Notes on BALANCE by Glenn Hubbard & Tim Kane –
The book is a review of the experience of great powers in world history and the political and economic lessons to be learned from studying them.
Two thousand years ago, Rome was a stable and prosperous civilization. After 3 centuries of decline from the relentless stagnation of its politics and economic vitality, Rome collapsed. It took a thousand years for civilization and economic prosperity to recover to Rome’s level at its peak.
The decline of Rome was not caused by imperial overstretch or external threat. An examination of history from ancient empires to modern Europe shows that the threat to great civilizations is less barbarians at the gates than self-inflicted economic imbalance within. Over centralization of political power is a common factor in imperial decline. Even when ignorance is not a factor, perverse incentives are. For example, we are well aware of the grave threat to the United States from its runaway national debt. Many plans to fix the U.S Federal Budget would work in a technical sense, but none can be enacted. Our political institutions cannot accommodate them.
The interaction of economics and politics is the game – with governments competing to find the right balance of laws and behaviors that would yield maximum prosperity with minimum instability.
There is a rising fiscal imbalance in nearly every advanced industrial economy. What changed to make the U.S debt level alarming was entitlement spending. In 1971, Medicare and Medicaid cost $11 billion, 1 percent of GDP; in 2010 their combined cost was $793 billion, 5.5% of GDP. Adding social security gets it to 10% of GDP. The CBO projects the 3 programs will cost 15% of GDP by 2030.
The symptoms and causes of the debt crisis for every western nation are well known, but the solutions are difficult, because the political structures that support the entitlements responsible will not allow them to be reformed in a way that is sustainable. We could change the rules of the budgetary game through a fiscal amendment to the Constitution.
Great power decline almost always follows the same pattern; denying the internal nature of the stagnation, centralizing power, and mortgaging the future to overspend on the present. Most nations are born and sustained by overcoming crisis. Sweden proved that welfare states can succeed with reforms and Greece seems determined to show how reform can fail.
The economic crisis now is a much bigger storm than most people realize, and slower; making it more dangerous. The world economic system is brittle, with demographics and debt compounding the risks. When great powers in the past declined, they were rarely replaced by challengers. When Rome failed, the world went dark for a thousand years.
Modern economic growth theory suggests that the miracle economies of Asia should be the norm because ideas flow freely and are copyable. Any economy should be able to adopt existing technologies – the best known successful ideas that others have discovered.
GNP is the market value of all final goods and services. Neither used goods nor intermediate goods count. In 1991, we changed from GNP to GDP to include goods made in foreign owned factories in the United States.
Economics has been improving for decades in understanding the business cycle, but has failed for years in its analysis of macro trends. PWT stands for Penn World Table, a huge data base of benchmark comparisons. Angus Maddison developed an enormous amount of historical economic data on countries going back two thousand years. His data shows the growth of Soviet GDP from 1950-73 did exceed the U.S growth average, but collapsed soon after. They grew by exhausting physical resources, ignoring pollution, human welfare, investments in technology and workers’ skills. Per capita output and income were lower in 2000 than in 1973.
There is a correlation between capital investment and growth rates, but it is growth that starts first and investment follows. The book, Why Nations Fail, by Acemogou and Robinson, explains that the foundation for all the various economic variables is institutions. A society’s economic institutions – property rights, work rules, market freedom – are the main factors that define relative prosperity and growth. There are three main types of growth defined economically. The first is Smithian Growth, resulting from specialization of labor. The second is growth from investment, or Solovian Growth. The third is Schumpeterian Growth, which is innovation sparked growth – technology and ideas – better ways of doing things.
Politics explains human progress more than anything else. Technology is a key cause of growth, but it stands on a foundation of institutions. Invention is common, but innovation rare. The successful commercial exploitation and subsequent diffusion of inventions make all the difference economically. Institutions explain innovation. Without the right institutions there is little benefit from invention because its use does not spread. Invention itself relies on institutional ingredients – a free market and a legal system that defends intellectual property, and a stable currency. All three types of growth rest on a foundation of institutions. Rome’s growth came from the benefits of scale through well supplied cities, through trade networks, secure borders, respect for law and public works. When the institutional development stagnated, so did growth.
Economic power is the foundation of military power. A reduction in military outlays does not automatically translate into a higher growth rate, nor is a higher growth rate incompatible with high military expenditures.
The authors have developed a measure of economic power.
Economic power = GDP X productivity X the square root of the growth rate
Productivity, used here, is the GDP per capita. For the formula’s math, GDP per capita is shown in thousands and total GDP in trillions. So $41,000 GDP per capita equals 41 and 12 trillion GDP equals 12.
