The storm approaches

Article Highlights

  • With Greece in turmoil and Europe on the edge, the US is sitting on the periphery of a major European crisis.

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  • At its core, the European crisis is one of investor confidence.

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  • Data suggests that there is no European nation in worse shape than the US – the crisis looks set on crossing the Atlantic.

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This article appears in the July 9, 2012 issue of National Review.

With Greece in turmoil, Spain not much better off, and the rest of Europe on edge, the U.S. has been sitting on the periphery of a major European crisis in a manner that is reminiscent of the period preceding World War II. As then, many Americans seem convinced that European troubles will never spread across the Atlantic Ocean.

At its core, the crisis is one of investor confidence, and it comes in response to sober analysis of the finances of southern-European countries. Their deficits are large; their future looks bleak because so many of them have enacted entitlement programs that grow without bound, and because the recent financial crisis put overwhelming strains on their near-term budgets.

As economists struggle over the design of reforms to restore stability to international financial markets, their starting point is to define the problem. While there can be much debate about how to achieve balanced budgets, the question of how much balancing is needed -- and in which countries -- is a matter of arithmetic.

A recent series of papers from the Organisation for Economic Co-operation and Development (OECD) explores the relevant calculations. One study, by economists Rossana Merola and Douglas Sutherland, focuses on long-term projections for OECD member countries. The authors calculate fiscal gaps -- the immediate and permanent changes in the governments' financial position that are required to ensure that debt meets a specific target by a certain time. When assessing how much "fiscal consolidation" is needed, the authors estimate the potential effects of threats to smooth budgetary reform, such as unexpected shocks or rapidly aging populations.

The nearby chart presents one of their scenarios, which takes into account an increase in spending on health-care programs and pensions but assumes that certain policies will be in place to control for these quickly rising expenditures. The chart shows the change required to stabilize debt at 75 percent of GDP in 26 OECD countries by 2050. Whether this target is high or low, it unquestionably represents a circumstance far superior to the current trajectory.
Click here to view a larger version of the chart.

Take Japan. The Japanese government needs to permanently increase revenues or reduce spending by 10.5 percent of GDP in order to put its finances on a glide path to the target debt-to-GDP ratio. The authors' assumption that the Japanese government will implement policies to contain spending on health care and pensions is particularly relevant, given Japan's graying population.

Some European countries, such as Sweden and Switzerland, have already taken steps to curb their deficits and have little or no work to do. Others, such as those in southern Europe, do not expect dramatic increases in entitlement spending, so their long-run picture is not as bleak as might be expected.

Consider, finally, the United States. It is in a different situation from that of the Europeans, but not in the way we would hope for. Our fiscal gap is the third highest, following Japan's and New Zealand's. As bad as things are in Europe, the chart suggests that there is no European nation in worse shape than the United States over the long run. Not Spain. Not Italy. Not Greece. The crisis looks set on crossing the Atlantic after all.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.

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