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Policy Credibility, Market Confidence And The Private Sector

Iyanatul Islam
is Chief of the Employment and Labour Market Policies Branch at the ILO in Geneva and Adjunct Professor at the Griffith Asia Institute, Griffith University, Brisbane, Australia. The author writes in a strictly personal capacity.

The notion of the credibility of policy-makers and how that creates incentives for the private sector to consume, save, invest and innovate is at the core of much of modern macroeconomics. Expectations-driven actions by the private sector are seen as the ultimate drivers of sustained economic growth that delivers jobs for all.

Policy credibility requires the use of signalling and commitment devices. They are represented by a resolute commitment by the government to price stability, typically defined as low, single digit inflation, monitoring public sector debts and deficits so that they do not exceed certain thresholds and current account sustainability. The proposed inflation rate is 1 to 3% for developed countries and less than 5% for developing countries. The proposed fiscal targets are as follows: 60% debt to GDP ratio and 3% deficit to GDP ratio for rich countries, as in the Eurozone fiscal compact. The comparable numbers are 40% debt to GDP ratio and less than 5% deficit to GDP ratio for developing countries. Foreign exchange reserves adequate to cover three months of imports have often been used as a threshold for current account sustainability for developing countries, but a comparable number is not used for developed countries.

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It’s All About Education

JP-pic 2Dr. John Psarouthakis is the Executive Editor of www.BusinessThinker.com Internet Magazine, Distinguished Visiting Fellow / Professor at the Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland, Publisher of www.GavdosPress.com and Founder and former CEO, JPIndustries, Inc., a Fortune 500 industrial corporation

The world is a better place because of great novelists and poets and painters and musicians and sculptors and actors.  We could include great chefs on a short list of specialists who add value to our cultural lives.  Even such a basic need as food, after all, can be lifted above the ordinary and into the realm of art.  As a voracious consumer of the arts (and occasional patron of the arts), and as someone who enjoys a wonderfully prepared meal, I obviously believe esthetic good things enrich us all.  I also believe everyone’s education should include a well-guided tour of the literary, visual, and musical arts.  But only a relative handful of citizens can pay the rent by knowing the difference between a sonata and a fugue, or by sharing their opinion of Moby Dick—or, for that matter, by knowing how to play a fugue or write a novel or choose the best fresh ingredients and bring them to table well enough to rent a building and start printing menus.  The world doesn’t work that way.  The overwhelming majority of us always have needed to make a living in the mundane realm of commerce and industry (or, via subsidy by the private sector, government).  Education’s role in that familiar dynamic must be fundamentally recast, however, for the 21st Century.

At a glance, educating young people for the 20th Century workforce didn’t look much different than what education must accomplish in the new age.  For example, all young people preparing for today’s job market know the lately fashionable acronym “STEM,” meaning “science, technology, engineering, and math.”  Pointing toward a STEM career means, according to a 2011 Bureau of Labor Statistics essay, preparing for a job that will . . .

“ . . . play an instrumental role in expanding scientific frontiers, developing new products, and generating technological progress. These occupations are concentrated in cutting-edge industries such as computer systems design,           scientific research and development, and high-tech manufacturing industries.  Although educational requirements vary, most of these occupations require a bachelor’s degree or higher. Accordingly, STEM occupations are high-paying occupations, with most having mean wages significantly above the U.S. average.”

That BLS quote is entirely true this afternoon, and was entirely true decades ago (many decades ago, if you eliminate reference to computers).  College graduates now in their 70s and older understood, back in their own school days, a marketplace distinction between a degree in “hard science” and a degree in “soft studies.”  If you possessed the inclination and grit and aptitude to follow the former path, toward being not a poet but a lab rat, you were more likely to be rewarded with “job security” and a larger paycheck.  So that part of the new acronym isn’t really news.  In 1940 parents would rather foresee their sons (and now, increasingly, daughters) as engineers or scientists or medical doctors than as shoe salespersons or postal workers or even “schoolteachers.”  That is not to demean the other occupations.  Parental preference for a hard-science education over an arts or literature degree, and certainly over jobs requiring only a high-school degree, did not derive from a love of calculus or biology.  It came straight from the near-universal desire to see one’s offspring thrive and lead a prosperous life.  The hard sciences were never a poor path to that result, especially in a parent’s mind’s-eye.  An engineer or a researcher or an M.D. with a bent for the arts could always, after all, afford a grand piano and season tickets to the opera.

What has changed about that dynamic, and continues to change at an increasing pace, is basically threefold and could be summarized as “it’s more truer than ever.”  First, more and more jobs—not merely those in the “STEM career” path—require a certain level of math and science literacy, and almost any career requires or is at least enhanced by advanced computer literacy.  Second, as countless studies and simple observation reveal, a larger and larger percentage of available jobs will require bachelor’s and advanced degrees in math and science and engineering.  Third, whether you are a Ph.D. doing pure research, or a community college night student making car components by day in a Midwest factory, your job will require appropriate continuing education as surely as do surgeons and psychologists.  Keeping one’s skills in sync with evolving technology means shooting at not just a moving target but an accelerating target.  Profound changes in the workplace will become more profound.  The need for parallel changes in how we prepare workers to be employable is obvious.

