Wednesday, February 03, 2010

My e-mail interview with a Polish news magazine

Here are their questions and my answers, the latter composed more or less at the limit of my typing speed. My answers are shown here in italics:

1. USA has to deal with budget problems, so does Germany, Greece, Poland, France, Japan, Russia, etc… it seems the public finance is now the main interest of world’s politicians and economist. You probably know of various solution proposed by different countries (including USA, of course). How do you perceive them? Most of them are based on simple ideas of public spending cuts or more borrowing or tax cuts/increasing…

In the long run, all government spending has to be paid for. That isn’t a policy recommendation, it’s an unavoidable fact of life because there is no free lunch. Defaulting on the debt, for example, would just be another way of paying for it (in effect, by taxing the bondholders). Economists call this “no-free-lunch” problem the inter-temporal budget constraint. In the long run, it holds just as much for a government as for an individual’s budget, although governments differ from us in that they can raise taxes or, if they’ve borrowed in their own currency, devalue it through inflation (whch doesn’t really stop the taxpayers from bearing the burden, given what will happen the next time the government tries to borrow).
Given all this, there is absolutely no alternative to imposing, at some point, higher taxes and/or lower spending so that the two will be in long-run balance with each other.

Borrowing is a useful tool, for governments just like individuals, if one would rather pay later than now. But it doesn’t actually finance spending in the long run, and the day of reckoning comes at some point.

2. Is there any historical proof of a working effective solution? Can you provide historical examples of failures and successes in fighting budget problems (like Chile)?

The historical example I like goes a bit further back, to the eighteenth century. Think of England versus France, which were almost continually at war throughout the eighteenth century and until 1815. England spent more on the war than it could contemporaneously raise through taxes. But it had an outstanding public finance system, with borrowing through a bond market that was backed up by (a) a well-functioning tax system, (b) bondholders’ confidence that Parliament wouldn’t allow a default, and (c) bondholders’ belief that the wars with France would end at some point, whereupon England would be able to repay the bonds by taxing in excess of post-war expenditure levels. This is exactly what ended up happening.
In France, by contrast, the eighteenth century monarchy was unable to pay for the wars it fought. This was the direct cause of the French Revolution, which started when the King was forced to summon the Estates General to stave off fiscal collapse. I believe France then simply renounced the monarchical debts, counting on the change in regime to avoid being blamed for this, and established more well-functioning finances, but obviously at a high price.
Governments today have well-established borrowing systems like eighteenth century England, but they don’t have a credible basis for suggesting that expenditures will at some point drop. For example, large-scale government-funded retirement programs don’t have an assumed end-date like even the past era’s seemingly endless European continental wars.

3. What can be the solution for Poland? We have positive GDP growth, but tax revenues going down, the public expenditures very high (the most money-eating is the retirement fund)?

One way or another, the path of spending and tax revenues must be brought closer together. I don’t know enough to comment on Poland’s retirement system, but it presumably needs to be put on a sustainable path, meaning that at some point it ceases to grow faster than GDP. Ideally, in the long run, it might be switched to a prepaid model, where retirees have funded their own benefits during their working years, but obviously this can’t help current retirees. What makes the transition so difficult is the aging of population (so every more retirees per worker) and increasing life expectancy (which of course is a good thing, but makes retirement programs costlier).
In all likelihood, both sides of the budget – taxes and expenditure growth – need to be addressed. If Poland’s political debate is anything like in the U.S. (and I hope for your sake that it is far less distorted and dysfunctional), this would require a compromise between parties on the left and the right of the political spectrum. This has happened in the U.S. in the past. For example, throughout the 1980s the Republicans and the Democrats cooperated to reduce budget deficits and improve the long-term financing of Social Security, our retirement pensions program. In U.S. politics today, however, this is utterly impossible, mainly because the Republicans have turned completely destructive and irresponsible (which is not to say that the Democrats would do the right thing either, but at least in their case we don’t know for sure that they wouldn’t).

4. Is there any universal solution you recommend?

Higher taxes and lower spending growth. In the U.S., since we don’t have a VAT, adding one to our system and putting Medicare, our healthcare program for seniors, on a sustainable growth path would get us most of the way there. But for other countires the same basic story – taxes need to go up, and spending cannot grow so much faster than GDP – may need to play out with different institutional details.

5. What possible mistakes (overestimations, understimations…) can government do while reforming budgets?

A long-term measure is needed, with independent experts allowed to implement it while shielded from direct political pressure. Annual budget deficits are too easy to manipulate, such as by increasing taxes or spending this year in exchange for making them much lower in the future. In the U.S., we call this “smoke and mirrors,” and politicians have gotten ever more aggressive in playing these games.

6. There’s always a controversy between two ideas: free marketers say: cutting taxes and social expenditures should increase tax revenues in long perspective; their opponents: it’s a complete absurd, the fast developing economy generate revenues but it can go along with a big welfare state. Which option would you chose and why?

There is a legitimate difference of opinion between people on the left who want government to play a bigger role, and people on the right who want markets to play a bigger role. In the end, it is really a matter of degree, given how socialism on the one hand, and unregulated markets with no social welfare safety net on the other hand, have in my view both been completely discredited.
That said, “supply side” claims that by cutting taxes one can increase revenues, while theoretically true at some point (e.g., suppose a 100% tax rate was lowered to 50%), have been conclusively been shown to be false within the range of debate over tax rates that usually are at issue politically.
So conservatives are almost invariably wrong, within the parameters of current debate, if they make supply side arguments that cutting taxes will increase revenue. But liberals or progressives are equally wrong if they claim that it is possible for government programs to keep on indefinitely growing faster than GDP.

7. What can be the effects situation in which governments decide to delay the reforms? The first is – growing debt, but… what about a Jones or Smith – a taxpayer?

Postponing a solution to fiscal problems means two things for Jones or Smith. First, older generations are handing off the problem to younger generations. Second, the problems are growing worse over time, and fixing them gets ever costlier. This includes the risk of catastrophic fiscal default or radical belt-tightening that leaves the then-current generation of seniors in very bad circumstances.
That said, we do need to wait for the current global recession to pass before taking major steps through currently implemented policy changes to move back towards fiscal balance.

UPDATE: I'm not entirely sure how this will read in Polish translation, and presumably will never get to know. But they called to ask me what I meant by my reference to "smoke and mirrors." I said, circus tricks to fool the audience.

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