Center for Business & Public Policy
Collaborative blog exploring the relationship between market forces and public policy.

Politicians like to say they want the U.S. to produce at least as much energy as it consumes – “energy independence”.  And they certainly want to reassure consumers that they are doing something about the high price of gasoline.  But the two goals are inconsistent.  You can’t have both.  Indeed, the current high price of oil is exactly what is now REDUCING our dependence on foreign oil!

We all know the price of gasoline has been increasing lately, now well over $4 per gallon in some locations.  Five-dollar gas is predicted by Summer.  In addition, the New York Times just reported that our dependence on foreign oil is falling.  “In 2011, the country imported just 45 percent of the liquid fuels it used, down from a record high of 60 percent in 2005.”  The article points out that this strong new trend is based BOTH on the increase of U.S. production of oil AND on the decreased U.S. consumption of it.  And both of those factors are based on the recent increases in oil and gasoline prices.  Those higher prices are enough to induce producers to revisit old oil wells and to use new more-expensive technology to extract more oil from those same wells.  The higher prices also are enough to induce consumers to conserve.  Purchases of large cars and SUVs are down.  Many people are driving less, even in their existing cars.  A different article on the same day’s New York Times, on the same front page, also reports that “many young consumers today just do not care that much about cars.”

Decreased dependence on foreign oil does sound like good news.   Actually, it is good for a number of reasons. (1)  It is good for business in oil-producing states, helping raise them out of the current economic slow-growth period.  (2) It is good for national energy security, not to have to depend on unstable governments around the rest of the world.  (3)  It reduces the overall U.S. trade deficit, of which the net import of oil was a big component.  And (4) the reduced consumption of gasoline is good for the environment. 

On the other hand, the increased U.S. production of oil is not good for the environment, as discussed in the same newspaper article just mentioned.   As an aside, I would prefer to do more to decrease U.S. consumption of oil – not only from increased fuel efficiency but also by the use of alternative non-fossil fuels – and perhaps less from increased U.S. production of oil from dirty sources such as shale or tar sands.  But that’s not the point for the moment.

The point for the moment is just that maybe the higher price of gasoline is a GOOD thing!  We can’t take even small steps toward decreasing U.S. dependence on foreign oil UNLESS oil and gas prices rise.  Any politician who tells you otherwise is pandering for your vote.  It is the high price of oil that is both increasing U.S. production and decreasing U.S. Consumption.

It is being reported today that Senator Sheldon Whitehouse (D-R.I.) is introducing a bill that would impose a minimum 30% tax on individuals earning more than $1 million per year.  This type of tax policy – which is essentially a new version of Alternative Minimum Tax – has been dubbed the “Buffett Rule” due to the news last year that Warren Buffet had a lower tax rate than his secretary.

Warren Buffett claims to have a tax rate of 17.4 percent.  His claim, however, is only true if one ignores one of the most basic economic principles of tax analysis: that the person who writes the check is not necessarily the same as the person that bears the economic burden of a tax.  In economics, this distinction is known as the difference between “legal incidence” (i.e., the entity with legal responsibility for paying taxes) and “economic incidence” (i.e., a measure of who really bears the economic burden of the tax).

In almost any undergraduate public finance textbook, one can find simple examples of how these concepts diverge.  For example, politicians often make a big deal of the fact that the FICA payroll taxes used to support Social Security and Medicare are split evenly between employers and employees.  But economists tend to believe that nearly all of the economic burden of the payroll tax falls on workers.  In other words, even though employers pay their share of the FICA tax, in the long-run the result is that workers are paid less than they would be paid in the absence of the tax.  Thus, it is the workers and not the firms who are truly paying the tax, in spite of how it appears.

The discussion around Mr. Buffet’s taxes – as well as the more recent discussion around the release of Governor Romney’s tax returns – has completely missed this point.  Those discussions have focused solely on the legal incidence of the personal income tax system, and have failed to think through the economic incidence of the overall tax system.

