International Finance

Why Excessive Debt is the Real Problem – Part II

One of the main reasons for the unemployment problem around the world is excessive debt. Only when we eliminate the underlying source of our problems will we be able to sustainably reduce the unemployment rate. In my last post about debt I talked about mortgage debt. This post is about government debt.

Consider the Greek debt problem. Examples of Greek government largesse are easy to find on the internet. For example, government workers get some of the best benefits anywhere in the world. All are paid in 14 monthly paychecks per year. (the two extra amount to negotiated bonus payments). Some workers can retire with a full pension as early as age 45. Pensions of deceased military officers continue to be paid to their unmarried daughters for life or until she weds. Some union members were once granted free unlimited transportation on the national airline. The state railroad payroll is 4 times larger than total ticket sales. There are many more examples like this.

To finance these generous benefits, and to remain popular, the Greek government had to borrow enormously. When the economic crisis hit in 2008, Greek government debt had already reached 100% of GDP. This year Greece’s total debt is expected to exceed 150% of GDP, which amounts to over $450 billion. And still the Greek government continues to run large budget deficits to fulfill promises that are clearly untenable.

The situation is a mess and the problem just keeps getting pushed further into the future. One necessary outcome is for Greece’s budget to be balanced quickly or even moved into surplus to reduce their enormous debt. However, if this is done too quickly it could cause sharp contractions in economic activity making it even harder to pay down the debt. The Greek people have already risen up riotously this year (and last year) to protest the proposed cuts in government programs or increases in taxes. After all, profligate or not, the Greeks feel entitled to these promises, just like Americans feel entitled to their Social security, Medicare and tax breaks. They are surely not willing to rein in excesses without a fight. Besides what is excess to one person is another person’s monthly paycheck.

Greece’s government doesn’t want to make the needed budgetary changes (no sane politician would!) because the changes are very painful and unpopular. So the only way to continue the largesse, quiet the protests, and move along is to get someone to lend them even more money. But with a CCC bond rating (worse than junk bond status) they can’t borrow on the private market unless the interest rate was extremely high to compensate for the high risk of default. The risk premium on short term Greek bonds currently exceeds 25% and borrowing at that rate would push up their deficits and debt even faster.

In July 2011, for the second time, the EU stepped in to provide up to $160 billion in loans to allow Greece to continue to borrow at relatively low interest rates and with longer maturities. In essence this is like an increase in Greece’s debt ceiling, allowing it to continue running deficits. However, these EU bailouts are funded by the other EU countries. Thus, if Greece can’t repay these loans, the losses will be borne by taxpayers in the other EU countries.

Of course, in accepting these bailouts Greece is required to bring its budget into balance in a reasonable time period. Interestingly Greece has not been doing a very good job at this. In the first half of 2011 – this is after the bailout loans they received last summer – the Greek budget deficit rose 24%. Of course some of this has to do with the fact that the economy is stagnant and unemployment remains above 15%.

So growth is slow to nonexistent, tax revenues are falling, government promises remain generous, and any attempt to reduce spending leads to massive riots in the streets. So why do they keep getting bailed out?

There are several reasons.

First, creditors – that is, the institutions holding the $450 billion in Greek bonds – want to get their money back someday. (Note it is not the bank’s money in jeopardy.. it is depositor’s money .. that’s the people’s money) If Greece defaults then some creditors may not get anything back. Better to get a deal and wait longer than get nothing. Also, defaults can be disorderly as creditors line up trying to squeeze as much value out for themselves as possible. For example, if Greece owes $50 billion but only $25 billion in cash, who gets paid and who doesn’t? Figuring that out can sometimes take years.

The bailouts amount to promises that creditors will get their money back eventually, but will have to wait longer for it. So the bailouts buy time. For Greece though, the bailouts result in forced austerity, especially for those most dependent on government programs or those who pay taxes … which, of course, means pretty much everyone, … hence the riots in the streets!

Actually it is worth noting that another way to solve the problem for Greece is an outright default. If Greece defaulted, they would have to first settle with the creditors to decide who will not be repaid (this is a contentious process) and second balance their budget immediately because no one will lend them money for a long while. Thus the austerity will be even more painful in the short run. If Greece receives bailouts, then the austerity still has to happen, but it will be spread out over a longer period into the future. One question worth considering is whether it is better 1) to suffer a greater austerity quickly, resolve the debt problems (basically determine who is getting money back and who isn’t) and move on with a healthy balance sheet, or, 2) to suffer a longer and milder, though still painful, austerity and hope that the economy can grow and change into a healthy one in the distant future?

