Practical Economics


Euro-style Debt Disaster? Not Here

The deficit causes problems, but America won’t follow in the footsteps of Ireland and Greece.



It’s a deficit hawk’s worst nightmare. The government fails to rein in excessive spending. Bond markets lose faith in the government’s ability to repay its debts. Interest rates spike, making it increasingly expensive for the government to borrow money, either to provide essential services or to finance existing debts. The bills come due. Unless a rescue package can be negotiated, the government defaults, sending shock waves through the global economy.

This doomsday scenario underlies every political argument about the importance of cutting the federal deficit. The sheer size of the U.S. government debt, now estimated at 95% of gross domestic product, makes this scenario seem all too real.

We’ve seen this play out in many emerging markets over the past two decades: Mexico in 1994-95; Thailand, Indonesia and South Korea in 1997-98; Russia in 1998; Brazil in 1998-99 and Argentina in 2001-02. Now we’ve had a front row seat while similar crises play out in Europe. First came Greece, then Ireland. Now Portugal, Spain and even Italy appear under threat.

But are Europe’s debt crises a glimpse of America’s future? Not necessarily.

Advertisement

That the U.S.’ gross debt, including IOUs to the Social Security Trust Funds, will soon exceed 100% of GDP is daunting. But it’ll level off soon after crossing that threshold. Contrast that with Greece, where debt will rise past 150% of GDP in 2011 and continue to climb for several years more, no matter how much Athens cuts government spending.

Ireland has been cutting government spending and raising taxes since April 2009, and sharper austerity measures are in the works. But its debt-to-GDP ratio will climb past 110% next year and 120% in 2012. Italy, which has shown less fiscal discipline, is on the threshold of 120% right now.

When it comes to government debt -- and more importantly, bond markets’ perceptions of government debt -- the U.S. enjoys two major advantages over the troubled euro zone states: The first is better economic growth. The U.S. is poised for 2.8% GDP growth in 2011. That’s a slow recovery by American standards. But compared to what’s going on across the Atlantic, it looks positively torrid. Most euro zone states can expect GDP growth below 2% for years to come, with Germany the main exception.

Furthermore, public spending plays an outsize role in euro zone economies, compared to that of the U.S. Austerity will retard their growth far more than will such cuts in America. That’s particularly the case for Spain. Its debt-to-GDP ratio is about 70% and climbing. Sounds modest, but Spanish unemployment is already at 20%. Spending cuts will drive it up further. That raises the question of where Madrid will get the revenues to pay its debts.

The second critical difference is that the U.S. can conduct an independent monetary policy. The Federal Reserve took a lot of heat over quantitative easing, but the move weakened the dollar, making U.S. exports more competitive. Euro zone members have no such option. In order to boost their competitiveness, they must cut costs, including wages. That promises deflation and slower growth for years to come. And again, the fewer euros their citizens earn, the less money governments will have to pay their creditors.

The bottom line? The U.S. enjoys a greater capacity to pay back its debts. For that reason alone, bond markets are likely to cut America more slack.



Get Practical Economics by e-mail for FREE. Registered users on Kiplinger.com can sign up to receive more than 20 valuable updates. Register Now »

Editor's Picks From Kiplinger


More Sponsored Links


DISCUSS

Permission to post your comment is assumed when you submit it. The name you provide will be used to identify your post, and NOT your e-mail address. We reserve the right to excerpt or edit any posted comments for clarity, appropriateness, civility, and relevance to the topic.
View our full privacy policy


Advertisement

Market Update

Advertisement

Featured Videos From Kiplinger