Lessons from Europe's debt crisis for the united states.

• Author: Lachman, Desmond
• Position: Essay

The European sovereign debt crisis offers a cautionary tale for the United States. This is the case since all too sadly the U.S. public finances appear to be on the same sort of unsustainable path that lies at the heart of the present European crisis. Whereas Europe, taken as a whole, currently has a budget deficit of around 3 percent of GDP and a gross public debt ratio of around 90 percent of GDP, the United States has a budget deficit of around 8 percent of GDP and a gross public debt ratio in excess of 105 percent of GDP.

This article attempts to draw out those lessons that are most pertinent to the present U.S. context of worse overall public finances than those in Europe. The first part of this article traces the origins of the European debt crisis. The second part explains why the recent pledge by the European Central Bank "to do whatever it takes to save the euro" through large-scale purchases of Italian and Spanish bonds is unlikely to resolve that crisis. The final part of the article sets out the relevant lessons that the United States might draw from the European crisis with a view to avoiding a similar fate to the struggling countries in the European periphery.

Origins of the European Debt Crisis

In January 1999, at the launch of the euro, Milton Friedman expressed the gravest of misgivings as to how the European Monetary Union (EMU) would operate in practice. However, it is highly improbable that, even in his darkest moments, he would have anticipated how poorly EMU's internal policing of member countries" macroeconomic policy would have worked and how miserably the markets would have failed to exert discipline over wayward fiscal behavior of individual EMU member countries. Nor would he have anticipated the staggering degree to which imbalances would have been allowed to buildup in those countries' public finances and external positions.

In 1992, before the start of EMU, the Maastricht Treaty had set out strict limits for member countries' public finances in recognition of the need for sound economic policies within a currency union. Budget deficits were not to exceed 3 percent of GDP while the level of public debt was to be contained to below 60 percent of GDP. Sadly, over the past decade, these limits were observed in the breach. According to the European Commission, by 2009 Greece and Ireland registered public deficits of the order of 15 percent and 14 percent of GDP, respectively. At the same time, the public deficits in Spain had reached 11.5 percent of GDP, while Portugal's was nearly 9 percent of GDP (European Commission 2012).

The emergence of massive deficits in the European periphery has placed the public finances of the periphery on a clearly unsustainable path and has created great difficulties for these countries in the Financial markets. The unsustainable nature of the periphery's public finances is most apparent in the case of Greece. Despite a 74 percent write down in Greek government private sector debt obligations at the beginning of 2012, Greece's public debt to GDP has now reached over 160 percent or more than two and a half times the Maastricht Treaty's 60 percent of GDP limit. However, the public finances of Ireland, Italy, Portugal, and Spain are also on unsustainable paths that have required the adoption of multiyear programs of severe budget austerity.

A second area where extraordinarily large imbalances emerged in Europe's periphery has been in the housing markets of Ireland and Spain. Fueled by easy access to global credit, as well as by an ECB whose one-size-fits-all interest rate policy kept interest rates too low for too long for Europe's periphery, Ireland and Spain experienced housing bubbles that made the U.S. housing bubble pale in comparison. Whereas housing prices in the United States increased by around 80 percent between 2000 and 2006, those in Ireland and Spain approximately trebled. And whereas employment in the construction sector peaked at around 6 percent of the labor force in the United States, that in Spain reached as high as 18 percent in 2005. The bursting of the housing bubbles in Ireland and Spain has been a primary driver in the dramatic deterioration in those countries' public finances. It has also been the primary factor in the rise in unemployment in Ireland and Spain to their present levels of around 15 percent and 25 percent, respectively.

The lack of macroeconomic discipline in Europe's periphery has 'also given rise to the emergence of acute external vulnerability. Over the past decade, a generally too easy monetary and fiscal policy stance has caused wage and price inflation in the European periphery to be consistently higher than that in EMU's more fiscally conservative members. As a result, over the past decade, Greece, Spain, Portugal, and Ireland have all experienced a loss in international labor cost competitiveness of at least 20 percentage points. This loss of competitiveness, together with a worsening performance in...