Committee for a Responsible Federal Budget

Why This Isn't Just a Greek Problem

May 10, 2010

The EU and IMF just recently agreed to provide a nearly $1 trillion rescue fund for European countries facing troubled fiscal waters. Meetings over the weekend between European finance ministers lasted until early today, after which the EU announced it would provide $560 billion in new loans and an additional $76 billion to existing lending programs to struggling countries. The IMF is prepared to supplement this with $321 billion in financial support, bringing the total size of the rescue package to $957 billion.

The purpose of these funds will be to help stabilize the market as Greece and others make necessary fiscal adjustments. The loans come with strict conditions, though, so as not to let countries like Greece completely off the hook.

Although the announcement of the rescue package has already appeared to improve European and global markets (as shown by the halving of Greece's 10-year borrowing costs and the rebound in global stock indices), it is not a cure for future fiscal woes. Overall debt levels remain very high throughout Europe, and market uncertainty over countries' abilities and/or willingness to reign in borrowing could prompt another crisis down the road. 

Robert Samuelson has a great op-ed in today's Washington Post on how a dire fiscal outlook is not just Greek's problem, but most "every advanced nation, including the U.S., faces the same prospect." He argues that advanced economies have promised huge health and retirement benefits for which they have not fully budgeted. With a debt level at about 115 percent and a deficit of about 13 percent of the economy, Greece has run into its fiscal wall. Given enough time, most other advanced economies will meet Greece's fate if current policies are left unchanged.

In reality, Greece's recent experiences are somewhat different than ours. Their current crisis was prompted by the misrepresentation of fiscal data and a subsequent deficit-driven shock, not just by growing entitlement costs. Even so, the Greek experience shows us the dangers of having markets lose faith in sovereign debt.   

Carmen and Vincent Reinhart clear up some other misconceptions about Greece's crisis in yesterday's Washington Post:

  1. This is a new type of crisis (actually, governments have borrowed beyond their means for centuries)
  2. Small economies such as Greece can't launch major financial turmoil (remember Thailand in 1997?)
  3. Fiscal austerity will solve Europe's debt difficulties (reduced borrowing now could threaten the recovery)
  4. The euro is to blame for Greece's financial woes (not true - the real question is why did investors facilitate overborrowing?)
  5. It can't happen here (we've heard that before -- but guess what, it can!)

As Greece illustrates, countries (including the U.S.) are in a bind right now. Cutting back on spending and raising more revenue now could undermine recoveries in a way that not only hurts the economy, but makes fiscal goals much harder to achieve (slower growth means lower revenue, increasing automatic stabilizer spending, and a smaller denominator in debt-to-GDP ratios). Yet, waiting too long to make fiscal adjustments can also lead to economic havoc and have many of the same consequences -- along with higher interest payments to boot.

There is a solution though: announce a fiscal plan now, which delays most fiscal adjustments until after the economy has recovered. Since markets are (at least somewhat) forward looking, such a strategy can help to avoid a hard landing.

And as CRFB argued in this policy paper, it's always better for a country to make fiscal adjustments on its own terms.  

The sheer number of countries facing future budgetary difficulties is daunting and could spark a worldwide economic collapse if nothing is done to curb the growth of debt. As Samuelson says, this is "why dawdling is so risky."