Perhaps the bigger problem for the world economy, though, is contagion. Many observers say Greece is small and so the problems there don’t matter much. That’s true, Greece is about the size of Maryland. But Portugal, and Ireland, and Spain and Italy are facing similar problems. If Greece’s problems migrate to these other countries then creditors will worry about the value of their loans to these countries too. And these loans are much bigger.

If Greece defaults, maybe the banking institutions can handle the losses. But what if Portugal, or Ireland, or Spain, decides to default? These could be large enough to force innumerable financial bankruptcies and threaten the entire financial system. Or what about the EU and IMF bailout of Greece? Again the values aren’t that large. But, what if the EU needs to lend money to Portugal, Ireland and Spain to keep them afloat too? (Note: they’ve already begun to do this!) How deeply into debt and how much risk are the Germans, French and other EU members willing to bear?

The essence of the true problem then is that numerous financial institutions around the world have taken deposits from its citizens and have saved the money by lending it to governments. Some of that money is in jeopardy of not being returned in full, but no one knows whose money is most in jeopardy or when those losses will materialize. Add on to this the US debt ceiling debate and the downgrading of US debt by S&P and we have financial institutions around the world questioning the true value of an enormous amount of their outstanding loans. It is worries like these, spread across the globe, that prevents the expansion of credit and the necessary risk taking that inspires economic growth. Sure, lending is occurring, but it is mostly safe and highly secured loans. These can keep the economies of the world running in place, but it is unlikely to fuel the rapid expansion we need to bring unemployment rates down.

If we want to solve the unemployment problem, there is no recourse but to alleviate the debt problems. There remains too much risk and uncertainty about the true value of outstanding loans for the world markets to function effectively. This is a reason why a large stimulus program may not work in this environment. Yes extra government spending can increase demand and create a few jobs for a little while, but this probably won’t speed up the debt restructuring. So if after the demand boost runs out, there remains a large number of underperforming loans, then we will also remain stuck in a stagnant economy. Only now we will be stuck with an even scarier level of government indebtedness that in turn could exacerbate the debt problems.

A useful analogy may be to think of the debt problem described above corresponding to a car that has been downshifted into 2nd gear. A fiscal stimulus represents stepping on the accelerator. Yes, the more we step on the gas (the bigger the stimulus) the faster the car goes, but if we remain in 2nd gear we’re in danger of burning out the engine. We can only return to a comfortable highway speed by upshifting to 3rd or 4th gear, and that requires resolving the debt problem first.

About

Steve Suranovic received his B.S. in mathematics from the University of Illinois at Urbana/Champaign and his M.S. and Ph.D. in economics from Cornell University. He has been a faculty member at the George Washington University since 1988. He has served several terms as the current Director of the International Trade and Investment Policy M.A. program at the Elliott School of International Affairs.

3 Comments

  • Looking forward to hearing your response. I am only able to write so frequently right now because my schedule permits it. I definitely agree with the perfect world comment as far as debt restructuring goes. I am specifically thinking of Europe. You are right if many of the European countries were to declare bankruptcy simultaneously it would be a disaster. In my opinion the United States still has the time and the institutions to act. The closest example to the US I can think of as far as a debt to GDP ratio is the UK. The UK GDP has been hurt by their austerity, the last figure I saw showed zero growth. The US will need growth to get out of our mess. Even though we have significant levels of debt, I do not know where that growth will come from without the government stepping in and spending. In a perfect world we would have an international restructuring of debts for several countries, including the US. Unfortunately the best example from our past of international debt restructuring only came after a world war (Specifically WWII). The political will just does not seem to be there. It has been a shame so far to see that countries and international political institutions have been trying to put band-aids over serious debt levels in Europe. Obviously, something will have to be done about the Eurozone in the long run because the way that it was constructed has proved disastrous. Perhaps there will be a way out of this but none of us truly knows what lies ahead. In my opinion the most politically feasible way for the international financial system to escape this conundrum is through a pseudo debt restructuring and growth. Could the financial system stomach the worst Eurozone offenders being kicked out of the Eurozone and being forced to return to their previous domestic currencies? It would have to be the smaller economies of Ireland, Greece, etc. Could Italy and Spain be given the help they need to survive? I do not think the financial system could handle any of the bigger economies being kicked out of the Eurozone right now. If the small and worst offenders were kicked out of the Eurozone it seems as if they would be forced to deal with their own problems if they had their own currency. Even if the previously mentioned Europe solution could work the international financial system still needs growth. Obviously we won’t be getting that from Europe any time soon. Everything I read points to the emerging markets (China, Brazil, India, etc) as slowing down. Where will the boost come from? I do not know the answer to that question with the current debate we have going on. I personally believe the U.S. should be taking the risk and leading. Yes, I agree it’s a significant risk (good quote from Romer). Yet there is also a risk of doing nothing. As far as the U.S., our unemployment situation could become too long term. New technology is constantly being developed as we speak that workers will not know how to utilize if and when they have the opportunity to return to work. Of course we don’t know when that will be because we are waiting for consumers to deleverage on their own (with the help of their stagnant wages). I listened to Ken Rogoff speak the other day and he had an interesting idea, but again, it would involve spending money. He suggested pairing serious mortgage relief with a modest sized and targeted fiscal stimulus. I only bring this up because debt concerned economists seem willing to listen to Rogoff.
    Personally, I think mortgage relief is a great idea if it’s going to be a real effort. However, as we all know in the United States that the bank lobby is strong and our campaign finance laws are weak.

