Money For Nothing?


…there is now a nagging fear that credibility in central bankers is being lost. Investors, it seems, are losing confidence in the Fed.

You think? I believe the definition of insanity is to keep doing the same thing over and over and expecting a different result. It seems to me the Fed has sidelined itself and the future path of the economy will be determined by markets, and it won’t all be good. As Stockman says (see second article below), the global economy in many respects is at peak debt, thus the global private and public sectors are both struggling to de-leverage. The only borrowers are national governments and those speculating in asset markets.

Thus, the Fed’s efforts to boost inflation to 2% have been for naught and merely goosed asset markets and resource misallocation. For the global economy to re-balance from peak debt requires debts to be written down, something that occurs with bankruptcy accompanied by price deflation. Forestalling instead of managing these corrections only means a larger correction at some point in the future.

On another note, our experience is confirming the weakness of Friedman’s monetarism. Inflation is not purely a monetary phenomenon – more important, it is a behavioral one based on demographics and the perceived level of uncertainty and risk regarding the future of the economy and policy distortions.

Markets reflect the collective intelligence of humans; they’re not all stupid.

Why Wall Street’s Stimulus Junkies Weren’t Thrilled by the Fed’s Rate Decision

By Anthony Mirhaydari
It wasn’t supposed to be like this.

In a massively hyped Federal Reserve policy announcement Thursday — one that threatened to end the nearly seven-year experiment with interest rates near 0 percent and usher in the first rate hike since 2006 — Chair Janet Yellen and her cohorts gave Wall Street exactly what they wanted: No change, in line with futures market odds.

And yet stocks drifted lower, even as the action in the currency and commodities market was as expected, with the dollar falling hard and gold up 0.8 percent. Why?

Cutting to the quick: Investors, it seems, are losing confidence in the Fed.

While the Wall Street stimulus junkies should’ve been happy with the continuation of the status quo, there is now a nagging fear that credibility in central bankers is being lost — something that RBS’ Head of Macro Credit Research Alberto Gallo took to Twitter this afternoon to reiterate.

Moreover, the Summary of Economic Projections by Fed officials revealed that, at the median, policymakers now only expect a single rate hike by the end of 2015. The futures market is now pricing in a 49 percent chance of a hike at the December meeting (although Yellen noted that the October meeting was “live” and could result in a hike should markets and economic data improve).

But the kicker — the one that pushed large-cap stocks lower into the closing bell — was the appearance of a negative interest rate projection by a Fed policymaker on the newly released “dot plot.” Someone, it seems, expects federal funds policy rate to be in negative territory at the end of 2016. Four officials don’t expect any hikes this year at all.

Not only does this undermine confidence in the state of the economy, but it calls into question the efficacy of the Fed’s ultra-easy monetary policy stance that has been in place, to varying degrees, since 2008. Moving forward, it will be critical for the bulls to recover from Thursday’s intra-day selloff. The day’s action resulted in a very negative “shooting star” technical pattern that signals buying exhaustion and often precedes pullbacks.

In their statement, Federal Open Market Committee members fingered recent global economic weakness and financial market turbulence as giving reason to believe that inflation would take longer to return to their 2 percent target. So the new dot plot shows the median rate projection for the end of 2015 falling to 0.375 percent from 0.625 percent as of June; to 1.375 percent for 2016 vs. 1.625 percent before; and 2.625 percent for 2017 from 2.875 percent. The long-term neutral rate declined to 3.5 percent from 3.75 percent, signifying ongoing structural problems in the economy holding down its potential growth rate.

But a tree should be judged by the fruit it produces. In this case, median household incomes are stagnating despite all the Fed has already done, including three bond-buying programs and the “Operation Twist” maturity extension program. With corporate profits rolling over and global growth stagnating, people are wondering: Is this all the Fed and its central banking counterparts can do? Fresh threats, such as another possible debt ceiling showdown on Capitol Hill this autumn and an election in Greece, are approaching.

