Tag: bailouts

Five Lessons from Ireland

The news is going from bad to worse for Ireland. The Irish Independent is reporting that the Swiss Central Bank no longer will accept Irish government bonds as collateral. The story also notes that one of the world’s largest bond firms, PIMCO, is no longer purchasing debt issued by the Irish government.

And this is happening even though (or perhaps because?) Ireland received a big bailout from the European Union and the International Monetary Fund (and the IMF’s involvement means American taxpayers are picking up part of the tab).

I’ve already commented on Ireland’s woes, and opined about similar problems afflicting the rest of Europe, but the continuing deterioration of the Emerald Isle deserves further analysis so that American policy makers hopefully grasp the right lessons. Here are five things we should learn from the mess in Ireland.

1. Bailouts Don’t Work – When Ireland’s government rescued depositors by bailing out the nation’s three big banks, they made a big mistake by also bailing out creditors such as bondholders. This dramatically increased the cost of the bank bailout and exacerbated moral hazard since investors are more willing to make inefficient and risky choices if they think governments will cover their losses. And because it required the government to incur a lot of additional debt, it also had the effect of destabilizing the nation’s finances, which then resulted in a second mistake – the bailout of Ireland by the European Union and IMF (a classic case of Mitchell’s Law, which occurs when one bad government policy leads to another bad government policy).

American policy makers already have implemented one of the two mistakes mentioned above. The TARP bailout went way beyond protecting depositors and instead gave unnecessary handouts to wealthy and sophisticated companies, executives, and investors. But something good may happen if we learn from the second mistake. Greedy politicians from states such as California and Illinois would welcome a bailout from Uncle Sam, but this would be just as misguided as the EU/IMF bailout of Ireland. The Obama Administration already provided an indirect short-run bailout as part of the so-called stimulus legislation, and this encouraged states to dig themselves deeper in a fiscal hole. Uncle Sam shouldn’t be subsidizing bad policy at the state level, and the mess in Europe is a powerful argument that this counter-productive approach should be stopped as soon as possible.

By the way, it’s worth noting that politicians and international bureaucracies behave as if government defaults would have catastrophic consequences, but Kevin Hassett of the American Enterprise Institute explains that there have been more than 200 sovereign defaults in the past 200 years and we somehow avoided Armageddon.

2. Excessive Government Spending Is a Path to Fiscal Ruin – The bailout of the banks obviously played a big role in causing Ireland’s fiscal collapse, but the government probably could have weathered that storm if politicians in Dublin hadn’t engaged in a 20-year spending spree.

The red line in the chart shows the explosive growth of government spending. Irish politicians got away with this behavior for a long time. Indeed, government spending as a share of GDP (the blue line) actually fell during the 1990s because the private sector was growing even faster than the public sector. This bit of good news (at least relatively speaking) stopped about 10 years ago. Politicians began to increase government spending at roughly the same rate as the private sector was expanding. While this was misguided, tax revenues were booming (in part because of genuine growth and in part because of the bubble) and it seemed like bigger government was a free lunch.

Eventually, however, the house of cards collapsed. Revenues dried up and the banks failed, but because the politicians had spent so much during the good times, there was no reserve during the bad times.

American politicians are repeating these mistakes. Spending has skyrocketed during the Bush-Obama year. We also had our version of a financial system bailout, though fortunately not as large as Ireland’s when measured as a share of economic output, so our crisis is likely to occur when the baby boom generation has retired and the time comes to make good on the empty promises to fund Social Security, Medicare, and Medicaid.

3. Low Corporate Tax Rates Are Good, but They Don’t Guarantee Economic Success if other Policies Are Bad – Ireland used to be a success story. They went from being the “Sick Man of Europe” in the early 1980s to being the “Celtic Tiger” earlier this century in large part because policy makers dramatically reformed fiscal policy. Government spending was capped in the late 1980 and tax rates were reduced during the 1990s. The reform of the corporate income tax was especially dramatic. Irish lawmakers reduced the tax rate from 50 percent all the way down to 12.5 percent.