How so?  It is not uncommon for wealthy individuals like Mr. Buffett to receive much of their income in the form of dividends and capital gains.  This type of income may appear as if it is receiving “preferential” tax treatment, but the reality is that it is taxed heavily.  This is driven by the fact that corporate income is taxed at the corporate level before it is available to be paid out as dividends (or used to repurchase shares, which can lead to capital gains for investors who retain their shares).  The U.S. imposes a very high – 35% – marginal tax rate on corporate income.  Thus, if a firm earns another $1000, it pays $350 in taxes, leaving only $650 to go to shareholders.  If those shareholders are then taxed at a 15% rate, that is another $97.50 that goes to the government.  This leaves only $552.50 in the pockets of shareholders for every $1000 of pre-tax earnings that are paid as dividends.  Thus, the effective marginal tax rate on this income is more like 47.5% than it is 15%.

Of course, there are at least two important caveats to this stylized example.  First, the economics profession has simply not been able to come up with a definitive estimate of who really bears the burden of the corporate income tax.  One of the leading tax scholars of our day – Alan Auerbach of the University of California at Berkeley – wrote a terrific summary of what we know on this topic back in 2005 (the paper, which was ultimately published in the NBER Tax Policy and the Economy series, is available as an NBER working paper here.)  He notes that one of the major lessons is that “for a variety of reasons, shareholders may bear a certain portion of the corporate tax burden … thus, the distribution of share ownership remains empirically quite relevant to corporate tax incidence analysis.”  This is hardly a ringing endorsement that we should assume the entire incidence falls on Warren Buffet and other shareholders, but it is quite clear that we should not be ignoring corporate taxes when making policy statements about the fairness of the tax system.

A second caveat is that not all corporations face a 35% marginal effective tax rate.  Corporate income taxation is nothing if not a complex labyrinth of rules, exceptions, and exceptions to the exceptions.  Again, however, we know that for most corporate earnings, the rate of corporate taxation is well above zero, which is the rate it would need to be for us to feel as if we can ignore it when making statements of the kind Mr. Buffett makes.

A fellow Forbes contributor, Josh Barro, points out a number of problems with the Buffett Rule, the most important of which is that it would exacerbate the already-existing tax distortion that favors debt over equity.  If Congress wants to do this, that is their prerogative.  But we should not allow them to justify potentially bad tax policy on the basis of a naïve and misleading understanding of tax incidence.

 As 2011 draws to an end, the Euro crisis appears to have taken a rest from the headlines. Perhaps it is just that the holidays have commanded our attention. But my first prediction for 2012 is that Europe will return to the headlines, soon. Given the pause, maybe it is time to reflect on what exactly the crisis is all about. I believe that the crisis needs to be re-framed. We have deluded ourselves about the exact cause and this inhibits progress to a solution.

Start with the idea that for every complex crisis there has, at base, a simple explanation, a simple cause or simple delusion. In the financial crisis of 2007-8 the simple explanation was that the populace of the US and elsewhere deluded themselves with the idea that real estate prices would keep on rising and could never fall. If you were conservative perhaps you thought that price increases could pause, but even the most conservative never thought that prices could, yikes, drop. From that simple “popular delusion of the crowd” lots of poor behavior decisions emanated – most notably taking on too much debt – to finance, and to take advantage of, ever rising real estate prices. When the delusion met reality all sorts of blame, shame and pain was passed out. Truth to tell, we were all to blame, and that includes everybody from house flipper to Investment banker. We deluded our selves.

Interests Rates on 10-year Goverment Bonds (in percent):

The question for the Euro crisis is what was the analogous popular delusion of the European crowd? The first graph contains the answer. (The graph is borrowed Atlantic Magazine’s Best Graphs of 2011.) When the Euro was introduced, the idea that took hold, by governments and consumer alike, was everyone using the same currency should be able to borrow at almost identical interest rates. The borrowing rates of the Euro zone members would converge. “Convergence” was the European crowd’s popular delusion. Greece could borrow as cheaply as Germany. As the graph shows, this delusion lasted for almost seven years from 2001 to 2008 and during this period Greece did borrow as cheaply Germany. So did Portugal, Ireland, France and all the rest. But as the graph also shows, prior to 2001 and the introduction of the Euro as “legal tender” the markets discriminated between the creditworthiness of Greece and Germany. They are beginning to do that again. Greece’s 10 year borrowing rate was 16% in 1996. It is again now. (Actually at the end of 2011 it’s probably almost double that; the borrowed graph was drawn mid 2011.)

