Part II: Politics
Our democracy is but a name. We vote? What does that mean? It means that we choose between two bodies of real, though not avowed, autocrats. We choose between Tweedledum and Tweedledee.
--Helen Keller
Students now arrive at the university ignorant and cynical about our political heritage, lacking the wherewithal to be either inspired by it or seriously critical of it.
--Allan Bloom
We the people are the rightful master of both congress and the courts - not to overthrow the Constitution, but to overthrow the men who pervert the Constitution.
--Abraham Lincoln
What About Government Size?
Charles and I, feeling slightly guilty at not having helped at all in getting dinner ready, carried the dishes into the kitchen, rinsed them off and loaded the dishwasher.
“You seem pretty cynical.” I said to Charles, “Do you really think the planners just make cities different and not necessarily better or worse?”
“Interesting question—so I don’t know—but I think the easy policies have mostly already been done,” said Charles mysteriously. “It seems to me, though I am not very certain about this, that most policies—of almost any kind—that are being considered have about as many disadvantages as advantages. The proponents focus on the advantages, trying to make them seem all-important. The opponents focus on the disadvantages, downplaying any advantages. In addition, since those advantages and disadvantages resonate differently with peoples’ basic ‘world views,’ what position to take, for or against, often seems obvious to any particular person. But, often, and maybe usually, in deciding whether to pursue a policy, we might as well just flip a coin, in terms of whether we collectively make ourselves better off or worse off.”
“Well, the guys down at Jake’s were thinking that the government does too much already. If you’re right about public goods being undervalued, though, you would recommend the that the government do even more, right?” I said, recalling our ignorant blather at Jake’s.
“I think the government does many things that it should not be doing at all. And, too, in those cases where government should be doing something, it seems to often do too much or just the wrong sorts of things,” said Charles. “So I think there could be room in the budget to do more of what government should be doing—providing public goods at higher levels through direct provision and indirectly through regulation—by giving up activities that it should not do at all, should do less of, or that the market would do better.”
Dad came into the kitchen and, hearing Charles’ comment, said, “But, how do we get government to do what we want? It seems like voters are frustrated, or at least I am, at our inability to actually have any impact on what happens.”
“Yes,” I inserted, “it seems like both Democrats and Republicans run on generally pretty similar platforms, with a few exceptions, but they do whatever they want after they get elected.”
“I like to think of government as a big candy store that gives away candy, and it is just a matter of who gets the candy.” Charles smiled, “…but both Republicans and Democrats give away more candy after they’re elected than they say they will in those big public debates before the elections.”
“Whatever happened to the effort to pass a constitutional Balanced Budget Amendment?” Michelle asked entering the kitchen. She had always liked that idea, part of the Republican’s so-called “Contract with America,” probably because she liked debits and credits to balance out.
“It sort of died on the vine, I think, when the high projected economic growth rates of the mid-to-late1990’s made it look—temporarily—like we were going to have budget surpluses for decades, because revenue was growing so fast,” offered Charles. “Nobody wanted government to spend more just to balance the budget!
But, of course, that was destined to be an illusion—we are back to huge deficits again, ‘officially’ because of the 9/11 terrorist attacks, the Iraq war, and to stimulate a weakened economy. But there would likely have been some excuse to spend more anyway, because politicians benefit politically from spending but not from taxing.”
“Wow, you really are getting cynical,” Michelle said as she started some decaf coffee.
“Hey,” protested Charles, “I’m just being realistic. Just look at the expenditure numbers and you will see what I mean. Averaging over decades, to smooth the impact of business cycles, the percent of total income spent by U.S. federal, state, and local governments combined was 22.8 (1950s), 25.1 (1960s), 28.2 (1970s), 30.6 (1980s), and 30.5 (1990-1998). Spending has grown dramatically at all governmental levels, actually faster at the state and local levels. It is noteworthy that state governments have balanced budget requirements, yet that has not curbed the rapid growth in spending. Moreover, the growth in spending as a share of income has occurred regardless of whether Democrats or Republicans were in charge.”