This policy was enormously successful in attracting new investment, and Ireland’s government actually wound up collecting more corporate tax revenue at the lower rate. This was remarkable since it is only in very rare cases that the Laffer Curve means a tax cut generates more revenue for government (in the vast majority of cases, the Laffer Curve simply means that changes in taxable income will have revenue effects that offset only a portion of the revenue effects caused by the change in tax rates).

Unfortunately, good corporate tax policy does not guarantee good economic performance if the government is making a lot of mistakes in other areas. This is an apt description of what happened to Ireland. The silver lining to this sad story is that Irish politicians have resisted pressure from France and Germany and are keeping the corporate tax rate at 12.5 percent. The lesson for American policy makers, of course, is that low corporate tax rates are a very good idea, but don’t assume they protect the economy from other policy mistakes.

4. Artificially Low Interest Rates Encourage Bubbles – No discussion of Ireland’s economic problems would be complete without looking at the decision to join the common European currency. Adopting the euro had some advantages, such as not having to worry about changing money when traveling to many other European nations. But being part of Europe’s monetary union also meant that Ireland did not have flexible interest rates.

Normally, an economic boom drives up interest rates because the plethora of profitable opportunities leads investors demand more credit. But Ireland’s interest rates, for all intents and purposes, were governed by what was happening elsewhere in Europe, where growth was generally anemic. The resulting artificially low interest rates in Ireland helped cause a bubble, much as artificially low interest rates in America last decade led to a bubble.

But if America already had a bubble, what lesson can we learn from Ireland? The simple answer is that we should learn to avoid making the same mistake over and over again. Easy money is a recipe for inflation and/or bubbles. Simply stated, excess money has to go someplace and the long-run results are never pleasant. Yet Ben Bernanke and the Federal Reserve have launched QE2, a policy explicitly designed to lower interest rates in hopes of artificially juicing the economy.

5. Housing Subsidies Reduce Prosperity – Last but not least, Ireland’s bubble was worsened in part because politicians created an extensive system of preferences that tilted the playing field in the direction of real estate. The combination of these subsidies and the artificially low interest rates caused widespread malinvestment and Ireland is paying the price today.

Since we just endured a financial crisis caused in large part by a corrupt system of housing subsidies for Fannie Mae and Freddie Mac, American policy makers should have learned this lesson already. But as Thomas Sowell sagely observes, politicians are still fixated on somehow re-inflating the housing bubble. The lesson they should have learned is that markets should determine value, not politics.

Three Things We Should Worry about in 2011

The mid-term elections were a rejection of President Obama’s big-government agenda, but those results don’t necessarily mean better policy. We should not forget, after all, that Democrats rammed through Obamacare even after losing the special election to replace Ted Kennedy in Massachusetts (much to my dismay, my prediction from last January was correct).

Similarly, GOP control of the House of Representatives does not automatically mean less government and more freedom. Heck, it doesn’t even guarantee that things won’t continue to move in the wrong direction. Here are three possible bad policies for 2011, most of which the Obama White House can implement by using executive power.

1. A back-door bailout of the states from the Federal Reserve – The new GOP Congress presumably wouldn’t be foolish enough to bail out profligate states such as California and Illinois, but that does not mean the battle is won. Ben Bernanke already has demonstrated that he is willing to curry favor with the White House by debasing the value of the dollar, so what’s to stop him from engineering a back-door bailout by having the Federal Reserve buy state bonds? The European Central Bank already is using this tactic to bail out Europe’s welfare states, so a precedent already exists for this type of misguided policy. To make matters worse, there’s nothing Congress can do – barring legislation that Obama presumably would veto – to stop the Fed from this awful policy.