The workplace is market-driven.  Competition creates profound change without new government policies, without any prompting from outsiders.  Any new manufacturing technology or more efficient process becomes a prerequisite for survival.  Large workplaces that don’t heed free-market cues to change will go under—or send their CEOs to Washington, hat in hand, to seek rescue via unorthodox, taxpayer-funded bankruptcy.  Industries that can infect an entire economy just by sneezing might find relief that way (though their secured creditors will not).  But even in the case of GM and Chrysler’s bailout, the result was massive change.  GM, in fact, became almost unrecognizable.  No such change is yet visible across an educational system that needs three new R’s: reform, refocusing, and response.

I am not here to suggest how our K-12 schools can best be reformed to produce students who are better readers, better at math, more devoted to scientific method, and more literate in those cultural enrichments mentioned at the outset of this chapter . . . to say nothing of making a better impression at job interviews.  The experts will need to find answers within a daunting environment that includes new family dynamics, social change, instant and omnipresent communications media, and budget constraints.  Such answers, however, must be found.  We are the world’s greatest nation and yet we have communities in which most kids do not graduate from high school, and many of those who do graduate lack credible readiness for further education.  Schools in almost every district have become engaged in a running battle with a standardized testing system that may or may not be adding value to the educational process.  The American public school system, including its urban schools, once could claim a gold medal for democratic excellence.  Today, among parents, some of the loudest educational buzz is about “charter” schools as a means to avoiding these same public schools.  Too many schools are failing both as educational institutions and as centers of socialization and security.  It will take some of the best minds of this generation, fully dedicated to the problem, to find solutions and instill public confidence. 

Meanwhile, every graduation day, for better or worse, millions of our offspring take one more step—we hope—toward entering a fundamentally changed, and changing, workforce.  In that regard I am here to suggest that our schools, however they attack their demons from the bottom up, must pay more attention to the workplace.  It’s true that schools are tasked with preparing students for a life, not just a work life.  I remain fervently in favor of providing that guided tour of the arts for everyone, and I do not believe eighth-graders need to be or should be deciding whether they will become surgeons or teachers or ironworkers.  But precious few students will find life rewarding without ability to compete—first for a job and then within a workplace culture, or as an entrepreneur.  Jobs that require only a high-school education while offering new employees a career that will support a family are virtually extinct.  A good salesperson can always make a good living, of course—sometimes a very good living.  But any young person with that in mind should interview a few sales managers and find out how many newbies must be hired and fired before a single success story is written.  There is no avoiding the fact that every 21st Century K-12 student needs to be exposed to all the “STEM” courses he or she is capable of completing successfully.    

Exceptions to the STEM advantage tend to be entrepreneurial, unless you are that 1-in-20 salesman or that 1-in-20,000 athlete.  Some exceptions are, of course, as enormous as it can get.  Bill Gates is often, and accurately, described as the world’s richest college dropout.  Gates is not the only entrepreneur who became wealthy without a college degree.  Almost every town in America includes high-school dropouts on its roster of serious entrepreneurial success stories.  Behind every statistic, including the BLS numbers regarding the workforce outlook for those trained in science and technology, lurks someone who has shattered that statistic’s expectations.  Unfortunately, the someone who did the shattering did it on his or her behalf alone, not for others in the statistical group.  Outliers—positive or negative, admirable or to be scorned or mourned—are mere blips in the statistics.  Many people live to defy the life insurance industry’s actuarial tables, but the tables nonetheless are bankable.  Do not quarrel with numbers that say the more science and technology you have in your educational resumè, the better off you will be in the job market.  The numbers are indisputable even if you know someone with a Ph.D. in physics who is living in his parents’ basement and working as a night-shift manager in the fast-food sector.

There you have a few words about the first two 21st Century “R’s” in our education dilemma, one bearishly difficult and one incredibly obvious.  The first, a bearishly difficult question about reform (which of course I leave to the experts to answer), is:  What must our educational establishment do to confront an era in which external social factors have helped diminish the quality of our K-12 output, even as career paths are demanding better-prepared high-school graduates?  The second, incredibly obvious puzzle piece is this refocus:  No offense to the “soft” or liberal-arts faculty and curriculum, but what today’s students will most need as adults is every successful hour of science and technological education they and the system can handle.  With a little will to act, this second element is simple (in concept, a least), nothing more than a bit of a shift in emphasis, and an intense effort to make science and technology education absolutely as inclusive as possible.  Through his or her K-12 studies, no capable student should be allowed to make a soft landing away from fundamental science studies.  It’s as obvious as the statistics about STEM graduates.  It becomes much more obvious if one simply looks around to see a citizenry that is literally plugged into technology most of their waking hours.

That leaves a third “R”—response.  This element is all about change, and relates to education as FedEx and UPS relate to the Pony Express.     “Exponential change” has been a popular phrase for a generation or two.  In the scientific sense of the word, exponential change means change of a magnitude equal to a mathematical exponent, those superscript numbers in an equation.  In other words, a particular exponential change would upset the proverbial apple cart to the second or third or fourth or 50th power—or as is also popularly, and without specificity, used in daily conversation, “to the nth degree.”  Despite all the common usage of such phrases, and despite my talk about fundamental change, it is important here to note that for the most part I am not talking about the need for our educational system to deal with “exponential change.”  If the exponent were merely modestly large and quick, it would be an impossible task.  We haven’t reached that point, at least not yet.

