The Welfare State Caused Europe’s Debt Crisis

Obama will go down in history as the president who lost America’s Triple-A credit rating. There is no doubt that Obama is fiscally reckless – borrowing 40 cents of every dollar you spend year in and year out is nothing short of reckless – but many critics of the president’s spending miss out on the fact that Obama is only putting the icing on the cake. America has been on a slow but steady ride to a debt crisis for a long time. Superficially, the reason is a notorious unwillingness to balance the federal budget, but there is a deeper explanation that is all too often overlooked: the welfare state.

Europe provides good evidence that even if you devote all your fiscal policy toward matching government spending with tax revenues – even if you put constitutional measures in place to force your government to balance its budget – you will still not escape the debt crisis. A story from CNBC makes this point:

Standard & Poor’s ratings agency has downgraded France’s credit rating, French television channels reported on Friday, citing a government source. The channels did not provide further details. S&P warned in December that it could downgrade the credit ratings of several euro zone nations if European leaders failed to find a lasting solution to the debt crisis at a meeting of EU leaders that month. Several euro zone countries including France face an “imminent” downgrade by ratings agency S&P, Reuters and Dow Jones news agencies reported, sending the euro to a session low against the dollar and European stocks down. … Germany and the Netherlands were not among the countries facing a downgrade later on Friday, but gave no further details. … John Wraith, Fixed Income Strategist at Bank of America Merrill Lynch told CNBC the confirmation of a mass downgrade would be another serious step in the crisis and would lead to a serious worsening of sentiment. “Clearly these won’t come out of a clear blue sky. These countries have all been on negative credit watch for the last four weeks and many observers — ourselves included — did expect that process to end with ratings action,” he said.

In 1992 the member states of the European Communities transformed the EC into the European Union by ratifying the Maastricht Treaty as the constitution of the EU. One of the most important articles of that constitution is Article 104(c) which effectively mandates a balanced budget in each member state. This paragraph comes on top of measures in individual member states to balance their national budgets. Some of these measures have been in place for many years – there was a wave of fiscal responsibility throughout Europe in the 1980s – but it was not until the Maastricht Treaty that balanced-budget measures became a constitutional issue for the Europeans.

It is important to remember that most countries in Europe have not even come close to national debts of the magnitude that the United States has reached. This is not because their government spending has been more restrictive. Instead, the reason is that they have had basically no compunctions about raising taxes. Over the short term this has allowed them to look fiscally responsible by keeping their deficits to a minimum (with occasional surpluses in some countries) but the ever growing tax burden has slowly but inevitably suffocated the private sector. Europe’s GDP growth numbers were far behind the United States in the 1990s and somewhat behind over the past decade.

Weak growth and perennially high unemployment erodes the tax base, which arithmetically is an important reason why Europe is now facing a debt crisis. Policy-wise, though, there is a more important explanation. The high taxes are there to pay for spending, and in a typical European welfare state the spending is dominated by income redistribution and other types of entitlements. These programs have created a permanent dependency on government where people have become habitually unable to provide for themselves; combined with the high taxes that discourage work, the entitlement programs have perpetuated a need for themselves, so to speak.

By eroding work incentives, Europe’s welfare states have also increased demand for the entitlement programs over the years. A steady rise in demand for entitlements combined with a steady erosion of work incentives is the perfect recipe for a government debt crisis. Europe has been able to put off this debt crisis by raising taxes, but even they have now realized that they are way past the point of having “maxed out” their tax rates.

The problem for Europe is that they now have no choice but to panic-cut spending. We are still a little bit away from that point. We can still choose a prudent path to limited government. But four more years with Obama will definitely take us over the edge into the fiscal dungeon where fiscal panic will set in.

My new book, out in February, elaborates on the difference between a responsible path to limited government and panic-driven budget cuts. In the meantime, take a look at my book on the dark side of the welfare state. It is an eye-opener to what America will become if we don’t start reducing government now.