Greece’s debt problems indicate that the financial crisis which came to a head in 2008 is not really over, but is still running its course. Initially, prompt actions by governments appeared to have succeeded in averting the outright destruction of the banking system and to have softened its economic consequences. But the heavy debts taken on by Western governments mean they are still exposed to considerable risk.
During the initial stages of the crisis, governments attempted to protect their economies from collapse by allowing budget deficits to balloon. The resulting rise in borrowing has provoked warnings of a sovereign-debt crisis among developed countries, of which Greece may be a harbinger. The scale of the increase in government debt reflects the depth of the economic crisis: the longest and deepest economic reversal since the Great Depression of the 1930s. While both episodes involved a collapse in the value of financial assets, a serious loss of confidence in banks and a steep global economic downturn, what distinguishes them from each other is a stark difference in government responses.
Learning from the past
During the latest crisis, policymakers were careful to heed the lessons of the 1930s, when, as it is now widely believed, government reactions actually served to deepen and extend the depression. Reflecting the economic orthodoxy of the times, key governments maintained unduly restrictive monetary and exchange-rate policies, and the actions of some worsened the crisis in other countries. Governments lacked mechanisms to prevent bank failure and resorted to beggar-thy-neighbour protectionist policies.
In 2008, governments across the West became highly interventionist. They stepped in to prevent bank failures, took aggressive measures to relax monetary policy and pursued active fiscal policies to offset a collapse in private-sector demand. Meanwhile, barriers set up by the World Trade Organisation making it difficult to increase import tariffs diminished the temptation to resort to protectionist policies. Governments also tried to adopt a more coordinated approach to policy, partly through the framework of the G20.
The early success of the response was viewed as a vindication of the interventionist economic policy proposals of John Maynard Keynes that emerged after the 1930s. The measures succeeded in reversing the collapse in financial market confidence and restoring most major economies to growth, at least for the time being. But they left a legacy: high budget deficits and a rapid growth in government debt, which are now triggering further financial anxieties.
Greek crisis risks destabilising eurozone
Greece’s request on 23 April for a rescue package from its 15 fellow members of the eurozone (which have adopted the euro as a common currency) and the International Monetary Fund worth €45 billion followed what was, in effect, a buyers’ strike by bondholders. Athens’ inability to attract investors reflected worries that the debt burden was growing out of control: a budget deficit of at least 13.6% of GDP in 2009 is expected to be followed, even after unpopular austerity measures that are provoking public street protests, with a deficit in 2010 of more than 9%. Meanwhile, Greek market borrowing costs were rising and the economy was continuing to shrink, implying the growing debt burden would have to be supported by a smaller economy.
It is not clear, however, whether the financial rescue package will be enough to prevent a default on Greece’s almost €300bn of outstanding bonds, most of which are held by banks within the eurozone. The downgrading by the Standard and Poor’s rating agency of Greece’s debt to ‘junk’ suggests a real prospect of default, which could pose risks to European banks that in turn could force governments to provide further bailout funds.
Meanwhile, the fear of default is evident in countries other than Greece. The bond market has signalled concerns about Portugal, and questions have been raised about Italy and Spain. Even France, at the core of the eurozone, is forecast to see its gross government debt rise to 100% of GDP, as are the United States and the United Kingdom. While it is hard to envisage a default in these three countries, particularly the US whose currency has reserve status, actions that are likely to be taken to reduce debts could hold back economic growth for years.
Greece’s troubles have posed a major challenge for the cohesion of the eurozone. Germany and France, the common currency’s core backers, share concerns about the effects on their banks but hold contrasting attitudes to the bailout. France has been a strong supporter on the basis of European solidarity and a dislike of the speculators who supposedly triggered the crisis. Germany, however, has been a reluctant participant, recognising that it will be the country footing a large part of the bill and fearing that it is rewarding Greece for profligacy.
These tensions further appear to have accelerated a shift in German attitudes towards the European Union, with strong opposition among the German public to a Greek bailout. This throws into question the long-held assumption that Germany would be a prime political motor for ever-deepening European integration, as well as its main financier. As a result, and in spite of the adoption of the Lisbon Treaty designed to increase the cohesion of EU foreign policy, the countervailing influence of more assertive national policies within the bloc appears greater than in recent times, reducing the EU’s ability to speak with one voice.
The prospect of a Greek default – and the economic weaknesses of other eurozone member states – has also exposed inadequate governance mechanisms within the euro area and revealed that member states may not have understood the full implications of monetary union. A roughly north–south split has appeared within the eurozone, raising the possibility, though not yet the probability, of future departures from the common currency – either by weak members or even its strongest, Germany.
Greece’s travails have also highlighted the fact that the eurozone has no mechanism for disciplining the economic misbehaviour of its member states. The European Stability and Growth Pact, which was meant to perform this function by limiting budget deficits to 3% of GDP and public debts to 60%, was in effect stillborn. No country has suffered sanctions for breaching these limits. Yet it is far from clear that the member governments of the monetary union are willing to cede more power to a pan-European economic agency, which is what an effective disciplinary mechanism would require.