Technology does advance with remarkable speed, sometimes with breathtaking speed, occasionally with stunning speed.  We have come to expect that technology will make fundamental changes in world within a single lifetime.  But we do not wake up on Monday and find the printing press invented, wake up on Tuesday to discovery of the microprocessor, arise on Wednesday to find the first personal computer being marketed, greet Thursday with our first peek at the internet, and end the week attending a dedication for the first advanced manufacturing plant that does not employ a single human being, not even a security guard.  Calculate an exponent spanning each of those morning surprises, if you wish.  But console yourself, as an education reform planner, in knowing that a 21st Century education system must move merely very, very fast . . . not impossibly fast.

It’s also important to note that despite my interest as a citizen in K-12 education, this little book is essentially about how, as the politicians always (meaning something that never changes, exponentially or otherwise) say, getting the country moving again.  That means growing the economy, in a free-market setting, so as to create a larger pie and thus benefit everyone who participates in the process.  And although better grade-school outcomes and better high-school outcomes absolutely will help in that effort, it is at the college and university levels where the fastest, most direct connection occurs.  That is the only connectivity level with which I have had direct experience as a technology manager and entrepreneur.  It is the only connectivity level where education can seek to move if not as rapidly as technology moves, then at least rapidly enough to nurture a competitive workforce and continue to produce a domestic “technology supply” that has fast become the world’s most valuable raw material.

In other words, when our colleges and universities offer curricula that turn on a dime to support the changing technological savvy required of world-class manufacturing employees, then our manufacturers will know their workforce can compete globally for the long term.  And if our colleges and universities continue to produce graduates who create world-class technology, either in academic research or in the private sector . . . then our great holistic economic engine, if allowed to run at full speed, will remain unchallenged as the world’s foremost sustainable generator of per-capita prosperity.  World-class research and scientific education have been our strong suit for a very long time, and remain ours to sustain or lose.  The quick-turnaround “continuing education” of the workforce, top to bottom, is the new, 21st Century imperative. 

Just-in-time manufacturing came on the scene as a managerial strategy that increased efficiency, reduced inventories, aided quality control, reduced costs, and enhanced profits.  It is tempting, and I think valid in a certain oxymoronic sense, to think here of “just-in-time technological education” for the manufacturing sector.  Similar to a new part being manufactured just in time to keep an assembly line moving efficiently, a college can create a new training class—whether an actual, semester-long course with hourly credits, or simply a seminar unique to a particular company—that will bring workers up to speed on a brand-new piece of technology.  Unlike just-in-time manufacturing, however, it’s not a matter of delaying the process until the last effective moment; “just-in-time education” is about providing knowledge at the first practical moment in the face of rapidly advancing technology.  In either case, something happens just in time.  With parts and inventory it’s a matter of being just in time, on the back side, for efficiency and profit.  In the educational arena it’s a matter of being just in time, on the front side, for survival.  A workforce that falls behind the educational curve is a workforce that might soon be without a workplace because others are moving quicker to integrate new technology.  It can happen not just to one plant, but to an entire market sector.

When I created JP Industries in 198X I walked straight into the world of acquiring manufacturing companies that could and should be doing better, improving their operations, and integrating each new unit as a synergistic piece of the larger corporate entity.  This is equity capitalism.  I did not invent the process, but I was an early student of the process and soon thereafter a practitioner.  Contrary to equity capital’s poor image in some quarters as a mere “bleeder” of companies that otherwise would have thrived, most such acquisitions—and every acquisition I was involved with—pursue the long-term best business plan and operational strategy for any acquired unit.  A hypothetical 200-employee company that survives and thrives for the foreseeable future as a 150-person company, for example, has emerged in a better position than an obsolescent 200-employee company that clunks along for a year or two or three, then goes out of business.  The numbers are different with every acquisition, and the possible parameters are infinite.  But that is the model I followed throughout my entrepreneurial career.

Some acquisitions are more successful than others.  Usually there is a near-instant reduction in payroll.  One could say “of course” that’s true, because in most cases the plant was for sale because it was bloated or otherwise inefficient.   Often the owner could not solve its problems and did not see a good future for it.  In some cases lost jobs eventually returned in part or in whole as efficiencies and new technology were implemented.  This entire era of American manufacturing, don’t forget, did not occur in the same environment as, say, the Eisenhower era.  In the middle of the 20th Century many undeveloped nations would have been hard-pressed to produce even those aforementioned cocktail-stirring umbrellas.  Most of Europe’s great factories had been bombed into rubble.  Japan was just beginning to reinvent its manufacturing base.  The cargo container had not been invented.  It was assumed that except for specialty items and products we did not wish to make, we owned the manufacturing trading lanes, and that most of what arrived here from the Orient was junk.  You know how that story turned out.

