Greece and how it manages its financial predicaments over the next year or so will provide a relevant object lesson for the US. Let’s recap what is going on:
The facts. After rapid expansion of the public sector, government spending makes up now 52% of GDP (up from 45% in 2007) – i.e., more than half of all products and services officially generated in the country are being paid for by the government. The Greek government has run persistent budget deficits, now at 13% of GDP. Deficits create debts and, over the years, Greece has accumulated a national debt of 113% of GDP. It keeps growing and is likely to exceed 120% by end of 2010. Most of the debt is to investors outside of Greece.
For now, the US is nowhere close to this situation, but closing in rapidly: Historically, budget deficits have averaged around 3% of GDP. Last year the deficit shot up to 9.9% of GDP and Obama’s 2010 budget forecasts a budget deficit of 10.6%. Our national debt has increased from 36% in 2007 to 63.6% this year and is forecasted to grow with the latest budget to 68.6%. Roughly 40% of our debt is held by foreigners, 25% of which by China.
When do deficits matter? Growing deficits and debt start to matter to a nation when it starts to matter to their lenders – i.e., lenders perceive that the risk of default is increasing and start to demand higher interest rates to keep lending. Persistent and increasing budget deficits fuel lender doubts about a country’s ability to keep borrowing more and more. As interest rates rise, the cost of financing the debt increases and, if other government expenditures don’t go down, deficits grow, which in turn require more debt. In a ponzi scheme of sorts debt is piled on debt. This vicious cycle accelerates until a country runs out of investors willing to lend it more money to pay off earlier investors, and the country can no longer pay the interest on its loans: It defaults.
Sudden death. Investor psychology plays a huge role in the sudden nature of the end. After a gradual build-up, the awareness of the problem spreads; and as the number of people concerned increases, the speed with which the concern is spread to additional investors increases faster and faster. Financial crisis seems to erupt suddenly, but was actually in the making many years.
What does default look like? Greece is not quite out of private lenders just yet, but interest rates have been increasing to the point at which Greece is now paying three times higher interest rates than Germany (considered the financially most stable country in Europe). And insurance against Greece’s default on its debt has risen an astronomically 10 times between September 2009 and now, following the revelations about the true extent of Greece’s budget deficit. If investor confidence further erodes, and interest rates increase further, Greece could find itself in a position where it cannot afford taking out more debt and these high interest rates. If Greece were to default – i.e., stop paying interest on its existing debt, investors would stop lending, and the government would be literally out of money to pay employees, contractors and beneficiaries of its social programs. Given the size of the public sector, economic activity would collapse. Banks and households would go bankrupt. Chaos would reign. Even the government’s ability to rule would be in question. The government will not let this happen. There are 3 alternatives:
1. Get loans from public lenders, such as other EU countries that like Greece are part of the EURO currency union, or the International Monetary Fund (IMF), who acts as lender of last resort to countries. Other EU countries will want to avoid a Greek default right now. A default would increase investor doubts about other member states with equally precarious financial situations (Portugal, Italy, Spain), and ultimately raise the borrowing costs for all countries in the EURO currency union. Also, not providing loans will leave Greece with no other alternative but to exit the monetary union. In return for loans, EU countries or the IMF, will demand from Greece to tackle its budget deficit in a serious way. The loans would be seen as a temporary stopgap to allow Greece to bring its household under control. But with money flowing once again, it will be even harder for the Greek government to enact reforms. Promises will be broken, and the only question will be when the EU or the IMF will stop providing new funds to bail out Greece. A bail out will most likely only defer and ultimately increase the necessary pain.
2. Exit the monetary Union. The EURO creates a straightjacket for Greece that prevents it from using inflation and currency devaluation to help solve its problems – at least temporarily. Other countries faced with immanent default have resorted to printing money to pay off their constituencies. But with more money in circulation chasing the same amount of goods, prices will go up. As constituencies catch on to this growth in the money supply, they will demand that their government payments will be adjusted for inflation. Temporary inflation could conceivably be used to lower the government’s real costs, if demands by constituencies could be held in check. But once inflationary expectations take hold, they are hard to reign back in, and inflation rates increase until money becomes meaningless. Other countries have also used currency devaluation to lower the cost of their labor compared to other countries and spur exports. Greater exports increase economic activity, which brings in more taxes and strengthen confidence of foreign investors in a country’s growth prospects. So exiting the EURO union is a definite possibility, but a high risk proposition. It could provide short-term relief and, if managed thoughtfully, could provide a path for growth. But unless it is coupled with real reductions in public expenditures, it will only make investors more skeptical.
3. Restore confidence of private lenders in Greece’s future ability to pay by reducing budget deficits dramatically and slowing down the growth in debt. The Greek government has promised to reduce its budget deficit from 13% of GDP to 2%. This will be very hard for Greece to do, since it has to come from expenditures cuts, not revenue growth from tax increases. With taxes already high (40% for everyone making over $75,000 Euros), Greece has created one of the largest underground economies in Europe (estimated to be 25-30% of all economic activity) where people pay and get paid in cash to avoid income and sales taxes. Raising taxes will only further drive economic activity underground and slow down economic activity. Expenditures will have to be cut. Most of its public sector employees are unionized with contracts and willing to go into streets (they are already) to demand that the government honors its obligations. And to cut social programs politicians will have to create laws that reduce benefits to the very constituencies who elected them. Reducing public expenditures will be painful to the point that tears Greek society apart.
What do you think will happen? Which path will Greece take? My bet is on first 1, then 2, then 3. Bail out from the EU but no real reform, followed by exit from the EURO union, followed by a crash that catalyzes the country into some limited reform. As public expenditures are cut and taxes are raised, the economy will invariably slow down leading to higher unemployment and lower incomes, which will increase pressures to step up spending again. They will muddle through, stop-and-go, some reforms, more politicking, followed by more pain. Not a pretty place to live: a prolonged period of slow growth, permanently lower standards of living and few growth opportunities. Still a great place for vacation, but not to build a life.
America’s Path. The US situation is a far cry from Greece’s – today. But remember, Greece didn’t get here overnight, and our path is similar to the one Greece took. Greece locked itself into permanently higher spending through social programs and entitlements. It has a huge public payroll with unionized workers who will go on strike the moment their enshrined wages and benefits are threatened. That all sounds eerily familiar. The US has locked itself into big entitlement programs (Medicare and Medicaid) that together with Social Security and interest on our debt require already more than three-quarters of government revenues. The latest budget has these items growing over the next 5 years by 9% annually. Over the last year, the US has just dramatically increased spending on other things, much of which was supposed to be one-offs. But as with every spending program, Congress and the Administration now have a hard time letting go of that temporary spending. And the public sector payroll is the only employment category that records employment growth and pay increases. All this appears to indicate that spending will grow significantly faster than revenue, adding to the national debt and increasing the velocity of the downward spiral.
As with Greece or the world financial crisis, financial disasters appear to erupt suddenly and unpredictably, but that it hardly the case. They are in the making many years, accelerating over time, until they explode in their final moments. There is a US financial crisis brewing. The current path clearly is not sustainable, and the longer the US continues on that path, the harder the pain later on.
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