Don't Follow Greece off the Austerity Cliff

Submitted by Editor on Wed, 2010-05-26 09:19

The following is an interesting economic analysis. While not a policy recommendation it helps explain the world economic situation and how decisions impact our economy.

Don't Follow Greece off the Austerity Cliff
By Louis R. Woodhill, Special to The Motley Fool
May 20, 2010

Louis R. Woodhill is an engineer and software entrepreneur and regular columnist for Real Clear Markets. In addition, he serves on the Leadership Council of the Club for Growth.

How can Greece, which accounts for less than 0.6% of global GDP, threaten the entire world economy? The same way that a wasp can kill a family of four—by presenting them with an opportunity to do something dumb.

By itself, a wasp is little more than an annoyance. However, if one gets into a car that is going 80 miles per hour, the people inside can panic, start flailing at it, run off the road, and hit a tree. Right now, Greece is the wasp, we are the people in the car, and the flailing is tax-hiking "austerity."

The death spiral

The capital markets lend money to a nation against the present value of its future GDP. The present value of GDP is extraordinarily sensitive to both economic growth rates and interest rates. This fact makes it possible for a country to leverage its debt capacity to produce a "growth spiral" yielding great prosperity. However, this same fact also makes it possible for a nation to get itself into an economic and financial "death spiral."

Greece is in a death spiral. The rest of the EU has (tentatively) decided to join it. This is why the European markets are falling, despite the $1 trillion EU/IMF "bailout" package.

To explain how the death spiral works, I'll use the U.S. as an example. Right now, the U.S. government's "debt held by the public" is about 58% of current GDP. Based upon the methodology and assumptions used by the Social Security Trustees ("present value to the infinite horizon," 2% real growth rate, and 2.9% real interest rate), and further assuming a federal "tax take" of 18% of GDP and that 5% of federal revenues are available for debt service, the maximum "debt capacity" of the federal government is 102% of GDP. In other words, based upon these assumptions, lenders would believe that the U.S. government would be able to service debt equal to a maximum of 102% of current GDP.

Now, let's say that the Obama administration were to get all of the tax increases that it wants (health-care reform bill taxes, 2001 and 2003 tax cut expirations, "Cap and Trade" energy taxes, etc.). And let's say that these managed to boost the federal "tax take" to 22%, but at the cost of reducing our long-term real annual economic growth rate from 2% to 1%.

Despite the higher "tax take," the lower economic growth would reduce America's debt capacity to just 58.5% of GDP. Noting this, the markets would demand higher interest rates on Treasury debt. If real interest rates rose from 2.9 % to 5%, this would cut U.S. debt capacity even further, to just 28% of GDP. At this point, the U.S would be like Greece: It would be effectively bankrupt.

The growth spiral

As popular as it seems to be with political and economic elites right now, a high-tax, low-growth death spiral is not the only way forward. Because the U.S. currently has debt capacity to spare, a "growth spiral" is also possible.

Here is an example of how a growth spiral could work. Canceling all of the tax increases noted above and eliminating the corporate income tax would reduce the federal "tax take" to 16% of GDP. However, it would also increase real economic growth. If average annual real growth increased to 3.5% (the U.S. average over the past 100 years was 3.3%), some interesting things would happen. The present values of both future GDP and future federal revenues would go to infinity, as would U.S. debt capacity. Despite the lower "tax take," federal revenues 10 years down the road would be about 3% higher than without the tax cut. After 30 years, they would be almost 38% higher. GDP available to the private sector plus state and local governments would be 18% higher after 10 years and 59% higher after 30 years.

Let's not join them

On April 22, Portugal announced tax increases. Instead of falling as expected, the interest rates on Portuguese debt rose. On May 14, Portugal announced more tax increases, and again their interest rates moved upward. On May 10, Angela Merkel announced that promised German tax cuts would have to be forgone in the name of "austerity." The euro has been plunging ever since.

Europe, led by Greece and Portugal, seems to want to take a ride on the austerity death spiral. Let's not join them. Let's give the growth spiral a try instead.