The German story of Faust is well known throughout literary and scholastic circles. In the story, Faust is a successful scholar who is unsatisfied with his life and bargains with the Devil. He offers his soul in exchange for unlimited knowledge and worldly pleasures. The popular term: “deal with the devil” originates from the story of Faust. This story has also been interpreted by some as a metaphorical representation of an ambitions person who compromises their moral integrity to achieve power and success.
A more appropriate interpretation for the current political climate is the process by which government entities borrow from future generations to finance social benefits that secure power for the political class. However, this model has begun to unravel in Europe as many countries are in the midst of a sovereign debt crisis that is on track to land in the United States.
The basis of this debt crisis comes from promises made by politicians for the bestowment of material prosperity in excess of what people produce. The narrative used to sell this package of fictional prosperity is a promise to “make the rick pay their fair share.”A The universal assumption of this redistributive economic model is that the ‘rich’ are taxed in excess of the services they receive so that the ‘poor’ can receive more than they produce. To many, this model carries a populist attraction because of its perceived benefit for those at the lower end of the social and economic spectrum. Unfortunately, it ultimately regresses toward Faust’s “deal with the devil” that requires the submission of a nation’s soul when the price comes due.
So how does a nation lose its soul in this way?A It all starts and ends with incentives. All people naturally have incentives to behave in ways that result in a better life for themselves and their family. For people in the productive class, a better life is achieved through taking risks and realizing gains. Furthermore, these people have incentives to structure their financial affairs such that their tax burden is reduced to the legal minimum. Conversely, there are many people in the lower classes who view their path to a better life as the election of political leaders that promise to tax the producers and redistribute the resources to them. Both groups of people are acting in a way that seems completely logical.
The fundamental problem with nations that engage in this redistributive economic model is that there is a fundamental limit to how much tax revenue can be raised. An empirical analysis known as Hauser’s Law has found that total US tax revenue since World War II has held steady at approximately 19.5% of Gross Domestic Product, despite a wide range of marginal tax rates and tremendous volatility in tax policy. This suggests that tax payers will self-select into activities that lower their tax burden when rates of taxation increase. This means that there is an implicit cap on sustainable government spending that is equal to approximately 19.5% of GDP. Spending in excess of this amount must necessarily be financed with borrowing or monetary inflation.
As nations incur deficit after deficit for decade after decade, the size of their national debt will eventually become so large that it becomes literally impossible for it to every be paid back without massive monetary inflation. In this situation, investors will frequently become wary of investing in the nation’s debt securities. As the number of willing investors decrease, the yield required on the debt necessarily increases. As the effective interest rate on debt increases, nations must devote more of their resources to debt service. Eventually this results in a debt spiral where a country’s debt obligations occupy so much of its resources that the government cannot function. In this situation, one of two outcomes inevitably occurs. If the nation owns a sovereign currency, it will simply expand the supply of its money, devalue the currency already in circulation, and eliminate the debt through inflation. If the nation’s currency is pegged to another currency or it is part of an economic union, the only remaining option is default.
Another complicating factor is the fact that taxation rates are inversely related to economic growth. This means that raising taxes to capture revenue will stifle future GDP growth. When entitlement promises exceed tax revenue, it results in terminal borrowing that eventually creates higher interest rates on the debt. These higher interest rates place a further pinch on the budget since taxes can only be raised so much before they stifle economic growth and incentivize people to either leave or shift their efforts toward activities that generate less output, but are more tax efficient. The recent protests in Europe over budget cuts by Greece in an attempt to curb its deficits demonstrate the difficulty implicit in reversing this course of systemic over-spending with borrowed money. The eventual result of perpetually delivering something for nothing can only be a financial collapse and default. This is the point where Faust’s bargain comes due and the devil lays claim to the nation’s soul.
For people who do not wish to be caught by the collapse of debt-based entitlement spending, it is critically important to ensure that your personal well-being is not tied to government programs. When the collapse occurs, it will most likely create dramatic cuts, reductions, or outright default on many of the programs that the government uses to perpetuate its base of political favor. When this river of support from the government stops, it will instantly impoverish millions of people who have been conditioned over multiple generations to depend on somebody else for their well-being. The unfortunate impact of this fact is that there will be massive amounts of people whose financial lives are literally destroyed by the collapse of debt-based entitlement spending. As an individual, I do not possess the power to stop or even influence this phenomenon. However, I do have the power to impact my own decisions and personal financial situation. By focusing on what we can influence, instead of worrying about what we cannot change, it will allow people to protect the future of themselves and the people they care about by taking prudent action.