“Perhaps the most important economic problem facing Western democracies over the remaining years of the twentieth century is the propensity of governments to operate in the red, to generate budget deficits in response to demand pressures from voters and special interest groups. The problem posed by this ‘red ink’ syndrome is multidimensioned, reflected as it is in oversized government, in the ever-present spectre of debt monetization via inflation and/or in the rising burden of real debt imposed on the future generations.”
James M. Buchanan, Charles K. Rowley and Robert D. Tollison (eds.) Deficits 1986
“As the White House tried one more time Thursday to galvanize support from a recalcitrant Congress for a deficit commission to tackle the nation’s dangerously bloated debt, fears are growing that the United States will once again resort to printing money and ginning up inflation to resolve its debt problem.” Patrice Hill, The Washington Times, February 19, 2010
Since 2001, government expenditures in the United States have rapidly increased as a per cent of gross domestic product. As the Index of Economic Freedom for 2010 indicates, total government expenditures, including consumption and transfer payments, equaled 37.4 per cent of GDP in 2009, and have increased more than 20 per cent over 2008. Stimulus spending alone over the three years, 2010-2012 is estimated to equal 5 per cent of 2009 GDP.
The burden of taxation itself is relatively high, running at 28.3 per cent of GDP in 2009, but yet is 9 percentage points shy of covering the total cost of government spending, even as conventionally measured, without its major off-budget items. There is no policy proposal before Congress at this time to increase tax revenues, except through increasing the burden on already heavily-taxed top earners who represent, for the most part, the most productive members of society. In the absence of significant policy interventions, the debt burden, as conventionally measured, is expected to increase from its current level of 60 per cent of GDP to 76.5 per cent of GDP by 2019, a level last experienced in the years immediately following the end of World War II.
There are only three ways for a government to cover the cost of its spending: debt, regular taxes, and inflation. Because regular tax increases cannot be hidden, at least easily, they tend to be vote losers, to be resorted to only as a last resort, and even then, only in a discriminatory manner designed to impact adversely on a small minority of voters. Because increased debt is less transparent to the voters, and therefore, politically feasible, deficit-financing tends to be the preferred instrument, up to the point where its burden becomes apparent to the international community. At that point, inflation tends to comes into play, as governments scramble to reduce the real burden of the debt by debauching its currency.
Of course, the real problem is located on the expenditure side of the budget. In the United States, this side of the budget is currently out of control, with spending on the major entitlements – medicaid, medicare and social security – seemingly untouchable, at least in the absence of any statesman-like leadership. A determined program of spending reductions, that would tighten the means-testing of medicaid, that would raise the age-eligibility for accessing medicare and social security benefits, that would means-test the latter eligibilities, and that would eliminate all federal subsidies to agriculture, education and the corporate sector, would surely lower government spending by the 9 percentage points required to balance the federal budget. However, if such targets eluded the grasp of Ronald Reagan, the probability of their being seized by Barack Obama is lower than a snowflake’s chance in Hell.
So, we are left with the inflation tax. As Patrice Hall notes in his above-mentioned column, signs are appearing that this prospect is drawing the attention of internal Federal Reserve Board deliberations. According to Hill, Thomas Hoenig, President of the Kansas City Reserve Bank, and the most committed anti-inflation hawk within the Fed, now ‘expects political leaders to be “knocking at the Fed’s door” to demand that it print money to pay for the debt.’ What Hill does not mention is that the Fed has no need to print additional money. The money has already been printed in trillions of dollars and passively awaits an inevitable uptick in the rate of price inflation.
The historical experience that drives this inflationary line of thinking, as Hill notes, is the first 15 years after World War II, when inflation rates ranging between 4 to 6 per cent per annum, coupled with moderate rates of economic growth, drove the real burden of the debt down from some 100 to some 30 per cent of GDP, all without raising undue concerns within the international community.
