UK takes medicine, Greece turns doc­tor away

The his­tory of the mod­ern wel­fare state is re­plete with ex­am­ples of fis­cal calami­ties. In good times, politi­cians ex­pand govern­ment spend­ing as far as soar­ing rev­enues will let them.

The Pak Banker - - Editorial5 - Kevin Hassett

The gov­ern­ments of the U.K., Ire­land and Greece have em­barked upon am­bi­tious, some­times painful ef­forts to re­store their economies to sus­tain­able growth paths. Of the three, the U.K. and Ire­land took their medicine, fol­low­ing the lessons of past ef­forts to pull na­tional economies away from spi­ral­ing debt. Greece de­cided the taste was just too aw­ful, and its ir­re­spon­si­bil­ity threat­ens ev­ery euro-zone coun­try.

The his­tory of the mod­ern wel­fare state is re­plete with ex­am­ples of fis­cal calami­ties. In good times, politi­cians ex­pand govern­ment spend­ing as far as soar­ing rev­enues will let them. In bad times, when the bub­ble bursts, coun­tries find them­selves in a ditch. Nu­mer­ous fixes have been tried over the years, and econ­o­mists have cre­ated a cot­tage in­dus­try study­ing them. What has emerged is a con­sen­sus about what works, a con­sen­sus that is about as strong as any in the macroe­co­nomics lit­er­a­ture.

The an­ti­dote to fis­cal cri­sis is fis­cal con­sol­i­da­tion, a dra­matic change in spend­ing and tax pol­icy that re­duces the in­debt­ed­ness of a nation. Such con­sol­i­da­tions have re­lied on vary­ing de­grees of tax in­creases and spend­ing re­duc­tions. Some have suc­cess­fully re­duced debt, some haven't. The data tell a clear story: What works is cut­ting govern­ment spend­ing.

A se­ries of in­flu­en­tial pa­pers by Har­vard Uni­ver­sity econ­o­mist Al­berto Alesina and var­i­ous coau­thors found de­ci­sive ev­i­dence that suc­cess­ful con­sol­i­da­tions rely al­most ex­clu­sively on spend­ing re­duc­tions, while un­suc­cess­ful con­sol­i­da­tions seek to close 50 per­cent or more of the gap with tax in­creases.

A re­cent study by the In­ter­na­tional Mon­e­tary Fund sup­ports the prin­ci­ple that cuts, par­tic­u­larly to en­ti­tle­ment pro­grams, are key.

Of the bud­get con­sol­i­da­tions ex­am­ined by the IMF, those that met the goal Alesina laid out in his lat­est paper --a 4.5 per­cent­age­point re­duc­tion in the ra­tio of debt to po­ten­tial gross do­mes­tic prod­uct --did so with spend­ing cuts that were about twice as big as tax in­creases. Cuts to pen­sion and health en­ti­tle­ments had the most ben­e­fi­cial ef­fect on eco­nomic growth.

Tax in­creases fail to achieve sus­tained debt re­duc­tion for two likely rea­sons.

First, they in­crease the risk that an econ­omy will ex­pe­ri­ence a dou­ble-dip re­ces­sion. Sec­ond, they il­lus­trate that the of­fend­ing govern­ment is un­will­ing to take a tough stand against soar­ing en­ti­tle­ments. A wel­fare state that can't shrink in a re­ces­sion will pos­si­bly never shrink, which means that to­day's high taxes pro­vide an omi­nous fore­shadow of even higher rates to come.

Spend­ing re­duc­tions suc­ceed be­cause they pro­vide a cred­i­ble as­sur­ance that the debt Le­viathan will not swal­low the en­tire econ­omy, in­creas­ing op­ti­mism and en­cour­ag­ing cur­rent in­vest­ment. They also sug­gest lower fu­ture tax rates, which in­creases the per­ceived wealth of con­sumers, driv­ing up cur­rent con­sump­tion. And they pro­vide cen­tral banks lee­way for ex­pan­sion­ary mon­e­tary pol­icy that tax hikes, which can in­crease mea­sured in­fla­tion, do not.

To their credit, the U.K. and Ire­land have pegged the spend­ing-cut share of their over­haul al­most pre­cisely at 66 per­cent, match­ing the av­er­age share I cal­cu­lated for suc­cess­ful con­sol­i­da­tions in the IMF study. Greece, on the other hand, seeks to close its bud­get gap with more tax in­creases than spend­ing cuts.

The U.K. gave it­self a strong chance of suc­cess by pri­or­i­tiz­ing spend­ing cuts over tax hikes. My one cau­tion is that the em­pha­sis on re­duc­tions is a good deal smaller than Alesina's find­ings sup­port.

Ire­land's out­look is more com­pli­cated. While the Ir­ish clearly re­lied on his­tory's lessons, this doesn't guar­an­tee suc­cess.

In the IMF study there were six coun­tries with suc­cess­ful con­sol­i­da­tions. (The top three were Swe­den in 1996, Fin­land in 19961998 and Bel­gium in 1993.) None of those was a coun­try that, like Ire­land to­day, shares a com­mon cur­rency with a large num­ber of other na­tions. This may be a cru­cial dis­tinc­tion.

The IMF's anal­y­sis sug­gests that ac­com­moda­tive mon­e­tary pol­icy, cur­rency de­val­u­a­tion and surg­ing ex­ports play ma­jor roles in help­ing a nation ad­just to tighter fis­cal pol­icy and sus­tain the eco­nomic growth that drives bud­get gains. In all three of those ar­eas, mem­ber­ship in the Euro­pean Union ties Ire­land's hands. More­over, since Greece and Ire­land both use the euro, their in­di­vid­ual as­saults on debt might best be thought of as a united ef­fort. If we com­bine the Greek and Ir­ish plans into one, it falls far short of the spend­ing-cut tar­gets sup­ported by the IMF data and is light years away from those of Alesina and his col­leagues.

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