Within a few decades, manufactured goods and components of every stripe, from cars to TV sets, were flowing in this direction.  Small and medium-sized companies across the heartland could no longer coast along with marginal efficiency, barely caring about new technology, and sending the sales force out twice a year for a seasonal handshake.  Many, however, remained stuck in the old culture.  That was the operational environment in which equity capitalists came on the scene to triage underperforming companies, creating a healthy new life for many, almost always with a regimen that included dead-weight loss.  It is fair to say that my company and others were not always the most popular arrivals in town.  It is also fair to say that an underperforming and troubled company’s prospects are seldom a secret, so our arrival was welcomed, though rarely cheered, more often than you might think.  At any rate, JPI never overleveraged a deal, and never bought a company for no reason but to sell its component parts for a quick profit.  I selected underperforming companies which, if brought up to their potential for efficiency and quality, could contribute to our corporation and stay around for a long time.  That was not merely an honorable way of doing business; it was vital to the economy—and will remain so.

One such acquisition was a small manufacturing operation in Grand Haven, Michigan, where about XXX employees made automotive camshafts.  That product was a good fit for JPI.  It came as no surprise to anyone when one of our first actions was to lay off perhaps 15 percent of the workforce, the first step toward bringing the operation into a reasonable state of competitive efficiency.  Soon thereafter we saw a way the plant could produce better, more competitive, more profitable camshafts by transferring newer technology to the operation.  The technology was already in use by a JPI unit in Germany.  Some of our German employees flew to the shores of Lake Michigan and led any necessary retraining of our Grand Haven technicians and machinists.  The new technology brought in more orders—meaning a workforce that previously had to be shrunk for efficiency’s sake was hiring new employees because of  technological efficiencies.

At another plant, in western Iowa, workers began feeling out the new ownership—us—to see what they could do to improve their own prosperity.  Some of their proposals, particularly on benefits that these days are called “legacy issues,” simply would not work within the plant’s bottom line.  Recent, and ongoing, debacles involving both government and private-sector legacy costs show what can happen when, at midday, you promise the moon. When JPI explained that to the Iowa workers, some of them raised the idea of profit-sharing.  I suggested that could be a fine idea, as long as productivity remained high and as long as there were profits to share.  We moved toward a plan that seemed like a win-win situation until we hit a surprise stumbling block.  It became clear that many employees, perhaps most, had no idea how to read a balance sheet.  Some could not differentiate revenue from profit.  What to do?  A call from JPI to the local community college resulted in creation of a brief “course,” just for us, on how to read financial statements.  Suddenly the workers had a profit-sharing program, understood it, knew how to communicate about it, and in most cases developed a heightened interest in creating a profit . . . for them and for JPI.

That is not an example of just-in-time technological training, but it certainly was just in time to rescue a win-win personnel situation that was going bad for no good reason.  The nature of JPI’s integrated auto-parts business plan meant that much technology-specific continuing education could be done in-house, the way our German unit worked with staff in Grand Haven.  Community colleges, however, offer excellent accessibility for manufacturers with plants scattered about the country, often in small cities and even semi-rural areas.  The junior colleges are not only geographically accessible, relatively affordable, with minimal bureaucracy and strong ties to . . . well, they aren’t called community colleges for nothing.

As competitors for tuition dollars, two-year schools generally are delighted to develop synergy with local employers.  As grassroots educators, most are willing to develop new programs specifically designed for a new business in town, or for an old business with new technology issues.  At JPI, though we took care of our own group training for new processes or machinery, we paid employees’ tuition for any college-based training that related to the workplace, be it in engineering or accounting or management.  And we paid any vocational training tuition for laid-off workers during their first year of a job search.

Community colleges are not America’s sexiest post-secondary educational institutions.  But they are vital, and they should become more vital.  I have been out of touch with that scene for two decades, but I know four-year institutions have begun to partner with two-year schools to build networks stressing preparation for the regional workplace—nursing, for example, where health-care is a major employer.  Small manufacturing operations looking for a new plant location put that kind of educational access on a short list of site priorities.  Response among the more nimble two-year schools is already happening.  We need more of that, with access to quickly custom-made science and technology curricula.  And we need the paradigm to trickle upward to four-year colleges and universities in every way that more advanced rapid response education to technological advances can be enhanced.  Not an original idea.   It is happening.  It needs to be intensified.  The public needs to be aware of this synergy, needs to know the stakes involved.  Good things happen when good ideas have broad support.

The above are simple examples of an American education system responding to specific job-training needs down at the retail level, where the “just-in-time” concept can work efficiently.   It’s a template that also can be viewed from within the philosophy of continuous change—which clearly is a fact as much as it is a way of thinking.  The institutions that fail and crumble sooner rather than later, whether taken in the broadest historical scope or within the much shorter timeline of an era, are the institutions that insist on static goals, insist on static ways of reaching goals, insist on fealty to “grandpa’s idea.”

Pretend for a moment that the greatest influence on contemporary life, technology, is a static thing.  Technology is the least unchanging thing imaginable, but try to imagine it anyway.  Even lacking new ways of designing things, making things, marketing things and using things, one hopes change in the form of “social progress” would occur.    We saw a great deal of that, for example, between the invention of the wheel and the invention of the steam engine.  I am one who raises both eyebrows at some “legislation” that emanates from our court system.  Yet it is also inarguably true that the only way our great Constitution has worked, and can continue to work, is via a certain amount of flexible interpretation.  Our national touchstone cannot be static.  Let us not forget that the founders themselves waited just two years before massively editing the Constitution with the Bill of Rights . . . but the Boston Red Sox won the World Series four times (and even the Chicago Cubs won it twice) before American women were allowed to vote.  The spirit of the founders’ Constitution, its grand sweep wrapping federalism and unprecedented individual rights into the same system of government, is indeed indelible.  It was the founders’ own genius that has prevented the document from falling into a landfill with other lifeless documents. 

