Solution to Europe's credit downgrades

In 2011, Mikhail Gorbachev said, "The United States needs its own perestroika." The same could be said for the EU. On Friday January 13th, 2012, S&P downgraded the credit rating of nine European countries. 

Most of EU nations, like the US, are living beyond their means: their governments are spending more than they're collecting in taxes. After several years, something has to give. This week, what's giving is their credit rating.

If Europeans (and Americans) don't vote for and support politicians who cut government spending (especially on the big ticket items like military, medical care, and social security), then credit ratings will continue to plummet, interest rates will rise, and Western Europeans will suffer like Eastern Europeans suffered when they transitioned away from communism 20 years ago.

Some argue that we shouldn't just cut spending, we should also increase taxes. Some tax hikes would be good. For example, a carbon tax would be helpful at capturing externalities like pollution.

However, believing that increasing taxes on the rich would solve everything is foolish. First, in the US, the top 1% already pay over 36% of federal income taxes; in Europe, the wealthy are taxed even more.

"So what? Let's tax the rich bastards even more!" you say?

The problem is that it's easier than ever for the rich to take their money and run. Let's say you're a rich guy in Paris and France increases your tax rate to 95%. Are you going to stick around? Or will you move to a neighboring country that lets you keep more of your income?

The same is true with companies. Tax the hell out of companies and they'll simply move their jobs to another country (even more than they're already doing). Besides, corporations simply pass the cost of any tax onto consumers (that's you and me). So go ahead and tax Exxon, Microsoft, and McDonalds super high; they'll just raise their prices accordingly and their customers will just pay more.

In short, be skeptical about anyone who thinks that squeezing every drop out of the rich and the corporations will solve all our financial problems. Politically it sounds much better than cutting medicare, social security, and military spending, but economically it makes less sense.

How will Europe's credit downgrades impact innovation?

Innovation thrives when capital is abundant (e.g., venture capital fuels Silicon Valley's innovation). High taxes encourages capital flight. So if the EU tries to solve its financial woes by jacking up taxes, innovation will suffer.

The downgrades will hurt innovation, because many innovators need to borrow money to pursue their inventions. The downgrades will increase interest rates, thereby increasing the cost of capital, thereby cramping innovation.

On the other hand, sometimes a good crisis is the mother of invention.

You may also enjoy reading "Europe, the credit downgrade and what it means for innovation," an article in The Washington Post that quotes me a couple of times.