Both Europe’s short-term and long-term economic futures do not look bright. The need to bail out Greece, and possibly also Spain, Portugal, and Italy is the immediate problem, but the fundamental problems go much deeper. Relatively rapid economic growth will cure many budgetary imbalances since the challenge is not the size of government debt per se, but its size relative to GDP. A faster growing economy can tolerate sizable growth in government spending as long as the growth rate of its debt is no faster than the rate of growth of GDP.
Unfortunately, large government spending and rigid economies, the European approach, tend to both increase the growth rate of government debt, and at the same time lower the growth rate of GDP. As a result, the prospects for rapid growth in most European economies, and for getting government debt under control, are dim unless major reforms are introduced into their welfare state, labor markets, regulatory framework, and other government policies.
Europe needs high income and other tax rates in order to finance its system of early retirements and generous pension benefits, especially among its large numbers of government employees, its liberal unemployment benefits, easy access to welfare payments to support unmarried mothers, the care of children, and many other government subsidies. Edward Prescott has shown (see e.g., his “Why do Americans Work so Much More than Europeans”, Federal Reserve Bank of Minneapolis, Quarterly Review, 28, July 2004) that higher marginal tax rates account for a significant part of the difference in employment, earnings, and hours worked between the US and the main European countries. High tax rates reduce both the level of income at any moment and the rate of growth of income over time.
Very low European birth rates contribute to the difficulty in financing generous support of the elderly since fewer men and women of prime working ages are available to be taxed to support the growing number of retirees, although the greater education, and hence greater productivity, of each young European partly but not fully compensates for having fewer young workers. The substantial increase in life expectancy is an enormous benefit of modern medicine and of greater knowledge about healthy personal care. However, longer expected lifetimes have greatly raised pension and health burdens in most European countries since their retirement ages have not increased in proportion to the growth in years lived of older persons.
The rigidities imposed by a single currency, the euro, will continue to cause frictions and difficulties for countries in the European Monetary Union. Part of the problem, as in the current Greek crisis, is the separate fiscal regimes of member countries. But budgetary deficits and reckless borrowing are not the only forces that create tensions within a common currency. Some countries using the Euro will at times experience severe shocks to their economy that create unemployment and deficits in their foreign trade accounts. Economically weaker countries with own currencies usually respond to such shocks by devaluating their currency, as Greece frequently did in the past when it had the drachma.
Devaluation is not available to individual countries within the euro monetary union. They have to adjust to bad shocks to their individual economies either through increased unemployment, reduced wages, or migration of some unemployed workers to countries that are doing better. These adjustments are difficult for Greece, Italy, Spain and other weak members of the EU because their labor markets are inflexible, and because many workers in these countries are reluctant to migrate elsewhere, partly because they would give up generous benefits.
States of the US also have a common currency, and also face state-specific shocks since they specialize somewhat in different commodities and services. However, the difficulties states face in adjusting to their economic shocks are reduced by the much greater flexibility of US than European labor markets, and the willingness of many unemployed Americans to move to states that are doing well.
Apropos of comparisons between US and Europe, the US faces many of the same problems as Europe, but generally they are in a more muted form. The US has more flexible labor markets, lower marginal tax rates, fewer invasive regulations, a smaller welfare state, higher birth rates, greater immigration, more rapid incorporation of immigrants into the general economy, greater encouragement to starting new businesses, greater competition, and many other economic advantages. Nevertheless, the US has large fiscal deficits, and large health care and retirement obligations that will be growing rapidly over time.
To manage effectively a growing federal government debt, it is essential that the growth in entitlements be reduced, in part by raising the age of retirement and of access to Medicare. It is also crucial that government policies encourage more rapid economic growth of the American economy. Unfortunately, this is not true of many policies proposed or implemented during the past 18 months. These include, among many others, higher income taxes on corporations and on persons with bigger incomes, government regulation of pay, especially the pay of executives, health care “reform” that will raise, not lower, government spending on healthcare, special subsidies to various unproven green technologies, so-called job creation bills that create few jobs per dollar spent, and more aggressive anti-trust actions against successful companies, such as Google. These and other policies will reduce US economic growth at a time when faster growth is more necessary than ever.