So What Should Be Done?

In my first substantive post I suggested not only that perhaps the stimulus had failed, but that we needed to make a major change in our approach, going so far as to suggest that we make a mistake in focusing on fixing the economy right now, rather than focus on changing the fundamentals. To make this explicitly clear, I fundamentally disagree with the following statement by Paul Krugman and Robin Wells:

Given [current] bleak prospect[s], shouldn’t we expect urgency on the part of policymakers and economists, a scramble to put forward plans for promoting growth and restoring jobs? Apparently not: a casual survey of recent books and articles shows nothing of the kind. Books on the Great Recession are still pouring off the presses—but for the most part they are backward-looking, asking how we got into this mess rather than telling us how to get out. To be fair, many recent books do offer prescriptions about how to avoid the next bubble; but they don’t offer much guidance on the most pressing problem at hand (emphasis added), which is how to deal with the continuing consequences of the last one.

No, the most pressing problem is not dealing with the consequences of our last mistake, but changing our behavior so we don’t simply make the same mistakes over and over again. (And on a side note, we once again see Krugman’s rather touching faith in the ability of government policy to save us–the man has simply never applied economic analysis to political behavior, or he’d be somewhat more disillusioned.)

Let me admit up front, that this is an almost impossible task for politicians. Politicians are driven by elections, and the public tends to vote retrospectively, rewarding or punishing them for what has been happening in the year or so before the election, rather than voting prospectively and rewarding them for what is likely to happen in the future as a consequence of their decisions. If ever there was an irrefutable example supporting Bentham’s utilitarian argument that people seek pleasure and avoid pain, it’s the American electorate. Nonetheless, however politically difficult the right path is, we have no hope of getting onto it, or even near it, unless people start preaching its virtues loudly and regularly.

Please note that the following is not meant to be a detailed map. I’m not trying to speak with exquisite precision about what America’s public finance should be over the next X years, but trying to point in a general direction.

Let’s start by noting the recent statement of Britain’s Deputy Prime Minister, Liberal party member Nick Clegg (if you watch the video, this statement begins at around the 8:40 mark).

If you deny you have a problem, and you don’t take action on your deficit, you know what happens? What happens is, you are asking your children, you are asking your kids and your grandchildren to carry on paying off billions of pounds of interest on your debts, on this generation’s debts, money which should be used for their schools and their hospitals in the future.

So, what we’re saying is, look, we have messed up as a generation. We have got to wipe the slate clean for the next generation. It’s very important that we don’t blight future generations because of our failings in this generation.

I want to emphasize that antepenultimate sentence: “We have messed up as a generation.” If Clegg was an American politician saying those words, he’d be just as correct. So how did we mess up, and what do we have to change to get off the messed up track?

1. Balancing the Budget
We have to balance the budget because we can’t borrow ever increasing amounts forever. China, one of our biggest lenders (the biggest lender to the U.S. gov’t is U.S. citizens) recently downgraded our debt. This may be simply a political statement as much or more than a financially justified response, but it’s not a political statement they would dare to make if doubts about the U.S. debt load didn’t exist, so it should be taken as a serious warning. A general downgrading of U.S. debt would make it harder for us to borrow, requiring that we increase interest rates on securities to attract lenders. Additionally, the larger our debt, the larger a portion of our federal budget it becomes, the more it hinders our ability to continue to pay for those programs we want and need.

There are essentially two or three budget elements that are killing us, social programs, defense, and criminal justice.
Social programs
Let’s set aside the issue of whether social programs are inherently good or bad. Personally I tend to be very dubious of many of them, but I just can’t achieve outrage about them when we have presidents claiming authority to completely avoid the rule of law. So let me stipulate for the sake of argument that social programs are legitimate government expenditures. The question is whether we can actually afford them. Keep in mind that the fundamental economic problem is scarcity–i.e., our wants are unlimited, but our ability to pay for them isn’t. The moral goodness of the things we desire is wholly irrelevant to that simple fact, so no matter how morally justified social programs are, we simply can’t afford all of them that people want. The social democratic countries of western Europe have been learning this recently, and have been taking steps to cut back on their generosity, recognizing–as Clegg has done–that it’s simply unsustainable.

Politically we’re not going to get rid of every social welfare program, and I’m not going to make an argument that we should. But we should at the very least get rid of the Medicare prescription drug benefit program. This is a program that may end up costing more than Social Security, but without a dedicated funding mechanism as Social Security has.

Defense Spending
I’m a fairly unabashed foreign policy hawk (although not at all a neo-con), but I can’t defend having a defense budget that is larger than the next, I think, ten countries combined? We need to cut that back radically, eliminate some of our overseas bases, and quit trying to play a military role in every single regional conflict.

