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Extend and Pretend

Flickr by Galería de Faustino

Most of us assume that the “extend and pretend” mindset stops at the water’s edge in Washington. But lately, we’re seeing the same mindset flourishing in Europe. By refusing to deal with structural deficiencies affecting the global financial system, politicians on both sides of the Atlantic are only prolonging the misery that we will suffer and compounding the problems that they will ultimately be forced to reckon with.

In Washington, many people make believe that the tepid attempts to restore financial stability by Congress, the Treasury Department, and the Federal Reserve were sufficient to put us on the road to economic recovery. They maintain that the banks have suddenly become safe and sound, that the housing crisis will eventually turn itself around, and the unemployed will secure decent jobs. Reality indicates otherwise.

In Europe, many people make believe that over-indebted countries’ long-term economic troubles can be cured by imposing drastic austerity measures on those countries and substantial haircuts on their creditors. That’s also wishful thinking. The truth is that such an approach does nothing to solve Greece’s and Europe’s long-term problems. It only buys time for European leaders to figure out how to save French and German banks from a cascade of imminent sovereign defaults. And the near term consequences of imposing austerity measures will be even more damaging than allowing a coordinated default. Such belt-tightening measures tend to slow growth, increase unemployment, and expand the burden on the private sector to pick up where the government has left off.

Without bold action, the United States and the European Union are on a dangerous course.

In the United States, politicians and regulators must finally make the financial system safer. They have the tools to constrain systemically dangerous institutions that pose grave threats to financial stability; they just need to use those tools. Additionally, they must once and for all attack the mortgage foreclosure crisis, requiring principal reductions based on honest assessments of current real estate values. Finally, they must create jobs programs to mitigate persistently high unemployment.

In the European Union, government officials must decide whether they want to stay on the Euro currency. If they don’t want to make the marriage last, they must figure out the most prudent dissolution plan. On the other hand, if they do want to make it last, they must get to the heart of the E.U.’s structural dilemma: there is a unified currency without a unified fiscal policy.

Unlike the U.S., the E.U. does not provide a federal baseline safety net for its member countries. The European Parliament’s budget is less than one percent of GDP (approximately $100 billion). Thus, the lion’s share of government spending is pushed onto the individual member nations, but this requires the member nations to accumulate more and more debt, which raises their borrowing costs and places them in a vicious debt trap. As a frame of reference, this spending dynamic would be equivalent to the United States having an annual budget of approximately $140 billion and requiring states to pay for all government services. That would force states to rack up insurmountable levels of debt and would quickly prove to be unsustainable.

The biggest danger from inaction here and abroad is from a disorderly breakup in Europe or a slew of European sovereign defaults. Either of these scenarios would spark contagion throughout Europe and across our shores. Because our banks are directly and substantially tied to Europe’s financial health through U.S. money market mutual funds and derivatives contracts, it would not take long for calamity in Europe to adversely affect our financial system. U.S. banks’ total exposure to a European collapse could reach $3 trillion. The ensuing fallout from such a catastrophe would easily place us right back into the depths of another global financial crisis.

We cannot afford for our leaders, both foreign and domestic, to continue to kick the can down the road. While preserving the status quo may be convenient, it will not fix our global financial system’s flaws. More fundamental changes are necessary but they are possible.