Greasing The Wheels For The Skid

Peter Boone and Simon Johnson at Baseline Scenario:

There are disconcerting parallels between Argentina’s catastrophic decade, 1991-2001, which ended in massive default, and Greece’s recent and impending difficulties.  The main difference being that Greece is far more indebted, is much less competitive in global markets, and needs a commensurately greater fiscal and wage adjustment.

At the end of 2001, Argentina’s public debt GDP ratio was 62%, while at end 2009 Greece’s was 114%.  Argentina’s public deficit reached 6.4% GDP in 2001, while Greece’s was 12.7% GDP (or 16% on a cash basis) in 2009.  Both countries locked themselves into currency regimes which made it extremely painful to exit:  Greece has the euro, while Argentina created a variant of a currency board system tied to the US dollar.  And both countries had seen their competitiveness, as measured by the “real exchange rate” (which reflects differential inflation relative to competitors) worsen by 20% over the previous decade, helping price themselves out of export markets – and boosting their consumption of imports.  In 2009 Greece had a current account deficit equal to 11.2% of GDP, while Argentina’s 2002 current account deficit was a much smaller 1.7% GDP.

The solution to such crises is rarely gradual.  Once financial market confidence is lost, yields on government debt soar, private capital flees, and sharp recessions occur.  The IMF ended up drawing tough conclusions from its Argentine experience – the Fund should have walked away from weak government policy programs earlier in the 1990s.  Most importantly, IMF experts argued that from the start the IMF should have prepared a Plan B, which included restructuring of debts and termination of the currency board regime, since they needed a backstop in case the whole program failed.  By providing more funds, the IMF just kicked the can a short distance down the road, and likely made Argentina’s final collapse even more traumatic than it would otherwise have been.

Sadly, the Greeks are today in a similar situation: the government’s macroeconomic program is not nearly enough to calm markets, or put Greece’s debt on a sustainable path.  By 2012 we estimate Greece’s debt/GDP ratio will rise from 114% of GDP to over 150%.  The interest payments alone on this would amount to 9% of Greek’s incomes at current rates, and almost all those funds are transferred to the German, French, and Swiss debt holders.

Greece’s 2010 “austerity” program is striking only for its lack of credibility. Under that program Greece, even in 2010, does not pay the interest on its debt – instead the government plans to raise 52bn euros in credit markets to refinance all its interest while at the same time it borrows 4% of GDP more.  A country’s “primary budget” position measures the budget without interest expenses — at the very least, the Greeks need to move from a 4% of GDP primary budget deficit to a 9% of GDP primary surplus – totalling 13% of GDP further fiscal adjustment, in the midst of what will be a massive recession, just to have enough funds to pay annual interest on their 2012 debt.  This is under the rather conservative assumption that interest rates would settle near 6% per year, where they stand today.  The message from these calculations is simple: Greece needs to be far more bold if its austerity program is to have a serious chance of success.

How did Greece manage to get into such a terrible situation?  Local politics that lead to profligate spending is one answer.  But remember that someone needs to supply the money that allows such profligacy.  In this case it was the European Central Bank that handed Greece the keys to the safe.

Megan McArdle:

Greece’s fiscal problems are turning into one of those endless sagas, the kind we watch unfold at Thanksgiving every year.  Aunt Daphne is going to leave Uncle John!  No, they’re in counseling! Wait, now Aunt Daphne is breaking up with the counselor, too!  The rumors are starting to take on a toxic life of their own, driving up the yields demanded on Greek debt–which in turn, makes it less likely that they’ll be able to finesse the crisis with a moderate infusion of outside cash.

Paradoxically, that seems to be good news for us, pushing our debt yields lower; we are the proverbial “any port in a storm”. This phenomenon is what makes it so difficult to assess the risk of US fiscal trouble.  On the one hand, the US budget is clearly on a completely unsustainable path, and frankly, our household budgets don’t look so much better.  This should make investors nervous about our bonds.

And as far as I can tell, they are.  But they’re even more nervous about bonds everywhere else . . . because everywhere else has worse demographic problems, and a less impressive history of economic growth.  So they aren’t signalling their nerves the way we’d expect, by slowly and steadily pushing up bond yields.

