Gerald O;driscoll (who is one of my favorite thinkers on the economy) says in WSJ article copied below:  “The underlying dilemma [in the EZ] is that governments have promised their citizens more social programs than can be financed with the tax revenue generated by the private sector. High tax rates choke off the economic growth needed to finance the promises. Economic activity gets driven into the underground economy, where it often escapes taxation ...  The sad fact is that there is not enough money in the EU to pay off the public debts incurred by the governments. Most countries have long since squeezed as much tax revenue from their citizens as they can. That is why they have toyed with a tax on financial transactions, the one remaining untaxed activity in all of Europe.”

Do we really want to see how high we can raise taxes in the US before we end up like Europe???  Is there any coincidence that   

O’Driscoll argues that the US is for all practical purposes already there (i.e. building an unsustainable social welfare state);  for one we are linked to the woes of EZ via banking and financial linkages. EX woes are our woes.  Second, and even more important …  “the U.S. has its own large and growing public debt burden. We have not gone as far down the road to entitlements, but we are catching up. If you want to know how the debt crisis will play out here, watch the downward spiral in the EU.”

>>>>

We are in a global recession caused by the aftermath of an easy money credit bubble that went bust.  The US government reduced private debt exposure but merely off loaded private debt onto the public balance sheet thus creating a public debt sustainability crisis.  We are told by the experts and pundits in mainstream media that we need a bipartisan solution that includes higher taxes to return to a sustainable fiscal path.

But how do you raise taxes into a recession, especially a "recession" (period of sub normal growth) that is supposed to last many years (as indicated by the Fed yesterday in their latest report).

The answer cannot be higher taxes and more government interventions in the economy.

As I see it the only realistic answer to the current chronic low-growth, high leverage, high financial risk economy and financial markets is to reduce the regulatory and tax burden on the private sector. 

Only then will we get a rebound in growth which is necessary to facilitate and speed-up the organic private sector creative destruction process.   we need a massive boost to growth to offset the contractionary effect of de-leveraging. 

if we use either fiscal or monetary stimulus to reduce the negative impact of deleveraging, what we do is prevent the market from adjusting to a new sustainable growth dynamic. 

fiscal and monetary stimulus DISTORTS markets by definition.  how are we going to fix the market with new distortions.  it makes no sense, but we are told by all of the experts that if the Fed wasn't such a party pooper, we would be on our way to higher inflation and recovery.

the government can't provide any such free lunch to society via fiscal or monetary stimulus. 

we have learned this lesson over and over and over again through history, but we keep trying anyway to fix government created problems with more government. 
 

As one of the great (but far from perfect) American Presidents said:  government isn’t the solution, it’s the problem.

The “law of no free lunches” (combined with the related “law of unintended consequences”) prevents government intervention in the economy from resulting in win/win outcomes for society.  Whatever good the government tries to do with interventionist policy (e.g. increase transparency and reduce risk in financial sector via regulation, or reduce business cycles via central bank, or reduce income inequality via highly progressive income tax) the result is a predictable constellation of negative unintended consequences that MORE THAN off-set any intended positive gains.

Government intervention is win for the few but lose for the many.   it must be that way.  otherwise the government would gradually take over every key sector of economy -- which it seems is the case today -- and yet the MARKET gets blamed for screwing everything up.

every key sector of US economy is massively distorted via government subsidies.  the idea that the US economy is a wild west model is a total myth.  Europe has its social welfare model.  at least they admit government intervention. 

