republic’s adoption of the Euro. It has kept its own currency, which the Czech National Bank has managed very well under an “inflation targeting” policy regime. However, Spanish economist Jesus Huerta de Soto spoke at the meeting in defense of the single currency. He favors a return to the gold standard but convincingly argued that the monetary discipline on Spain provided by giving up its own currency to the Euro was a good second best.  The key to success or failure of the Euro for the overly indebted countries that use it is whether they reform deeply enough to live within their own means within a few years and to sufficiently improve their competitiveness with the rest of Europe and the rest of the world. Failure to do so will harm the defaulting country far more than it will harm the Euro.  I wish them well.

Spain’s Financial Crisis: First Principles

Europe’s debt crisis has many contributing elements: bloated government bureaucracies, unaffordable social welfare programs, and productivity stifling labor and commercial laws.  However, none is as central as the condition and behavior of those European banks that overlent to and undercharged many European governments, and whose potential insolvency should one or more European governments default (as Greece has already to some extent) has dominated the EU’s slow, halting approach to dealing with it. Focusing on the case of Spain, the following note illustrates the importance for the future of Europe’s financial markets of resolving the banking sector’s problems properly.

Overview

In some respects the financial and debt situation of Spain is similar to that of the U.S.[1] Its central government debt is less than the U.S.’ and Germany’s (68%, 103%, and 83% respectively). This year its public sector deficit is expected to be 5.9% (8.5% last year), less than the U.S. at 7.6%, but more than Germany’s at 1.3%. Its total debt (public and private) to foreigners (external debt) is less as well (84%, 103%, and 142% respectively). Spain’s housing bubble and subsequent collapse were average. The decline in Spain’s real housing prices from their peak in 2007 of about 20% was about the same as the UK’s and the Euro zone’s and less than in Ireland and the U.S.

To over simplify, what sets Spain apart is a) its lack of competitiveness (its current account deficit with the rest of the world relative to GDP was 9.6% in 2008 and is currently almost 3% while the Euro area as a whole is balanced – i.e., 0); b) the heavy reliance of its banks on borrowed funds (its loan to deposit ratio is about 150% compared with 80% for U.S. banks; and c) its banks’ large exposure to the real estate and construction sectors (56.5% compared to 30% for U.S. banks). In addition, Spanish and European banks in general operate on much less capital than do American banks. Going into the recent financial crisis—2007—the ratio of total European bank assets to capital—i.e., the leverage ratio—averaged around 30, while for American banks it averaged around 13 (i.e. capital gearing ratios of 3.3% and 7.7% respectively).

Spain was confident that it could make sufficient budgetary and policy adjustments to convince markets that it was still safe to lend to while gradually winding down excess spending and liberalizing rigid labor and product markets (its no bailout strategy). But after four years of inadequate measures Spanish voters ousted the Socialist Party and gave the center right party of Mariano Rajoy a solid majority in Parliament with a mandate to move more aggressively. Prime Minister Rajoy’s reform program has been a mixed bag (see “Spain’s Economic Reforms: A Mixed Bag”). The central government’s spending and deficit are falling rapidly, though excessive regional government spending remains a problem. Labor market reform has been quite quick and strong and is already producing improvements in competitiveness. However, Spain has fallen back into recession and unemployment is the highest in Europe at over 24%.  (see Rajoy government reform program)

Spain’s Banks

Spain’s primary vulnerability comes from its banks. In fact, a central feature of the European debt crisis is the relatively large exposure of European banks, including German banks, to the sovereign debts of Greece, Portugal, Ireland, Italy, Spain, etc. If depositors think that their deposits are at risk, they will move them. If they think all banks in Spain suffer this risk, they will move them out of Spain to other banks that accept Euros. If depositors withdraw their deposits too rapidly (i.e., bank runs) then even solvent, well capitalized banks can have trouble liquidating assets fast enough to fund the withdrawals. The total deposits of Greek banks have fallen from 245 billion at the end of 2009 to 175 billion at the end of April 2012. However, Spanish banks’ deposits have not begun to decline until very recently.

