A Primer on the National Debt

On May 8, 2012, in credit, economic theory, insurance regulation, tax policy, by admin

Simon Johnson and James Kwak. White Housing Burning: The Founding Fathers, Our National Debt, and Why It Matters To You. Pantheon Books, 2012, pp. 352, $26.95 The two constants in the upcoming 2012 general election likely will be an inordinate amount of negative campaigning and vigorous disagreement about how to best foster economic growth. Implicit [...]

Simon Johnson and James Kwak. White Housing Burning: The Founding Fathers, Our National Debt, and Why It Matters To You. Pantheon Books, 2012, pp. 352, $26.95

The two constants in the upcoming 2012 general election likely will be an inordinate amount of negative campaigning and vigorous disagreement about how to best foster economic growth. Implicit in any discussion about the nation’s economic woes is the national debt, which as of May 7, 2012, was $15,671,202,480,642.98. While the political center-left has highlighted the perils of rising consumer and student debt, the Tea Party movement and political libertarians have ensured that the perils of this country’s rising national debt remain in the public consciousness. But what should be done about the country’s debt? Should we enter into an age of austerity in which public spending at the federal level is significantly curtailed and once-cherished safety net programs such as Social Security and Medicare are quasi-privatized? How did we get ourselves into debt to begin with? At a more theoretical level, should we be asking ourselves whether debt is always such a bad thing for a country?

In White House Burning, Simon Johnson (Massachusetts Institute of Technology) and James Kwak (University of Connecticut School of Law)* argue that the debate over the national debt comes down to how Americans want to respond to risk, either on their own volition, or through government-run insurance programs. The same is true for the deficit. “The great deficit debate,” write the authors, “is about how much risk people should bear themselves and how much they should pool with each other via the government.” The authors contend that it is indeed possible to maintain a sustainable level of debt and simultaneously have the federal government continue to play its role as an insurer against risk. Indeed, in chapter seven, they delineate what they believe to be the best method for achieving this goal. While most conservatives would likely not agree with their recommendation that the Bush tax cuts expire, others surely will appreciate their preference that tax expenditures, including the mortgage interest deduction, be eliminated or reduced.

While the direct policy sections of White House Burning are somewhat dry reading and do not break substantially new ground, the book’s earlier chapters do merit attention, particularly by those readers interested in economic history. In their Introduction, they discuss how the country’s fiscal weakness during the War of 1812 led to the burning of the White House by British troops in 1814, “the low point of the war, a moment of national humiliation that remains an iconic image in U.S. history” and, one should note, accounts for the title of the book. The problem during the War of 1812, contend the authors, was that Great Britain had money, while Congress opted for “higher spending without higher taxes.” Today, the approaching fiscal crisis comes not from the threat of a literal land invasion, but by a greying population and rising health care costs.

In Chapter 1, entitled “Immortal Credit,” Johnson and Kwak provide an overview of how the United States dealt with its national debt prior to the end of the gold standard in the Nixon era. Not surprisingly, Alexander Hamilton, America’s first Treasury Secretary, and the man responsible for enacting the country’s earliest fiscal policies, plays an important role. In the book’s second chapter, “End of Gold,” the authors posit that the changing relationship between gold and money over the past three centuries has had important consequences for the national debt. The breakdown of the Bretton Woods system for international finance in the early 1970s, led to a growth of American national indebtedness. “Under the Bretton Woods system, the capacity of the world to buy American bonds was limited by American gold reserves; today it is limited only by market demand, which has turned out to be much more forgiving.” Indeed, international investors still consider Treasury bonds to be safe assets. But, as the authors aptly warn, markets could turn against the United States should the world begin to doubt Washington’s ability to manage the dollar effectively.

In conclusion, White House Burning is a useful primer for those readers interested in learning about the national debt and what drives it. Although not as compelling as the authors’ previous work, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, in which they argued that the close ties between Washington and Wall Street are not healthy for the American economy and polity, this most recent publication is still worth reading. This is particularly true for readers interested in how the federal government acts as an insurer against risk for a large segment of the population. Whether their work will have any impact on the gridlock in Washington remains yet to be seen.

Jon Lewis (c) 2012
* I received my J.D. from the University of Connecticut School of Law prior to Professor Kwak taking the position at the law school.

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Rethinking the State and the Economy

On December 16, 2011, in economic theory, tax policy, by Jon Lewis

Government versus Markets: The Changing Economic Role of the State. Vito Tanzi. Cambridge University Press, 2011, pp. 376, $35.00 If the past is any guide to the present, many voters in the 2012 presidential primaries, as well as in the general election, will make their choices based upon the personalities of the candidates. While unfortunate, [...]

Government versus Markets: The Changing Economic Role of the State. Vito Tanzi. Cambridge University Press, 2011, pp. 376, $35.00

If the past is any guide to the present, many voters in the 2012 presidential primaries, as well as in the general election, will make their choices based upon the personalities of the candidates. While unfortunate, this is not entirely without good reason. It would be preferable, however, if the majority of the voting public were able focus less on the quixotic personalities in the race, and more on the most pressing, and interrelated, issues of our time; namely, the size and scope of the federal government and the national debt. Whatever one might think of their methods or their ideology, the American public has the Tea Party largely to thank for bringing attention to the debt crisis and the unsustainability of the current entitlement system.