As for what comes next, Societe Generale Chief U.S. Economist Aneta Markowska suggests a replay of the late 2013 experience surrounding the beginning of the end of the QE3 bond-buying program: “Our scenario is reminiscent of 2013 when the ‘taper tantrum’ spooked the Fed in September, a government shutdown spooked the Committee in October, and the fog finally lifted by December when the taper was finally announced.”

If the Fed left rates unchanged, there were some new wrinkles in its statement. In explaining their decision, Fed officials elevated issues like global economic growth and the dollar’s valuation seemingly above its traditional mandate regarding labor market health. J.P. Morgan Chief U.S. Economist Michael Feroli believes investors shouldn’t read too much into the new factors being cited. In a paraphrase of the infamous rant by former Arizona Cardinals coach Dennis Green: Yellen is a dove. She is who we thought she was. And until higher inflation becomes a clear and present problem, this continual moving of the goalposts for Fed rate hikes — deferring until more data comes in — looks set to continue.

But that may no longer be enough to keep stocks happy.



David Stockman is not a fan of the Fed. In fact he claims that the Fed is on a “jihad” against retirees and savers.

The former Reagan budget director and author of “The Great Deformation: The Corruption of Capitalism in America” visited Yahoo Finance ahead of the Fed announcement to discuss his predictions and the potential impact of today’s interest rate decision. “80 months of zero interest rates is downright crazy and it hasn’t helped the Main Street economy because we’re at peak debt,” he says.

Businesses in the U.S. are $12 trillion in debt. That’s $2 trillion more than before the crisis, but “all of it has gone into financial engineering—stock buybacks, mergers and acquisitions and so forth,” according to Stockman. “The jig is up; [the Fed] needs to get on with the business of allowing interest rates to find some normalized level.”

While Stockman believes that the Fed should absolutely raise rates today, he isn’t so sure that they will (Note: they did not). But even if they do, he says they’ll muddle the effect by saying “‘one and done’ or ‘we’re going to sit back and watch this thing unfold for the next two or three months.’”

This all fuels an inflationary bubble on Wall Street, according to Stockman. “This massive money printing we’ve had has never gotten out of the canyons of Wall Street. It’s sitting there as excess reserves.”

According to Stockman, the weakness of the U.S. economy has been due to a lack of investment over the past 15 years and inflated labor costs in America that can’t compete on a global scale. “Simply printing more money and keeping interest rates at zero do not help that problem.”

Zero interest policies, says Stockman, are leading to the global economic turmoil we are currently experiencing. “In the last 15 years China took its debt from $2 trillion to $28 trillion… it’s a house of cards with an enormous overcapacity and enormous speculation and gambling that is beginning to roll over,” he says. “It’s just the leading edge of a global deflation that I think is underway as a consequence of all this excess credit growth that we’ve had.”

If the Fed raises rates and doesn’t mince words there’s going to be a long-running market correction, says Stockman. If the Fed doesn’t raise rates there will be a short-term relief rally but eventually the markets will lose confidence in the central bank bubble and we’ll be in store for a “huge correction.”

Notable and Quotable


Notable quote:

The fact that we are here today to debate raising America’s debt limit is a sign of leadership failure. It is a sign that the U.S. government can’t pay its own bills. It is a sign that we now depend on ongoing financial assistance from foreign countries to finance our Government’s reckless fiscal policies. . . . Increasing America’s debt weakens us domestically and internationally. Leadership means that “the buck stops here.” Instead, Washington is shifting the burden of bad choices today onto the backs of our children and grandchildren. America has a debt problem and a failure of leadership. Americans deserve better.

-Senator Barack Obama, 2006.

Americans deserve better. I wholeheartedly agree.

A Game of Political Chicken


A good quote from former Sec. of State James Baker III:

Presidents always negotiate in order to get an increase in the debt limit—its their job. “It’s a failure of leadership to say, ‘I’m just gonna sit here while the government remains closed,’ or, with respect to the debt limit, ‘I’ll sit here and not negotiate and the catastrophic consequences I warned you of will just have to happen.’ . . . He has the burden of moving forward. He’s the leader of the country. He has to get the debt limit raised to avoid default.”

