Europe’s Last Best Chance

A credible path to sufficient primary surpluses would lower interest rates. In the long run, if primary surpluses are achieved by controlling spending, the increase in national saving will promote investment and growth, whereas higher tax rates would work in the opposite direction. Successful post-World War II fiscal consolidation in OECD countries averaged $5-$6 in spending cuts per $1 of tax hikes.

Some experts, such as former ECB President Jean-Claude Trichet, argue that fiscal consolidation would be expansionary. Specifically, it would boost confidence, which would lower interest rates and offset any direct effect on demand, as occurred in Ireland and Denmark in the 1980’s. But that is less likely now, as many countries are undertaking fiscal consolidation simultaneously, non-sovereign interest rates are already low, and monetary union prevents the most troubled countries in the eurozone – Portugal, Italy, Ireland, Greece, and Spain – from devaluing their way to competitiveness.

Substantial primary surpluses will be needed for many years in order to stabilize the debt ratio and gradually reduce it to the economic safety zone of less than 60% of GDP (Italy and Greece are over 100%). A credible long-term program of reforms must be implemented now, while temporary emergency measures – bond purchases by the EFSF, IMF, and the ECB – provide breathing room. If the primary surpluses are insufficient, temporary measures will only postpone the inevitable debt debacle.

Even more fundamental arithmetic lies at the core of the debt quandary. The tax rate required to fund social-welfare benefits depends on three factors: the dependency ratio (the ratio of recipients to taxpayers); the replacement rate (the ratio of benefits to average wages); and the economic-growth rate (roughly, productivity plus population growth).

In other words, the more generous and widespread the government benefits, the higher the required tax rate. This core problem will increasingly affect even the Northern European countries, notwithstanding their current appearance of economic strength and fiscal soundness.

In Europe’s highly taxed economies, better tax compliance or selective revenue measures can produce only a small amount of additional tax revenue without undermining growth. Spending cuts are the only way to improve the budget position significantly. But that course will be difficult. In many European countries, the government pays benefits to a majority of the population.

A key question is whether incoming Greek Prime Minister Lucas Papademos and his new Italian counterpart, Mario Monti, both highly regarded economists, have the leadership skills to navigate these treacherous waters. Their examples will test whether other European democracies with heavily benefit-dependent populations can rein in the welfare state’s excesses.

It is not an impossible challenge. Canada has staged a substantial retreat from the welfare state’s worst excesses, as center-left and center-right governments alike reduced the share of government spending as a proportion of GDP by eight percentage points in recent years. Several European countries are considering raising their remarkably low retirement ages, or have already done so. Given demographic trends, this may well be Europe’s last chance to build a firmer foundation for future prosperity.

Winston Churchill once famously said of America that you can count on it to do the right thing once it has exhausted all other alternatives. Let us hope that his dictum proves correct for Europe as well.

Michael Boskin, 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.

Copyright: Project Syndicate, 2011.www.project-syndicate.org

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