Beware of Greeks Bearing Debts (Paper)

May 1, 2010

In recent weeks, turbulence has returned to global financial markets due primarily to deepening fears about the ability of Greece to service its sovereign debt and widening concerns about the ability of some other advanced European countries with large budget deficits and/or high ratios of public debt to GDP to meet their obligations. Led by Greece, interest rate spreads for some European sovereigns have shot up, equity markets have sold off in Europe and beyond, and measures of financial stress and volatility have escalated (although they generally remain well below their crisis peaks in late 2008 and early 2009).

The official international community has responded to this new challenge with a very large financial support package for Greece, involving both the European Union (especially the euro area) and the IMF—in conjunction with firm pledges by the Greek government to undertake rigorous fiscal consolidation and other reforms to restore creditworthiness and international competitiveness. To address remaining concerns about fiscal sustainability in other advance European countries, the European Union and the IMF have pledged to supply up to $1 trillion of financial support, and more if needed, to aid euro area members who face critical financial challenges—provided that these countries take appropriately vigorous measures to address their perceived fiscal weaknesses. The European Central Bank (ECB) has also indicated that, under this same proviso, it will purchase in the secondary market debts of euro area sovereigns when these markets appear to have become “dysfunctional.”

In this talk, I plan to address primarily the situation in Greece and the challenges to the IMF-EUsupported program that is designed to assist Greece. Before turning to that subject, however, it is important to reflect on the broader financial and economic challenges in Western Europe. Then, after discussing Greece in some detail, it will be relevant to reflect on the broader lessons from the Greek case for Europe and for the rest of the world, including especially the United States.

What’s at Stake Beyond Greece

If Greece were perceived to be essentially alone in its present difficulties, then several different approaches by the international community to assist in dealing with Greece’s problems would be reasonable to contemplate—and quite possibly adopt. But, Greece is not entirely alone in its present predicament.

Other countries in the euro area (specifically Portugal, Ireland, Italy, and Spain) are perceived to share, qualitatively if not quantitatively, some of the same concerns about fiscal sustainability and 2 international competitiveness (within the euro area and externally) that now afflict Greece. If Greece were to default upon and/or restructure its sovereign debt in the present environment, this would undoubtedly incite concerns that others might follow—contributing to the possibility of a self-fulfilling prophesy. In the extreme, if Greece were to exit from the eurozone in an effort to gain international competitiveness and spur economic growth, this would undoubtedly escalate concerns about the viability of the European Monetary Union for all of its members. This means that exit of Greece from the euro area must be viewed as an extreme step that should be avoided at virtually all cost.

More generally, while most of the world economy now appears to be recovering moderately vigorously from the great global recession, recovery in Western Europe is anemic and uncertain. There are some recent signs that recovery in France, Germany, and several other euro area countries is accelerating. A deepening crisis in Greece that spread to an economically more substantial group of euro area countries could seriously blunt recovery in the rest of Western Europe. Most of the rest of the world (except for Central and Eastern Europe) would be more modestly affected, but the effect would not be positive or trivial.

In sum, this is an especially inconvenient time for Greece to blow up into a major financial crisis raising fears of considerably broader problems in Western Europe and beyond. Indeed, an international effort that helps Greece avoid sovereign default—or at least postpones it until generally better times—is desirable not only and perhaps not primarily for how it may help Greece but also for its more general benefits.

Debt Dynamics and the Situation in Greece

The notes at the end of this paper detail the basic equation of debt dynamics. Specifically, the rate of increase of a government’s debt to GDP ratio, D/Y, is the sum of two terms: first, the ratio of the primary deficit to GDP, P/Y; and second the product of the difference between the interest rate on government debt minus the growth rate of GDP, i – g, times the debt to GDP ratio, D/Y.

The significance of this equation of debt dynamics, especially the importance of the differential between the interest rate on government debt and the growth rate of (nominal) GDP is well illustrated by example of the United States over the past 60 years. The US government has run persistent overall fiscal deficits virtually every year during this period and the primary budget balance (excluding interest on the government debt held by the public) has recorded a large cumulative deficit. Nevertheless, the debt to GDP ratio has fallen from 98 percent of GDP in 1950 to about 60 percent today. The reason is that, on average, during this period, the growth rate of nominal GDP (g) of 6.7 percent has exceeded the average interest rate on federal debt by about 2.5 percentage points.

For the nine years from 1999 through 2008, Greece enjoyed reasonably rapid nominal GDP growth, which generally exceeded the interest rate on Greek government debt. But, growing primary deficits dominated debt dynamics and D/Y grew. With the sharp slowdown in Greek growth in 2008–09 and further rise in P/Y, D/Y shot up to 115 percent at end 2009. The D/Y ratio now stands at about 120 percent (see scenario 1 in the notes below). With nominal GDP growth now expected to be significantly negative and with the increase in interest rates on Greek debt, forward-looking debt dynamics indicate rapid rises in D/Y. Greece’s fiscal situation is clearly unsustainable under these conditions.

Meanwhile, Greece’s international competitiveness has deteriorated in recent years as wage increases have substantially outpaced productivity increases (in key tradable goods industries and more generally). With the exchange rate pegged within the euro area, Greece requires outright wage deflation to restore competitiveness within the area. Achieving this will not be good for nominal GDP growth and for debt dynamics.