Page 1 of 2 Public debt and the EU patch
By Hossein Askari and Noureddine Krichene
If on April 30 you had listened to Group of 20 (G-20) central bankers, senior
officials and International Monetary Fund experts, the world was almost back to
normal: the banking crisis has been solved, the financial sector was solidly on
its way back to stability, economic growth was picking up everywhere and even
employment was perking up, though slowly in a number of countries. This almost
rosy picture was shattered by the week that was!
This rosy outlook overlooked the facts of how we got to this point and the
price we might still have to pay: the cost of bailouts and bad loans were
simply pushed on to governments, causing public debt to rise from 50% of gross
domestic product (GDP) before
bailouts to past 100% of GDP following bailouts for a number of countries.
Moreover, the G-20 countries affected by the financial crisis had to further
expand their spending for their stimulus programs with the goal of re-inflating
their economies and preventing an economic recession akin to the Great
Depression. The financial sector was bailed out both by governments and by
For instance, the Fed expanded its balance sheet beyond US$2.3 trillion, a
record, in April 2010. The G-20 countries called for no limit on their
re-inflationary monetary expansion and fiscal deficits in order to bail out
banks and increase public spending. As a consequence, the US public debt
ceiling is at $15 trillion and US fiscal deficits at record of 13% of GDP.
Similar fiscal expansions hold for a number of other countries. Public debt in
a number of G-20 countries has already surpassed 100% of GDP (Japan at over
220% and Italy and Greece at over 110% and projected to rise much further). The
average public debt to GDP ratio for the advanced countries in the G-20 is
projected to go over the 110% mark by 2014.
Yes, the eurozone countries, with the crucial backing of Germany and France,
have agreed to set up a Euro Stabilization Fund to stabilize financial
conditions in Euroland. The size of the proposed fund is unprecedented. The
European Union agreed to a 720 billion euro (US$909 billion) bailout fund to
fight speculative attacks against the creditworthiness of euro member
countries. The plan would consist of 440 billion euros of loans from euro-zone
governments, 60 billion euros from an EU emergency fund, and 220 billion euros
from the International Monetary Fund. Is this enough? It is too early to tell.
The Greek debt crisis could still be the beginning of a drawn-out debt crisis
that may still spill over to many other countries, not only in Europe. In fact,
this may be the beginning of the most critical phase of the financial crisis
that erupted two years ago. The bailout of severely indebted countries will be
much more difficult than the bailout of bankrupt financial institutions.
Countries could bailout their financial institutions, but who will bail them
The recurring public debt problems during 1980-2000 were essentially a
developing country problem - Africa, Latin America, Eastern Europe, and Asia,
with Western economies portrayed as a model of financial stability and fiscal
discipline. For example, in the case of Africa, many countries sunk under the
debt burden, abandoned their development programs, and became entangled in
endless fiscal deficits. Consequently, their roads disappeared, their schools
and hospitals crumbled, public buildings collapsed, and private capital fled.
The African debt financed higher wages for workers providing public services
and for their armed forces, and other wasteful current expenditures. In some
instances, borrowing even financed civil conflicts. This debt contributed to a
long process of capital decay and economic stagnation. Real economic growth was
stagnant, or negative, over a two-decade period. Poverty worsened. The dynamics
of the African debt are not limited to Africa. Debt that finances consumption
and inefficient investment can hardly be repaid. History has been witness to
plenty of sovereign debt defaults.
The Greek debt crisis illustrates the dynamics of a debt that financed
government consumption expenditures and led to rising deficits. More
specifically, public spending financed by loans or grants is here to stay;
however, its financing is ephemeral, which results in growing deficits.
Unproductive debt has not created a larger capital base and thus no additional
income stream; the debt cannot be repaid; it can only be re-financed or
defaulted. If this debt had financed economic and social infrastructure and
capital accumulation, it would have led to no structural fiscal deficits; more
importantly, it would have created faster economic growth, higher tax revenues
at unchanged tax rates, and reduced fiscal and external deficits.
The bailouts of financial institutions by the United States, United Kingdom and
the EU governments have simply transferred to the government balance sheet all
the non-performing debt that had earlier financed unproductive subprime
mortgage and consumer spending and speculative gains by speculators.
This debt had left behind little or no productive capital to service the debt
and is, therefore, pure deadweight on government balance sheets. It is akin to
government subsidies to borrowers who defaulted.
Government expenditures are easy to expand, but very difficult to roll back. It
is easy to grant public service workers a raise of 20% and allow them to retire
at the age of 53 with 80% of their salary, but it will be very difficult to
initiate a freeze or a reduction of even 1%.
Academicians who call for an expansion of government spending to stimulate the
economy are forgetting that government spending cannot be easily rolled back.
The severance costs for laid-off employees could be very high or lay-offs could
be politically not feasible. If government spending was easy to cut, then the
Greek crisis would have long been solved and Greece would not have requested
$120 billion in short-term loans.
In most cases, governments can easily expand expenditures, but they are almost
powerless to reduce expenditures. Ironically, the easiest expenditures to cut
are the ones government should not cut - productive capital expenditures.
Countries that face budgetary impasses simply discard capital expenditures in
order to finance priority expenditures, namely salaries. The more capital
expenditures are reduced the more the economy suffers. Moreover, the more
resources are diverted to government current spending, the less resources are
invested. Economic stagnation follows. A veritable vicious circle.
The Greece debt crisis, the surging debt tensions in Portugal and Spain, and
the soaring debt of Japan, Italy, the UK, the US and other advanced G-20
countries to beyond 110% of GDP are not totally independent phenomena. The
sharp rise in government indebtedness is not independent of the subprime market
The debt build-up can be traced to ultra loose monetary policy of Federal
Reserve chairmen Alan Greenspan and Ben Bernanke. Abundant liquidity created by
the Fed, very low interest rates worldwide and a depreciating dollar encouraged
banks to push debt onto all type of borrowers, including mortgages, consumers,
There will never be a lack of demand for loans as long as banks are willing to
lend. Greece has no self-limit to borrowing and is willing to borrow as much as
banks are willing to lend. Greece was lulled into sleep, thinking that its
credit was as good as Germany's as the single currency, the euro, allowed
Greece to borrow without the fear of an attack on its currency. It seems that
bankers believed it too. And the Greek government borrowed without worrying
about the consequences or making the needed structural adjustments, and the
banks were happy to go along.
Cheap-money policy encouraged governments to increase their borrowing and
expand their fiscal deficits. Such is also the case of the US, UK, and many
other countries that are borrowing massively at very low interest rates and are
running the largest fiscal deficits in their history. But when the chickens
come to roost, as money becomes expensive, these governments will all find
themselves in a hole.
The urge of central bankers to push more debt has not receded yet. The Fed and
other central banks have cut money market interest rates to near-zero bound and
forced mountains of cash on banks. President Barack Obama, the US Congress, and
a number of other governments have been threatening banks and admonishing them
to lend money regardless of risk. Fortunately, banks have learned their hard
lesson and are reluctant to fall again into the debt trap of the Fed and other
central banks and loose their capital. In the US, they are holding over $1
trillion in excess reserves. They have become cautious not only regarding
subprime lending but also lending to bankrupt or over-indebted governments.