Is Europe Sleep-Walking Toward a Lost Decade?

As the United States faces a crisis of spilled black gold, the Eurozone is facing a crisis of spreading red ink. The leading world economies have repudiated stimulus spending, and America's liberals are going berserk over the implications for Europe's economies, and ours.

The short story of Europe's contagion crisis is that international investors, having clued in to Greece's wonky budgeting, now suspect many more European states of flirting with default. This has sent the entire continent into a preemptive panic. States like Germany and England, who are at no risk of default, are talking about cutting back stimulus in anticipation that the markets will demand it in the future.

To get wade through the confusion and contagion, I spoke with AEI's Desmond Lachman. A lightly edited transcript follows.

Paul Krugman is having a conniption fit over the G20 announcement that the world's leading economies are preparing to rein in their fiscal stimulus. I have to admit, it looks pretty worrying to me, too. What do you think?

This is a very serious issue. There are too many countries that have highly compromised finances, not just the Greece and Spain, but also Italy and the UK and Japan and even the United States. We all have high deficits and high debt-to-GDP ratios. There can be huge changes in markets, huge swings that can raise interest rates. One must address them. It's not an easy problem. Krugman is right that withdrawing fiscal stimulus in a recession isn't a good idea.

On the other hand, you're inviting a crisis in the markets when your finances aren't sustainable and you're not acting. My view would be you want to find a fine balance between the two objectives: maintain the stimulus but come up with a medium term plan. In the U.S. if there were real commitments to raise the retirement age in Social Security or cut back on Medicare, you'd have the best of both worlds.

Let's say we cast you as financial minister for some of these better-off countries, like France, Britain, and Germany. Are you saying: "Cut back spending now!" Or are you advising a different a stimulus now/re-balancing later approach?

You can't have everybody tightening their budget at the same time. That way, we'll go into a hell of a global slump. You need some countries tightening while others are expanding their fiscal help. When I see Germany cutting their budget, they're just making it harder for the other cutting to work, because they're slumping global demand. Germany's tightening compounds the global problem.

Still, Krugman seems to take the line that there are no consequences to throwing money at the problem forever. I'd look at Jeffrey Sachs commentary in this morning in the Financial Times. He's arguing that Keynesian economics has run out of its use, and that issues of sovereign debt [that is, debt of foreign countries] now takes precedence.

I'm interested in the case of the United Kingdom. The new British Prime Minister David Cameron recently said spending cuts were forthcoming and the country should prepare for decades of ripple effects. That shocked me. The UK is running a similar deficit to the United States, near 10% of GDP. Its debt-to-GDP ratio is also similar the U.S. But here in America, we're not talking about austerity or decades of pain, at all. What's going on with Britain I'm not seeing?

I haven't looked at their case very closely. But first they're more closely tied to Europe, so you've got that higher threat of contagion. It's also got to do with their financial system. They've got a huge banking system that took a real big hit and the government might still have to take over a lot of the loans. Their public finances are compromised beyond the numbers that you can see. They're really not in good shape, and they're very clearly on a path that cannot be sustained.

However, Britain is in the fortunate position that is not stuck with a fixed exchange rate [like Greece, Spain, Portugal and other peripheral countries in the EU who will likely have to go through a period of deflation to become competitive with the rest of the continent]. As they're tightening their budget they're letting the pound depreciate like crazy. That will lead to high exports down the road. They can do fiscal adjustment in a way that Greece and Spain cannot.

Let's bring it back to the United States. In the short term, a crisis in Europe will lower our yields, which might have the ricochet effect of making it cheaper to, say, finance a home. So that's not bad. But how might this play out for us in the medium/long term?

As I see it there are three big challenges for the U.S. as a result of this crisis. First, a strong dollar means our export prospects are bad. Second, if Europe goes into recession, that's also bad for our exports. And third, if Europe has banking sector crisis that can hit us really hard because of the inter-linkages in the system. We can get a financial shock. The rate at which companies and households borrow will go up. The US banks have $1.5 trillion exposure to Europe companies and households and the like, so if Europe goes into a recession we will feel it.