Countries limit the risk of deposit runs by explicitly insuring bank deposits up to a limit and/or by standing ready to intervene (bailout) failing banks. In Spain, all deposits are insured up to 100,000 per depositor. If governments guarantee all deposits as a result of a comment to bail out insolvent banks, deposit insurance is redundant and not needed. Even a full deposit guarantee provides some market discipline of bank behavior if the regulator intervenes promptly when a bank becomes insolvent, because shareholders lose all of their investment in the bank. Market discipline is strengthened further if bank bondholders also incur losses when the assets of an intervened bank are not sufficient to cover their repayment.

The Importance of Bank Capital

Without deposit insurance or government deposit guarantees, their bank’s capital is the primary protection for depositors against the risk of loss.  If depositors think that their bank’s capital is too low to cover potential losses, they will move their deposits to safer banks. Unfortunately, the value of a bank’s capital cannot be known with certainty. Economic capital (net worth) is the difference between the value of assets and the value of liabilities. A large share of banks’ assets is loans. The value of a loan is less than its face (book) value if it is not repaid fully or on time. It is impossible to know for sure which loans are “good” and which are doubtful and how doubtful they might be in the future.

Minimizing the risk of deposit runs via capital adequacy consists of three elements:

  1. The level of capital banks are required to hold in normal times (dynamic or cyclically adjusted capital requirements deserve more serious attention) must be sufficient to absorb possible losses. Higher capital requirements provide more deposit protection.
  2. The rules for valuing assets and thus capital must reflect their real value as best as possible. Most bank loans have no secondary market from which to measure their value. Thus bank regulators have established rules of thumb for estimating the probable loss in value for loans that are not performing or are at risk of falling into arrears and potentially defaulting. Banks are required to provision (write down capital) to cover such probable losses. This is the equivalent of “marking to market” the probable value of loans that have no market. Loan valuation and loan loss provisions need to realistically reflect and cover the most likely repayment outcomes.
  3. Depositors must have confidence in the adequacy of the first two measures and the faithfulness with which banks apply them. This is the issue of transparency. The recent deployment of stress tests, when properly explained (especially when undertaken by third parties, such as the IMF), is meant to reduce the uncertainty surrounding the adequacy of measured capital.

The risks to Spanish bank depositors come primarily from three sources:

  1. The potential losses from loans to Spain’s now busted housing and construction markets and from holdings of sovereign debt of Greece are uncertain and have almost certainly been underestimated and under provisioned in the past. Significant exposure to Spanish sovereign debt is now becoming an issue as well. Capital injections are needed just to keep actual capital at currently reported levels. Higher levels of capital are needed to compensate depositors for the uncertainty of the actual level of capital.
  2. The ability of Spain to honor its deposit insurance commitments or its implicit commitments to cover deposits in the event of an intervention are increasingly in doubt because the ability of the Spanish government to borrow additional amounts to cover such commitments is in doubt.
  3. The ability of banks to fund their loans from non-deposit sources or to fund deposit withdrawals even if they are well capitalized are in doubt in current market conditions. This is a liquidity problem, not a solvency problem, and should be handled by the provision of central bank liquidity.

Spanish banks fund a large part of their loans with relatively short-term borrowed money rather than deposits. Access to such funds has become difficult and expensive. From the beginning of central banking, a core function of central banks has been to provide banks with the liquidity they need in such circumstances. The long-established principle is that the central bank should provide illiquid but solvent banks with all the liquidity they need (generally by lending to them against good collateral), but should not lend to insolvent banks (banks lacking sufficient good assets to cover their deposit and other liabilities). The ECB’s three-year Long Term Refinancing Operation is addressing banks’ liquidity problem (#3).

But even without deposit runs (or walks), Spanish and other European banks (especially) need to reduce the extent to which they lend long-term on the basis of short-term borrowed funds. They can only do so by reducing lending until their deposits finance a larger share of it and/or by increasing capital. The bank deleveraging now underway around the world is an important source of reduced bank lending and the slow pace of recovery (see Carmen M. Reinhart & Kenneth S. Rogoff, “This Time is Different: Eight Centuries of Financial Folly”).

Spanish banks were better capitalized than most at the onset of the international financial crisis but more recently have been overwhelmed by the magnitude of the collapse of Spain’s housing and construction markets. The government (previous and current) has taken measures to address banking sector weaknesses but always a bit behind the curve.  Seven failing cajas (regional savings banks heavily exposed to real estate) were merged in 2010 to form Bankia making it Spain’s fourth largest bank. In May the bank was largely nationalized (costing the Spanish government around 20 billion Euros to date) and trading of its shares was suspended on May 25, 2012. Deposit insurance was established then raised. Government guarantees of senior bank bond holdings were introduced (October 2008).

