Democracy Reform

Sir Winston Churchill once said that democracy is the worst form of government except for all the rest. He is right. Its the best form of government but it also has its flaws. I think that its flaws endanger democracy and needs to be fixed. This blog is for like minded people who want to see democracy improved. I invite people to sumbit essays. I will publish even those I do not agree with so long as I find them interesting.

Thursday, May 27, 2010

The root cause of the Euro Crisis

Much has been written about the Euro sovereign debt crisis. But all the commentators in newspapers have missed an important point. The crisis is at its heart a crisis of democracy.

The Euro Crisis started with Greece running out of money to pay its debts. The EU rallied to lend it money to keep Greece from defaulting. This is with much understandable reluctance from the Germans. Greece had been very naughty. It spent the money to lavish on its people a cushy welfare state where its civil servants retire much earlier than Germans do. It had given false figures to sell its bonds and some say even false figures to get into the EU. Now its debt to GDP ratio has risen to 12.6% when EU rules stipulate 3% at most. But then again, most EU countries failed to follow this rule.

Also according to the rules, each country must keep its finances in order and must not expect others to subsidize their expenditures. So nobody should expect other members to bail them out. But this rule was broken too.

But the fear is that if they don't help Greece out, other PIGS (Portugal, Italy, Greece and Spain) countries could default on their debt as well. You see, these countries also borrowed to the hilt and banks and investors might not buy their government bonds at an affordable interest rate if they think richer northern countries are not coming to help them. If a large country like Spain defaults, then it would damage the European economy.

Clearly, all these governments have been overspending and over borrowing for many decades. This crisis did not start overnight. So what happened?

Karl Marx once said, 'Democracy is the road to Socialism.' He was wrong on nearly everything but on this occasion he was right. I would also like to add:

'Socialism leads to ruin.'

As I wrote in my previous essays, income distribution does not follow a normal curve but is skewed. In simple language, there are more poor people than rich people. So votrepreneurs (politicians) get votes by promising to transfer wealth from one group of people to another.

That is why all democracies end up with welfare states. So taxation will have to go up to fund all these government expenditures. But there is a limit to how much you can tax. With higher taxes, you get disincentives to work harder or to take risks. Investors would also prefer to invest elsewhere where taxes are lower. Higher income people also prefer to migrate to lower tax jurisdictions. Or some will simply cheat on taxes. This is the explained in the Laffer curve. Economist Arthur Laffer advanced a theory that is beautiful in its simplicity.

If income tax rate is zero, government revenue would also be zero. When you raise income tax rate income will initially rise. But if the income tax rate is 100%, government revenue will also be zero because nobody would want to work. So somewhere in between there is a point where government revenues are maximized. Income tax rates higher or lower than this point will result in lower tax revenues.

In other words, there is a maximum amount governments can squeeze from the taxpayers. If you keep squeezing taxpayers, they will migrate, work less hard, invest less or simply cheat on taxes and you end up with less tax revenues.

But for votrepreneurs to get elected, they keep promising to redistribute wealth. If tax revenues cannot keep up with their promises, then they resort to borrowing. As I explained in my earlier articles, democracies suffer from a serious flaw. Its political leadership is very short term in its thinking. This is not the fault of invidiual politicians but a systemic flaw. If you have elections once every four or five years, you cannot blame the votrepreneurs for not thinking long term. Thus problems are passed on to future leaders.

So they borrow and borrow because they know that when the debts come due, they won't be in office by then and it would be someone else's problem. Thus in every major democracy, you have huge government borrowings. See chart:

So the problem appears to be systemic for the reasons I have stated in this and earlier essays. Democracy leads to Socialism but as Margaret Thatcher once said:

'The Problem with Socialism is that you eventually run out of other people's money.'

That eventuality is happening now across all the developed democracies. Bond investors are begining to wonder how long more can governments postpone paying the bills. But these numbers, horrible as they may be, are not the total liabilities of governments. They do not include promised entitlements like retirement benefits that politicians promised in order to get elected.

According to Jagadeesh Gokhale of the CATO Institute, the public sector debt plus promised social welfare spending such as retirement benefits amount to an average of 434% of GDP for Europe and a whopping 890% for the US. The total government liabilities comprising of actual debt plus politicians' promises are 549% for France, 442% for the UK and 418% for Germany.