History indicates that the biggest threat to great powers is not rising adversaries, empire overstretch, or misallocation between military and economic investment. Great powers lose their leadership when they stop pushing the technological frontier. A nation’s military power comes from its economic productivity. That’s what made England, a tiny country, so powerful when it started the Industrial Revolution. Relative economic power is important. Great power decline is fundamentally economic in nature and economic decline is a consequence of stagnant institutions; primarily, when the political system’s bias is status-quo inaction. Economic imbalance occurs because states stagnate politically. A society needs good rules to govern human passions in all its markets. Many times in history empires and nations did reform their institutions to save themselves.
Only by the 1970’s, did living standards begin to approximate todays. There is a powerful, undeniable path of progress in the human condition. Human behavioral factors on an aggregate level seem to cause the imbalance of nations. Consideration of social factors is just as important as the application of hard power metrics.
Two economists at RAND, Flood and Dreasher, developed the Game Theory version of Prisoner’s Dilemma. The model helped prove that people acted in ways that were harmful to the market and to the individuals themselves. Game Theory transformed micro economics and has been invaluable in the development of nuclear strategy, international finance, and public policy.
Keynesianism is an over simplified macro-economic model that became dominant in the 1960’s and seventy’s, but has been discredited by empirical experience since, though it has recently regained popularity. Keynesianism is used to justify fiscal deficits to increase demand, but it morphed into permanent stimulus. Keynesianism did not anticipate stagflation, or offer a way out of the mess. Robert Lucas developed a hypothesis emphasizing the role of expectations and shows why Keynesianism is flawed as theory. Keynesianism is so popular with politicians because it justifies their doing what they wanted to do in the first place – spend more money.
Game Theory in microeconomics and Expectation Theory in macroeconomics fundamentally shifted how economists think. Analysis of the behavior of the real world measured against hard data is essential to policy.
Behavioral Economics is the study of situations in which people make choices that do not appear economically rational. Bounded Rationality means that people have a limited endowment of time, information, and brain power so, instead of trying to maximize outcomes, they seek good enough. Bounded Rationality encourages irrational fads and following the crowd. The way constrained brains think forces humans to use heuristics, logical short cuts to decision making.
The objective for most legislators is not maximizing economic growth in the long term, but maximizing re-election in the short term. The legislator is often also unaware of what the best policy choice might be. Most legislators are smart and able, but simply don’t have enough time or experience to make a fully informed choice, because the choices they have to make are so numerous and so tremendously varied. Gordon Tullock is one of the fathers of Public Choice Theory – “In the case of politics, the information problem is much worse than it is in the market.” The political information problem leads to political parties with brands. Economic truth is never fully revealed, and policy making is a very tricky endeavor, because of a) ignorance of what is the right policy and b) political incentives that discourage use of the best policy. The boundaries of economic rationality afflict every great power in decline because they don’t know what truly fuels their economy, or if they do, they are politically constrained from properly addressing it.
Every nation must mind its institutions if it hopes to develop. Norms are a powerful source of motivation and drive life changing decisions. Identity can help explain a wealth of counterintuitive economic behaviors. Our class, faction, religion, and creed affect our identity, and identity groups within states, especially democracies, harden over time into ideologically rigid political identities. Rigid political identities prohibit consensual progress so that institutional reform, short of revolution, becomes impossible. Norms can become a barrier to economic progress. The American brand that emphasizes limited central power is eroding.
There’s a strong correlation between children’s impulse control and their later academic success. Nations act the same way, those that build strong economies orient themselves to long term payoffs even though this requires short term pain.
Behavioral economics has discovered a range of irrational instincts. Humans are not statistically intuitive, i.e., naturally numerate. They are not the statistically intuitive rational agents of high theory – they don’t act like high theory thinks they do. Prospect Theory says that humans are guided by the immediate emotional impact of gains and losses, not by long term prospects of wealth and global utility. A collective sense of loss aversion makes countries hesitant to change their economies. Politically, campaigns target loss aversion by shirking from fundamental reforms, especially detailed reform proposals. Our inability to weigh choices rationally across time also occurs in the aggregate.
Short term election cycles bracket legislator’s time preferences, and their discounting of larger horizons is arguably total. This is a response to voter time preferences, so the voters are ultimately to blame.
Change is hard. National institutions are the key to a balanced economy, but behavioral economics suggests there are social political barriers to long term prosperity.
Major changes should never be made without sufficient evidence of their worth shown through research and experimentation.
Our news cycle is one big culprit in our loss of long term perspective. Economists know that a nation’s economic institutions are ultimately what determine higher productivity levels and growth rates. Virtually, no one thinks Keynesianism will help a nation’s long term growth.
Economic and industrial revolution began in England around 1750 because England had created the institutions that allowed entrepreneurship to flourish. Institutional changes protecting freedom and property rights gave entrepreneurs the incentives to make the most of technological inventions.
