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

Montreal, QC, April 16, 2010

Is a First World Debt Crisis in the Making?

This time is No Different

In their recent book Carmen M. Reinhart & Kenneth S. Rogoff (2009), This
Time is Different: Eight Centuries of Financial Folly, Princeton University Press, report the findings of their recent studies based on 66 countries, across 5 continents and 8 centuries of economic history.

They find that sovereign debt and default crises have actually been more
common than we realize, that

during major episodes more than a third (33%) of countries are undergoing
default or in the process of a serious debt restructuring

they have exhibited a continuing serial pattern of recurrence throughout history they have involved
countries from both the developing as well as the developed world. every time there is a lull experts pronounce that this time is different and yet the cycle of defaults keeps on repeating itself

Is a First World Debt Crisis in the Making?

Sovereign Defaults have been a normal feature of all periods and all countries 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

Is a First World Debt Crisis in the Making?

Sovereign Defaults have been a normal feature of all periods and all countries

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 governments 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

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

From Reinhart & Rogoff Sovereign Defaults have been happening in the past and will happen in our future!

You Should not be Surprised, This is what History Teaches us

Canadians have been fortunate enough to have escaped the ravages of major financial defaults

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

What are the Major Types of Sovereign Debt Defaults?

External and Internal 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

What are the Major Types of Sovereign Debt Defaults?

External and Internal 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.

Alternatives Methods for Reducing Sovereign Debt Burdens

Currency Debasement and Currency Depreciation

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 currency s

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.

What are the Major Precipitating Causes of Defaults

Commodity Cycles, Large Uncontrolled International Movements of Capital, Wars and now Banking Crises

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

Banking on the State to a Degree of Biblical Proportions

Following the global financial crisis the banking system of the developed world has come to rely on the state to a degree of BIBLICAL proportions

In a recent study for the Bank of England, titled anking on the State B
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!

A Role Reversal Between the State and the Banks

Whereas before the banks were the victims of sovereign debt defaults today the sovereign state is the victim of bank defaults

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.

Government Support to Financial Industry

The support given to financial industry since the inception of the Anglo-American financial crisis has been of biblical proportions
G o v e r n m e n t S u p p o r t P a c k a g e s to F in a n c ia l S e c to r U n ite d S ta te s , U n ite d K in g d o m a n d E u r o z o n e

T r illio n s o f U S $

UK

USA

EURO

T o ta l

C e n tr a l B a n k - " M o n e y c r e a tio n " - C o lla te r a l s w a p s

0 .3 2 0 .3 0

3 .7 6 0 .2 0

0 .9 8 0 .0 0

5 .0 6 0 .5 0

G ov e rnme nt - G u a r a n te e s - In s u r a n c e - C a p ita l 0 .6 4 0 .3 3 0 .1 2 2 .0 8 3 .7 4 0 .7 0 1 .6 8 0 .0 0 0 .3 1 4 .4 0 4 .0 7 1 .1 3

T o ta l ( % o f G D P )

74%

73%

18%

1 5 .1 6

Source: Alessandri & Haldane, Table 1, Banking on the State, Bank of England, November, 2009

Implications Arising From Extension of Banking Safety Net

When banks win they keep the profits, when banks lose, the state takes the losses!

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

World Economic Growth, 2001-2009 and Projections for 2010 & 2011
The global economic downturn that followed the global financial crisis impacted the world s developed economies far more than it did the developing economies
10 8 6 4 2 0 -2 -4
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Advanced Economies

Emerging Economies

World Average

Source: IMF WEO Update, January 26, 2010

Government Budget Deficits, Percent of GDP, 2009

Budget deficits have exploded all over with the worst affected being in the advanced industrial world

Iceland UK Ireland Portugal Japan Belgium Turkey Netherlands

Greece Spain USA France Czeck Russia Italy Canada

10

12

14

16

18

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

Debt-GDP ratios have been rumped up dramatically in many countries
250 Percent (%) of GDP

225
200 175 150 125

Japan
Greece

Iceland
Italy

Belgium
France Portugal

USA
Canada Israel Germany Austria Spain

100 75 50 25

UK Ireland Netherl

Strategies for Fiscal Consolidation in the Post-Crisis World, IMF, February 4, 2010