Yet the GOP too bears responsibility for the impasse. “I don’t think it was a very wise strategy for we Republicans to say we would not fund the government unless we defunded ObamaCare. I don’t think that’s a smart political strategy, and I think we’ll pay a price for it. . . . If you’re gonna make your stand, make your stand on something you can accomplish.”

Barron’s Interview with John Taylor

Fiscal Follies, Monetary Mischief


Stanford Prof. John Taylor believes that government economic policies should be constrained and predictable rather than ad hoc and discretionary. In particular, he is extremely leery of stimulus spending, and the looming possibility of QE3.

Stanford University economics professor John Taylor is perhaps best-known as the creator of the “Taylor Rule,” which seeks to determine the Federal Reserve’s interest-rate target according to a simple formula. He has also become an outspoken critic of both fiscal and monetary policy as practiced over recent years.

Taylor writes a lively blog called “Economics One,” and, early this year, published the book First Principles: Five Keys to Restoring America’s Prosperity. Professor Taylor recently sat down with us for an interview at our offices in New York. Here are some edited excerpts:

Barron’s: What’s the best case you can make on behalf of those who defend the recent fiscal stimulus?

Taylor: The case that has been made for the discretionary fiscal stimulus is based on quite conventional Keynesian theory. It is basically that, if the government gives people a lot of extra money on a one-time basis, they will spend it. Not all of it, but most of it. Similarly, when the federal government gives money to states and localities as part of the temporary fiscal stimulus, it will be spent in such a way as to boost gross domestic product. And that will greatly help when economic activity is otherwise either contracting or stagnant.

My own view is that the theory is flawed, and the evidence that the fiscal stimulus achieved the desired result is practically nonexistent. The surge in federal spending only increased the burden of the already burdensome federal debt.

Start with the evidence.

The attempt to stimulate consumer spending in 2009, or the earlier attempt under President Bush in ’08, showed the expected rise in consumer income as government payments were made, but little or no response from consumer spending. Inconveniently for the advocates, consumer spending actually declined in some of the calendar quarters when it was supposed to have been stimulated. If you use statistical analysis to take into account the factors that would have brought increases or decreases in consumer spending, you find virtually no boost to spending from the stimulus.

As for the money sent to states and localities, economist John Cogan and I found that the funds were either put into financial assets or used to reduce borrowing. The hoped-for increase in infrastructure spending was negligible.

What is also inconvenient for the advocates: According to the national income and product accounts, state-and-local government purchases were lower every quarter in 2009 and 2010 than in 2008.

And you would expect these results from the standpoint of economic theory?

Let’s start with consumer spending. It’s basic economic theory that most people look beyond the very short-term. To expect them to rush out and consume more when the government cuts them an extra check on a temporary basis is not realistic. Instead, they will bank most of the extra money or use most of it to pay down debt. There are exceptions, of course. Some people will feel so pinched, they will need to spend the money. But the data show that the exceptions don’t dominate the story.

It has been argued, however, that the Reagan tax-cuts of 1981 were an example of effective fiscal stimulus.

The Reagan tax cuts were not temporary or targeted, which are defining characteristics of discretionary fiscal stimulus packages. The Reagan tax package was meant to be permanent, and a permanent tax cut can certainly influence consumer behavior for the same reason that a temporary tax cut does not. Consumers can rely on the extra income and might boost spending accordingly. Businesses might then respond by expanding capacity, because they feel they can rely on the extra sales. And the permanently lower tax rates will encourage more hiring and investment.

But let’s even imagine that, with temporary tax cuts, consumers do spend all the extra money at the malls. Can we expect business to respond by hiring more workers on a lasting basis? Of course not. Businesspeople will know better than anyone that the pop in spending won’t last.

The Obama administration’s “cash-for-clunkers” program did seem to have the desired effect, however. Consumers in possession of a qualified clunker could trade it in for an inflated rebate, and then apply that government-funded rebate to the purchase of a new car. And yet that was a temporary stimulus.

It certainly was, and it taught us the unsurprising lesson that if you offer consumers a financial incentive to buy a new car, people already planning to do so will take advantage of that incentive and make the purchase sooner rather than later.

