The Debt Death Trap
The Greek financial saga is the tip of an iceberg of problems of public-debt sustainability for many advanced economies, and not only the so-called PIIGS (Portugal, Italy, Ireland, Greece, and Spain). Indeed, the OECD now estimates that public debt-to-GDP ratios in advanced economies will rise to an average of around 100% of GDP. The International Monetary Fund has recently put out similar estimates.
Within the PIIGS, the problems are not just excessive public deficits and debt ratios (in different degrees and measures in the five countries). They are also problems of external deficits, loss of competitiveness, and thus of anemic growth.
These are economies that, even a decade ago, were losing market share to China and Asia, owing to their labor-intensive and low value-added exports. After a decade that saw wages grow faster than productivity, unit labor costs (and the real exchange rate based on those costs) appreciated sharply. The ensuing loss of competitiveness manifested itself in large and growing current-account deficits and slowing growth. The final nail in the coffin was the appreciation of the euro between 2002 and 2008.
So, even if Greece and other PIIGS had the political resolve to reduce massively their large fiscal deficits – and that is a big if, given the political resistance to spending cuts and tax increases – fiscal contraction may, at least in the short run, make the current recession worse as higher taxes and lower spending reduce aggregate demand. If GDP falls, achieving a certain deficit and debt target (as a share of GDP) becomes impossible. This, indeed, was the debt death trap that engulfed Argentina between 1998 and 2001.
Restoring sustained growth requires real currency depreciation. There are only three ways that this can occur. One is deflation that reduces prices and wages by 20-30%. But deflation is associated with persistent recession (see Argentina again), and no country’s society and political system can accept years of recession and fiscal austerity to achieve real depreciation. Default and an exit from the euro would occur well before that.
The second path is to follow the German model of accelerating structural reforms and corporate restructuring to increase productivity growth while keeping wage growth moderate. But it took a decade for Germany to reduce its unit labor costs that way; if Greece or Spain were to start today, the short run costs of resource reallocation would be large, while the benefits in terms of higher growth would take too many years to achieve.
Finally, the euro could fall sharply in value. But the main beneficiary would be Germany. And, in order for the euro to fall far enough, the risk of default in Greece would need to be so large, and the contagion to sovereign spreads of PIIGS so severe that the widening of those spreads would cause a double-dip eurozone recession before currency depreciation could yield benefits.
Short of a miracle, Greece looks close to insolvency. At the onset of its crisis, Argentina’s budget deficit, public debt, and current-account deficit (as a share of GDP) were about 3%, 50% and 2%, respectively. Those ratios for Greece are far worse: 12.9%, 120% and 10%. So it will take a Herculean effort, luck, and support from the European Union and the IMF to reduce the probability of an eventual default and exit from the eurozone.
Greece is currently too interconnected to be allowed to collapse: since it has about $400 billion of public debt – three-quarters of which is held abroad, mostly by European financial institutions – a disorderly default would lead to massive losses and risk a systemic crisis. Moreover, the contagion to the sovereign spreads of the other PIIGS would be massive, tipping over several of these economies.
So, despite revulsion on the part of Germany and the European Central Bank at the idea of a “bailout,” Greece needs large official financial support this year at rates that are not unsustainable to prevent its current illiquidity from devolving immediately into insolvency. But official support will only kick the can down the road until next year. The magic trifecta of sustainable debt and deficit ratios, a real depreciation, and restoration of growth looks unlikely to be achievable even with official financial support.
All successful rescues of countries in financial distress – Mexico, Korea, Thailand, Brazil, Turkey – require two conditions: the country’s credible willingness to impose the fiscal austerity and structural reforms needed to restore sustainability and growth; and massive amounts of front-loaded official support to avoid a self-fulfilling rollover crisis of maturing public and/or private short-term debts. Reform without money on the table does not work, as nervous and trigger-happy investors would rather pull their money out if the country lacks the foreign-currency reserves needed to prevent the equivalent of a bank run on its short-term liabilities.
