The Fiscal Cliff and How We Got Here - Public Choice Theory
The article below is a very good explanation of how "we got to where we are". It is a discussion about Public Choice Theory, why it is rational, and the consequences of a series of poor decisions. The discussions continues into how this ultimately led to the issue of the Fiscal Cliff, the consequences of going or not-going over the cliff, and possible solutions.
By the way, I found this article at a website that I recently discovered called the Global Economic Intersection. This site publishes a number of new posts every day and many of them are very interesting. I encourage to visit the site.
As the fiscal cliff
approaches on January 1, 2013, when automatic spending cuts, tax rate hikes and
elimination of certain deductions goes into effect, we must consider how we got
to this point – and how to get out of it, if we can. The effects are economic,
but the causes are psychological, sociological and political. Let’s explore the
causes of why we are here, with a mountain of federal government debt that
rivals our economic output. While it may seem strange to consider, perhaps
entirely logical decisions led to a rather illogical state of affairs.
First, politicians do
not simply appear in office. We elect them. We should hopefully know what policies
they support beforehand, and we might reelect them based on what they did while
in office. If we had any objections, we could have made a different choice. Our
obligation – and certainly that of all elected officials – is to vote for what
is in the best interest our nation. As we will see, however, people acting
entirely rationally can act in a way that is in the best interest of the fewest
people at the expense of that of the most.
Politicians make all
sorts of promises, and at least some of us seem to believe them. A car in every
garage – with lower taxes at the same time to boot! Who wouldn’t vote for such
things? But remember, if it sounds too good to be true, it probably is. No
matter how clever at legislating, politicians haven’t been able to outlaw the
rules of simple math. To balance a budget, income must be greater than or equal
to expenses. It’s just that simple.
Public Choice Theory
But really, it’s quite
complicated. At this point, we must introduce a concept known as public choice
theory. Public choice theory uses modern economic tools to study problems that
are generally in the realm of political science. From the perspective of
political science, it explains how voters, politicians and bureaucrats all act
in rational self-interest, but which results in political decision-making
outcomes that conflict with the preferences of the general public. Several
public choice scholars have been awarded the Nobel Prize in Economics, notably
James Buchanan (1986), along with others, including George Stigler (1982) and
Gary Becker (1992).
Delving into how this
theory works in practice, consider the example of special interest groups –
those lobbying efforts by corporations or other agents who want spending for a
particular project. Even though the public might oppose this type of spending
on pork barrel projects in principal, few members of the public have the time
or energy to combat the intensive lobbying efforts for the many individual
projects that go before lawmakers.
Proponents invest much more in the outcome
than those who might oppose the measures, simply because those few people stand
to gain quite a bit, compared to individual members of the public, whose costs,
individually, are quite small.
After all, one project
by itself might not seem like a large sum to the government, but it is a very
big deal to the special interest group in question. Not to mention, of course,
voters in a district that benefits from these projects will certainly not
complain. Instead, they might be more, not less, likely to vote for a
politician who proposes these spending projects, even if it might be considered
by others to be “wasteful.”
As such, the
cost/benefit relationship is distorted. Proponents invest much more in the
outcome than those who might oppose the measures, simply because those few
people stand to gain quite a bit, compared to individual members of the public,
whose costs, individually, are quite small. Suppose a new, hypothetical “bridge
to nowhere” cost $30 million to build. Is it worth me fighting about it when
its costs average out to be ten cents to me (and every other American)? Am I
even a voter in that representative’s district, where the legislator will heed
my complaints?
It’s in my own,
individual best interests not to fight this one hypothetical project. This is
not the most productive use of my time and energy, especially given my poor
chances of succeeding in a one-man effort against a lobbying firm. Hence, even
if I am angered by excessive spending, I am acting in an entirely rational
fashion to ignore this particular project, preserving my own resources of time
and energy, but acting against the nation’s long term best interest.
… many small bad decisions get multiplied into
a much bigger problem.
Then there are other
reasons beside the money involved. Politicians might feel a bit more powerful
and might feel like they have a bit more clout on Capitol Hill, if they can get
the project in question passed. More importantly, politicians might want a new
career as a lobbyist themselves at one of those firms after leaving government.
It always helps to play nice with someone who might be your new boss.
All of this means that
many small bad decisions get multiplied into a much bigger problem. There are
535 members of the US Congress, with plenty of opportunity for special interest
spending to be introduced.
Public choice theory - individuals acting in a
rational fashion, focused on their own self-interests, can lead to a very poor
outcome for the nation as a whole.
Meanwhile, voters in
each district are focused only on the policies proposed – and the results
delivered – by only their representative when casting a vote, reducing the
accountability of the institution as a whole. Costs are diffused, while
benefits are concentrated, and all of it is someone else’s money, anyway.
Thus, public choice
theory shows that individuals are acting in a rational fashion, focused on
their own self-interests, leading to a very poor outcome for the nation as a
whole. When it comes to public policy, not free market enterprises, perhaps Ayn
Rand might not be entirely correct in her views that there is a virtue to
selfishness, or rational self-interest, as she describes in her writing,
including her book, “The Virtue of Selfishness.”