Economies pursue anti-growth strategies because of political considerations. Political constituencies are created that support bad policies. Reforms in favor of growth need to create coalitions to overrule privileged interests. Static economies are dominated by Rent Seeking coalitions. Rent Seeking describes a group that manipulates the rules of government to their advantage. Monopolistic firms and labor unions are natural rent seekers. Countries that prosper have institutional explanations: national security, order, the rule of law, independent judiciary, stable currency, well developed capital markets, and secure property rights. Countries that don’t have them fail. Political institutions can be inclusive with broadly shared political power or extractive with concentrated political power. There’s a connection between inclusive economic and political institutions and economic prosperity. Extractive institutions fail to protect property rights and reward incumbent firms and interest groups.
Great power decline happens when political institutions are unable to adapt to changing economic realities. To keep growing, a society has to keep modernizing its physical and intellectual infrastructure, but it also has to continue to modernize its institutions, and especially its political institutions. Although the runaway U.S fiscal crisis is occurring in an economy with inclusive economic and political institutions, the modern politically inspired creation of special interest groups, whose members take far more from government than they contribute to it, is transforming America into a country with the characteristics of one with extractive institutions.
The World Bank has developed a doing business index that is really helpful to economic analysis in comparing countries.
The real challenge is when political institutions become stagnant, making economic evolution impossible. Every decade that a great power can maintain balance is a triumph because the pressures to fall are natural, powerful, and constant.
CHAPTER on Rome
No society approached Rome’s degree of technological sophistication for over a thousand years.
The one political institution that may explain the Roman Empire’s longevity is hostility toward hereditary rule. The Roman state left member cities administratively independent, so they were self-governing. Rome had a federalist government structure. No Roman institution was more important than its legal system, particularly, its protection of property rights. Rome had unique trading markets, and an institution that was a forerunner of the modern corporation.
Rome’s decline was accompanied by a collapse of scale in its vast trading markets. Without scale, specialization dried up. Rome suffered three centuries of self-inflicted economic wounds before its fifth century collapse. These wounds included food subsidies, rising taxation, inflation, and ultimately, state socialism. The barbarian invasion was a culmination of three centuries of deterioration in the fiscal capacity of the state. Only in the centuries after its internal economic stagnation did Rome’s foreign threats prevail. Its imbalance was its inability to match its fiscal outlays with available resources, which led to monetary debasement and coercive central planning. All this was accompanied by weakening of its constitutional institutions.
Security is the essential public good, but transportation, common currency, and basic utilities are all necessary conditions to enable private economic prosperity.
Hadrian effectively bribed cities to sell their independence by funding their financial burdens directly from the central treasury; providing early confirmation of the theory of Moral Hazard.
As large as the Roman Empire was, until the last stages, the economy was largely unregulated by government. There was almost complete freedom for trade and private initiative. Deficit spending was not an option because treasury bonds had not been invented. Around AD 200, the legions were given bonuses by each new emperor, so had a perverse incentive to assassinate the emperor. Repeated dilutions of the purity of the coinage resulted in ruinous inflation and elimination of coin trade, so trade reverted to barter. Without money, long term trade is impossible. With the decline of trade economic prosperity contracted. In AD 300, Diocletian instituted ruinous price controls, restrictions of trade, increased centralized bureaucracy, and killed labor flexibility.
Mancur Olson, in his book, The Rise and Decline of Nations, explained how special interest groups form naturally in a society to protect their status at the expense of the greater good. Labor unions, monopolistic corporations, trade groups, etc. lobby for policies that secure rents through subsidies and by limiting competition. A natural problem in democracy is that policies with high gains to narrow interests and small costs to the general public have more effective political support than policies where the benefits are more widely distributed. Over time institutions benefiting from such policies become thickets of rent seeking.
Eventually, the military gained complete control over Roman imperial succession and the legions adopted rent seeking tactics at the expense of stability, prosperity, liberty of the citizens, and national security. These drove an escalation of taxes that destroyed the tax base, the currency, and the money economy. The later Roman emperors’ ignorance of how economically damaging their rule changes were set up Roman civilization for epic failure. The ignorance of inflation costs, of scale economies, and of the dangers of rent seeking and of nationalizing industries, was tragic.
Emperors’ ignorance of moral hazards set bad precedents, the most remarkable of which follows. Each new emperor, in the later years of the empire, forgave all private debts of citizens to the state. Lesson one, borrow heavily and don’t pay your debt while the emperor lives. Lesson two, kill the emperor often.
