Europes Lesson: Overspending Is Not The Answer

At the G-20 summit, leaders agreed to a $1.1 trillion capital injection to be provided by the IMF and the World Bank so that they can provide emergency credit to countries in distress, particularly developing countries. Unlike what President Obama had wanted, however, no global “stimulus” spending will be forthcoming and European leaders resist more deficit spending. Why? The answer lies in entitlement reform.

Resisting calls to spend more in order to “stimulate” the economy out of its downturn, German Chancellor Angela Merkel said this past weekend: “I will not let anyone tell me that we must spend more money...We must look at the causes of this crisis. It happened because we were living beyond our means...We cannot repeat this mistake.” Germany has set aside about 4% of GDP for stimulus so far and has resisted increasing that to the extraordinary American level of about 8% of GDP.

French President Nicolas Sarkozy, meanwhile, has defied left-wing strikers by refusing to spend more on stimulus than he has consented to so far: just $17 billion in new spending of which $8 billion will go towards France’s auto-industry. Sarkozy is, however, holding firm on his plan to cut taxes on higher earners and implement other reforms to boost France’s economic vitality.

President Obama remains a popular figure in Europe: so why are European leaders vocally resisting his lead, and that of the Democrat-controlled Congress, in spending the big bucks to stimulate the economy?

The answer can be found in a difficult process that has pre-occupied continental European leaders for almost twenty-five years: entitlement reform. Since the mid-1980s, most European countries have eschewed easy spending policies in favor of austere budget-cutting. This process has been politically and socially difficult and it has carried a significant human cost: it has nevertheless been pursued by leaders from the left and the right out of necessity. European leaders are not willing to interrupt this difficult, multi-decade process for the sake of temporary political expediency.

Indeed, the persistent budget crunch that many Western European welfare states have faced for decades is a vivid warning of what may happen in the United States if entitlement programs are not reformed soon. Looking at Western European countries, it’s easy to forget that as recently as the 1960s, levels of public spending in Western European countries were similar to those in the United States: about 30% of GDP on average.

What has changed since 1960 to make the contrast in public spending between the two sides of the Atlantic so dramatic? Europe’s welfare states sharply boosted spending as a percentage of GDP in the 1970s and 1980s: in many cases this was not the result of fiscally irresponsible governments (although there were some) or the result of new entitlement programs (although there were some). Rather, the boost in spending often reflected the delayed costs of entitlement programs that had been adopted by previous European governments under rosy economic assumptions.

Figure 1: Government spending in Western European countries was similar to that of the United States in 1960. Between 1960 and 1980, government spending as a percentage of GDP soared in most European countries while it rose only slightly in the United States (Source: Tanzi & Schuknecht 2000).

To the extent there was any reform of entitlement programs in European countries in the 1970s and 1980s this was for the most part a reactive process, not a pro-active one. As President of Business Europe Ernest-Antoine Sellière stated recently: "Unfortunately, governments tend to reform as a last resort, yet this is highly detrimental.”

Today, European leaders are doing their best to put their fiscal balance sheets in order. What is striking is that so many austerity measures have been implemented by left-of-center European leaders. Often, only they have enjoyed the legitimacy to administer the tough medicine welfare states need to regain economic vitality, particularly in countries where labor unions are powerful political players.

Upon taking office in 1983, left-of-center Portuguese Prime Minister Mario Soares declared: “This government will be austere, uncompromising, and unpopular if that is what is required to achieve economic recovery.”

In Sweden in 1992, Mona Sahlin, a leading Social-Democrat, issued a remarkable mea culpa: “We went too far in telling everyone ‘We will take care of you’ with always more wages, more vacation, more benefits…You have to teach people now to take responsibility for their families and their kids.”

In Italy in 1992, Socialist Prime Minister Giuliano Amato announced budget cuts of $75 billion, mostly in pensions and public healthcare, as he stated publicly: "The state can no longer guarantee everything to everybody.”

In France, the Socialist government of Lionel Jospin that governed from 1997 to 2002 surprised many with the strength of its privatization program, even floating shares of France Telecom and Air France—politically sensitive companies—on the Paris stock exchange. Asked on TV in September 1999 what he was going to do about the 2,000 layoffs announced by tire maker Michelin, Jospin said : “I don’t believe that one should expect everything from the state or the government.”

In 2003, Gerhard Schröder, Germany’s left-of-center Chancellor, called for a “change of mentality” in his own party, the SPD, and in German society as a whole. “Much will have to be changed to keep our welfare and social security at least at its current level,” he stressed, as he argued in favor of reforms that would trim entitlements, and cut taxes. The Chairman of the SPD, Franz Muntefering, supported the tough medicine administered by Schröder (Merkel’s predecessor) by saying: “we believe that things must be rearranged and restarted in Germany in this decade.”

In July 2006, then-Prime Minister Romano Prodi of Italy and his minister for economic development Pierluigi Bersani strongly defended an economic liberalization law then under consideration. After a meeting with Confesercenti, an association of small business owners, the left-of-center Prodi defended the measures by saying: ’Protests are always understandable, but the more I examine the decision taken the more I see that they are in the general interest…This maneuver by the government will allow Italy to lose 10 kilos of fat and gain 5 kilos of muscle.”

American policymakers, however, have not been very good at all at implementing austerity measures in recent decades, particularly outright spending cuts. On the campaign trail, President Obama publicly voiced a commitment to entitlement reform, but it now seems that his Administration favors a significant expansion of entitlements rather than a reduction of their future growth.