“How did you happen to know those numbers off the top of your head, Charles? Don’t tell me you are working on a political paper?” said Michelle.
“Yeah,” said Charles, “I was ‘given’ an idea about how to transfer control over government spending to the voter at the same time I was given the public goods valuation idea. As I think I’ve said, I was given both of those ideas, and several others I haven’t followed up on, virtually instantaneously, although I had to do a little work to flesh them out…”
I interrupted, “Charles, are you really trying to say that God ‘gave’ you your ideas? You’ve always been smart…what makes you think the ideas weren’t yours? Besides, and maybe I shouldn’t bring this up, but weren’t you having psychoses around the same time because of the weird ‘smart drugs’ you were taking? Maybe the psychoses made you think God gave you the ideas, when they were really yours?”
“Let’s save the full conversation about that for a later time,” said Charles. “But, yes, I have some reasons that are really convincing, at least to me, for thinking that the ideas, all of them, were gifts. However, I can’t ‘prove’ that for reasons that will become clear sometime when we talk more about theology. And, it is true that I did have to string the words together on paper, so I certainly helped, but the ideas came from God, I think.”
“Ok, fair enough, for now,” I said, registering my skepticism, “so what is your idea about how to take control of government spending from politicians and give it to the voter?”
“Dave, before I get to that, I would like to try to explain what I think is undesirable about the approach the Michelle mentioned, an amendment that requires a balanced budget. Ok?”
“Sure.” I poured myself a cup of decaf. I was pretty proud of myself for not drinking after dinner as I went into the living room.
Balanced Budget Amendment Flaws.
Charles brought his decaf in to the living room, then went back out to the kitchen, returning a minute or two later with two glasses of ’77 ruby Port, one for him and one for me. I took mine without so much as a murmur of protest—I’m so weak, I thought. But then I began to mull over the possibility that it really might not be “weakness,” when it happens so often. Maybe I really want to do those things and I was actually being weak in failing to pursue truthfully my real goals? Perhaps what I always call weakness might really be the strength to do what I really want in a world of “should-nots” and “ought-nots” imposed on me by others. I was mulling over this happy possibility when Charles began talking about what was wrong with the various balanced budget approaches.
“Economists have argued for years, using a variety of models of government,that government expenditure would tend to be too large from society’s perspective…”
“Come on, Charles,” I interjected, “be careful with the jargon…it is after dinner and, being full and mellow, it won’t take a lot to bore us, especially me now with the Port…if you’re going to talk about models, at least make them lingerie models!” Michelle chuckled, but gave me her well-practiced “slightly disapproving” look.
“Ok, I was just emphasizing that excessive expenditure is what one would expect from a lot of different ways of looking at how governments work, one of which I’ll come back to. Anyway, the various proposed Balanced Budget Amendments were really advanced to gain control over spending.”
“I’ve forgotten how the Balanced Budget Amendment was supposed to work. It has been a long time since I’ve heard much about it,” said Dad, who was coming into the living room with Michelle.
“Yeah, people lost interest when we were running surpluses, I think. The basic idea of these proposals is to require that the federal budget be annually balanced, except in times of war or national emergency. If there were a disaster of some sort, deficits could be run, or taxes raised, if both the House and Senate vote to do so with a two-thirds majority.”
“Seems pretty restrictive,” said Michelle, “in that it might be pretty hard to get a two-thirds majority…”
“Well, they wanted to make it difficult to do and noteworthy when it happened. But, there was also a weaker version. It allowed taxes to be increased to balance the budget if both chambers voted to do so with a simple majority. And deficits could be run with a three-fifths majority,” Charles explained. “The presumption, particularly in the stronger version, was that such an amendment would work to reduce the size of government.”
