Greece’s embrace of partial default is being heralded as a triumph. And if avoiding rampant disaster can be hailed as a victory, so it is! Although it remains to be seen what will follow in regard to credit default swaps being activated and Greek’s credit rating, it appears that an orderly, as opposed to tumultous disorderly, default has been arranged, while insulating the rest of Europe from the fallout.
Of course, this momentary optimism may fade — the ECB has managed this event by effectively taking over Greece’s debts and those of other EU indebted countries, rendering private bondholders junior parties. This may eventually create trouble for Portugal, Spain, and Italy, if private bondholders decide to bail out to avoid the risk of having a similar haircut imposed on them.
Yet what of the big picture — is Europe, and its southern tier in particular, on course to avoid future rounds of crises? Or is pain just being delayed, as it has been for the last three years?
To answer this, let us focus on the distinction between “austerity” and “adjustment.” The real problem of Europe’s economies is that they have to make a major adjustment to changing global realities. The populations of European countries are aging and their workforces shrinking, this will upset the established financing mechanisms for pensions and health care and limit growth. The limit in growth comes from two directions — First, more government spending will go to health care and pensions; this may crowd out financing for universities, basic research, infrastructure, and other basic underpinnings of growth. Second, the growth in the labor force and consuming public that was created by a half-century of solid 1% per year growth after WWII is ending or being reversed; not only will there be fewer workers but also less demand for new homes, appliances, cars, and other major consumption items.
To wit: In 2000, the ratio of potential workers aged 25-64 to those over 65 in Germany, Italy, and Greece was 2.5, 2.3, and 2.3. If each of these workers paid taxes toward pension support of 20% of their income, pensioners in 2000 could receive 50% or 46% of the prevailing average wage.
But this ratio is changing with staggering speed: by 2030 the ratio in these countries will be 1.26, 1.4, and 1.6. This means that in order to provide pensions worth 50% of the prevailing average wage, taxes on those working would need to rise to 40% in Germany, 36% in Italy, and 31% in Greece. That does NOT include additional taxes needed to cover the higher health costs and nursing care for an older population.
In short, taxes for pensions alone will need to nearly double — either that or retirement must be modified with regard to age and level of benefits.
There are a couple of less drastic solutions that will make everyone happier. That is for states to borrow instead of tax to pay the costs of transitioning to when the baby-boomers have departed and the ratio of workers to retirees returns to over 2.0. But for that to occur, state debts must be reduced without further draining growth, as states are already near the limits of the debt that they can support.
A second is for growth to pick up, raising productivity among workers, allowing higher taxes to be paid for transfers to the elderly without driving out either other government income or depressing private consumption. But that requires state investments in energy, infrastructure, education, and research, which can be financed out of either current tax revenues or debt.
The logical answer to this problem of adjustment is to take advantage of today’s already locked-in low government debt by encouraging inflation – to reduce the real value of both private debt and government debt. This will speed the deleveraging process and allow more private consumption growth and more government spending to promote growth. It will also pave the way for state debts to decline in real value before 2020 when they then could be increased again to manage the baby-boomer’s late years.
However, the plan Europe is following to deal with its current crisis is not adjustment, but austerity — depress government spending, keep inflation low, and pay off today’s debts at nearly full value (except for Greece, which is promised to be a one-off exception).
It should be obvious that austerity will lock out both of the pathways to reducing the pain of tomorrow’s necessary adjustment to the demographic changes already established in Europe. On this course, Europe will face surging pension and health care expenses while burdened with still large real debts and a decade of lost opportunities for state investments to boost growth.
This is a recipe for greater pain in the future; so enjoy today’s little triumphs. They do not bode well for the decades ahead.