Fiscal policy and the future of the euro.

• Author: Kotlikoff, Laurence J.

The United States and most of the euro-member countries are effectively bankrupt. Resolving these bankruptcies is going to be extremely painful and is likely to spell the end of the European Monetary Union.

The Fiscal Gap

This problem can be understood from the perspective of any government's intertemporal budget constraint, which requires that

T = S + D + [DELTA]M.

In this equation, T stands for the present value of the government's current and future tax and other receipts. S stands for the present value of the government's current and future spending on goods and services and transfer payments. D stands for the government's net debt (its financial liabilities minus its financial assets). And [DELTA]M refers to the present value of the money that the government prints to help pay its bills.

When T falls far short of S plus D, governments routinely raise [DELTA]M to cover the difference. If the difference is large, the amount of additional money created will be substantial, leading to inflation and, indeed, potentially hyperinflation.

The European Central Bank effectively determines the size of [DELTA]M and, thereby, limits the amount of inflation a country can experience. This, at least, is what everyone hopes will be the case. The reality, however, is that the fiscal gap (S + D - T) is so large in most member countries that printing money appears to be the only solution.

Unfortunately, we do not have up-to-date figures on the fiscal gap in the current and perspective euro-member countries. But from previous work, we know that the fiscal gaps in almost all of these countries, measured as a share of GDP, are much larger than in the United States. That would not tell us much if the U.S. fiscal gap were modest. It's not. Indeed, it's enormous, totaling $45 trillion, which is roughly 4 times GDP and 12 times official debt. Imagine everyone in our country working for 4 years and handing over every penny earned to pay this bill, and you'll grasp its size.

This $45 trillion figure is not my calculation. Nor is it some other academic's calculation. Instead, it was produced by economists and budget analysts at the U.S. Treasury. The study was ordered in 2002 by then Treasury Secretary Paul O'Neil and was slated to appear in the President's budget, released in February 2003. O'Neil instructed his team, led by Jagadeesh Gokhale, then Federal Reserve Senior Economic Advisor and now Senior Fellow at the Cato Institute, and Kent Smetters, then Deputy...