In Government versus Markets, Vito Tanzi (formerly the director of the Fiscal Affairs Department of the International Monetary Fund) opens with the premise that, “[t]here is no more fundamental question in economics than what role the state or the government should play in a country’s economy.” Although some might dispute this characterization as demonstrating a bias toward macroeconomics, it is inarguable that the relationship between the state and the private sector is likely to be significantly redefined in the next decade. The question, of course, is in what direction. Will the next decade witness a move toward greater federal government involvement in education, energy, and health care or toward a smaller government that does less, but with greater fairness and efficiency? Or something in between?

In what can best be described as a sweeping intellectual history of the role of the state in modern industrial economies, Tanzi demonstrates how, from the late nineteenth century onward, the state has taken on an increasingly greater role in the economy. With references to economists Adam Smith, Karl Marx, and John Maynard Keynes, as well as to Bismarck’s social insurance legislation in Germany, which the author rightly notes “had a major impact on the world and must be seen as a major and perhaps the most important landmark in social legislation,” the author successfully integrates economic history with political philosophy. In Chapter 8, for instance, the author devotes his attention to both the voluntary exchange theory and public choice, citing the work of James Buchanan.

In Tanzi’s assessment, in the first half of the twentieth-century in industrialized countries, “the government became a huge insurance company and intermediary for the citizens.” This, of course, did not come without a cost; namely, increased taxation and spending. In a passage particularly relevant to the fiscal morass in which we currently find ourselves, Tanzi, in the book’s introduction, reminds the reader that there is a direct correlation between current fiscal policy and the future role of the state in the economy. “When governmental intervention comes through higher spending and higher taxes, as it often does, it can change for future years the economic role of the state and the status of a country’s public finances.” It would seem that, at times, large segments of the American public have forgotten Milton Friedman’s pithy observation that there is indeed no such thing as a free lunch.

In light of the ongoing public debate over income inequality, Tanzi’s discussion of the subject matter, albeit not the central focus of Government versus Markets, is worth consideration. He contends that, “in a competitive and globalizing world, reduction in income inequality, although important, cannot be the sole of the main objective of economic policy. If that were the case, the policies pursued by the planned economies in the past, and by Cuba and North Korea today, would be praised and imitated.” Indeed, if twentieth-century has taught us anything, it is that well-intentioned social engineering projects aimed at reducing income inequality have, unless constrained by an open, pluralistic political system and a commitment to the rule of law, will often backfire, which lead to greater misery for a larger number of people.

If the state’s power in the economy has increased throughout the past century, what is the likely role of the state in the future? It is here that Tanzi makes his most provocative contentions. Regulations, rather than the government’s taxing and spending powers, will become more influential. He suggests that governments have focused too much on replacing the private market with the public sector and too little on preventing market failure. A fundamental principle to guide the state’s economic role, Tanzi posits is an “ambitious normative option,” wherein governments should focus on the prevention of market failure, more than on remedying failure after the fact. Of course, regulatory policy is hardly an uncontested terrain. For this reason, it is likely that Tanzi suggests that, “a clear, binding, legal guideline may be necessary” to deal with the myriad political problems associated with regulatory policy, such as regulatory capture. This is perhaps much easier said than done.

In terms of fiscal policy, Tanzi enumerates four possible developments that, either by themselves or in combination, can contribute to large reductions in debts and fiscal deficits: substantial drops in interest rates for government debt; high economic growth; unanticipated inflation; “and reforms in taxes and in public spending associated with a major change in the role of the state in the economy that lead to large reductions in public spending and/or significant increases in tax levels.” It is the last approach – one, it should be noted, that is not altogether different from the path suggested by Congressman Paul Ryan – that Tanzi suggests is the better option.

Tanzi appears to call for a form of “libertarian paternalism,” a term that he uses in quotes. In this approach, the government’s focus would be on reducing risks, rather than correcting ex post preventable outcomes. Under this approach, the government would have a direct role in assisting the deserving poor. With lower taxes and less spending, the middle class would use its larger share of post-tax disposable income to buy protection from the market place and some social services formerly provided for by the government. “This,” opines Tanzi, “is not an easy way out from the current fiscal mess, but it may be the only realistic one for many countries over the long run.” Policymakers supportive of expanding the federal government’s role in health insurance would be well advised to take Tanzi’s arguments seriously.

In conclusion, Government versus Markets is an excellent and highly thoughtful book that deserves a wide audience. It is no longer possible to believe that the current fiscal trajectory in the United States is sustainable over the long term. Although reduced taxation and spending will come at a significant cost, it is likewise true that continuing business as usual will come at an even greater cost, particularly for the recent college graduates who are inheriting a future with limited opportunity.