So, after a totally flawed plan that would have given money to Greece too late – only when the country risked a refinancing crisis – and at market rates that would make its debt unsustainable, the EU regained its senses and designed a new scheme that is closer to typical IMF conditionality: tranched support with some early front-loaded support and a semi-concessional interest rate.
Only time will tell if this plan will work: i.e. whether Greece will turn out to be illiquid but solvent, conditional on credible fiscal austerity and structural reforms and with the help of large amounts of financial support. But, as with Argentina, Russia, and Ecuador, Greece may also be insolvent if adjustment fails to restore debt sustainability and growth. For now, the official community has decided to stick with Plan A; if that fails, Plan B is default to reduce unsustainable debts and a Greek exit from the eurozone to allow depreciation and restoration of competitiveness and growth.
This piece was written for Project Syndicate.
All rights reserved, Roubini GlobalEconomics, LLC. Opinions expressed on RGE EconoMonitors are those of individual analysts and may or may not express RGE’s own consensus view. RGE is not a certified investment advisory service and aims to create an intellectual framework for informed financial decisions by its clients.
12 Responses to “The Debt Death Trap”
GMeli • April 20th, 2010 at 8:38 pm
a voluntary structured default will take place.But what do I know? I’m just a physical therapist.
Guest • April 20th, 2010 at 10:42 pm
Reading Mr. Roubini, I think default will take place eventually. Default is not the end of the world, but a good opportunity for the Greek to rebuild a better economy. The problem is, I think, most people/nations do not seem to learn from failures; and greed usually leads us to another disaster.People’s lifestyle, in general, is economically unsustainable; and hence their nation’s economy unsustainable in the long run. Today, most people are competing to own/enjoy more than what they service/produce/preserve, this of course will create him/her a “deficit life”, hence contributing to the nation’s deficit figures.
tutterfrut • April 21st, 2010 at 3:24 am
If the biggest chunk of their economy was based on creating strong euros into existance by borrowing what they could only pay back by ever borrowing(private or government) more(as more countries do). Then how exactly do you create a competitive economy by depreciation, knowing that your northern neighbour(Bulgary) works for 15cents to the greeks euro? It has become a consumption/debt based economy, only thanks to the strong euro. Take it away and all that’s left will be souvlaki, feta and dancing the sirtaki around ruins and ancient Gods and philosophers.And this goes for most consumptionized(no longer industrialized)nations.
economicminor • April 21st, 2010 at 11:20 am
I think the fear is that there are so many countries in distress that it could be the domino effect which could spread throughout not only Europe but the entire world.Unfortunately, this is moving from a maybe to a probably. It has been a tendency for governments and corporations alike to make promises to their employees, mostly in union contracts, that were never fully funded. The unions were just as culpable because any third grader with good math skills should have known that the 8-10% gains for 30-50 years projections were Alice in Wonderland dreams. At the end of all contract negotiations and legislative sessions, everyone went home from the negotiations with smiles and bs rhetoric. And the early retirees too.Now that Zero Hours over taken them and there really isn’t enough income to fund existing programs and absolutely no way to raise incomes a crisis has arisen.. There is really no way out. Even borrowing at low interest rates is just temporary. The only real answer is to lower expenditures and increase incomes from value added productive endeavors… AND that takes time that no one has. AND the expenditures are mandated by contract law or legislation…Almost all governments in the OECD are in this same situation to some extent. Professor Roubini keeps intimating that the world can work its way out of these problems. Like the Euro can go down but that doesn’t fix the inequalities of real incomes.So far all the solutions seem to make the rich more secure and the poor have less income. Then the rich say that they pay to much in taxes.. Yet they are the only ones with real after expense incomes left to tax because trickle down economics or the policies of hidden inflation that transferred the wealth up the chain to the top have left the lower and middle classes with little left after living expenses, sales and property taxes and debt servicing. There is an old saying, that you can’t get blood out of a turnip. Piling on or wishing won’t make it so either.So in the big picture of who has income to pay the servicing of all the new debt being created is the same people who are complaining that they have to pay the most.. Does any one think those in power are going to push to raise their own levels of taxation to pay for the bailouts?Does anyone think that the unions will get real and the pensioners will demand to have less either? AND then less means less consumption and less taxes collected… Damned if you do and worse damned it you don’t. Win win just became lose lose…The sensible thing would be to take the losses and move on. What is happening is a piling up of more losses instead.. INSANITY!!!At some point, this entire pyramid of unserviceable debts is going to crash because no one wants to admit to past mistakes. No one wants to take a cut in current lifestyles and few are actually working towards alleviating the real pressures on the global economic system. Gridlock and rhetoric have taken over discussions of reform. It is an endless election cycle with no true leaders.
