Outside the Beltway

Lets Have Some Limited Government Please

Steve Verdon · Monday, November 22, 2004 · 13 comments

After reading an article like this by Robert Kuttner, I find myself longing for a far more limited government.

Given low domestic savings rates, budget deficits of this magnitude require foreign financing. For years economists have been warning that the “co-dependency” between the U.S. and Asian central banks — in which the immense American budget and trade deficits are financed mainly by Japan and China as long as we keep importing their products — cannot be sustained indefinitely. Bush’s budget deficits have pushed this arrangement close to a tipping point and a dollar crash. The trade deficit is in excess of 5% of gross domestic product and heading toward 7%. At some degree of U.S. foreign indebtedness, the world will start dumping the dollar and shorting it in the currency markets.

The trade deficits would be smaller if China and Japan ran more open economies. But Bush’s heavy dependence on the central banks of these countries undercuts any leverage Washington has to induce them to open further to U.S. exports and to run more transparent economies. In addition, a weakening dollar scares off non-central bank private foreign investors in American securities. There has been very little private foreign investment in U.S. equities and government bonds lately.

I have always been rather frustrated (too put it mildly) by Bush’s spending. I thought No Child Left Behind was a huge mistake, and the prescription drug plan a nightmare. But, I also see these things as natural outgrowths of activist government.

Suppose there is some issue that the government decides to get involved in. They go talk to some experts and actually come up with a plan that will yield the best outcome. Now if everybody believes this plan the government will have an incentive to deviate from the plan in an attempt to make things even “better”. Example: the inflation/unemployment trade off. There is a concept known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU). The idea behind this awful sounding term is that there is a rate of unemployment that if maintained there will be a constant rate of inflation. So if policymakers (i.e., politicians) want a certain inflation rate, they can implement certain policies to achieve this. Now if everybody believes this, then there can be an improvement by deviating from those policies to achieve say a lower rate of unemployment. Now, the problem is that if people are forward looking, they will see this temptation to deviate and they will not believe the initial policy announcement. Thus, the initial plan is not achievable, and the later deviation for an even better outcome is also not achievable. This problem is know in economics as the time inconsistency problem. While time inconsistency usually crops up in regards to monetary policy (like the example just given) it also applies to things like spending as well.

For example, suppose there is a river that floods is banks every few years. Those living near the river suffer economic hardship whenever the river overflows. The people living there cannot get insurance since it is known the river regularly overflows its banks. So the government mandates that nobody should live within the areas that flood. Problem solved right? Nope. People realize that if they move in there and enjoy the river that when the river does overflow the government will step in and bail them out (no pun intended). So they move in. There is almost no way to commit to the best strategy of not having the government mitigate the economic damage. To pay for this taxes have to be raised, and taxes introduce inefficiences in the markets that are taxed, and the welfare of those not living near the river goes down.

Here is another one. Some people foolishly do not plan for their retirement years and don’t have enough money for prescription drugs. Now, one possible policy response is to not help these people and thus induce others to plan more wisely. But once everybody who is still of working age is saving for their prescription drugs, the government has an incentive to deviate and help the current foolish retirees. Not being stupid, the current workers would see this coming and not save. Hence the government ends up having to cover even more people.

Note that so far we have not thrown in things like elections and serving one’s constituents as well. Factor that in and you get rent seeking as well. Rent seeking is where a group tries to secure unearned economic benefits. A crude example would be where one group of voters secures a monetary transfer from another group of workers. Currently we call this program Social Security. Another example would be where specific consumption by one group of voters is subsidized by another group of voters. This program is currently called Medicare. Another example would be increases in protection of intellectual property. The last version of this kind of rent seeking was put forward by Sonny Bono and provides exactly no economic benefits to society and merely transfers income from those who want to consume intellectual property to the pockest of those who hold the rights to the intellectual property. Evnironmental lobbying/legislation is a type of rent seeking. The environmentalist want to obtain something and instead of buying it outright, they basically take via legislative fiat.

The bottom line is that activist government is usually going to be a mess. More and more spending, and when the voters don’t want to keep paying more and more in taxes for these kinds of things, you get deficits. The problem with deficits is that eventually it means higher taxes. Someday the debt will have to be paid off. A deficit is basically spending tomorrow’s government reciepts today, and then raising taxes in the future. One could argue that the tax increase under George H. W. Bush was a result of deficits. By having a limited government it would be harder to enacting policies like No Child Left Behind, the prescription drug plan, and other programs that basically suck up money and waste it. So it is with some amusement when I see people like Robert Kuttner, Brad DeLong and others bemoan fiscal irresponsibility and deficits. I can’t help but think that the Clinton years where we actually had surpluses were a fluke and not the result of careful and deliberate planning. Remember opposing parties had control of different branches of government, was that part of Clinton/Rubin’s grand scheme? Did they really set out to lose control of the House and Senate so that they could get a surplus years down the road? Was Clinton’s healthcare plan a clever ruse to help achieve a balanced budget? Somehow I don’t think so. In looking at Kerry’s platform it was breath taking in terms of the scope of spending. You want to do something about the deficit? Get rid of activist (discretionary) government.