This is a very long article. I tried to keep it as short as possible, but the topic does not lend itself to brevity. I therefore decided to let the discussion, not the format, determine its length. 

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The European debt crisis has reached such proportions that it is now threatening the political stability of many EU member states. This raises the important question of what the consequences will be for Europe’s chosen form of government, the parliamentary democracy. If voters in, e.g., Greece, Spain and Italy see that their democratically elected governments are not governing based on their preferences and desires, but taking marching orders from entities outside their country, will they at some point lose faith in their democratic system?

Not much attention has been paid to this issue. That is unfortunate: based on what is happening in Europe on an almost daily basis you cannot draw any other conclusion than that there is a slowly but steadily rising threat to democracy in the very part of the world that invented it.

Not everyone is turning a blind eye to the perils associated with the debt crisis. In the German news magazine Der Spiegel, Cordt Schnibben writes a good analytical piece about how the debt crisis is eroding the status of the parliamentary system. His conclusion is wrong – he blames the creditors who lend money to governments for effectively nullifying democracy – but his route to that conclusion is filled with good observations and pertinent questions.

Since Schnibben is German, he has a very wordy writing style. Therefore, his piece has spilled out into three long sections. For the purposes of reasonable brevity we are not going to discuss them all in great length, but instead highlight some of his main findings.

His opening question is:

Be it the United States or the European Union, most Western countries are so highly indebted today that the markets have a greater say in their policies than the people. Why are democratic countries so pathetic when it comes to managing their money sustainably?

The answer is obvious: too much government spending. But as Schnibben shows, a longer answer can sometimes be instructive and helpful. This is especially true when it comes to the relationship between government indebtedness on the one hand and freedom and democracy on the other.

On to his first part, where Schnibben paints a grim but accurate picture of a Western world deeply mired in debt:

In the midst of this confusing crisis, which has already lasted more than five years, former German Chancellor Helmut Schmidt addressed the question of who had “gotten almost the entire world into so much trouble.” The longer the search for answers lasted, the more disconcerting the questions arising from the answers became. Is it possible that we are not experiencing a crisis, but rather a transformation of our economic system that feels like an unending crisis, and that waiting for it to end is hopeless? … Is it possible that financial markets will never become servants of the markets for goods again? Is it possible that Western countries can no longer get rid of their debt, because democracies can’t manage money?

The first question is of a more eclectic nature, but the question of how a democratic form of government can sustain under the heavy pressure from government debt takes us right to the frontline of the European crisis. The immediate reason for this is that all governments in the EU that are currently subjecting their citizens to harsh austerity policies are democratically elected. Large segments of the populations in austerity-hit countries are vehemently opposed to those policy measures. The tougher government gets on entitlements, the more serious the hardship that people suffer through. As their lives get tougher, people alienate themselves from their elected officials whose policies inflict that hardship.

So long as the only ones suffering are the poor and needy, a cynical observer could make the point that there won’t be enough voters around to vote for totalitarian alternatives to the democratic form of government. But I have never been a fan of political cynicism, and I also want to point out that the current austerity measures in Europe are eating their way into deeper layers of the population. Austerity is now entering the living rooms of the middle class.

Europe is not yet turning its back on democracy, but there are enough signs across the continent for everyone to be concerned.

It is important to keep in mind, though, that government indebtedness is not just a problem for democratic governments in Europe. We here in the United States are very wise to pay attention, in part because we are vulnerable to the same socio-economic mechanics as Europe, and in part because our culture of borrowing to pay for government entitlements is at least as old as it is in Europe. Schnibben again:

Until 1971, gold was the benchmark of the US dollar, with one ounce of pure gold corresponding to $35, and the dollar was the fixed benchmark of all Western currencies. But when the United States began to need more and more dollars for the Vietnam War, and the global economy grew so quickly that using gold as a benchmark became a constraint, countries abandoned the system of fixed exchange rates.

It is correct that the U.S. borrowing during the Vietnam War era was the beginning of the end of the Bretton Woods system of fixed international exchange rates. However, it is an irresponsible over-simplification to say that the deficits were driven by the war in Vietnam. During that same period of time the federal government created or significantly expanded a number of entitlement programs, the foremost among them being Medicaid and Medicare.

The emergence and expansion of the American welfare state is a key explanatory factor behind our persistent deficits. The Vietnam War ended in 1974, but the federal deficit prevailed.

Back to Schnibben, who makes an interesting point about financial-market deregulation and the proliferation of deficits in welfare-state budgets across the Western world. We need to examine this point in order to move on to the issue of whether or not democracy is threatened by the debt crisis:

A new phase of the global economy began, and two processes were set in motion: the liberation of the financial markets from limited money supplies, which was mostly beneficial; and the liberation of countries from limited revenues, which was mostly detrimental. This money bubble continued to inflate for four decades, as central banks were able to create money out of thin air, banks were able to provide seemingly unlimited credit, and consumers and governments were able to go into debt without restraint.

