Topic: International Economics and Development

Sweden, Spending Restraint, and the Benefits of Obeying Fiscal Policy’s Golden Rule

When I first started working on fiscal policy in the 1980s, I never thought I would consider Sweden any sort of role model.

It was the quintessential cradle-to-grave welfare state, much loved on the left as an example for America to follow.

But Sweden suffered a severe economic shock in the early 1990s and policy makers were forced to rethink big government.

They’ve since implemented some positive reforms in the area of fiscal policy, along with other changes to liberalize the economy.

I’m particularly impressed that Swedish leaders imposed some genuine fiscal restraint.

Here’s a chart, based on IMF data, showing that the country enjoyed a nine-year period where the burden of government spending grew by an average of 1.9 percent per year.

Swedish Fiscal Restraint

From a libertarian perspective, that’s obviously not very impressive, particularly since the public sector was consuming about two-thirds of economic output at the start of the period.

But by the standards of European politicians, 1.9 percent annual growth was relatively frugal.

And since Mitchell’s Golden Rule merely requires that government grow slower than the private sector, Sweden did make progress.

Real progress. It turns out that a little bit of spending discipline can pay big dividends if it can be sustained for a few years.

This second chart shows that the overall burden of the public sector (left axis) fell dramatically, dropping from more than 67 percent of GDP to 52 percent of economic output.

Swedish Spending+Deficit as % of GDP

By the way, the biggest amount of progress occurred between 1994 and 1998, when spending grew by just 0.27 percent per year. That’s almost as good as what Germany achieved over a four-year period last decade.

Let’s Try Anti-Sanctions

As U.S. policymakers develop their response to the Russian incursion into Ukraine, it seems quite likely that some form of sanctions will be employed.  But sanctions are always harmful to innocents and never particularly effective.  It’s worth considering, then, whether there are policy options that would have a positive impact on the geopolitical situation in Ukraine while directly improving human lives and increasing liberty.  We could call them “anti-sanctions.”

One possibility would be to liberalize U.S. exports of natural gas.  John Boehner and others in Congress have argued that doing so would reduce Russia’s influence in the region by providing countries like Ukraine a non-Russian source of energy.  Even if the geopolitical benefits are slow to materialize, allowing more oil and gas exports would have tremendous economic benefits for the United States.

A much simpler anti-sanction response would be to drop U.S. tariffs on imports from Ukraine.  Normally, many products from Ukraine would be allowed to enter the United States duty free under the Generalized System of Preferences.  But that program, meant to aid development in poor countries, expired last summer.  Renewing GSP would reduce Ukraine’s economic dependence on Russia while directly helping Ukrainians and the Americans they do (or would do) business with.  

Perhaps I am hopelessly naïve, but exploring avenues for peaceful interaction seems to me like a much friendlier and more constructive way to approach international problems.  I suspect there are a great number of pro-liberty “anti-sanctions” that the U.S. government could employ as a response to the crisis in Ukraine that might actually make a positive difference in the lives of Ukrainian people.

A Bumpy — but Hopeful — Road Ahead for Ukraine

Even when one tries to ignore the current developments in the East of the country, Ukraine is in a pickle. With one of the lowest incomes per capita among the transitional economies of Eastern Europe, rampant corruption, and quickly depleting foreign reserves, the country is overdue for a reform package in many areas, including fiscal and monetary policy, the judiciary system, bankruptcy law, energy policy, state ownership, to name just a few.

While there is no shortage of foreign experts offering their views on what policies Ukraine needs or does not need, the future of Ukraine is for Ukrainians to decide. Still, the outside world can help. The Cato Institute, for example, is teaming up with the Atlas Network and the Kyiv-based European Business Association this week, hosting an emergency conference on Ukrainian economy.

Instead of policy wonks from Washington, the conference convenes a stellar group of policymakers from the region, who have direct experience with reforms enhancing economic freedom. The speakers include Einars Repse, the former Prime Minister of Latvia, Ivan Miklos, author of Slovakia’s flat tax revolution, Kakha Bendukidze, who as Minister of the Economy was the driving force behind economic reforms in Georgia, Sven Otto Littorin, the former Minister for Employment of Sweden, who assisted with the liberalization of the country’s labor markets, Jan Vincent-Rostowski, until recently the Minister of Finance of Poland, as well as Cato’s very own Andrei Illarionov.

