Too Small to Fail: Could Greater Public Trust Solve Our Debt Crisis?

There is growing evidence that smaller nations are succeeding because social cohesion makes them easier to govern and economically efficient. It is argued that in smaller, more homogeneous societies citizens have greater trust in their governmental institutions, as well as in their fellow citizens. With greater trust, elected officials are given wide discretion in designing public policies. For example, smaller European nations, such as Sweden, are perceived to be more successful in designing policies in response to the financial crisis in 2008, and the current coronavirus pandemic. Critics argue that the failure in U.S. policy responses to these economic shocks is due to lack of trust in our governmental institutions, and that elected officials should be given greater discretion in designing policy responses.

However, analysis of policymaking in small European nations suggests a more nuanced explanation for their success. This is especially true in analyzing the fiscal response in Sweden to the economic shocks in recent decades. Elected officials in Sweden are constrained in fiscal decisions by stringent statutory and constitutional rules. These fiscal rules set explicit targets for balancing the budget, and for reducing debt to sustainable levels. The fiscal framework sets clear budget process rules to achieve these targets. A Fiscal Responsibility Council assures the transparency required for citizens to hold their elected officials accountable. In other words, the attitude of citizens in Sweden toward the fiscal decisions of their elected officials is “trust but verify.”

In the 1990s, statutory fiscal rules were enacted in the U.S. to constrain the fiscal decisions of elected officials. With these fiscal rules in place the federal government not only balanced the budget, but also generated small surpluses to pay down the debt at the end of the decade. The ratio of debt to GDP in the United States was comparable to that in Sweden and other low-debtor countries. Economists refer to the decade of the 1990s as the ‘Great Moderation in monetary and fiscal policies. Over the past two decades, however, America has virtually abandoned the fiscal and monetary rules in place in the 1990s. The federal government has incurred deficits and accumulated debt at an unsustainable rate, leaving us with one of the highest debt burdens in the world.

Some economists argue that the debt crisis that has emerged over the past two decades is the result of debt fatigue in responding to the financial crisis and the coronavirus pandemic. But Sweden and other European countries responded to these economic shocks with countercyclical fiscal policies, without incurring unsustainable debt.

Some economists question whether there is public support for prudent fiscal policies. The coronavirus pandemic has exacerbated a deep division between citizens in the states. Support for federal bailouts comes primarily from citizens in high-debtor states that have a high percentage of urban populations, and that stand to capture most of the rent from federal bailouts. Citizens in low-debtor states have a low percentage of the population in urban areas, and therefore do not capture as much rent from the federal bailouts. Citizens in states such as Utah that balance their budgets and limit debt are challenging the federal bailouts. Citizens in Salt Lake City are asking the obvious questions about this bailout money. Why should their federal tax dollars be used to bail out elected officials in Illinois who have failed to balance their budget and where debt is growing at an unsustainable rate? Public employees in Utah, where reforms have significantly reduced unfunded liabilities in pension and other post-employment benefit (OPEB) plans are asking why their federal tax dollars are used to prop up pension and OPEB plans in Illinois with unfunded liabilities that cannot be paid off within a 30-year amortization period. When the federal government addressed similar problems in Puerto Rico, it enacted legislation mandating that Puerto Rico declare bankruptcy in order to restructure its debt. If bankruptcy is the solution for Puerto Rico, why is it not the solution for unsustainable debt in Illinois and other high-debtor states? 

In 2020, the United States is at a crossroads. Over the past two decades, each economic shock has left the country with a greater debt burden, and with a greatly expanded role for the federal government in the economy. The economic impact of the coronavirus pandemic has been comparable to a wartime economy. In responding to this recession, the federal government has incurred unprecedented amounts of debt, and has all but abandoned rules-based fiscal and monetary policy.       

The long-term forecast by the Congressional Budget Office is for a continuation of these trends over the next three decades. The federal government will account for a greatly expanded share of GDP, and much of this expanded role for the federal government will be financed by debt. Higher debt levels will be accompanied by retardation and stagnation in economic growth. The United States is on the path of other high-debtor countries such as Japan.

The question for the United States is whether there is an alternative path, and if so, how can citizens choose this alternative path? The experience in Sweden and other European countries reveals that there is an alternative path, and that citizens in a democratic society are capable of choosing that path. In our research, we explore the potential impact of more effective fiscal rules on the budget and the economy over the next three decades. The dynamic simulation analysis reveals that with these fiscal rules in place it is possible for the United States to stabilize and reduce debt to sustainable levels. With these fiscal rules in place downsizing the federal government, America can restore long-term economic growth. It is time for American citizens to adopt the Swedish approach to elected officials: trust but verify.

John Merrifield and Barry Poulson are policy advisors at The Heartland Institute, a free-market think tank located in Arlington Heights, Illinois.