Greece fell first, and now Ireland has followed. Portugal seems likely to be next—and then the dominoes get bigger. At some point in the future, the mighty United States could even be one of them.
For now, the European debt crisis seems to be easing, with a $90 billion bailout for Ireland providing enough financing to salvage the nation's banks and keep the Irish government afloat for the next couple of years. But global investors are far from satisfied. The stock markets, instead of surging, have drifted downward in the aftermath of the Irish bailout, a sign that the crisis is far from over. Some eventualities are predictable. It's well-known, for instance, that Portugal, Spain, Italy, Belgium, and other European countries face a combination of high debt loads and other economic problems that will force spending cuts and tax increases in coming months.
It's the unknowns, however, that are spooking the markets and causing deep worries about the bonds of governments teetering on the edge. It's still not clear, for instance, how big the losses are likely to be at Irish banks, which have been hemorrhaging cash thanks to falling property values and a severe Irish housing bust that still isn't over. Spain is suffering its own real estate collapse, and it's not clear where that bottom is, either. Portugal has a chronically weak economy, which makes a smaller debt load a bigger problem because it can't outgrow its debt. In each case, however, the biggest question isn't about debt loads or growth projections—it's about the ability of political leaders to make the tough decisions necessary to fix their nations' finances.
The parallels to America's fiscal follies are hard to miss. The United States isn't facing an imminent debt crisis just yet. Despite a decade of deficit spending, our debt-to-GDP ratio is a moderate 65 percent or so, compared with levels of more than 100 percent in the most imperiled European nations. For all of its problems, America remains one of the richest places in the world, with an economy that's vibrant compared with most of those in Europe. And thanks to its relative stability, America's borrowing costs are still extremely low.
But America's debt levels are rising rapidly, and if nothing changes they'll hit the danger zone in less than 10 years. A stagnant economy makes it unlikely that we'll outgrow our debt, and the Federal Reserve has conjured just about all of the black magic at its disposal to help stimulate growth and manage America's finances. The most worrisome problem is political: Like some of the struggling European nations, America seems addicted to spending that it can't afford, with politicians more inclined to keep pushing the nation toward insolvency than to tell voters that it's time for the party to end.
That makes the European debt crisis a parable that Washington should pay close attention to. Here are four lessons that America's politicians need to learn:
You can't stall forever. A recurring theme among the Greek and Irish bailouts—now playing out in Portugal—is that politicians waited too long to solve their own problems, and lost control as a result. In each case, the spending cuts, tax increases, and other discomforts that would have been necessary to fix the country's finances were abhorrent to voters, which prevented politicians from passing the measures. But the final result ended up being worse. Ireland, for instance, must now agree to rules dictated by its neighbors in the European Union, who, along with the International Monetary Fund, provided the $90 billion in bailout funds. Among other things, the EU could pressure Ireland to raise its famously low corporate income tax rate, now at 12.5 percent—a move Ireland would be sure to fight. Low taxes have helped Ireland attract some of the world's biggest companies, which in turn have provided thousands of high-paying jobs and helped boost Irish living standards. But it will be hard for other countries financing an Irish bailout with funds from their own taxpayers to justify corporate giveaways in a nation they're now subsidizing. The Irish government also plans to slash its minimum wage, raise a variety of taxes, lay off thousands of federal workers, reduce pensions, and make drastic cuts in social services. The EU could demand more as a condition of the rescue.
It's impossible to make direct parallels to a theoretical American debt crisis, because nobody would have enough money to finance such a big bailout if it ever became necessary (no, not even the Chinese). That has produced a kind of hubris in Washington, where members of Congress seem to regard America as too big to fail. But well before a default scenario, borrowers buying a nation's bonds start to demand higher interest rates, since they view the odds of default as higher. When that happened in Greece and Ireland, it raised the government's costs and made fiscal conditions more difficult, which made the ultimate austerity measures more severe than they would have been a few years earlier. The takeaway for Washington is that today's benign borrowing conditions won't last forever, and once the markets start to dictate tougher terms, they tend to ratchet up their demands much faster than governments can react. So it's vital to address the mushrooming debt, even in small ways, before markets lose confidence.
Small steps can have a big impact. Markets tend to be more forgiving than some people presume. Economist Nouriel Roubini of New York University's Stern School of Business points out that deficit spending to stimulate a weak economy remains acceptable, even preferred, by investors—as long as it's coupled with cutbacks later, when the economy is stronger. That sort of measured approach allows gradual cutbacks in spending, when the economy is healthy enough to absorb them, rather than draconian cutbacks like those now underway in Greece and Ireland that come at the worst possible time.
The problem, obviously, is that most governments that have gotten into trouble—including the United States—have instituted short-term spending without the longer-term discipline. To rectify that in Washington, ascendant Republicans who will take control of the House of Representatives next year are talking about slashing government spending to rein in the national debt—even though the economy is still anemic. That may be overkill. "I'd tell the U.S. to do another short-term stimulus and then medium-term fiscal consolidation," Roubini said in a recent speech. "But in the U.S. they're doing the opposite of what they should do." The result, he believes, is likely to be depressed growth that keeps government revenues down and makes the whole problem worse.
Credibility is crucial. Ireland seemed to be doing okay earlier this year, after the government stepped in to guarantee the debt of its banks, which were facing mounting losses. At first, that looked like a reasonable step by the Irish government to stand behind its own banks. The crisis developed because the banks kept coming up with new losses that the Irish government was compelled to cover, and even the government couldn't say where it would stop. That created the impression that Ireland's leaders weren't divulging the full extent of the problem, and may not even have known. And there's no better way to trigger a financial panic than to signal that huge unacknowledged losses are lurking in the economy, somewhere.
American political leaders are slowly losing credibility with the markets because their talk-to-action ratio when it comes to the debt is way too high. Automatic increases in spending, such as trillions in Medicare, Social Security, and other entitlement payouts, will make it hard for even a determined budget-cutter to get much traction. And now, with the government split between Democrats and Republicans, we're likely to have "gridlock" that some view as a net gain for businesses, since new regulations are likely to be scarce. Business might in fact do better if the government bothered them less, but if gridlock paralyzes Washington and makes action on the debt impossible, it will harm businesses a lot more than it will help.
Austerity isn't fun. In many democracies, it takes a crisis to accomplish something as big and unpopular as cutting spending and raising taxes—which is what it will take to start paying down America's debt. Still, relying on a crisis to create motivation is about the worst possible way to solve a problem like this. The new austerity measures in Greece, Ireland, and other parts of Europe, for instance, will finally impose some discipline on profligate governments. They'll also cause another recession. Moody's Analytics predicts that austerity measures and other cutbacks in government spending could cut 2 percentage points off of Europe's growth in 2011, with overall growth turning negative. That means many more unemployed people, lower incomes, higher taxes on those still working, and less public aid for those who fall through the cracks.
The United States is already facing a long period of slow growth and high unemployment over the next several years. One of the key variables is the national debt. If politicians beat the odds and work together to craft a credible debt-reduction plan, markets will cheer, optimism will rise, and the economy will turn out better than expected. But if Washington waits for a crisis to provide the justification for tough decisions, it may not even get to make those decisions. A crisis might be a terrible thing to waste, but it's a terrible thing to endure, too.