As time passed, depositors have only become more concerned about the safety of their deposits. In an effort to finally get ahead of the curve, the authorities have increased the provisions required against weak and doubtful loans and other assets, and initiated third-party stress tests of its banks. The IMF’s recent Financial Sector Stability Assessment found Spain’s large internationally active banks to be well capitalized and able to absorb the new capital strengthening requirements. However, its former savings banks and some of its medium and small private sector banks are more vulnerable and will need capital injections from the government to cover insured or guaranteed deposits. Because of its own financing difficulties, the government of Spain has turned to the EU to backstop its ability to recapitalize (replace capital lost by or potentially lost by defaulting loans) those of its banks with inadequate capital. For this purpose the EU has committed 100 billion.

The Way Forward

Deposit runs on Spanish banks (including the drying up of wholesale funding) can be prevented only by convincing depositors that their money is safe, i.e. that their banks have sufficient capital to cover any losses. This requires honest accounting and full implementation of the indicated provisioning, and adequate capital; or creditable government guarantees.

For the future health of Spanish banks, it is important that Spain’s banking interventions preserve the intended discipline of excessive risk taking that results from imposing losses on shareholders and senior bond holders while honoring its commitments to protect depositors. Thus liquidity support should only be given to solvent banks. Nonperforming loans should be properly provisioned. Banks that are critically undercapitalized and are unable to raise their own capital to required levels within a reasonable period should be intervened. Intervened banks should be resolved according to the least cost principle (least cost to the tax payer). Shareholders and senior bondholders should be wiped out before government money is injected to cover other liabilities. Viable banks should be continued and sold to new owners within a reasonable period of time. Non-viable banks should be wound down (liquidated) paying off all insured or guaranteed depositors with the help of public funds as needed.

In requesting EU financial assistance, Spain is committed to abiding by EU rules on state aid to banks. However, emergency responses to a financial crisis much too often produce the foundation of moral hazard and excessive risk taking that creates the next crises delaying true and long-lasting resolution. More market discipline of risk taking needs to be reintroduced via a sound bank resolution policy. Spain will contribute to the future soundness and vitality of its banking sector and that of all of Europe if it adheres to the above principles as it “cleans up” its financial sector.


[1] The International Monetary Fund’s “Financial Sector Stability Assessment”  provides an excellent summary as of May 2012.

The Hutchinson Lecture at the Universtiy of Delaware

Tuesday (April 17) I spent an enjoyable day in Newark, Delaware as the guest of the Economics Department of the University of Delaware. My afternoon, more technical, lecture to the graduate students and faculty covered my proposal for the reform of the international monetary system: http://works.bepress.com/warren_coats/25/

My evening lecture, this year’s Hutchinson Lecture, is reviewed here by the U. of Delaware newspaper (in which there is also a link providing background on the Hutchinson Lecture): http://www.udel.edu/udaily/2012/apr/HutchinsonLecture042012.html.

Saving Greece: Austerity and/or growth

Econ 101: When discussing Greece’s economic problems public officials and the press regularly toss out the need for “austerity” and/or “growth” as if they were clearly defined and understood concepts. I suspect that they mean quite different things to different people. While it is convenient to summarize complicated policies with single words, it can also stand in the way of understanding what is really meant. So what are the policies needed for Greece’s recovery and what should we call them?

Stocks and flows: For starters we need to distinguish the stock of Greek debt (the existing outstanding amount of previous, unrepaid borrowing) from its annual deficit. Greece’s debt reflects the past history of its annual deficits. Its current and prospective deficits foreshadow the future stock of debt. A full default on Greek debt—wiping it all off—would reduce Greece’s annual interest payments on its debt but beyond that would do nothing to reduce its annual deficit and the build up of its future stock of debt, which eventually would again become unsustainable. So forgiving (defaulting on) all existing Greek debt, by itself, will not resolve Greece’s problems.

Sticking with broad simplifications, Greece has two major economic problems. First, its government spends more than it can pay for without borrowing (the deficit — the flow of new debt). Moreover, like the U.S. and many other governments, it has made commitments to spend in the future (e.g. unfunded pension commitments) that are not yet reflected in its stock of debt or its annual deficits. This must change because it is not sustainable. Lenders will lose confidence in the government’s ability to service its debt and will stop lending. This calls for “austerity”, i.e. eliminating the annual deficit, by some combination of reducing expenditures and increasing tax revenue. I will return later to the distinction between structural and cyclical deficits.

