Wealthy Europe and the US, crown jewels of mixed capitalist democracies, are drowning in deficits and debt, owing to bloated welfare states that are now in place (Europe) or in the making (the US). As Europe struggles to prevent financial contagion and the US struggles to reduce its record deficits, their dangerous debt levels threaten future living standards and strain domestic and international political institutions. The ratings agencies are threatening additional downgrades; others envision an eventual breakup of the euro and/or demise of the US dollar as the global reserve currency.
The economists Ken Rogoff and Carmen Reinhart estimate that public debt/GDP ratios of 90 percent are associated with sharply diminished growth prospects. Greece’s debt ratio is more than 120 percent, Italy’s is about 100 percent and the US’ is at 74 percent, up from 40 percent a few years ago — and rapidly approaching 90 percent. The IMF estimates that each 10-point increase in the debt ratio lowers economic growth by 0.2 percentage points. Thus, increases of 40 percent to 50 percent of GDP risk cutting long-run growth in half in parts of Western Europe, and by one-third in the US — a devastating reduction in gains in living standards over the course of a generation.
Worse yet, the burden of banking losses that will sooner or later be socialized, and that of future unfunded public pension and health costs, are often understated in official debt figures. Moreover, the problematic finances of some sub-national governments, for example in the US and Spain, will place pressure on central governments for fiscal aid.
In Europe, voters in fiscally responsible countries like Germany and the Netherlands are balking at bailouts of governments, banks and bondholders. US voters traditionally have favored smaller government and lower taxes than Europeans have favored (or at least tolerated). Add continued anger over financial bailouts, rising spending and the exploding national debt, and even the US’ Democrats — the country’s traditional big-spending party — are finally talking deficit reduction.
Following the last deep US recession, from 1981 to 1982, when the unemployment rate peaked at a higher level than in the recent recession, Democrats blasted then-US president Ronald Reagan over deficits of 6 percent of GDP. Republicans now berate US President Barack Obama for deficits of 10 percent of GDP. Similar political and substantive jockeying occurs in European countries.
The simplistic categorization of political parties by their preference for a particular size of government masks more complex intraparty tendencies. The US’ Republican Party has three types of fiscal conservatives: supply-side tax-cutters, those who would limit government spending and budget balancers. They historically have feuded over tactics and strategy, but, since the deficit is the difference between revenues and outlays, they are closely interconnected. Indeed, because the sum of all future tax revenues (discounted to today) must cover the sum of all future spending plus the national debt, the only way to keep taxes relatively low is to control spending.
Just as Democrats have long championed more government spending, and more benefits for more people, either on ideological grounds or as a political coalition-building strategy, so Republicans have regarded the goal of lowering taxes. So, not surprisingly, Republicans are using the vote on the debt ceiling to force cuts in entitlement spending, while Obama and congressional Democrats are using it to force higher taxes, in part to fracture their opponents’ coalition.