CHAPTER on China
For two thousand years, China was ruled by the Confucian Party, which emphasized tradition, virtue, and benevolence; but China never generated a rule of law or mechanisms of political accountability. There were no corporate bodies outside the state and no independent cities. The corporation is a keystone institution in western economies. It enables innovation and competition, and normalizes failure without personal bankruptcy, etc. Without the key elements of commerce provided in law, Chinas great inventions were never effectively capitalized on. Chinese government was always managed hierarchically, where local political arrangements were agents of the center. Firmness of Chinese culture explains the perseverance of its great power.
China suffered from the high cost of its centralized bureaucracy. China, with its numerous important inventions, had great potential to make the technological leap to the industrial revolution, but was unable to capitalize on them commercially because of its institutional inability to support innovation. China began a rapid decline by 1500 when it abandoned its Navy and oceangoing commercial fleet. The Navy and foreign trade were controlled by one of the two most powerful groups in Chinese government. The rival group succeeded in passing laws to eliminate the primary source of their rivals’ power and income.
The Mandarin order, with its well-defined interest groups, locked the political and economic institutions into inflexibility. Politics explain China’s decline and the same story can be told about any great power. Institutional senescence doomed Ming China. The dangers from centralization of administration can’t be overstated. The political institution of Chinese governance morphed into a zero sum struggle for influence among interest groups. The modern Chinese economy remains centrally organized rather than federally, which makes institutional progress less likely.
Chapter on SPAIN
An executive with unrestrained ability to raise the national debt practically guarantees fiscal chaos.
The industrial Revolution followed rather than preceded structural change in property rights.
Labor freedom is the mother of labor productivity.
Large government risks distorting the broader economy in many ways, taxation being the most obvious. The secondary effect of expansive fiscal activity is crowding out – discouraging private investment by higher interest rates. The broader theory applies to any state action that distorts economic incentives. Spain distorted the market for talent with the Inquisition by driving out innovators in business, science, and technology; and its policies shifted the most talented labor from entrepreneurship and business to military and government employment.
Great Power Imbalance Theory holds that political decay locks a society into a status quo economy resistant to productivity growth through disruptive new technologies. Spain set back development in its colonies by establishing anti-growth institutions in Latin American that still haunt today.
CHAPTER on the Ottoman Empire
In the 16th century, the Turks were the most civilized people in the world in many ways. The Janissaries became rent seekers over the centuries and eventually became the de facto rulers. They became the king makers and the primary rent seekers. The Janissary Corps was the institution most responsible for the political stagnation of the Ottoman Empire. They held up all kinds of reforms that would have let the empire modernize.
CHAPTER on Japan
The East Asian miracle was a contagion of double digit growth rates in nearly a dozen countries. In the Pacific region during the 1960’s and 70’s, these countries pursued a set of common institutions and policies that started in Tokyo. All these countries copied features of Japan’s state managed export oriented economy. The Japanese model emphasized free markets for final goods that were supplied by government guided private corporations. There were close links between Japan’s industrial elite, liberal Democratic Party politicians, big business, and the banking system. Culture was a factor with the higher savings rate and a strong work ethic. Japan’s large firms exceled in marginal innovation through R&D, but not in the type of pioneering innovation common in America. There’s a big difference between catch up capitalism and entrepreneurial capitalism. The catch up model relies on centralized management of industry, export manipulation, and heavy infrastructure investments. These approaches stop being effective for an economy near the innovation frontier. Such an economy needs decentralized competition in cutting edge sectors, an abandonment of government policy of picking winners, a strong consumer culture, and relatively lower government expenditures. Japan’s root problem is that their interest groups aligned against sectorial evolution of the economy, and that government in Tokyo has totally centralized control over the regulatory environment. There is no competition between cities and prefectures to experiment with different regulatory and tax environments.
Japans dilemma confirms the thesis that economic imbalance is rooted in political stagnation. Rent seeking by a coalition of big companies, big banks, and political elites have kept the political system from making structural reforms. Lacking a federal structure for its politics, Japan’s local governments cannot provide the institutional experimentation which might foster the entrepreneurial leap. The Asian model developed by Japan is fine for a country aiming to catch up to the technological frontier, but not for surpassing it.
CHAPTER on Britain
Britain’s industrial revolution was fueled by a tremendous expansion of opportunity for low income labor to use capital equipment, and consequently enjoy a higher level of productivity and pay. There were mutually reinforcing liberalizations in governments, property rights, culture, commerce, religion, and science a full century before 1820. Britain’s economic power increased twenty fold in only eight decades. Adam Smith predicted that British America would become one of the greatest empires ever if it became independent, and urged that Britain should allow American representatives in Parliament.
Britain’s expansive national health system is a cautionary tale, expensive to the taxpayer, famously inefficient, and difficult to reform.
