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The debt crisis in Europe has highlighted how Greece, Italy, and many other countries have obscured the long-standing problems in their bloated public sectors and their unsustainable social-welfare benefits.
European governments have promised too much, to too many, for too long. This fundamental problem has now manifested itself in these countries' unsustainable debt dynamics. Euro membership, which temporarily enabled massive borrowing at low interest rates, has merely aggravated this. For many of these countries, meaningful reform has now become unavoidable.
One hopes that, with the help of national governments, the European Central Bank (ECB), the International Monetary Fund (IMF), and the European Financial Stability Facility (EFSF), the holes in the sovereign-debt-funding dike will be temporarily plugged, and that European banks will be recapitalized. But if the primary surpluses -that is the budget balance net of interest payments - of European countries are insufficient, temporary measures will only postpone the inevitable debt debacle.
Substantial primary surpluses will be needed for many years in order for European countries to stabilize their debt ratio and gradually reduce it to the economic safety zone of less than 60 percent of GDP - the debt ratios of Italy and Greece are currently more than 100 percent - and spending cuts are the only way to improve the budget position significantly.
A credible long-term program of reforms must be implemented now, while temporary emergency measures - bond purchases by the EFSF, IMF, and the ECB - provide breathing room.
There are three fundamental factors that determine the evolution of a country's sovereign debt: its rate of economic growth; its borrowing costs; and its primary budget position, A country with a balanced primary budget collects enough revenue to pay its current expenses but not the interest on its outstanding debt. Higher interest rates, slower growth, and a weaker primary budget position all raise the debt-ratio trajectory. Italy is now paying 7-percent interest annually on its sovereign debt, while its economy is growing at only 1 percent.
Reforming social-welfare benefits is the only permanent solution to Europe's crisis as there are now too many people collecting benefits relative to those working and paying taxes.
The social-insurance systems in Europe, as in the United States, Japan, and elsewhere, were designed under vastly different economic and demographic circumstances - more rapid economic growth, rising populations, and lower life expectancy - from those prevailing today, and in many European countries, the government now pays benefits to a majority of the population.
In the long run, if primary surpluses are achieved by controlling spending, the increase in national savings will promote investment and growth, higher tax rates, however, would work in the opposite direction.
The tax rate required to fund social-welfare benefits depends on three factors: the dependency ratio (the ratio of recipients to taxpayers); the replacement rate (the ratio of benefits to average wages); and the economic-growth rate (roughly, productivity plus population growth). The more generous and widespread the government benefits, the higher the required tax rate. And in Europe's highly taxed economies, better tax compliance or selective revenue measures can produce only a small amount of additional tax revenue without undermining growth. This problem will increasingly affect even the Northern European countries, notwithstanding their current appearance of economic strength and fiscal soundness.
A key question is whether incoming Greek Prime Minister Lucas Papademos and his new Italian counterpart, Mario Monti, both highly regarded economists, have the leadership skills to navigate these treacherous waters. Their examples will test whether other European democracies with heavily benefit-dependent populations can rein in the welfare state's excesses.
It is not an impossible challenge. Canada has staged a substantial retreat from the welfare state's worst excesses, as center-left and center-right governments alike have reduced the share of government spending as a proportion of GDP by eight percentage points in recent years. Several European countries are considering raising their remarkably low retirement ages, or have already done so. Given demographic trends, this may well be Europe's last chance to build a firmer foundation for future prosperity.
Unless temporary stopgaps are combined with fundamental long-term structural reform, another disaster like the current one - or worse - will become inevitable. But that course will be difficult.
Winston Churchill once said of the US that you can count on it to do the right thing once it has exhausted all other alternatives. Let us hope that his dictum proves correct for Europe as well.
The author is a professor of economics at Stanford University and senior fellow at the Hoover Institution. Project Syndicate
(China Daily 11/29/2011 page8)