Criminal Justice
The U.S. has the highest incarceration rate of any developed country, and still there are conservatives who say we’re soft on crime. Fine, then, let’s save money by eliminating the courts and the prisons and just appoint our police forces to be judges, juries, and (instantaneous) executioners. OK, let’s not. Rather, let’s decriminalize drugs and stop locking up pot dealers. If there’s a textbook definition of a failed program, it’s our “war” on drugs. It costs like a war and it looks like a war, what with the militarization of the police and our militaristic destabilization of Colombia, but it’s pretty much the war Iraq fought in Kuwait–a massive expenditure for no gain. No, wait, it’s worse than Iraq’s invasion of Kuwait, because at least that had some initial success, and a faint hope of long-term victory. The war on drugs has neither of those virtues, but it sure costs us a lot of money, not only in the direct costs, but in increased social welfare caused by having such a large proportion of men who are effectively unable to provide for their families because of their criminal records.

Taxes
In general, we need to keep taxes reasonably low. Economist Alberto Alesina recently reported on a study that compared the economic effects of high spending vs. low taxes.

Our paper looks at the 107 large fiscal adjustments—defined as a cyclically adjusted deficit reduction of at least 1.5% in one year—that took place in 21 Organization for Economic Cooperation and Development (OECD) countries between 1970 and 2007. …

Our results were striking: Over nearly 40 years, expansionary adjustments were based mostly on spending cuts, while recessionary adjustments were based mostly on tax increases. … In addition, adjustments based on spending cuts were accompanied by longer-lasting reductions in ratios of debt to GDP.

In the same paper we also examined years of large fiscal expansions, defined as increases in the cyclically adjusted deficit by at least 1.5% of GDP. Over 91 such cases, we found that tax cuts were much more expansionary than spending increases.

So tax cuts are a better bet for the long-term than spending increases. But I still advocate for a bit of a mix of tax increases and spending cut–it seemed to work for both Bush I and Clinton in reducing the deficits of the Reagan era. I would not advocate large tax increases, however. What I think is both an economically defensible and politically viable path is to extend the middle class tax cuts while allowing the upper class tax cuts to expire. Yes, there’ll be a lot of screaming, but the rich would still be paying a lower effective rate than they did a couple generations ago, and I think that rate has proven compatible with solid economic growth.

By the way, for those who critiqued my investor uncertainty thesis, here’s this from Alesina:

How can spending cuts be expansionary? First, they signal that tax increases will not occur in the future, or that if they do they will be smaller. A credible plan to reduce government outlays significantly changes expectations of future tax liabilities. This, in turn, shifts people’s behavior. Consumers and especially investors are more willing to spend if they expect that spending and taxes will remain limited over a sustained period of time.

You’re free to disagree, of course. At some level this is a mere appeal to authority. I just want to note, particularly for those who do not yet know me, that on these matters I do tend to rely on the expertise of real economists, rather than just make it up on my own. (Economists disagree among themselves, of course, so we could easily play a game of competing economists, but my point is that I promise you that you can generally rely on my having done some homework on these issue, rather than just speaking off the cuff.)

2. Changing the Expectations
Now to be contrary, there has to be one area where we shake up and reduce investor confidence, and that is that we need to eliminate bailouts. I can provide no solid evidence for this, but I have become persuaded that a fundamental part of our continuing economic problem is the moral hazard created by the near certainty of government bailouts for large failing firms. The “too big to fail” phenomenon has to be countered. The Obama administration (and the Fed) actually exacerbated this problem by bailing out a number of large firms, and by consolidating failed banks with surviving ones to actually increase the net size of the remaining banks. If the reason it was necessary to bail out the banks was because the collapse of any one of them might have sent irreversible shock waves through the financial sector, causing a wholesale financial collapse (which I think was a reasonable possibility, and so the fear of it was well placed), then further increasing that fundamental fragility was a move of astonishing short-sightedness.

That’s not just true of banks. Many people are now touting GM’s looming IPO–optimism about which has grown markedly in recent weeks–as evidence of the wisdom of the bailouts. After all, a complete collapse of GM would have indisputably have sent Michigan into a Depression-level economic freefall (as if things aren’t bad enough here already). But GM’s far from out of the woods. The bailout and bankruptcy has allowed them to improve their cost structure, and they have wisely eliminated some brands. But the question remains as to whether they’re going to be able to change their corporate culture, which was the real problem. Astonishingly, they spent years selling cars at a loss just to maintain market share, rather than focusing on a profitable niche. Have they really changed? It’s possible, but far from certain. We also helped bail out Chrysler, and that’s the second time we’ve had to do that. Clearly the first bailout of Chrysler was not a true success, unless we count struggling through until the next bailout to constitute a successful business.