CHAPTER on EUROPA
Perhaps because the continent was fractured into competing polities, Europe’s aggregate economic power made it the unraveled leader of the world – pioneering in the sciences, domineering in war, and imperial in diplomacy; but was the scene of one tragedy after another in the 20th century – almost unimaginable horrors, forced starvation, genocide, and total wars.
The Nazis’ technological achievements were based on excellent German universities developed long before Hitler’s dictatorship. Nazism represents a governing philosophy hostile to growth. It stood for central authority and a heavy handed role for the state. It had little appreciation for the entrepreneur. Growth of Nazism in Germany and Fascism in Italy followed a familiar model – the statist takeover. When a government transitions to a more interventionist role, transforming a free economy to a command economy, it thrives on a one time extraction of wealth from formerly independent private companies, but like any sudden wealth tax, confiscation by a dictator diminishes the incentives of the private sector to create wealth going forward.
The Nazi economy with its statist model would have slowed and imploded eventually, but a longer lived statist economy did exist, the Soviet Union. It attempted to plan and command the total supply of goods through a centralized committee in Moscow known as Gosplan. Moscow issued orders for every conceivable product. Prices did not reflect market equilibrium, they were accounting tools skewed toward favored products. Soviet slave labor camps were partially for punishment for political non conformity and partly for their industrial utility. Millions died through forced starvation during the forced agricultural collectivization and in concentration camps. By 1940, the Gulag Archipelago had over ten million inmates, with death rates of 10-30% a year. Despite the horror, the Soviet Union grew dramatically.
Statism offers a timeless appeal, but its promise is built on forced labor. Slavery in the private or the public sector is never efficient, let alone moral. Soviet institutions allowed Russia to industrialize quickly at great sacrifice of its people. Its growth was based on a typical short term boost in total GDP at the expense of institutional incentives and it succeeded in catching up to a level about 50% of that of a normal developed economy. Eisenhower understood that a state managed economy wouldn’t work.
The relative growth experience of various nations is profoundly important. Nations have a diverse mixture of institutions that determine their convergence productivity level. Parente and Prescott maintain that the differences in relative income levels between countries are due primarily to countries’ specific policies that either foster or constrain better work practices and production methods. An economy with below average GDP per capita should have an above average growth rate, but for its barriers.
The lure of the Euro for investors and nations alike was a low interest rate on government debt. That assumption of a common interest rate was the fundamental error that led to the Eurozone’s present crisis. Low interest rates created a perverse incentive for member states to borrow excessively, especially when local inflation made real interest rates negative. Investors shouldn’t have assumed that Italian or Greek debt was as safe as German debt simply because they shared a common currency. The convergence of European’s sovereign rates never made sense. Interest rates on America’s states’ bonds are not harmonized; those with weak credit have higher risk ratings and higher interest.
The monetary policy of Europe is being wrongly blamed for the disastrous fiscal policies of some its members. Central Bank crisis loans to Greece would probably have never happened if so much European money were not already invested in Greece. Nearly all members of the European Union have used fiscal deficits to bridge the illusion of permanent prosperity with unaffordable transfers, pensions and public employment programs. The bailout solution for Greece represents a second systemic risk to the Eurozone. It establishes a precedent, another moral hazard. It incentivizes global investors to treat European Union member debt as partially German debt.
At some point, successive deficits, instead of countering a recessionary low in GDP; are merely artificially propping up the economy rather than allowing it to find its natural equilibrium. The performance of dozens of countries, in recent decades, has revealed time and again that austerity, cutting expenditure, does not hinder growth, but tax raising does. Spending austerity can, in fact, encourage private sector investment. The effect of government spending on output lasts only as long as the government spending. German policy makers consistently highlight the importance of upholding the Central Bank’s foundational principles: political independence and controlling the money supply to maintain price stability. Its role should be as lender to the banking system, not to shore up governments. It lacks tools to address structural fiscal problems. The Marshall plan focused on loans to businesses, not grants to governments.
Eurozone trade imbalances between the core and the periphery created an unsustainable dynamic. The World Bank now publishes a Doing Business Report that includes a large number of indicators about the ease of doing business in various countries so that the competitiveness of each can be ranked against the others.
For half a century, the U.S has built increasingly generous features of the welfare state that mimic those in Europe. For the first time we are seeing a vicious cycle in which the unsustainable debts of the future can no longer be rolled over to the next generation.
CHAPTER on California
The agglomeration effect is the natural clustering of human capital in one location like Silicon Valley. California had been reliably Republican since the Party was formed. The tectonic shift occurred in 1992 and underlying demographics kept it shifting left. Democrats outnumber Republicans 43% to 30%. The California political shift is radical because it is an ideological shift from conservative to liberal; not just a party change. The make-up of the voters became more and more liberal reflecting shifting cultural attitudes and a migration of voters. New migrants tend to be liberal and out migrants- conservative. So Democrats in the capital have adopted liberal economic institutions, the most progressive taxes, the most generous welfare programs, and the thorniest regulatory system. Massive debt has become the new normal in California politics.
