What we can learn from Europe's mess

Today, the Western world, and Japan, have a single overriding problem: We have borrowed more than we can afford to pay back.

This has happened because we are democratic societies with very large aging populations. Programs to serve those populations were set up with the expectation that many more people always would pay taxes than would take out benefits. It no longer works.

Social Security in 1955 had 15 people paying taxes for every person receiving benefits. Today, it’s just two taxpayers per beneficiary.

In addition, governments have become extraordinarily large in Europe, and potentially in America under President Obama, and are overwhelming the private sector’s ability to support them.

The average Western government in Europe constitutes 35 percent to 45 percent of its economy. With Obamacare and the explosion in spending during the first two years of the Obama administration, our government — which has historically accounted for about 20 percent of our economy — will by the end of a second Obama term hit almost 30 percent.

In Europe, we are watching the slow and painful process of coming to terms with this problem. We can learn a great deal from their experience.

First, you do not solve the problem by raising taxes beyond what a productive society can tolerate.

Almost every European state has a top income tax rate well into the 40 percent range. They have layered on top value-added taxes in the high teens. Yet despite all this revenue they are going broke.

Why is that? Democratic governments will spend everything they raise because that is how elected individuals see themselves getting reelected.

All democratic governments move left. This leftward movement is pulled by the amount and type of revenue governments receive.

When an income tax is joined to a value-added-tax system, it creates huge momentum for governments to grow. This is what has happened in Europe.

In the process, the ability of the private sector to expand is dampened. The forces of productivity are muted and the economies stagnate under the weight of excessive taxation and unsustainable government borrowing.

All the incentives that are essential to a market economy’s ability to expand, such as individual risk taking, cheap capital, affordable debt and manageable regulations, are undermined by the expansion and tax burden of these growing governments.

Thus, their only real options are to accept a massive reduction in their standard of living, like Greece, or massively write down sovereign debt obligations through a somewhat orderly reordering of the debt or through such forced events as defaults.

The problem with either solution is that each is untenable in democratic societies where the politician views reelection as his or her priority.

Greece might be managed before it becomes a really ugly situation. But Italy cannot be finessed. Italy’s debt is approximately 2 trillion euros, much more than its economy can pay back or even support. Approximately 50 billion euros of that debt must be rolled over in February. But who is going to buy this debt, and at what price? This is not clear.

What is clear is that to manage this situation without a massive economic disruption, the Italian people are going to see their standard of living drop and some bond holders are going to lose a great deal of money. It will be a painful awakening for many.

The only nation that so far seems to have figured out how to handle this massive debt problem is Ireland. It took significant steps to restructure the cost of its government. It will mean a reduction of its standard of living, but because it was done in an orderly way the pain will be much less.

It was also done while maintaining a tax structure that does not overburden the growth engines of their economy, which could allow economic growth to abate some of the pain.

We are on the exact same fiscal path, only with a more resilient economy and political system that, in theory at least, is better able to act and respond.

The lessons are clear. First, act decisively to stop the out-year debt growth through adjusting entitlements.

Second, limit the government to a percentage of the economy that allows the private sector to flourish.

Third, use tax policies that generate the revenue needed to support a reasonably sized government and that do not suffocate growth.

And, last and most importantly, act before the crisis comes and the markets force action. The latter will be extremely painful and lead to an abrupt reduction in the nation’s wealth, prosperity and standard of living.

Judd Gregg is a former governor and three-term senator from New Hampshire who served as chairman and ranking member of the Senate Budget Committee and as ranking member of the Senate Appropriations subcommittee on Foreign Operations.