Tonight I want to have a chat about what I see as a major flaw in modern liberal democracies – namely, their tendency to overspend on services and under-tax. A flaw which is made possible by voters choosing politicians who promise more services but do not increase taxation (or reduce expenditure) to pay for them.
This flaw manifests itself in continual national deficits, as almost all OECD countries in the last few decades have spent more than they’ve received in payments. This is evident in the graph below, with only Australia and Canada bucking the trend compared to the G7 nations.
A Short History on Government Debt – the US Example
Examining a long-term history of the United States’ federal debt, the US government has been in net debt since the early to mid 1880s. The massive spike is due to the debt required to fund WW2, whilst I believe the big increase after 1860 was the result of reconstruction following the civil war. The last trough was at the end of the 1960s, with a continual increase since then. I am not sure what year the data ends on, but I am pretty sure the current projections are for large increases into the future.
If debt has been a constant companion of the US government, why do I think we have a big problem now? Because the makeup of modern government budgets is very different now compared to one hundred years ago.
Prior to the concept of the welfare state, governments were relied upon to fund basic government services (police, prisons, the courts, parliamentary assemblies), defence (army, air force etc), major public infrastructure (highways, telegraph/telephone systems, railroads) and public works. This was also the case in Australia, as bonds issued in the London were used to fund infrastructure for the fledgling colony. No matter what your economic take on government vs privately-funded infrastructure, the upshot is that major budget items in the early democracies were often spent on increasing capital stock, wars or the basic runnings of a guv’mnt.
However, since the advent of the modern welfare state in the 1960’s, the proportion of the government budget being spent on infrastructure has shrunk as welfare and heathlcare expenditure grew substantially. The extent of the growth in healthcare expenditure for several countries can be seen in the following graph:
For some info a little closer to home, the breakdown of Australia’s FY12 budget is shown below:
Of the 366 billion dollars to be spent, just under 50% ($182 billion) is being spent on welfare and health (which come in at 33% and 16% resapectively). While it’s hard to get long-term historical data on these two items, from every thing I’ve read both welfare and heatlhcare spending are growing at a rate faster than our GDP. This is reinforced by the fact budget outlays on these two items 100 years ago would have been in the range of zero to bugger all. The story is the same for most of the other industrialised nations.
Unsustainable Spending
Now whatever your belief in the good of public health and welfare spending, the simple fact is these two items cannot grow faster than GDP indefinitely. If they do, they will consume all other items in the pie until the only thing the government does is employ nurses and fund a legion of Bob Hawke surf teams. This obviosuly is not a viable scenario because New Zealand would have conquered us with 2 Hercules and a dozen boy scouts the day after we retrenched our last soldier.
So far countries have gotten around this fact by borrowing money to fund the gap between outlays and tax receipts. However, borrowing to fund non-investment assets will always end badly – whether you’re a person or a nation state. Economists often say that nations (unlike people) have infinite lives and can always tax their people to pay back the debt – but there are limits. History (and the current Greek situation) shows that nations can borrow too much and that their creditors sometimes take bad haircuts. If the developed world continues to borrow to fund services that increase in size beyond their rate of GDP growth, then Greece will soon have company at the debt crisis party.
How did it happen?
In short, I believe the massive increase in living standards expereinced during the early 20th century (even with the world wars) gave the developed world enough spare cash to indulge in the idea of the welfare state. And to be honest, it could have worked if it stayed limited. However, voters have shown that they have a habit of voting in the pollie that offers the most free stuff (welfare, healthcare, baby bonsues, tax cuts) whilst offering the least amount of pain (tax increases, removal of subsidies/benefits). This has lead to a creep of government-provided services as politicians battle for the votes – services which were once paid for by the individual (like healthcare) or by community groups (charities providing welfare).
Given that this sort of bribery worked across many different countries with some very different cultures (think Japan and the UK) tells me that humans have a tendancy to vote poorly on matters that require long-term discounting. As creatures we seem to be hard-wired to go for the short-term benefit despite the fact some initial pain (or even just a delay of pleasure) will provide better rewards in the long run. How else can you explain the fact western governments have run ever-lasting deficits for over 30 years? This fact is not hidden – it is talked about often, especially now with the Greek crisis and the ever-increasing pile of US debt. But the political discourse has been almost entriely one of kicking the can down the road – never-ending projections of a turnaround in the economy to pay off today’s debts. And it’s not the politicians fault! Over such long-term time frames in democratic nations, the politicians will inevitably enact legislation that most people want.
Australia’s superannuation scheme is a real-world example of a rare and far-sighted government policy addressing this major flaw. The government knows the average Joe Punchclock won’t save enough for his retirement. Humans just don’t do it – some will, but most won’t. So we have to be forced to put away 9% of our wage to ensure we aren’t penniless when we’re wearing diapers once more.
It is this fatal flaw which has lead to the Greek debt crisis. It is this flaw which has lead to ballooning developed world government debt. And ultimately, it is this fatal flaw which must be confronted if the developed world wants to avoid a calamitous economic future.
How do we fix it?
I honestly don’t think the problem will be solved until western governments face a Greek-style crisis – one where the market forces them to do something about their debt unless they want to go down the inflation route. The voters just won’t allow anything to be done until the economic proverbial hits the fan.
I see three possible scenarios as this crisis point approaches
- Welfare and healthcare expenditure will be more tightly means-tested and recipient behaviour will be monitored, with non-compliance resulting in removal of benefits. We are seeing this already with cigarette and alcopop taxes as well as welfare controls ensuring people spend x% of their dole checks on clothes or food. This will be extended to routine checks on general health and lifestyle habits or your commitment to training or job seeking, with removal of medical or welfare benefits if you do not conform to government-approved guidelines. Basically the nanny-state on steroids and an infantilised population.
- Economic evolution (or revolution in the case of a major economic crisis) of the liberal democratic state, with constitutional limits placed on the % of government spending, the content of that spending and the amount of debt governments can take on. This has already happened culturally in Australia to a limited extend, with the citizens expecting surpluses from their federal governments. To ensure it stays entrenched though, governments will need constitutional limits that cannot be violated.
- New technology will eliminate many of the lifestyle diseases that suck up healthcare dollars, thereby reducing health expenditure dramatically. This will only delay the inevitable though as welfare spending expands to take up the budget vacuum
I’m a libertarian, so my preference is for scenario 2. Scenario 3 is pie in the sky and a plan based on hope, whilst scenario 1 is far too Orwellian for my liking. However, in a country like Australia with its love of governments that promise to fix everything, I think scenario 1 is the most likely.
What do the weekend musers think? Am I completely off the mark with my concern about human’s bad long-term discounting? Have I got my facts wrong about debt and the makeup of modern budgets?
If I’m on the money, then how is the developed world going to confront this growing problem?