Our Current Situation
That leads us to our
current dilemma. We’ve seen debts grow and grow after many, many years of
deficit spending. All those little sums of individual projects have added up in
a very, very big way. What were we thinking?
Perhaps we were just
hoping it would all go away. For decades now, we’ve engaged in mass delusion;
that somehow, growth would subsume the need for restraint. We’ve believed that
the magical powers of some yet-to-be-determined force would create powerful economic
growth that would obviate our need for maintaining smaller deficits that won’t
grow faster than the economy as a whole. But one must never build a budget or
economic models based on just hopes and wishes; yet that is what we, as a
country, have done.
We’ve had ample
opportunity to see that this hasn’t worked, over decades, if not entire
generations. We’ve spent more than we’ve earned in the difficult 1970’s and in
the prosperous 1980’s. We did it again in the booming 1990’s, except maybe for
a year or two, and then again in the austere 2000’s. We’ve had ample
opportunity to see that there is no economic genie that will grant our wishes
for the problem to simply go away.
But one must never build a budget or economic
models based on just hopes and wishes; yet that is what we, as a country, have
done.
We could have voted
for politicians that were realistic, but people don’t like to hear Debbie
Downer giving a political speech. A salesman always sells more cars than does
the engineer who actually knows how they work.
Now, things have come
to a head. We’ve seen the disaster that excessive debt has wreaked in Europe,
and we’re eager to avoid those problems now. We do recognize the European model
of generous spending has failed. But perhaps Europe’s attempt of a solution of
immediate austerity does not work, either. Indeed, a starvation diet to wean us
off gorging on debt spending can lead to problems with our economic health.
Like a rubber band stretched too far and snapping back in the opposite
direction, is our current fixation with rapid deficit reduction going too far
in the other extreme?
Indeed, a starvation diet to wean us off
gorging on debt spending can lead to problems with our economic health.
After all, deficits,
like many things in life, can be beneficial in smaller, more moderate amounts,
but can become problematic in excess. We should point out that our trade
deficit and budget deficit are intertwined: the capital account must equal the
current account. If we are going to tackle our budget deficit – remembering
that foreigners buy many of our Treasury instruments – the corollary must be
that our economy would slow from reduced government spending to the point that
our imports would be reduced, unless our exports somehow increase.
So, we might ask, can
we have a better solution, perhaps a more moderate approach to cutting the
deficit rather than try to do most of it all at once? What businesses (and
consumers) want mostly is to know what is going to happen with
taxes and spending; they aren’t necessarily asking that all of these things
happen right this second, as long as they know that there is a credible plan.
And a more gradual implementation of this fiscal restraint can give both
businesses and consumers more time to plan and adjust, rather than going off
the fiscal cliff.
The Problem: The
“Fiscal Cliff”
By now, many of you
have heard about the federal belt tightening that is scheduled to begin January
1, 2013. This is because our two primary political parties are unable to
compromise, the same factor that Standard & Poors cited when downgrading
our federal government debt. The Congressional Budget Office (CBO) reports that
fiscal tightening will lead to a recession in 2013. They detailed their
findings with a number of economic projections, comparing if we go off the
fiscal cliff (meaning lawmakers do nothing), or if politicians change the
current law to reduce the impact of the fiscal restraint.
Specifically, here’s
what the economy might look like without going off the
cliff, that is, if current law is changed, but current policies remain
the same. (Remember that the way the law is currently written, we will go off
the fiscal cliff. Lawmakers must change the current law to retain taxes and
spending as they are now to avoid the cliff.)
§ In 2013, the deficit would total $1.0
trillion, almost $400 billion (or 2.5% of GDP) more than the deficit projected
to occur under current law (but it is still $91 billion less than in 2012).
§ Real GDP would grow by 1.7% between the fourth
quarter of 2012 and the fourth quarter of 2013, and the unemployment rate would
be about 8% by the end of 2013 (basically, right near where it is now), the CBO
projects.
Now, here is what
happens if we do go over the cliff (remember, this
happens if lawmakers simply do nothing).
§ The deficit will shrink to an estimated $641
billion in fiscal year 2013 (or 4.0% of GDP), almost $500 billion less than the
shortfall in 2012.
§ Such fiscal tightening will lead to a
recession, with real GDP declining by 0.5% between the fourth quarter of 2012
and the fourth quarter of 2013, and the unemployment rate rising to about 9% in
the second half of calendar year 2013.
§ Because of resource slack, the rate of
inflation, as well as Treasury yields, will remain low in 2013, in the CBO
forecast.
Pick your poison: a
recession now or more debt. The CBO notes, though, long term, our economy will
be in much better shape with the deficit reduced significantly – though it does
not need to be eliminated entirely. We now must pay the price for decades of
voters who seem to always want politicians to give us more spending with lower
taxes. If we didn’t want to accumulate that debt in the 1970s, the 1980s, the
1990s and the 2000s, we sure had ample opportunity to break out of this debt
snare long before it hit a crisis.
