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December 26, 2011 at 07:00 PM
Contrary to the widespread view that the European debt crisis is acting as a drag on the U.S. economic recovery, it actually has been beneficial for the United States. The euro-zone debt crisis has given Washington a respite by boosting the safe-haven premium of Treasury bonds and reducing the debt-service burden for the U.S. government. But the current plight of Italy, Spain and other euro-zone debtors provides a blueprint for the way a debt crisis could develop in this country, as well, in the next 12 to 18 months.
The euro-zone debt crisis didn’t begin in late 2009, and not even in September 2008, when the collapse of Lehman Brothers unleashed the global economic slump. The crisis dates back to the mid- and early 2000s, to the last global economic boom, when the Greek budget deficit averaged over 6 percent of GDP despite a favorable economic environment. The same was true of Italy: even though the country was running a primary budget surplus (i.e., excluding debt service payments), its debt burden didn’t budge during the fat years and remained above the 100 percent of GDP mark.
Both countries, which in the fourth quarter of 2011 were the crux of the euro-zone debt crisis, entered the global economic downturn in an extremely weak fiscal condition. Regardless of whether one embraces Keynesian economics or sides with its critics, it should be noted, first, that John Maynard Keynes expected governments to run fiscal surpluses during economic booms in order to cool off the overheating economy and accumulate resources to fall back on in downturns. And, second, modern industrial economies are all based on the Keynesian model. In all rich industrial countries, government spending constitutes a big part of the economy, so that whenever the economy begins to slow, deficit spending kicks in to moderate the severity of the downturn. When economic activity slows, tax receipts fall while unemployment payments, transfers to local governments and other such expenditures increase.
Not a V-shaped Recovery
While the first condition was universally ignored, and budgetary red ink flowed freely during the economic boom in Europe and North America, not to mention Japan, the second condition, deficit spending, kicked in promptly. Governments also put in place large fiscal stimulus packages in the hopes that public works and subsidies to consumers to buy cars, among other measures, would jump-start economic growth.
The result was that heavily indebted euro-zone countries, already lacking fiscal discipline entering the recession, faced a dramatic widening of their budget deficits and a rising borrowing requirement. Had it been an ordinary recession, of the kind we have seen several times since the early 1980s (which were mild and then followed by swift, V-shaped recoveries), the euro-zone fiscal crisis might not have occurred — or at least it would have been swept under the rug yet again. But this was a different kind of economic slump. The economies in Western Europe and the United States weakened and, unaccountably, didn’t rebound. No clear wellsprings of growth emerged, consumer demand remained weak and private investment slumped. Rich economies were flapping along the bottom and governments were forced to continue to supplement aggregate demand with deficit spending.
It took financial markets about a year after the Lehman collapse to realize that the likes of Greece, Ireland, Portugal, Spain and Italy would not be able to sustain their torrid pace of public sector borrowing. Investors began demanding higher interest rates on the money they were lending to their governments; plus, bondholders faced margin calls from clearing houses, which led to higher yields. A vicious cycle was born. While Italy could continue to service its debt at a 3-4 percent rate on long bonds, it was very likely to face bankruptcy if rates rose to 7.5 percent or even 8 percent.
Starting in 2010, governments across Europe were forced to cut spending and raise taxes, thereby plunging their economies deeper into a recession. In Greece, an increase in certain sales and value-added taxes ended up reducing the overall government take because consumption and economic activity promptly ground to a halt.
America’s Gain
In recent months, as the euro-zone crisis intensified, a widespread opinion has emerged in the U.S. blaming Greece and Italy, and also Spain and France, for creating market uncertainty and weighing on a nascent U.S. economic recovery. In reality, the exact opposite is true: the crisis in Europe has given America some breathing room — albeit most likely only for a short time.