Greece’s second major problem is its low productivity and uncompetitive prices. By themselves these would simply imply a lower standard of living for Greeks. But the average Greek has been spending more than his income by borrowing, giving the temporary illusion of a higher standard of living. To the extent that Greek spending is for foreign produced goods and services and these imports are not fully paid for with Greek exports, they must be paid for by borrowing. This artificial standard of living is obviously not sustainable.

Greece shares the same currency, the Euro, with 22 other European countries (including non members such as Monaco, Kosovo, and the Vatican).  If Greeks borrow domestically to pay for imports, Euros will flow out of Greece, tightening liquidity. This should put downward pressure on wages and prices in Greece, which would help restore its competitiveness with the rest of the Euro zone. If Greeks borrow abroad, interest rates on such borrowing should eventually increase to cover the increased default risk. This will discourage Greek borrowing. Greece has reached this point.

Some argue that if Greece had its own currency it could reduce its real wages by devaluing its currency and thus restore external competitiveness. Cutting real wages in this way would be easier, they argue, than cutting nominal wages directly as Greece has just done for government employees. Experience in other countries suggest that devaluing its own currency, if it had one, would set off domestic price increases to offset the loss of real wages unless labor markets were made more competitive. A spiral of devaluations and inflation would likely ensue. Only when real wages can be reduced to competitive levels one way or another can Greece hope to grow out of its current problem.[1] Thus the Greek government is undertaking structural adjustments to liberalize labor and product markets in order to make them more efficient and to make wages and prices more responsive to market conditions.

Some argue that the emphases in Greece should be put on growth.  Given the debate in the U.S. between Keynesian and neo classical economist over whether growth requires “stimulus” to increase demand (the Keynesian view) or “structural adjustments” to make labor and product markets more efficient and to encourage investment (the neoclassical view), it is not completely obvious what the proponents of growth in Greece have in mind. Attempting to promote growth with government stimulus to demand is not in the cards, as that would require more government spending and/or lower taxes and thus even larger deficits that no one is willing to finance. The only way for Greece to enjoy a higher standard of living is to undertake structural reforms that will allow the economy to be more productive and its wages and prices to be more competitive with the rest of the world.

So Greece needs to eliminate its deficits (actually run surpluses to reduce its outstanding debt) and liberalize its labor and product markets to establish balance in its external trade. All serious students of the Greek situation agree with this. The policy debate is complicated, however, by the interaction between growth and deficits and the speed with which an economy adjusts to changes.

If the Greek economy grows more rapidly it helps its debt problem in several ways. First, a growing economy generates more tax revenue from the same tax system. This reduces the deficit. It also tends to reduce government expenditures linked to safety net expenditure (e.g. unemployment insurance). This also reduces the deficit. In addition, the capacity of an economy to sustain and service debt is linked to its size. Thus economists look at the ratio of debt to GDP. A more rapidly growing economy tends to reduce the debt/GDP ratio by increasing the denominator.

While Greece must eliminate its deficits, the initial impact of expenditure cuts and higher taxes is to temporarily reduce income and tax revenue. Greece is experiencing this now. Its expenditure cuts have not reduced its deficit as much as expected because the temporary slow down in economic activity as displaced government employees (for example) look for new jobs, has been larger than expected thus reducing tax revenue by more than expected. A reduction in income has the same but opposite effect on the deficit as does an increase in income. This phenomenon is called automatic stabilization. Both Keynesian and neoclassical economists favor allowing such cyclical swings in government deficits and surpluses. But in the long run the government’s structural deficit (its full employment deficit) should be zero or at least smaller than the economy’s long run average growth rate. In Greece’s case it should be in surplus for a number of years to reduce its existing stock of debt.

The positive impact on competitiveness and income of liberalizing labor, services and product markets will also take time to develop. Balancing Greece’s fiscal budget now, before structural reforms have had time to work, would require much larger fiscal corrections (spending cuts and tax increases) than would be needed for long run balance.

