The document summarizes the issues surrounding the European debt crisis and austerity measures. It discusses how the crisis was sparked by government budget deficits in Greece, Portugal, Spain, and Ireland. In response, the EU and IMF created a $1 trillion stabilization fund to provide financial support with strict conditions of austerity through spending cuts and tax increases. While this may stabilize the situation short-term, the long-term challenges of economic recovery in Europe and budget deficits globally were not fully addressed.

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Weekly Commentary by Dr. Scott Brown
The Age Of Austerity
May 24 – 28, 2010
The European debt crisis encompasses many issues, including problems in the construction of the monetary union.
However, the main catalyst has been concerns about government budget deficits (Greece, Portugal, Spain, Ireland). The
solution, which should be considered a least-worse alternative, is austerity – cuts in government spending and tax
increases for specific countries. Such moves dampen the pace of economic recovery and, in some cases, may lead to
recession. The U.S. is not Greece. The U.S. budget deficit is currently very high (roughly 10% of GDP), but should
decline as the economy recovers and temporary spending (the bank rescue and the fiscal stimulus) fade. The bigger
problem for the U.S. federal budget deficit lies 10 to 20 years out, as Medicare expenditures are projected to surge. At
the state and local level, budget deficits are leading to tax increases and cuts in government services. The trick will be
to trim deficits without dampening growth too much.
Concerns about Greece’s budget situation have been simmering for several months, but reached a boiling point toward
the end of April. Rating downgrades of the sovereign debt of Greece, Portugal, and Spain contributed to a widening in
spreads in government bonds relative to German bunds and ignited worries that one or more countries could exit the
euro. Fear begets more fear. A lack of clear, strong leadership seemed to make matters worse. Greece’s external debt is
relatively small in the grand scheme of things. The bigger worry has been the risk of contagion. After Greece would
come Portugal, then Spain, Ireland, and Italy. These last three represent a much more substantial risk to the big banks in
Germany, France, and the United Kingdom.
On May 9, European finance ministers agreed to a stabilization fund, worth up to €500 billion, to be supplemented by
an additional €250 billion from the International Monetary Fund (which brings the total size to roughly $1 trillion).
Swap lines between the U.S. Federal Reserve, the European Central Bank, the Bank of England, the Bank of Canada,
and the Swiss National Bank were reopened. These moves and the size of the EU/IMF stabilization fund caught
speculators off guard – at least, for a day. A lack of details and the realization that the problems were still there soon
sent global equity markets down again. The EU/IMF plan has merely bought some time. The challenge will be to use
that time wisely. The response from global investors does not appear to be optimistic.
Aid to Greece was conditional on severe austerity moves, cuts in government pensions and wages. This led to protests
in the streets – and the television images of these protests generated more concerns, particularly among U.S. investors.
Austerity is also being self-imposed by the potential problem economies.
These countries are recovering from the global financial crisis. The last thing you want to see in a fledging recovery is
tighter fiscal policy (higher taxes, cuts in government spending). That weakens the recovery. However, the prescription
here is seen as the least-worse alternative. Financial conditions, and in turn, long-term economic growth, would be
worse if these budget problems were not addressed. The bottom line is that we’re looking at a slower pace of recovery
in Europe in the near term.
Budget issues aside, some of the worries about the euro go back to its construction. With its own currency, a country

2. could devalue, making it more competitive. With a common currency, that’s not possible. In the U.S., fiscal policy can
address downturns that are more severe in some states, but not in Europe. We could ultimately see a strong fiscal
authority in Europe, but that’s not expected anytime soon.
In general, the level of exchange rates is not a major worry for policymakers. The key issue is the speed of adjustment.
Sharp moves in the currency markets discourage global trade and investment. Intervention could provide temporary
restraint on currency movements, but would have to be a coordinated effort. Interestingly, rumors about possible
intervention were enough to check the dollar’s rise last week.
So how does the U.S. budget situation compare to Greece? Greece’s budget deficit had been projected to rise even
further as a percentage of GDP in the years ahead. In contrast, the U.S. budget deficit is expected to fall to about 3.5%
of GDP in four or five years, as the economic recovery leads to a rebound in revenues and temporary spending fades.
Longer term projections are more worrisome. Demographic issues (the retirement of the baby-boom generation) may
require minor adjustments to Social Security, but Medicare spending is projected to rise sharply (and this is nothing
new, we’ve know about the problem for many years). We need a credible plan on how to deal with the situation in the
years ahead.
State and local budgets in the U.S. remain under enormous strain, leading to tax increases and cuts in government
services (which have subtracted a few tenths of a percent from GDP growth in the last two quarters). Revenues should
improve as the economy recovers, but tough choices will have to be made over time regarding taxes and spending at
every level of government. This implies that the pace of economic growth will be somewhat lower than it would be
otherwise.
The European debt crisis is largely regional. There will be positive and negative effects on the U.S. economy – some
weakness in exports to Europe, but the flight to safety has already lowered long-term interest rates and reduced oil
prices, both of which will help aid the U.S. economic recovery.