Europe Facing Difficult Fiscal Choices

In last week’s posting on this site, I argued that the Federal Reserve may be overestimating its ability to restimulate consumer enthusiasm with its aggressive interest rate and new money policies. Diminished resources and the past decade’s multiple financial disruptions may have convinced former free spenders to reduce debt and to tuck away some assets for the proverbial rainy day.

While that decision to save or to spend may be extremely important at the household level, it has even greater implications at the national and international level. We see this dilemma playing itself out most dramatically today in Europe.

With most world economies in serious recessions in 2009, the International Monetary Fund (IMF) strongly urged many of its member countries to increase deficit spending. Combined with aggressive action from leading central banks, this widely employed approach succeeded in calming the financial crisis, albeit at the cost of adding heavily to already bloated debt loads.

Recognizing the dangers of outsized deficits and debt levels threatening many countries’ long-term stability, the IMF quickly urged fiscal discipline once the panic of 2009 had passed. By 2010, the IMF pushed stronger countries to slash annual deficits in half by 2013 and to prudently plan to reduce their burgeoning debts as quickly as possible.

Unfortunately, the best laid plans sometimes backfire. European countries that have implemented strong austerity measures have seen their economies fall into recession. Recent violent riots in Greece and Spain vividly reflect public attitudes toward losing cherished benefits.

Bowing to that social pressure and reevaluating the apparent inability of many economies to stabilize under austerity programs, the IMF has reversed course and acknowledged that slashing deficits and debt may be preventing economic growth.

But what’s a country to do? If austerity is imposed or continued, recession may be the result with no progress made against deficits and debt. Should austerity be abandoned, existing deficit levels may continue for years with the resultant annual addition to debt. As we have seen all too tragically in recent years, when debt reaches unsustainable levels, defaults or bailouts become the alternatives. The inability of European countries to grow out of their problems indicates that an increasing number of countries will face that unfortunate choice in the years ahead.

Bringing the dilemma closer to home, we’re faced with the same choice in the United States. We will begin to hear more and more about this choice as we move ever closer to the year-end “fiscal cliff.”

Almost certainly, our debt level has reached a point from which there is no easy recovery. Our legislators’ inability even to put a dent in the projected debt load is clear testimony to the difficulty of the task. That failure of the super-committee earlier this year prompted an immediate downgrade of the US’s formerly sacrosanct AAA debt rating. A similar legislative failure in the next few months is highly likely to precipitate another downgrade.

Having spent and promised our nation into its untenable debt position, largely over the last three decades, no good choices remain. How we deal with a few unpleasant alternatives will dictate the economic background that we and subsequent generations will inherit. That background will powerfully influence the opportunities available to investors in the decades ahead.