Fiscal Hubris: Lessons from History

As the 2024 election year progresses across the world, a familiar narrative is emerging from political candidates: bold promises of unprecedented fiscal stimulus aimed at addressing the growing discontent of voters.

This discontent is fueled by a decade of low productivity, sluggish economic growth rates, and widening disparities, including income, wealth, corporate and social inequalities (especially on the side of millennials, soon to become the largest cohort of voters).

The response, it seems, is a relentless drive to increase governmental debt by using fiscal policy capacity, often for both productive and unproductive purposes, such as “helicopter drops” and military expenditures.

It seems that governments across the world have fully embraced the untested Modern Monetary Theory (MMT), which posits that governments in fiat currency regimes can unleash unlimited “printing” of money by central bank proxies for governments with no adverse inflationary or economic growth effects.

This secular trend, accelerated at times such as during the Global Financial Crisis (GFC) and the COVID-19 pandemic, is the new economic dogma at play, with no end in sight. Regrettably, it has also contributed to a historically imbalanced market economy and fragile financial markets. As central banks begin to lower policy interest rates, we are witnessing the culmination of a dangerous combination of monetary and fiscal largesse, driven by short-term political motives and the urge to appease new generations of unhappy voters. But is outsized fiscal spending in both good and bad economic environments the only way forward? Are intrusive policy making, massive government intervention and central bank manipulation the only tools? History provides critical lessons that indicate the potential downside of the path we are on.

The Data: A Grim Picture

United States

US federal debt has increased at a staggering pace over the past few years. At the end of 2019, US federal debt stood at approximately $23.2 trillion. Today, it has ballooned to around $35.3 trillion, marking an increase of about 50% in just a few years. The US debt-to-GDP ratio has also surged from 108% in 2019 to about 124% (as of June 2024), reflecting the growing burden on economic growth. In addition, between March 2020 and today, the Federal Reserve's balance sheet expanded by nearly 75%, from approximately $4.2 trillion to around $7.3 trillion (as of May 2024).

Europe

Europe faces a similar scenario, with many countries grappling with high levels of public debt. For example, Italy’s debt-to-GDP stands today at c. 140%, after having been at 150% in 2020-2022. France has also shouldered a sustained high debt-to-GDP ratio with 115% to c. 111% over a similar time period (2020-2023).

Japan

Japan, already known for its long-standing extreme debt levels, has seen its debt-to-GDP ratio increase from around 236% in 2019 to around 263% as of March 2023; Japan’s federal debt is currently equal to $9.2 trillion (1.30 quadrillion yen), 43% of which is held by the Bank of Japan itself.

For countries such as Japan, Italy, Germany, the situation is particularly alarming, given a rapidly aging population and stagnant economic growth, which compound the challenges of managing such a high debt burden.

This situation underscores a trend of increasing fiscal recklessness across major economies, raising valid concerns about the long-term sustainability of such policies.

Historical Lessons: The Warnings of Friedman, Erhard and Werner

Milton Friedman on The Hidden Cost of Government Spending

Milton Friedman, one of the most influential economists of the 20th century, famously warned to keep your eye on how much the government is spending because that is always a tax in disguise. “You pay for it!’’ either in the form of direct taxes or indirectly in the form of inflation or debt. “There is no free lunch." Friedman's critique of massive government spending and debt is particularly relevant today. He argued that when governments increase the money supply, often to cover their spending without raising taxes, it inevitably leads to inflation. The only real cure for inflation, Friedman asserted, is to reduce government spending and limit the printing of money. Otherwise, the economy faces the dual threats of recession and double-digit inflation.

Friedman's emphasis on the dangers of excessive government intervention and the importance of free markets remains a critical lesson today. However, he also recognised that free markets should be responsive to societal needs, highlighting the balance between economic efficiency and social responsibility. For example, Friedman’s idea of a ‘negative income tax’, whereby individuals earning below a certain threshold would receive supplemental pay from the government, effectively ensuring a minimum income while maintaining incentives to work. Perhaps a similar but improved form of Universal Basic Income (UBI).

Ludwig Erhard: Free Markets and The Social Market Economy

Ludwig Erhard, the political architect of Germany's post-war economic miracle (‘Wirtschaftswunder’), provides another relevant lesson today. Erhard’s concept the "social market economy" was built on the foundation of a free market economy characterised by competition, private enterprise and limited government interference. However, Erhard also recognised the importance of balancing these principles with social policies that protect the welfare of the population.

