Greece and Sovereign Debt

June 2010

Moderator: Greece has been in the news a great deal lately because of the financial crisis caused by its level of sovereign debt. The monetary union known as the euro area has experienced significant turmoil as the region's leaders attempt to contain the crisis and prevent it from spreading to other countries.

Andrew Flowers of the Atlanta Fed's research department has written an article about the Greek sovereign debt situation and its potential implications for other European economies, as well as the global economy. He is here to speak with me about the situation and why it matters to Americans. Andrew, thanks for joining me today.

Andrew Flowers: Thank you for having me.

Moderator: Andrew, the fiscal woes of Greece, and by extension those of the European Union, have been in the news a great deal lately. What are some of the reasons people outside the EU, and Southeasterners in the United States, should be concerned about Greece's debt crisis?

Flowers: Those of us outside of Europe, and in particular, say, in the Southeastern United States, should care about these developments in Europe, obviously, because they have economic impacts on the U.S. recovery and the world economic recovery. There are two main channels through which this European crisis can affect us. The obvious one is just through the real economy, and by "real" economy what I mean is, given that there's going to be weaker demand in Europe there's going to be weaker demand for U.S. exports. There's going to be slower growth in Europe; the overall world economic recovery is going to be slower. So, this is going dampen the U.S. recovery as well; have a spillover effect on the real economy.

Through the currencies, the dollar has been appreciating against the euro, and as it strengthens that makes U.S. exports more expensive and European imports relatively cheaper. So, that's another channel through which there's going to be a slower growth in the United States, and for us.

The other channel, and in some ways arguably it's more worrisome, is through financial markets, and particularly through the banking systems of Europe and in conjunction with the U.S. banking system. So as the sovereign debt by these European countries—mostly on the periphery, particularly Greece, but also Spain, Italy, Portugal, and others—as they lose value, what happens is the banks that hold this debt, predominantly European banks, face two problems. One is, as those bonds, as that sovereign debt, becomes worth less and less, those banks—when they pledge that debt as collateral, as they try to get collateral, liquidity for that debt—as these bonds lose value, their liquidity dries up and they're less likely and they have less opportunity to make transactions in the financial system.

Moderator: Right, I see. However, as you know Greece is far from the only country running a large deficit. Why was its debt problem the first one to escalate to this point?

Flowers: As most people know, the vast majority of developing countries—excuse me, of developed countries—are having fiscal problems of one sort or another and to one degree or another: the United States, the United Kingdom, and several other euro-area members, Japan, etc. But as to why Greece was singled out first—and not to say that other countries aren't, for example currently Spain is coming under stress—the reason Greece was singled out first is, they have an enormous budget deficit. So for a given fiscal year—the amount of expenditures over revenues—they have an enormous budget deficit even relative to other European countries. Ireland, Spain, the United Kingdom have large budget deficits around the 10 percent of GDP [gross domestic product] range, but Greece is the highest. Similarly, their total debt levels, or the debt to GDP level in Greece, is also the highest in Europe, over around 130 percent or so of total GDP. And Italy, for example, is also near there; it's around 115 percent, it's high too. So, furthermore, it has fiscal problems tied in with low growth prospects. Throughout a study of the economic history we learn that the easiest way to get out of a fiscal problem is just to grow out it, have high growth rates. The United States post-World War II is a great example. But Greece has very low forecasted GDP growth for a lot of reasons that we'll probably get into later.

The other reason Greece has been singled out is that their cost competitiveness is way out of whack. And what do I mean by that? Well, since the euro area countries have adopted a common currency, not all of them have had their, say, for example, labor costs, rise at the same rate, or other costs within that country rise at the same rate. So, looking at unit labor costs, for example, Greece's unit labor costs have risen quite strong, dramatically, relative to Germany, so in other words they're less competitive. It's easier for a firm to operate and to be competitive in terms of wages offering the correct equilibrium wages in Germany than it is in Greece. So it's more expensive to operate there.

So this highlights one of the difficulties of having a common monetary framework but different fiscal policies: to get your cost pressures in line you have to either devalue, if you had your own monetary policy. And through the depreciation of your exchange rate you get your cost pressures back in line. Or given that they have common monetary framework right now in Greece, in a perfect world what they would need is deflation, namely wage deflation. But, of course, this is a very hard structural reform to implement as you see through all the protests in Athens and the union strikes. So, without being restricted on your monetary policy and unable to devalue you're left with the very hard choices of a forced wage deflation.

Moderator: You referenced the monetary framework, and I wanted to touch on that. The euro system has structural similarities to the way the U.S. dollar is the common currency of all the states. But there are significant differences in the monetary unions as well. Can you discuss the similarities as well as the differences?

Flowers: For the similarities between the fiscal and monetary structure in the U.S. and Europe, as you know, in the U.S. we have a common monetary policy carried out by us here at the Federal Reserve, but obviously state governments have their own fiscal finances, and that could be analogous to euro area country budget deficits or budget surpluses in other times. It's not a perfect analogy of course. For example, most states can't run countercyclical deficits, whereas obviously European countries can and have. But, that doesn't mean, to take California as an extreme example, it doesn't mean that U.S. states can't have some urgent need for fiscal consolidation. It doesn't mean that they can't have fiscal problems, and in fact many state and local governments are having fiscal problems post recession.

But one of the differences is the reliance on either, in the United States, federal government financing. So, just to take that California example and extend it, California will still get federal financing, whether it be through defense contracts or Medicare payments, or other social program transfers. They'll still come through and support the California economy to that extent even though they on the state and local levels have huge deficits. Whereas, for Greece, for example, it's much more heavily hit given that its entire finances are, the majority of the public finances are at the Greek federal level and less at the euro area level. So, that's the primary difference.

The other way that this manifests itself is, in terms of adjustment, the U.S. is much more flexible. So take labor markets, for example: It's much easier to have labor mobility in the United States either through common language or through more porous, so to speak, porous state borders that you can have workers move from California to, say, Texas. Whereas as in Europe, that kind of labor mobility, which helps this adjustment, is much more difficult. Not that it is impossible, and the common currency framework and the European Union have made some improvements in that respect: improving labor mobility and lowering transaction costs. But that currency area, the euro, is not nearly as flexible as the United States is in solving these problems and making the adjustments to grow out of it and go forward.

Moderator: Andrew, my last question to you concerns the Asian financial crisis of the late '90s, which left the U.S. relatively unscathed. Why would a pan-European financial crisis be any different?

Flowers: While sharing a lot of similarities, the two experiences are different in some important ways. The manifestation of the Asian financial crisis does seem similar to what we're seeing in some ways here now in Europe: namely the euro has been declining against the dollar and against other currencies as those currencies in Asia were in the 1990s. There've been lower growth prospects, stock markets have declined, bond spreads have increased, all these signs. So, the manifestations are the same, but the original problems are different; in Asia it was a currency issue.

Now, in Europe it's different why? The core cause of these manifestations is fiscal; it's not currency based. Yes, the euro has been depreciating, and some forecasters expect it to continue to do so, though how to predict that is very hard. Though that's a symptom, but the cause has been, as we've talked about, fiscal problems within Europe. Large budget deficits, high debt burdens, and the ongoing structural problems: This is at the core of the current European problem.

Moderator: Right. Andrew, I'd like to thank you for being with us today.

Flowers: Thank you for having me.

Moderator: Again, we've been speaking today with Andrew Flowers of the Atlanta Fed's research department. This concludes our EconSouth Now podcast on the Greek sovereign debt crisis. For more information, please see the second quarter 2010 edition of EconSouth magazine. On our Web site,, you can read the full article about this topic or subscribe to EconSouth in print.
