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ROHAC: ‘Fiscal cliff’ caused by philosophies that don’t work

Band-Aid solutions won’t fix this problem

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Commenting on America's "fiscal cliff," Jay Leno observed, "It's 4 a.m. for our economy, and Lindsay Lohan is behind the wheel." Just a few days before Jan. 1, there is no solution in sight, and both sides of the debate seem deeply entrenched in their positions.

However, given Washington's political landscape, a compromise solution to the problem of the fiscal cliff will do little to avert the real fiscal crisis facing the nation. None of the plans under consideration can address the problem of unsustainable dynamics, driven by an expansion in entitlement spending, a long-term economic slowdown and faltering demographics.

Margaret Thatcher famously said, "The problem with socialism is that you eventually run out of other people's money." Let's be honest: Over the long term, the U.S. government is bankrupt. Stephen Cecchetti, Madhusudan Mohanty and Fabrizio Zampolli, economists at the Bank for International Settlements in Basel, Switzerland, predict that unless deep reforms are adopted, the public debt of the United States will reach more than 400 percent of gross domestic product by 2040.

Democrats are deluding themselves if they think they can close the gap by simply making the rich pay for an increase in the size of the federal government. To solve the long-term debt problem without major changes to spending, taxes on the rich and the poor would have to rise by a hefty amount, with disastrous effects on the economy.

The United States is not alone. For decades, the industrialized West has been on an unsustainable fiscal trajectory: France and Greece can be expected to reach a debt-to-GDP level of 400 percent by 2040 as well, with Germany rising above 300 percent by the same year. In Japan, the debt-to-GDP ratio easily could attain 600 percent. Any sensible investor will dump government bonds way before we are anywhere near such levels.

The American -- and Western -- fiscal problem is not an accident of history. It does not help to single out specific policy mistakes, either. Our problem cannot be blamed on (depending on your perspective) George W. Bush's tax cuts, bank and auto bailouts, the Iraq War, President Obama's stimulus, a single European currency, the Spanish real estate bubble or Greek tax avoidance.

Instead, our fiscal problem has been driven by the widely held Keynesian belief that deficit spending is harmless and even desirable -- especially in recessions. Since World War II, Western governments have used deficit financing indiscriminately, under all economic conditions.

Moreover, although democracy is the best political system out there, it also encourages fiscal recklessness. H.L. Mencken noted that "democracy is the theory that the common people know what they want and deserve to get it good and hard." However, voters and politicians seldom have to carry the full costs of their actions. As a result, democratic politics encourages deficit financing as a way of hiding the true costs of government spending and imposing those costs on politically less-vocal groups -- including future generations.

Democrats make one valid point: If you want a bigger government, you ultimately will have to live with higher taxes. Much as we dislike taxes, they at least introduce transparency to the cost of government -- unlike the fiscal illusion with which we have been living for past decades. Yet a permanent hike in taxes also means a permanently poorer economy and permanently lower living standards. Good luck selling that to middle-class Americans.

There are no smart fixes to the problem. Whatever one's ideological priorities, to balance public finances, one either needs to cut spending in a credible and lasting way or increase revenue, potentially wrecking an already-frail economy with tax hikes. These are tough choices that politicos in Washington would rather avoid.

What is needed, on both sides of the Atlantic, is honesty about what government can deliver, and at what cost. We ultimately will need to have a discussion about ideology or political philosophy. Although the outcome of that discussion may be unclear in Europe, there is little doubt that -- if given the choice -- Americans would opt for low taxes and a lean federal government. In any case, it is imperative that we have that discussion sooner rather than later. Remember, it's well past 4 a.m., and unless we can find a way of restraining the Lindsay Lohans behind the wheels of Western economies, we are off for a very bumpy ride.

Dalibor Rohac is an economist at the Legatum Institute in London.

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