My second piece, “The Problem With Greece” is up at Yahoo.
Greece takes center stage again in the markets as investors worldwide get spooked by the increasingly alarming situation in European government debt. But why does Greece, a country that has only 1/3rd the GDP of India and just 2% of the Eurozone economy, matter to world markets?
It’s not just Greece. Portugal, Italy, Ireland and Spain – known with Greece as PIIGS – are also in some danger. All these countries have borrowed a lot during good times, and now it’s time to pay that money back. Unfortunately, the economies haven’t recovered much from the recession in 2008, and some of them run large deficits – meaning, amounts by which expenses exceed revenues, so they can’t pay everything back just yet.
Here’s how this works. Governments borrow to meet expenses or for capital expenditure (such as building infrastructure). These loans are either short-term, with less than a year to maturity (sold as treasury-bills), or long-term (bonds). The interest rate paid on these loans is usually very low, because Governments are ultra-safe avenues to invest in. (That concept is so 2005, come to think of it.) Eventually, because the government has the power to raise taxes or cut expenses, we believe they will ‘balance the budget’ – meaning, make revenues equal to or greater than expenditure – and thus, pay back interest and principal to the lenders. Lenders are usually banks, pension funds, insurance companies, and even retail investors who buy for safety.
Once in a while, that trust gets shaken. Countries such as Greece borrowed a lot during the good times, at low rates. But they didn’t balance themselves – they built up very large deficits by spending more than they made from tax revenues. They did what you do when you spend more than you earn: borrow the rest. Investors lent thinking this is probably temporary, and eventually they’ll balance it out.
At some point, and that point is about now, investors get jittery that deficits continue to build up and there’s a risk that money will not be returned; so they demand higher and higher interest on new debt. Greece’s two year bonds recently needed 15% before investors would buy – and just a year ago, they were less than 4%.
What’s the problem? The interest is too large and will strain the country’s already stretched finances. Greece has already borrowed 120% of its GDP. Since that borrowing is in Euros, they can’t even print the money and pay lenders back – an option open to the US and India, for instance. India borrows largely in rupees, and in an extreme case we can print rupees and pay investors back, even if that will lead to inflation. Greece has no such option.
Greece is currently running a deficit of 14% of GDP, and if the interest rates spike, they have to pay more interest next year – meaning expenses go up. So their deficit will widen, and they’ll require more borrowing to finance that, and that will increase interest rates even more and so on. At some point, the cookie will crumble. To stem the flow they need two things:
a) A massive reduction in spending and increase in revenue so investors have reason to believe deficits won’t go out of control.
b) A temporary backstop right now that allows them access to money at low interest rates so they can implement a) above, which takes time.
Without the above, Greece will have no choice but to ‘default’ – by telling lenders they may not get all their money back, just some of it, over time. This is where some of the problem really is – a lot of the lenders to Greece aren’t Greeks. They are banks and investors in other countries – France and Germany for instance. A default will require those entities to take big losses, and that will hurt those other economies. More importantly, Greece is in the Euro, and a Eurozone default means investors will get wary of all Euro debt and therefore force other countries to pay higher rates for their debt.
That is truly a scary proposition because the recent recession has left all these governments with extremely high deficits. France, for instance, has deficits at 8% of GDP; Spain, Ireland and Italy are already above 10%. The US is at around 10% of GDP and the UK is touching 12%, so it’s not just Mainland Europe. (To provide a local comparison, India is officially at 6.5%) These deficits will require repeated trips to the market to request investors to please, please, pretty please buy sovereign debt, and at low interest rates. While that has worked till now, it’s looking under threat as governments like Greece find themselves overstretched. A whiff of a default there, and everyone around that needs to borrow is in a spot.
(To see where the trouble is, have a look at these two graphs of the PIIGS: 1, 2.)
How then does one control all of this? If Greece must be rescued, it will be to protect other countries, not just for Greece itself. Germany balked at the bailout – the Euro after all was set up with a no-bailout provision of sorts – but soon gave in once they realized the contagion will spread fast. But the rescue must come with a cost -with no cost, there is moral hazard, meaning the remaining countries can continue to widen deficits without fear, since they expect to be bailed out as well. What then is the cost?
The 120 billion Euro rescue package for Greece from the European Central Bank (financed mainly by Germany and France) and the IMF over three years will need Greece to dramatically cut expenses and hike taxes – austerity measures are not popular with the Greeks. It’s also counter-productive in a way; when you hike taxes and reduce government expenditure, you will reduce your GDP in the short term. Mathematically, even if deficits come down, deficits as a percentage of GDP will remain high. Greece needs to aim to reach deficits of 3% of GDP with all these measures, and come up with a plan fairly fast; but it’s a warning to other countries to get their act together, or else.
Already, the European Powers have decided to spend nearly a trillion dollars along with the IMF to “support” Euro zone government and private debt. This is a bailout in the sense that it moves the risk from private hands (banks, investors who hold government debt) to governments (who buy each other’s debt). The money will come from the central bank – which has the power to print money – and will be financed by individual governments, which effectively means all the taxpayers of the Euro region.
Colour me naive, but the idea of fixing a high-debt problem with even more debt doesn’t quite gel. Yet, a long stretch of time may pass before sovereign debt balloons out of control; perhaps we only pass on this problem to our children. And then, maybe the coroner is just around the corner.