California has developed institutions that are barriers to growth and ranks 47th or 48th out of 50 in measures of economic freedom. The California economic crisis reveals the political foundations of imbalance. Public workers have such a strong grip on elective officials that they control the rules.
The federal structure is an excellent institutional arrangement for economic growth. Federalism allows internal competition among fifty states in two ways. Competition among state policymakers to see which policies work best, and second, citizens can migrate between states to find the best mix of low taxes and ample public goods. In terms of economic power, California ranks third behind the U.S and China and ahead of every nation in Europe. The concentration of innovation capacity in this one region is profound and unparalleled, but it’s blinded us to the weakness of its fiscal situation, which has been crumbling for decades. It has the tenth largest economy in the world; just a few years ago, it was the fifth.
Cheap foreign imports are much more beneficial to domestic consumers than harmful to domestic producers. It’s a fact that countries more open to trade tend to grow faster and enrich their poorest citizens. The real unfair trade is theft of intellectual property. A globalized world economy that cannot protect intellectual property cannot sustain growth at the technology frontier. The right way to think about governmental competition is to see government’s supplies of public services as competing for migrating taxpayers, consumers, laborers, and capital. Governments are in an unavoidable competition to discover new institutional mixtures.
Fiscal tension is the crux of democracies’ instinct for dysfunction: the incentives for politicians to spend more money than they tax. These pressures are different at each level of government. Whole levels of government resolve the spend/tax tension by paying their work forces with future revenue. The biggest source of red ink that cities face is pensions. Pensions are a budget problem, but changing them appears impossible, a typical behavioral dysfunction of time preference and loss of vision in the extreme. The explosion of compensation through benefits instead of higher salaries makes little sense except for the tax preference and the political incentive to pay with future revenue rather than current. Governments regulate private pension plans under-fundings, but there’s no regulation of governments’. Bargaining power of public employee unions can bankrupt any state. Texas does not allow public sector unions, nor does it have a fiscal crisis.
The looming question is whether the federal government should bail out a state when it can’t handle its debt. If this happens, it will kill federalism.
SUBCHAPTER – Meet The New Praetorians
Economically, California’s fiscal crisis resembles modern Greece, but politically the parallel is Rome and its army’s control over imperial succession in the third century AD. “An emperor would be chosen by a gang and would rule only as so long as he pleased the assassins”. All power during Rome’s political crisis was in the hands of the Praetorian Guard. The public sector unions are California’s Praetorian Guard and the California Teachers Union is the largest and most powerful.
California shows how poorly structured political institutions can lead to a death spiral of economic mismanagement. Budget deficits are cemented with votes for expenditures that have a lower threshold for passage than tax increases.
If a state’s credit markets freeze, should the federal government step in and guarantee a loan to the state? If that happens, the backbone of American federalism will have been broken. It will signal another step toward the centralization of authority and the incentives for states to control spending will erode. The likely fiscal behavior of states will make “too big to fail” on Wall St. look like little league. This bad behavior is moral hazard at work. “Capitalism without failure is like religion without sin – it doesn’t work”. There’s a huge potential for systemic risk. If the federal government backstops California, the anxiety about California bonds shifts to U.S treasuries. Investors will understand the primary check on state budgets has been removed. The total of state debts is estimated to be 4 trillion, 1/4th of the federal debt. After a bail out, that number would grow much faster. Federalism is an important institution. For it to work, governments must be allowed to experiment and even fail. Trial and error doesn’t work without penalty for error. Consider a limit on tax deductibility of interest on new state and municipal bond debt.
Term limits are a poor way to fix a broken political system. Term limits are at odds with the economic theory of time preference. Politicians, instead of maximizing profits, maximize power. Think of the analogy of the owning farmer’s vs. the renting farmer’s care for the land he farms. Term limits will lower the quality and potential effectiveness of elected officials. The amount of operational power in government will shift from elected officials to the unelected staff of bureaucrats.
The cycle of historical decline is characterized by centralization of authority, weakening of individual liberty, and strengthening of rent seeking groups. The challenges facing America are within. The most obvious signs are fiscal – a rising tide of budget deficits since the 1970’s. The U.S is cursed with behavioral dysfunction in the political system that makes a math problem look easy. The polarization of American politics is a primary cause of the budget deficit. The ideological center in Congress has thinned and the distance between the parties has widened. The dangerous trends in both our economic and political institutions have become obvious. The federal budget faces enormous long term obligations from unfunded future entitlements guaranteeing more spending every year in the future. The trajectory is unsustainable.
