February 29, 2012

The Austerity Morass

Who has handled the economic crisis worse, the European Union or the United States?

A close look at the economic woes at home and abroad raises this unedifying question: who has proved more inept at handling the current economic crisis, the European Union or the United States? To Paul Krugman, this question has an easy answer: The Europeans for their maddening insistence on fiscal austerity when large government expenditures and credit infusions are needed to prop up a sagging economy. With fiendish glee, Krugman denounces the EU’s austerity measures as “pain without gain.”

The spending cuts of the EU nations, Krugman argues, have shrunk their economies, without offering any prospect of generating long-term growth. The Europeans, it seems, have emulated the worst of President Herbert Hoover’s skinflint budgets that helped prolong the Great Depression. The United States, which this time around has been more liberal with the purse, has suffered far less damage than the EU, which shunned Keynesian prescriptions.

Epstein
Illustration by Barbara Kelley

Krugman’s cryptic Hoover reference is telling. In addition to worshiping balanced budgets, Hoover got economic policy wrong time and again. On trade, he acquiesced to the 1930 Smoot-Hawley Tariff; on labor, he signed on to the Davis-Bacon Act of 1931, which calls for “prevailing [i.e. union] wages” on government funded projects; on taxation, he championed the Revenue Act of 1932, which raised the top tax bracket to 62 percent; more globally, he stubbornly accepted the general deflation of the time. The combined effect of these various measures did much to deepen and prolong the Great Depression. His policies sadly misfired in so many directions that it is difficult to attribute his disastrous presidency to any one factor.

Krugman would do well to dwell on the multiple mistakes of the Hoover presidency. Yet, in his monochromatic way, he focuses in on only one piece of the larger mosaic: that governments here and abroad are not spending enough. For the United States, Krugman advocates for large transfers of federal revenues to the states to provide a large shot in the arm to local governments, putting them in a position “to rehire the hundreds of thousands of schoolteachers they have laid off and restart the building and maintenance projects they have canceled.”

The federal government’s trillion dollar deficits can wait for another day when interest rates start to rise. His dismissive views on the deficit match those of his colleague at Princeton, economist Alan Blinder, who acknowledges that sometime in the future, it will be necessary to right the deficit ship—but not until at least five years from now. Enjoy the low interest rates while the getting is good.

Simply put, we must reduce public expenditures and grow the economy.

If this single-minded perspective sounds too good to be true, that’s because it is. The deep errors of both of these economists need some close attention.

The first question that one has to face is the trade-off between long- and short-term considerations. Let us assume for the sake of argument that short-term borrowing is now available at attractive rates, even as it has pushed the U.S. deficit to over $1.2 trillion per year for each of the past three years and counting. Even if we don’t share Hoover’s obsession with a balanced budget, sooner or later, we are going to have to reverse course before the cumulative deficits become unsustainable. Some years out, newly refinanced short-term debt will carry higher interest rates, with nobody around to bail us out.

To be sure, some of this debt is held internally, so that, in a sense, we are just taxing ourselves to pay ourselves. The sunny view is that these payments will just be one giant wash. That point ignores the large amount of foreign debt in the mix. It also underestimates the explosive domestic situation. The collective “we” only functions as a harmonious unit if the proportion of the debt held by everyone is identical to the fractional shares of the tax liability needed to service it.

Unfortunately, that benign assumption is empirically wrong because there is no reason to think that all wealthy individuals or large pension funds are equally invested in government debt. Hence, the high debt will initiate a domestic struggle as to who gets left holding the bag, as political factions work overtime to push the debt toward other groups. That struggle itself will dissipate still more wealth. In all likelihood, new taxes will, again, fall disproportionately on high-income taxpayers, assuming that their dwindling wealth is not used for propping up, as economist Charles Blahous notes in his recent Defining Ideas column, the social security system, or, for that matter, paying for universal education and health care. Even the Obama administration cannot wring tax revenues out of a stone.

The fight over distribution therefore will do nothing to stop the long-term deficit. Sooner rather than later, the debt burden will no longer be supportable. There are only two ways to reduce that debt. The first is to reduce public expenditures. The second is to grow the economy. The two turn out to be opposite sides of the same coin, which is why under current policies neither is likely to happen.

It takes a stupendous failure to get the left and right to coalesce around a repeal agenda.

Regarding the former, the collapse of the recent bipartisan negotiations on debt reduction showed just how hard it is to cut funding from entrenched government programs. The fundamental theorem in this politics game is that a good defense stops a good offense, whether we are debating farm-subsidies, zoning, or labor relations: each interest group swears that its special deal is fully justified and necessary in order to stave off the demonic market. It takes a stupendous failure, like the misconceived ethanol subsidy, to get the left and right to coalesce around a repeal agenda.

Blinder does not share this grim view. Rather, he takes some solace in claiming that the deficit can be brought under control in time, if we only can domesticate the elephant in the closet, which is our current health-care system, whose voracious appetite eats an ever larger part of the GDP each passing year. But who is he kidding? Medicare is a sacred cow, and no one will be able to put a dent in it anytime soon. Medicaid is a worse problem because Obamacare takes strong steps to expand eligibility under the program to cover an estimated 17 million more individuals, while forbidding the states to cut down on the benefits to existing Medicaid recipients.

The private exchanges, which are the darling of the health-care law, are so heavily regulated in what they must provide and how they can compete, that its dysfunctional markets will drive more people into a public system that will not be able to support them. Nonetheless, the law cannot fund these new obligations on a sustainable basis. Unfortunately, the financing problem will reach its zenith exactly at the same time that Blinder and Krugman propose we go into deficit reduction mode. The deficit ship cannot be made to turn on a dime. Unless some preparations for deficit reduction are made today, it will be too late to address the problem tomorrow.

