STATS ARTICLES 2012
We're Not Greece
Stephen J. Rose and William T. Dickens, May 29, 2012
The meaning of Greece for the US
Many people see the rising unemployment and economic decline of Greece as problems caused by public sector profligacy. They then jump to the conclusion that the same fate awaits the US because of its large federal deficits. This is a false analogy that misrepresents the effects of large deficits as well as the specific problems that Greece faces.
While large government deficits can lead to economic distress, the relationship is weak and complicated. Since the financial crisis began in 2008, lenders have progressively lost confidence in Greece’s ability to pay back its debts. As a result, they have demanded much higher interest rates to buy Greek debt, in the form of bonds issued by the Greek government. These added costs have made it that much more difficult for Greece to pay off its debts. Eventually, foreign bailout packages were required to avoid a complete default. The terms of the bailout have forced the Greek government to curtail public spending, causing a weak economy to get even weaker.
This is the pattern that critics have in mind when they say that high debt leads to rising unemployment and declining production. But economic problems can be the cause of debt rather than its consequence (as in Spain, Ireland, Portugal, and to some extent, the United States today). And much higher levels of debt can be tolerated when circumstances are different (for example, in Japan today or the U.S after World War II).
A sign that debt problems are becoming economic problems occurs when the interest rates on a country’s debt rise. This indicates that investors are nervous about default and demand a premium to hold this debt. Of course, rising interest costs make the problems worse and put more pressure on the affected country.
Usually when countries face this situation, the value of their currency declines, and this has two contradictory effects. On the one hand, if the country borrows in a foreign currency, the effective cost of the debt is greater because it takes more of the local currency to pay it off. On the other hand, a cheaper currency tends to increase exports and decrease imports. This can provide a positive boost to economic output and increase government revenues, making it easier to pay off the debt and regain international trust.
As a member of the European Monetary Union (EMU), Greece does not control its own currency. The value of the euro is mainly determined by the stronger economies of countries such as Germany and France. The United States has its own currency and its own monetary policy. Greece does not, and if it goes back to the drachma, its debts will have to be paid in euros at a much worse exchange rate.
Not only does the U.S. have its own currency, its debt is denominated in dollars. Further, because the dollar is the primary currency in which trade is conducted, and is used as a store of wealth by banks all over the world, the dollar is the de facto currency of the world.
Over the past three decades, many people have predicted that foreigners would stop buying our debt, or at least demand higher interest rates for the extra risk of currency devaluation. But this has not happened. Instead, when the world financial crisis exploded, investors flocked to US debt, driving rates down to very low levels. When one of the rating agencies downgraded US debt last year, there was no world response, as the interest rate on our debt stayed low and may have even declined a bit.
Part of the reason for the strength of US government debt is that our competitors are in worse shape than we are. If not the dollar, then what? The euro? The pound? The Chinese renminbi? (That would be difficult, because the Chinese restrict foreign investment.) Economic factors matter, and the size, stability, openness, and productivity of the US economy still make it the obvious currency of choice The U.S. Gross Domestic Product (GDP) is 50 times as big as that of Greece, seven times the size of Great Britain’s, five times the size of Germany’s, and almost four times the size of Japan’s GDP.
In terms of the size of its economy, Greece is less like the U.S. than one of its 50 U.S. states. But Greece is part of greater Europe, which is not a single entity but a moderately connected group of countries. While Greece has benefited in many ways from this relationship, its productivity levels are much lower than most of the countries in the EMU. This means that Greek firms cannot compete unless they pay lower wages than the rest of the EMU. Part of Greece’s problem is that the money it borrowed in the run-up to the current crisis caused wages to rise above levels that Greek productivity could sustain.
Furthermore, during economic hard times, the difference between being a small country in a monetary union and a state within a larger country becomes much more significant. In the US, the southern, mountain, and central states have historically had less output per person than states in the Midwest, or on the east or west coasts. But this gap has fallen over time, as the federal government subsidizes low income states through road construction, social security payments, etc.
In addition, federal aid is very responsive to local business conditions, due to shared federal funding of unemployment compensation, Temporary Assistance to Needy Families, and Medicaid. In total, the federal government provides 20 percent of state and local budgets. In some states, total federal payments are 40 percent greater than the total federal taxes paid by the state’s residents.
While there are transfers between the countries of the European Union, they are nowhere near as large or as responsive to economic conditions as in the U.S. Thus, Greece is much more on its own than any state of the U.S. would ever be in an economic downturn.
Greece is unlike a U.S. state in another important way. Americans can relocate when local conditions are bad. While European Union laws make mobility between countries easy in theory, cultural and language differences make mobility much harder than in the U.S. Thus, Greece must go through a protracted period of falling wages in order to recover from its current crisis. When an imbalance like Europe’s exists in the U.S., people move to where the jobs are.
In conclusion, the future of US economy must be assessed on its own merits, and the experience of Greece has little relevance to our situation. While high deficits during economic downturns aren't a major problem now, continuing high deficits are unsustainable in the long run. If Congress does not agree on some combination of spending cuts and revenue increases, deficits after the economy recovers will only fall to five to six percent of GDP rather than the two to three percent that is sustainable. This will have negative consequences on growth and will probably lead to a rising debt to GDP ratio and then larger deficits as interest payments on the debt grow. Ultimately, no country can continue to increase its debt faster than its ability to pay that debt and at some point credit markets will demand larger and larger premiums to lend a country money. The U.S. has a long term debt problem and will have to deal with it at some point.
However, the current political stalemate in Washington could lead to serious problems much sooner. As a result of last year’s debt negotiations, along with earlier compromises between the President and Congress, existing income and payroll tax cuts will expire by the end of the year, at the same time that automatic cuts in federal spending will be triggered. While this combination of higher taxes and lower government spending would certainly lower the 2013 deficit, it would also be a disaster for the recovery.
Together these changes would take money out of the pocket of consumers and decrease government spending by about three percent of GDP—something Fed Chief Ben Bernanke has called a “fiscal Armageddon.” The non-partisan Congressional Budget Office (CBO) estimates of spending and tax multipliers suggest that follow-on effects could easily add another one to three percentage points to this total over the next couple of years. That is the reasoning behind a new CBO report saying that, with no action, GDP growth in 2013 would shift from a projected +2.5 percent to -1.3 percent. This is a far more immediate threat to the U.S. economy than the deficit.
We are not Greece, but we could face unnecessary short and long term economic problems if our political leaders don’t come to sensible compromises.
Dr Rose is a Research Professor at the Georgetown Center on Education and the Economy, and an EconoSTATS Contributor. Dr. Dickens is University Distinguished Professor, Northeastern University.