How Can Western Countries Get Out of Debt? Only By Paring Down Unsustainable Entitlement Programs – A New Social Contract

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By Paolo von Schirach

May 1, 2010

WASHINGTON – In the case of Greece’s nasty fiscal debacle,  everybody’s focus has been mostly on assessing the unfolding drama. Will this Eurozone-IMF rescue package work? Or will it be the next one, until finally something that would stick is cobbled together? Will Greece precipitate into the bankruptcy abyss; and, if it will precipitate, will this ruinous fall bring about further havoc within the already strained fabric of European monetary cohesion?

A growing debt, not this year’s deficit, is the issue

But, while not unreasonable, this focus on crisis management and related countermeasures takes all observers away from the real systemic problem which is not: “How to stem the hemorrhaging and thus bring down next year’s deficit”; but instead is: “How to reverse the systemic, creeping growth of public debt”. And the creeping debt crisis is by no means confined to Greece. It affects many advanced countries, in fact most of Europe and Japan, among others.

The real issue here is not about how to avoid another Greece; but about recognizing the urgency to reverse established –yet deeply  toxic– public spending trends, so that huge and growing amounts of debt will no longer weigh so heavily on so many countries, eventually crippling their ability to invest and grow, since most resources are devoted to spending or to finance borrowing to be channelled into the same spending. But nobody will act to stop this spending and borrowing until there will be a new, truly shared societal consensus that indeed, however well intentioned they may be, large and growing welfare systems, now a common feature in most advanced societies, force a progressive resources diversion from investments to entitlement spending and debt service; thus crowding out and ultimately smothering new productive investments, new research, innovation and new growth.

British elections: candidates avoid details about spending cuts

However, as things stand now, while everybody wants to avoid Greece’s fate, not many are prepared to take today the steps necessary to get out of a very similar course. Staying on this course does not guarantee becoming a basket case like Greece; but it does guarantee under performance, low growth and ultimately societal stagnation and possibly decline. And yet, as bad as all this is, getting out of this spending trap is politically dangerous, if not outright impossible. 

Indeed, days before critical national elections in Britain, none of the leaders of the three main parties dared to articulate what they would do to cut the monstrous UK debt, in case the voters may not like what they hear and punish at the polls who may tell them the truth about losses of benefits. And so Britain, as The Financial Times recently commented, goes into a critical national election without any idea of what any debt reduction plan may be; with the negative political consequences that whoever will end up governing will have no clear electoral mandate to take the harsh measures that, one way or the other, will have to be taken. (Unless Britain decides to do nothing, thus setting the stage to become the next Greece).

Greece will be fixed, somehow

Greece’s crisis eventually will get under control. Greece is, after all, a small country. Its problems, however dramatic and unprecedented for the Eurozone, are not unmanageable. But the issue of systemic growth of public debt in so many countries: Italy, Spain, Belgium, Britain, Portugal, Japan, and the US, among others, is a different story. The fact that higher and higher debt is eventually unsustainable is now blatantly obvious in Greece’s case. But we do not seem ready to acknowledge that the same disease, albeit in a less acute phase, is everywhere.

Between Greece and the other countries the difference is only about the speed of debt accumulation. All these countries are ailing. But many, for the moment, (and this includes the US), manage to mask the severity of the problem, thanks to the availability of sufficient credit that allows them to finance their chronic fiscal shortfalls.

The real lesson from the Greek crisis

Indeed, the real lesson from Greece is not about how to avoid Athens’ extravagant level of recklessness –this is not that difficult. The real problem is how to get out of the far less obvious trap of creeping higher and higher debt levels that may or may not degenerate into a Greece-like crisis; but that are nonetheless very damaging, in as much as too much debt saps precious energy from the economy. Just like a parasite, without being necessarily lethal, severely weakens the body, debt damages society’s fabric, even though it may not deal a mortal blow. The society somehow survives, just like the human body afflicted by the parasite; but it loses vitality, energy and dynamism.

This is the real problem.

