Don't Follow Greece off the Austerity Cliff

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.

Those are guest columnist Louis R. Woodhill's thoughts about balancing the U.S.'s budget. Share yours in the comments section below.

Email the author at: louis@woodhill.com. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (6)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 20, 2010, at 5:46 PM, jambenfool wrote:

    I see some merit libertarian thinking, but I wish that the "taxes are bad..." proposals included "...and here are the services that you will not pay for" consequences. Please don't argue that lower taxes will stimuate growth which will be taxed at the lower rates and still pay for all the services that we consume; we have tried that (unless any failure to meet the desired result is tied to not cutting taxes enough). And given the deficits that Pres. Bush ran up, I think it's a bit disengenuous to assign tax increases to pay for a deficit that Pres. Obama inherited. My $0.02's worth.

  • Report this Comment On May 20, 2010, at 6:02 PM, DDHv wrote:

    Search on "Laffer curve". According to Wikipedia, the idea has been around from the 14th century. Simply, a 0% tax percentage produces zero government income, a 100% tax percentage also produces none since there is then no economy. A tax % change either raises or lowers the net income, depending on which side of the net income peak you are on already.

    Do you think that some century, the politicos will be able to consider this basic idea? Our current bipartisan crop seems to have forgotten the fable about killing the goose that lays the golden eggs.

  • Report this Comment On May 20, 2010, at 9:19 PM, jambenfool wrote:

    If only there were a single income peak, no confounding variables, if only everyone agreed on an objective cuntion of maximizing productivity without constraining variables, it would be so easy to apply. And at an intuitive level, it's very appealing. But decision makers (and that is us, not the current bipartisan crop) have different objective function, and different state and local, as well as federal governments, define their own constraining variables. You know, like lifting people out of poverty and stuff. Search on "Arrow's Impossibility Theorem."

    Democracy is messy.

  • Report this Comment On May 20, 2010, at 9:24 PM, jambenfool wrote:

    Sorry for the typos. Meant to say:

    If only there were a single income peak, no confounding variables. If only everyone agreed on an objective function of maximizing productivity without constraining variables, it would be so easy to apply. And at an intuitive level, it's very appealing. But of the decision makers (and that is us, not the current bipartisan crop) have different objective function, and each state and local government, as well as the feds, define their own constraining variables. You know, like lifting people out of poverty and stuff. Search on "Arrow's Impossibility Theorem."

  • Report this Comment On May 21, 2010, at 9:29 PM, jerryguru69 wrote:

    Ahem. Beg to differ big time:

    "Now, let's say that the Obama administration were to get all of the tax increases that it wants ...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%"

    OK, This assertion is important to me, inasmuchas I have made it myself more than once. However: on what authority that you can site states that: "increased tax rates = lower economic growth"?

    Agreed: it seems to be intuitive, but what solid, academic resouce can you site (and that will stand up in an ugly political fight) that supports this assertion?

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