“Borrowing … the Disease Is Incurable”
By the end of the 1980s, you could almost see the desperation in Europe's eyes. Economic growth was flat, other economies around the world were surging ahead, and the two obvious means of raising revenues to support entitlements had died of natural causes.
But the Great Experiment isn't called the Great Experiment for nothing. In 1992 the Maastricht Treaty established the European Union under its current name and required that all countries in the EU adopt the euro.18 From the very beginning it was recognized that one great advantage of the euro was that it would allow everyone in the currency union to borrow at rates formerly offered only to its most creditworthy states. The idea was that low borrowing rates would spur economic growth across the Continent.
This might actually have worked out as hoped—indeed, like the first two revenue-raising strategies, borrowing initially worked. In the aggregate, European growth rose, although in real terms most of that growth was isolated in the northern countries. There are, after all, good reasons for countries to borrow money. Short-term borrowing can smooth otherwise seasonal cash flows, for example. Long-term borrowing can be used to build out infrastructure—roads, railroads, pipelines, airports, the Internet backbone—which is really a form of investing in the long-term growth of the society.
When borrowing rates are low, and even more especially when low-credit countries are able to borrow at rates more appropriate to high-credit countries, and most especially of all when countries are desperate to meet entitlement demands and all their other strategies have run out of steam, the temptation to overborrow is overwhelming.
And overborrow is what the Europeans did, as we all know. The borrowing wasn't designed to smooth out seasonal cash flows and it wasn't designed to fund infrastructure spending. No, it was designed to fund current spending, with virtually all that spending being used to fund middle-class entitlements. When a country's borrowing is mainly to support current spending, it isn't long before a large part of the borrowing is used up paying interest on past borrowing: Soon enough, “current spending” mainly means paying interest on past spending, at least in terms of discretionary versus nondiscretionary spending.
At that point, the jig is pretty well up. And if interest rates demanded by bond investors should move up sharply, matters end quickly and badly.
Reinhart and Rogoff have shown that once sovereign indebtedness reaches about 90 percent of GDP, the competitiveness of a country begins to decline, as the burden of interest repayment eats into more productive spending. At ratios above 90 percent, average growth declines, according to Reinhart and Rogoff, by about 1 percent.19 Of course, this paints with a broad brush. Economies that are especially robust can carry higher debt loads. Countries whose debt is mostly internal, rather than external, can carry higher debt loads. As noted, countries spending heavily on infrastructure can carry higher debt loads. Unfortunately, none of this applied to Europe, where economies were feeble, debts were externally held, and borrowing was in support of current spending.
Because the overborrowing in Europe was, at least in the intermediate term, in everybody's interest,20 overborrowing continued endlessly while everyone winked at the Maastricht Treaty's supposed debt limits (60% debt-to-GDP) and budget deficit limits (3% of GDP) and partied on (truly, the borrowing “disease” is incurable, as Shakespeare put it so well in Henry IV.) As we know, this ended catastrophically for the countries that had borrowed the most, and all of Europe will be paying a steep price for decades. The last and final revenue-raising strategy has blown up in the Great Experiment's face.