Europe's Only Choice

April 18, 2012

The social-insurance systems in Europe, as in the United States, Japan and elsewhere, were designed under certain economic and demographic circumstances -- rapid economic growth, rising populations and lower life expectancy -- vastly different from those prevailing today.  This has led to upheaval in the fiscal healthiness of Greece and Italy in particular, which must now implement drastic economic reforms, says Michael J. Boskin, a senior fellow at the Hoover Institution.

Of primary issue for European welfare states is that they have paid too much to too many people for too long.  The number of people who rely upon government payouts as their primary form of income is too large, while the number of taxpayers who support this top-heavy system has dwindled.  This has led to rapid debt accumulation.

There are three primary determinants of the debt trajectory of a given economy:

  • The rate of economic growth.
  • The country's borrowing costs.
  • The current budget position (the budget balance net of interest payments).

Marked against these factors, Italy's outlook is grim.  The country is growing at a meager 1 percent annually, it faces borrowing interest rates of 7 percent, and it has run persistent deficits for years that have kept it from retiring old debt.

Furthermore, because of its membership in the European Union, Italy has forfeited control over its currency and therefore cannot devalue -- the economics textbook response to the current debacle.

The answer then, is fiscal consolidation, specifically by lowering government spending.

  • While many claim that higher taxes would help to close budget gaps, they would also have the simultaneous effect of stifling consumer demand and undermining tax compliance.
  • Fundamental change in the spending habits of these imperiled governments would restore investor confidence and likely yield positive results for borrowing costs.
  • Lower spending is also historically justified: Successful post-World War II fiscal consolidation in OECD countries averaged $5 to $6 in spending cuts per dollar of tax hikes.

Source: Michael J. Boskin, "Europe's Only Choice," Hoover Institution, April 6, 2012.

For text:

http://www.hoover.org/publications/hoover-digest/article/112911

 

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