This background should help understand and evaluate Greece’s options. Without external financial help (as is now provided by the EU, IMF and ECB), Greece could not adjust its fiscal deficits enough in the short-term to avoid the need to continue borrowing temporarily. Under these circumstances market lenders are likely to charge such a high risk premium to buy Greek sovereign debt to cover the prospects of default that deficits would become worse rather than better. Greece would default (with or without leaving the Euro). If it had defaulted in December 2011, it would have saved 16.3 billion Euros in interest payments on outstanding debt out of total government expenditures of 76.8 billion, but would have had to cut expenditures instantly an additional 6.3 billion to keep it within its tax revenues of 54.2 billion, over a 10% cut in non-interest expenditures instantaneously. This is austerity on steroids. The Greek economy had already stopped growing in 2008 and shrank by 3.3%, 3.5% and 5.0% in 2009, 10, and 11 respectively. The shock of default would surely depress the real economy further than the 2.0% decline currently forecast for 2012, reducing tax revenue further and requiring even larger cuts in spending. This does not take account of the impact of a Greek default on its banks, which hold a significant amount of Greek sovereign debt, and which the government would no longer be in a position to support. Default is no panacea, and this has not taken into account the possible negative effects in Spain and Italy, to name but two other European countries.

The approach taken by the IMF and EU is to agree with Greece on targets for both deficit reduction (austerity) and structural reforms (growth) that aim to restore full balance by 2021 and to finance the declining deficits in the interim at modest interest rates so that Greece does not need to borrow from the market. The program requires the “voluntary” write down of private sector holdings of Greek sovereign debt by about 70%. Greece would reduce its deficit from almost 10% in 2011 to less than 5% in 2012 (a primary surplus – i.e. not including interest on its debt—of 0.2%, raising to a primary surplus of 2.4% in 2013 and 5.0% in 2014). This “austerity” is being supplemented by significant structural reforms. The program is a balance between the pace of austerity and growth. Slower implementation of austerity requires a longer period of IMF/EU financing but with potentially more rapid growth.

Government employment is being reduced by 22% between 2010 and 2015 (150,000 employees). Future pension commitments have been reduced. Inflation has fallen below the Euro area average. However, external competitiveness has improved as the result of wage reductions in Greece rather than improved productivity, i.e. living standards have fallen. In general, labor market and business sector reforms have lagged. Changes in labor laws to allow more flexible wage bargaining and to ease the cost of lay offs are showing positive results. A number of services and professions have been liberalized to subject them to greater competition (cruise ships, highway freight, tourist coaches, regulated professions). The cost of starting new businesses has been reduced (“The new law reduces the number of steps (from 11 to 1), days (from 38 to 1), and cost (by more than 50 percent) required to start a business.”). Nonetheless the slow pace of such reforms is the major weakness of the program. Public acceptance of its changed circumstances and how best to deal with them has not be easy or smooth either.

It is noteworthy that the Greeks work more hours on average than any other European county (2,017 hours per year compared to 1,408 hours a year for Germans). German’s enjoy a higher standard of living because they produce more each hour they work. Greece needs to liberalize its markets to become more productive. Lowering wages will make Greek output more competitive beyond its borders but will not raise the standard of living for Greek workers.

The euro group has stated in its communiqué, “We reiterate our commitment to provide adequate support to Greece during the life of the program and beyond until it has regained market access provided that Greece fully complies with the requirements and objectives of the adjustment program.” The proviso is standard but also reflects Greece’s poor record of honesty and implementation.

IMF financial support is parceled out in quarterly installments contingent on Greece meeting the conditions agreed to for each quarter. This combines the carrot of financial assistance with the stick of close monitoring of Greece’s compliance with the reforms needed for long run success. There are no good options for Greece, but the current agreement between Greece and the IMF/EU seems to hold out the best hope for potential success. It balances austerity and growth. It will not work without public acceptance. Government promises to its public are being and must be broken. The Government needs to convincingly explain that these promises cannot be kept and that a brighter future requires the reforms that have been promised to the IMF/EU/ECB and the increased productivity and growth they should make possible.

Iceland and Ireland are well on their way to recovery from their debt disasters. If Spain and Italy can get and stay ahead of the adjustment and reform curve, and they have new governments committed to doing so, Europe should pull through and be stronger for the experience. But the next few years will be difficult.


[1] Mario Blejer and Guillermo Ortiz, “Latin Lessons”, The Economist February 18, 2012, page 94.

