Four forces threaten a fiscal crisis in several Western countries

Horizons article
April 9, 2024

The recent disaster in Baltimore, where a bridge collapsed and has since blocked the city’s harbor, not only reflects a larger issue with infrastructure quality in the US, but points to an even bigger challenge facing the country: the growing pressure on the US government’s finances. As we showed before, the budget deficit of the US is at levels last seen during World War II. Beyond the aging, crumbling infrastructure, other parts of the economy will require financial support from the US government as well. In fact, in recent years, four types of costs have suddenly emerged for the US government:

  1. Demographics. The aging population has led to a structural increase in government spending on healthcare and pensions.
  2. Geopolitics. New international conflicts have led to more government investment in defense and local production (or “autarky”, as we describe here).
  3. Infrastructure. The deterioration of infrastructure has led to more investment in new transport and energy systems as well as maintenance.
  4. Interest rates. As a result of higher interest rates (for the first time in decades), interest payments on the national debt now account for about half of the US budget deficit.

Critics argue that because of these four changes, US government spending is on an unsustainable path and the country is headed for a fiscal crisis. The Congressional Budget Office (CBO), for example, has warned ahead of the 2024 elections that the US could face a fiscal crisis similar to the one that hit the UK in September 2022. Back then, the Bank of England was forced to intervene when a new government budget nearly triggered a crisis in UK pension funds due to a spike in the risk premium on UK government debt. It also led to the quick resignation of Liz Truss' administration.

Perhaps more importantly, all of these fiscal challenges also apply to other countries as well, including most of the Western world. In France, for example, the 2023 budget deficit will be 5.5 percent, well above the 4.9 percent target. In the Netherlands, political parties have been trying to form a government for nearly six months, and the government’s finances are a key issue in this process.

The need to reform public finances has become clear, but the way in which this will happen is not. The key question is whether there will first be a bond market crisis, as threatened in the UK in 2022 and occurred in Greece in 2010, or whether governments will take action by reforming public finances before being forced to do so by the bond market.

Another key question is what these reforms will look like. We can learn from Greece’s austerity measures between 2010 and 2017 to answer this question. Between February 2010 and May 2016, the Greek government implemented 14 (!) different packages of austerity measures, consisting of both tax increases (on income, corporate profits, VAT, gasoline and car imports) and spending cuts (reducing salaries, lowering pensions, cutting spending on health care, defense and education).

Although Greece is an extreme case, its history offers lessons for other countries facing public finance reforms. The sequence of measures may accelerate during a crisis, when market pressures increase and economic growth remains slow (exacerbated by austerity measures). Meanwhile, there is no choice between tax increases and spending cuts; both measures are likely and both have a direct impact on people's disposable income. In such a situation, political resistance becomes increasingly likely, as it is difficult for people to be repeatedly confronted with significant income cuts or increased spending. Indeed, in Greece, from the third package on, the country faced nationwide strikes and violent and deadly protests.

While it is unlikely that the US will reform its public finances before being forced to do so by a crisis (which would force Democrats and Republicans to build consensus), the example of Greece shows that such a crisis can cause years of economic pain in the US. Nevertheless, the eventual reform of Greek public finances also laid the foundation for a stronger economy, despite the immense suffering of the Greek people. All of this shows that Western governments that take the initiative to reform their public finances before a crisis forces them to do so, are on the right track. Germany, for example, has already begun to do so, under constitutional constraints.


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