Channeling continuous change toward positive and productive ends is an excellent definition of progress, one that good business managers understand and call “continuous improvement.”  I once adapted the idea to a little book for my own employees entitled Better Makes Us Best.  Research showed, by the way, that lower-level workers were most likely to have read the book.  For sure, any institution that seeks to thrive and grow must steer itself across the seas of change rather than try to build a dike and hide, unaffected by such a powerful force.  That includes our largest and greatest institutions of learning, which to my observation are doing quite a decent job of continuous improvement.

Reference: Book “The Technology Imperative: What Jobs! Jobs! Jobs! Really Means in the 21st Century”, www.GavdosPress.com, September 2012.

The End of Socialism but Not The End of Social Welfare

Dr. Allan H. Meltzer is an American Economist and the Allan H. Meltzer professor of Political Economy at Carnegie Mellon University’s Tepper School of Business. He is the author of a large number of academic papers and books on monetary policy and the Federal Resrve Bank. Dr. Meltzer’s two volume books, “A History of the Federal Reserve”, are considered the most comprehensive history of the central bank.   He is considered one of the world’s foremost experts on the development and application of monetary policy. Currently he is also President of the Mont Pelerin Society.

Dr. Meltzer originated the aphorism “Capitalism without failure is like religion without sin. It doesn’t work.”

This Paper was presented in the September 2012 Mont Pelerin (Society) Meeting, Prague, Chekia


Socialism – public ownership of all (or most) productive assets – failed whenever it was tried.  Only two avowed socialist states remain – Cuba and North Korea.  Cuba is dragging itself slowly toward some private ownership.  Literally no one admires North Korea.

For reasons that Freidrich Hayek and some other founders of this society understood well, most socialist states were authoritarian and non-democratic.  India and Britain are obvious exceptions.  Both tried so-called democratic socialism.  Both eventually increased free market arrangements.  Growth rose and poverty declined markedly.

Only capitalism achieves growth in living standards and personal freedom.  Freedom depends on ownership of physical and human capital because capital permits people to become one’s own boss.  But freedom and capitalist development require the rule of law.  Rule of law mandates that all citizens are equal before the law and to the extent possible all are treated the same.

Hayek claimed that the rule of law contributed greatly to the success of British and U.S. capitalism.  Socialist countries rarely observe the rule of law.  They work to apply someone’s idea of a utopian society.  What they believe is good and right replaces the rule of law with decrees that allegedly achieves conformity to the socialist ideal.

In contrast, capitalism adapts to many different cultures.  Capitalism in Japan differs from capitalism in Western Europe, as these differ from U.S. capitalism or state capitalism in China and elsewhere.  In free societies, people choose the rules under which they choose to live.  In socialist societies, rulers impose their utopian vision.

The postwar years began with a widely shared belief that socialism would be the arrangement chosen in most countries.   Even Joseph Schumpeter drew that conclusion.  The founders of the Mont Pelerin Society dissented.  They were a small minority, but they understood that freedom was valuable to people in a way that rigid socialist orthodoxies never could duplicate.  And they understood that free men and women could achieve sustained growth.

The attraction socialism once had weakened as the Soviet Union failed to achieve either growth or freedom.   With the decision by authoritarian China and domestic India to expand private ownership and adopt liberalizing measures, all but a few, small countries abandoned socialist orthodoxy.

This defeat or rejection of socialism should not be misunderstood.  One of the main appeals of socialism was its advocacy of an egalitarian distribution of wealth, income and influence.  Hostility toward capitalism always highlights inequality and recessions or business cycles.  As many could see, and a few like Djilas wrote, socialism did not eliminate income differences.  It transferred power influence and high income to a “new class.”  And to the extent that measures of income inequality showed less dispersion, the price paid in income levels and freedom was high.  People in East Germany, North Korea, and China compared their fate to residents of West Germany, South Korea, and the Chinese Diaspora including Hong Kong, Singapore, and Taiwan.  The famous German wall restricted emigration not immigration.  No one chose to move east.

Political pressure for redistribution remained.  The social democratic welfare state offered grants and subsidies that redistributed wealth and income and increased the reported unemployment rate.  After climbing to within 80 percent of the per capita income in the United States, on average, Germany, France and Italy began to pay some costs of the welfare state.  From 1980 to 2005, these countries averaged one percent slower growth than the U.S.  After 25 years, a gap of 25 percent was almost entered explained by lower employment rates.

No country, democratic or authoritarian, accepts the distribution of income ground out by the market.  All modify the market outcome, most of them by taxing and transferring from high incomes to low.  The politics of the social democratic, welfare states can only reduce transfers and costly redistribution in a crisis.

You may be wondering how this introduction to the failed policies for recovery in the EU and the U.S.  I contend that failure reflects the dominant influence of social welfare redistribution over recoveries.  In the United States, President Obama’s principal economic adviser, Lawrence Summers, said in 2009 that policy actions should be “timely, targeted, and temporary.”  The so-called stimulus policies that the U.S. adopted gave temporary relief to public employees, teachers and police and subsidized investment in solar power, batteries, electric automobiles, and insulation.