“So, what is wrong with this approach?” I asked. “Since taxes are pretty unpopular and hard to raise, wouldn’t requiring budget balance keep spending lower than it otherwise would be?”
“Many economists didn’t support a balanced budget amendment because they were afraid that it might make the economy more unstable, deepening recessions.”
“Would you expand on what you mean by that...how would that happen,” asked Dad.
“Well, suppose we have a mild recession…what do you think automatically happens to government spending and revenue?” Charles asked.
“Let’s see…I guess spending would go up on things like food stamps, unemployment insurance, welfare, and the like. And, of course, income tax revenue would fall, since people won’t be making as much money as normal. And there could be less sales tax revenue for cities and states that depend on those,” Dad said.
“Yep,” said Charles, “so, even if we had planned a level of spending that would be balanced by expected revenue, there would be a deficit, unless something was done about it. To avoid that deficit and balance the budget, government would have to cut spending or raise taxes. But, both of those actions would further reduce demand for goods and services, which could worsen the recession and possibly even plunge us into a major depression.”
“I can see that this could be a problem, I guess. Anything else wrong with a Balanced Budget Amendment?” I asked.
“A couple of things. First, as you already inferred, Dave, some people are actually concerned that imposing a Balanced Budget Amendment is really just a sneaky way of cutting the growth of spending, which it probably is. The percent of income going to government would almost certainly get smaller, maybe more like in the 1950s, yet some people may actually want bigger governments. They may believe, for example, that large overall levels of government spending are necessary to reflect the diversity of opinion about which things should be funded. Or, perhaps a large government doing many things even has an effect in reducing the tyranny of the majority over the minority. I am a little concerned about this, too, because of the public goods valuation point, which suggests that government should be providing, directly or indirectly, more of most public goods. But, I’m guessing that the majority of people would like to see a smaller government or at least government spending growth at a smaller rate than the general economy for a while. So maybe this wouldn’t be too bad.”
“You said there was a second problem?” asked Dad.
“Well, yes and it is kind of subtle…suppose we pass a Balanced Budget Amendment. Which do you think, Dad, is more important, how much government spends or whether that spending is balanced with tax revenue?”
“I don’t know…offhand, I would say that both seem important.”
“It turns out that how much government is spending is much more important than whether the budget is balanced or not. The spending is using real resources that could be used for other things, while whether there is a deficit or not is just a matter of financing and turns out not to be terribly important.”
I was confused at this point, “I can see why the spending would matter…it’s your old scarcity point. We have a limited amount of productive resources, so getting more government goods means getting fewer private goods—and we know private markets will give what we want, as we talked about the other night. But I think that people are less confident that governments will give us things that we value as much as the taxes we have to pay to get them. But why doesn’t the deficit matter, too?”
“Dave, did you finance your Subaru or did you pay cash?”
“I paid cash because, if I had financed it, I would have paid quite a bit in interest over a five-year loan.”
“But, where did the money come from that you used to pay for the Subaru,” Charles asked.
“I took it out of a mutual fund.”
“Dave, what were assets in your mutual fund earning in interest? Was it pretty close to the interest rate you would have had to pay to finance your car?” asked Charles.
“I don’t know for sure, but I think the finance charge might have been a little higher than what I was earning on the money in my mutual fund.”
“Yes, that would be generally true, because there would usually be some costs of getting the loan set up and so on. So there is usually a small spread between what borrowers pay and lenders receive. But, for simplicity, suppose that what you would have earned on your assets was the same as the interest being charged on your car loan. Would it have mattered whether you financed or not?”
Hmmm…I thought, “I’m not sure, but I hate to borrow.”
“I don’t think any of us Petersons like to borrow all that much, Dave, but would you have actually been any worse off if you had borrowed? I’m arguing that you would not have been, or at least that it didn’t make much difference…the interest you lost on your mutual fund offset what you saved by not financing.”
“I guess I never thought about it that way,” I said, “but is that relevant for the case of government deficits?”
