Crisis Deferred, Uh, Averted

This is almost getting too easy. Just last week the world appeared to be at the brink of its second financial meltdown in 20 months. The debt crisis in Greece was going to spread to Spain and Portugal, then sail up to Ireland and the U.K. and eventually bring down the world. But the finance ministers of the European Union put together a trillion dollar European version of our American TARP and suddenly everything was okay. The Euro and European stock markets had their best day in more than a year-Spain, up 13%, had its best day on record - and the U.S. stock market leapt at the open. If this were ancient Greece, Phidippides, the runner who delivered the news of victory in the battle of Marathon, would be halfway back to Athens by now.

But if the American version of economic bailout is any indication, a declaration of victory might just be premature, or at least short-sighted. The euro and the European Union are now in roughly the same place as the U.S. now - we have bought off financial crisis by throwing trillions of borrowed dollars at it. But in the U.S., financial peace has come at a price to our long-term economic prospects.

Here's what we've learned in the U.S. about the cost of financial rescue missions, drawing on a recent post I wrote for The Fiscal Times:

We were in a fiscal hole before the bailout. We are now in a fiscal mine shaft. The Keynesian bargain in our recovery strategy was this: Government spending would cover the hole in private spending, rebuild confidence, and hold open the door to economic recovery. Private enterprise would then walk through the door and growth in the private economy would allow us to pay off even a vastly increased government debt without too much pain.

The problem is, there can only be so much deficit spending before things start to come undone. (See Greece, riots in the streets of.) The idea that massive deficits will necessarily lead to hyperinflation is not borne out by history, but that doesn't mean that Dick Cheney's alarming conclusion - "Reagan proved that deficits don't matter" - is true. Economic historians Kenneth Rogoff and Carmen Reinhart have documented that runaway government borrowing in developed economies does indeed become a drag on output once it exceeds 90% of GDP (for comparison, the ratio of public-debt-to GDP in 2009 was 119% in Greece, 21% in China, and 84% in the U.S.). Projections of President Obama's budget by Alan Auerbach of the University of California, Berkeley and William Gale of the Brookings Institution would put the national debt over the 90% tipping point by 2020. Unless the deficit is brought under control, say Auerbach and Gale, the upshot will be reduced national income and a falling standard of living.

That is as true for Europe as it is for the U.S. The question for all developed countries is whether they can pull together the political will to control their soaring budget deficits once recovery has taken hold. The only thing certain about a trillion-dollar bailout package is that it deepens the hole that governments will have to dig out of. And governments, of course, doesn't just mean finance ministers. It means voters, taxpayers, unions, municipal workers, Germans as well as Greeks, Social Security recipients, Republicans and Democrats. Put that way, the political challenge of squaring up fiscal policy in a democracy becomes pretty stark.

The Euro package has quieted the markets and apparently quieted the streets in Greece as well. But if the unprecedented gamble on Keynesian economics doesn't pan out, turmoil in the financial markets will be back. So will the rioters.

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