We have our Subsidy Welfare Model that appears to be more more because subsidies are channeled into ostensibly private firms.  Consider these industries:  housing, banking, education, health, food processing, farming, military industrial complex.  you name it.  the government is massively involved and causing massive distortions.  

it is no coincidence the most subsidized sectors of economy display the worst inflation:  education and health.  We are told the government needs to fix the inflation because private firms are greedy and taking advantage of consumers.  this is silly.  government regs and subsidies drive prices up in health and education -- and then we blame the market and add more government to the equation, which will lead to an even worse outcome.  you might get lower prices (but probably not)  -- but if you do get lower prices the cost will be some combination of lower quality, lower output (forced rationing)  and likely also operating losses funded by tax payers.  look at post office for a perfect model of government managed business. 

lower quality:  check  (compare to FedEx)

forced rationing:  check.  (long lines and no delivery on weekends happening soon)

chronic losses paid by taxpayers:  check  (US post office is making multi billion dollar annual deficits)

the same will happen in any universal healthcare system dreamed up by the experts and do gooder nanny state geniuses who know how to fix social issues if only the idiotic conservatives would get out of the way...

It is no coincidence that there was never a global economic boom and bust cycle like the Great Depression until AFTER the Fed was established in 1913 ostensibly to eliminate such cycles!

The idea that there was large de-regulation (or lack of enforcement of regs) by GW ahead of the financial crisis is a myth.    The very markets that are MOST regulated were the worst impacted in the post Lehman collapse period, including mortgage and banking.  The least regulated financial industries, including hedge funds, were NOT coincidentally the least affected.    New regs fix the previous problem not the new problem that will happen next time.  policy makers ALWAYS fight the last war, and not very well at that!

Higher marginal tax rates have been used throughout world history including US history as a means to reduce income inequality and   it never works.  I would like someone to show me a correlation between highly progressive income tax rates, income equality AND robust sustained economic growth.  If you want income equality, the easiest thing to do is raise taxes high enough to kill the economy and thus make everyone equally poor.  actually, when countries have done this in practice, there remains a tiny political elite who remain fabulously wealthy, while the rest of e country suffers.  Consider Soviet russia or North Korea.  Large countries with sustainably low income inequality are very rare.  Japan is one such country.  The cost of low income inequality is 20 years and counting of continuous near recession growth.   Europe has less income inequality than US but also a massive public debt problem that might sink the entire enterprise!!!!

To the extent income inequality causes social tensions, what I can say is that the cause of such exaggerated  income inequality is NOT the market.  the cause of the sort of stretched income inequality that is socially de-stabilizing is well intended government intervention that ends up hurting the poor and favoring the wealthy!!! 

Central banking is a perfect example.  Easy money flows first to asset markets, the rich get richer as their 401k and house value goes up, the poor pay higher rents and get poorer.  Next easy money flows to commodities (gas and food).  The Fed says gas and food inflation is not core inflation, so the easy money policy is maintained while the poor are let to suffer with higher costs and lower disposable income ... all the while the easy money bubble builds up even further.  the rich also have access to cheap credit in order to leverage asset purchases.  The rich get even richer.  This process causing the rich to get richer and poor to get poorer has nothing to do with any inherent evil in the market.

the market is subject to the "garbage in garbage out" problem.  if distorted signals are fed into the market via government intervention (e.g. easy money), the result will be distorted outcomes.  THis is no fault of the market.  The market doesn't fail us, we fail the market.

in fact the market doesn't "do" anything.  the market emerges naturally when free people exchange goods and services and specialize their labor.  it is that simple.

the so called "economy" that emerges from such free trade and specialization is NOT perfect.  free traders who claim the market can solve every problem are dead wrong.

the market is no more perfect than humans.

Raising taxes on a system that is already distorted by easy money will not reduce income inequality.  Higher taxes will merely make the system more distorted, dysfunctional and less able to generate wealth for society over all.

Let me repeat:  There is no such thing as a market failure.  There are only market “features.”  Some features are good and some are bad.  All natural systems (inlcuding we humans) have good and bad features.   Just like life.  yin and yang.  good and evil.  There is no way to eliminate the bad features of the market via government regulations because government regs also inherently possess both good and bad features. 

In the case of free markets, however, the good features by definition outweigh the bad.  Yes there is income inequality in a market.  income inequality is a vital feature of robust and dynamic economies.  Get rid of income inequality and get rid of the market.  perfect equality only occurs when an economy is effectively dead, when everyone is equally poor.  once trade and division of labor occurs, this is when society enjoys the win/win result of higher productivity. 