“Yes, for exactly the same reason. If you cash in some asset to pay the taxes necessary to avoid paying interest on the national debt, then you lose the return on that asset that would have later enabled you to pay those interest charges. In fact, since government bonds are considered so low-risk, the asset you sell might be expected, though there are no guarantees, to earn more than the interest charges on the debt. Holding the government spending level constant, people could actually be worse off with a balanced budget because the interest they give up to balance it might be greater than the interest charges on a federal deficit.”
“In other words, if they had kept their assets and run a deficit, they could have paid the interest on the deficit out of their asset earnings and had something left over?” said Dad.
“Yes, that’s certainly possible,” said Charles. “Remember those great years in the late1990s when the stock market was returning an average of twenty or twenty five percent for several years in a row. If the government had cut taxes, even to the point of running large deficits, we would have been far better off investing the tax refunds, than worrying about the interest cost of those deficits. Of course, we would have needed to get out of the market before it went down, but the general point is still valid. Interest rates on government debt are far lower than average long-term returns in the stock market.”
“Well, I’m still not completely convinced,” I said. “Could you give me another example?”
“Yes,” said Charles. “I’m not sure whether they still give this advice or not, but Consumer Reports used to recommend to their subscribers that they pay for their refrigerator, stove, dishwasher and so on with cash, rather than put it in their mortgage. They made this recommendation because if those appliances were included in mortgages, people would end up paying two or three times the appliances’ original cost in interest charges over the thirty year terms of their houses’ mortgages.”
“And that’s wrong?” asked Michelle and E almost in unison.
“Yes, and for exactly the same reason,” said Charles. “In fact, in this case it is pretty obvious that you should definitely put your appliances in your mortgage. The reason is that mortgage rates are often very low—and, importantly, mortgage interest payments are deductible from federal income taxes, a deduction that will be difficult to eliminate politically, so you can pretty much count on that continuing. So, if you have a 7% mortgage, after taxes that is only maybe 5%, while the average return in the stock market over the last hundred years or so is 10 or 12%. So, over a thirty-year period the foregone interest of giving up existing assets to pay for those appliances is much greater than the benefits of saved mortgage interest. In fact, Dave most likely would have been better off to take out enough extra to buy his Subaru when he refinanced his house a while back—with the 6% mortgage you got, Dave, the after tax finance charge would have only been 4% or so.”
“Wow…I never thought about it that way,” said Michelle, glancing my way.
I started wishing I had pulled out more on that refinance, but in the back of my mind was the possibility that I might just blow the cash I took out on something frivolous.
Charles went on, “I don’t want to unduly emphasize this case, though, and there are some that would argue that both of my examples are a little simplistic, and leave out some things. And, some people are concerned about intergenerational equity, too.
“Intergenerational what?” asked Michelle.
Future Generations and Deficits
Charles continued, “People are often concerned about the damage to future generations resulting from deficit financing. Suppose we build a road or clean up the air and can either run a deficit to finance it or raise taxes to pay for it. It might seem that it would be better for future taxpayers—our kids, grandkids, and great grandkids—if our generation raised taxes on us to pay for it, rather than financing it and leaving the debt burden for them. If we paid for it, they could have the road and no tax liability for it, hence they would clearly be better off, or so it would seem,” said Charles.
“…Or so it would seem? Why wouldn’t they clearly be better off?” I asked.
“Well, again, it depends on how we paid for it. If we consumed less to pay our taxes, and didn’t pay them out of our assets, yes, they could be better off. They would have the road, no tax liability for it, and the same amount of inherited asset wealth. But, if we paid for the roads out of our assets, assets that reduce the amount being passed on to the next generation, they don’t have that tax liability but they also don’t have the assets, either. So, like financing your Subaru, it probably won’t make much difference either way.”
