The Right and Wrong Way of Responding to the Financial Crisis

Panama City, Panama, January 27, 2009

The Economy and Financial Markets

The United States is now officially in recession.The stock market has suffered a steep decline.Financial institutions are very weak.The bailout does not seem to be working.Other industries are seeking to stick their snouts in the public trough.

Global Downturn

No nation with a significant financial services sector is immune.Iceland’s economy collapsed.Other nations, such as Ireland and Spain, are seriously impacted.Economic forecasts are uniformly grim, though the so-called experts failed to predict the downturn, so they probably are the least likely to correctly predict the recovery.

Who Deserves the Blame?In the U.S., the problem was largely created by government policy mistakes.Easy-money policy by Federal Reserve.Corrupt system of subsidies from Fannie Mae and Freddie Mac.So-called affordable-lending rules that extorted banks into making bad loans.Preferences for debt in the tax code.The result: A bubble that now has collapsed.

The Misguided BailoutThe federal government should not bail out any private companies.Bailouts reward the people who make mistakes.Bailouts create moral hazard.Bailouts hinder the necessary and desirable reallocation of resources.Paulson’s incoherence added to the crisis.No hope and change with Obama

What Should Happen?

President Reagan did nothing after the huge stock market crash in 1987.The market quickly recovered and the economy enjoyed strong growth.If taxpayers are on the chopping block, the approach used during the S&L bailout is far preferable to what is happening now – paying healthy institutions to absorb bankrupt ones.Bad investments must be liquidated.

What Will Happen?

Mitchell’s Law: Bad government policy leads to more bad government policy.Politicians will increase financial regulation, perhaps even creating more systemic risk with global, one-size-fits-all, rules.In the short run, the financial crisis is an excuse to substantially increase the burden of government spending.The return of Keynesianism.

The Return of Keynesianism

Obama’s $825 billion bailout will not work.Keynesianism is the fiscal equivalent of a perpetual motion machine.Borrowing with one hand and redistributing with the other hand does not increase national income.Where is the evidence? Keynesianism does a decent job of showing how economies contract, but a poor job of explaining how they can grow faster.

Real-World EvidenceObama’s plan repeats the mistakes of Hoover and Roosevelt.Tax rebate schemes did not work for Ford and Bush.Keynesianism failed in Japan during the 1990s, even though infrastructure was the main beneficiary.Bush dramatically increased spending and deficits, yet that did not help the economy.Small-government countries grow fastest.

What Should Government Do?

To create conditions that encourage people to create wealth and improve their living standards.To create a large tax base so that the legitimate functions of government can be financed at low tax rates.To preserve and enhance liberty so people can enjoy freedom.

Two Major Fiscal Policy Issues

What is the appropriate role of government?The classical liberal vision of small government.Or the welfare state vision of large government.

How should government be financed?Broad-base and low-rate system designed to minimize distortions.Or a tax code as a tool of social policy.

What is Good Tax Policy?Tax Income at one low rate, ideally no more than 20 percent.Define the tax base correctly, taxing Income only one time.Tax all income alike, since neutrality ensures economic criteria rather than tax provisions determine resource allocation.Tax only income earned inside national borders, the common-sense notion of territorial taxation.

The Ideal Tax System

To minimize economic distortions and satisfy the principles of good tax policy, nations should adopt single-rate, consumption-base tax systems.The flat tax is the best-known option, but other choices exist.Lower tax rates and less double taxation of capital are important steps in the right direction.

Obama’s Dismal Tax Agenda

The good news is that Obama will not be raising taxes…right away.He claims to have nearly $300 billion of tax relief in the stimulus, but the real number is $200 billion since some new spending is being laundered through the tax code.The tax cuts that are in the “stimulus” will not be effective. Now for the bad news.

America Will Move Backwards

The new administration intends to punish successful people with higher income tax rates, higher payroll tax rates, a 45 percent death tax, and increased double taxation of dividends and capital gains.Other tax increases are likely to, a) finance the extension of the economically useless portions of the Bush tax cuts, and b) to “fix” the alternative minimum tax.

America’s Dismal Spending RecordAfter considerable restraint during the Reagan and Clinton years, the burden of government spending skyrocketed during the Bush years.Federal spending has jumped from a bit more than 18 percent of GDP when Clinton left office to 24 percent of GDP today.The only “good” news is that some of the new spending represents temporary bailout costs.