Everyone “wins” in a free market except some win more than others.  that is a fact of markets.  income inequality isn’t bad per se.   income inequality is no more a failure of markets than hurricanes are a failure of earth weather systems.   We live with and adapt to natural disasters, we don't eliminate or control them.  ( i read recently that scientists are trying to reduce the impact of hurricanes by injecting aerosols into them.  that is going to work about as well as central banking.  doing this might reduce individual storm activity, but in the end the energy will be disippated through more storms or some other channel.) 

The economy is a natural system of exchange just like the earth biosphere or weather systems or any other complex natural system of energy/material exchange.  The key to understanding the economy is not that it is made up of artificial goods and man made services.  the economy does appear to be made up of artificial “stuff” like i-pads.  But, if you look past the artificial goods and services and infrastructure and buildings and cars and airplanes that make up the modern economy what you see is a massive system of exchange.  the natural part of the economy is the exchange part. 

The only way to understand the economy is to understand it not as a pile of man made stuff that is put together by humans in some enlightened design aimed at maximizing social justice and human welfare.  NO.

"The economy" is not planned.  There are centrally planned parts of the economy (e.g. big companies, families, government), but these are component parts that exchange and interact with the larger economy.  the economy is a natural system of exchange.

The process of free trade (=exchange) and division of labor supported by an underlying “natural” system of private property rights (e.g. common law) leads naturally to a totally natural ecosystem we call “the economy.”  The economy is a totally natural (and spontaneously organizing) sub system of the larger earth system.  all sub systems of earth are seemlessly coordinated via ironclad laws of nature.

We cannot engineer outcomes into the economy.  we can’t inject virtue into society.  Government cannot level the playing field -- at least not without causing negative unintended consequences that are togehter worse than the original problem. natural complex systems that spontaneously organize (like the weather and economy) don’t work according to cause and effect rules.  The natural ecosystem pattern that we call “the economy” spontaneously emerges as a result of free trade.  It really is that easy.  Anything that reduces free trade will cause negative unintended consequences for the system as a whole.  Therefore if “we” try to reduce income inequality – via interventions that reduce the freedom of individuals to trade how they want and intend – then this requires a trade off in the form of some constellation of unintended consequences.

No free lunches!!!  The market is not perfect, but it is the best we can do.  if we want to improve the market, we need to think in terms of trade offs.  Lower income inequality = lower growth.  lower income inequality doesn’t mean higher growth as many progressives / liberals claim.  The experts claim that high income inequality is bad, so fixing it must be good.  that is NOT correct.  Income inequality is natural to markets.  what we see as income inequality leading to social stress is not “natural” and it is not a “market failure” that needs to be fixed via new govt intervention.  NO. 

large income inequality can only result from a set of previous well intended (or selfishly motivated) government rules, regulations, taxes and other assorted interventions.  All markets MUST lead to income inequality.  When markets breach some level of income inequality beyond the “natural rate” then this is not the result of market failure, but must be a result of some human intervention (well intended or selfish). 

The solution to reducing income inequality in America is not to increase marginal taxes on the rich or to subsidize education or level the playing field or any other well intended intervention.  The solution is to unwind the non-market causes of income inequality, number one of which is easy money.  Get rid of the Fed and get rid of all subsidies aimed at leveling the playing field. 

these two proposals are unlikley to get traction of course because politicians don’t want to get rid of easy money because easy money pays for all of the interventions and subsidies the politicians say are necessary to fix market failures (but which are really just convenient ways to pay off special interest groups).

Until we get rid of central banks, we will always be stuck in a self defeating cycle of more govt interventions implemented to fix the unintended consequences of some previous interventions.  This is the Road to Serfdom described by FA Hayek.

• NOVEMBER 2, 2011

Why We Can't Escape the Eurocrisis

EU and U.S. debt are interlinked through the banking system.

