The Disorderly Bankruptcy of the Welfare State

by Mario Rizzo

In his recent statement regarding the auto bailout, George Bush expressed concern that if the Big Three were not to get assistance from the Treasury there would be a likelihood “disorderly bankruptcy.” This brought to mind whether he or any other politicians are prepared for the coming disorderly “bankruptcy” of the welfare state.


The debt the U.S. government is now incurring, and will soon be incurring with the stimulus packages Obama and the new Congress are preparing, will prove to be extraordinary. This debt must be viewed in the context of the unfunded liabilities of Medicare and the Social Security system. At the same time the Federal Reserve is creating an explosion of its balance sheet that will remain in the economy until such time as it might seek to contract.


But contraction would raise interest rates. This means that contraction would raise the cost of servicing the national debt, putting pressure on all government programs, especially the “entitlements” (since they will be an ever increasing share of the budget). There will be an extraordinary temptation simply to keep the liquidity in the system and inflate the nation out of its debt. This will lower the burden of the debt for a while. But holders of government debt will be pretty angry. This experience will require that future holders be compensated for the risk of further inflation. Of course the dollar will then surely collapse further driving up interest rates in the longer-run.


Admittedly, this dismal prediction might have to be modified if the planned fiscal stimulus really did its job in raising, relatively speaking, real GDP.  In that case, the burden of the welfare state might be lighter than if there were no stimulus at all. However, even some of the leading advocates of stimulus like Paul Krugman do not foresee a large stimulus multiplier: perhaps a little more than 1. Interestingly, economists who label themselves “stimulus skeptics” (rather than opponents) informally estimate a multiplier of roughly the same magnitude. See Greg Mankiw’s blog. And see Marginal Revolution. But I think, in the end, this is all a pipe-dream.


Even Keynes would have cautioned. Consider his views on stimulus in a 1942 article:


The difficulty of predicting accurately the appropriate pace of the execution of the building programme is extremely tiresome to those concerned. You cannot improvise a building industry suddenly or put part of it in cold storage when it is excessive. Tell those concerned that we shall need a building industry of a million operatives directly employed – well and good, it can be arranged. Tell them that we shall need a million-and-a-half or two million – again well and good. But we must let them have in good time some reasonably accurate idea of the target. For it the building industry is to expand in an orderly fashion, it must have some assurance of continuing employment for the larger labour force. (Keynes, Collected Writings, vol. XXVII, p.268).


Timing is everything. Keynes himself was not an advocate, at least in the 1940s and probably earlier as well, of start-stop countercyclical policy but of stabilization of investment over the longer run by well-thought-out permanent policy of government investment. (More on that another time.)  


Thus, the upshot is this: Sooner or later the pressure on the Federal budget will be tremendous. Cuts will have to be made. And none of this analysis takes account of any continuing or renewed recessions or periods of slow economic growth due to new poor policies that we cannot now foresee.


Is this how the welfare state will shrink? It seems so. I should have preferred that this would have come about in an “orderly” fashion – as a result of piecemeal reforms. But our politicians, and the American people, would not bite the bullet. Years of delaying the difficult choices, combined with the “solutions” to the current crisis, will not produce an orderly retrenchment of the welfare state – quite the contrary.

4 thoughts on “The Disorderly Bankruptcy of the Welfare State

  1. “I should have preferred that this would have come about in an “orderly” fashion – as a result of piecemeal reforms.”
    Has there ever been a piecemeal reform that actually helped, and wasn’t immediately swamped by 200 counter-regulations?

  2. Regarding the investment multiplier, this is simply the change in consumption (in units of currency) due to a change in investment (units). Since consumption is the final stage of production, consumption prices are greater than wholesale prices, resulting in the illusion of a multiplier – one unit in (via investment), can produce more than one unit out (consumption).

    Business to business expenditure in a modern economy is about six-sevenths of total expenditure, household consumption being the other seventh.

    Consequently the multiplier is about seventh-sixths (1.167). That is, “perhaps a little more than 1”.

    The investment multiplier is just another way of stating selling price over cost price.

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