The Age of Austerity

We have entered the Age of Austerity. It's already arrived in Europe and is destined for the United States. Governments throughout Europe are cutting social spending and raising taxes—or contemplating doing so. The welfare state and the bond market have collided, and the welfare state is in retreat. Even rich countries find the costs too high, but the sudden austerity could perversely trigger a new financial crisis.

Europe's plight is now the most obvious threat to the already lackluster global recovery. The International Monetary Fund forecasts the world economy will expand about 4 percent in 2011. Although this sounds respectable, the underlying growth predictions for the United States (2.3 percent) and Europe (1.8 percent) are so low that there would be little, if any, reduction in the 38 million unemployed in these two major economies.

Clearly, most European nations waited too long to overhaul their welfare states. (The same is true of the United States.) The added costs of the global recession have now forced them to do the politically unthinkable: chop social spending and raise taxes in trying economic times. They have little choice, but it may be a mission impossible.

On the one hand, huge deficits and debts—the sum of past deficits—mean some countries can no longer borrow at reasonable interest rates. Last week, rates were about 10 percent on Greek 10-year government bonds and more than 6 percent on Irish and Portuguese bonds. Even these rates would be higher if these countries hadn't acted to cut long-term budget deficits. By contrast, rates are about 2.3 percent on 10-year German government bonds and 2.4 percent on 10-year U.S. Treasuries.

On the other hand, abrupt tax increases and spending cuts threaten deeper recessions. In Greece, the value-added tax (a national sales tax) was increased four percentage points; the normal retirement age is also being raised. Portugal approved a VAT increase of two percentage points. In Ireland, government workers' salaries were cut an average of 7 percent. In Spain, grants for new children are being abolished. Unemployment rates are already about 11 percent in Portugal, 12 percent in Greece and 14 percent in Ireland.

To some economists, this is folly. Desmond Lachman of the American Enterprise Institute foresees a futile downward economic spiral. As recessions worsen, losses in tax revenue and higher jobless spending will offset some projected improvements to budget deficits. So, more tax increases and spending cuts will be needed.

People will lose patience, Lachman says. Governments will fall or decide that default—repudiating some debts—is a lesser evil than tolerating persistent mass misery. "It's a race between Greece and Ireland" to see which defaults first, he argues. The defaulting country will also abandon the euro and create its own currency to regain some control over its interest rates and exchange rate.

The danger: another financial shock, perhaps like Lehman Brothers' failure. If one country defaults, investors will dump bonds of others. European banks, with more than $1 trillion in loans to Greece, Ireland, Portugal and Spain, will suffer more losses, Lachman says.

Not so fast, argues Jacob Kirkegaard of the Peterson Institute. Europe has acted "pragmatically" to avert doomsday, he says. Because bond markets can force weak countries into bankruptcy—by not buying the nations' debt or imposing punitive rates—Europe has created temporary lending sources. In May, the European Union and IMF rescued Greece with a $146 billion package. The E.U. and IMF have also pledged a roughly $1 trillion fund that other countries (say, Ireland or Spain) could tap. Finally, the European Central Bank—Europe's Fed—is buying the bonds of weaker borrowers.

The ultimate hope is to buy time. Effective deficit cuts, it's argued, will spur economic growth by reassuring bond markets that debt levels are sustainable and justifying lower interest rates. That's also the theory of new British Prime Minister David Cameron, who has proposed shrinking government spending by a sixth by 2015.

Austerity is transforming economics and politics. The Age of Entitlement was about giveaways; the Age of Austerity will be about take-backs. The Age of Entitlement was about maximizing economic growth; the Age of Austerity will be about minimizing economic reverses. Similar dilemmas confront most advanced societies. Even Germany's government debt as a share of the economy is large (73 percent in 2009).

Governments are caught in a vise. Without unpopular spending cuts and tax increases, unmanageable deficits may choke their economies. But those same spending cuts and tax increases also threaten economic growth. The United States is not exempt. Low American interest rates mean bond markets haven't yet turned on us. We need not threaten the recovery by immediately slashing budget deficits. But we do need to act convincingly to curb future deficits. Austerity can't be fun, but how painful it will be is still partially up to us.