Buying time for Italy

Buying time can be useful if you get something useful with it, otherwise it is a waste of time and money. Italy needs to borrow less domestically to finance its government’s expenditures (reduce its fiscal deficit) and to borrow less abroad to finance its imports in excess of its exports (reduce its trade deficit). The lower interest cost of the IMF and/or EU lending money to the governments of Italy and Spain at German sovereign debt interest rates can buy them time to enact and implement government spending cuts, tax increases, and market reforms that improve productivity and reduce labor costs before they need to borrow in the market at potentially much higher interest rates. Why might the IMF and the EU’s European Financial Stability Facility (EFSF) be willing to lend money at German rates when market investors aren’t? That is a good question without a clear answer, though most commentators seem to assume it without much question.

The pay off from the measures Italy needs to implement will take time to materialize. Liberalizing markets takes years to actually improve productivity and exports. Some domestic wage and price deflation will probably be needed as well. Reforms to the tax system take time to produce revenue. Above all it will be difficult for the Italian economy to grow (the essential ingredient of financial sustainability) while the rest of Europe, if not the world, is stagnating. In the interim, Italy’s deficits will remain above the levels expected to result from current reforms in the future (say two to four years down the line). If they cannot be financed at “reasonable” interest rates, Italy will be forced to default on its fiscal debt of about 2 trillion U.S. dollars (of which about $500 billion falls due and needs to be refinanced in 2012). The impact on the banks, pension funds, and others that hold this debt would be devastating beyond our experience.

Thus IMF et al financing can be useful if a) Italy actually enacts and implements now the reforms needed to become viable in the future, and b) if the IMF is more confident that Italy will achieve the desired outcome than are market lenders. Without condition “a”, buying time is a waste of time because Italy would default anyway only somewhat later after running up even more debt. With regard to “b”, it may be that the IMF is better able to assess and enforce Italy’s reforms than the market (the IMF reviews progress every quarter against agreed performance criteria before authorizing the next quarterly tranche of its loan), but it is not obvious that this is so. Market lenders can see any reforms actually undertaken and the result almost as easily as the IMF can. If these measures are credible and convincing, market lenders will reduce their risk premiums for lending to Italy. If so, no funds from the IMF would be needed.

On the other hand, lenders may have become risk averse in the conditions now existing in Europe and the U.S. and world economy. If so, they will demand an interest rate to lend to Italy that is more than the premium needed to cover the expected loss from default. In these conditions IMF/EU financing could make the difference between success or failure. Undermining confidence in the ECB and the purchasing power of the Euro would be bad under all scenarios. While more rapid growth in the supply of Euros as the result of ECB purchases of Italian and Spanish debt might not be expected to be inflationary in today’s depressed economies, the effect on Euro interest rates will depend heavily on public confidence in the ECB’s anti-inflation commitment (i.e. inflationary expectation. See my earlier note on the role of the ECB: https://wcoats.wordpress.com/2011/11/17/saving-italy-and-the-euro/).

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Comments:

Here are some interesting comments from friends on my earlier note on the use of the ECB to buy Italian debt.

Thanks Warren, it is hard to be optimistic that the politicians and technocrats of Europe will stumble on the only thing that will work.

Thought experiments: why do we never see calls for “break up of the $ zone” such as when Puerto Rico got into fiscal troubles (see Stossel and Cal Thomas or recent reforms)?  Why don’t El Salvador, Ecuador and Caribbean Islands “leave the $ zone” so they can devalue to prosperity?  So far, we have a credible “no bailout policy” so even Harrisburg must go into bankruptcy.  In the US $ zone, counter-party risk is still important.

What if: instead of a “euro zone” we had seen 16 countries in the EU unilaterally adopt the DM?  The Frankfurt-managed currency would have appreciated sharply in recent years compared to the US $, much like the C$, Aus$, et. al.  The adopting countries would then have been in the position of Chile 1981.  When pegged to a weak US $ during the Carter years, Chile thought pegging was great.  Then, on the first Tuesday of November 1980 the US $ started to appreciate, and Chile found themselves holding the tail of a tiger until they rediscovered the virtues of floating.

If Italy and others are to stay on the “paper-gold standard” of Frankfurt, they will have to reduce real wages (& pensions etc.) the old fashioned way.  If that is too painful politically, and if Frankfurt refuses to abandon administration of “paper gold”, then Italy, et. al. must remain the Appalachia of the euro zone.