It also taught us something else about the problem with temporary-stimulus programs: Even when they work, there is payback shortly afterward. Cash-for-clunkers caused a pop in new-car sales for only a month or two, soon followed by a downside correction.

Let’s return to your point about the states failing to spend the fiscal stimulus money on infrastructure. One theory in support of such policies is that they depend on competent people implementing them, and in this case, we just didn’t have enough competent people. So more competence will make that kind of fiscal stimulus work.

But the competence you are assuming is based on the unrealistic idea that we have a completely different federal-state political system. For example, some observers think China’s government was recently successful in boosting infrastructure spending to spur economic activity. We don’t know for sure, but let’s assume they’re right. There is no lesson in that for the U.S. because we can’t choose China’s system—and wouldn’t want to even if we could.

For one thing, local governments in China have no access to capital markets. They basically take what they get from the central government, and spend what they get. And since they always have a list of projects on the shelf, all the central government need do is lower the hurdle for what is a good project, and suddenly the project gets implemented.

By contrast, we have a decentralized system in which state and local governments do have access to borrowed funds. That is what you have to take largely as a given.

You are saying we don’t really have shovel-ready projects that can be quickly implemented by government?

Back in the 1970s, the Carter administration made stimulus grants to the states, and that did not work, either. There are some who say: Just use the military—they can always spend the money somewhere. But how useful, or politically realistic, is that? It would probably be worthwhile to have more information technology in medicine, and better record-keeping. Part of the stimulus went to that. But how could that possibly stimulate the economic recovery from recession, when it should all be planned and implemented carefully over time?

Government officials imagined they had a little textbook model. You boost the “G” that stands for government spending, and voilà, it works. But that is not the reality.

But if, as you say, consumers and local government used to the money to reduce borrowing and pay down debt, could that be a completely bad thing?

It can’t be bad to reduce the debt of consumers and of state and local government. But it can’t be good to boost federal debt in the process by the same amount. So that’s a wash. It’s really hard for me to see it as a net positive.

Is there any part of the huge increase in the federal deficit during this period that you do not oppose?

Absolutely—the part that is normally referred to as “automatic stabilizers.” When the economy contracts or barely grows, certain fiscal responses happen automatically. Revenues from taxes decline, as profits, capital gains, and wages and salaries decline or barely grow. Spending also increases—on welfare programs, unemployment insurance, and when some people retire earlier than planned and claim Social Security payouts. So you automatically get a decline in revenue and increase in spending.

I emphasize the “automatic” quality of these events. They are predictable, and they occur in a timely fashion. What is unpredictable and not timely is the futile attempt to engage in proactive, discretionary fiscal policy.

Right now, the Federal Reserve’s official interest-rate target on federal funds is 0% to 0.25%. Is that where the target should be according to the Taylor Rule?

No, the interest-rate target would be at 1%, or a little higher. That is based on starting with a multiple of the inflation rate, and then adjusting up or down for the growth rate of the economy compared with its potential growth rate. Right now, the growth-rate part of the formula would call for a downward adjustment, so you end up around 1%.

The Taylor Rule is based on empirical research about what tends to work best for the short-term interest rate. It is far from perfect. It just works better over the long run than the discretionary tinkering of imperfect human beings. And in fact, through most of the period from the early 1980s through 2002, when the economy performed relatively well, the central bank’s interest-rate target tracked the Taylor Rule fairly closely.

But not since then. You have said that during the period from 2003 through 2005, the fed-funds rate violated the Taylor Rule by being too low.

Yes, at times by as much as three full percentage points. And that helped cause the financial crisis, as I have argued in my book Getting Off Track.

Federal Reserve Chairman Ben Bernanke, who was a Fed governor under Chairman Alan Greenspan when this policy was implemented, has responded publicly to your criticism. What would you say is his best argument?

His argument has been that, at the time, they were forecasting a slowdown in the rate of inflation. And that if you used this forecast, the target they maintained would have been consistent with the Taylor Rule.

And what’s your response?