Not without restraint. The only reason why banks will ever lend money to private citizens with sub-prime credit is that governments create artificial conditions on the credit market. If banks do not have to accurately assess the credit risk of a sub-prime borrower, then obviously it will be more inclined to lend on that market than if free-market conditions prevailed.

The same goes for governments. They don’t borrow because there is easy credit available. They borrow because they have come up with a reason to spend money.

There is, however, an important element in Schnibben’s argument, namely the parallel between private and public debt. It is true that private debt ratios have grown by unhealthy numbers over the past few decades, but so has the cost of government. Taxes in the Western World are higher today than ever before, and the trend of rising tax ratios – taxes as share of private earnings – began about three decades ago. That was the point in time when government spending in many welfare states had grown past the magic 40-percent of GDP mark.

Beyond that point, it becomes too costly for the private sector to absorb and adapt to the costs of government. Instead they simply choose to go into long-term decline. This affects GDP growth over time, which in turn leads to an erosion, in relative terms, of the tax base. Government spending, on the other hand, continues to grow as per the preferences of our elected officials.

As a result, we see persistent deficit problems in every welfare state. This in turn motivates government borrowing and a monetization of the deficits. Hence the point Schnibben makes. But it is also important to note that higher taxes make it increasingly difficult for middle-class families to finance a house, a car, even furniture, appliances or other long-term items. Germany is one example of what this can lead to; the Spanish mortgage crisis is another example.

Schnibben then goes on to his second part and addresses the consequences this debt accumulation has for democratic government:

The one sovereign stalks the other, while the pressure of the markets contends with the pressure of the street. In Europe, in particular, this has become an unequal battle. Since Jan. 14, 2009, when Standard & Poor’s downgraded Greek government bonds, the markets have determined the direction and pace of European integration. They want bigger and bigger bailout funds, they want to safeguard their claims, they want a European Central Bank that buys up government bonds indefinitely, they want slashed government budgets, they want labor market reforms like the ones in Germany, they want wage cuts such as those in Germany and, at the same time, they want these incapacitated countries mired in recession to offer the prospect of healthy growth.

This is where Schnibben goes wrong. He gives the impression that the credit rating institutes somehow dictate the economic policies of heavily indebted European countries. That is not true: the governments in Greece, Italy and Spain are bound to the last euro they spend by dictates or nosy oversight powers from the EU, the ECB and the IMF. The Italian prime minister is not even elected by the Italian people – he is a bureaucrat appointed by the three aforementioned organizations.

The Greek austerity programs that have decimated the economy over the past three years were not forced upon Greece by Standard & Poor; they were put in place by the European Union in exchange for loans that provided fiscal life support for the government.

Schnibben implies that the credit rating institutes have replaced the legislative part of government in indebted countries. But credit rating institutes only respond to how countries handle their debt. It is not their fault that Greece has accumulated a debt and thereby has made itself a ward of the EU. If anyone outside of Greece has taken over that country, it is the eurocracy in Brussels.

Despite missing this point, Schnibben correctly argues that the indebtedness of Europe’s governments reinforces the mistrust that has already created a rift between European institutions and national governments, and between national governments and their voters. He then makes an interesting and provocative observation:

The democratic decision-making process reaches its limits in this fundamental crisis, but even in the decades when debt was being accumulated, it was clear that democracies have a troubled relationship with money. There was always justification for new debt. The catchphrases included things like more jobs, better education and social equality, and the next election was always around the corner. Debt was justified at the communal level to expand bus service or build playgrounds, at the state level to hire more teachers or build bypasses and, at the federal level, to buy tanks and fund economic stimulus programs.

This problem has been exacerbated by the expansion of entitlement programs that make endless commitments of cash or in-kind services to “entitled” citizens. These programs reached their full “maturity” in the ’70s and came with tax increases. Those increases in turn caused a permanent slowdown in GDP growth all across Europe. (The United States did not reach this point until after the Millennium recession.) As a result the tax base eroded and Europe’s welfare states found themselves dealing with perpetual budget-balancing problems.

What to do? Politicians who had created the welfare state ruled out spending cuts. That of course did not solve the problem: tax revenue shortfalls despite record-high taxes led governments into accumulating debt.

Schnibben misses out on this aspect, but his point about a long-term trend in debt is nevertheless valid. Then he reaches one of the most provocative parts of his analysis:

A closer look at which countries acquire and pay off debt, and to what degree, reveals unsettling correlations: The more often governments change and the more pluralistic they are, the faster the debt increases and the more difficult it becomes to pay if off. The more democracy, the looser the money.