The big difference between 1996 and 2011 is that Greece no longer has the ability to redeem its debts in Drachma. It has to now generate Euros, and obtaining those is harder than printing Drachmas. In fact to generate Euros the country has to manufacture and sell more goods to customers who pay in Euros, or buy fewer Euro-denominated imports. That is proving to be difficult because the price of Greek goods in Euros is too high. That is true of Greek holidays, Greek labor, Greek shipping, Greek cotton, Greek olives and the rest. The only solution is to cut labor costs, or equivalently, raise productivity. That is hard to do when you have had seven fat years.

Imagine if you once had to pay 16% on your debts and suddenly some people start lending to you at 5 %. (It was even less by 2006, around 3.5 %.) Well the traditional economic response from the rational buyer of credit, i.e. borrower, is to use more of it. Greece borrowed a lot. It was not alone. All the major countries with higher credit risk in the pre- 2001 period, including Portugal and Ireland took advantage of the largess of lenders. Shame on them! They should not have done it. But they did, so they must pay it back. As long as they could roll the repayment through further debt sales, it was well and good. However after the financial crises the largess of lenders became more rationed. It cost more to refinance. In fact it has got to the point where the refinance rates are usurious. Greece and the rest may not be able to redeem their debts. They may default. Shame on these profligates!

But why chastise them alone?

Isn’t the opprobrium more sensibly shared with the lenders? Didn’t the lenders just mess up? As a credit analyst why would you ever lend to Greece and the rest at 5%, if you previously thought 16% was the correct rate?  It was true that they could no longer print their own currency, but that did not mean that could not spend money inappropriately if it was poured upon them. Surely the lenders were the deluded ones.

Exactly who were those irrational lenders? That is the significance of the second graph. (This graph is borrowed from the New York Times, May 2010, and based on then-current BIS data.)

The big lenders were Germany, France and the U.K. Between them they lent the Greek Government $135 Billion (33% Germany, 56% France and 11% U.K.). Collectively those three countries lent a total of $2 Trillion (35% Germany, 45% France and 20% U.K.)  to Portugal, Ireland, Italy, Greece and Spain, also known as the PIIGS, at incredibly low rates. The mechanism for the loans was buying the sovereign bonds of those countries. They made bad lending decisions; they should accept the consequences by marking their bonds to market, by accepting the loss. Bad lenders, shame on them!

Why did conservative and sensible Germany lend so much to Greece? Well we are suggesting here that they deluded themselves into the convergence scenario that would magically appear with the introduction of the Euro. Certainly the Euro was not the only vehicle for “Convergence” expectation, cross-country and cross-product subsidization had always been part of the EU, but the fantasy really took flight with the introduction of the Euro. But perhaps there is even more to it than that. Germany is the number one country that Greece imports from. France is number five. One way to think of the whole Euro crisis is therefore as a giant “vendor financing” scheme that went wrong. It will not be the first time that vendor financing schemes went awry – General Motors, Toyota and Ford car leasing programs among others have been prime examples. When those schemes went wrong however the managements (and eventually the shareholders) had to take their lumps and move on. They didn’t stop leasing cars they simply recognized the mis-pricing, re-priced and moved on. Germany and France seem less inclined to do the same.

France strongly resisted taking any kind of haircut (diplomatic-speak for marking to market) and German tax payers do not want to pay for their governments mistakes.  European banks who hold European sovereigns don’t want their capital to be impaired through mark to market.

 So, shame on whom?

To move forward it’s not shame that needs to be apportioned it’s the pain. The seven fat years don’t have to be followed by seven lean (depression?) years. Re-price and move on. If there were no transfer-union entanglements the lenders, be they governments or private banks would write off the bad loans and then make a decision at what price they were prepared to now lend to a bad credit. Greece and the others could then calculate whether or not the price of still using the Euro at market rates was worth the cost. They may decide to leave the Euro, as might other countries. That does not necessarily kill the Euro. It can still exist for those who want to use it, just as some countries e.g. in Central America, have chosen to use the Dollar as their official currency. A country that uses the Euro in the future will know two things, a) that it surrenders the printing press to the ECB and removes that lever from domestic politicians, and b) that it will face difficult and expensive borrowing unless it keeps its fiscal house in order.