My main response is that the Taylor Rule does not, and should not, depend on forecasts. Forecasts are subjective—and therefore too discretionary. Based on what was known at the time about inflation and economic growth, the target was far too low.

Bernanke once claimed that economists generally agree that the Fed’s policies in 2003 and ’04 did not contribute to the housing bubble.

Yes, but Bernanke mainly cited himself or the Fed board staff, and did not cite others who concluded just the opposite: that the Fed’s policies did help fuel the housing bubble. More recently, Bernanke has retreated from that position. He now says there is no consensus among economists about the Fed’s role. I regard that as progress.

On another important component of Fed policy, what do you think of quantitative easing?

I opposed the large-scale asset purchases of QE1 and QE2, and believe it’s unfortunate that the central bank is still publicly considering a QE3. They were ineffective, and potentially harmful.

These massive purchases of mortgages and medium-term Treasuries were aimed at lifting the value of these fixed-income securities, and thereby bringing down the relevant interest rates. At best, that was the short-term effect. But how long can such an effect last? What basically determines these interest rates are expectations about future interest rates, which in turn are partly determined by inflationary expectations.

You don’t believe purchases by the Fed have any long-lasting influence?

Let’s suppose something even more misguided: For QE3, the Fed decides to buy the stock of publicly traded companies in order to lift stock prices. Equity prices would rise. But how long could that last, unless the earnings of these companies rise proportionately? Price-earnings ratios would become unsustainably high, and the market would soon correct for the Fed’s aberrational influence. The same dynamics work for the bond market.

Apart from not helping, quantitative easing has also hurt?

Speaking of the stock market, notice that stock prices have become sensitive to whether or not the Fed will implement QE3. I see no reliable relationship between equity prices and quantitative easing, but the fact that many people believe in it is at least a source of concern. Another important concern is just how the Fed will manage to sell off all the mortgage-backed securities and medium-term government bonds it now holds on its balance sheet without causing disruptions in the market.

But my real worry is that quantitative easing may become a pillar of Fed policy. If the economy speeds up, you do less of QE; if it slows down, you do more. Quantitative easing may become not just the wave of the present, but of the future, which could be very damaging.

What’s the basic lesson for both fiscal and monetary policy?

Both policies should be predictable, not discretionary and unpredictable. It is always possible that some brilliant policy maker can do something unpredictable that will yield a better outcome. But history has shown us repeatedly that this usually yields worse outcomes. My new book, First Principles, names “policy predictability” as one of five key principles.

And the other four?

Rule of law, strong incentives, reliance on markets, and a clearly limited role for government.

Thank you, John.

Our Cheap Debt Will Come Back to Haunt Us


The Fed’s mandate to maximize employment will undermine its other mandate, to keep inflation at bay. Seduced by what can only be called low teaser rates, the U.S. Treasury is piling up staggering debt that does not cost much to finance right now, but will ultimately bust the budget.

You may have heard by now of the Federal Reserve’s “dual mandate.” Not content to merely protect us against the ravages of price inflation (mandate No. 1), our fearless Fed is equally committed to fostering “maximum employment” (No. 2). And right now, with the unemployment rate still at 8.3%—far too high to meet anyone’s definition of full employment—the central bank understandably favors No. 2 over No. 1.

That was again made clear in the release last week from the Federal Open Market Committee—Chairman Ben Bernanke’s group of Fed governors and presidents empowered to set short-term interest rates. The FOMC statement declared that the target range for the interest rate on federal funds would be kept at 0% to 0.25%. It also reiterated the somewhat astonishing commitment that these “exceptionally low levels for the federal funds rate” would be maintained “at least through late 2014.”

Set aside for the moment the potential distortions that such a regime might introduce into the structure of the economy. As CEO Peter Schiff of Euro Pacific Capital has pointed out, the Fed’s interest-rate policy has mortgaged the economy at an “adjustable rate” that will eventually cause damage once the rebound in rates inevitably occurs. Among other profligate borrowers seduced by what can fairly be called low teaser rates, our own U.S. Treasury is piling up staggering debt that does not cost very much to finance right now, but whose financing costs might ultimately bust the budget once rates climb.

