Fill out the brief form below for access to the free report.
Europe's Worsening Fiscal Spiral
Europe probably poses more near-term risk to the global economic outlook than other problems such as the record-high U.S. national debt, the Federal Reserve’s unprecedented bond purchases, and China’s bad loans. True, there’s a dangerous bunching of U.S. budget problems at year-end when taxes are scheduled to increase across the board, and defense and Medicare are slated for spending reductions through a sequester. At the same time, Congress will be required to increase the $16.4-trillion debt limit (it’s a badly designed law), and the chaos may trigger another downgrade in our once-AAA credit rating. But Europe’s problems are more serious and more immediate. The positive impact of late 2011 policy improvements has worn off, leaving a dangerous fiscal spiral across southern Europe. As recessions deepen, tax receipts are declining while government spending stays large. Budget deficits are getting bigger, making it hard for governments to sell their bonds. In Spain, equities have fallen below their 2009 low, when most of the world hit bottom after the financial crisis. Europe’s current plan seems to be to use financial sticks and carrots to force structural changes in southern Europe. Economic growth would solve a lot of Europe’s debt problems, but most of the economies aren’t set up for it. In return for creating stabilization facilities, Germany is requiring a euro-zone charter change with the goal of balanced budgets. The problem is that governments are allowed to choose whether the burden of deficit reduction falls on the private sector (through taxes and mandates) or on the public sector (through spending cuts, asset sales, and reduced benefits for government workers). The choice between austerity for the public sector or austerity for the private sector matters a lot, since deficit reduction through smaller government adds to economic growth whereas deficit reduction through a smaller private sector subtracts from growth. Not surprisingly, governments in southern Europe keep choosing to impose austerity on the private sector, not themselves. The direction is toward minimal reforms, delay, and collecting just enough temporary tax receipts to win new aid from Germany and the IMF. Greece found it too hard to sell government assets, and therefore instead raised the value-added tax to 23%. A “growth” plan being circulated by a senior Greek politician in early April counted on Greece becoming a strong agricultural exporter even though Greece has never really been able to feed itself since antiquity. The plan is unrealistic in other ways, counting on a $30-billion solar project from Germany and a European Union decision to issue bonds to fund infrastructure development linking Greece and eastern Europe. François Hollande is expected to win the French presidency on May 6 and his party to then win parliamentary elections in June, putting in place a socialist prime minister and government leadership. Hollande has rejected Germany’s call for fiscal restraint and promises to raise France’s already-high tax rates. The result would be a bigger government and smaller private sector. In upcoming elections, Greece and the Netherlands are probably headed for weak coalition governments. If so, this makes decisive downsizing of their governments also unlikely. Thus, Europe’s fiscal spiral is getting worse. As their cash resources are exhausted in coming months, several European governments face the possibility of renewed crisis. Whereas the 2011 crisis centered on bank capitalization standards and Chancellor Merkel’s call for private-sector bond write-downs, the next euro-zone crisis will probably center on cash shortages and the tension within the central banking system. Meanwhile, immigration and emigration are becoming central election issues and are challenging European society and the rule of law. Europe has a strong interest in keeping the euro intact since the consequences of unexpected exits would be severe. Growth programs based on reduced government spending, sale of government assets, and labor-market liberalization might counteract the deteriorating fiscal conditions, but seem unlikely at least for now. The U.S. shares most of Europe’s interests in structural reform, growth, and the euro. We’ve benefitted from Europe’s expanded market, the common currency within the euro-zone, and the higher European living standards that came with the adoption of the euro. Leading by example would probably help, but the U.S. has had as much trouble downsizing government as have the Europeans. This points to a very challenging political and financial environment for Europe in May and June.