Apparently, once again mankind has proven that when people can vote themselves free money, they’ll do it…

Just to drive home the point about how difficult it is to rein in this kind  of structural deficit, Schnibben explains:

To hold an administration responsible for the debts of its predecessors, there are debt limits in democracies. In Helmut Schmidt’s day, for example, there was a provision in the German constitution stipulating that total debt could not exceed total investment. In Europe, the provisions of the Maastricht Treaty, which is aimed at ensuring the stability of the common currency, limit the amount of debt a government can accumulate to no more than 60 percent of gross domestic product. So far, such debt limits have never worked in any country.

In addition to the problem with the ideologically driven welfare state, there is also a problem of a cultural shift. Before the welfare state people defined progress as them being able to make more money, expand their business, climb up the career ladder or in other ways bettering their own lives – based on their own work. By contrast, under the welfare state progress becomes associated with more spending on entitlements.

Living off someone else’s money becomes part of the culture. When you run out of that someone else’s tax money you borrow to keep “improving” and making “economic progress”.

This cultural shift from self determination under a limited government to self subjugation under a welfare state has been hard to grasp for Americans, but the 2012 election probably provided a glimpse of what this means in reality. This new culture has almost become part of the European genome, and once our welfare state has reached European proportions we will inevitably experience the same type of cultural metamorphosis. (This is why we need to end the welfare state, not just rein it in.)

Since entitlement spending almost by definition grows faster than tax revenues, this cultural shift reinforces a trend of perennial budget deficits. As Schnibben explained, that trend is strong enough to blow right through any legislatively imposed debt limit.

So where do we go now? Do we sacrifice democracy, acknowledging that it does not work because people will always vote themselves a slice of someone else’s pie? Schnibben draws his conclusions in the third part, but unfortunately he goes really wrong. Asking three questions, he turns on capitalism and the free-market economy:

First, how can a debt-ridden economy grow if a large part of demand in the past was based on debt, which is now to be reduced?

This is fairly simple. Structurally reform away the welfare state, cut taxes proportionately to each reform and restore the self-determining individual that was the foundation of the economic success of Western Civilization.

Schnibben’s second question:

The second major problem of modern capitalism is this: How can the unleashed financial markets be reined in again, and how should the G-20 countries come up with joint rules for major banks, which are their financiers and creditors, and for markets, which punish and reward these countries through interest? How much freedom do financial markets need to serve the global economy as a lubricant, and what limits do they need so that banks, shadow banks and hedge funds do not become a threat to the system?

Once again: the current crisis was not caused by banks. It was caused by:

a) Entitlement-minded politicians in America who thought that it was everyone’s right to own a home, who therefore took over most of the mortgage market in order to incentivize, encourage, strong-arm or force banks into giving loans to people with as low a credit score as 480;

b) Likeminded politicians in Europe, primarily Spain, who wanted to make sure that people who made less than $19,000 per year could get a mortgage loan; and last but absolutely not  least,

c) Spending-addicted politicians whose relentless expansion of the welfare state has created fiscally unsupportable entitlement programs.

When welfare states cause budget deficits, governments issue treasury bonds. Up until a couple of years ago such bonds from Western countries were considered iron-clad investments. As a result, lenders asked for very low interest rates.

Today, we know that welfare states can default on their loans – it is called “debt restructuring” or something similarly fanciful, but it is always, at the end of the day, a partial default where lenders are forced to forgive part of the loans. This has of course led lenders to demand higher interest rates, for the very same reason as someone with excellent credit gets a lower interest rate than someone with a fair credit rating.

This simple fact is hard for many analysts, talking heads, politicians and other pundits to grasp. Perhaps it is easier for them to do so if they ask themselves: would I rather lend $100 to my hard-working, always-reliable brother, or to my other brother who drinks, can’t hold a job and always has a stupid story to tell to explain why he needs to borrow from you?

Bottom line: banks were roped into the current crisis by lending to private citizens based on artificial credit market conditions, and by lending to governments that had promised more spending than they could ever earn from taxpayers. Their crisis is a symptom, not a cause, of the real crisis.

Schnibben’s third question reinforces the impression that he is not entirely clear as to what has caused the debt crisis:

Third, how do governments mediate between the power of the two sovereigns, how do they reestablish the primacy of citizens over creditors, and how does democracy function in debt-ridden countries?

End the welfare state. That is the only way for the Western world to avoid going over the fiscal cliff.

Again, Schnibben makes a good point that democracy is in danger in countries that are about to default, or already have defaulted, on some of their debt. But the threat does not come from credit rating institutes or banks – it comes from people whose lives are being destroyed by austerity. They lose faith in democratic government because the democratic government is the one subjecting them to hardship.

It would be a terrible mistake – a fateful one in fact – if the West decided to try to get out of its crisis by crippling capitalism and the free market even more than is already the case. The welfare state cannot live without a functioning free-market economy.

On the other hand, the free-market economy can live without the welfare state.