The Euro need not die, but the delusion of “Convergence” will, or already should have. Instead the Germans and French lead other Euro-Zone nations to cling to the delusion. They have proposed even greater mutualisation of fiscal policy among Euro-Zone members. Lectures are forthcoming with regularity from those who made bad credit decisions to those who were deemed to be profligate. This is a posture that might be acceptable from a bank that was setting new loan conditions and rates to a previously recalcitrant borrower, but was still willing to provide finance. Instead what is offered is a “my way or the highway” policy from a collective of lenders who refuse to recognize their own mistake, refuse to mark down their past errors and continue to cling to the “Convergence” objective. It ain’t gonna happen, but if it did it has a greater chance of success as a voluntary consequence of the cost of profligacy, i.e. countries paying market credit rates, than from the demeaning business of being bailed out and lectured to by the very people who pushed cheap credit in the first place.

Enough already! Taking losses is never pretty, for borrower or lender, but it is surely the best and quickest way to correct errors and faulty assumptions. As they say in the bond market, there are no such things as bad bonds, just bad prices. Sovereign credits were badly mis-priced; re-price and move on. Or, to non bond market mavens, when you are in a “Convergence” hole, stop digging.

Here is an interesting article, in the Washington Post, entitled “Payroll tax cut raises worries about Social Security’s future funding“.  It points out that the recent payroll tax cuts are intended for short term stimulus, but they muck with the way that social security benefits are funded.  Instead of coming frm payroll taxes, that money now will haveto come from general revenue. 

As it points out: “For the first time in the program’s history, tens of billions of dollars from the government’s general pool of revenue are being funneled to the Social Security trust fund to make up for the revenue lost to the tax cut. Roughly $110 billion will be automatically shifted from the Treasury to the trust fund to cover this year’s cut, according to the Social Security Board of Trustees. An additional $19 billion, it is estimated, will be necessary to pay for the two-month extension.” 

As it goes on to say, “The payroll tax cut changes that. Instead being a protected program with its own stream of funding, Social Security, by taking money from general revenue, becomes more akin to other government initiatives such as Pentagon spending or clean-air regulation — programs that rely on income taxes and political jockeying for support.”

Just a couple days ago, the Wall Street Journal reported that “U.S. exports of gasoline, diesel and other oil-based fuels are soaring, putting the nation on track to be a net exporter of petroleum products in 2011 for the first time in 62 years.”  Taken literally, this fact is strictly “correct”, but it is misleading.  It is therefore very poor reporting.  The authors either don’t understand the words they use, or they are deliberately trying to mislead readers.

The reason it is misleading is because the article implies the U.S. is headed toward “energy independence”, and that implication is wrong.  It goes on to say:  “As recently as 2005, the U.S. imported nearly 900 million barrels more of petroleum products than it exported.  Since then the deficit has been steadily shrinking until finally disappearing last fall, and analysts say the country will not lose its ‘net exporter’ tag anytime soon.”  That statement and several expert quotes in the article clearly imply the U.S. is headed toward “energy independence”.   

Strictly speaking, the WSJ is correct that the U.S. exports more “petroleum products” than it imports, … but “petroleum products” do not include crude oil!!  “Petroleum products” include only refined products like gasoline, diesel fuel, or jet fuel.  The implication is only that the U.S. has a large refinery capacity!

The U.S. is a huge net importer of crude oil, and a huge net importer of all “crude oil and petroleum products” taken together, as you can see from the chart  below (provided by the U.S. Energy Information Administration).   In other words, we import boatloads of crude oil, we refine it, and then we export slightly more refined petroleum products than we import of refined petroleum products.  Big deal.

If the WSJ reporters knew what they were talking about, or if they were not trying to mislead readers, then they should have just stated that the U.S. is a huge net importer of all “crude oil and petroleum products” taken together.  They didn’t.  That is why I conclude they do not understand the point, or that they are trying to misrepresent it. Neither conclusion is good for the Wall Street Journal.

They are simply wrong when they say:  “The reversal raises the prospect of the U.S. becoming a major provider of various types of energy to the rest of the world, a status that was once virtually unthinkable.”  Just look at the figure!

Two institutions come out looking good from the MF Global fiasco, the Chicago Mercantile Exchange and the Commodity Futures Trading Commission. 

MF Global, one of the biggest of the futures clearing firms, failed.  As a clearing firm, not only are its direct clients affected, but also the firms that clear their trades through MF Global, and those firms’ clients.  MF Global was unable to fulfill its obligations as a clearing member.  As a clearing firm, it deals with the central clearinghouses at the CME and other futures exchanges for itself and its clients, but also acts for other firms as their channel to the clearinghouse.  It is responsible for collecting and paying margin from its own clients and from the firms who clear through it.

