European Debt Could Speed Reform

When governments around the world rushed to save banks, bail out companies, and pump up their economies, it seemed to presage a new dawn of big government. In Europe, the expansion of state powers and spending snuffed out more than a decade of economic liberalization and welfare-state reform. The very idea of reform has become associated with the trust-the-markets mindset so thoroughly discredited by the financial crisis. And if that weren't enough, the funneling of taxpayers' billions to banks (and wealthy bankers) has poisoned the atmosphere for any future reform debate.

Big government, however, has run into a wall faster than anyone expected, thanks to an unprecedented run-up in public debt and deficits. In Europe, several governments are on the brink of a deficit crisis, including Ireland, Greece, Britain, and Spain. According to the EU Commission, EU-wide deficits will average 7.5 percent this year, the result of stimulus spending, rising jobless payments, and declining tax revenues. Deficits are exploding just as the demographic crunch is starting to hit many European countries' pay-as-you-go welfare systems, which use the wages of citizens working now to support the jobless, the sick, and the retired. In France and Germany, that pool of current workers has begun to shrink. Rising costs—and fewer working-age people to pay them—are a second crisis fueling deficits and debt. Together, they put governments' backs against the wall.

And that's a good thing. The likely turn of events is that all this pressure on government spending will boost the cause of economic reform in Europe, to the surprise of everyone who hoped for (or feared) a renaissance of state power. That would come as welcome news for Europe's future competitiveness, on which jobs, economic recovery, and so much else depends.

The big beneficiary could be Europe's sickly southern tier, which has long been falling behind more competitive neighbors like Germany. Already, some of these countries are tackling deep-seated problems. Greece has been an economic basket case for decades, gaining entry into the club of countries using the euro only by faking its official economic statistics. Now that it's closer to the embarrassing step of asking the IMF for emergency help, it is finally beginning to tackle the structural flaws of a state-run economy calcified by corruption and patronage. Spain, whose collapsing bubble economy in real estate and tourism has produced 20 percent unemployment, just announced plans for a wave of labor-market reforms.

Big countries, too, will be forced to restart reform. Germany, responding to the run-up in crisis-related spending with a constitutional amendment requiring balanced budgets by 2016, is just beginning the debate over how that mandate should be met—including annual budget cuts beginning this year. No doubt some taxes will be raised, but the bulk will have to come from paring the size of the state.

It often takes a crisis before most politicians even think of risking reelection for necessary but unpopular policy change. Johnny Munkhammar, in his astute 2007 study of the modern history of economic reform, shows how crises have triggered reforms in the past. In Germany it took a decade of crippling mass unemployment before then-chancellor Gerhard Schröder launched an unpopular but effective overhaul of the country's luxurious jobless programs in 2001. Ireland and New Zealand are former basket cases for which liberalization became the only route to growth. In Sweden, a 1990s banking crisis accelerated a reform marathon that has turned a stagnant, overregulated economy into one of Europe's most competitive, while keeping intact many elements of the country's welfare state.

A look at economic history also teaches that recovery will come not from jobs and innovation created by government, nor by big companies that receive bailouts and enjoy state protection, but from small companies and entrepreneurs thriving on open markets and a lighter hand of regulation. That does not preclude—in fact, it requires—strong guarantees of competition and rules that prevent the abuse of market freedoms at the cost of consumers or taxpayers. The crisis hasn't changed this equation, or else you'd see those countries that opened up their economies in the past—such as most of Eastern Europe—reversing course in the crisis. They aren't. For the cause of sane, prosperity-producing policies, there may sometimes be nothing as good as a crisis.