The results show that the subsidized autos did not sell well, that the main subsidized producers of solar panels failed, and error, corruption, and political favoritism reduced effectiveness.  A detailed study of the nearly $900 billion called stimulus offers some examples.  (Grabell, 2012)

In Illinois, inspectors failed to detect a gas leak from a newly installed furnace that could have seriously injured the home’s residents.  Contractors billed for labor that wasn’t done and materials that weren’t installed.  Fourteen of fifteen homes visited failed inspection.  In New Jersey, auditors identified twelve households that were approved for free repairs despite having income of more than $100,000.  Agencies bought $1,500 GPS systems and underpaid their workers.  The state’s system of eligible applicants contained the Social Security numbers of 168 dead people.  A nonprofit in Waukesha, Wisconsin got stimulus money despite having spent weatherization funds on Christmas decorations, gift cards for employees, and a parking ticket.  An audit found that one employee’s husband received new windows from the agency, charging it $10,000—more than ten times the average cost.  West Virginia had to take over one agency’s weatherization program after finding “shoddy work, falsified reports, credit car abuses, and missing inventory.”  An inspection of a Houston nonprofit found that work was so sloppy that contractors had to go back and repair thirty-three of the fifty-three homes reviewed.  Investigators in California found untrained workers.  And Delaware suspended its entire program for nearly a year after a scathing report documented problems with nearly every aspect of the program, leading the Department of Energy to freeze its funds.

The most successful fiscal policies in postwar United States were the Kennedy-Johnson and Reagan tax cuts for households and businesses.  These programs marshaled profit incentives to guide investment choices.  The Obama program, like most political decisions were less concerned about gaining economic efficiency.  Their primary interest was to choose who paid and who received.  One of the major flaws in what are called Keynesian policies is that the designers act on the premise that what matters is the amount spent, not the way spending is allocated.  Keynes did not make that mistake.

In the European Union and the ECB, the daily discussion is about getting Germany and a few other fiscally responsible countries to bail out welfare state spending in the debtor countries.  I am frankly appalled by the pressure from bankers and their friends to get Germany to subsidize foreign welfare states.  The Financial Times is particularly outrageous.

Prime Minister Thatcher said that welfare states would shrink when they ran out of other people’s money.  We are there.  But instead of adjusting down, the bankrupt governments propose institutional changes that, if adopted, would sustain profligate redistributive policies.

High unemployment and prolonged recession or slow recovery are serious problems that require rational policy action.  Most welfare states are so large that rational policies are politically unpopular, perhaps unacceptable.

We are reaching the point at which welfare state promises of redistribution will shrink.  Or we will lose democratic capitalism.  Voters will not end the welfare state and redistribution, but promises in many countries greatly exceed resources available for payment.  Sweden, once the envied model welfare state has made a start by reducing some transfers.

The crisis is here now in the European Union and the United States.  Even those who favor programs and policies that transfer responsibility and decisions from the market to the bureaucracy must see how difficult it is for government to develop meaningful reforms.  No one believes that the unfunded promises that drive future U.S. debt and deficits will be paid if nothing is done.  On the contrary, everyone who seriously discusses the future welfare state debt and deficits uses the word “unsustainable.”

Many in the European Union point their finger at the “rich” Germans requesting even demanding transfers of one kind or another.  The German government points back saying “we have given ample support.  You, the debtors, must reduce domestic transfers and become more competitive by reducing real wages.  Another continuing stalemate.  Reluctance to recognize the problems of welfare states prevents a solution.

I find it appalling that almost all the daily discussion of the European crisis is about the debt incurred by Greece, Italy, Spain, and Portugal.  Almost daily the Financial Times publishes pieces that urge Germany to accept more inflation to bail out the banks and other lenders.  Do the writers and the editor think that the problem is entirely monetary, to be solved by lowering interest rates and printing money?

Germany recognizes that the problem is real, not just monetary or debt related.  Cost of production are 25 to 30 percent greater in Greece, Italy, Spain and Portugal.  Without lowering costs in these countries, growth cannot resume, or remain even if some stimulus gives temporary relief.  Germany wants real reform of labor, commodity markets, and government policy.

There are two ways to reduce real wages.  The so-called austerity favored by Germany would both reform the economies and force reductions in real wages.  After three years of economic decline, getting an additional 25 to 30 percent reduction in real wages in this way seems to me to be politically impossible.  Voters will not retain in office a government that adopts that policy; political opportunists oppose “austerity.”

Devaluation is an alternative way to reduce real wages.  The ECB should permit the indebted southern countries to form a weak euro temporarily.  The strong euro countries would adopt the fiscal restrictions to which their own representatives have agreed.  The weak euro countries would float down against the strong euro.  Once devaluation reduced real wages, countries in the weak euro would rejoin the strong euro by agreeing to the fiscal rules.

Devaluation would work quickly.  It is not without cost.  Two are of particular importance.  First, the devaluing countries must limit bank runs or currency runs by enforcing temporary exchange controls.  And they must avoid subsequent inflation.  Second, German and French banks would suffer losses on their holdings of foreign bonds.  The French and German governments should require their banks to raise half of their capital shortfall.  Government would supply the other half.  If a bank failed to raise its half in the market, it would be declared insolvent and taken over by regulators.  That gives the bank an incentive to raise its share of the capital infusion.