But since it is a problem that grows subtly and incrementally; it is relatively easy to ignore it or to explain it away, in the meantime readjusting goals and expectations down. The Minister of Finance of a leading European power just recently said in Washington that a 1.5% projected growth rate for his country is acceptable. Coming out of a severe recession, 1.5% is fine? Not for people who believe in the need to do all you can to nurture the economy. But if 1.5% is alright now, then may be next year 1% growth will also be acceptable. Lowering goals and thus expectations is not too difficult, apparently.

Debt is like “termites in the basement”

Everybody understands a crisis when we are already in it. But before getting to where Athens is today, there is a long journey featuring, among other things, increased levels of public spending unmatched by corresponding revenue and thus higher borrowing requirements as its key milestones. But the problem with an increased debt level is that its damage is slow and incremental; and so this damage  does not manifest itself all of a sudden, as an immediate crisis.

The crisis comes later, some time much later, once debt has piled up beyond some threshold that convinces some key players that it is too much. With that judgment, warranted or not, comes the creditors’ mad rush to unload the bonds, now deemed to be junk, panic and thus the whole thing just falls apart, just as in the current case of Greece. But until debt can be financed with reasonable rates of interest, the process is fairly painless and thus it is easy to ignore its highly damaging and truly corrosive consequences, not just for public finances, but for the netire economic fabric.

As it has been observed: “Debt is not the wolf at the door; it is more like termites in the basement”. So, growing debt levels are not an imminent, visible threat; but rather a subtle, invisible enemy that literally “eats its way into your home”. If you do not catch it and eliminate it, it will destroy your property.

You can fix the immediate crisis without seriously addressing the debt problem

But if we look at Greece purely as a unique crisis, then we shall evaluate everything purely in terms of the success of a rescue package. If the EU-IMF 60 billion or 100 billion dollars rescue package over so many years comes along, Greece will not go belly up. Somehow, it will manage to cut spending, increase revenue collection, streamline public administration, at least to some degree. And so, everybody, (except the Greeks who will have to live through all this), will be happy. Crisis resolved, let’s all go out and celebrate over dinner.

And yet the larger issue is not Greece’s almost fantastic levels of both private and public irresponsibility. Historic evidence shows that crises brought about by extravagantly bad behavior can be dealt with and managed. However, the real systemic problem is not this year’s or next year’s deficit; but the long term fiscal trajectory created by excessive spending and insufficient revenue growth resulting in high debt. The Wall Street Journal of 1-2 May 2010, (“Athens Confronts Sisyphean Task in Austerity Program”), cites a revealing consideration from a report released by the Brussels based Centre for European Policy Studies: “The goal of the large fiscal adjustments is to make public finances sustainable. However….this goal was rarely achieved”. In plain language, you may avert disaster; but this does not imply successful inoculation against the debt malady. So, in the end you may not die, but you will be chronically ill.

Ad why is that? 

The roots of the debt problem are in the promises of the welfare state

In most western nations a key pillar of public policy is the firm belief that the state is supposed to take care of people. And so, to this end, we have created entitlement programs, ever more complex and ever more onerous, largely based on the fantasy that somehow any level of spending is affordable, that there is enough revenue to finance education, health, pensions and assorted subsidies to more and more constituencies. Policy makers who know that this is not possible, for fear of alienating voters, instead of telling the truth, borrow the difference between what they promised and the actual revenue in hand. Hence growing debt.

But, since borrowing has some limits, policy-makers, as they focus on financing what is politically more important to them, that is social welfare programs, short change discretionary spending, cutting spending in all the sectors that do not have huge, clamoring constituencies. And so they cut defense spending, (now, on average it is about 1% of GDP in Europe and Japan); thus creating the foreign policy of the weak, grounded on crisis avoidance, rather than on meeting threats. And they cut capital investments in infrastructure and in research and development. In so doing, they keep their voters happy, thus gaining confidence that they can face the next election. In all this, there is no concern for the aggregate, long term consequences of a trend that, by privileging social spending while shortchanging investments, objectively weakens the economic foundations and the chances of future growth.