The precursor to anarchy is almost never a center that cannot hold, but instead a center that holds too tightly. Because the Founding Fathers understood this, they designed the Constitution with every care to preserve democratic rule against the encroachment of national power. They delivered a carefully balanced social contract as a negative constraint on government power in defense of natural human rights. The Bill of Rights guaranteed individual and state freedom against growth of federal authority. The First Amendment was the most important, affirming the absoluteness of the three freedoms explicitly beyond federal authority – religion, speech, and assembly. These three freedoms have not been modified by subsequent Constitutional amendments. The Framers did not believe the government had the authority to grant rights. Those rights are natural. They knew governments always tried to curb freedoms, which is why the Constitutional text is written as an ironclad band on federal authority. “Congress shall make no law respecting an establishment of religion – abridging the freedom of speech, the right to assemble, to petition government”. Their design of government was conspicuously hostile to centralized power. The states were sovereign entities, not merely administrative provinces. States were allowed their own militias.
Party extremism has increased dramatically since the 1970’s.
Mann and Ornstein blamed the Republican Party for gridlock, characterizing it as, “an insurgent outlier – ideologically extreme; contemptuous of the inherited social and economic policy; scornful of compromise; un-persuaded by conventional understanding of facts, evidence in science; and dismissive of the legitimacy of its political opposition.” The Economist magazine summed up their book as “committing the very sin they decry”. A 2012 Pew study found that Americans of all ideologies distrust centralized government.
Consider the underlying institutions that create the perverse incentives for politician’s to play the game the way they are playing it.
David Broder said, “The Democratic Party is far more motivated to gain and keep political jobs than to deliver essential programs, and the people who pay the Party’s bills, the contributors, care more about keeping their friends in office than about fulfilling policy objectives.” Since this was written in 1996, those institutional pressures have worsened. The self-centered orientation of a modern political party produces politics that avoids hard choices, best exemplified by the refusal to address the crisis of health care costs and entitlements.
What’s qualitatively different about the current debt spike is that it is occurring during peacetime. All previous spikes occurred during wartime. Demographics are pushing the system toward bankruptcy. The Social Security and Medicare trust funds have nothing but IOU’s from the Treasury. The money has been spent on other programs.
If Social Security were means tested, people would have the incentive to spend all their savings by retirement or hide them overseas. A sensible reform might equalize payments for all seniors. The tendency of all entitlement programs is to expand beyond the obligation assumptions. With Medicare and Medicaid, Congress made binding expenditure commitments beyond the horizon of political consequences. The healthcare entitlements have driven a growing wedge that has left millions uninsured by distorting the idea of what health insurance is and how the American medical market operates. Medicare and Medicaid displace private insurance and generate perverse incentives in the larger health care market by removing consumption behavior from the normal demand function through the third party payer arrangement, leading to overconsumption and price inflation. These programs amplify problems existing in private insurance. In 1975, Medicare cost $14 billion and in 2012, $520 billion. These programs hurt patients by elevating the bureaucracy over the caregiver and by rationing care. Entitlement outlays are on track to double from 8.7% of GDP in the 2000’s to 18% in the 2040. The only way to get out of the trap is to hold expenses steady and grow the economy rapidly. Getting the federal budget under control is impossible given the current rules of the political game. We have evolved into a classic prisoner’s dilemma where a stable equilibrium produces self-destructive behavior. The two parties have the wrong incentives. Electoral incentives are pulling them away from a budget solution to the entitlement spending problems. Republicans want to decrease the rate of spending and reduce taxes and Democrats want to increase the rate of spending and increase taxes.
It is politically rational for Republicans to maintain higher spending because if they legislate spending cuts, they are attacked by the Democrats and tend to lose seats. The American public opposes both tax increases and spending cuts. Political punishment is the payoff for the party that seeks budget balance, so fiscal imbalance is an institutional failure. For most of the nation’s history, the rules of the budget game worked, but they no longer do. America is becoming unbalanced in a way that echoes the fiscal rent seeking of the Roman and Ottoman empires. The pressures of the special interests, the rent seekers, are no different in modern democracies than in dictatorships of empires past.
James Madison explained that ideological political factions were, “political diseases under which popular governments had everywhere perished,” and could only be controlled by a well-constructed government, but never eliminated. He defined faction as a group of citizens united around a common interest which is adverse to the rights of other citizens and the community. The two parties weren’t polarized for most of American history. For two centuries, factions were well controlled within the Constitutional system, they balanced one another out.
Something big changed in 1974. Good government requires political agents with the longest possible consequence horizon. The authors were pleased with the Citizens United decision and believe that instead of making politics less polarized, the campaign finance reforms beginning in 1974 made it far worse.
