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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 Bailout
The 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 Evidence
Obama’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 lowrate 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 Record
After 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 makebelieve 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 Growth
If 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 Curve
Academic 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
50
Expenditures as a percent of GDP
45
Sweden
40
UK
35
US
30
Japan
25
Germany
France
20
15
10
5
0
1870
1913
1920
1937
Source: Tanzi and Schuknecht, "Reforming Government: An Overview of Recent Experience,"
1960
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
7 percent growth
6 percent growth
5 percent growth
1
4 percent growth
3 percent growth
2 percent growth
1 percent growth
0
10
20
30
40
50
60
70
80
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 valueadded 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
2004 Per Capita GDP
$45,000
$40,000
$35,000
$30,000
$25,000
$20,000
U.S.
OECD in Figures
E.U.-15
America Growing Faster than EU-15 Nations
1994-2004 Average Real Growth Rate
4.0
3.0
2.0
1.0
U.S.
Source: OECD in Figures
E.U.-15
Conclusion
Government 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.