In the face of these chronic deficits, what good can come of another massive round of transfer payments to the states? No good whatsoever, unless there are fundamental structural reforms regarding how states deliver their services. But Krugman turns a blind eye to this difficulty. His uncritical praise of those thousands of teachers who have lost their jobs makes it appear as though our system of public employment is in fine shape, when the reality is that it cries out for major overhaul.

It is simply foolish for the federal government to borrow money that it will turn over to the states so that they can perpetuate a system that has proved itself utterly incapable of reigning in expensive health-care and pension obligations to public employees. Following Krugman’s course will only worsen the economic situation. In five years time, stagnation will remain, but there won’t be any federal money to spend on stimulus.

Even the Obama administration cannot wring tax revenues out of a stone.

Public unions are not the only problem. Private labor markets in the United States have not descended into the regulatory abyss seen on the continent, but they are still far from perfect in their operations. As such, they are hindering the pro-growth stance needed to make a dent in the deficit. The toxic combination of the minimum wage, overtime pay, maximum hour regulations, antidiscrimination laws, labor statutes, family leave acts, and, most of all, the huge financial overhang from Obamacare, have combined to induce would-be employers to scale back on their plans for the future. This, in turn, has led to a feeble level of growth coupled with a decline in the standard of living for the middle class.

These mid-level distortions are not confined to labor markets. State and federal regulations have imposed large costs on the real estate markets, too, which are burdened with petty local zoning restrictions and aggressive environmental restrictions at the local and national level.

It is hard to see how any changes in our economic fortunes will occur with the Obama administration pushing its toxic combination of high taxes, regressive labor policies, and rearguard resistance to free trade. The president’s recent tax proposal contain a welcome measure to lower the general corporate tax rate to 28 percent, but is otherwise larded with so many gimmicks—like carving out special rates for privileged domestic manufacturing programs and “extend[ing], consolidat[ing], and enhanc[ing] key tax incentives to encourage investment in clean energy”—that it will surely be another loser of a policy.

None of this dithering is likely to do much good for stimulating the growth we need to bring the deficit back into line. But don’t take my word for it. In speaking of the deficits, Krugman heaps praise on Mario Draghi, the incoming president of the European Central Bank, for opening up the credit lines to Greece, Italy, and Spain. Given that, it is worth noting that Draghi recently had some choice words to say about these matters to the Wall Street Journal:

[Draghi] said Europe's vaunted social model—which places a premium on job security and generous safety nets—is "already gone," citing high youth unemployment; in Spain, it tops 50%. He urged overhauls to boost job creation for young people.

There are no quick fixes to Europe's problems . . . He argued instead that continuing economic shocks would force countries into structural changes in labor markets and other aspects of the economy, to return to long-term prosperity.

No surprises here. Draghi’s candid admission of the European model’s defeat illustrates the danger in social safety nets. These can cushion individuals from shock in the short run, but the balance is not sustainable in the long run. Too many people climb into the nets, leaving too few productive individuals to support them. The only structural changes worth thinking about are those that, in guaranteed entitlements, restore the power of employers to hire and fire at will, and those that cut the power of private and public unions to bring the economy to its knees with well-timed strikes. On those tough issues, we have radio silences from Krugman and Blinder. The optimists among us could say that someone like Draghi might have the fortitude to impose the types of restrictions that Krugman and Blinder cannot stomach. But the issue, unfortunately, is not just one about resoluteness in the face of economic disintegration.

The larger question is one of incentives. The first round of debt renegotiations is complete. The Greek government has been released from over half of its debts. As the Journal reports, Commerzbank AG Chief Executive Martin Blessing did not take gracefully to his financial haircut, which he denounced, appropriately enough, "as voluntary as a confession during the Spanish Inquisition." Now that Greece has gotten its way, why should it reform its economic policies when there are riots in the streets of Athens from those who think that they can restore the status quo ante?

In the end, the real tragedy of profligate policies is not whether they will work, but that they will put off the necessary austerity measures that will lead us out of the financial wilderness. If we keep up with the current dithering on these structural reforms, then we will have our next brutal round of austerity in the United States and European Union out of necessity, not choice.


Richard A. Epstein, Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, Laurence A. Tisch Professor of Law at New York University, and senior lecturer at the University of Chicago, researches and writes on a broad range of constitutional, economic, historical, and philosophical subjects. He has taught administrative law, antitrust law, communications law, constitutional law, corporate law, criminal law, employment discrimination law, environmental law, food and drug law, health law, labor law, Roman law, real estate development and finance, and individual and corporate taxation. His publications cover an equally broad range of topics. His most recent book, published in 2013, is The Classical Liberal Constitution: The Uncertain Quest for Limited Government (2013). He is a past editor of the Journal of Legal Studies (1981–91) and the Journal of Law and Economics (1991–2001).


Letters to the editor

What Is the 'European Model'?

Richard Epstein's recent article, "The Austerity Morass," argues that the European Model has been defeated and speaks of "the danger in social safety nets." This argument falsely conflates the very real problems of Greece and, to a lesser extent, Spain and Italy, with the general notion that safety nets are somehow unwise policy. I ask Mr. Epstein to define what, exactly, he means by the defeat of the European Model? Last I checked, the Nordic countries excelled at nearly every cross national measure of human progress, all while generally maintaining both budget surpluses (at least until the onset of the current global recession) and some of the world's highest levels of public expenditure. Does Mr. Epstein not consider the Nordic countries part of European Model? Or are his conclusions based on ideology instead of data?

---Nicholas Kaasik


Letters to the editor may be sent to definingideas@stanford.edu. Editors reserve the right to reject or publish (and edit) letters.