Econ 101: The Problem with Greece

Greece has been in the headlines as its government has teetered on the edge of default. The European Union (EU) and the International Monetary Fund (IMF) announced May 3 they would provide 110 billion Euros, about $146 billion, to the Greek government to enable it to make its debt obligations.

EU members will contribute 80 billion Euros and the IMF will contribute 30 billion Euros to the bailout. This is the first time that the 16 EU countries that use the Euro will have to rescue one of their members from a possible default in the 11 years that the Euro has existed.

It appears that Greece would receive its first payment by May 19, when it must repay a maturing bond of 9 billion Euros. Under the deal Greece will receive a three year loan at a 5 percent rate, a substantial reduction from the nearly 9 percent rate investors were requiring to purchase Greek long term debt. In return, Greece will undertake austerity measures designed to reduce its deficit to GDP load from the current 13.6 percent to 3 percent by 2014. This will be done by increases in the sales tax and value added tax and a reduction in public spending by 30 billion Euros, about 13 percent of its GDP.

As government wages and social benefits represent 75 percent of total public spending in Greece, this will require acceptance by the government unions. In particular, it will require a freeze on government salaries, the elimination of the standard bonuses paid to government workers that amount to roughly two months pay, and an increase in the retirement age to 63 by 2014.

The Greek problem has been a long time coming. In order to join the Euro zone countries were to keep their deficits to no more than 3 percent of GDP. Greece has managed to more than quadruple that. The country already has a top income tax rate of 40 percent, and a value-added tax of 21 percent.

In addition, employers pay 28 percent of salary for social security and employees pay 16 percent. These high tax rates have led to a culture of tax evasion, with the government struggling to collect the revenues due it. The high tax rates also lead to a reduction in economic growth. Indeed part of debt problem of Greece is that its GDP is estimated to shrink by 5 percent in 2010, according to Economist Intelligence Unit Forecast.

The Greek government has made many more promises than it can keep. It has a bloated public sector with high retirement benefits that are not sustainable given the country’s growth rate and aging population. It has a Socialist government with all the attendant difficulties of central planning that were endemic to the Soviet Union.

Greece managed to use swaps agreements with securities firms to mask the size of its debt and circumvent the debt and deficit requirements for membership in the Euro zone. Given the extensive political power of its unions, it is not quite credible that the Greek government is capable of implementing the policies upon which the IMF and EU bailout depends. All of this makes it conceivable that, if not on May 19, sometime in the next year Greece will still not be able to make a payment on its debt.

As a result of the riskiness to investors, the interest rate on Greek debt has soared, with the 10 year bond approaching 9 percent and the 2 year bond hitting almost 19 percent last week. These high interest rates make it difficult for the Greek government to make interest rate payments, further exacerbating the riskiness of holding Greek debt. On April 27, Standard and Poor’s (S&P) dropped its rating of Greek government bonds to BB+, below investment grade.

S&P said bondholders were likely to get back only 30 percent to 50 percent of their principle in the case of a Greek restructuring of its debt or an outright default. At this point it may be that speculators, the disparaged traders that governments love to blame for driving down their bond prices, may be the only ones willing to purchase Greek bonds.

If Greece had its own currency, it could use a currency devaluation to reduce the real burden of the debt. Greek workers would see a decline in their real wage and Greek bondholders would suffer a loss in the real value of the debt they are holding. This is a somewhat standard procedure for relieving some of the pressure from a large debt burden. But the value of the Euro is controlled by the European Central Bank, so devaluation is not an option.

Since Greece is a small economy, its GDP is about $330 billion compared to the U.S. GDP of more than $14 trillion, and its total debt is less than 5 percent of the U.S. housing market, why should we worry about a Greek default? The concern is there may be a contagion effect, with foreign investors fleeing from the other weak Euro countries, in particular, Portugal and Spain.

When Moody’s credit rating agency hinted at a possible downgrade of Portugal’s credit rating May 4, U.S. stock futures tumbled. The Dow Jones Industrial Index also dropped 225.06 points (2 percent) that day over worries about Greece and the EU.

Like Greece, Portugal and Spain have high debt and deficit to GDP ratios and slow economic growth that will make it difficult to get their deficit and debt to GDP ratios down.

A default on Greek bonds would put significant pressure on Greek banks. S&P has already downgraded four Greek banks to junk status as well. Other Euro zone banks are holding about 75 billion Euros of Greek bonds (about $97.5 billion). French and German banks are holding about 34 and 20 billion Euros respectively, so a noticeable amount of their capital is at risk. A retreat of investors from the debt of Greece, Spain, and Portugal could lead to high interest rates, declining investment, and slow economic growth in Europe. This will affect countries, including the U.S., that export to Europe.

The lesson to be learned from this is that government spending on social services and a large public employee sector inevitably lead to problems. The right solution to the Greek problem is to reduce government spending, reduce taxes, and reduce government regulation of labor markets in order to become competitive in a global economy, and let the market move labor out of the public sector to industries that are sustainable.

Unfortunately, this will be very difficult to do politically, especially for a Socialist government. The IMF and EU conditions are likely to provoke strikes that will further hamper the economy. Already there have been protests in Greece against government spending cuts.

The U.S., with its publicly held debt of 70 percent of GDP and unfunded liabilities in Social Security and Medicare in excess of $100 trillion, according to the National Center for Policy Analysis, should take note and reign in the growth of the federal government before it too ends up in the headlines as the next sovereign debt default candidate.

Gary Wolfram is the William Simon Professor of Economics and Public Policy at Hillsdale College and a Business & Media Institute adviser.