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Tuesday, June 29, 2010

Greece: The Canary in the U.S. Coal Mine?

With everything that was going on in the U.S. economy this past winter, the beginnings of the crisis facing the Greek economy were certainly easy to miss. As that crisis has now come to full flower, American observers overlook it at their peril: Greece’s problems, and those of other European countries, might well represent a possible future for the U.S. economy if we cannot get our fiscal house in order.

Like a canary in a coal mine, the crisis in Greece should serve as a warning that polluting the fiscal air with large budget deficits, a growing public sector, and high debt-to-GDP ratios is a sure way to kill an economy. A serious examination of the situation in Greece should lead other Western countries to think carefully about the paths they are on. Continuing growth in government expenditures means continued deficits, which means growing debt—which means temptation to inflate and the possibility of default.

The cycle of deficits and debt leads down a dead-end road. Once a nation starts on that road, it must make a conscious decision to turn around or it will find itself with the same sorts of problems that plague Greece.

Understanding the crisis that faces Greece, and could face the United States, requires a short detour into the world of fiscal policy. In their path-breaking book, Democracy in Deficit, Richard Wagner and Nobel laureate James Buchanan offer one of the clearest examinations of the nature of the bind we find ourselves in. They argue that for most of the history of the West, governments treated their budgets much like a household would treat its budget: Expenses should be paid out of current income, with two exceptions. First, large expenditures on capital items with long lives could be financed with debt. Second, in times of crisis, especially war, debt was an acceptable way to pay. But, they note, the expectation was that any such debt incurred would be paid off with surpluses during the life of the capital item or after the war. Temporary deficits were acceptable, but permanent ones were not.

Permanent debt was problematic because its costs were borne by future generations. This reduced future economic growth while unjustly taxing not only those “without representation” but also those who had not even been born yet!

The rise of Keynesian economics changed all of this by offering a theory of government and the economy that drove a stake through the heart of the old implicit fiscal constitution. Keynesian economics removed the long-observed constraints on deficit spending by arguing that governments should use the budget to steer the economy: running deficits during recessions to stimulate macroeconomic aggregates and surpluses during good times to prevent the economy from getting out of hand.

Politicians were thrilled with this change, since increasing spending without raising taxes is a sure-fire way to get votes. Because most government spending concentrates benefits on a few identifiable groups but spreads the future costs of borrowing thinly across many people, it is easy to get votes for spending. Perennial deficits resulted because politicians had no incentive to do what Keynesian blackboard models advised: run surpluses in good times. Budget surpluses are generally vote losers for politicians. Buchanan and Wagner demonstrate that once the old restraints were broken, a cycle of spending, deficits, and debt was sure to follow.

To finance that rising debt governments must be able to sell bonds. As long as bond markets have confidence that governments will be able to pay back the debt, the bonds will be sold. And because most governments are considered politically stable, government bonds usually have no risk attached to them and thus provide safe, if low, returns.

If bond buyers hesitate, however, governments face one of two scenarios: They will have to sell their bonds at a lower price, which implies higher future interest payments, or they will use their central banks to create money to buy up their own bonds, which is likely to be inflationary. Rising debt is also self-perpetuating since continued deficits mean more interest payments, which increase future expenditures and contribute to future deficits.

Herculean Profligacy

Against this background, Greece found itself in trouble early this year. After the country moved to the euro in 2001 it had better access to investment markets; politicians naturally reacted by dramatically increasing government spending. Government accounts for approximately 40 percent of Greek GDP, and government workers there have some of the most lavish benefits in Europe, including the possibility of retirement at age 50 or earlier. That large State sector explains Greece’s low ranking (81st) on the Index of Economic Freedom. Not surprisingly, it has a high degree of economic and political corruption, as well as rampant tax evasion. By 2009 the budget deficit was 12.7 percent of GDP and the debt was 113 percent of GDP. The government tried to cover up the extent of its debt by fudging its numbers, which helped precipitate the crisis.

