Europe and the United States: on the fiscal brink?

• Author: Gokhale, Jagadeesh

What are the implications of Europe's economic troubles for America? Several EU economies now face deep private and sovereign debt overhangs--a situation not unlike that in the United States, which also faces its own challenges with fiscal policy. How do the economic conditions in America and the EU compare in the short and longer terms? This article provides an overview of key indicators that summarize and help to project the two regions' economic prospects. It should be noted at the outset, however, that economic conditions and policies in the two regions differ in substantive ways. As in the United States, most European economies--members of the European Monetary Union (EMU)--now participate in a single currency (euro) system operated by the European Central Bank the counterpart of the U.S. Federal Reserve System. However, the EU lacks a single central fiscal authority that operates a significant cross-nation transfer system. Having surrendered authority over monetary policy and, by the definition of a single currency, exchange rate policy, EMU member nations must depend on national fiscal policies to exert stewardship over their economies.

Many analysts predicted that such a system would display increasing fiscal deficits in response to cyclical downturns--deficits that would be difficult to reverse because of the incentives that such a system creates: Short-term economic (and political) benefits of expansionary fiscal policies occur domestically, but long-term costs are spread throughout the single-currency area through higher interest rates on sovereign debt (Feldstein 2005: 1-2).

Since the advent of the euro, all EMU countries have had to navigate through two key transitions: (1) an aging population and (2) intensifying competition in global labor markets, especially for low-skilled workers. Those trends imply increasing demands for social protection--particularly retirement and health care benefits--for a bulging retiree cohort and welfare support for low-skilled workers facing stagnant wages, greater job-market volatility from business outsourcing, and a progressively shortening skill-obsolescence cycle.

But both the U.S. and EMU regions already face large debt overhangs. For EMU countries, different domestic economic pressures imply different capacities to adhere to the Stability and Growth Pacts statutory fiscal limits on national debt and annual deficits. In the United States, massive global defense commitments compete with other spending priorities in discretionary spending. And the discretionary component of the U.S. federal budget competes with growing spending projected for mandatory (entitlement and welfare) programs--a clash that is likely to intensify during the next few years.

Social Protection Spending in Europe and the United States

Figure 1 shows expenditure components within general government "social protection" programs in the United States and EMU nations that include central government public retirement and disability, health, and housing and welfare programs. Figure 1 shows that while both economic blocs spend similar shares of their social protection expenditures on housing and welfare programs, the United States spends a much larger fraction of its "social protection dollar" on health care expenditures (43 percent) than EMU nations collectively spend out of their "social protection euro" (30 percent). It turns out that the ratio of the higher health-spending share in the United States compared to EMU nations (1.45) is identical to the ratio of the higher share of Social Security (old age and disability insurance) expenditures of EMU nations (53 percent) compared to the United States (37 percent).

Figure 2 shows that U.S. social protection expenditures are much smaller as a share of total government spending (42 percent), compared to EMU countries (58 percent). In addition, U.S. general government expenditures are also smaller as a share of GDP (36 percent) compared to EMU nations (51 percent). These two relative expenditure shares imply that U.S. social protection expenditures are a much smaller fraction of U.S. GDP (15 percent) compared to EMU nations' social protection expenditures as a share of EMU GDP (30 percent).

It is noteworthy that across all government function classifications, the United States expends larger shares of its GDP on defense expenditures (international and domestic) than EU-27 nations as a whole. But EU-27 nations spend more out of GDP on each and every other government function category, with the largest spending-share difference occurring in social protection services. It may be that U.S. expenditures on defending Europe is inducing greater spending by EU nations on social welfare and other expenditures. But prospects for EU nations' future economic and budget outlook will depend on how well they can consolidate budget expenditures to live within their means. Ultimately, however, Europe's economic and fiscal sustainability prospects depend on the evolution of fundamental economic factors, namely, file growth of its population and productivity.

Population and Employment

As for population growth, three factors--immigration, mortality, and fertility--will determine the age structure of the population, which is crucial for the sustainability of age-related expenditure programs such as Social Security and health care. For short and medium terms, however, demographic factors are predetermined and the population's age structure cannot be altered except through very substantial changes in European net international immigration policies, which appear unlikely. What economic policies could target, however, is the share of the population that is employed. This could be achievable through the adoption of pro-work economic policies. Such policies will determine whether the direction of causality will be from demographics to social protection spending to consumption and ultimately to (low) growth in economic output or...