NOT TO WORRY, HOWEVER; between now and late 2014, soaring financing costs of the federal debt probably won’t be a problem. Nor do I agree with the other objection about the intermediate term frequently raised by the Fed’s critics: that over the next year or two, the central bank’s pursuit of the employment mandate will undermine its other mandate, the need to keep inflation at bay.

As I’ve argued before (“Inflated Inflation Worries,” Feb. 21, 2011), the Fed’s current monetary expansion is a necessary, but not sufficient, condition for a sustained rise in prices. Also required is a sustained rise in the price of labor, which I doubt will occur with the slack labor markets implied by the 8.3% jobless rate. The great inflation of the 1970s began in a state of low unemployment—although, of course, it ultimately resulted in the stagflation of high unemployment and double-digit inflation.

The Fed clearly shares my complacency. Mindful of the threat of high prices at the pump, last week’s FOMC statement acknowledged that the “recent increase in oil and gasoline prices will push up inflation temporarily,” but that “subsequently inflation will run at or below the rate” the committee judges “most consistent with its dual mandate.”

Friday’s release of the February consumer-price index offered some vindication of that outlook. The 12-month rise in the all-items CPI ran 2.9%, but excluding the price of energy, the rise was a tamer 2.4%. Also, the Fed prefers to focus not on the consumer-price index, but on the index for personal-consumption expenditures, which almost always runs a few tenths of a percentage point lower than the CPI. So when the February PCE index becomes available, it will probably show an even lower inflation reading.

IF THE NEXT COUPLE OF YEARS ARE a not-to-worry, and if we forget about long-term distortions from today’s low interest rates, what else is there to object to? Well, for one thing, there is the central bank’s hubris in assuming that it can handle the potential contradictions of the dual mandate, as evidenced by the stagflation of the 1970s.

In his recent testimony before Congress, Bernanke candidly acknowledged that “dual objectives of price stability and maximum employment” are not always “complementary.” But in those difficult cases, he assured the gullible legislators, in somewhat obscure prose, the Fed “follows a balanced approach…taking into account the magnitudes of the deviations of inflation and employment from levels judged to be consistent with the dual mandate, as well as the potentially different time horizons over which employment and inflation are projected to return to such levels.”

Now, that kind of prescience is quite a magic trick for the Bernanke Fed, which, based on evidence that recently came to light, completely missed the coming of the 2007-08 mortgage meltdown that brought soaring unemployment; or for an FOMC that, based on a track record that I recently ran, generally fails to forecast inflation and unemployment accurately even in the same year.

In his book The Age of Turbulence, Bernanke’s predecessor, Alan Greenspan, foresees serious price inflation beginning around 2030. He points out, first, that the benign “disinflationary pressures” from economies like that of China will have played out by then. And at the same time, inflationary forces will be intensified by the fiscal “tsunami” brought on by retiring baby boomers. By then, if not sooner, the Fed will probably fumble its dual mandate.

And the Crisis Winner Is? Government

From Greece to Washington to New York state, there’s no effective mechanism to control spending.

Across Europe and the United States, the fiscal crisis is setting up an epic battle among government services, pensioners, government employees, creditors and taxpayers. There is simply not enough money coming in to pay all the promises politicians have made. The shortfalls and fights are challenging our democracies and shifting wealth from the private sector to ever bigger government.

The hope has been that Europe’s debt crisis would force government downsizing in time to meet cash flow requirements. Newfound fiscal discipline would provide a silver lining to the debt crisis. But that’s not working out.

Germany’s insistence on centralized fiscal discipline for the euro zone will lead to a massive expansion of bureaucracies in Brussels, Frankfurt and Berlin. They’ll include temporary and permanent bailout funds, dangerously intrusive powers for the International Monetary Fund and the European Central Bank, endless summits, new taxes on property, and recessions.

With Europe’s government structures assured of getting even bigger, the U.K. reacted immediately by opting out. U.S. lawmakers are already objecting to the European plan to expand the IMF. As in Greece, IMF programs are antigrowth, imposing austerity on the private economy, not the government. Greece has raised value-added and property taxes, then projected revenue increases that never materialize in order to keep payments flowing to creditors and the government’s entourage.

