Sunday, January 28, 2018

A Note on Deficits and Economic Stability

Forecasting is the most thankless endeavor an economist can get involved in. Well, not from an earnings viewpoint: if you want to make big money as an economist, do quantitative forecasting for a living. Businesses, universities and research institutes invest heavily in quantitative models and top talents to put them to good use.

Yet the list of economists who correctly predicted the Great Recession - which started ten years ago - is as empty as the list of French military victories. Overall, economic forecasting is at its best when nothing happens; it is when the economy undergoes a radical change that standard forecasting fall flat.

Why is that?

At the core is the concept of economic stability. It is crucial to standard economic forecasting, where it makes life complicated for economists. However, it has also come to shape the role that the welfare state plays in our economy, which has caused systemic, macroeconomic problems that - if left unaddressed - coming generations are going to have to pay a dear price for.

Our very system of entitlement programs is configured as a permanent institutional structure, aimed at performing the same type of economic redistribution ad infinitum. The welfare state, as it is designed, is actually a static presence in a dynamic economy. Its continued existence depends on the perennial stability of the economy upon which it was built: a static structure can remain in place if and only if its surrounding environment is either equally static or perennially stable. In practice, the effect is the same in both cases.

The welfare state's dependency on macroeconomic stability has both short-term and long-term consequences. The short-term ones are related to the regular business cycle - as much as we have a regular cycle - where the welfare state is supposed to fulfill two purposes:

a) finance itself over the course of one cycle, and
b) mitigate recessions by means of entitlements that expand when times are tough.

This way, the welfare state is supposed to prevail within the framework of a long-term stable economy. The problem is that the welfare state's incentives structure is such that the entire system of taxes and entitlements does not move along with the economy through its ups and downs. Instead, the welfare state alters the short-term cycle by cutting the tops of the growth period (high marginal rates in personal income taxes eventually discourage further pursuit of profitable economic activity) and extending the troughs (redistributive entitlement programs encourage people to stay unemployed or in low-paying jobs).

Over time, the effect of this incentives structure is a slow downgrade of economic activity, pushing the growth rate of an otherwise stable economy downward. Eventually, this causes long-term problems for the welfare state: static as it is, it depends on a certain rate of macroeconomic expansion to stay fully funded, both short term over a business cycle, and long term.

It is here that the long-term consequences of the welfare state's dependency on a stable economy come into play. Those consequences began showing up in industrialized economies, primarily in Europe, as early as the 1970s, in the form of new cyclical problems - the stagflation phenomenon - and a new, structural growth problem.

Eventually, the welfare state weighed down the long-term trajectory of Western economies to a point where those welfare states are now notoriously under-funded.

Which leads us over to the public policy side of the issue. When politicians build spending programs, and craft a tax system to pay for that spending, they operate - as mentioned - on the premise that the "surrounding" economy is long-term stable. Therefore, when revenue declines their first and foremost assumption is that the economy has entered into a recession. 

Since recessions are temporary in standard economic theory, all that politicians need to do is to find temporary measures to abridge the budget gap. 

Anything else would require structural, permanent reforms to welfare-state spending programs. As has been proven abundantly in the Western world over the past few decades, it is easier to repeal environmental regulations than to even have a conversation about reforming away the welfare state. Sadly, even large, concerted efforts at deregulation of the scale initiated by President Trump, will fall short of solving the structural problems caused by the incongruity between the welfare state and its surrounding economy. Deregulation, like tax cuts, will buy governments time by means of a short-term injection of new tax revenue, but eventually government spending catches up again.

A good reform strategy for the welfare state starts with good economic theory that is built on the premise that there is no such thing as inherent stability - or Walrasian general equilibrium - to the economy. 

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