This problem is worsened by the fact that birth rates are below replacement level in the developed democracies:

The above picture shows the total fertility rate (births per woman) in Europe. The comparable figure for the US is a still respectable 2.06 and a abysmal 1.2 for Japan. Since all governments are selling long term bonds (as long as 30 years in the case of the US), how are future governments going to repay for their excessive expenditures? Their tax base shrink as there are fewer young workers to pay those taxes.
In the old days, people depended on their children to see to their retirement. There was an incentive for more children and strong family ties. Today, modern societies still need the young to take care of the old. But instead of depending on our own children, we are depending on other people's children, albeit indirectly. The young will pay their taxes to pay for cushy retirement benefits. But raising children takes time and effort and costs money. So lets enjoy ourselves and let someone else do it. In the end, people don't have children or have less than they should.

These debt figures presented above are for current debts owing by the governments. Many of the votrepreneurs' promises are based on the pay-as-you-go system. For example, those working will pay retirement benefits to those who have retired. But with the low birth rates in Europe and Japan, you will soon have a serious problem. There won't be enough workers to pay for the votrepreneur's promises made decades ago. In some countries the projection is that there will one day be one worker to support one retiree. This means that either the worker must be heavily taxed or the retirement benefits and medical care spending will have to drop.

In the case of the Europeans, the votrepreneurs are trying to find a solution to the aging population with Muslim immigrants from North Africa, Turkey and Pakistan. This is a mistake for they bring in an incompatible culture which is likely to cause conflicts into with the native Europeans. Once again, votrepreneurs in democracies cannot see beyond the next elections. I think its far better to get immigrants from South America which has a similar culture.

This game of getting votes by promising one group of voters the money belonging to another will soon collapse. In the following article, my good friend, Fjordman, said that we should look at democracy as a mechanism. That is correct. We need to understand how the mechanism works. Democracy is a mechanism in which votreprenuers (politicians) get elected into office by promising one group of people the money of another group.

But because the law of economics is such that there is a limit to how much tax revenues you can squeeze from the economy, the cost of their promises will soon outstrip the tax revenues. Governments then resort to borrowings which will eventually lead to crisis that we now see in Greece and soon to come to other democracies. The future looks bleak.


At 12:17 AM, Anonymous Anonymous said...

a good essay

At 2:07 AM, Anonymous Anonymous said...


At 1:42 AM, Anonymous Anonymous said...

I'm not clear about the eu rules on debt. You say the rule is 3% of GDP and that Greece at 12.6% has broken this rule. But then on your world map you show Germany as having 67.2% debt. Could you explain?

At 3:56 AM, Blogger Ohmyrus said...

Dear anonymous,

The EU rule is that the government budget deficit for any year must not exceed 3%. German debt at 67.2% referrs to the debt that accumulated from the past. Suppose the budget shortfall in year 1 is 2%. This must be made up by borrowing money. Next year, its 3% and the year after that is 1%. Thus after 3 years, total debt as % of GDP would be 6% assuming gdp remains the same.

At 4:52 AM, Blogger haggis1938 said...

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At 11:24 AM, Anonymous Pieter said...

Winston Churchill was right about democracy. The most important aspect of our problem as meticulously laid out in the work of Professor Bernard Lietaer, Magrit Kennedy, Professor Franz Hörmann, Joseph Stiglitz, David Ruskoff and many others is left out in this article. Only one of the mentioned scientists and writers was assigned the Nobel price, but they all should have it. They show us that our monetary system is a pyramid game that has to collapse. It certainly will, but by that time the West, Japan, Australia and New Zealand will be third World Countries with a few dazzling rich oligarchs and a vast impoverished population. In old-peoples homes in Amerika (its inhabitants are often younger and more vital than here in Europe) the social and economical situation improved considerably by introducing a local coin. This shows the flaw of the article. Unfortunately people can only learn by sheer misery. By the time they accept that we need a fundamental change it will be too late.

At 8:14 AM, Anonymous Anonymous said...

Hi All,
enjoyed the essay.
who is the world debt owed too?
what happens if all united nation countries (plus others) just refused to repay this and walk away from the debt?
in the real world what would or could happen?
im not concerned with the threats made by bankers or credit agents as they are subject to their country of origin. they also dont have a right to destroy civilisation by their demands.
cheers Jeff

At 9:32 AM, Anonymous Zainab Al-Sammak said...

what a great article is this !

my professor wanted that we write about eurozone crises .. this made me understand it clearly..

thaaaanx alot !

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