The Crisis Next Time: Public Finance

The financial crisis of 2008 paved the way for the employment crisis of 2009, which has now paved the way for the upcoming public finance crisis of 2010. Most federal, state and municipal budgets are strained to the breaking point while the economy still has not found its footing. Meanwhile our national politics is obsessed with expensive overhauls of environmental policy and healthcare reform. Our latest policy strategy is an attempt to borrow and spend our way to prosperity, ala Japan of the past twenty years.

It?s tempting to point to a few simple causes of these economic misfortunes, such as mortgage subsidies, loose credit standards, or excess financial leverage, but the truth is that we are experiencing the fallout of a failed policy paradigm.

This paradigm was rooted in the past century with the creation of the Federal Reserve in 1913, the Employment Act of 1946 and the Humphrey-Hawkins Full Employment and Stabilization Act of 1978. It?s a paradigm dependent on many admittedly useful policy tools, including both Keynesian demand stimulus and the Austrian school?s theory of money and credit, the monetarism of Friedman, as well as the supply-siders of the 1980s.

So, in what ways have these approaches failed?

The policy goals are clearly stated: stable GDP growth and full employment. But the economic results have been decidedly mixed: the growth of real incomes laden with an exploding entitlement state, structural budget crises, widening wealth disparities, a catastrophe-prone banking system, and volatile asset markets. We?ve heard the term ?systemic risk? bandied about the recent financial crisis, but this report card captures the true risks of the system we?ve created.

Politically and socially, Americans clearly want a society where a growing middle class thrives, opportunity exists for individual success and advancement, and a prosperous elite accepts the responsibilities of power not to exploit the weak and disadvantaged. Instead, our political economy is hollowing out the middle class, creating more dependency among the poor, and fostering a culture of corruption and irresponsibility among the elites. Elsewhere I?ve characterized this current state of affairs as Casino Capitalism and Crapshoot Politics.

Second question: why has our democratic politics failed to deliver? The short answer: Our government is doing too much of what it shouldn?t be doing and not enough of what it should.

Free market economies are very good at producing wealth by harnessing the incentives of market participants. Market prices are valuable information signals that tell everyone how much of each good to produce. Governments, however, no matter how enlightened, cannot attain this efficiency. But, due to the political imperative to ?do something? in response to countless demands, they feel compelled to try. Thus the focus on ?growing the economy? and ?creating jobs.?

Unfortunately, these goals often demand incompatible policies, highlighting the differences between the private and public sectors. Private firms earn profits (i.e., create wealth) by increasing productivity, often by reducing labor costs. However, the public sector follows no profit criteria, so the government increases employment without attention to productivity. Thus, with more public sector jobs we create more employment while producing less. At the same time, the growth of the public sector empowers a politically powerful public union interest in its continued expansion. This is no way for a nation to grow rich.

When we peel away the logic we find the true goal of public sector job creation: political redistribution of the economy?s wealth-creating capacity in order to mitigate the effects of markets. This is not an unworthy societal goal, but our public policies adopt counterproductive means to achieve it.

To be fair, the political problem arises because private markets are agnostic towards the distributional effects of their success. Inequality, poverty, pollution, environmental degradation, the concentration of economic and political power ? all these are unfavorable distributional effects of markets that give rise to political demands. The question is over how government should meet these demands.

The 20th century attempt to tax and redistribute wealth has landed the modern welfare state in a cul-de-sac of exploding budgets, rising costs of living, slower economic growth and structural unemployment. We?re robbing Peter to pay Paul and neither ? except for a relative handful of bureaucrats and rent-seeking capitalists ? is better off for it. This adds up to less opportunity all around. Again, the problem is with our failed paradigm. We need to align our policies with behavioral incentives without surrendering our policy goals to an agnostic market mechanism.

To construct a new paradigm we might do best to return to first principles of what Americans want: freedom, opportunity and justice. In order to enjoy these principles, citizens need to be empowered with choice, autonomy, and protection from unmanageable risks. Only functioning free and competitive markets can provide the necessary resources.

So, what should be the proper role for government?

The maldistribution of resources can be mitigated if citizens participate in the wealth creating process as more than an input labor cost. Public policy should cease deficit spending to promote employment and instead look to creating the necessary environment for private risk-taking, saving, investment, and production. This includes insuring market competition and mitigating the effects of economic risk and uncertainty. Tax and regulatory policies should promote the widespread accumulation, diversification, and access to capital to empower individuals and families with the necessary resources to build wealth and insure themselves against uncertainty. Where private insurance markets are incomplete, there is a role for limited social insurance to fill the gap.

Numerous specific policies flow from this general paradigm shift, for example, we can stop penalizing savings through overly loose credit and onerous tax policies on interest and dividend income. There is no reason not to have a tax-free threshold for capital income that reflects the desired savings level of the median annual income household.

Why have we stuck with a failed policy paradigm? Part of the answer is the Kuhnian nature of scientific revolutions, but the pursuit of power and influence by narrow interests is certainly a determinant factor. Economically and socially, we know where we need to go. Getting there politically is another matter. Our present political leadership (of both parties) certainly is not taking us in that direction.

Michael Harrington is a policy analyst and writer with a multidisciplinary background in economics, finance and political science. His specialties are international capital markets, trade, and social insurance. He has taught political science at UCLA and conducted economic research for The Reason Foundation, The Milken Institute and the US Chamber of Commerce. His published writings and opinions have appeared in numerous business journals, including the Wall Street Journal, Barron?s, BusinessWeek, the Economist, the Christian Science Monitor and the Los Angeles Times.