What Will Obama Do on Spending?

President-Elect Obama is promising to be George Bush on steroids.During the campaign, he called for $300 billion of new spending – that’s an annual figure, not the eight-year total.That’s in addition to the $825 billion make-believe stimulus.The entitlement tsunami is about to sweep across America.

Curtailing the Welfare State

“Public Choice” makes spending restraint a political challenge.At a minimum, spending should grow slower than GDP, causing the burden of government to fall over time.This happened during the Reagan years and Clinton years.Some nations have been successful with dramatic spending restraint.

Government Spending and GrowthIf government spending is zero, presumably there will be very little economic growth because enforcing contracts, protecting property, and developing an infrastructure would be very difficult. Some government spending is necessary to uphold the rule of law. Government spending reduces growth, however, when the public sector becomes too large, leading to punitive tax rates and misallocation of labor and capital.

The “Rahn Curve”

There is a “Rahn Curve” relationship between government spending and economic growth similar to the “Laffer Curve” relationship between tax rates and tax revenue.

Empirical Estimates of the Rahn CurveAcademic studies generally find that the growth-maximizing level of government is 17 percent-23 percent, though a European Central Bank study put the figure as high as 30 percent.Every single western nation spends above the growth-maximizing level in these studies.Because of data limitations, the actual growth-maximizing level of spending presumably is lower than shown in the studies.

What About Wealthy Welfare States?Don’t Europe’s welfare states show that big government is not an impediment to growth?No. They became rich because they used to have small public sectors and laissez-faire policy (indeed, still have laissez-faire policy).Government expanded after they became wealthy and could afford anti-growth policies.A nation (or state) can tolerate one percent growth once it is rich. But a poor nation (or state) will never become rich with one percent growth.

Burden of Government Used to be Small

0

5

10

15

20

25

30

35

40

45

50

1870 1913 1920 1937 1960

Ex

pe

nd

itu

res

as

a p

erc

en

t o

f G

DP Sweden

UK

US

Japan

Germany

France

Source: Tanzi and Schuknecht, "Reforming Government: An Overview of Recent Experience,"

Growth is the Best Option

You can’t redistribute without first producing.It is better to be a poor person in a rich nation than a middle-income person in a poor nation.Rich nations can afford redistribution, and the accompanying tepid growth.Poor nations will never become rich if they adopt welfare state policies.

Years Needed to Double Economic Output

1 percent growth

2 percent growth

3 percent growth

4 percent growth

5 percent growth

6 percent growth

7 percent growth

0 10 20 30 40 50 60 70 80

1

What is Being Maximized?

Is the goal wealth maximization or equality of outcomes?Incomes are more widely dispersed in the US than in most European nations.But poor people in the US almost always have more income and higher living standards than poor people in Europe.In the long run, higher growth rates will increase relative prosperity of poor Americans.

What Does this Mean for Taxes?

The rising burden of government means a permanent environment of higher taxation.Rising income tax rates, rising payroll tax burdens, increased death tax.America eventually will be saddled with a value-added tax.The risk of unrestrained majoritarianism – meaning 51 percent of the population can pillage 49 percent of the population.

When Does Atlas Shrug?

How long do the wealth-creators acquiesce?Possible responses include being less productive, being less compliant, and escape.Government cannot stop the first option and is trying to stop the third option with anti-tax competition schemes.Many Americans are moving to Panama to benefit form better policy.

Americans Richer Than Europeans

$20,000

$25,000

$30,000

$35,000

$40,000

$45,000

U.S. E.U.-15

2004

Per

Cap

ita G

DP

OECD in Figures

America Growing Faster than EU-15 Nations

1.0

2.0

3.0

4.0

U.S. E.U.-15

1994

-200

4 A

vera

ge R

eal G

row

th R

ate

Source: OECD in Figures

ConclusionGovernment is causing major problems around the worlds – and using the problems as an excuse for even more government intervention.The bailouts mean more government interference – on a permanent basis.The Keynesian “stimulus” schemes mean more government spending – on a permanent basis.The world needs places such as Panama to be havens so that people can escape.