By GERALD P. O'DRISCOLL JR.

When is a bailout not a bailout? When the bailor is short of funds. The recently announced debt plan in the European Union comes up short in almost all respects.

The debt crisis is not just an EU problem, but a trans-Atlantic financial crisis. The overwhelming debt problems on either side of the pond are interlinked through the banking system.

First to the EU. The underlying dilemma is that governments have promised their citizens more social programs than can be financed with the tax revenue generated by the private sector. High tax rates choke off the economic growth needed to finance the promises. Economic activity gets driven into the underground economy, where it often escapes taxation.

Nowhere is this truer than in Greece, which has a long history of sovereign defaults in the 19th and 20th centuries. There is a bloated public sector, and competitive private enterprise is hobbled by regulation and government barriers to entry. Successive Greek governments ran chronic budget deficits, and the Greek banks lent to the government. Banks in other EU countries, such as France, lent to the Greek banks.

In Greece and elsewhere in the EU, the banks support the government by purchasing its bonds, and the government guarantees the banks. It is a Ponzi scheme not even Bernie Madoff could have concocted. The banks can no longer afford to fund budget deficits, yet they cannot afford to see governments default. Governments cannot make good on their guarantees of the banks.

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Details differ by country. In Ireland, problems began with an overheated property sector that brought down the banks. The economy went into depression, which threw the government's budget into deficit. Further aggravating the deficit was the government's decision to guarantee bank deposits, converting private, financial-sector debt into public-sector debt. The details differ from Greece, but the linkage between the government and the banks is the common factor.

France's growth is weak to nonexistent. Germany's economy has performed well since the recession, but concerns are growing regarding its banks' exposure to greater EU risk. And U.S. banks and financial institutions are exposed to EU banks through funding operations, issuance of credit default swaps and unknown exposure in derivatives markets.

The Federal Reserve has engaged in currency swaps with the European Central Bank to support the dollar needs of EU banks. The ECB deposits euros (or euro-denominated assets) with the Fed and receives dollars in return. It promises to repay dollars plus interest.

The Fed maintains they cannot lose money because the ECB promises to repay the swaps in dollars. And yet, with the world awash in greenbacks, it is unclear why the Fed and the ECB even needed to engage in these transactions—except that it suggests funding problems at some EU banks. And if neither EU banks nor the ECB can secure enough needed dollars in global markets, there is a serious counterparty risk to the Fed. The ECB can print euros but not dollars. Sen. Richard Shelby (R., Ala.), ranking member of the Senate Banking Committee, was correct to raise concerns about the Fed's policy last week. Losses on the Fed's balance sheet hit the U.S taxpayer, not EU citizens.

The sad fact is that there is not enough money in the EU to pay off the public debts incurred by the governments. Most countries have long since squeezed as much tax revenue from their citizens as they can. That is why they have toyed with a tax on financial transactions, the one remaining untaxed activity in all of Europe.

Greece is the first of other sovereign defaults to come. With last week's bailout, the EU leaders might have bought time, perhaps a year. But at some point, the ECB will cave and monetize the debt, leading to euro-zone inflation.

The debt calculus changed dramatically this week with the announcement of a Greek referendum on the bailout agreement next January. If voters reject the agreement, the ultimate outcome is unpredictable.

Americans must not be smug about the suffering of Europeans—our financial system is thoroughly integrated with theirs. Moreover, the International Monetary Fund will most likely be involved in the event of future bailouts and will likely need large funds from its members, which ultimately means the taxpayers.

And, of course, the U.S. has its own large and growing public debt burden. We have not gone as far down the road to entitlements, but we are catching up. If you want to know how the debt crisis will play out here, watch the downward spiral in the EU.

Meanwhile, expect more volatility in financial markets. U.S. traders in particular simply have not grasped the enormity of the EU debt crisis.

Mr. O'Driscoll, a senior fellow at the Cato Institute, is a former vice president of the Federal Reserve Bank of Dallas and later Citibank.