The conference website is here, and you can follow my live twitter feed at this link. Notwithstanding the pessimism of the daily news coming from that part of the world, the recent events in Ukraine have given its people and its leaders a unique window of opportunity to make a departure from the country’s post-Soviet legacy and to put in place institutions that will lead to economic opportunity, freedom, and shared prosperity.

A Fiscal Lesson from Germany

Germany isn’t exactly a fiscal role model.

Tax rates are too onerous and government spending consumes about 44 percent of economic output.

That’s even higher than it is in the United States, where politicians at the federal, state, and local levels divert about 39 percent of GDP into the public sector.

Germany also has too much red tape and government intervention, which helps to explain why it lags other European nations such as Denmark and Estonia in the Economic Freedom of the World rankings.

But I have (sort of) defended Germany a couple of times, at least on fiscal policy, explaining that the Germans didn’t squander much money on Keynesian spending schemes during the downturn and also explaining that Paul Krugman was wrong in his column on Germany and austerity.

Today, though, I’m going to give Germany some unambiguous praise.

If you look at last decade’s fiscal data, you’ll see that our Teutonic friends actually followed my Golden Rule on fiscal policy for a four-year period.

Here’s a chart, based on IMF numbers, showing total government spending in Germany from 2003-2007. As you can see, German policy makers basically froze spending.

German Fiscal Restraint

I realize that I’m a libertarian and that I shouldn’t be happy unless the burden of spending is being dramatically reduced, but we’re talking about the performance of European politicians, so I’m grading on a curve.

By that standard, limiting spending so it grows by an average of 0.18 percent is rather impressive. Interestingly, this period of fiscal discipline began when the Social Democrats were in power.

And because the economy’s productive sector was growing at a faster rate during this time, a bit more than 2 percent annually, the relative burden of government spending did fall.

The red line in this next chart shows that the public sector, measured as a share of economic output, fell from almost 49 percent of GDP to less than 44 percent of GDP.

German Spending+Deficit as % of GDP

It’s also worth noting that this four-year period of spending restraint also led to a balanced budget, as shown by the blue line.

In other words, by addressing the underlying problem of too much government, the German government automatically dealt with the symptom of red ink.

That’s the good news.

The bad news is that the German government wasn’t willing to sustain this modest degree of fiscal discipline. The Christian Democrats, who took office in mid-2005, allowed faster spending growth beginning in 2008. As I noted above, the budget increases haven’t been huge, but there’s been enough additional spending that Germany no longer is complying with the Golden Rule and the burden of the public sector is stuck at about 44 percent of GDP.

The moral of the story is that Germany shows that good things happen when spending is restrained, but long-run good performance requires long-run spending discipline.

That’s why I’m a fan of Switzerland’s spending cap. It’s called the “debt brake,” but it basically requires politicians to limit spending so that the budget doesn’t grow much faster than inflation plus population.

And that’s why Switzerland has enjoyed more than a decade of good policy.

To see other examples of nations that have enjoyed fiscal success with period of spending restrain, watch this video.

The Canadian example is particularly impressive.

Will Venezuela Be Next?

Last year, Nicholas Krus and I published a chapter, “World Hyperinflations”, in the Routledge Handbook of Major Events in Economic History. We documented 56 hyperinflations – cases in which monthly inflation rates exceeded 50% per month. Only seven of those hyperinflations have savaged Latin America (see the accompanying table).

At present, the world’s highest inflation resides in Latin America, namely in Venezuela. The Johns Hopkins – Cato Institute Troubled Currencies Project, which I direct, estimates that Venezuela’s implied annual inflation rate is 302%. Will Venezuela be the eighth country to join the Latin American Hall of Shame? Maybe. But, it has a long way to go.