Social welfare state governments in Europe cannot agree on a solution to their major problem.  They resist imposing the requisite costs on their voters.  Often they fail to carry out the pledges they make.  They cannot agree to change who pays and who receives, the main point of the welfare state.  Most common is a demand for Germany to be more generous.  The German public refuses to pay more transfers to foreigners.

The euro problems are common problems for fixed exchange rate systems.  Governments must limit their budget deficits, the size of outstanding debt, and must keep their terms of trade close to their exchange rate.  Like many other fixed exchange rate systems, the euro failed to meet these requirements.  And it has not been able to agree on a program to restore stability and growth.  These failures will restrict the welfare state and egalitarianism.  It will not end pressures for redistribution.


The United States

The United States also fails to act to reduce or moderate future budget deficits.  Again, the problem is failure of the political system to reduce spending or agree on a comprehensive program to achieve budget balance.

The problem is not new.  From 1930 to 2012, the federal government approved a balanced budget or a budget with a surplus of revenues over spending in successive years only twice.  President Eisenhower was a fiscal conservative.  He favored balanced budgets in all years without a recession, and he gave many speeches about fiscally responsible spending.  President Clinton raised marginal tax rates early in his term.  But he also slowed spending growth enough to run budget surpluses for several years.  Budget surpluses raise expectations that future tax rates will be reduced.  Investment and growth increase.

In contrast, from the beginning of the presidency of George Washington in 1789 to 1930, the federal budget had a surplus in two-thirds of the non-war years.   Wartime deficits did not continue after wars.  Peacetime governments reduced debt.  As late as the 1920s, Secretary Andrew Mellon was able to reduce tax rates and wartime debt by running budget surpluses.

After 1930, the Great Depression followed by several wars brought increased government spending.  The size of government, measured by the ratio of federal government spending to GNP or GDP rose from three percent in 1930 to about 18 percent average for recent decades.  The current administration increased spending to 25 percent of GDP.  Its budgets are rejected unanimously by Congress.  Unlike the early postwar budgets that included a heavy component for defense, social spending is by far the largest share of federal spending.  Most of social spending is labeled “entitlement spending” suggesting (falsely) that it cannot be reduced without depriving recipients of something that is their due.

So-called “entitlements” put future budgets on an unsustainable path in the United States and many other countries.  For the United States, future spending for healthcare and retirement has a present value of $70 trillion dollars or more.  There is no combination of tax rates, expected growth, and reductions of other spending that permit the promised entitlements to be paid.

Why was the modest size of government in the 19th and early 20th century maintained and accepted almost everywhere?  I credit two main, but related, reasons.  One was the international gold standard.  The other was the widespread belief that governments, like households, should balance their budget.  Persistent peacetime budget deficits were a cause for concern that a country would have to devalue against gold.  The currency would move to the gold export point, requiring intervention.  Intervention could succeed in stabilizing the gold exchange rate only if the market expected fiscal discipline to improve.

I have never advocated a return to the gold standard.  The principal reason is that the public prefers stable domestic prices and employment to a stable exchange rate.  A second reason is that a single country that fixed its exchange rate to gold would buffer shocks for all other countries by inflating and deflating when others demanded to buy or sell gold.  An effective gold standard must be universal or, at least, multi-lateral.

The enduring lesson from the gold standard years is that a publicly accepted a monetary rule that maintains a stable domestic price level (or low rate of inflation) also restrains budget deficits, just as fiscal restraint supports the monetary rule.


Collapse of the Welfare State

            After John Maynard Keynes read Hayek’s Road to Serfdom, he wrote to Hayek praising the book but disagreeing with its conclusion.  Keynes claimed that if well-intentioned people made the decisions, outcome would be beneficial and desirable.  This is a major flaw in the organization and operation of social democratic governments and welfare states.  They presume most often that they are selfless and know better than the public what is right.

The great German philosopher, Immanuel Kant, had a better understanding of human character.  He wrote: “Out of timbers so crooked as that from which man is made, nothing entirely straight can be carved.”  Christian theology at the time saw humans as morally imperfect.  Some exceptions can be found in all eras, but it is a mistake to rely on goodwill and good intentions.  Twentieth century experience in authoritarian states and the democracies of Western Europe and India alike reminds us that “power corrupts.”

Kant’s judgment warns us that we should not expect benevolent government regulation.  The rule of law directs government to treat all citizens as equal before the law.  This is an ideal that guides regulation toward desirable outcomes.

Detailed regulation often proclaims that it is done “in the public interest.”  Most often it brings special privileges, crony capitalism, corruption, and circumventions.  Powerful Soviet or Chinese officials had access to better opportunities, better food and healthcare than ordinary citizens.  Democratic India became known for bribery and corruption of officials to obtain special privileges.

After writing the Constitution of the United States, James Madison contributed to the Federalist papers to promote ratification.  He insisted that the Constitution limited the power of the federal government, and in Federalist 10, he warned about the threat posed by “factions.”  Today we replace factions with interest groups.  As Madison warned, interest groups protect their interests at the expense of others.

