Commentary: Fiscal credibility and the European debt crisis

Fiscal credibility and the European debt crisis

Glenn Hubbard explains why the Eurozone and the US have a problem of credibility and that the advice of the US Government for Europe is unwise and reflects a limited understanding of the source of the crisis.
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The European debt crisis threatens growth in the Eurozone — and globally.  The crisis is one of credibility, and any solution must understand this link. Unfortunately, the U.S. government’s advice to Europe and to Germany in particular misses the point. Heretofore virtually absent in exercising U.S. economic influence in the developing European crisis, the Obama administration is now pressing Germany for a bailout of financially weak Eurozone governments and banks to prevent contagion from a Greek exit from the euro.

In particular, the U.S. Treasury is advocating Eurobonds, effectively offering German guarantees for debts of all members. The Treasury also advocates direct recapitalizations of insolvent Spanish banks via the European Stability Mechanism (ESM), as well as large-scale purchases of financially-weak-country government bonds by the European Central Bank (ECB).

This advice is unwise and reflects a limited understanding of the source of the crisis and a growth-oriented economic path forward.

Low euro interest rates led to private and sovereign borrowing booms in now-troubled European economies. Indebtedness reflects unwise fiscal choices made in the context of a monetary union that had limited fiscal controls. 

In addition, stark differences in competitiveness in the Eurozone have raised within-zone current account surpluses in countries like Germany and current account deficits in countries like Greece. Reductions in public spending (and hence in future tax rates) in weaker Eurozone countries and reforms in labor markets offer pro-growth opportunities.

Eurobonds are held out as a 'Hamiltonian' solution to the European debt crisis. The reference is to America’s first Treasury Secretary Alexander Hamilton, who championed federal assumption of state debts incurred during the American Revolution. This bold move increased confidence in the finances of the new republic. 

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