The most obvious sign of Greece’s problems was the rise in the interest rate on its ten-year bonds to 7 percent, which is high for government bonds. (By contrast, the yield on U.S. ten-year bonds averaged 3.5-4 percent for the first three months of 2010.) Those high rates reflected a loss of confidence in Greece’s ability to pay its debts. The problem, of course, is that those high rates exacerbate the self-perpetuating nature of deficits by requiring larger interest payments in the future, leading to greater deficits.

Since Greece, as a euro country, has no central bank of its own to buy up its bonds, and foreign investors (who own 80 percent of the debt) found the lending too risky, concerns about default rose substantially, prompting calls for emergency bailout loans from healthier European Union countries such as Germany.

The Greek government proposed a variety of measures to try to cut expenditures, including raising the retirement age, overhauling the tax system, and reducing government-employee pay and benefits. Government workers and other union members, predictably, reacted with protests and threatened social unrest if the austerity measures took effect.

This is the trap that Buchanan and Wagner identified. By concentrating benefits on the few, government spending creates beneficiaries who would sustain concentrated losses when spending was cut—giving them every reason to resist the cuts. So Greece finds itself in a bind: To reduce its debt and the possibility of default it must cut spending, which is enormously unpopular among influential constituencies. The near trillion-dollar bailout engineered in May only enables Greece and other beneficiaries to delay the difficult decisions they will eventually have to make.

If we look at some comparable numbers in the United States today, we can see how far the Bush and Obama administrations have taken us down Greece’s path. The most recent data from the Congressional Budget Office (CBO) are sobering. If the Obama administration’s proposed budgets pass, the deficit would be $1.5 trillion this year and $1.3 trillion in 2011, representing 10.3 percent and 8.9 percent of projected GDP, respectively. That is not far from the 12.7 percent Greece faced in 2009. The CBO estimates the deficit will fall as a percentage of GDP toward the middle of the coming decade, but that rests on the heroic assumptions that new reasons for major welfare-state, corporate-bailout, and military spending will not be found and that spending on the health insurance revamp does not grow in the exponential ways we have seen with other social programs.

At the end of 2009 the cumulative debt of the U.S. government was about $12 trillion, with $7.5 trillion—53 percent of GDP—held by the public. The CBO estimates that at the end of 2020 publicly held debt will be a staggering $20.3 trillion—90 percent of GDP—with total debt being notably higher than that. By 2020, therefore, we will not be far behind where Greece is now. Looked at differently, in 2020 the value created by the U.S. economy for the year would be just enough to pay off our total public holdings of debt, but barely. The CBO also provides some evidence for the self-perpetuation process: Between 2010 and 2020 net interest payments are projected to more than quadruple in nominal dollars, and as a share of GDP they will rise from 1.4 percent to 4.1 percent of GDP.

New Money for the New World

The United States, however, has one piece of the puzzle that Greece lacks, which could change the way this process unfolds. As noted, Greece is on the euro, so it lacks a domestic central bank with which to monetize its debt. The United States has the Federal Reserve, so one outlet the federal government has, if skeptical bond markets demand higher yields, is the Fed’s purchase of bonds with newly created money.

Buying bonds in the open market is how the Fed normally increases the money supply, so this is not a new process. When the Fed does this, it returns the yield to the Treasury, thereby giving the government an interest-free loan. Each time the Fed buys a government bond from the public, it enables the government to run additional debt—float more bonds—without a net increase in interest payments.

The Fed could also buy bonds directly from the Treasury and instantaneously extend an interest-free loan through the creation of new money. Historically, it has not done this, but since the current recession and financial crisis began in 2008, it has dipped its toe into those waters. Doing so will become increasingly tempting for the Fed if the rising level of U.S. debt begins to scare off bond buyers.

Of course the danger of doing this too much is inflation. The Greek economy has a very low rate of inflation at the moment, thanks to the relative stability of the euro. However, many other countries faced with similar fiscal situations have resorted to the printing press, generating high levels of inflation that did major damage to their economies.
The U.S. government will be tempted to monetize the debt. If China’s demand for U.S. bonds weakens, driving up yields, the alternative to reducing deficits and paying off debt, or getting a bailout, will be monetization and debasement of the dollar. It will be tempting because the costs of inflation are disguised, dispersed, and stretched over the long run. Politicians rarely get punished for it as they get punished for cutting expenditures.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.