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.

In Europe, voters in fiscally responsible countries like Germany and the Netherlands are balking at bailouts of governments, banks, and bondholders.

American voters traditionally have favored smaller government and lower taxes than Europeans have favored (or at least tolerated).

Add continued anger over financial bailouts, rising spending, and the exploding national debt, and even America’s Democrats – the country’s traditional big-spending party – are finally talking deficit reduction.

Following the last deep American recession, in 1981-1982, when the unemployment rate peaked at a higher level than in the recent recession, Democrats blasted President Ronald Reagan for deficits of 6% of GDP.

Republicans now berate President Barack Obama for deficits of 10% of GDP. Similar political and substantive jockeying occurs in European countries.

The simplistic categorization of political parties by their preference for a particular size of government masks more complex intraparty tendencies.

America’s Republican Party has three types of fiscal conservatives: supply-side tax-cutters, those who would limit government spending, and budget balancers.

They historically have feuded over tactics and strategy, but, since the deficit is the difference between revenues and outlays, they are closely interconnected.

Indeed, because the sum of all future tax revenues (discounted to today) must cover the sum of all future spending plus the national debt, the only way to keep taxes relatively low is to control spending.

Just as Democrats have long championed more government spending, and more benefits for more people, either on ideological grounds or as a political coalition-building strategy, so Republicans have regarded the goal of lowering taxes. So, not surprisingly, Republicans are using the vote on the debt ceiling to force cuts in entitlement spending, while Obama and Congressional Democrats are using it to force higher taxes, in part to fracture their opponents’ coalition.

High levels of debt combine with slow economic growth in a devilish dance. Interest payments on the debt eventually become so burdensome that bondholders demand higher interest payments (Greek debt recently yielded over 30%).

Interest rates on US government debt remain low, so this threat is prospective, but future deficits will be far higher than government projections when rates normalize.

The best response would be to enact strong controls on budgets, together with structural reforms to promote growth.

In the US, which has the most progressive income tax among the major economies, federal tax reforms that would lower the rates and broaden the base are being discussed. In Europe, structural reforms focus on higher retirement ages and labor-market flexibility.

The deleveraging of governments, financial institutions, and households is one major cause of the sluggish economic recovery. But sluggish growth means less tax revenue and more demands for payments to cushion hardship, placing pressure on government budgets.

The gamble has been that a solid, durable recovery would enable banks and households to rebuild their balance sheets quickly enough to avoid the need for additional bailouts. But, so far, that gamble isn’t working as well or as rapidly as hoped.

Banks are profitable on an ongoing basis, borrowing at very low interest rates, often from the central bank, and collecting higher interest rates on their loans. But, while instantaneous mark-to-market accounting can overstate the expected losses during a panic, the current values are often an accounting and political fiction.

Further action on Fannie Mae and Freddie Mac (America’s huge quasi-government mortgage agencies) and on some weak banks in America, as well as on some of Europe’s weaker, more thinly capitalized banks (the recent stress tests were a tepid first step), will be necessary.

Banking systems need more capital. The best solution is private capital – from retained earnings, new entrants, new ownership, and new investment. But in some cases, additional public capital probably cannot be avoided, as distasteful as it is.

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, in a doomed effort to circumvent the laws of economics and revoke the laws of arithmetic.

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.

These debates represent just one round in an ongoing struggle, with vast political and economic consequences for years to come.

Michael Boskin, currently Professor of Economics at Stanford University and a senior fellow at the Hoover Institution, was Chairman of President George H. W. Bush’s Council of Economic Advisers, 1989-1993.

Copyright: Project Syndicate, 2011.
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