By Simon Johnson
If economic performance is in part a beauty pageant, as John Maynard Keynes suggested, both the U.S. and Europe seem to be competing hard this summer for last place. If anything, based on the latest flow of news coverage, Europe might seem to be experiencing something of a resurgence – last week the eurozone agreed on a big deal involving mutual support and limiting the fallout from Greece’s debt problems. In contrast, the U.S. this week seems to be completely mired in a political stalemate that becomes more complex and confused at every turn.
But rhetoric masks the reality on both sides of the Atlantic. The eurozone still faces an immediate crisis – the can was kicked down the road last week, but not far. The United States, on the other hand, is in much better shape over the next decade than you might think listening to politicians of any stripe. The American problems loom in the decades that follow 2021 – the good news is that there is still plenty of time to sort these out; the bad news is that almost no one is currently talking about the real issues.
In a policy paper released by the Peterson Institute for International Economics last Thursday, Peter Boone and I went through the details on the eurozone crisis, including how this common currency area got itself into such deep trouble – and what exactly are the likely scenarios now (you can also see the discussion and contrasting views at the launch here).
In our assessment, the issue is lack of effective governance within the eurozone. Governments had an incentive to run reckless policy – either in terms of budget deficits (Greece), out-of-control banks (Ireland), or refusing to create an economic structure that would support growth (Portugal). These policies were financed by loans from other countries, particularly within the eurozone, because there was a widely shared perception that if any country were to get into trouble, it would be bailed out by deep-pocketed neighbors (Germany).
At the heart of this system was a great deal of “moral hazard,” meaning that investors stopped doing meaningful credit analysis – consequently Greek or Spanish or Italian governments could borrow at just a few basis points above the rate for the German government (where one basis point is a hundredth of a percentage point, 0.01 percent).
The shock to investors’ thinking over the past three years has been the combined realizations that Greece and some other “peripheral” countries have so much debt they may not be able to make all the contracted payments by themselves, while Germany and other northern countries have become convinced that foolish investors should suffer some losses. Imposing losses on banks that made bad decisions is a sensible principle – but getting from here to there is not easy, particularly when the “periphery” includes Italy, which has gross debt of nearly 2 trillion euros (about 120 percent of its GDP).
Either Europe really ends moral hazard, in which case there will be widespread restructuring of sovereign debts or it keeps the bailouts coming, particularly involving the European Central Bank, which will ultimately be inflationary. The package announced last week is a classic case of “muddling through,” meaning that it doesn’t really solve anything. (See also the Economix Q&A on Greece’s latest debt deal: http://economix.blogs.nytimes.com/2011/07/22/economist-q-a-on-europes-debt-accord/.)
If Europe and the world now experience a growth miracle, these debt problems will recede in importance – because solvency is all about debt burdens relative to GDP. But if near term growth is not strong – as seems increasingly likely – market participants will soon resume their contemplation of European dominoes.
In contrast, the United States has a simple fiscal problem – as discussed in my testimony to the House Ways and Means Committee this week. Government debt surged from 2008, not due to Greek-style profligacy but rather due to Irish-style banking disaster. When credit collapses, so does revenue. As the economy recovers, revenue comes back.
The single most interesting point about today’s “debt ceiling” debate is that over the 10-year forecast horizon that frames for the entire discussion, there is simply no fiscal problem by any conventional definition. In 2021, the US will likely have a small primary surplus at the federal level – meaning that the budget, before interest payments, will no longer be in deficit. (James Kwak, elaborates on this point elsewhere on BaselineScenario.)
The really bad budget numbers for the US come after 2021 – but these are not the focus of anyone’s current proposals on Capitol Hill. Compared with other countries, it is the increase in health care spending, 2010-30, that will ruin us (see Statistical Table 9 in the IMF’s Spring 2011 Fiscal Monitor; or, if you prefer a single picture that cuts to the chase, look at where the US falls in Figure 1 on p.9 of the IMF’s recent report on how to handle “fiscal consolidation” in the G20.) [“From Stimulus to Consolidation: Revenue and Expenditure Policies in Advanced and Emerging Economies,” Fiscal Affairs Department, April 30, 2010.]
The debate in Washington DC is fraught not because anyone is grappling with the difficult issue of how to control health care costs. Rather the tea party wing of the Republican party is intent on insisting on near term government spending cuts, as a condition of supporting any increase in the debt ceiling.
It seems increasingly likely that some version of this libertarian tax revolt will carry the day. The resulting fiscal contraction will slow the economy and result in fewer jobs being created. It does nothing directly to address the looming budget issues beyond 2021 – there is no “down payment” on the table, just measures that are tangential to rising health care costs.
In the near term, the Europeans have the big problem – and this will only be compounded by slower growth in the US (we’re about one-quarter of the world economy). Over the longer haul, it remains to be seen when and how US politicians will get to grips with our real budget issues; so far the evidence is not encouraging.
An edited version of this post appeared on the NYT.com Economix blog this morning; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.