We’ve been through this before, with the S&L bailout. The S&L problem was created by changing the rules governing them so that they could be more aggressive in making loans, seeking higher rates of return, but still insuring investors’ deposits. The result is fairly predictable–it’s like buying your 16 year old a car and saying, don’t worry, if anything happens to it I’ll buy you a new one.

We need to develop the cojones to let businesses fail, even big ones. We need people to suffer for their mistakes, so that they are more cautious in their future decisions. Instead of seeking the next economic boom, we need to condition ourselves to looking for steady, not spectacular, economic growth.

The problem for government is that even if it tries to signal that it won’t rescue any more large firms, it has trouble establishing credible commitment–that is, really making people believe it. We all know that the next election could bring in someone unwilling to abide by predecessors’ promises, and we all know that the prospect of re-election can pressure even the promise-maker to renege. The difficulty of democratic governments establishing credible commitment is one of the important lessons from the field of public choice theory.

3. Odds and Ends
We need to consider something like the proposed Economic Responsibility act proposed for Britain by Eamonn Butler:

This briefing calls on the next government to pass an Economic Responsibility Act, which would place legally binding restraints on government’s fiscal policies. Specifically, it would: (1) cap government spending at one-third of GDP; (2) cap the budget deficit at 3% of GDP; (3) cap the national debt at 40% of GDP; (4) require that off-balance-sheet obligations were fully calculated and openly stated; and (5) allow government to borrow only to invest in capital projects, not to fund current expenditure. This briefing also recommends that new rules be introduced to limit government’s ability to raise taxes.

Those details can certainly be quibbled with. I won’t make any pretense of being expert enough to take a stand on any specific GDP figures, but the general concept of such target is, I believe, a good one. I do definitely agree with #4 (fully calculating and openly stating, rather than hiding, off-balance-sheet obligations) and #5 (borrowing only for capital projects, not for funding of current expenditures–even though money is fungible, this would still help constrain debt so that it correlates with investment projects, not simply supporting day-to-day operations).

Do I expect any of this to happen? No, not even if the Republicans take over the whole government in 2012. While our politicians speak about the need to make changes, they refuse to get serious about actually specifying any. Witness the post-election posturing of John Boehner, who spent the campaign season demanding spending cuts, but then refused to publicly suggest any, sloughing that responsibility off on the president because “the president sets the agenda.” That’s not an entirely false statement, but you know damn well Boehner’s efforts over the next two years are going to be to absolutely obstruct Obama’s agenda, so he’s not really taking the president’s agenda-setting capacity seriously, he’s just using it as cover for his own fear of taking the lead.

And conservatives, despite their public claims to being fiscally responsible, have not shown any inclination toward fiscal responsibility in more than a quarter century. Although the Democrats controlled much of Congress throughout Reagan’s presidency, not only did they sometimes actually reduce the deficits of his proposed budgets, but he passed his budgets with a combination of Republicans and conservative southern Democrats–the boll weevils who would mostly jump to the Republican Party after that party’s 1994 takeover of the House. Shallow political commentators (George Will has done this) continue to criticize the Democratic liberals for the actions of those southern dems (especially their obstruction of civil rights), but sophisticated and honest political observers know that it is the ideological position that counted, not the party label. They were conservatives as Democrats, and they’re conservatives now as Republicans (in fact they’re responsible for the disturbing right-ward shift of the Republican Party).

It was a conservative president who pushed through the budget destroying Medicare prescription drug program (although to be fair, many congressional conservatives were not supportive, and it required the support of liberals to pass). And it was conservatives who used 9/11 as justification to ratchet up discretionary non-defense spending like mad between 2002 and 2006.

Republicans as a group aren’t serious about cutting government expenditures. They’re only interested in cutting spending on things the Democrats want and shifting it to the things they want.

But if we want to give ourselves better future economic prospects, we need to take our medicine now and bring our budgets down to a manageable level. It may take a constitutional amendment to make this happen, as whatever good rules Congress sets up–like the former pay as you go rules–they can just override with a simple majority vote. That is, Congress literally cannot discipline itself, and the public gives no evidence of wanting to discipline it in regular elections, so constitutional disciplines may be our only prospect for substantive change.

Obviously any proposal like this can’t hope to be accepted without objection. Paul Krugman has presumptively responded even without reading me (without even, I’m sure, being aware of my existence). And politicians in both parties have already signaled their refusal to consider such fundamental changes. Based on the response to my prior post (and what a different crowd this is than I’m used to from my time at Positive Liberty and The One Best Way!), I’m sure many here will have objections, too. Well, I’m out of town for the rest of the week, and won’t be able to respond. So have at it. Feel free to give it to me with the bark on.