But that in itself is a vulnerability.  If at any point we are not seen as the safest game in town, we will take a gigantic–the better word might be “catastrophic”–hit on our bond interest.  If there’s somewhere safer to park our money, suddenly we lose the premium we currently enjoy for having bonds considered the “risk free” rate.  So while our super-sterling credit rating may delay the onset of a fiscal crisis, if we ever let it get to that point, the onset may be even more sudden and disasstrous than these things usually are.  All the more reason to start getting our fiscal house in order now.

Paul Krugman at NYT:

The debt crisis in Greece is approaching the point of no return. As prospects for a rescue plan seem to be fading, largely thanks to German obduracy, nervous investors have driven interest rates on Greek government bonds sky-high, sharply raising the country’s borrowing costs. This will push Greece even deeper into debt, further undermining confidence. At this point it’s hard to see how the nation can escape from this death spiral into default.

t’s a terrible story, and clearly an object lesson for the rest of us. But an object lesson in what, exactly?

Yes, Greece is paying the price for past fiscal irresponsibility. Yet that’s by no means the whole story. The Greek tragedy also illustrates the extreme danger posed by a deflationary monetary policy. And that’s a lesson one hopes American policy makers will take to heart.

The key thing to understand about Greece’s predicament is that it’s not just a matter of excessive debt. Greece’s public debt, at 113 percent of G.D.P., is indeed high, but other countries have dealt with similar levels of debt without crisis. For example, in 1946, the United States, having just emerged from World War II, had federal debt equal to 122 percent of G.D.P. Yet investors were relaxed, and rightly so: Over the next decade the ratio of U.S. debt to G.D.P. was cut nearly in half, easing any concerns people might have had about our ability to pay what we owed. And debt as a percentage of G.D.P. continued to fall in the decades that followed, hitting a low of 33 percent in 1981.

So how did the U.S. government manage to pay off its wartime debt? Actually, it didn’t. At the end of 1946, the federal government owed $271 billion; by the end of 1956 that figure had risen slightly, to $274 billion. The ratio of debt to G.D.P. fell not because debt went down, but because G.D.P. went up, roughly doubling in dollar terms over the course of a decade. The rise in G.D.P. in dollar terms was almost equally the result of economic growth and inflation, with both real G.D.P. and the overall level of prices rising about 40 percent from 1946 to 1956.

Unfortunately, Greece can’t expect a similar performance. Why? Because of the euro.

Until recently, being a member of the euro zone seemed like a good thing for Greece, bringing with it cheap loans and large inflows of capital. But those capital inflows also led to inflation — and when the music stopped, Greece found itself with costs and prices way out of line with Europe’s big economies. Over time, Greek prices will have to come back down. And that means that unlike postwar America, which inflated away part of its debt, Greece will see its debt burden worsened by deflation.

Arnold Kling:

What Krugman never mentions in his column is the fact that defense spending fell dramatically as a share of GDP in the United States after World War II. In fact, even as late as the 1990’s, the fiscal outlook in the United States appeared to be improving because defense spending’s share of GDP was falling. As of now, defense spending is already too low relative to GDP for further cuts to make a meaningful difference.

According to the Committee on the Fiscal Future of the United States, by 2030, U.S. debt will be 117.6 percent of GDP, roughly the same as that of Greece today. And that is with total non-interest, non-entitlement spending of only 8.5 percent of GDP. (The report pre-dates the Obama Administration, which has substantially increased the path for both debt and spending.)

I have said this before, but the Left’s favorite solution to this, which is bending the health care cost curve between now and 2080, is whistling past the graveyard. We will not get to 2080. Instead, the crisis will come before 2030. If you have not done so already, stare at the table.

Several years ago, I wrote that the future will be a Great Race between technological progress and Medicare–a contest between the technological Singularity and a fiscal Singularity, if you will. Back then, I thought that the technological singularity had a better chance of winning than I do now.

The next time the United States hits a debt-to-GDP ratio of 100 percent or more, we will look much more like Greece in 2010 than the United States in 1945. That is, our government will be in a state of paralysis, the public-sector unions and pensioners will be in a state of hysteria, and defense spending will be only a few percentage points of GDP. Like Greece, we will be devoid of options. At that point, “inflating away the debt” will not be some mild, harmless act–it will require a virulent inflation and/or capital levy that wipes out the savings of everyone except those who have found safe havens overseas.

Have a nice day.

Matthew Continetti at The Weekly Standard

Tom Maguire:

First, the notion of hyper-inflation followed by default probably takes its inspiration from Weimar Germany and Latin America.  However, neither example is useful since they (like Greece, but unlike the US) were dealing with debt denominated in something other than their own currency.  In fact, as Krugman notes in the passage above, inflation is probably a substitute for formal repudiation of our debt.