Interest group politics make it difficult to reform the welfare state or the pressure for egalitarian outcomes.  Here are some examples.  In the 1980s, it became clear that many savings and loan associations would fail.  Deposit guarantees protected depositors, but failure imposed losses on taxpayers.  The U.S. Congress acted to hide the problem, but managements knew that delay created opportunities to take risky gambles that would restore the value of equity if the investment paid off.  Since equity was low or negative, the cost of additional losses would be borne by taxpayers.  Some took the gamble.  Taxpayers’ losses reached $150 billion.

A few years later, President Clinton appointed Jim Johnson to head the Federal National Mortgage Association, FNMA.  FNMA began in 1937 as a purchaser and occasional seller of outstanding mortgages to smooth fluctuations in mortgage rates and create a more liquid market.  Later, the Federal Home Loan Bank Board created a separate organization (Freddie Mac) to buy and sell mortgages also.

Jim Johnson had been a campaign manager in Walter Mondale’s 1984 presidential campaign.  He was well connected politically and wanted to make housing ownership more egalitarian.  He saw an opportunity to expand FNMA’s operations while offering opportunity to low income home buyers.  The political appeal of expanding home ownership was popular.  To facilitate this program, the government agencies lowered down payments and eventually offered to buy sub-prime mortgages that had no down payment to borrowers that had no credit history.

Selling sub-prime mortgages to the two government sponsored buyers, FNMA and FHLMC, was a very profitable business.  Some mortgage lenders actively worked to issue such mortgages that could be resold profitably.  Major banks did the same.  An international agreement required the banks to hold larger reserves behind mortgages in their portfolios.  The banks circumvented the costly regulation by chartering subsidiaries that held the mortgages but evaded the requirement.  Regulators did not object.

A few voices that pointed to the risk of defaults and losses were ignored or dismissed.  Congressman Barney Frank was chairman of the House Committee that had oversight responsibility.  He urged expansion of the program.  President George Bush viewed the programs as part of his “ownership” program.  He did not ask: What did the homebuyers own?  Many made no down payments; they “owned” an option to gain home equity if home prices rose, but they also owned the prospect of loss if home prices fell.

Contrary to repeated forecasts that home prices would not fall throughout the country, the unexpected happened.  The social welfare experiment in expanding home ownership to minorities and low-income families failed in a wave of mortgage defaults and foreclosed houses.

In January 2009, the Obama administration inherited the housing and financial failures.  Their program design called for a massive increase in government spending and temporary tax reductions.  Professor Lawrence Summers, head of the new president’s economic staff, said that the program should be targeted and temporary.  Bad advice!  Decades of economic research showed that temporary tax reduction and spending increases get very little response.

Congress developed the program details.  Their interest as always was in distributing financial support to their political supporters, so the supposed economic stimulus became an example of welfare state redistribution.  For example, money was spent to help states avoid laying off teachers.  When the funding was not renewed, lay offs resumed.  What was achieved?

A principal weakness of the program was its short-term focus.  A large stock of unsold houses and projected defaults on mortgages implied the recession would be deep and long lasting.  Properly designed policy changes would have avoided targeted and temporary changes and offered permanent incentives for investment.

The social welfare state empowers interest groups that demand support from their political allies.   Their main concern is benefits to them and their members.  They oppose efforts to reduce spending on their benefits.  Fire and police unions receive such large pension and health care benefits that state and local governments are forced to reduce spending on such basic functions of government as police or fire protection.  At the federal level, spending for pensions and health care forces reductions in spending for defense against terrorism.

Every knowledgeable observer agrees that projected growth of federal government spending is unsustainable.  Still, the federal government does not propose reductions.  Any solution that reduces spending acts like a tax levied against particular groups – the retired and their families, the teachers union, or some other organized group.  Greece, Italy and Spain waited for the crisis to force sudden changes that could have been phased in gradually and less painfully.  Must the United States repeat their error?

Similar problems threaten the survival of the European Union.  As in the United States, voters agreed to increase spending on redistribution for pensions, health care, and the unemployed, but most do not vote to pay for the benefits.  Budget deficits increase until they are unsustainable and markets are unwilling to finance them.

The political system cannot agree on a program.  Short-term palliatives prevent an immediate crisis, but the problems remain.  Uncertainty rises, so investment falls.  The debtors urge the creditor countries to pay more and to forgive debts.  The creditors demand reforms that open markets, reduce the power of labor monopolies, raise retirement ages, sell state industries, and reduces transfer payments.  Each of these affects a powerful interest group.  And it reduces the welfare states.



            James Madison warned that “factions,” now called “interest groups,” are a threat to democratic governance.  His fears are now reality.  The social welfare state has become the prisoner of interest groups that demand ever increased benefits and resist any changes that lower their benefits.

That puts the social welfare state on an unsustainable path leading to its eventual collapse.  Experience in the European Union and the United States shows these political unions headed for a crisis.  But it will not end the welfare state.  Political pressure for redistribution carried out in the name of equality is always present.  The most we can expect is enough less spending to maintain democratic capitalist governance.  And perhaps we can convince governments that changing incentives, not exhortation and direction, is the effective method for bringing change.




Grabell, Michael, (2012).  Money Well Spent?  New York: Public Affairs.