stillnotbraveenoughtoputaname • April 21st, 2010 at 9:53 pm
for a moment, it feels like reading the good ole’ blog again..thanks e and t, this blog used to be my addiction, man… withdrawal from the Truth sucks…
economicminor • April 22nd, 2010 at 12:55 am
There certainly is a lot of information out there but not many pundits can add two and two and actually get four.To many believe in the religion of money and its current priests who preach a neo Keynesian doctrine to the uneducated yet faithful. Having a degree is not having necessarily having an education. An education where one is taught to think independently appears to be rare. Group think and herd mentality is prevalent in this world.I am constantly amazed how people can confuse and mix Christianity and Free Market Capitalism.. Like they can some how go happily hand in hand skipping thru the playground together. These two concepts have little in common yet the same people who fervently support neo Keynesian Free Market Capitalism say we need to go back to our Christian roots too? What is Christian about a monopoly or a TBTF institution that dictates to the governing body and demands blackmail and a free reign to accumulate capital in any way they see fit? At others’ expense?It was obvious to me in the 1980′s that Trickle Down was only good for those at the top of the economic ladder. The priests of that era were great con men and the foolish faithful wanted to believe. They still believe it is a good idea. Even after they have lost their current job and home or are in jeopardy. Even though it brought with it ever increasing debt and ever deflating dollars. Even though wages have stagnated while debts has soared. Even though it has obviously been a disaster, many still are faithful to their priests. Even though the rich have gotten really rich while the poor have grown by leaps and bounds. What trickles down from many of the really wealth isn’t much more than a slave owner would provide for his servants.So many were hopeful that they would be one of those who actually benefited from a group of theories that created larger and larger bubbles and more and more debt. Most still reject the Business Cycle Theories and rhetorically reject the government while their priests have been using the government to transfer what they hope will be your future earnings to them. Their actions are almost diametrically opposed to their words yet few of the faithful actually can see. Government has sure been good to the Money Priests yet they preach against it.. What do they think? That life will just be splendid with no public services? That way they can have their monopolies and conglomerates that employ slaves? And who will be their customers? Or is their rhetoric just something to give to the faithful. Something they can hate or despise, other than the actual cause of their sufferings?All of this has been pretty amazing to watch.
