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Friday, November 4, 2011

CUT, SPEND, TAX? THE EUROPEAN LESSON

While the Congress and the White House seek simultaneously to find a workable campaign strategy and an actual cure for the nation's sluggish economy recovery, the debate essentially is whether to engage in additional significant government spending or reduce taxes to stimulate economic growth and thus job creation while cutting spending to reduce the annual deficit and enormous outstanding federal debt. 

Economists agree that increasing the money supply i.e. putting more money in the hands of consumers is the best strategy for increasing demand for goods and thus stimulating production and job creation.  The debate is about which method is best to do that.  The Federal Reserve which is in charge of monetary policy has been doing this on a grand scale with it's bond purchase programs of "Quantitative Easing".  Obama's "stimulus" program of 700 billion dollars of federal spending was also intended to achieve this goal. 

So far, along with two years of interest rates at historic lows, the strategy has failed to  produce much relief.  In the mean time, the 2011 federal deficit came in at 1.3 trillion dollars and the accumulated federal debt is now 99.6% of Gross Domestic Product (GDP) at 14.3 trillion dollars and growing.

Meanwhile, the whole world is watching the economic crisis that is unfolding in Europe.  This crisis has vast implications for the world economy and the U.S. economy in particular and should provide some insights into the proper strategy for the Congress and the President to shape our own response to the jobs and growth issue.

Economic issues are complex and economic policies often have circular or contradictory influences.  However, essentially the European crisis, which is centered on the Euro Zone of  seventeen nations which have shared a common currency since 1991, is about "sovereign (govt.) debt" which has been used for decades to finance excessive government spending on ever expanding advanced welfare states.

Only Greece is in intensive care but Italy, Spain and Portugal are all in the emergency room.  The symptoms are instructive.

Greek debt in 2010 was 143% of GDP.  A majority contributor is the huge number of public sector employees with generous benefits and retirement.  Twenty-five percent of Greek workers are public employees. The Euro Zone nations, the European Central Bank  and the International Monetary Fund (IMF) have been pumping billions of Euros (currently 1.375 per U.S. dollar) in loans into the Greek government to keep them from defaulting on their debt which is in the form of government bonds held mostly by Greek and European banks.  The last bail out deal negotiated by the European Central Bank (ECB) and the Euro zone nations is to be a 50% write down on outstanding bonds, an additional cash loan of 130 billion euros and an additional round of austerity cuts to Greek government spending.  Although this is intended to avert a default, a 50% write down on investments held by private banks and pension funds "is" a default.  And it may not be sufficient to permanently correct the Greek crisis.  Banks in the other at risk economies in Europe will feel the loss of capital on top of the risks associated with their bond holdings from their own and other at risk nations.  Italy's potential crisis dwarfs that of Greece.  Italy's sovereign debt is approximately 2.6  trillion dollars or 119% of GDP (2010).  In Spain the numbers are 917.4 billion dollars and 65.2 % plus regional government debt of 12.4 %;  in Portugal, 213 billion dollars and 93%.  These are already high tax countries, a necessary condition to support the cradle to grave social programs and subsidies demanded by their Left leaning electorates.

Members of the U.S. Congress and the President are faced with similar issues.  The U.S. is not going to default since the dollar is the primary international reserve currency which most nations use to engage in international trade.  Unlike Greece and the others, the U.S. is thus able to print currency for payment of international debts.  While this deters actual default, it devalues the currency making everything imported more expensive and causing large holders of dollar reserves like China (1.6 trillion) and Japan (765 billion)  uneasiness as their reserves lose value.

The President's "jobs bill" would spend an additional $447 billion on grants to states to hire or retain public service workers, and create an "infrastructure bank" to spend money on "bridges, roads, and damns" etc. which would provide short term work for the construction industries and their related support industries.  If it works, it would create a temporary jobs stimulus before the funds were expended and would put more money into the economy.  Obama wants to offset some of the increased debt incurred with taxes on his political nemesis, the "rich".  Republicans in the House and some Democrats in the Senate have opposed the plan and it is dead, in spite of Obama's country-wide campaign tour touting it.  Taxing the "millionaires and billionaires" to reduce the deficit is a favorite Democrat strategy.  Whether this is a viable strategy from an economic standpoint depends on what taxes are raised, how much might be raised, and the definition of “rich”,  as opposed to how much the impact of investment loss on the economy would be.  It is generally popular across the country but the Republicans remain adamant in their opposition to any new taxes and  have conceded the campaign issue involved, which may well hurt them in the 2012 elections.

But the European crisis should have an impact on U.S. decision makers with respect to the spend or cut choices they face.  All the proposed cuts to future deficits, currently running at 8.6% of GDP, simply cut the rate of growth of the deficit so the accumulated federal debt will continue to grow.  The interest on the debt alone added $454 billion in fiscal year 2011. In the last decade (2000-2010) the number of non-military federal employees has increased by 138,000 and currently stands at 2,840,000.  In Greece, 20% of earners blatantly evade taxes.  In the U.S. 47% of families pay no federal taxes at all because of tax credits and deductions.  The lessons are there to be learned.

Greek social programs and the huge number of government employees needed to run them offered cash payments for:  old age; disability; maternity; funeral expenses; lost income from sickness; medical expenses; workmen's comp.; unemployment insurance; family allowances; spa treatments and more.  The so called "austerity" measures the governments of Greece and Spain are implementing seem minor with respect to their debt problems but are instructive in that they indicate the strategies of the IMF, ECB and Euro Zone governments.  These include raising sales taxes; freezing old age pensions; reducing public worker's pensions; increasing retirement ages; cutting public workers wages; and legislation to make it less costly to hire and fire workers.  Spain has passed a quasi-"balanced budget amendment which restricts future deficits to .4% of GDP and will reduce total government debt to 60% of GDP by the year 2020. 

The Socialist Party government of Greece is facing a parliamentary "no confidence vote" shortly, which if passed would cause the government to fall.  The Socialist Party government of Spain is expected to lose in the upcoming national elections in November.

Again, the U.S. is not just a big Greece.  Greece is a small country with an economy mostly based on agriculture and tourism.  But the dynamics of advanced welfare states are like physics, they are the same everywhere.  Liberals point to the relative economic stability of the Scandinavian welfare states but these are small, low growth, relatively homogeneous nations with populations similar to mid-sized cities in the U.S. and with virtually no international security responsibilities or military budgets.  As the poorer segments of their societies, much of it caused by immigration, slowly overwhelm their welfare systems the same symptoms will result. 

In Greece, attempts to cut spending always run up against a tradition of strikes and violent protest which historically have intimidated Left leaning governments and perpetuated the upward spiral of deficit spending.  Now, faced with relatively similar levels of out of control spending, the U.S. is also facing the so called Occupy Wall Street protests which are as uninformed about economic realities as their Greek counterparts.  These groups are making demands for debt forgiveness, guaranteed incomes, free health care and college education and they don’t understand the basic contradiction between their demand for job creation and their “Destroy Capitalism” banners.   They are also taking the inevitable turn towards irresponsible violence.  Their influence on the political leadership is hard to estimate but they have been embraced by the far Left Pelosi wing of the Democrat Party, as well as organized labor and the “progressive” commentariat. 

All spending cuts are difficult and painful because all spending benefits specific groups.  But there is an end point to all government expansion when wealth production doesn't match wealth consumption and even the most socially liberal governments, as in Greece, are called to account. 

Because of its huge size and its unique position in the world’s economy, the U.S. still has some flexibility in terms of priorities, strategies and timing but the European example cannot be ignored.  The question is, will common sense or ideology prevail.

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