2. A front-door bailout of Europe by the United States – Welfare states in Europe are teetering on the edge of insolvency. Decades of big government have crippled economic growth and generated mountains of debt. Ireland and Greece already have been bailed out, and Portugal and Spain are probably next on the list, to be followed by countries such as Italy and Belgium. So why should American taxpayers worry about European bailouts? The unfortunate answer is that American taxpayers will pick up a big chunk of the tab if the International Monetary Fund is involved. Indeed, this horse already has escaped the barn. The United States provides the largest amount of  subsidies to the International Monetary Fund, and the IMF took part in the bailouts of Greece and Ireland. The Senate did vote against having American taxpayers take part in the bailout of Greece, but that turned out to be a symbolic exercise. Sadly, that’s probably what we can expect if and when there are bailouts of the bigger European welfare states.

3. Republicans getting duped by Obama and supporting a VAT – The Wall Street Journal is reporting that the Obama Administration is contemplating a reduction in the corporate income tax. This sounds like a great idea, particularly since America’s punitive corporate tax rate is undermining competitiveness and hindering job creation. But what happens if Obama demands that Congress approve a value-added tax to “pay for” the lower corporate tax rate? This would be a terrible deal, sort of like a football team trading a great young quarterback for a 35-year old lineman. The VAT would give statists a money machine that they need to turn the United States into a French-style welfare state. This type of national sales tax would only be acceptable if the personal and corporate income taxes were abolished - and the Constitution was amended to make sure the federal government never again could tax what we earn and produce. But that’s not the deal Obama would offer. My fingers are crossed that Obama doesn’t offer to swap a lower corporate income tax for a VAT, particularly since we already know that some Republicans are susceptible to the VAT.

Don’t Blame Ireland’s Mess on Low Corporate Tax Rates

Ireland is in deep fiscal trouble and the Germans and the French apparently want the politicians in Dublin to increase the nation’s 12.5 percent corporate tax rate as the price for being bailed out. This is almost certainly the cause of considerable smugness and joy in Europe’s high-tax nations, many of which have been very resentful of Ireland for enjoying so much prosperity in recent decades in part because of a low corporate tax burden.

But is there any reason to think Ireland’s competitive corporate tax regime is responsible for the nation’s economic crisis? The answer, not surprisingly, is no. Here’s a chart from one of Ireland’s top economists, looking at taxes and spending for past 27 years. You can see that revenues grew rapidly, especially beginning in the 1990s as the lower tax rates were implemented. The problem is that politicians spent every penny of this revenue windfall.

When the financial crisis hit a couple of years ago, tax revenues suddenly plummeted. Unfortunately, politicians continued to spend like drunken sailors. It’s only in the last year that they finally stepped on the brakes and began to rein in the burden of government spending. But that may be a case of too little, too late.

The second chart provides additional detail. Interestingly, the burden of government spending actually fell as a share of GDP between 1983 and 2000. This is not because government spending was falling, but rather because the private sector was growing even faster than the public sector.

This bit of good news (at least relatively speaking) stopped about 10 years ago. Politicians began to increase government spending at roughly the same rate as the private sector was expanding. While this was misguided, tax revenues were booming (in part because of genuine growth and in part because of the bubble) and it seemed like bigger government was a free lunch.

But big government is never a free lunch. Government spending diverts resources from the productive sector of the economy. This is now painfully apparent since there no longer is a revenue windfall to mask the damage.

There are lots of lessons to learn from Ireland’s fiscal/economic/financial crisis. There was too much government spending. Ireland also had a major housing bubble. And some people say that adopting the euro (the common currency of many European nations) helped create the current mess.

The one thing we can definitely say, though, is that lower tax rates did not cause Ireland’s problems. It’s also safe to say that higher tax rates will delay Ireland’s recovery. French and German politicians may think that’s a good idea, but hopefully Irish lawmakers have a better perspective.

