Far fewer Europeans than Americans believe public sector defaults are
beneficial. But important Europeans share with Republicans the view that
there are still worse outcomes. For reluctant Europeans, the eurozone must
not be a “transfer union”. For recalcitrant Republicans, taxes must not be
raised. Fiat justitia, et pereat mundus – let right be done even if the
world perishes – is the motto.

The fiscal crises we see are a legacy of the west’s private and public sector
debt binges of recent decades. As the McKinsey Global Institute tells us in
an update of last year’s study of the aftermath of the credit bubble, this
is an early stage of a painful process of deleveraging in several economies
(see chart).* “If history is a guide,” noted the 2010 report, “we would
expect many years of debt reduction in specific sectors of some of the
world’s largest economies, and this process will exert a significant drag on
GDP growth.” So it is proving, with disappointment almost everywhere.

The link between private and public sector debt is intimate. In some
countries, notably Greece, easy credit led to an upsurge in public sector
borrowing. In others, notably Italy, it encouraged governments to relax
attention to debt reduction: its primary fiscal budget (before interest)
moved from a surplus of 6 per cent of gross domestic product in 1997, before
joining the currency union, to 0.6 per cent in 2005. Elsewhere, the sudden
end of private sector credit booms led directly to collapses in government
revenue and surges in public spending: the US, UK, Spain and Ireland are
examples.

Exploding fiscal deficits are mainly the result of collapses in activity and
revenue rather than of bank bail-outs. But fiscal weakness then undermines
the banks, partly because the latter hold large quantities of domestic
public debt and partly because they rely on fiscal support. The private and
public sectors are intertwined. The view of Republican hawks in the US and
of German or Dutch hawks in Europe that the crisis has fiscal roots alone is
wrong. Easy credit ends up in fiscal crises.

US evidence is striking. Compare the forecasts for fiscal years 2010, 2011 and
2012 in the 2008 and 2012 presidential budgets, the first under George W.
Bush shortly before the crisis and the second under Barack Obama well after
it (see chart). The 2011 deficit was forecast in 2008 to be a mere $54bn
(0.3 per cent of GDP). But in the 2012 budget, it is forecast to be $1,645bn
(10.9 per cent of GDP). 58 per cent of this rise is due to unexpectedly low
revenue and only 42 per cent due to a surge in spending, both of these
changes mostly due to the financial crisis, not the modest stimulus package
(about 6 per cent of GDP).

The astonishing feature of the federal fiscal position is that revenues are
forecast to be a mere 14.4 per cent of GDP in 2011, far below their postwar
average of close to 18 per cent. Individual income tax is forecast to be a
mere 6.3 per cent of GDP in 2011. This non-American cannot understand what
the fuss is about: in 1988, at the end of Ronald Reagan’s term, receipts
were 18.2 per cent of GDP. Tax revenue has to rise substantially if the
deficit is to close.

It is not that tackling the US fiscal position is urgent. At a time of private
sector deleveraging, it is helpful. The US is able to borrow on easy terms,
with yields on 10-year bonds close to 3 per cent, as the few non-hysterics
predicted. The fiscal challenge is long term, not immediate. A decision not
to allow the government to borrow to finance the programmes Congress has
already mandated would be insane As the fiscal expert, Bruce Bartlett, has
argued, the law requiring Congressional approval of extra debt might even be
unconstitutional.

Yet, astonishingly, many of the Republicans opposed to raising the US debt
ceiling do not merely wish to curb federal spending: they enthusiastically
desire a default. Either they have no idea how profound would be the shock
to their country’s economy and society of a repudiation of debt legally
contracted by their state, or they fall into the category of utopian
revolutionaries, heedless of all consequences. Meanwhile in Europe, happily,
nobody believes that defaults are good. But Europe is trapped in its own
utopian project: the single currency. Just as members of the Tea Party hate
paying taxes for those they deem unworthy, so, too, do solvent Europeans
hate transfers to those they deem irresponsible.

Alas, as many have long predicted, what would, in the absence of the currency
union, have been a straightforward currency crisis has now morphed, within
these constraints, into an agonising fiscal cum financial crisis. Worse,
spreads on Spanish and Italian 10-year bonds over German bunds have reached
328 and 296 basis points, respectively.

In slow-growing economies with overvalued real exchange rates, these spreads
begin to be dangerous. If they became and remained, say, 400 basis points,
the real interest rate on long-term debt would be 5 per cent. These
countries would then be slowly shifted from a good equilibrium, with
manageable debt, to a bad equilibrium, with close to unmanageable debt.
Italy, with the fourth-largest public debt in the world, is probably too big
to save: Italians themselves must make the decisive moves needed to restore
fiscal credibility. That, in turn, requires both a sharp tightening and
measures to raise the growth rate. Can this combination be managed? Only
with difficulty, is the answer.

These are dangerous times. The US may be on the verge of making among the
biggest and least- necessary financial mistakes in world history. The
eurozone might be on the verge of a fiscal cum financial crisis that
destroys not just the solvency of important countries but even the currency
union and, at worst, much of the European project. These times require
wisdom and courage among those in charge of our affairs. In the US, utopians
of the right are seeking to smash the state that emerged from the 1930s and
the second world war. In Europe, politicians are dealing with the legacy of
a utopian project which requires a degree of solidarity that their peoples
do not feel. How will these clashes between utopia and reality end? In late
August, when I return from my break, we may know at least some of the
answers. * Debt and Deleveraging (update): http://www.mckinsey.com/mgi

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