Political philosopher Jonathan Rauch calls our current political paradox, demosclerosis. He said, “set up a rule to channel the baser tendencies of human nature and human nature will find a way to subvert those rules”.
Economic prosperity will always rely on political reform. The authors derive seven lessons from their study of great power history.
One: At any given moment in time no great power is destined to succeed or to fail.
Two: Growth will accelerate in any country that establishes superior institutions with incentives for commerce, entrepreneurship, and technological change.
Three: Great powers decline internally centuries before external threats topple them. The decline in Rome was economic. Fiscal imbalance is the key to decline in case after case. Nothing external caused California’s crisis.
Four: Great powers decline because their leaders do not know something essential about their economy. The Romans and the Spanish had no clue about the dangers of inflation. The Chinese didn’t appreciate the importance of trade.
One obvious flaw in modern democracies is the over reliance on monetary policy to cover destructive fiscal policy. There’s rarely a fiscal stimulus that remains temporary. Another blind spot is in our economic models. Elected officials don’t typically appreciate the fundamental importance of intangible institutions, particularly, the rule of consistent law and its effect on trust.
Five: The task of a well-run democracy is to balance the interests of the inevitable factions. The faction that threatens to destabilize the democracy that is more dangerous than any other is government itself. When the people who control the levers of government are able to enrich themselves at taxpayer expense, and when such centralized rent seeking is unchecked, the situation can deteriorate to a fiscal ruin.
Six: In most cases of imperial decline there was some faction that controlled the government and insisted on preservation of the status quo.
Seven: Lack of fiscal rectitude as a consequence of rent seeking has ruined most great empires. Once a country stops innovating, which it will do when it excessively hinders economic freedom, it will decline. The authors believe that the balance of economic power is more critical than military power.
A smart fiscal balance is one that prioritizes outcomes, not inputs. The goal of good fiscal policy should be more about achieving the fiscal mix that optimizes long term prosperity, rather than merely equating revenue with outlays. The optimal is the one that generates the most economic growth. The three types of economic growth are innovation, investment, and scale. The danger in embracing globalization naively is that foreigners steal U.S intellectual property to undercut its innovation advantages.
Three strategies will accelerate American growth.
One: Tax reform – to encourage investment driven growth and innovation.
Two: Expand the scale of the economy by lowering regulatory barriers to trade and the flow of ideas.
Entrepreneurship rates should be trending up in the United Stated; the fact that they’re not shows there are institutional barriers imposed by government through increased and ill-advised regulation.
The debt crisis is a reflection of representative democracies’ worst tendencies – the perverse incentives of politicians to pursue re-election and the bounded rationality of voters who will not consider the need to require long term fiscal constraints. We see what happens when the behavioral dysfunction goes to extremes as in Greece, Argentina and California. The failure of self-government to self-control is due to aggregated affiliates. Much of the public holds deeply held biases about basic economic principles that are at odds with reality.
James Buchanan described how fiscal illusion conceals the costs of publically provided goods. Citizens think the entitlements they are promised represent wealth. They fail to consider the future taxes required to pay them.
Debt financing reduces the perceived price of publically provided goods and services, so citizens increase their demands. They have the illusion that government financed goods are less costly than they are in fact. William Niskanen describes federal spending as “buying government services at a discount equal to the deficit”, the cost of which will be borne by someone else in the future.
The legislators face election cycle incentives that favor short term performance of the economy at the expense of long term growth and solvency. The weakness of democracy is not so much voter irrationality, as it is politicians’ rationality. Without hard budget constraints, politicians have no incentive to limit deficits so we are now validating the curse of fiscal illusion; political paralysis in the face of excessive government expenditure; and the current budget rules are designed to generate exactly this result. Congress temptation to do the wrong thing is unconstrained.
There are four basic types of fiscal rules; balanced budgets, targets for debt and deficits, limits on expenditures, and limits on revenues.
A more honest and transparent accounting of how the federal budget is made is essential to get the public more engaged. The CBO should estimate dynamic effects of policy changes as well as static effects.
The federal government continues to use cash accounting rather than accrual accounting which appropriately counts the cost of new long term obligations.
A Constitutional Amendment is probably required to control our fiscal situation since the legislature can otherwise change any rule that constrains it. An amendment requiring annual fiscal balance is objectionable because it would amplify the business cycle, but using a moving average of federal revenues over a period of years would solve that problem.
The authors recommend a Constitutional Amendment that controls expenditures, not deficits. The moving average constraint would limit expenditures to about 20% of GDP. The best variable to constrain is expenditures, rather than debts, deficits, or revenue.
This summary largely consists of direct quotations from the book, (often without identifying them as such by quotation marks), and often shortened, paraphrased or otherwise changed.
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Copyright @ 2013 by Glenn Hubbard and Tim Kane
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