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2005 Annual Report—Federal Reserve Bank of Dallas

Racing to the Top: How Global Competition Disciplines Public Policy

Fiscally Unfit

Market economies rely on the private sector for food, clothing, shelter, entertainment and much more. Government meets needs that markets can't supply efficiently—roads, police protection, a legal system, to suggest just a few.

Public sector wish lists grow longer as societies grow richer. If governments become too big, economies suffer as resources siphoned from the private sector become subject to political decision-making.

Although bigger government can sap economic vitality, the public sector is expanding in many countries, the most globalized as well as the least. Fraser's scores on government size show that the most open countries aren't doing much better than the least internationalized ones. When it comes to government transfers and subsidies, the most globalized actually score worse. (See Exhibit 5.) The data suggest globalization hasn't disciplined fiscal policy to the same degree it has monetary policy.

Tax cutting may have lowered top rates, but even highly globalized countries are still exacting a heavy toll to support social spending. In France, for example, income taxes are 9 percent of labor costs, but levies on workers and employers for social programs total another 39 percent. Germany maintains costly programs that give the unemployed as much as 63 percent of their working income—paid for by taxpayers, of course.

Countries have found they can't tax mobile factors heavily. So workers and their employers, less able than money to move across borders, get stuck with the tab for an expanding public sector.

Fiscal policy shouldn't be exempt from globalization—at least in theory. Companies and workers ought to realize that ever-growing spending, when not covered by existing or new revenue streams, will someday lead to budget cuts or higher taxes. Knowing this, they should seek the safety of economies with sounder fiscal policies.

Why aren't mobile factors on the run from bigger government? Many businesses and workers, of course, have language, cultural and other bonds to their home countries. Many governments operate on debt, so the lag between receiving benefits and paying for them may also be key. Companies, investors and even workers may be willing to stay put for short-term advantages of government spending, including lucrative subsidies and contracts aimed at attracting business. Otherwise-mobile factors can pocket the money now, knowing they are free to relocate when the bills come due and leave the debt to future generations.

Openness itself may also take some of the pain out of running deficits—at least in the short run. Borrowing abroad reduces deficit spending's tendency to crowd out private investment and raise interest rates. Political pressure to cut spending is less likely to build without the spur of higher borrowing costs.

Australia, Canada, Britain and several of the smaller EU countries, all highly globalized, have cut deficit spending since the early 1990s. Germany and France, less open to globalization, haven't maintained the EU standard of deficits below 3 percent of GDP. After a few years of budget surpluses, the United States now faces substantial federal deficits and huge, unfunded long-term obligations for retirees and health care. The red ink for 2006 has been estimated at 3.2 percent of GDP.

Persistent deficit spending can create problems for monetary policy. When fiscal authorities run large deficits, they leave central banks with a troublesome choice: monetize the red ink and cause inflation, or take a stand for price stability with higher interest rates that dampen economic activity.

To guard against easy money, the United States and other nations grant their central banks a high degree of independence from political influence. When monetary authorities are insulated, they've usually proven capable of resisting pressure to pump up the money supply to finance deficits.

Such independence can't be taken for granted. Overflowing red ink can divide monetary and fiscal authorities on the importance of price stability. Weakening the consensus on fighting inflation only increases the temptation for political meddling in monetary policy.

Central bank independence carries even more weight in a globalized world, with its increasingly mobile capital. The more politics encroaches on monetary policy, the greater the risk of fiscal folly, serious inflation and capital flight.

Exhibit 5

Fiscal Policy and Globalization

Bigger government bogs down economies, but interconnected ones aren't reducing the size of their public sectors (top). They tend to maintain costly transfers and subsidies (middle). And despite pressure to cut rates, they have maintained a high tax burden to support generous social programs (bottom). Countries become more globalized moving from quartile I to quartile IV.

Government size