Jon Lewis (c) 2011

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EU Insurance Regulation

On June 8, 2011, in Basel, insurance regulation, Solvency II, by Jon Lewis

Executive’s Guide to Solvency II. David Buckham, Jason Wahl, and Stuart Rose. John Wiley & Sons 2011, pp.194, $95.00 In the United States, the states, rather than the federal government, are primarily responsible for regulating the insurance industry and the business of insurance. This is due to both longstanding custom and, most significantly, to Congress’ [...]

Executive’s Guide to Solvency II. David Buckham, Jason Wahl, and Stuart Rose. John Wiley & Sons 2011, pp.194, $95.00

In the United States, the states, rather than the federal government, are primarily responsible for regulating the insurance industry and the business of insurance. This is due to both longstanding custom and, most significantly, to Congress’ passage of the McCarren-Ferguson Act in 1945. McCarren-Ferguson established a regulatory system in which, unless Congress specifically indicated otherwise, the states were to be the primary regulators of insurance companies. This is why, to this day, each state and territory has its own insurance commissioner; unfortunately, there is no federal insurance regulatory agency in Washington D.C. to oversee and to regulate a national insurance market. Indeed, for a modern economy with a large financial services industry, the American insurance market is quite decentralized.

By way of contrast, the European Union (EU) is in the process of harmonizing its system of insurance regulation to prepare for the challenges of the 21st-century economy. Beginning January 1, 2013, the EU will implement Solvency II, an initiative designed to replace the Solvency I, a reform that the European Commission and European Council agreed to in 2002. In Executive’s Guide to Solvency II, the authors argue that those cynical about this new phase in EU insurance regulation are wrong and that “Solvency II is a well-thought out directive, painstakingly developed over many years by collaboration between the European Commission, member states, and the insurance industry.” Buckham and Wahl, of Monocle Solutions, and Rose, of SAS Institute, have written a comprehensive overview of the Solvency II Directive in a book that will most likely be a standard reference guide for years to come.

The authors begin their work with a cursory introduction to the role that insurance fills in mitigating and transferring risk. For those unfamiliar with the historical development of insurance and its importance in market economies, Chapter 1 is particularly worth reading. The authors rightly note that “the optimal goal” of Solvency II and similar regulations “is to promote a socially optimal balance between the profit motive of organizations and individuals’ rights” and cite Article 27 of the Solvency II Directive which emphasizes that “[t]he main objective of (re)insurance regulation and supervision is adequate policyholder protection.” In Chapter 3, the authors argue, “the important role that insurance companies play in the financial system today makes it imperative that the industry should be regulated.”

As with any regulatory system for financial products, the question is where to strike the appropriate balance between consumer protection, managing systemic risk, and allowing companies to compete and to innovate. (Indeed, the ongoing debate over the how best to write and to implement regulations for the recently enacted Dodd-Frank reform legislation highlights this tension). Significantly, the authors state with clarity “that the production cycle in insurance is inverted; that is, insurers receive a premium up front but are obliged to pay out only if the risk materializes at some future date.” Because an insurer bankruptcy would expose both policyholders and the beneficiaries of insurance contracts to losses, insurance regulation focuses on solvency. That said, according to the authors, insurer insolvency is not very frequent.

For those readers most interested in the nuts and bolts of Solvency II, Chapter 5 provides a useful overview of the Directive. The authors point out that Solvency II, like the Basel II banking regulations, has a three-pillar structure and that its “primary objective is the protection of policyholders and beneficiaries.” What makes Solvency II unique is that it is principles-based, rather than rules-based, and that “it explicitly states that capital is not the only (or necessarily the best) way to mitigate failure.” In the United States, by way of contrast, the states utilize a rules-based system for financial regulation, in which insurers have specific regulations with which they have to comply. Within the Solvency II framework, EU (and Norwegian, Liechtensteinian, and Icelandic) insurance companies “will be required to meet regulatory principles rather than rules.” Under the Solvency II regulations, good governance of insurance companies is emphasized and insurers are given wide latitude to develop internal modeling systems. The new rules “will inevitably shift business attitude from a compliance-based culture to a risk management culture.” What will be interesting to watch is how competitive EU insurance companies will likely be under this principles-based system.

Should Solvency II prove to be a successful regulatory framework for EU insurers, it would likely further expose the weaknesses of America’s current rules-based, compliance-oriented insurance regulation. For those policymakers and legislative staffers interested in modernizing insurance regulation in the United States, Solvency II, as noted by insurance regulation scholars, Martin F. Grace and Robert W. Klein, “could be used as a template, but U.S. regulators need not mimic any particular system to create the best possible system.” That said, for those interested in harmonizing and streamlining insurance regulation in the United States so as to make American insurers more competitive, the Solvency II Directive is worth ample consideration.

In conclusion, Executive’s Guide to Solvency II is not for the general reader, nor is it for readers without a serious interest in the economic and policy aspects of insurance regulation. For individuals working in the EU insurance industry, this book will be invaluable; for Americans interested in bold thinking about how the United States might want to restructure insurance regulation after Dodd-Frank, as well as for those interested in an Optional Federal Charter, this book — and Chapter 5, in particular — is worth reading. It may very well come to pass that by the end of 2013 EU insurers will be far more competitive globally than American insurers.
Jon Lewis © 2011

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