Europe’s Über Bailout

I’m semi-impressed with the Europeans for choosing the hog-wild approach to bailouts. Not because it is good policy, but rather because it will be a useful demonstration of the old rule that bad policy begets more bad policy (which begets God knows what, but it won’t be pretty). The background is that many European nations have been over-spending, over-taxing, and over-regulating. This has created a poisonous combination of weak economies, pervasive dependency, and political corruption, with Greece being the nation farthest down the path to Krugman-topia. Europe’s political elite at first thought they could paper over the problems with a $140 billion Greek bailout. The ostensible motives were to stop contagion and to demonstrate “solidarity,” but behind-the-scenes lobbying by big European banks (which foolishly own a lot of government debt from profligate nations such as Greece, Portugal, Spain, and Italy) may have been the most important factor. Regardless of the real motive, the original bailout was a flop, so the political class has decided to go with the in-for-a-dime-in-for-a-dollar approach and commit nearly $1 trillion of other people’s money to prop up the continent’s welfare states. The Wall Street Journal reports on the issue, noting that American taxpayers will be involuntary participants thanks to the financial world’s keystone cops at the International Monetary Fund:

The European Union agreed on an audacious €750 billion ($955 billion) bailout plan in an effort to stanch a burgeoning sovereign debt crisis that began in Greece but now threatens the stability of financial markets world-wide. The money would be available to rescue euro-zone economies that get into financial troubles. The plan would consist of €440 billion of loans from euro-zone governments, €60 billion from an EU emergency fund and €250 billion from the International Monetary Fund. Immediately after the announcement, the European Central Bank said it is ready to buy euro-zone government and private bonds “to ensure depth and liquidity” in markets, and the U.S. Federal Reserve announced it would reopen swap lines with other central banks to make sure they had ample access to dollars.

Back when Greece first began to collapse, I argued that bankruptcy was the best option. And I noted more recently that my colleague Jeff Miron reached the same conclusion. Everything that has since happened reinforces this viewpoint. Here are a few additional observations on this latest chapter in the collapse of the welfare state.

1. A bailout does not solve the problem. It just means that taxpayers bear the cost rather than the banks that foolishly lent money to corrupt and incompetent governments.

2. A bailout rewards profligate politicians and creates a moral hazard problem by letting other politicians think that it is possible to dodge consequences for reckless choices.

3. A bailout undermines growth by misallocating capital, both directly via bailouts and indirectly by signaling to financial markets and investors that governments are a “safe” investment.

4. A bailout will cause a short-term rise in the market by directly or indirectly replenishing the balance sheets of financial institutions, but this will be completely offset by the long-run damage caused by moral hazard and capital misallocation.

The last point deserves a bit of elaboration. Assuming markets continue to rise, the politicians will interpret this to mean their policies are effective. But that is akin to me robbing my neighbor and then boasting about how my net wealth has increased. In the long run (which is probably not too long from now), though, this system will not work. At best, Europe’s political elite have postponed the day of reckoning and almost certainly created the conditions for an even more severe set of consequences. No wonder, when I was in Europe a couple of weeks ago, I kept running in to people who were planning on how to protect their families and their money when the welfare state scam unravels. Their biggest challenge, though, is finding someplace to go. People use to think the United States was a safe option, but the Bush-Obama policies of bigger government have pushed America much closer to European levels of fiscal instability.

Greek Chutzpah

There’s an old joke that if you owe a bank $10,000, you have a problem, but if you owe a bank $10,000,000, the bank has a problem. The Greek government certainly seems to have that attitude. Short-sighted and corrupt politicians in Athens have spent their nation into a fiscal ditch and they now want to mooch from both the IMF and other European nations (especially Germany). The German Prime Minister (if only for political reasons) is talking tough, saying that Greece should do more to reduce subsidies and handouts. Why should Germans work until age 67, after all, so Greeks can enjoy overpaid government jobs and retire at age 61? So what is the response from the Greeks? Amazingly, one of the politicians had the gall to say his nation “cannot accept” further wage cuts. Here’s an excerpt from the Daily Telegraph:

It is far from clear whether Athens will agree to further austerity as strikes hit the country day after day. Andreas Loverdos, Greece’s labour minister, said the EU-IMF team wants further wages cuts. “We cannot accept that.” Greece knows it can opt for default at any time, setting off an EMU-wide crisis and bringing down Europe’s banks. It also knows that key figures in the Bundestag favour debt restructuring. ‘Those who chased high yield by purchasing Greek debt must share the costs,’ said Volker Wissing, chair of Bundestag’s finance committee. Leo Dautzenberg from the Christian Democrats said banks should prepare for a `haircut’ of up to 50pc. The ECB, Brussels, and the IMF have been fighting feverishly to head off such a move, fearing a financial chain-reaction.