Governments on both sides of the Atlantic are trying to use the crisis to grow rather than shrink. News of Europe’s fiscal incompetence abounds, but Washington had no budget at all in 2010 or 2011 and the federal deficit grew at record pace. President Obama sailed through 2011 without any significant spending cuts or government downsizing.

With year-end approaching, the federal budget horizon has contracted to two weeks. Common practice is for Congress and the president to spend as much as possible in December and then adjourn, hoping voters will forget about it after New Year’s Eve.

Financial markets are so sensitive to the $3.6 trillion in annual federal spending that they would likely see huge gains if Congress simply adjourned without the normal year-end blow out. Even better would be for the president to call a January cabinet meeting with the purpose of cutting spending and regulation to encourage private job growth.

In February, President Obama will be able to impose another $1.2 trillion debt-limit increase using special voting rules forced through Congress last August to avoid a government shutdown. It should be clear by now that politicians will not voluntarily reduce government or government debt. The so-called debt limit is harmful because it threatens default and broad government shutdowns, both unacceptable, but doesn’t limit spending at all.

The debt limit should be replaced with a new debt ceiling that forces Washington to cut spending. When the debt-to-GDP ratio is above target, Washington should suffer escalating penalties on its power, benefits and spending authority. There should be no threat of debt default or government shutdown. Instead, Washington should face a benefits straitjacket that is so uncomfortable for the president, his senior executives and Congress that they work around the clock to enact spending cuts and asset sales to bring debt back below target. They should get a bonus if they get the job done and embarrassing, escalating penalties if they don’t.

Here are some possible penalties: 1% pay cut per month for the 10,000 highest-paid government employees with a prohibition on it being restored; suspension of limousines for assistant secretaries and higher; market-rate monthly fee for free government parking. During periods of excess debt, the president should have impoundment authority but also be required to write a monthly letter to Congress stating preferred spending cuts equal to 20% of the fiscal deficit.

Grappling with out-of-control government spending in southern Europe, Germany is seeking automatic penalties when fiscal deficits are too large. The problem is that governments will probably write the penalties so they hit taxpayers and the private sector. It’s unlikely European governments will write penalties aimed at themselves. There’s already talk of the bloated Italian government taxing the property of the Catholic Church to avoid spending cuts and asset sales.

Across the U.S. and Europe, big government is winning the crisis game, adding taxes, regulatory power and whole new institutions. Voters want restraint, but there’s no mechanism to control government spending, so debt-to-GDP ratios go up rather than down.

Even at the state and local level, which is supposed to be closer to the people, governments find ways to grow. In an age-old government shell game, tax increases are projected to cause big revenue gains, which governments rush to spend. When actual revenues fall short, the government blames the economy, borrows the shortfall, and proposes new taxes, creating a debt cycle.

This budgeting trick is replayed year after year around the nation. New York state demonstrated this last week with Gov. Andrew Cuomo’s $2 billion increase in annual income taxes to “balance the budget.” The increase in projected tax revenues will allow a major increase in state spending in 2012. And despite balanced budget requirements, New York state and local debt has surged above $300 billion.

One of the few hopeful signs in the two-continent budget mess is that a few U.S. states and localities are experimenting with different political responses, some of which will promote growth. Wisconsin’s government stopped collecting union dues, changing the balance of political power. Heavily Democratic Rhode Island passed a law allowing a hybrid 401(k) pension system, a key structural reform that would transform the nation’s fiscal outlook if widely adopted.

The fiscal questions facing Europe and the U.S. are central to our democracies. Can politicians be incentivized or penalized enough to lead a downsizing of government? Which unaffordable contracts and promises should be reduced? How fast will the outlays grow for lifetime pensions and retiree health care?

To win elections, politicians have promised practically endless government spending and covered up the cost, leaving generations of taxpayers obligated to pay off the debt. That’s wrong, but neither the U.S. nor Europe has a plan to stop it. A first step would be to use more effective debt and deficit limits to force governments to spend less and end the debt cycle.

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