stillnotbraveenoughtoputaname • April 22nd, 2010 at 1:20 am
e im in that bracket of age…to tell you the truth i’ve sensed “it” since my teens (maybe thats why i loved Pearl Jam so much)its just that feeling is stronger now….the tides are changing, you cant fight the tide, eventually it will come..http://www.marketoracle.co.uk/Article18805.htmlU.S. In the Midst of the Greater Depression, Fourth Turning Generational Crisisexcerpt:-The 13th Generation (Nomad, born 1961-1981) survived a “hurried” childhood of divorce, latchkeys, open classrooms, devil-child movies, and a shift from G to R ratings. They came of age curtailing the earlier rise in youth crime and fall in test scores—yet heard themselves denounced as so wild and stupid as to put The Nation At Risk. As young adults, maneuvering through a sexual battlescape of AIDS and blighted courtship rituals—they date and marry cautiously. In jobs, they embrace risk and prefer free agency over loyal corporatism. From grunge to hip-hop, their splintery culture reveals a hardened edge. Politically, they lean toward pragmatism and nonaffiliation, and would rather volunteer than vote. Widely criticized as “Xers” or “slackers,” they inhabit a Reality Bites economy of declining young-adult living standards.“When World War II hit, the Lost shed their isolationism and provided the war-winning generals whose daring (Patton), warmth (Bradley), and persistence (Eisenhower) energized younger troops. At home, they managed the world’s most efficient war machine. With little philosophizing, their first president dropped two atom bombs and then arranged a peace that was less vengeful and more secure than the one he recalled from his own soldier days.”The Lost Generation willingly sacrificed in their old age by paying exorbitant tax rates in order to allow younger generations to live a better life. Eisenhower’s eight years in the White House were marked by conservative fiscal policies, choosing to not use deficit financing and building a stable economic foundation for the benefit of future generations. They died as one of the poorest generations, fulfilling their moral obligation to past and future generations of giving more than they received. Eisenhower warned the younger generations about the dangers of a military industrial complex. His wisdom was ignored.“They will have reached full adult maturity without ever having believed in either the American Dream or American exceptionalism. They will never have known a time when America felt good about itself, when its civic and cultural life didn’t seem to be decaying. From childhood into midlife, they will have always sensed that the nation’s core institutions mainly served the interests of people other than themselves.”To everything there is a season, and a time to every purpose under the heaven;A time to be born, and a time to die; a time to plant, and a time to pluck up that which is planted;A time to kill, and a time to heal; a time to break down, and a time to build up;A time to weep, and a time to laugh; a time to mourn, and a time to dance;A time to cast away stones, and a time to gather stones together; a time to embrace, and a time to refrain from embracing;A time to get, and a time to lose; a time to keep, and a time to cast away;A time to rend, and a time to sew; a time to keep silence, and a time to speak;A time to love, and a time to hate; a time of war, and a time of peace.
Guest • April 22nd, 2010 at 4:00 am
In the world of IT, I am amazed with GNU/FSF/Linux/Debian/BSD etc, they seemed like moving to the direction of alleviating some problems.I remember reading an article about a small town in USA, which is socially independent and economically self-supporting, but I forgot the name.I think, we need to help ourself from now on. Then, help people surrounding us, then our society, then our country, the world…I think, the key issue facing people today is morality.
economicminor • April 22nd, 2010 at 12:20 pm
Yes, the problem facing the US today is a lack of morals and ethical conduct. We preach morals and pretend we have morals but as a whole, there are few in leadership positions that know what fiduciary or ethical conduct actually is. It is hard to put one’s personal interests on the back burner while really representing your client. Attorney’s mostly understand this but also practice the art of warfare where winning is more important than anything else.We have developed a culture whereas winning is the only goal. And one where the game is rigged favoring those at the top. Not much chance of wining unless you have an edge, have low morals and absolutely no ethical standards. Or are EXTREMELY Lucky! There are some but the proof is in the growth in income inequity.Personally I appreciate Steven Covey’s writings about First Things First. What is most important in anyone’s life? Money, but money won’t buy you love or real respect. Love, but then is that physical love or emotional love. Emotional Love gives most people the most satisfaction, yet money drives the world. Quite a dilemma. So we distract ourselves with Gladiator Sports and Casinos or other games. People know more about Texas Holdum and their favorite team than they do about their neighbor and sometimes more about those things than they know about their wife and kids. It is such a shame and such a waste. Giving is a function of lowing taxes in many cases rather than from real love or caring for thy neighbor.So people go thru life playing games rather than living and loving. Morals and ethics? Not even on the radar except to complain about….
Guest • April 22nd, 2010 at 10:19 pm
Yeah, and that is why the crisis is spinning that way, nonstop :]The core theme of today’s education system, in general, is competition. So, fighting/war/winning is planted in our mind since school time. But, such attitude is the destruction force of civilization…I think, mankind have a better option, to live in a better condition. In my life, so far, I have been trying very hard to live and love…
Guest • April 28th, 2010 at 2:12 pm
agree.
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