Financial Crises, National Debt, and Consequences

June 27, 2011

On June 27, 2011, the American-German Institute (AGI) and the Brandenburgisches Institut für Gesellschaft und Sicherheit (BIGS) co-organized a conference on “From Greece to the U.S.: Financial Crises, National Debt, and their Consequences for Europe and the U.S.,” in Frankfurt, Germany. The conference was generously supported by the Transatlantik-Programm der Bundesregierung der Bundesrepublik Deutschland aus Mitteln des European Recovery Program (ERP) des Bundesministeriums für Wirtschaft und Technologie (BMWi). Additional support was provided by the AGI Business & Economics Program and the American Chamber of Commerce in Germany.

After a keynote speech by Dr. Thomas Mayer, Chief Economist at Deutsche Bank Research, the first panel featured Amy Medearis from the Delegation of the European Union, Nathan Sheets from the Federal Reserve Board, and Bruce Stokes from The German Marshall Fund of the United States. The speakers focused on the topic of “U.S. Public and Private Debt: Consequences for the U.S. and the Rest of the World.”

The U.S. budget deficit has reached almost 10 percent of GDP. Half of this deficit is temporary and consists of the most recent fiscal stimuli and automatic stabilizers. But the structural deficit is not sustainable and the deficit must be reduced to 2 to 3 percent of GDP. This requires short-term fiscal cuts of 2 to 3 percent of GDP and the reform of entitlement programs (such as Social Security and health care) by 2020. While Europeans have undertaken larger reforms than the U.S., Europe’s demographic challenge leaves them still worse off than the U.S., which has a higher fertility rate and higher numbers of immigration. The U.S. debate currently focuses on the issue of the legal debt limit, which will be reached by August 2011 and which will have to be increased by Congress. A U.S. default, which would be likely if the legal debt limit is not increased, would mean that the U.S. would lose its AAA rating; it would have negative consequences for the dollar as a safe-haven and its dominance as a global currency; and there would possibly be negative consequences for Europe and the rest of the world through higher interest rates and vitality in asset and foreign exchange rate markets.

In addition to the crisis on the federal level, U.S. states and local governments are also facing a severe budget crisis. Because most are required to present balanced budgets by law, the resulting fiscal cuts will become a drag on the slowly recovering U.S. economy. Fiscal spending in the U.S. is largely driven by mandatory spending (55 percent of the budget is spent on entitlement programs); as such, in order to solve the debt crisis, all potential solutions need to be discussed, which include spending cuts, raising public revenues, reforming entitlement programs, and strengthening fiscal rules. However, although many proposals have been put forth, solutions have been elusive as parties do not agree on many concepts. As the U.S. engages in a discussion about its debt, three key challenges have to be met: finding the right balance between austerity and investment for future growth; determining how much space the U.S. has to cut government programs; and reconciling radically opposed visions of the role and the size of governments.

The mood in the U.S. is decidedly partisan, especially surrounding economic issues. The population views the economic outlook as very glum and is especially concerned about high unemployment and high gas prices. Only 29 percent of Americans believe that the economy will be better in the future, which has decreased from 48 percent in 2010. This is especially problematic for President Barack Obama, whose re-election likely depends on a positive economic outlook. Americans are also increasingly concerned about the U.S. deficit and Republicans were successful in dominating this debate. Due to the economic challenges, the U.S. public has turned increasingly isolationist, which will also affect transatlantic relations.

The second panel featured Andreas Freytag from Friedrich-Schiller-Universität Jena, David Marsh from SCCO International/OMFIF, Martin Mühleisen from the International Monetary Fund, and Paul J.J. Welfens from the European Institute for International Economic Relations and focused on “The End of Euroland? The Future of the Euro in the International Currency System.”

The Greek crisis is a clear breach of the European Monetary Union (EMU) but, despite the implications for Europe of the crisis, the government responses have been driven by domestic pressures. Going forward, there are three options for the euro: stability, bailout, and common economic policy. The stability option, preferred by the European Commission as a return to the stability and growth pact, would institute a debt brake, would not bailout troubled member states, and would leave national governments in charge of their own finances. The second option, a bailout, implies a willingness of members to bailout their neighbors from national debt; this has negative associations with a transfer union and would be politically unpopular. Common economic and social policy, the third option, is equally politically unlikely. Indeed, fears exist that the latter two options would spur populist reactions, causing enthusiasm for the EU to wane even more, and possibly promote nationalism and disintegration of the Union. Going forward, the EU should involve the G20 in dealing with the crisis by restructuring the Greek debt and including the Doha Round in discussions. Within Europe, the EU should broaden the European agenda (for example, admitting Croatia to the Union) but avoid further deepening–or even take a step back. To avoid populist backlash, members must keep the EU rhetoric low-profile.

Europe is dealing with the issues of debt in Greece and the potential implications for the EU and the euro-zone. The discussion centered on whether a Greek default would severely impact the euro-zone or if this would not be as challenging as feared. Permitting the Greek debt to reach its crisis level demonstrates a failure of recognition, investigation, and understanding of how the market works by the European governments. The idea of the euro was conceived to give Europeans greater power on the world stage, however, the euro is now distracting from this project. Additionally, Germany is beginning to assess its national interests, and increasingly its economic interests, as being outside of Europe (trade with China, for example, has greatly increased). As a result, Germany will even be less enthusiastic about bailing out countries that are becoming less relevant to it. However, the economic crisis in Europe influences more than just the periphery; the financial system is–much more than the trade system–a transmitter of economic shocks. In order to strengthen its financial system, Europe will have to disentangle its banking system from the individual member states and the European banking system will have to be strengthened.