Why would Cameron want the ECB to monetize euro-zone debts?  Is it because more inflation in the euro zone as well as the US will take the pressure off the UK pound?

Jerry [Jordan, former President of the Federal Reserve Bank of Cleveland]

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Warren,

You make a very elegant and compelling case. But I’m not convinced that it will work. The likelihood of the ECB remaining politically independent is slight. And the only way Germany will be able to enforce the kind of austerity it’s promoting will be to invade and occupy these countries’ finance ministries (which has already begun, but without decisive popular support). Just as in the US, the people who need to bear the brunt of a recovery–the largest banks (in this case, the French banks which are the most exposed) and the bond markets–are the least likely to do it, and so hold a near monopoly on the recovery. At some point the people really bearing the brunt—the people least able to do it–may just give up: on the ECB, on the Euro, on the EU. Russia in the 1990s is a case in point. How many European Putins are there waiting in the wings? So long as the US and China and nearly every other power is dealing with this crisis publicly at the other end of a ten foot pole, I find your, and any other positive, outcome, very unlikely at the present moment. Sacred tenets of central banking aside, from where I sit this looks like little else besides beggar thy neighbor. On every level.

Ken [Weisbrode, in Boston]

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Hi Warren,

I don’t have the time these days to read your lengthy blog essays, alas, but I did want to make an admittedly superficial comment or two.  I really wish somebody would actually treat a sovereign borrower like an ordinary client some time.  These Greek demonstrations are disgusting. Your country doesn’t have money, and you’re insisting that it keep the generous welfare taps wide open.  Just where is the budget supposed to get the money to pay you to shut you up?  It would be wonderful if the Greek demonstrators were given what they want, the country would default in a few days, and then the banks would take over the bankrupt estate and liquidate it.  Not that banks are such wise and nice entities, but I just feel the Greek demonstrators deserve exactly this.  It’s the logical consequence of their irrational demands.

Next topic:  I’ve never understood the phrase (one that I have translated you saying many a time, I might add) that “of course, interest rates can’t go negative, so central banks are seriously constrained in their ability to loosen the money supply once the rates are down near zero already”.  Why can’t they go negative?  If the economy is so moribund that banks aren’t lending any more, only fuelling the moribundity further (not that you can fuel moribundity…), why can’t/shouldn’t the central bank loan money to the banks at negative interest in order to kick start lending and economic activity in general?  It’s Keynesian deficit spending by other means – monetary instead of fiscal.

Just having a rare moment of economic musing, sorry to bother you with my infantile thoughts.  Hope all is well with you, and that you have a good Thanksgiving.  Nailya and I will be passing through DC in the next month or so, but literally passing.  If plans change and we end up staying a little while, I’ll let you know and perhaps we can get together for a bit of socializing.  Nailya’s gotten quite interested in economic and political affairs (she never had been in Russia, because there’s no point in getting excited about something that gets arbitrarily decided by the corrupt suits in the Kremlin without regard for anybody else), so I know she’d make a lively conversationalist.

Steve [Lang, former personal Russian/English translator for Mikhail Khodorkovsky after being the same for me and the IMF]

Thinking about the Public Debt

The U.S. Federal Government spent $1.7 trillion dollars last year more than its tax revenue. It had to borrow that amount. This increased the outstanding public debt of the Federal government to 14.2 trillion dollars or 96 percent of GDP. This includes that part owned by the Social Security trust fund and the Federal Reserve but does not include the unfunded liabilities of Medicare, Medicaid and Social Security, which will add an additional $46 trillion to the deficit in present value terms over the next 75 years.

This year’s federal deficit is expected to be 1.4 trillion. Interest payments on this debt are forecast to be $287 billion this year (almost 8% of total outlays) and are expected to grow to three or four times that over the next decade as the stock of debt grows and interest rates rise.

This is not sustainable. Without spending cuts and/or tax increases this amount will not only continue growing without end but will increase as a share of GDP until bond holders are no longer willing to trust the government’s ability to pay the interest required. At that point they will dump U.S. Treasuries and the U.S. will be forced to default. Standard & Poors has already downgraded its “credit outlook” for the U.S. to negative.

