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How to Avoid the Fate of Greece

March 1, 2012 7 minute Read by David Malpass

Everyone would like to see more growth, less debt, and a recovery in living standards. That applies to both the United States and Greece. The economics of achieving this are in conflict. Greece’s plan isn’t likely to work because it’s based on burdening the private sector with tax increases rather than downsizing the public sector. It’s an austerity program, not a growth program. This distinction will have direct relevance to over-indebted U.S. states where governments will argue that they should spend more in order to avoid Greece’s fate. The reality is that Greece is two years into an all-out crisis, yet the government has so far avoided downsizing. Instead, it has taken on a heavy burden of debt with the IMF and European Union, raised the value-added tax rate and imposed a nationwide property tax, all of which discourage private sector investment. A common formula for calculating a country’s GDP adds together private sector consumption with business investment, net exports and government spending on goods and services. The proponents of more government spending use this formula to show that government spending adds to GDP while spending cuts reduce GDP. The problem with this argument is obvious. It relies on static analysis and thus assumes that the other elements of the formula remain the same regardless of the size of government – that a country can increase its government spending without it causing a cut in private sector consumption and investment. The reality is that increased government spending causes the private sector to expect an increase in taxes and government debt, both of which discourage businesses from investing and hiring. Likewise, an efficiently-managed government downsizing creates the prospect of lower taxes and less government debt, encouraging job creation. In its latest negotiations with the IMF and the rest of Europe, the Greek government has postponed cutting the size of government for several more years. It hasn’t wanted to reduce government pensions and overstaffing, stop the losses at state-owned companies, or sell government assets (though some are promised in future years). Greece has kept its parliament and Brussels delegations very comfortable – hundreds of legislators, the requisite large staff, government cars and a health club. The large lifetime pensions for politicians –a popular practice as well in New York’s sprawling state and local governments and state-controlled companies – are euro-denominated and protected by law. Strong investment will come back to Greece when the government votes to reduce itself. The same is true for the U.S. and many U.S. states. The key is to cut current and future government growth in order to encourage private sector investment and job creation. President Obama could convene his cabinet and request large spending cuts, creating hope for private sector job creators and breaking Washington out of its tax-and-spend mindset. Some will argue that this would reduce GDP because government spending is part of the GDP formula. More likely, actual reductions in government spending would add to U.S. growth prospects, strengthen the dollar and invite more private sector investment and jobs. There’s a technical aspect of the growth versus austerity conflict. The IMF is only allowed to lend to programs that are “fully funded” in the near term. It’s like limiting a bank to making a one-year loan to a company that needs two years to build the factory to pay back the loan. IMF-approved programs seek to extract enough from the private sector to pay for fiscal deficits and near-term debt obligations. This requires tax increases even if the result is less future growth due to reduced private sector investment. The U.S. imposes a similar constraint on itself through the ten-year budget window. Spending cuts outside that timeframe don’t get any credit when scored by the Congressional Budget Office even though they might be fabulous for growth. Conversely, near-term tax increases get extra credit because they are assumed to have no impact on growth, especially not in the ten-year budget window. Meanwhile, China and Japan have offered to help fund European structural reforms since European growth is in Asia’s interest. However, they want to channel their resources through the IMF in return for more voting control. They see the writing on the wall. With the U.S. promoting global governance and our share of world GDP in rapid decline, financial leadership is rapidly shifting to the Group of 20 and the IMF where the current crisis gives Asia a golden opportunity to increase its global leadership role. Greece’s economic future has gotten lost in the shuffle. Its economy has shrunk 17% so far under the anti-growth austerity program. Rather than starting its structural reforms with a VAT tax increase, which the IMF likes to impose in order to project larger tax collections, Greece should have taken at least a symbolic step to downsize government. A reduction in the benefits for politicians would be a good first step. Similarly, U.S. growth has gotten lost in the shuffle. Legislation in recent years has focused on increasing taxes and regulation rather than reducing them. There have been few actual or even symbolic attempts to reduce government spending. Cynicism regarding growth-oriented spending restraint reached new heights in 2010 when new spending was “paid for” by distant 2014 cuts in food stamps, reductions no one expects. In sum, Greece’s private sector is laboring under too much debt piled on it by long-gone politicians and an economic program that adds to the burden rather than lightening it. The U.S. is headed in the same direction. The solution is to recognize that making government smaller and more efficient would be a powerful stimulus to private sector investment and job growth. That’s the opposite of the economic theories advocating increased taxes and more government spending as a path to growth.


Author

David Malpass

2012 Economic Growth Fellow

David Malpass is president of Encima Global, and chairman of GrowPac. He writes a regular Current Events column in Forbes magazine, and his opinion pieces appear regularly in the Wall Street Journal. He sits on the boards of the Economic Club of New York and the National Committee on U.S.-China Relations. Formerly, Mr. Malpass was chief economist of Bear Stearns. Between February 1984 and January 1993, he held economic appointments during the Reagan and Bush Administrations. He was Deputy Assistant Treasury Secretary for Developing Nations, a Deputy Assistant Secretary of State, Republican Staff Director of Congress’s Joint Economic Committee, and Senior Analyst for Taxes and Trade at the Senate Budget Committee.

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