PALO ALTO –The current financial crisis in Europe providesa unique update to Lenin’s dictum that nothing so destabilizes a country as a run on its currency. In today’s EU, nothing so destabilizes a currency union as a flight from a member’s sovereign debt.
The turmoil from the Greek debt crisis and concern over analogous problems in Ireland, Portugal, Spain, and Italy have spread fears about the stability of European banks, the global financial system, the eurozone, and the global economy. German Chancellor Angela Merkel recently echoed these fears in public and added worries over whether the euro will survive the crisis.
The €750 billion (almost $1 trillion) bailout package from the EU, the European Central Bank, and the International Monetary Fund provided only a brief respite in international markets. This has now given way to a more sober analysis of the crisis and the efficacy of the response.
The bailout is no solution to the fundamental problems that the eurozone confronts; at best, it buys time to spread the inevitable wrenching adjustments over time and across people. And it carries its own serious risks of moral hazard and the loss of the ECB’s credibility and independence.
The fundamental problem for Greece is its bloated fiscal commitments, enabled by lower borrowing costs when it joined the euro. But the problems are not limited to Greece – or even to the other countries on the eurozone’s periphery. Fiscal folly is widespread throughout Europe and much of the rest of the world. If Greece paid no interest on its debt and regained full employment, its fiscal deficit would still be an astounding 6% of GDP, but the corresponding figures elsewhere are similar, if not worse: 8% for Ireland, 5.6% for Spain, 6.8% for Great Britain, and 7.5% for the United States.
Some argue that the only way to save the euro is for monetary union to be followed by fiscal union. Their recipe is for the high-tax, high-social-spending (and not-so-small deficit) policies of the large northern European economies, Germany and France. But that would be a big mistake. What is needed are constraints on fiscal policy by each country, not a supranational fiscal authority.
The problem plaguing many advanced democracies, in Europe and elsewhere, is rising government spending, taxes, and public debt, all of which gravely threaten economic growth. In response to this trend, the IMF urges a return to pre-crisis debt-to-GDP ratios. Otherwise, the vast explosion of public debt will permanently depress per-capita growth by one-third or more in most advanced economies – a stunning permanent stagnation – and would hamstring governments’ ability to combat the next recession.
But to return to the pre-crisis safety zone will require a decade of large primary budget surpluses (excluding interest payments) of roughly 4% of GDP for the US, 3% for the eurozone (higher for higher-debt countries), and 7% for Japan.
The fundamental lessons of the Greek debt fiasco are not new: 1) elected officials systematically ignore long-run costs to achieve short-run benefits; 2) they wait to act until they are forced; 3) government policies cannot circumvent the laws of economics; 4) governments cannot revoke the laws of arithmetic; and 5) budget policy is not merely accounting.
When a government borrows a euro (or a dollar, pound, peso, or yuan), it commits itself to pay a euro in present value of future interest payments and eventual repayment of principal. That money must come from higher taxes, from eroding the real value of money balances and government debt through inflation, or from outright default and debt restructuring. The eventual costs of any of these actions are severe.
Moreover, the problem is not just one of public debt. A much higher ratio of taxes to GDP only trades a deficit problem for more sluggish economic growth. In recent decades, the large advanced economies with the highest taxes have grown most slowly. And the higher-tax economies did not even have smaller budget deficits than the lower-tax US; rather, higher taxes merely enabled higher spending.
Will a new Stability and Growth Pact, with eurozone members assessing the fiscal policies of their peers, solve these problems? IMF consultations and evaluations have had little impact outside of economies that are heavily dependent on IMF programs. Citizens and local politicians will not outsource their policies to neighbors or international organizations unless forced to do so by strict bond covenants.
So it would be far better for each country to enact serious legal constraints on its legislators’ budget authority. Restrictions on budget deficits are a start, but are not sufficient. The immense growth of the welfare state and soaring public deficits and debt have become the major source of systemic economic risk at both the national and global level. Simultaneous restrictions on spending, taxes, and debt are thus required to avert future economic and financial crises.
Analogous rules for federal budgeting were somewhat helpful in the US in the 1980’s and 1990’s, but were abandoned in 1998. Future legislatures cannot be completely bound by such rules unless they are embedded in constitutions. The constitutional balanced-budget rules (for operating budgets, with borrowing allowed for capital spending such as school construction) found in many US states have by and large worked well, and Germany has recently moved in this direction.
These rules include appropriate temporary safety valves for recession, and some have super-majority voting requirements. Sensible rules promise big payoffs, given the current and long-term global crisis in public finances.
The problem is not that governments lack resources to spend, but that higher government spending, taxes, and debt are eroding economic growth and future living standards. Such a future seems to be on the horizon not only in Europe, but everywhere, unless governments rein in their spending.