The Hanke-Krus Hyperinflation Table
Latin American edition

Country Month With Highest Inflation Rate Highest Monthly Inflation Rate Equivalent Daily Inflation Rate Time Required for Prices to Double
1. Peru Aug. 1990 397% 5.49% 13.1 days
2. Nicaragua Mar. 1991 261% 4.37% 16.4 days
3. Argentina Jul. 1989 197% 3.69% 19.4 days
4. Bolivia Feb. 1985 183% 3.53% 20.3 days
5. Peru Sep. 1988 114% 2.57% 27.7 days
6. Chile Oct. 1973 87.6% 2.12% 33.5 days
7. Brazil Mar. 1990 82.4% 2.02% 35.1 days

Source: Steve H. Hanke and Nicholas Krus (2013), “World Hyperinflations”, in Randall Parker and Robert Whaples (eds.) Routledge Handbook of Major Events in Economic History, London: Routledge Publishing.

Bulgaria’s Currency Board versus Ukraine’s Chaos

When Communism inevitably and finally collapsed, Bulgaria’s economy was a basket case – behind almost all other communist basket cases, including Ukraine’s. Indeed, Bulgaria defaulted on its debt in 1990. By February 1991, Bulgaria had broken out in a bout of hyperinflation, with the inflation rate at 123% per month. And in February 1997, Bulgaria experienced the agonies of hyperinflation again, with the inflation rate reaching 242% per month. 

As he looked into the abyss, President Petar Stoyanov decided against taking the plunge and appointed me as his advisor in January 1997. I immediately prescribed a currency board system to put an end to Bulgaria’s malady, something I had laid out for Bulgaria back in 1991 (Steve H. Hanke and Kurt Schuler, Teeth for the Bulgarian Lev: A Currency Board Solution. Washington, D.C.: International Freedom Foundation, 1991.).

Bulgaria installed a currency board in July 1997. The lev was backed 100% by German marks and traded freely at a fixed rate of 1000 leva to 1 mark. Inflation and interest rates fell like stones. The economy stabilized, and the Bulgarians learned that, even though stability might not be everything, everything is nothing without stability. Discipline at last.

Yes, the main feature of a currency board is the fiscal and financial discipline that it provides. No more running to the central bank for a fiscal bailout. A currency board ties the hands of those meddlesome monetary authorities. And forget the silly theoretical and obscure arguments made by economists who don’t embrace fixed exchange rates. A currency board regime is all about discipline.

As we watch Ukraine melt down once again, we can see what could have been (and what could be) if Ukraine would have only embraced a system of discipline (read: currency board) – like Bulgaria did in 1997. The following table tells the tale:

Bulgaria versus Ukraine

Country

GDP per Capita (USD)

Fiscal Balances %GDP

Current Account Balances %GDP

General Govt. Gross Debt %GDP

Gross Borrowing Needs %GDP

Import Coverage Ratio (FX Reserves / Imports)

W.B. Ease of Doing Business 2014 Rank

Bulgaria

$7,623

-1.9%

1.5%

16.0%

2.6%

6.7

58

Ukraine

$4,011

-8.7%

-8.9%

42.8%

11.0%

1.9

112

Sources: Bulgarian National Bank, National Bank of Ukraine, J.P. Morgan (Emerging Markets Research), International Monetary Fund (IFS), World Bank (Doing Business). 

Prepared by Prof. Steve H. Hanke, The Johns Hopkins University.

The Missing Data in Krugman’s German Austerity Narrative

There’s an ongoing debate about Keynesian economics, stimulus spending, and various versions of fiscal austerity, and regular readers know I do everything possible to explain that you can promote added prosperity by reducing the burden of government spending.

Simply stated, we get more jobs, output, and growth when resources are allocated by competitive markets. But when resources are allocated by political forces, cronyism and pork cause inefficiency and waste.

That’s why statist nations languish and market-oriented countries flourish.

Paul Krugman has a different perspective on these issues, which is hardly a revelation. But I am surprised that he often times doesn’t get the numbers quite right when he delves into specific case studies.

He claimed that spending cuts caused an Estonian economic downturn in 2008, but the government’s budget actually skyrocketed by 18 percent that year.

He complained about a “government pullback” in the United Kingdom even though the data show that government spending was climbing faster than inflation.

He even claimed that Hollande’s election in France was a revolt against austerity, notwithstanding the fact that the burden of government spending rose during the Sarkozy years.

My colleague Alan Reynolds pointed out that Krugman mischaracterized the supposed austerity in the PIIGS nations such as Portugal, Ireland, Italy, Greece, and Spain.

We have another example to add to the list.

He now wants us to believe that Germany has been a good Keynesian nation.