The central clearinghouse is the apex of a pyramid of collateral protection.  Whether a position is long or short, each client posts margin as a guarantee against default.  The margin account is marked to market daily, forcing any losses (or gains) to be realized immediately, and deficiencies in the balance must be made good right away.  A client may trade through a smaller firm, which in turn trades through a clearing firm.  The margin deposited by the client with the small firm is passed to the clearing firm, which passes it to the central clearinghouse of the exchange.    

Clearing firms do not fail all that often.  Perhaps the most famous recent case was that of Barings Bank in 1993. When a clearing firm fails, the accounts of the clients and firms who clear through it are transferred to another clearing firm.  Their open positions and the corresponding margin balances are simply moved from the failed firm’s account to another clearing firm.  Because the positions have been marked to market on a daily basis, there are no accumulated losses or gains to be paid when the transfer is made.

In MF Global’s case, however, this transfer of accounts has run into problems.  Some of the money is missing. 

And this is where the U.S. regulatory system looks good.  Under U.S. law, client margin accounts are supposed to be kept separate from a firm’s own proprietary trading accounts; they are “segregated.”  The intent is to keep a financially troubled firm from raiding client’s margin accounts, which seems to be exactly what happened in this case.  You can see why this is desirable: if client accounts are segregated, they can be transferred immediately to other clearing firms, and trading can continue with a minimum of contagion.   The violation of customer account segregation in this case prevented the clearinghouses from immediately transferring the client accounts to surviving clearing firms.

Bad as it was, it could have been worse.  This is where the CME looks good.  All client positions are collateralized, and the collateral is passed to the clearing firm.  The clearing firm may forward all margin to the central clearinghouse, or it may be allowed to forward only enough margin to cover the net position of its various clients, retaining the rest for its own protection. 

Different clearinghouses allow different amounts of netting.  The CME is very conservative, requiring all margin to be forwarded to the clearinghouse.  This more conservative policy meant that the CME had more margin on deposit, and was thus able to transfer more accounts more quickly than clearinghouses which allowed more netting of margin deposits.

MF Global is in the news.  But it is not threatening the world economy with collapse.   When a major financial intermediary fails, the ramifications for other major market players can be huge.  When Lehman went down, the world shook.  When AIG failed, the systemic effects were thought to be so severe as to warrant government intervention, even though the firm was not a bank.  The system of collecting margin and prompt marking to market of gains and losses does not prevent a collapse, nor does it keep a firm from raiding client funds.  But it certainly minimizes the damage when bad things happen.

The Budget Control Act of 2011 established a joint congressional committee (the “Super Committee”) and charged it with the responsibility of reducing the deficit by $1.2 trillion over 10 years.  If the Super Committee fails to reach an agreement, automatic cuts of $1.2 trillion over 10 years are triggered, starting in January 2013.  These are said to be “across the board”, but they are not.   They would apply $600 billion to Defense, and $600 to other spending.  Entitlements are exempt, including the Supplemental Nutrition Assistance Program (SNAP, formerly food stamps) and refundable tax credits such as the Earned Income Tax Credit and child tax credit.  These entitlements are exempt from the cuts because anyone who qualifies can participate (that spending is determined by participation, not by Congress).

In addition, the Bush-era tax cuts are set to expire at the end of 2012, so doing nothing means that tax rates would jump back to pre-2001 levels.  That combination might be the best thing yet for our huge budget deficit.

The Federal government’s annual deficit has been more than $1 trillion since 2009.  Continuation of that excess spending might create a debt crisis similar than the one now in Europe.

The Center on Budget and Policy Priorities estimates that the trigger would cut $54.7 billion annually in both defense and non-defense spending from 2013 through 2021.  Meanwhile, U.S. defense spending is around $700 billion per year, with cuts of about $35 billion per year already enacted, so the automatic trigger would reduce defense spending from about $665 billion to about $610 billion.  Some may view that 10% cut as draconian, but the simple fact is that the U.S. needs to wind down its spending on two wars.  Congress and voters are fooling themselves if they think the U.S. can continue to spend the same level on defense, not raise taxes, and make any major dent in the huge annual deficit.