However, Japan’s Lost Decade provides a more relevant example – a long, grinding deflation could push the US into an untenable financial position.  And that might happen despite a sustained Fed policy of low interest rates and easy money.  Imagine that China maintains its link of the yuan to the dollar, so that easy dollars simply result in easy yuan, thereby stimulating employment and production in China (actually, that is pretty easy to imagine, since it has been the story of the last several years, although China’s policy may change.)  The Fed will never achieve either inflation or robust growth here, since China swallows it up by buying dollars and selling yuan, and the US might be pushed to the brink.

But to the brink of what?  What might a US default look like?  Since we control our own printing presses, it is not that easy to picture logical scenarios in which we default on our debt rather than spinning the presses and printing the legal tender needed to pay off our bills, notes and bonds.  But we are talking about Washington, so why rely on logic?

Matt Welch in Reason

Felix Salmon:

There are two outcomes which no one wants in Greece but which are still becoming increasingly likely: default and devaluation. Argentina did both in 2001. But these aren’t binary things: both can be relatively mild or extremely severe. In Greece’s case, they would surely be much more modest than they were in the Argentine.

The first option is default. If it happens, it’ll happen, as Thomas says, in the form of a debt restructuring, where holders of Greek debt would end up getting new bonds with new terms — lower interest payments, lower principal amounts, that kind of thing. Debt restructurings are messy and unpleasant things at the best of times, but what we’re really talking about here is the sovereign equivalent of a loan modification which, if it goes according to plan, makes both the borrower and the lender better off.

What we’re most emphatically not talking about here is an Argentina-style default, where the country simply unilaterally stops paying any interest on its debt, and then takes years to address the issue, trying to drive the hardest bargain it can all the while.

Then there’s devaluation. If Greece leaves the euro, that would allow it to devalue its currency. If it redenominated its debt from euros into drachmas, that alone would constitute a default, even without a bond exchange. But again, in the event that Greece did leave the euro, it wouldn’t see its currency plunge overnight to a third of its previous value, as Argentina did.

This is where being a member of the EU really does help — not least because of the large exposure that many European banks have to Greece. Even if Germany insists on a hardline refusal to bail Greece out, it equally doesn’t want a Greek failure to be the just the first of the PIIGS dominos to fall, in a series of sovereign collapses which would make the 1998 Asian crisis look positively tractable in comparison. As a result, even in the worst-case scenario, the EU and IMF are at least likely to step in somewhere to cushion the blow and to try to isolate Greece’s problems. What happens in Athens must stay in Athens: if it spreads to Rome and Lisbon and Dublin and Madrid, London would probably be next, and at that point we’d have a major global financial crisis at least as severe as the one we just went through.

So while it’s true that, as Mohamed El-Erian says, things will likely get worse for Greece before they get better, it’s worth being a little bit realistic here about just how much worse they could possibly get. For the time being, everybody’s still hoping that Greece will somehow manage to get through this crisis — and Greece’s debt spreads, while wide, aren’t yet trading at distressed levels. That’s grounds for hope. And it’s also an indication that traders see much less downside here than there was in Argentina.

Robert Wielaard at Huffington Post:

Trying again to halt a debt crisis that has hammered the euro, fellow eurozone governments tossed struggling Greece a financial lifeline Sunday, saying they would make euro30 billion in loans available this year alone – if Athens asks for the money.

The International Monetary Fund stands ready to chip in another euro10 billion, said Olli Rehn, the EU monetary affairs chief.

The promise – filling in details of a March 25 pledge of joint eurozone-IMF help – was another attempt to calm markets that have been selling off Greek bonds in recent days.

Markets viewed the March pledge as too vague and carrying such tough restrictions that Greece could not easily get the money. As a result, investors demanded high rates to loan to the government as it struggles to avoid default – rates the government says it can’t go on paying. Greece has some euro54 billion in debt coming due this year and a huge budget deficit.

In an emergency video conference, the finance ministers of the 16-eurozone nations agreed on a complex three-year financing formula that generates an interest rate of “around 5 percent.”

EARLIER: A Scattering Of Blog Posts Concerning Greece, Germany, And EMF

Beware Goldman Sachs Bearing Gifts

About these ads

Leave a comment

Filed under Economics, Foreign Affairs, The Crisis

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s