Greek Fiscal Crisis: Is a First World Debt Crisis in the Making

1. Greek Fiscal Crisis: Is a First World Debt Crisis in the Making? Dr. Kenneth Matziorinis Dept of History, Classics, Economics and Political Science John Abbott College

3. Is a First World Debt Crisis in the Making? Reinhart & Rogoff report the following findings: 1) There have been long periods where a high percentage ( > 40%) of countries have been in a state of default or restructuring 2) Since 1800, there have been 5 major default cycles. with one ot two decade lulls in between 3) Serial default is the norm throughout every region in the world, including Asia and Europe 4) Global economic factors such as commodity prices and center country interest rates have played a major role in precipitating these crises 5) Periods of high international capital mobility have produced international banking crises, not only as in the Asian, South American, Russian and more recently global financial crisis, but historically

4. Is a First World Debt Crisis in the Making? 6) Contrary to contemporary opinion, domestic debt constituted an important part of government debt in most countries 7) A significant share of domestic debt was of a long-term maturity 8) The government?s gain to unexpected inflation often derives at least as much from capital losses inflicted on holders of long-term government bonds 9) The median duration of default spells in the post WWII period is half (3 years) the length of what it was during the 1800-1945 period

5. Sovereign External Debt: 1800-2006Percent of Countries in Default or Restructuring

6. You Should not be Surprised, This is what History Teaches us Since its creation in 1867 Canada has never experienced a sovereign default or debt restructuring although we came danerously close to ones in the 1930s and again in the 1990s Unlike most countries, Canada has experienced few episodes of excessive inflation, the highest inflation rate ever recorded in Canada was in 1917 when inflation reached a maximum of 23.8% Our history of relative monetary and fiscal stability have ill prepared us to understand what other countries have gone through or what we may go through in the future, but it is never too late to learn

7. What are the Major Types of Sovereign Debt Defaults? External debt default: Here a country defaults on its payments to foreign debt holders. When a country runs into a sovereign debt crisis interest rates rise, capital flows stop and the country is thrown into a severe period of economic contraction and fall in living standards. When this happens, the country has a choice of debt repudiation which means it renegs on its debt to foreign debt holders entirely as Argentina did recently, as the Soviet Union did with Czarist bonds and Mexico in the 19th century or debt restructuring and debt rescheduling which means that it sits down with its foreign creditors and negotiates a settlement. Usually, the creditors are forced to take a loss on some portion of the debt, known as a �haircut�, interest rates are renegotiated towards more favourable terms and external lending resumes The IMF was created in 1945 to assist countries when they run into this type of crisis by extending emergency lending at concessionary rates based on conditionality, that the government undertakes a specific set of reforms to balance its budget and return the country to financial solvency

8. What are the Major Types of Sovereign Debt Defaults? Internal debt default: Here a country runs into an inability to service its debts to its citizens but is not forced to default, because the government has the power to print money to service its debts. This results in a rise in unexpected inflation and results in economic stagnation -stagflation The inflation unleashed by the printing of money reduces the real value of the bonds held by debt holders who are its own citizens and thus the government lessens the burden of its debts. Inflation shifts the burden of debt from the state to its citizens and represents the ultimate form of taxation. The process of unwinding the sovereign debt burden results in a period of moderate inflation (10% - 20%) and moderate contraction. The Developed world went through such an episode during the 1970s. Today, with central bank independence, it is questionable to what extent central banks will allow this to happen without breaching their inflation control mandates. If they resist, interest rates will rise.

9. Alternatives Methods for Reducing Sovereign Debt Burdens Currency debasement: When a sovereign debtor is unable to pay its bills it may resort to debasing its currency. In the past when metalic money was used, it came in the form of dilution in the amount of gold or silver contained in the metalic money and this ofcourse, produced inflation and resulted in a devaluation of the country?s currency Currency devaluation or depreciation: When a sovereign debtor is unable to meet its obligations it can resort to currency depreciation. This works when a country is utilizing a flexible currency regime whereby it allows the value of its currency to be determined by demand and supply in the foreign exchange market. Devaluation and depreciation help a country boost its exports and reduce its imports thereby stimulating domestic economic activity and moderating the contractionary effects on production and employment arising from the debt pressures.

10. What are the Major Precipitating Causes of Defaults World Commodity Price Cycles: When commodity prices fall many countries exposed to the exportation of commodities succumb to external defaults Large Movements of Capital Flows: When large amounts of capital flow into a country they increase its indebtedness and when the cycle ends and interest rates rise, they are unable to repay, forcing them to default Wars: Wars -both external and civil- have always disrupted the monetary and fiscal stability of nations leading to sovereign debt defaults and due to a relatively recent and perhaps biggest financial innovation in the history of banking the introduction of bank safety net i.e. liquidity insurance, deposit insurance and capital insurance that can cause a sovereign debt default when the losses are transferred to the state: Financial Leverage and Banking Crises

11. Banking on the State to a Degree of Biblical Proportions In a recent study for the Bank of England, titled ?Banking on the State? Alessandri and Haldane (November, 2009) have tabulated the total support provided by the US, UK and Eurozone governments to the financial sector of the economy It totals over $14 trillion or almost 25% of global GDP!!! This figure tallies the support given only to the financial sector and does not include the fiscal stimulus packages introduced by these governments nor the sizeable cumulative fiscal deficits that have resulted from the global economic downturn. The liabilities and losses from the banking crisis have been transferred to the sovereign to a degree never seen before in economic history!

