This article first appeared in the St. Louis Beacon, June 5, 2012 - There are no cute cats or amazing special effects in “Sovereign Debt: A Modern Greek Tragedy,” but the 10-minute online video by the St. Louis Federal Reserve is worth a look for a quick lesson on how Europe’s PIIGS -- Portugal, Italy, Ireland, Greece and Spain -- have sent the global economy to the doghouse again.
The video is a stand-alone companion piece to an essay by research director Christopher J. Waller and senior economist Fernando Martin that was published in the St. Louis Fed’s annual report, released in May. Each year, the report tackles a topic that is both timely and relevant to the U.S. economy.
Waller and Martin discuss the European mess in terms that non-economists can appreciate, with lots of charts and creative illustrations of modern-day belt-tightening amid classic Greek architecture. Here are some quick points about why tough times across "the pond" matter so much:
- For perspective, the 2007-2008 global financial meltdown was rooted in overextended U.S. households defaulting on subprime mortgages. Individual defaults created international shockwaves because of the way subprime mortgages had been sliced, diced and bundled into complicated financial packages and sold to investors throughout the world.
- The current European crisis is fueled by national debt: overextended countries that continue to borrow on the promise of tomorrow by spending more than they collect in tax revenue. The fear now is of the global implications should entire nations (think PIIGs) default on their debts -- something that hasn’t happened among developed nations since 1946.
- How much debt are we talking about? One simple measure of debt burden is the ratio of national debt to national income, such as Gross Domestic Product (GDP). In 2009, Greece’s debt-to-GDP ratio was about 125 percent. By 2010, Ireland’s had grown to 93 percent.
- All sovereign debt isn’t the same, and much depends on the willingness of creditors to allow nations to roll over debt. This is tied to confidence in a government’s willingness to raise taxes or cut spending to control debt. Brazil and Mexico defaulted in the early 1980s when their debt-to-GDP ratios were 50 percent, while Japan has not defaulted despite a debut burden of 200 percent.
- Greece’s precarious financial situation didn’t happen overnight. Europe’s Economic and Monetary Union -- approved by treaty in 1992 -- said no to Greece’s initial attempt to join in 1998 because it didn’t meet economic criteria. In addition to high inflation and interest rates, Greece’s debt-to-GDP ratio was nearly 100 percent at the time.
- Since the recession, investors have turned away from mortgage and other private asset markets -- and debt markets of at-risk nations -- and turned to more solid ground, such as the U.S. and its treasury bonds. But the U.S. is also running massive annual federal deficits. In 2011, the U.S. deficit was $1.3 trillion and total national debt was about $10 trillion.
Why tiny Greece matters
Waller said a common question is how a country the size of Greece could be dragging down the 17-nation European Union.
“It’s not so much Greece, it’s the bigger economies of Spain and Italy,” Waller said in an interview. All the countries in the European Union taken as a group make up the largest economy in the world, he said.
“So if they go into a severe recession as an entity, that is going to have dramatic impacts on the U.S. and China both through trade and finance,” he said. “We’re seeing it in China for the first time. China’s growth has slowed down mainly because of a loss of exports to the EU. So it does spill back to us in that way.”
To understand the ramifications to a country that defaults on its debt look at individuals who declare bankruptcy -- and then magnify the impacts on them.
“If a country defaults on its debt usually two things happen: One, they get shut out of financial markets for some period of time. Nobody will lend to them. At all. The idea of running a deficit is not possible and that means the country has to go through some pretty severe restructuring,” Waller said.
While some might argue that a country would be in better shape after shedding its debt load, it doesn’t seem to work that way, he said.
“Countries go through very severe recessions afterward. There is a lot of structural transformation, a lot of political upheaval. And then typically once you come back into the international markets, usually you’re going to get charged a risk premium that’s pretty substantial,” Waller said. “Countries will not lend to you in your own currency. They’ll lend to you in some foreign currency to make sure you can’t just print your way out of a debt. Historically, countries can also harass your trade if you default on debts.”
Lesson for the U.S.?
The European debt crisis, now in its third year, was calmed for a while last December when the European Central Bank committed up to $1 trillion of funding to the banking system to give troubled governments time to make necessary adjustments. But in recent weeks the value of the euro has dropped amid declines in private sector growth throughout the European Union, including stronger members such as Germany. There is growing concern over Spain’s banking crisis and worries that Greece will depart the European Union -- one of its biggest creditors -- after its June 17 national elections. Greek voters have reacted negatively to austerity measures by their government to rein in the nation’s debt.
Waller said the Fed’s essay and video on sovereign debt have been in the works for months but are even more timely because of the recent headlines.
“Often things explode in the press and people are suddenly inundated and have no context of history or economics to organize all of these facts into a coherent story,” said Waller, a former economics professor at the University of Notre Dame who is used to explaining complicated concepts to the general public.
He adds that the situation in Europe offers a warning to the U.S. regarding its own national debt.
“Right now everybody is fleeing to U.S. debt, but at some point that will reverse, or suddenly they will look at the U.S. and think we’re not in a very tenable position,” he said. “That’s the lesson from this -- that we’re not an exception in the big scheme of things. At some point this could all turn around on us and we could be facing similar problems down the road.”
The annual report includes a statement from James Bullard, president of the St. Louis Fed, who points out that the U.S. gross debt-to-GDP ratio is now higher than 90 percent -- with projections indicating that it will continue to rise.
“Now is the time for fiscal discipline to maintain the credibility in international financial markets that the U.S. built up over many years,” Bullard writes. “Failure to create a credible deficit-reduction plan could be detrimental to economic prospects. Furthermore, as the European sovereign debt crisis has shown, by the time a country reaches the crisis situation, fiscal austerity might be the best of many unappealing alternatives. Returning to more normal debt levels will take many years, but the economy would likely benefit if the U.S. were to get on a sustainable fiscal path over the medium term.”
Citing the experience of the 1990s, Bullard disagrees with the notion that deficit and debt reduction can’t occur while an economy is in dire straits.
“During the 1990s, the U.S. had substantial deficit reduction, and the debt-to-GDP ratio declined. The economy boomed during the second half of the decade, which helped to reduce the debt more quickly,” according to Bullard. “While reviving economic growth would also help now, temporary fiscal policies and monetary policy are not the best way to do that. Having a credible deficit- and debt- reduction plan in place would likely spur investment in the economy, as it did during the 1990s. “