The same point can be made for automatic cuts in Social Security, which in its current form is unsustainable.  Since it was enacted in 1935, life expectancy has increased dramatically, which means more payouts than anticipated.  Birth rates have declined, which means fewer workers and less payroll tax than anticipated.  The system will run out of money in 2037.  Congress either needs to raise taxes or cut spending.  But they won’t do either!  The only solution might be the automatic course, without action by Congress!

For further reading, see “Why doing nothing yields $7.1 trillion in deficit cuts”.

The point of this blog is to inject some substance into discussion of Presidential candidates. To see the problem, consider what I wrote on my facebook page: “In an airport for an hour yesterday, we could not avoid hearing CNN talk about the upcoming presidential debate. For the entire hour, we heard only comments like: Perry needs to come out swinging; or, ‘Is Cain a viable candidate?’; or, Bachmann has really fallen in the polls; or, ‘This now boils down to a two-man race’, followed immediately by the wisdom that ‘Yes, but we don’t know yet who the two men are.’  What inanity! It is JUST a horse race! Not a single comment during the entire hour had anything whatever to do with any substantial issue of policy. Is this all we get?”

There must be more to consider, in this important decision.  So, I started by looking at Herman Cain’s 999 tax reform plan.  See more at his website, with the key bullets in the insert below. 

Bear in mind that I’m a former Deputy Assistant Secretary of the U.S. Treasury (1985-87), so I worked hard on President Reagan’s successful “Tax Reform Act of 1986” to lower the rates and broaden the base.  Since 1986, however, Congress has managed to reintroduce plenty of new deductions and tax breaks, while raising the rate.  Maybe it’s time to do something again!

Cain’s proposal has a lot of similarities to the 1986 reform, if perhaps more extreme.  It is meant to be revenue neutral, raising the same total tax.  It would eliminate virtually ALL deductions, like mortgage interest paid, and it would cut rates drastically.  It would eliminate the income tax as we know it, and introduce a national sales tax (or value added tax).   What about the accuracy of Cain’s claims below?  By reducing rates drastically, this proposal probably WOULD reduce the distorting effects of taxation by reducing the interference of taxes in the productive activities of workers and business – what economists call “deadweight loss”.  For similar reasons, it probably would provide greater incentive for work and investment, and therefore probably provide some stimulus to growth.  That’s all for the good.

However, ANY tax reform plan of ANY politician EVER, no matter what motivation, will always have two effects to watch out for.  First, any tax reform will always raise taxes on some taxpayers and reduce taxes for others.  It will have distributional effects worth analyzing.  Second, it will therefore create disruptions and reallocations.  Activities to pay additional tax may shrink – laying off workers who may remain unemployed for some time until they can re-train and find work in other activities that now face lower tax rates and hope to expand.  That is, for only one example, the Cain plan might hurt homeowners and homeownership by eliminating the mortgage interest deduction.  With such pervasive changes, however, the disruptions will be widespread and costly in themselves.

Finally, for now, note the point about distributional effects.  Nothing in any of Cain’s bullets says anything whatever about distributional effects.   I’m afraid this point is the Achilles heel of Cain’s 999 plan.  According to the non-partisan Tax Policy Center, Cain’s plan will greatly reduce taxes of those with the highest incomes and raise total taxes on those with low incomes.  It is ‘regressive’.  And you don’t even need to read the TPC analysis to know this is true.  Cain’s plan cuts the top personal rate from 35% to 9%.  There is no amount of tax-base broadening for those high income taxpayers that can get back the same tax revenue from them.  And currently those with the least income pay no Federal tax at all.   Under Cain’s plan, everybody will pay the 9% sales tax, on everything they buy.  Moreover, if those low-income individuals are working, they will probably bear some additional burden of the 9% business tax that applies to all profits AND wages paid: it applies to all sales revenue minus purchases and capital investment, not subtracting wages paid to workers.

I’d personally favor another revenue-neutral reform like the TRA of 1986, one that lowers the rates and broadens the base.  Such a reform would undoubtedly cause some disruptions and adjustments costs.  And it would help some while hurting others.  But perhaps it could be designed in a way that also tries to be distributionally neutral, not adding tax burdens on those least fortunate while cutting taxes on those already doing well.