12. A Role Reversal Between the State and the Banks Alessandri & Haldane (2009) in their insightful paper state the following: Historically, the link between the state and the banking system has been umbilical. Through the ages sovereign default has been the single biggest cause of banking collapse For the past two centuries, the tables have progressively turned. The state has instead become the last-resort financier of the banks. As with the state, banks? needs have typically been greatest at times of financial crisis. The Great Depression marked a regime-shift in state support to the banking system. The credit crisis of the past two years may well mark another Then, the biggest risk to the banks was from the sovereign. Today, perhaps the biggest risk comes from the banks. Causality has reversed.

13. Government Support to Financial Industry

14. Implications Arising From Extension of Banking Safety Net Alessandri & Haldane state that there is an unwriten social contract between the state and the banks: state support for the banks is one side of the contract, state regulation is the other. While the state expanded its support for the banks it has not expanded its regulation of the banks When banks know that the state will run to their support in times of crisis they can afford to take bigger risks. Without more regulation they are driven to increase their returns by taking bigger risks. When they win they keep the profits, when they lose, it is the state that pays We all know who is behind the state: you the taxpayer and the recipient of public services. Something has gone terribly wrong with this picture

15. World Economic Growth, 2001-2009 and Projections for 2010 & 2011

16. Government Budget Deficits, Percent of GDP, 2009

17. Advanced Economies: Gross Debt-to-GDP Ratios, 2010 IMF Projections

18. Debt-to-GDP Ratios: Advanced vs. Emerging G-20 Nations, 2010

19. Fiscal Consolidation Required to Achieve Debt Target Between2010 and 2020

20. The Economics of Debt-GDP Ratios Government Debt Debt-GDP Ratio = ------------------------- x 100 Nominal GDP Government (or public) debt grows when the government has a budget deficit and it stops growing when it balances its budget To reduce the debt-GDP ratio, nominal GDP must grow faster than the government debt. For this to happen, the economy must experience economic growth in output (real GDP), rise in prices (inflation) or both. Low interest rates also help in that they contain the interest cost of servicing the country�s debt and help balance the budget sooner In the long-run demographic factors also play a role, in that a country with stagnant or declining population experiences much slower growth in its nominal GDP and makes it harder to bring down the debt burden

21. What are the Prospects for Economic Growth and Debt Reduction? In light of the large debt loads advanced economies will have to undertake a series of fiscal consolidation measures to reduce government spending and increase taxes which will lower the growth rate of these economies for a number of years to come Most of these countries have high and rising age dependency ratios and low or falling population growth rates which put additional pressures on the state and reduce the growth potential of the economies All of these countries have expensive social and entitlement programs which add to the burden of the state and reduce room for manuevre The Eurozone countries are especially vulnerable because they are tied into a monetary framework that places priority on monetary control and low inflation

22. Why has Greece Garnered so much Attention lately? A country of 11.2 million and GDP of US$ 360 billion, representing 2.8% of Eurozone and 27th biggest economy in the world Has one of the highest debt-GDP ratios in the world: 113% of GDP Has one of the highest budget deficits in the world: 12.9% of GDP Has a large current account deficit: 11.0% of GDP Has a high degree of net foreign debt: 70% of GDP Has not had a credible financial reporting of its fiscal position Is viewed as the first domino in a potential first world sovereign debt crisis Greece�s total outstanding public debt amounts to 290 billion euro If Greece were to default on its debt payments it would amount to the biggest sovereign default in history, bigger than that of Russia and Argentina combined If Greece were to default, it would raise fears that the crisis will spread to other Eurozone members and this could cause the collapse of the euro currency

23. Why has Greece Garnered so much Attention lately? Since it joined the Eurozone, it has ceeded control of monetary policy to the ECB and can no longer print money Wages have risen faster than in Germany and has not adapted its economy rapidly enough to global competition, especially from Asia Two of its largest industries, maritime shipping and tourism were hit strongly from the global economic downturn The Eurozone has not injected the same degree of monetary liquidity as did the UK and the USA while the ECB has maintained a more contractionary monetary stance than the other two central banks The euro has appreciated by about 65% since 2001 against the US Dollar and by 47% against the Chinese Yuan

24. 10-Yr and 1-Yr Greek Government Bond (GGB) Yields: 1998-2010

25. USD/EUR Exchange Rate Since Greece�s Entry Into the Eurozone: 2001-2010

26. Greece/euro vs UK /euro Exchange Rates: March 2008 - March 2010

27. Value of US Dollar Relative to Price of Gold: 1900-2009

28. US GDP IN NOMINAL US DOLLARS VS. US GDP MEASURED IN GOLD, 1929 - 2009

29. US Federal Gross, Net and Foreign Debt as Percent of GDP , 1939-2009 and Projections to 2011

30. US Foreign debt as percent of publicly held debt, 1969-2009

31. Total US Debt Outstanding: Household, Business & Government, 1974-2009

32. Is the Greek Crisis Coming to America ?