  • Thanks for this interesting response. I can't answer all the questions now but will try to address some in my next few posts.

    I don't think we need sit on our hands but I do think we need to work towards resolutions that are sustainable. More and more government debt right now moves us in an unsustainable direction. If it pays off and kickstarts the economic engine like you suppose, then it could be worth the risk, but it is a big risk because if it doesn't work than we are even more f**ked” to quote Christina Romer.

    What to do now is anything and everything to reach resolutions on the questionable debt contracts. In a perfect world insolvent households, businesses and governments would declare bankruptcy and the scramble to figure out who gets the recoverable assets would proceed quickly to a conclusion. Most likely though if too many bankruptcies occur simultaneously it could inspire a ripple of insolvencies that collapses the whole financial system. So we want to push the resolution of bad debt as fast as we can without toppling the system. I'm not sure how to do this, but I do think this should be the focus of government policy.

    Note though the sensitivity of this issue. If governments publically announce that the big problem is that too many outstanding debts will not be repaid, then that knowledge itself can lead to runs on the financial system. The system is very unstable now and so drastic measures and quickly shifting perceptions can be extremely destabilizing.

    This is why I don't think there is an easy and obvious solution. Eventually the bad debts will be resolved … perhaps after an episode of inflation. It would be nice if we could get there in two years rather than 10 years though.

  • I agree with basically everything you said involving Europe. Although, I am more worried about the larger countries (Italy, Spain…. And now introducing France (possibly)). However, I am confused at your take on the United States. You acknowledge that we have an unemployment problem. You acknowledge that we have a demand problem. I agree with you on those two fronts. Perhaps we diverge on the urgency of the unemployment problem though. This is a crisis and not just a problem. This is not the time to take the approach of Classical Economists and let the market correct itself. Could we be stuck in second gear after a stimulus? Possibly, but I believe history shows us that will most likely not happen. You mentioned in a previous article that the WPA and other programs did not help unemployment very much. However, we both know that the main area of disagreement between scholars lies in 1937 (the pullback on fiscal stimulus carried out by one of our political parties – I bet you can guess which one). Yet you show the unemployment numbers from 1935 and 1938… you completely discount the pullback of fiscal stimulus in 1937. We need to relieve the suffering by the unemployed right now. You seem terrified of higher taxes in the future more than the plight of the unemployed. Again you're trying to justify arguments made by the Classical Theory of Economics. Andrew Mellon and others likened that same approach of hesitancy to take action in the beginning of the Great Depression. Is there a risk of us staying in second gear after the stimulus runs out? Yes. However, this should be a cost versus benefits analysis. I personally believe that risk is worth taking. We need inflation (to reduce the burden on consumers) and it is hard to get any in this liquidity trap. The consensus that we should consign ourselves to sitting on our hands is not a good one. As treasury yields show, we have the ability to borrow and pay little or no interest. Considering we are handing out unemployment benefits on a massive scale, do you really not believe that paying many of those same people to repair bridges, roads, sewer systems, etc would not have a return on investment? Would it not help inflation to rise and therefore relieve household debt? Would it not create more jobs and therefore reduce the excess supply of labor? Would the reduction in the excess of supply of labor not boost wages? Would it not boost the GDP (and therefore tax revenue) and in doing so help to close our gap between revenues and expenses? Your fear of the debt (not shown by the market through extremely low yields) and some taxation in the future appears to me that you have not grasped what mainstream economists took away from spending during the Great Depression. If this is your view, then we should all resign ourselves to low growth for years to come for an overblown fear of our debt.

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