Over the next several decades, the U.S. faces an estimated $50 trillion shortfall stemming from existing budgetary commitments to the Social Security, Medicaid and Medicare entitlement programs. Of these three programs, the shortfalls affecting Medicare are by far the most severe. The three entitlement programs normally grow on auto-pilot: Congress does not change their appropriations through the political process on an annual basis.

Whereas European policymakers in the late 1970s and 1980s could say with reasonable justification that they were caught off guard by rapidly deteriorating public deficits and rising rates of spending, by now U.S. policymakers have received warnings for years that entitlement reform is a necessity: these policymakers will not be able to proclaim ignorance of the urgency of entitlement reform in coming years.

Figure 2: U.S. federal pending projections issued by the Congressional Budget Office in December of 2007 are grim: the “alternative” scenario discounts budgetary gimmicks and is a more realistic set of projections than the “baseline” estimates. These projections do not include spending on the troubled assets and stimulus packages passed in 2008 or 2009, nor do they include bold new spending programs eyed by the Obama Administration.

The President of the San Francisco Federal Reserve Bank, Janet Yellen, has said that when looking ahead five, ten or fifty years, “we begin to look at numbers that are truly staggering and frightening…the growth of the federal budget is explosive.” She elaborated: “The federal budget deficit is not sustainable…I’m concerned that the people take it as a given they have Social Security, Medicare and support from Medicaid to pay for nursing home care…A lot of people are not well prepared for retirement.’ ”

Current Federal Reserve Chairman Ben Bernanke told Congress in January of 2007: “We are experiencing what seems likely to be the calm before the storm… spending on entitlement programs will begin to climb quickly during the next decade…” In February of the same year, Bernanke added that “if early and meaningful action is not taken, the U.S. economy could be seriously weakened, with future generations bearing much of the cost.”

In August 2007, then-Comptroller-General of the United States David Walker drew parallels with the decline of Rome and said bluntly: “Long-range simulations from my agency are chilling... much of government today is on autopilot, based on social conditions and spending priorities that date back decades…by 2040 our government could be doing little more than sending out Social Security checks and paying interest on our massive national debt…there are striking similarities between America’s current situation and that of another great power from the past: Rome.” Walker later told a concerned Financial Times writer that he meant what he said and that “he had mentioned some of the issues before but now wanted to ‘turn up the volume’…I’m trying to sound an alarm and issue a wake-up call.”

With all of these warnings, one would expect American policy makers to act pro-actively, to take actions while problems are still manageable. But instead, they seem to be dodging a politically sensitive issue. The current Democratic-controlled Congress is adding severely to America’s financial liabilities: after spending trillions on bank asset relief packages, auto bailouts and a highly flawed stimulus measure, many remain firmly committed to spending an additional $600 billion or more as a “down payment” on healthcare reform.

The stimulus package poses a risk to future fiscal stability: one reason for which a number of U.S. governors (Jindal of Louisiana, Palin of Alaska and others) have rejected parts of the stimulus package is because it would create a permanent increase in spending at the state level that would be extremely difficult to reverse in future years.

Many policy makers are reluctant to oppose well-organized groups of Social Security and Medicare recipients. The recent eligibility expansion of government health insurance for children (SCHIP) to families of four with span>an annual income of $66,000< highlights just how much the current Congress has forsaken fiscal discipline and rationality for the sake of easy voting on the basis of raw emotions.

Members of both parties seem to share the view of progressive economist Paul Krugman, who writes:

“I'm all for looking ahead. But most of this is just wrong-headed, on multiple levels. Let me start with the easiest piece: why the distant future of Medicare is something we really should ignore…the main reason medical costs keep rising is that the range of things medicine can do keeps increasing…. Long-run projections assume, perhaps correctly, that this trend will continue… But does it make any sense to worry now about how to pay for all that? Intergenerational responsibility is a fine thing, but I can't see why the cost of medical treatments that have not yet been invented, applied to people who have not yet been born, should play any role in shaping today's policy” [emphasis added].

Anyone who is familiar with the experience of Western European welfare states in recent decades reads Krugman’s words in disbelief: there is every reason to be pro-active in tackling entitlement reform.

Many Republicans did not lead on the issue of entitlement reform when they were in control of Congress: they often avoided making tough choices and in some ways worsened coming shortfalls. On the pressing issue of Medicare reform, Republicans voted narrowly in 2003 to add a new prescription drug component to the program: titled Medicare Part D, the benefit will cost trillions over future decades.

The desire of the current Democrat-controlled Congress for more spending seems insatiable, and the feeling remains strong in Congress that America’s most pressing needs can somehow be “fixed” by spending of additional trillions.

The experience of European countries ought to tell us otherwise--expanding entitlements is a deeply harmful process that can create severe budgetary turmoil and economic harm to future generations. The grim CBO projections don’t even capture the most recent rounds of spending in its projections on future U.S. spending and deficits.

The U.S. is almost unique among industrialized countries in that it is in a position to avoid the mistakes made by many Western European countries, in part because American youthful demographics are more favorable than Europe’s older composition. The U.S. will only succeed in doing so, however, if its policy makers act with far more determination than European policy makers did in the 1970s and 1980s to stem the tide.

In future years, when they regain political power, conservatives will likely face the difficult task of reforming entitlements while minimizing the social fallout of the citizens who have come to view them as acquired rights. All the more reason to take Western Europe’s lessons on public spending growth seriously: at the moment, it seems that even with plentiful European evidence of the dangers of too much public spending, American policy makers are unwilling to change course, willing to repeat the mistakes of Western European countries while the leaders of these very countries argue in favor of a different course.