With headlines warning us of yet another European country in crisis and the possibility of the collapse of the Euro - or perhaps the entire European Union - the question of how these disaster scenarios might be avoided becomes increasingly pressing.
Several European countries find themselves deep in debt thanks to over-extended government spending, particularly on social programs, combined with rigid labour markets with generous unemployment programs and other social programs that reduce productivity. Raising new revenues to pay off that debt is difficult as unemployment across the EU averages more than 11%, with Spain at 24%, Greece at 22%, Portugal at 15%, and Ireland at 14%.
Greece, Ireland, and Portugal all have government debt to GDP ratios of more than 100%, while others, like Spain, are facing banking crises. As those ratios have climbed, investors have demanded higher interest payments on Greek, Irish, and Portuguese bonds, threatening their ability to pay off the principal and increasing their current expenditures and deficits. All of this increases the likelihood of default.
For countries facing immediate crises and the rest who are on that same path, there is only one way out of this mess. Government spending must be dramatically cut in order to reduce current deficits and enable governments to devote resources to paying off past debt. Many have argued that so-called austerity should also include tax increases to help that process. But tax increases are not necessary if spending reductions are accompanied by growth-inducing deregulation.
One of the few European success stories of the last decade has been Germany.
With unemployment at 6.8%, Germany is well below the EU average. Its debt-to-GDP ratio is near the EU average.
Germany eliminated some of the most harmful regulations in its labour markets, leading to lower unemployment and stronger growth. As employment expands, income grows, leading to rising tax revenues, which can help drive down deficits and debt. Increasing tax rates to accomplish this goal, by contrast, will discourage the growth needed for long-run debt reduction by punishing productivity and profits.
The use of monetary expansion and bailout loans to help the countries in crisis do not address the real problem, which is the growth in government.
In fact, they simply reward the countries who have made the largest mistakes, reducing their incentive to make the institutional changes necessary to solve the long-run problem.
EU countries will only step back from the edge of disaster if they realize that their current fiscal policies are unsustainable and that only a serious commitment to reducing government spending, particularly social programs that do not have enough workers per recipient to survive, can do the job.
Deregulating and increasing labour market flexibility will help generate the jobs necessary to help reduce debt. Austerity may be painful for those accustomed to such government benefits, but it will be temporary.
Default, by contrast, will inflict worse pain, and for decades.
- Michel Kelly-Gagnon is president of the Montreal Economic Institute (www.iedm.org). The views reflected in this column are his own.