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

Debt-GDP ratios for advanced countries are bearly triple those of developing countries. Clearly it is the developed world that is facing a sovereign debt crisis
120

100

80

60

40

20

Advanced G-20

Emerging G-20

Source: IMF

Fiscal Consolidation Required to Achieve Debt Target Between 2010 and 2020
IMF study has calculated that many advanced industrial countries will have to undertake a high degree of fiscal consolidation over the next 10 years to achive debt targets 16 14
Percent (%) of GDP

12
10 8 6 4 2 0
GRC IRE JAP USA UK SPA POR FRA BEL AUS ITA GER CAN

Degree of Fiscal Consolidation Source: IMF, Strategies for Fiscal Consolidation in the Post-Crisis World, February 4, 2010

The Economics of Debt-GDP Ratios

Countries with higher growth rates and inflation can reduce debt-GDP ratios faster

Debt-GDP Ratio =

Government Debt ------------------------- 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

the countrys debt and help balance the budget sooner

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

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

What are the Prospects for Economic Growth and Debt Reduction?
Growth prospects are poor, entitlements are large and the European countries have placed themselves into a deflationary straightjacket

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

Why has Greece Garnered so much Attention lately?

Greece has the worst combination of high debt level, large budget deficit and large external debt

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 Greeces 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

Why has Greece Garnered so much Attention lately?

But because it part of the Eurozone, has given up control pf monetary policy and the printing press

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

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

Greeces entry into the Eurozone has allowed long-term interest rates to be cut in half and short-term rates to be cut 5 -fold which stimulated borrowing
12

10

0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

1-yr GGB

10-yr GGB

USD/EUR Exchange Rate Since Greeces Entry Into the Eurozone: 2001-2010
Between January 2001 and January 2010 Euro has appeciated by 65% against the US Dollar, undermining the competitiveness of Greek exports
1.6 1.5 1.4 1.3 USD/EUR Exchange Rate

1.2
1.1 1 0.9 0.8 0.7 0.6 2001 2001200120022002200320032004200420052005200620062007200720082008200920092010 2010-12 USD/EUR Exchange Rate

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

Being part of the Euro Area Greece exchange rate remains fixed compared to Euro Area s member countries while UK has allowed the Pound to depreciate against Euro Area countries
1.1

0.9

0.8

0.7

Greece/Euro

UK/Euro

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

The USA has been able to sustain its economy by debasing its currency at the cost of product and asset inflation which in recent years has produced serial asset bubbles, financial crises and international trade imbalances. At some point this game will come to an end with devastating consequences Index (1900 = 20.67) Formula: ( 1 / USD Price of Gold ) x 20.67 x 100
1000

100

10

1 1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010

Series 1

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

When measured in gold terms, this chart clearly shows the peaks and valeys in US economic history since 1929 and shows that since 2000, the US economy has entered a period of decline
100000

Trillions of US Dollars

Billions of oz of Gold

100

10000

1000

10

100

10
30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 0 2 4 6 8 10

USA GDP Current $

US GDP in Gold

US Federal Gross, Net and Foreign Debt as Percent of GDP , 19392009 and Projections to 2011
US Federal debt levels have risen dramatically since the global financial crisis. Gross debt will reach 100% of GDP in 2011 and foreign debt 35%
140 120 100 Percent of GDP

80
60

40
20 0 39 44 49 54 59 64 69 74 Net Debt 79 84 89 94 99 04 09 11

Gross Debt

Foreign Debt

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

The US has been relying increasingly on foreign savings to finance its debt. In 2008, foreign borrowing accounted for over 50% of money raised to finance its debt
Foreign debt as % of Publicly held debt

60 50 40 30

20
10 0 39 44 49 54 59 64 69 74 79 84 89 94 99 04 09 Series 1

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

Total private and public debt in the US is now 370% of GDP
400 Percent of GDP Trillions of Dollars 60

50 300 40

200

30

20 100 10

0
1974 1979 1984 1989 1994 1999 2004 2009

0 Total Debt to GDP Total Debt

Source: Federal Reserve Board, Flow of Funds Accounts Z1 d3 Canbek Economics

Is the Greek Crisis Coming to America ?