The social market economy sought to harmonise economic efficiency with social justice, ensuring that the benefits of a thriving economy were shared more broadly across society. This approach helped Germany recover rapidly from the devastation of World War II, laying the groundwork for sustained prosperity. Erhard’s model serves as a reminder that economic policies should not only aim at growth but also at enhancing social cohesion.

Another key element in Erhard’s conceptual framework was the Decentralised Economic Participation it entailed, a type of economic system that distributes decision making among various economic agents or production units. Local communities facilitated decentralised participation in the economy. By encouraging local entrepreneurship and small businesses, they ensured that economic power was not overly concentrated in large corporations or distant government entities. This decentralisation was critical for maintaining competition, innovation and diversity in the marketplace, which were key components of Erhard’s vision of a dynamic and resilient economy.

Richard Werner: The Dangers of Credit Manipulation

Richard Werner, a more contemporary economist, is best known for his work on quantitative easing (QE) and the "Quantity Theory of Credit." Werner’s theory posits that the amount of credit created by banks plays a crucial role in determining economic activity. He distinguishes between productive credit which finances GDP transactions, and unproductive credit, which finances asset transactions. According to Werner, the manipulation of credit can lead to economic booms and busts, contributing to financial instability.

Werner also advocates for regional and community banking systems, arguing that localised banking can better serve small and medium-sized enterprises (SMEs) and promote regional economic development. This perspective aligns with Erhard’s emphasis on balancing market efficiency with social responsibility. Both economists underscore the need for a financial system that supports sustainable and widely distributed economic growth without exacerbating inequality or creating financial bubbles.

In general, Friedman, Erhard and Werner all speak of the merits of a free market economy characterised by competition, private enterprise and limited government interference, social conscience and localised agents.

The “Social Platform Economy’’: A Silent Rebalancing in the Real Economy is Underway

In light of these lessons, one might ask: what is the alternative to the current trend of centrally-planned fiscal and monetary dominance? While governments and central banks continue to grapple with the challenges of managing large economies, a silent rebalancing is taking place in the form of new technologies for the real economy and a rising ‘platform economy’. Fintech companies and other localised financial agents are stepping in to fill the gaps left behind by traditional, centralised commercial banks and central agents. These fintechs are leveraging data-driven processes and advanced technology to serve underbanked SMEs and financially excluded individuals, providing a new model of financial (dis)intermediation.

Market System in Transition

This decentralised system of specialised agents is finding its footing in a new stable equilibrium, one that is more responsive to the needs of diverse economic actors. It represents a shift away from the concentrated power of universal banks towards a more fragmented, but potentially more resilient financial ecosystem. This rebalancing could offer a path forward, one that avoids the pitfalls of fiscal irresponsibility and excessive government intervention while fostering inclusive economic growth.

Conclusion: A Call for Prudence

As we progress through elections over the remainder of 2024, the rhetoric of increased fiscal spending will likely dominate the political discourse. However, history teaches us that such an approach is fraught with risks. The warnings of economists like Milton Friedman, Ludwig Erhard and Richard Werner remind us of the dangers of unchecked government spending, the importance of balancing free markets with social responsibility and the perils of credit manipulation in centrally-planned economies.

The alternative to fiscal recklessness lies in a more decentralised, responsive, free financial system, one that leverages the power of technology and data to meet the needs of all economic actors and the social market economy. As voters and policymakers, we must heed these lessons from history and chart a course that ensures sustainable and inclusive economic growth.

Further Reading

For further reading on these topics and to explore our work on 'narrow banking' and the social 'platform economy' please also see our recently-published book here: https://www.fasanara.com/insights/posts/book-launch

• Research: Redefining Financial Stability: Narrow Banking Excels in the Digital Age: https://www.fasanara.com/insights/posts/narrow-banking
• Research: Fintech Lending and the Platform Economy: A New Paradigm in Financial Networks: https://www.fasanara.com/insights/posts/fintech-lending-and-the-platform-economy
• Scenario: The Market Economy in 2025: A Visualisation Exercise: https://www.fasanara.com/insights/posts/the-market-economy-in-2025
• Scenario: The Digital Future: https://www.fasanara.com/insights/posts/digital-future
• Research: Recession Risk Looms: https://www.fasanara.com/insights/posts/recession-risk-looms

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