Any solution to the euro crisis must meet two objectives. One is short run and the other is long run. Unfortunately they tend to conflict.
The first necessary objective is to put Greece, Portugal, and other troubled countries back on a sustainable debt path, defined as a long-term trajectory where the ratio of debt to GDP is declining rather than rising. Austerity won’t restore debt sustainability. It has raised debt/GDP ratios, not lowered them. A write-down would do it. New bigger bail-outs might too, or might not. But either write-downs or bailouts would then create moral hazard and thus make even it even harder to satisfy the second necessary objective.
Everywhere one looks, problems of fiscal policy are now center stage. Among advanced countries, the news is bad: Europe’s periphery teeters, the U.K. slashes, the U.S. deadlocks, Japan muddles. But in the rest of the world there is better news: In an historic reversal, many emerging market and developing countries have over the last decade achieved a countercyclical fiscal policy.
In the past, developing countries tended to follow procyclical fiscal policy: they increased spending (or cut taxes) during periods of expansion and cut spending (or raised taxes) during periods of recession. Many authors have documented that fiscal policy has tended to be procyclical in developing countries, in comparison with a pattern among industrialized countries that has been by and large countercyclical. (References for this proposition and others are available.) Most studies look at the procyclicality of government spending, because tax receipts are particularly endogenous with respect to the business cycle. Indeed, an important reason for procyclical spending is precisely that government receipts from taxes or mineral royalties rise in booms, and the government cannot resist the temptation or political pressure to increase spending proportionately, or even more than proportionately. One can find a similar pattern on the tax side by focusing on tax rates rather than revenues, though cross-country evidence is harder to come by.
By now just about everybody agrees that the European bailout of Greece has failed: The debt will have to be restructured. As has been evident for well over a year, it is not possible to think of a plausible combination of Greek budget balance, sovereign risk premium, and economic growth rates that imply anything other than an explosive path for the future ratio of debt to GDP.
There is plenty of blame to go around. But three big mistakes can be attributed to the European leadership. This includes the European Central Bank – surprisingly, in that the ECB has otherwise been the most competent and successful of Europe-wide institutions.
Most prominent economists and the sensible political middle ground in Washington agree that the federal government must eventually address its long run fiscal problem; but they also know that it is not possible to begin to eliminate the budget deficit if tax increases and entitlements cuts are ruled out. The Bowles-Simpson Commission in December made specific proposals, many of which are the sort that we are going to need — all of them highly unpopular….proposals like raising the retirement age, limiting tax expenditures, and raising the gas tax. Many reasonable-sounding editorialists and commentators have said recently that President Obama ought to be brave enough to lead, by coming out in favor of unpopular measures such as those in the Commission’s report. Supposedly the American public is mature enough to rally around such a candid position.
The current economic question is what to do about budget deficits. The Greek crisis has made sovereign debt a genuine concern even among advanced countries. (I should say “especially among advanced countries,” because developing countries now have stronger fiscal positions, in a historic reversal of roles.) At this weekend’s G-20 Summit, Germany and the UK are defending strong fiscal austerity, with language that doesn’t even allow for the idea that short-term spending might be expansionary under severe recessionary conditions such as 2008-09. In the US, Peter Orszag is reported this week to have resigned as OMB Director, not just to get married, but supposedly in part out of frustration about the fiscal outlook and President Obama’s refusal, as part of any comprehensive deficit correction program, to reverse his campaign pledge against raising taxes on those earning less than $250,000.