Spending Restraint and Red Ink

I'm not a big fan of central banks, and I definitely don't like multilateral bureaucracies, so I almost feel guilty about publicizing two recent studies published by the European Central Bank. But when such an institution puts out research that unambiguously makes the case for smaller government, it's time to sit up and take notice. And since these studies largely echo the findings of recent research by the International Monetary Fund, we may have reached a point where even the establishment finally understands that government is too big.

The first study looks at real-world examples of debt reduction in 15 European nations and investigates the fiscal policies that worked and didn't work. Entitled "Major Public Debt Reductions: Lessons From The Past, Lessons For The Future," the report unambiguously concludes that spending restraint is the right way to reduce deficits and debt. Tax increases, by contrast, are not successful. The study doesn't highlight this result, but the data clearly show that "revenue increases do not seem to have induced debt reductions, whereas cuts in primary expenditure seem to have contributed significantly in the case of major debt reductions."

Here's a key excerpt:

[T]his paper estimates several specifications of a logistic probability model to assess which factors determine the probability of a major debt reduction in the EU-15 during the period 1985-2009. Our results are three-fold. First, major debt reductions are mainly driven by decisive and lasting (rather than timid and short-lived) fiscal consolidation efforts focused on reducing government expenditure, in particular, cuts in social benefits and public wages. Revenue-based consolidations seem to have a tendency to be less successful. Second, robust real GDP growth also increases the likelihood of a major debt reduction because it helps countries to "grow their way out" of indebtedness. Here, the literature also points to a positive feedback effect with decisive expenditure-based fiscal consolidation because this type of consolidation appears to foster growth, in particular in times of severe fiscal imbalances.

The last part of this passage is especially worth highlighting. The authors found that reducing spending promotes faster economic growth. In other words, Obama did exactly the wrong thing with his so-called stimulus. The U.S. economy would have enjoyed much better performance if the burden of spending had been reduced rather than increased. One can only hope the statists at the Congressional Budget Office learn from this research.

Equally interesting, the report notes that reducing social welfare spending and reducing the burden of the bureaucracy are the two most effective ways of lowering red ink:

The estimation results indicate that expenditure-based consolidation which mainly concentrates on cuts in social benefits and government wages is more likely to lead to a major debt reduction. A significant decline in social benefits or public wages vis-a-vis the overall decline in the primary expenditure will increase the probability of a major debt reduction by 31 and 26 percent, respectively.

The other study takes a different approach, looking at the poor fiscal position of European nations and showing what would have happened if governments had imposed some sort of cap on government spending. Entitled "Towards Expenditure Rules And Fiscal Sanity In The Euro Area," this report finds that restraining spending (what the study refers to as a "neutral expenditure policy") would have generated much better results. 

Here are the main findings:

[T]he study assesses the impact of the fiscal stance on primary expenditure ratios and public debt ratios and, thus, provides a measure of prudence or imprudence of past expenditure policies. The study finds that on the basis of real time rules, expenditure and debt ratios in 2009 for the euro area aggregate would not have been much different with neutral expenditure policies than actually experienced.

...Primary expenditure ratios would have been 2-3½ pp [percentage points] of GDP lower for the euro area aggregate, 3-5pp of GDP for the euro area without Germany and up to over 10 pp of GDP lower in certain countries if expenditure policies had been neutral.

There's a bit of academic jargon in that passage, but the authors are basically saying that some sort of annual limit on the growth of government spending is a smart fiscal strategy. And such rules, depending on the country, would have reduced the burden of government spending by as much as 10 percentage points of GDP. To put that figure in context, reducing the burden of government spending by that much in the United States would balance the budget overnight.

There are several ways of achieving such a goal. The report suggests a spending limit rule based on the growth of the overall economy, which is similar to a proposal being developed in the United States by Senator Corker of Tennessee. But it also could mean something akin to the old Gramm-Rudman-Hollings law, but intelligently revised to focus on annual spending rather than annual deficits. Some sort of limit on annual spending, perhaps based on population plus inflation like the old Taxpayer Bill of Rights (TABOR) in Colorado, also could be successful.

There are a couple of ways of skinning this cat. What's important is that there needs to be a formula that limits how much spending can grow, and this formula should be designed so that the private sector grows faster than the public sector. And to make sure the formula is successful, it should be enforced by automatic spending cuts, similar to the old Gramm-Rudman-Hollings sequester provision.