If the Germans have any brains and pride, they will tell the Greeks to go jump in a lake (other phrases come to mind, but this is a family-oriented blog). And if this means that German banks take a loss on their holdings of Greek government debt, there’s a silver lining to that dark cloud since it is time for financial institutions to realize that they should not be lending so much money to corrupt and wasteful governments.

Greetings from Spain

I arrived in Madrid yesterday for a speech to the annual Convention of Independent Financial Advisors, and it is somehow fitting that Spain was downgraded by Standard and Poor’s as I entered the country. I’m not a fan of the bond-rating agencies, and the fact that it has taken so long for Spain to be downgraded simply reinforces my skepticism about their value. So let’s focus instead on identifying the sources of Spain’s fiscal crisis. If you look at the OECD’s fiscal database, you will see that Spain’s short-run problem is solely the result of a growth in the burden of government spending. Over the past seven years, the budget in Spain has skyrocketed from 38.4 percent of GDP to 47.2 percent of GDP. And since tax revenues have stayed the same as a share of national economic output, it is difficult to see how anyone can conclude that the fiscal crisis is the result of inadequate revenue. In the long run, the problem also is excessive government spending, largely because demographic factors such as an aging population will push up outlays for pensions and health care.

In other words, Spain is in trouble for the same reason that Greece is in trouble. Government is too big and politicians are unwilling to take the modest steps that are needed to rein in dependency. This, of course, is exactly why there should not be a bailout. Subsidizing Greek politicians and Spanish politicians – regardless of whether the bailout comes from German taxpayers and/or the IMF – will send a signal to other European nations that there is an easy way out. But the “easy way out” simply postpones the day of reckoning and makes the eventual adjustment much more challenging. Here’s an excerpt from the Washington Post report:

European and International Monetary Fund officials on Wednesday were considering a dramatically increased $158 billion bailout package for Greece as the country’s debt crisis continued to ripple across Europe, with Standard & Poor’s downgrading the credit rating on Spain, the continent’s fourth-largest economy. …In Europe, the most intense focus remains on Greece, but fears were intensifying elsewhere, especially in Portugal and Spain. Though analysts noted that both countries are in better shape than Greece – with lower ratios of debt – they both shared large fiscal deficits and poor long-term economic prospects. On Wednesday, the government in Portugal announced that it would move up a program of painful spending cuts to shrink its budget deficit and shore up confidence amid signs that fearful depositors were moving capital out of Lisbon banks. After lowering Greek debt to junk bond status on Tuesday, Standard & Poor’s kept Spain at investment grade status, but lowered its rating one notch, to AA.

Don’t Be Fooled — GM Is Still Government Motors

General Motors chairman Ed Whitacre is appearing in ads on all the Sunday morning shows repeating the message of his Wall Street Journal op-ed, titled “The GM Bailout: Paid Back in Full,” and the company’s full-page newspaper ads:

We’re proud to announce: We’ve repaid our government loan. In full. With interest. Five years ahead of the original schedule.

But wait: In the Wall Street Journal, Whitacre says the company has made a $5.8 billion payment to the governments of the United States and Canada. But don’t I recall that the GM bailout was $50 billion? Shikha Dalmia of the Reason Foundation explains the whole story in Forbes: First, part of the bailout went into an “escrow fund,” and that government money is being used to pay back the small part of the bailout that was officially a loan. Second, GM is asking for another $10 billion loan to retool its plants to meet the stiffer Corporate Average Fuel Economy standards, and paying back one government loan – with other government money – will make it easier to get another government loan.

And finally, of course, most of the bailout money was transferred to GM in return for a 60 percent stake in the company. And the taxpayers will get that money back if and when GM becomes a publicly traded company again, provided that the company’s market capitalization is eventually higher than it’s ever been in history. Don’t hold your breath.

These are called GM ads, but they could just as well be called BS ads.