So I got a bit frustrated while reading a NYTimes piece this morning on the European debt crisis, which had the following statements:

“Just like the United States, Europe built up trillions in debts in past decades.  What is different is that more of the United States borrowing was done by consumers and businesses, while in Europe it was mainly governments that piled on the debt.  Now, just as the United States economy is held back by households whose mortgages are still underwater and  won’t begin to spend again until they have run down their debts, Europe can’t begin to grow again until its countries learn to live within their means” (pA9)

Governments piling on the debt?  Really??  The first sentence just doesn’t jive with the stats I could find doing a quick morning search.  The authors seem to buy into the old hoary chestnut of European governments digging themselves into debt with lavish spend.  OK – you can take Greece (aside: think Henny Youngman here).  But Ireland and Spain?Ireland went into the crisis with balanced budget and Spain’s government debt has been relatively flat (see Spanish debt chart over time by clicking on Spain in the map.  In Ireland, the government stated it would cover bank losses to stem potential capital flight.  And in Spain, it’s the corporate debt that has increased substantially, and along with it, the worry that the government may have to step in and bail some that corporate debt out (country-by-country primer on the EU debt crisis).   Meanwhile, government bonds are being continually downgraded, causing borrowing costs to skyrocket, and, to quote Paul Krugman, we’re seeing a modern-day version of a bank run, but against governments.

In 2009, Spanish government debt as a % of GDP was lower than that in the US, Canada, Brazil, India, Germany, France… .  In fact, as you click through the countries listed in the map from McKinsey, it’s clear that heading into the crisis, the problem was not government spending increasing, but debt in other sectors.  As an interesting article in the Economist points out, it was the merging of the public and private debt that has many government books on the ropes, in Europe as well as the United States.

If one town’s water pollution flows into another town, the two towns can negotiate a solution with no need for the state to intervene.  But if all towns are polluting all neighboring towns, the lines of communication are too complex to negotiate – requiring the state to pass a law to solve the problem.

If one state’s water pollution flows into another state, the two states can negotiate a solution with no need for Federal intervention.  But if all states are polluting all neighboring states, the lines of communication are too complex to negotiate – and it takes a national government to solve the problem.

In other words, those problems have solutions.  If one nation’s water pollution flows into another nation, then (potentially, at least) the two nations can negotiate a solution with no need for a global government to intervene.  But if all nations are polluting all neighboring nations, the lines of communication are too complex to negotiate – and no global government exists to solve the problem.

I’m currently pessimistic about two of the worst problems the world has faced: global climate change, and global financial contagion.  Both are “externalities” in the classic sense.  Each nation’s greenhouse gas emissions pollute the whole world, and the only really effective solution is a worldwide global agreement to reduce emissions.  In fact, we don’t really “need” all nations to reduce emissions; all we really need is an agreement among all nations saying that if SOME countries reduce emissions then the other countries won’t increase emissions to steal their business.  But the lines of communication are too complex to negotiate – and no global government exists to solve the problem.

Environmental policy is my usual bailiwick.  At the moment, however, I’m even more worried about global financial contagion.  It seems that one small country can have lax financial regulations that allow banks or investment companies to take on too much risk.  Or a small country can overspend, taking on too much debt.  In the olden days, that country could go down in flames, with no big problem for the rest of the world.  With tremendously increased globalization, however, all financial markets are highly integrated.  One country’s borrowing may come from any or all other countries of the world, and one nation’s problem become the world’s problem.  If banks in other countries loan to that small country, then a financial crisis in that small country may create fear about the financial well-being of the banks that lent to them, causing a run on the banks in all those other countries.  Moreover, globalization means much more trade in commodities.  If one small country faces severe financial difficulties and must cut back all spending, that reduces aggregate demand worldwide, and can spread a recession worldwide.

A strong global government could rein in the poorly managed countries by requiring larger capital requirements, careful financial scrutiny, and only tax-financed spending.  But we don’t have any such global government.  As a result, even a small country like Greece can over-spend for years without oversight.  The situation in Greece may be made worse when banks in other countries raise the rate at which Greece can turn over its debt and borrow again, making the financial situation in Greece even worse.

The problem may be caused by Greece or not.  Regardless of “fault”, if Greece any small country were to go into default in years past, then the cost would be primarily on that small country.  Now Greece could go bankrupt and impose horrible costs on the entire World?!?