… people acting in a rational fashion can,
ultimately, act against their own best interests when viewed as citizens, members
of the nation as a whole, not individuals. That is the paradox.
But as we learned, in
our nation’s journey on the way to the fiscal cliff, perhaps we weren’t as
irrational, as individuals, as an outside observer might think. Yes, who would
vote against the best interests of the country? But, as public choice theory
demonstrates, people acting in a rational fashion can, ultimately, act against
their own best interests when viewed as citizens, members of the nation as a
whole, not individuals. That is the paradox.
Possible Solutions and
their Impediments
No matter how we got
to this point, or what theories explain it, we are in a difficult bind.
Competing paradigms now battle each other. With gridlock in place, current law
will undo decades of overspending relative to our revenues in just one short
year. Yes, we need to move closer towards reasonable deficits over a reasonably
short period of time, but a compromise solution certainly could allow for,
well, compromise, from lawmakers on both sides of the aisle.
The only way that we
can gradually descend from our mountain of debt, instead of tumbling headlong
off the edge, is for the leadership of both parties to work together.
Unfortunately, that is less likely than not.
Maybe deliberately
jumping off the cliff could still be avoided. However, the problem is, economic
troubles may start sooner if businesses and consumers start cutting back before the
fiscal cliff arrives. By then, it may be too late, as a recession may start,
based on worry and doubt. But relying on hopes and wishes rarely leads to
prosperity, either. Can there be a middle ground, a rational decision process
that leads to our mutual best interest, for all of us and our nation as a
whole?
Finding a middle
ground is vital. But few politicians seem to advocate for the solution that is
most necessary: a combination of both spending cuts and revenue increases.
Entitlements need to be addressed for younger generations, and we may need to
cut defense spending.
But some good news is that we don’t need to
eliminate deficit spending entirely…. additions to our debt would be no
greater, proportionally, than additions to our aggregate economic output.
Otherwise, if we were
to try to balance the budget through spending cuts alone, without addressing
entitlements or defense spending, we would need to close every single
government agency and department. (See table S-4 in the attached budget http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/tables.pdfif
you’re curious.)That’s everything from
the FBI to the IRS and everything in between, whether it’s NASA, national
parks, federal courts or Amtrak. Our nation would suffer enormously if we tried
a rigid, partisan approach to balancing the budget, without compromise or
consideration of realistic economic models.
But some good news is
that we don’t need to eliminate deficit spending entirely. In the same general
vein that a consumer may undertake some debt, such as to buy a house or car, or
a business may borrow to expand, the federal government may find it beneficial
to borrow a bit. The general thesis, though, is that the debt should not grow
faster than the economy. This means that deficits should be in the general
range of long-term, potential economic growth, say, perhaps 3% or so. Thus,
additions to our debt would be no greater, proportionally, than additions to
our aggregate economic output, and debt as a percentage of GDP will remain
more-or-less stable over time.
Why would we want to
have some deficit spending? One is our current environment. As consumers
deleverage, and pay back debt, their consumption tends to fall, all things
equal. That debt isn’t going to be replaced by more bank lending, and those
funds basically get taken out of the economy. This can cause economic growth to
be sluggish, or in some cases, even contract.
When the government
steps in to be the “consumer of last resort,” government borrowing replaces
consumer borrowing to goose the economy. Paradoxically, this is the exact
opposite of “crowding out theory,” where government borrowing displaces
borrowing by businesses and consumers. In normal times, this could limit
economic growth. But now, in the “Great Stagnation,” to borrow a term from
Boston Federal Reserve Bank President Eric Rosengren, we are not in a normal
environment, when such theories tend to hold.
Perhaps the government could raise taxes when
inflation rises and cut them when inflation falls below desired levels.
Instead, government
borrowing, in moderation, can steady the economy, adjusting upwards or
downwards to right the ship if more extreme behavior in the private economy
takes place. This is the best use of deficit spending, when fiscal policy can
expand during lean times and contract during strong expansions.
Such flexible
approaches to deficits can help keep inflation from moving too far above or
below the target, 2% or just a bit less, as well as keep economic growth from
contracting too much in recessions. Perhaps the government could raise taxes
when inflation rises and cut them when inflation falls below desired levels.
The trick is getting politicians to consider
deficits through the lens of economics theory.
Coincidentally, this
may tend to stimulate the economy when it needs to be juiced and recoup tax
revenues to lower the deficit when the economy is more amped. This would help
keep inflation and growth steady and our deficits under control.
Conclusion
The problem is that we
haven’t been able to use deficit spending either appropriately or in
moderation. Politicians don’t seem able to choose judiciously when to spend and
when to use restraint. But as we have seen, public choice theory explains why
our addiction to excessive debts can make logical sense when viewed as such,
even if the result of our behavior does not.
The trick is getting politicians to consider deficits through the lens
of economics theory, not economists viewing deficits through the lens of
political science. For our economic well-being, one might come to trust an
economist over a politician, even if their promises fail to excite.