All of this is by now well-known as is the fact that there is no longer any choice about the need to cut spending and/or raise taxes. But that is just the beginning of the search for responsible and effective governance by our representatives here in Washington. It makes a big difference which expenditures are cut and which taxes are raised. The deficit will fall and our ability to finance it will increase with the growth of our output/income. Specific spending cuts and tax increases effect income growth differently.

The job of our political representatives is to determine what the government should be doing within the set of things it is permitted to do by the Constitution and the resources the public wishes to make available. Their job is to carefully and wisely set priorities on the use of the limited resources available to them.

David Ignatius provides one of many examples that I strongly agree with: “Today, the United States is allocating about $110 billion annually for the Afghan war, about $3.2 billion for military and economic aid to Pakistan, and about $0.15 billion in special assistance to help Egypt’s democratic revolution. In terms of U.S. national interests, those spending levels don’t make sense. The pyramid is upside down.”[1]

The budget for the Defense Department in 2010, including our several wars, was $664 billion while the State Department (including all foreign aid) was $52 billion.  We have the best fighting machine the world has ever seen and rather mediocre diplomatic capabilities. Better and more extensive use of diplomacy and less use of drones and lesser-guided bombs can often produce better results (improved security for the U.S.). Spending more to develop well-trained (history, culture, language) Foreign Service officers and less to manufacture more munitions might be a good idea. It is hard to imagine that spending less on DOD and more on DOS wouldn’t improve our security for less money.

All spending should pass a strict cost benefit analysis but setting a cap on total spending relative to GDP (e.g., 18 or 19 percent) would be a useful disciplining tool for forcing more careful prioritization. So we must cut deeply but not evenly. We can and should spend less and get more benefit by better prioritizing what is really important to our safety and quality of life. This will not be an easy debate.

The same must be said for taxes. Not all taxes have the same effect on the economic growth that lifts our standard of living and makes a given debt easer to service. And not all taxes are equally fair.  So while the revenue generated by taxes should match the level of government spending over the business cycle, how that revenue is raised is as important as how it is spent.

The primary standards for judging tax systems are neutrality and fairness. Neutrality means that the tax does not distort business and spending decisions so that the allocation of investment and economic resources are not distorted. A neutral tax damages economic growth less than, say, a tax that falls largely on investments. A neutral income tax, for example, treats all sources of income the same.

If tax revenue is raised in ways that do not discourage economic growth, income growth itself will increase tax revenue and reduce a given debt as a share of national income (an indicator of the government’s ability to services it). The arguments in favor of the most neutral possible tax structures are well-known and broadly accepted by economists across the political spectrum. The tax base (whether income or consumption) should be comprehensive making the marginal tax rate as low as possible.

Business income taxation double taxes the same income (by the business and again by the shareholders as individuals) and introduces wasteful and risky corporate behavior in their effort to minimize the tax. Everyone agrees that the corporate profits tax in the U.S. should be lowered more in line with the rates in other countries, but in fact the corporate tax should be abolished. It raises only modest revenue and causes great damage. I favor complete reliance on a flat comprehensive consumption tax (VAT) because it does not tax saving and thus encourages more investment and growth, is simpler to collect and is fairer. [2]

There is less agreement about what is fair. Everyone agrees that the rich should pay more taxes than the poor but how much more. Actually, under the existing tax code those with incomes in the top 1 per cent paid 40 per cent of all income tax revenue in 2006 and earned only 22 per cent of all income, the top 10 per cent paid 71 per cent and the bottom 50 per cent less than 3 per cent.

President Obama thinks that this is not progressive enough and wants to tax high income families even more and the Republicans think it is already too progressive both in terms of fairness and in discouraging investment that promotes faster growth.

A “flat” income tax, the same marginal tax rate for everyone with incomes large enough to pay taxes at all, is the most neutral rate structure when applied to a comprehensive income (or consumption) base. But it is also a good benchmark for discussing fairness. A flat rate means basically that someone with twice the income pays twice as much tax. I consider that fair, but of course our existing rate structure increases with income so that tax payments would more than double when income doubles. Increasing marginal rates is a rather open field. Where should you stop? Clearly our tax system needs to be made more neutral and more fair. The debate over how to do that will not be easy either.


[1] “Time to up the ante on Egypt”, The Washington Post, April 20, 2011, A17.

[2] Warren Coats, “U.S. Federal Tax Policy” , Cayman Financial Review, July 7, 2009