The Euro-American Debt Dilemma

The debt dilemmas in Europe and the US prove yet again that elected officials will ignore long-run costs to achieve short-run benefits, and will act only when forced. And that implies an extended period of episodic economic disruption and political upheaval far beyond this summer’s debates on America’s debt ceiling and Europe’s distressed sovereign debtors.

PALO ALTO – Wealthy Europe and America, crown jewels of mixed capitalist democracies, are drowning in deficits and debt, owing to bloated welfare states that are now in place (Europe) or in the making (the United States). As Europe struggles to prevent financial contagion and America struggles to reduce its record deficits, their dangerous debt levels threaten future living standards and strain domestic and international political institutions. The ratings agencies are threatening additional downgrades; others envision an eventual breakup of the euro and/or demise of the dollar as the global reserve currency.

The economists Ken Rogoff and Carmen Reinhart estimate that public debt/GDP ratios of 90% are associated with sharply diminished growth prospects. Greece’s debt ratio is over 120%, Italy’s is around 100%, and the US is at 74%, up from 40% a few years ago – and rapidly approaching 90%. The International Monetary Fund estimates that each 10-point increase in the debt ratio lowers economic growth by 0.2 percentage points. Thus, increases of 40-50% of GDP risk cutting long-run growth in half in parts of Western Europe, and by one-third in America – a devastating reduction in gains in living standards over the course of a generation.

Worse yet, the burden of banking losses that will sooner or later be socialized, and that of future unfunded public pension and health costs, are often understated in official debt figures. Moreover, the problematic finances of some sub-national governments, for example in the US and Spain, will place pressure on central governments for fiscal aid.

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