The problem with this line of thinking is that 1945 is not 2010. The United States no longer towers hegemonic over a war-shattered world economy. It is a relatively declining participant in a growing global world economy that is no longer driven by the United States and Western Europe. Furthermore, in an information-conscious environment, the US government can no longer fool the electorate into accepting real income reductions through creeping inflation. Inflationary expectations are poised to pounce on any sign of an inflation uptick. It is simply impossible to hold inflation within a 4-6 percentage range in the absence of imposing the kind of fiscal and monetary discipline that the President and the Congress will not tolerate. The problem with this line of thinking, in a nutshell, is that it is a harbinger of stagflation, that nasty phenomenon that brought the progressive movement to its knees for some 20 years following the debacle of the Carter administration. As President George W. Bush might have said, before his voice was stilled: ”Bring it on!”
Tags: budget deficits, control over public expenditures, inflation tax, inflationary expectations, rising debt burdens, stagflation
February 22, 2010 at 7:50 pm |
[...] Rowley, economist at GMU , explains it well. There are only three ways for a government to cover the cost of its spending: debt, [...]
February 22, 2010 at 9:02 pm |
I love that statement: “A snowflake’s chance in hell”. That is a good one
.
Even in my lowly status of having a very modest degree, I do agree that a very good case can be made for not comparing the current situation to post WW2. I think this is the case because of all of the changes that have been made and because we are facing stagflation and that means that the appropriate policies are those that brought the USA and the rest of the world out of the 1970s stagflation.
Indeed, some of the most painful changes made in Australia put in the detested means testing for the provision of some government “welfare spending”.
I should add here, that it is dishonest for any politician to claim that a tax deduction for paying into one’s own health insurance is welfare spending. On the contrary, that is not the case. As I see it, more people should be encouraged to take out private health insurance, so that they are not a burden on the taxpayer when it comes to the ancillaries and the hospital services provided on the public purse. Whenever Govt takes away that tax benefit more people drop out of the private health insurance, which inevitably increases dependence upon the government funding – with an enormous increase in demand for govt funds. Also, and this is based upon the Australian experience, there needs to be less govt interference and regulation in regard to doctor fees. The scheduled fee as set by the govt. is unrealistically low. The out of pocket expenses for the patient is extremely high, considering this is supposed to be a universal health scheme. That gap is sort of tax deductible: it is deductible for the balance of out of pocket expenses that are above the limit that has been set by govt. (yes there is a catch) and it is then deductible at a certain percentage of the marginal rate of tax (or something like that), which means the whole thing is a sleight of hand.
So long as govt continues to hold these kind of whacky ideas on income redistribution then the govt share of GDP will continue to increase. The “doctrine” of the fairness of income distribution is illusory. What it means is that taxes are being drawn from a decreasing pool of people who are in paid employment and that money is expended upon people who tend to be parasites. For many it means no benefits because they do not qualify for those benefits.
February 22, 2010 at 9:04 pm |
Great stuff as usual. I was wondering how the CPI plays into all this though. What’s your take on the chained CPI number, does it accurately rate inflation? From what I read, and I’m not an economist just a hobbyist, the new CPI measure weighs falling prices more than rising prices and it leaves out such pesky things as energy and food. I would think that most Americans spend most of their incomes on energy and food, so leaving those out is dubious at best. From a public choice perspective, isn’t it in the governments interest to low ball inflation rates anyway?
Using that line of reasoning, couldn’t the Government get way with a nominal inflation rate of say 2 or 3%, even though real inflation would be 4 to 6%?
I’m just very reluctant to trust any politically sensitive numbers that are generated by the government. How prevalent is that in the economics profession?
February 23, 2010 at 2:15 pm |
For zombiehero213:
You are absolutely right to be suspicious of government-provided CPIs. In fact the government puts out one that excludes food and energy and should be ignored and one that includes them. But the broader CPI puts housing in at rental values than at prices, and thus reduced emormously the volatility of the CPI over the period 2001-2010. In any dealings with government, caveat emptor is my trusty guide!