“But,” I said, “if I had consumed less to buy the Subaru, then I wouldn’t have had to cash in my mutual fund and I wouldn’t have had to pay interest, either. Wouldn’t I have been better off?” I had been thinking about how I might frivolously blow money I pulled out on a house refinance, and this just seemed like the flip side of that.
“In a purely financial way, I suppose,” said Charles, “but you’re losing track of why you work in the first place…to consume things. Sheesh, don’t you remember our discussion the other day about this for private and public goods! It isn’t at all clear that you would be better off consuming less to buy the Subaru, because that would be giving up a lot of things that you really like…maybe some of those nice California cabernets, huh? In principle, your consumption decisions shouldn’t be much affected by whether you cash in assets or borrow to finance purchases.”
“I keep making the same mistake, don’t I,” I admitted sheepishly.
“Well,” said Charles sympathetically, “it is a subtle point and one that gives lots of people, even many economists who should know better, trouble. The fancy economics name for this notion, that it doesn’t matter whether you finance or pay out of existing assets, is ‘Ricardian Equivalence.’”
“I’m still having trouble with this notion,” said Michelle. “Won’t it be the case, sooner or later, that by running deficits now, future generations will be forced to run surpluses to offset them?”
“Why?” asked Charles, though I was fairly confident he was just baiting Michelle.
“Because, the interest burden would just keep building, if we continually run deficits, wouldn’t it?”
“The government supplies you with government services, and your house supplies you with housing services, right?”
“Yes,” said Michelle uneasily.
“And, both government and your house are going to be supplying services to people in the future, huh?”
“Yes.”
“When you and Gary earn income you save some of it, don’t you?” continued Charles.
“Yes, of course we do,” said Michelle.
“With your savings you can either buy an asset or pay off your house—which do you think is better for your kids?”
“Oops,” said Michelle, seeing where Charles was going.
“It all just comes down to a portfolio choice, invest in housing or other things…the only thing that matters to future generations—except for perhaps irreversible environmental damages—is how much net worth they inherit. And, the form of wealth that you give them when you die doesn’t affect that much. People often keep refinancing their houses indefinitely, because to pay them off would mean that those people can’t buy the other assets they would have bought.”
I thought I was beginning to understand this Ricardian Equivalence stuff, adding, “It’s sort of like having dollars in both pockets of your pants, and taking them out of one pocket to put them in the other pocket, huh? We call what we take out of the first pocket a ‘deficit’ in that pocket, but we get a surplus in the other pocket, so our net worth isn’t affected.”
“Exactly,” said Charles, “there may be reasons to be concerned for future generations about how much we are saving, individually and as a nation, because that will affect their welfare. But, how we allocate our saving, as a portfolio matter, isn’t very important. We can pay taxes to avoid a federal deficit or have the deficit and some earning assets. It is somewhat interesting to me, actually, that people care so much about future generations. While this is grist for an interesting discussion, it seems very likely to me that saving for future generations represents a transfer from poorer generations to richer generations. If history is any guide at all, as I think it is in this case, future generations will be better off than we are, just like most of us are better off than our parents and grandparents.”
“Are you sure?” asked Michelle, still somewhat skeptical about this whole discussion.
“What matters to future generations, apart from environmental or other irreversibilities, is how much wealth they receive. They can determine for themselves how to allocate that wealth among various assets—paying off the federal debt with the larger amount of assets they will have, if our generation doesn’t pay off the debt, for example.”
“So,” continued Charles, “the main point, regardless of all the subtleties, is that the level of spending matters much more than whether the budget is balanced. A government has a much bigger, and generally more negative, impact on the economy if its budget is balanced at 40% of income, than if it spends 25% of income and taxes at 20% of income, with a five percent deficit. In the first case, people only get to spend 60% of their income, and have to sell assets to avoid a federal budget deficit. In the second case, they get to spend 75% of their income on the things they want, and the 5% deficit is offset by earning assets they get to retain.”
