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Europe’s Storm, and Ours

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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.

As the euro slouched toward collapse, the risk premium on U.S. Treasury bonds rocketed. The yield on the 10-year bond, which in mid-2010 neared 4 percent, dropped to less than 1.75 percent in September 2011, an all-time low. The decline in two-year yields has been even more dramatic, from nearly 1.5 percent in mid-2009 to around 0.25 percent in the fourth quarter of 2011.

This explains why spending on interest by the federal government has remained manageable, despite the government’s debt burden having increased by over $1 trillion a year, doubling since 2005. In fact, the government laid out around $200 billion in net interest costs in 2011, approximately the same as in 2005 and less than in the final years of the Bush-era boom in 2006-07.

This is a special situation, reflecting uncertainty in Europe. It is unlikely to last indefinitely. Current bond yields are well below the rate of inflation, meaning that bond investors are paying the U.S. government real money for the privilege of giving it a loan. If the long bond yield were to return to 4 percent (which is close to the current rate of inflation), we may see interest payments double, to $400 billion. This would merely signal the return to “normal” conditions.

Yet since our debt now measures over $16 trillion and is approaching the Italian level of 100 percent of GDP, the situation is far from normal. In the late 1990s, the Treasury paid some $240 billion annually on debt that was less than one-third as large as it is today, or around $5 trillion. If the relentless printing of money by the Fed awakens inflationary expectations among bond investors, interest payments could jump to more than $750 billion a year.

Curbing the Deficit

Some economists have been critical of the Republicans for proposing to cut government spending while the economy teeters on the brink of another recession. In fact, reducing the budget deficit voluntarily, while bond yields remain extremely low, is preferable to doing so the way the Greek and Italian governments were forced to do, in an environment of rocketing bond yields. Republicans and Tea Party activists deserve credit for raising the issue before it is too late.

However, addressing the budget deficit won’t solve the underlying problem — namely, the inability of the economy to rebound from the economic crisis on its own accord. Cutting the deficit, either by reducing spending or raising taxes or a combination of both, will inevitably put a brake on the economy.

It would be naive to expect that cutting taxes or reducing government regulation will create a substantial boost for the economy. Profits at S&P 500 companies in the July-September quarter increased 4.6 percent, outpacing analysts’ expectations for 11th straight quarterly period. This shows that many American companies, across a variety of industries, are thriving in the current environment. Nor was the existing system of regulations, or an even more onerous rate of income taxes, an impediment to the technological revolution of the 1990s, when the U.S. economy experienced an acute shortage of labor and when new college graduates commanded fabulous salaries.

The fact that the normally resilient, irrepressible and entrepreneurial U.S. economy has remained dead in the water for more than three years is extremely worrisome. Getting it afloat again may require a more serious overhaul, comparable in scope to revolutions accomplished during the Franklin Roosevelt and Ronald Reagan administrations. Unfortunately, it now appears that it may have to come after a second leg of the financial crisis is played out and the massive Treasury bond bubble is deflated, probably with dramatic consequences.

Alexei Bayer is an economist and author based in New York City.


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