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As the European economy slides deeper into recession, it is none too early for the United States to draw cautionary lessons from Europe’s painful budget experience, since the dismal state of the U.S. public finances now bears an uncomfortably striking resemblance to that of the worst performers in the European periphery. And the United States would be ignoring those countries’ difficult experiences with addressing high budget deficits at its peril.
The most common lesson that many observers draw from the recent European experience is that the United States must at all costs avoid the fiscal profligacy of a country like Greece if it is to avoid painful fiscal retrenchment. Sound as that lesson might be, a basic problem is that the United States’ train of fiscal recklessness has long since left the station. As a result of unchecked public spending over many years, including the financing of two unfunded wars, together with tax cuts that the country could ill afford, the U.S. public finances are now widely perceived as being on a clearly unsustainable path.
According to the latest IMF estimates, the U.S. budget deficit will still be more than 8 percent of GDP in 2012, or little different from that expected in Greece, and more than twice the average European level in 2012. At the same time, the IMF estimates that by the end of 2012 the U.S. general government debt will exceed 100 percent of GDP. Such a level would be some 20 percentage points of GDP higher than the corresponding average public debt level in the euro zone. More disturbing still, there is every indication that this disparity will widen in the years ahead on account of the increased strain on the U.S. budget deficit from its lavish entitlement programs.
Watch for Bubbles
It is also late in the day for the U.S. to draw the lesson from Europe that excessive credit and housing market bubbles, whose bursting are at the core of Spain’s and Ireland’s present budget difficulties, can give rise to the need for massive fiscal retrenchment. Though perhaps not on quite the same scale as that in Ireland and Spain, between 2000 and 2006 the U.S. experienced such bubbles in spades. The subsequent bursting of those bubbles was the fundamental underlying cause of the U.S. Great Economic Recession in 2008-2009, which has wreaked havoc with the country’s public finances.
Remain Ever Vigilant
An important lesson that the U.S. can draw from the recent European experience is not to be lulled into a false sense of budget complacency by the extremely low long-term market interest rates at which the U.S. government can presently fund itself. These low interest rates should certainly not be used as by the U.S. as an excuse to delay any further the adoption of a credible program of medium-term budget adjustment.
“An important lesson that the U.S. can draw from the recent European experience is not to be lulled into a false sense of budget complacency by the extremely low long-term market interest rates at which the U.S. government can presently fund itself.” -Desmond LachmanAs recently as 2009, the Greek government was still able to fund itself on a long-term basis at a mere 20 basis points above the corresponding rate at which the German government could do so. And it could do so despite growing evidence that the Greek public finances were on a clearly unsustainable path. When markets did finally turn against Greece, they did so in a dramatic fashion, which has highly complicated Greece’s task of restoring order to its public finances. Considering the high proportion of the U.S. budget deficit that is financed from abroad, the U.S. would be making a grave mistake not to pay heed to its acute budget financing vulnerability.
Another highly relevant lesson from the European experience is how painful budget adjustment has been within the euro straitjacket. That straitjacket has precluded member countries from the use of an independent monetary and exchange rate policy as an offset to the adverse impact of budget tightening on economic activity and employment.
As the latest IMF projections suggest, the recessions in Italy and Spain, which are stuck in the euro, are proving to be much deeper than that in the UK, which is also engaged in an aggressive medium-term fiscal consolidation program but which is not similarly constrained by euro membership from actively using monetary and exchange rate policy as an offset to fiscal tightening. This experience would provide support for the view that when the U.S. does embark on a serious program of medium-term fiscal consolidation, it should be supported by a highly accommodating monetary policy stance by the Federal Reserve.
A further important lesson that the European experience offers is that the speed and composition of budget adjustment does matter. Excessively front-loaded fiscal adjustment programs, such as those in Greece and Portugal, have led to deeper economic recessions than those in countries where budget adjustment has been more back-loaded. Similarly an excessive reliance on tax increases in general, and on indirect tax increases in particular, appears to have proved to be more harmful to economic output and employment than programs more focused on public spending cuts.
Europe’s present economic difficulties are contributing to historically low U.S. government borrowing rates as investors seek safe havens. The U.S. would do well to take advantage of these low interest rates to start a serious program of medium-term budget retrenchment rather than to allow those low interest rates to lead the country further down the path to fiscal ruin.
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