The debt troubles of Greece and others also signal the end of a symbiotic economic relationship that governed the eurozone’s existence in the years following its birth in 1999. For a decade, in effect, the private and public sectors of the countries in southern Europe went deeper and deeper into debt to buy German goods. The counterpart of their deficits is Germany’s giant current-account surplus with the rest of the eurozone. Now, however, debt constraints mean there is no more capacity for southern Europe to sustain Germany’s intra-eurozone surplus. That means Germany must look elsewhere for its markets, or change the export orientation of its economy – something it has shown no inclination to do.
Debt burden felt globally
Although the eurozone is the current focus of debt strains, they are not limited to that region. The speed of the expansion of Western government debt since 2008 has no precedent in peacetime: it is reaching levels that in the past have often had important economic consequences.
Historical studies by economists Carmen Reinhart and Kenneth Rogoff show that a surge of government debt typically follows a financial crisis, in part because tax revenues drop sharply largely owing to the resulting economic slowdown. They calculate that central government debt increases in real terms by 86% on average during the three years following a crisis. This suggests that most major Western economies will see government debt burdens rise to between 80 and 110% of GDP. These increases are already well under way.
The effect of rising debt burdens will vary from country to country. Gross federal public debt in the United States will, even according to government estimates, rise above 100% in 2012 from 64% at the end of 2007. This compares with its historical peak of 121% reached in 1946 following the Second World War. (A substantial minority of this debt is, however, in the hands of other government bodies such as the Social Security Trust Fund.) For the United Kingdom, whose government debt expanded in two years by more than 25 percentage points of GDP to 68%, the peak could also exceed 100% of GDP. This is well below the twentieth-century peak of close to 240% in 1947.
The differing experiences of the US and UK after 1945 suggest that though a high level of debt may be a long-term constraint on future growth, it does not have to be. In the US, powerful economic growth, low interest rates and budget surpluses (before interest payments), together with a dose of inflation when price controls were lifted, brought about a sharp reduction in publicly held government debt as a proportion of GDP. By contrast, Britain’s government debt did not fall below 100% of GDP until 1961. And while the 1950s marked a period of rapidly increasing prosperity for the US, they were a period of austerity for the UK. (Britain’s heavy government debts after the two world wars of the twentieth century did not cause Britain’s decline as a global power, but they certainly accelerated it.)
Under current conditions, however, it is not easy to see how the post-war economic recovery in the US can be replicated. After the Second World War, Americans had suppressed consumption for years and GIs returned home with money in their pockets. Now, Americans remain heavily indebted and will probably try to repair their own personal balance sheets before they start spending again. Elsewhere in the West, the prospects are for a feeble economic recovery. The prospect of slow growth means that if governments are to bring debt burdens down they must generate so-called ‘primary budget surpluses’ – that is, surpluses before interest payments on debt.
This implies difficult policy choices for heavily indebted governments. They will be cutting budget deficits while at the same time overseeing substantial transfers of resources from taxpayers to bond holders in interest payments. In countries heavily dependent on foreign creditors, these transfers will be made abroad. In Greece, for example, annual transfers could exceed 9% of GDP. Elsewhere, as in the US and China, tensions between debtors and creditors could emerge.
The need to curb spending is already leading to reductions in defence expenditure across most of Europe, suggesting a further shrinkage of the strategic weight of the continent in world affairs. But serious cuts are also likely in social-welfare programmes. When such programmes are being cut to pay off debt that is seen as the consequence of bailing out banks rather than, for example, a war for national survival, governments may face heightened social tensions or popular resistance to meeting their obligations.
Some economists also worry that the policy tools that have softened the economic impact of the latest crisis are beginning to lose their effectiveness and may be close to exhausted, leaving governments without ammunition to deal with future financial or economic shocks – especially if there were one soon. The 2008 global credit crunch was solved – like the 1987 stock-market crash, the 1991 recession, the 1998 Asian financial crisis and the 2001 technology-stock collapse – partly by cutting interest rates. But each relaxation of monetary policy has made it cheaper to borrow and created a bubble of debt, which has in turn sown the seeds of a future crisis.
High debt at the expense of strategic influence?
In summary, high debt burdens could have significant consequences for Europe. They appear to be sapping the appetite for ever-closer union that led to the creation of the euro, in part because Germany appears to be losing interest. Financial cracks have opened up within the eurozone that, if they linger or intensify, could lead members to leave it. Meanwhile, member states do not appear to be willing to cede power over fiscal and other policies to a European agency to allow the policy coordination and discipline viewed as a necessary minimum to assure the future of the eurozone.
Globally, high government debts could expose financial strains and suppress growth in big economies for many years. If this happens, governments could be left with little room for manoeuvre. Given that other regions of the world, in particular emerging economies in Asia, appear to have escaped from the crisis relatively well, high debt may be the catalyst for extended economic weakness in the West. This in turn would accelerate a trend that appeared already under way before the crisis: a growing Asian, and particularly Chinese, weight in world affairs and a relative decline in Western influence.