No more babies: welfare spending levels become unsustainable

But other parallel trends will make it harder and harder to sustain this act in the future. Until now, growing debt notwithstanding, it was possible to keep financing this onerous welfare system. Looking ahead, this is going to be more difficult. Indeed, most advanced societies are facing negative fertility rates: well below population replacement levels.

In simple language, this means fewer young tax payers and growing numbers of old people who depend on the state for various costly benefits. A growing number of elderly citizens –and they are those who receive the most in terms of welfare—will have to be supported by the shrinking revenue produced by a dwindling number of younger, active citizens. At some point the mismatch between too many old people receiving benefits and too few active young ones paying into the system will become unsustainable. Recurring to debt will no longer be enough to fix the gap between what has been promised and what is financially possible.

Too late to change course?

What will happen then? Who knows. But we can bet that at that point it will be way too late to reverse the cumulative effects of policies that for decades have privileged social spending over productive investments. Sure enough, some benefits will be curtailed, some may be eliminated altogether, in order to diminish the fiscal imbalance. But I very much doubt that it will be possible to bring before the public and then successfully implement a new public policy philosophy strongly grounded on the basic notion that by far the best way to ensure public welfare is to maintain and safeguard above all else the full functionality of a vibrant economic system; in as much as this is the only engine for wealth generation. If you want to distribute wealth, you have to produce it first.

Until people will be prisoners of the idea that welfare is a basic right and that we can think about how to pay for it later, we shall privilege distribution of benefits and shortchange policies aimed at keeping the economic engine going full force. It should be clear to all that in the end you have to produce some added value in order to be able to distribute it. But the established distortions that make welfare policies untouchable allow most people to overlook this rather basic consideration. And so, we keep on distributing benefits financing the expenditures via borrowed funds.

Strong focus on welfare means less attention for growth

The end game of insisting with these entitlement policies in societies that are becoming less productive, (because the money goes to finance these very entitlements), is that over time there will be less and less to distribute. These societies will be progressively more impoverished, while their standing in the world will be diminished. My hunch is that Europe as a whole is well on its way to economic and societal decline, while I do not see any significant new tendencies that would reverse course. Japan is not too far behind.

What will happen in the US?

In the US it is still a toss up. Certainly there are large, powerful, mostly urban, constituencies located in the large states on the two coasts that aspire to something close to the European model. There are others, witness the spontaneous, if boisterous, anti-government, anti-tax “Tea Party Movement” phenomenon, who instinctively abhor statism and the attendant welfare state public policy approach. Can America find a reasonable balance between maintaining some sort of public safety net and a focus on doing whatever is necessary to keep investments and innovation at the highest possible rate? As of now, because of the impact of the 2008-2009 recession, our debt is  approaching European levels. We can retreat from this bad course and once again emphasize growth, while doing what it takes to keep this economy nimble and competitive. But this benign outcome is not a sure thing. The Obama administration repeatedly stated that high spending is a temporary counter cyclical remedy because of the horrible recession and that it will soon announce a convincing long term decifit and debt reduction strategy. And when will this be? Well…soon. Somehow, I think that we shall have to wait until at least after the November congressional elections. And, after the November elections, we shall be gearing up for the 2012 presidential elections. If, just like other governments, the Obama administration does not want to upset voters by announcing serious spending cuts, there are good chances that we shall not see any bold deficit and debt cutting strategy.

Will we learn anything from the wider debt story highlighted by the Greek crisis?

In the end, the Greek crisis is not an especially useful example of what to avoid, as Greece is clearly an extreme case, whose specific circumstances are not going to be easily replicated. Few other modern countries will accumulate so many distortions and so many inefficiencies.

But the Greek crisis did illuminate in some fashion the debt issue and the cumulative damage brought about by growing and growing public debt. Not as clear, by reading the copious commentary, is whether we are in agreement on the primary cause of structural debt: growing social spending out of sync with revenue. Will anybody, be it in London, Lisbon or Washington DC look at the nasty consequences embedded in spiraling debt and realize that it would be good to change course as fast as possible?

 

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