“Ok, I think I’m finally with you on this,” I said. “So what really matters is controlling spending, but the Balanced Budget Amendment doesn’t directly do that. So, what’s your idea for how can we control the spending of politicians?”
Special Interest Politics and The Tragedy of the Commons
I nodded as Charles came around with the Port bottle, impressed by my newfound insight that I should pursue my true feelings, if I was going to make wise choices. But, I did ponder for a moment Charles’ discussion of whether peoples’ tastes are “good” or “bad” when he was talking about the market giving us what we want. But, hey, I figured they are the only tastes I’ve got, so I might as well respect them—at least until I get around to improving on them!
“Would government spending on a project be a problem if the project had benefits greater than costs to society?” Charles asked, looking specifically in my direction.
I thought the answer was pretty obvious, but the way he looked at me left me feeling a little uneasy. “No, it shouldn’t be a problem in that society would be better off, because the tax cost would represent foregone private goods, and if the benefits of the project were greater than that, well, the project must make society better off.”
“Not bad,” Charles said, somewhat unconvincingly, “but when you said ‘society’ who is that?”
“We, the people, the ones who pay the costs and receive the benefits,” I said, maybe a little defensively.
“Well, what you say would be fine if we were all affected equally…if the benefits were greater than the costs for everyone. But, that is almost never the case, right?” Charles asked.
“Oh, ok…yes, some people will probably have benefits greater than costs while others will have costs greater than benefits…but won’t it average out?” I asked.
“It might,” said Charles, “as long as there isn’t systematic discrimination against any particular group. And, too, sometimes the policy gets modified, if the costs fall disproportionately on people we care about. For example, Dave, whose cars generally flunk the emissions inspection tests you have to take in the Front Range counties in Colorado…rich peoples’ cars or poor peoples’ cars?”
“The poors’ cars would flunk, I suppose, since their cars are older and likely to be less well maintained.”
“Yes,” continued Charles, “and that is probably why we have limits on the expenditures that you are forced to incur if your car flunks. We could, after all, require that people not drive a car until it meets emission specifications, maybe even requiring that engines be replaced with newer, clean engines or scrapping the old cars.”
“So, you’re not too worried about the distribution of the benefits and costs then?” I asked.
“Well, what if the benefits are very concentrated, while the costs are widely dispersed, doing just a little bit of damage to every tax-paying household?” asked Charles.
“Oh, I see where you’re going,” said Dad, “those who receive the concentrated benefits will work hard politically to get what they want, while those who are damaged won’t find it worthwhile to resist.”
“Exactimundo,” said Charles, “perfectly correct…the ‘special interest’ problem of such great concern to economists and political scientists.”
Michelle, having replenished her coffee cup, said “but weren’t you arguing, in talking about developers, that special interests are still interests, and hence real legitimate interests?”
“Yes,” said Charles, “special interests are real interests, but there is sometimes a problem with them in the context of the political process. Suppose that we have an ideal world in that the benefits and costs average out over people as we just discussed. Then, as Dave observed, we should do projects with benefits greater than costs, because on average that makes us better off…it raises the value of our scarce resources to transfer spending from the private to the public sector. Sure, there will be some griping from people who are harmed by specific projects, but it will average out, or—like the car inspection—we can modify the project to give less harm to those paying the costs, if we have particular sympathy for their circumstances.
But, in cases where the benefits are very concentrated, what keeps those receiving the benefits from using some of them to ‘bribe’ politicians with political contributions, lobbying with expensive free dinners, and the like?”
“Nothing, I guess,” said Michelle, “but those concentrated special interests could still be greater than the costs, right?”
“Yes,” admitted Charles, “in which case, the bribes would, at least in principle, not be necessary because the project is in our collective interest, apart from the possible problem that overall unfairness results from the many projects not ‘averaging out’ across people.
But, Michelle, the problems arise when the concentrated benefits are smaller, possibly much smaller, than the costs. Let me give you a simple example to make the problem clear. Suppose there is some project that has concentrated benefits