Let’s hope Europe does the right thing at last

by Michael Boskin

The resignations of Greek Prime Minister George Papandreou and Italian Prime Minister Silvio Berlusconi have highlighted how Greece, Italy and many other countries obscured for too long their bloated public sectors’ long-standing problems with unsustainable social-welfare benefits. Indeed, for many of these countries, meaningful reform has now become unavoidable.

The social-insurance systems in Europe, as in the United States, Japan, and elsewhere, were designed under vastly different economic and demographic circumstances — more rapid economic growth, rising populations, and lower life expectancy — from those prevailing today. Governments have promised too much, to too many, for too long.

This fundamental problem has now manifested itself in these countries’ unsustainable debt dynamics. Euro membership, which temporarily enabled massive borrowing at low interest rates, merely aggravated it.

Reforming social-welfare benefits is the only permanent solution to Europe’s crisis. One hopes that, with the help of national governments, the European Central Bank, the International Monetary Fund, and the European Financial Stability Facility, the holes in the sovereign-debt-funding dike will be temporarily plugged, and that European banks will be recapitalized. But this will work only if structural reforms make these economies far more competitive. They must both lower the tax burden and reduce bloated transfer payments. Too many people are collecting benefits relative to those working and paying taxes.

Meanwhile, the bond market’s concern over fiscal deficits and debt dynamics is driving these countries’ borrowing costs higher. Short-term and long-term policies are therefore closely related; unless temporary stopgaps are combined with fundamental long-term structural reform, another disaster like the current one — or worse — will become inevitable.

There are three fundamental factors that determine the evolution of a country’s sovereign debt: its rate of economic growth; its borrowing costs; and its primary budget position (the budget balance net of interest payments). A country with a balanced primary budget collects enough revenue to pay its current expenses but not the interest on its outstanding debt. Higher interest rates, slower growth, and a weaker primary budget position all raise the debt-ratio trajectory. Italy is now paying 7 percent interest annually on its sovereign debt, while its economy is growing at only 1 percent. Thus, Italy needs sustained, large primary surpluses, much faster growth, and/or far lower interest rates to avoid a debt restructuring.

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 to $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 1980s. But that is less likely now, as many countries are undertaking fiscal consolidation simultaneously, nonsovereign 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 percent of GDP (Italy and Greece are over 100 percent). 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 (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 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 is a professor of economics at Stanford University. © 2011 Project Syndicate