1. One should not underestimate the seriousness of the Greek economic crisis for the US economic outlook for the following three reasons:
There is every prospect that within the next twelve to eighteen months Greece will default on its US$420 billion in sovereign debt. This would constitute the largest sovereign debt default in history.
A Greek default would almost certainly result in contagion to Spain, Portugal, and Ireland, which all have highly compromised public finances and international competitiveness problems. This would raise the potential for a major shock to the European banking system.
A major European economic recession and banking crisis would considerably heighten the probability of a double-dip US economic recession in 2011.
Greece's Road to Default
2. The underlying cause of Greece's present economic crisis is years of public sector profligacy that flagrantly flouted Europe's Maastricht criteria. Whereas the Maastricht criteria had set a 3 percent of GDP budget deficit limit for all Euro-zone members, by 2009 Greece's budget deficit had swollen to around 14 percent of GDP (Figure 1). Similarly, by end-2009, Greece's public debt to GDP ratio had increased to 115 percent, or around double the corresponding Maastricht limit.
3. Greece's fiscal policy recklessness has been a primary factor in Greek wage and price inflation consistently exceeding that of its main Euro-zone partners over the past ten-years. The IMF estimates that Greece has lost around 30 percent in international competitiveness over this period, which has contributed to a widening in Greece's external current account deficit to around 12 percent of GDP (Figure 2).
4. The essence of Greece's present predicament is that, stuck within the Euro-zone, Greece cannot resort to currency devaluation to restore international competitiveness. Nor can Greece devalue its currency to boost exports as a cushion to offset the highly negative impact on its economy from the major fiscal retrenchment that Greece needs.
5. The recently agreed US$140 billion IMF-EU program for Greece envisages that Greece aim to reduce its budget deficit from 14 percent of GDP at present to below 3 percent of GDP by 2012. It also envisages that Greece aims to restore international competitiveness through domestic price and wage deflation. If the experience of Latvia and Ireland, two countries that are engaged in savage budget retrenchment within a fixed exchange rate system, is any guide, Greece could very well see its GDP contracting by 15-20 percent over the next three years.
6. The IMF acknowledges that Greece's public debt to GDP ratio will rise to 150 percent of GDP by 2012 on a relatively benign economic outlook. If instead Greece's GDP were to decline by 15-20 percent over the next three years and if the Greek government were obliged to provide major financial support to its banking system, Greece's public debt to GDP ratio could very well rise to 175 percent.
7. It is little wonder then that markets consider that Greece has a solvency problem that is not being addressed by the massive IMF-EU support package. The markets are presently assigning a 75 percent probability of a major Greek sovereign debt restructuring within the next few years. At the same time, in downgrading Greek sovereign bonds to junk status, Standard and Poor's is indicating that Greece's sovereign debt could be written down by anywhere between 50 and 70 cents on the dollar.
Major Risks to the European Banking System
8. A Greek debt default would almost certainly result in intense contagion to Spain, Portugal, and Ireland since markets will no longer have the assurance that no Euro-zone country will be allowed to fail. Like Greece, all of these countries have highly compromised public finances and severely eroded international competitiveness positions (Figures 2 and 3). And like Greece, their Euro-zone membership, precludes their using exchange rate devaluation as a means to address these two problems.
9. The Spanish case is particularly troubling since the Spanish economy is five times the size of Greece's, the country has over US$1 trillion in sovereign debt, and its overall gross external debt amounts to 135 percent of its GDP. Further, Spain will need to rapidly reduce its budget deficit, which is presently at around 11 ¼ percent of GDP, at a time when Spain is in the midst of a worse housing market bust than that recently experienced in the United States and when its unemployment rate already stands at 20 percent. One has to expect considerable social opposition in Spain to further budget retrenchment.
10. The deep economic problems in Greece, Spain, Portugal, and Ireland constitute a serious risk to the European banking system (Figure 4 and 5). The total sovereign debt of these countries exceeds US$2 trillion and the major part of this debt is held by the European banks. The banking systems in France and the Netherlands are particularly exposed to default risk in the Club-Mediterranean countries. An eventual write down of these countries' debt by 30 cents on the dollar would constitute as large a shock to the European banking system as that which it experienced in 2008.
Risks to the US economic recovery
11. Any further deepening in the Euro-zone crisis would heighten the risks of a double dip US recession in 2011 since the US economy would be negatively impacted by the European crisis at precisely the time when the support to US GDP growth from the fiscal stimulus is fading. The European crisis would negatively impact the US economy through the following three channels:
The dollar would continue to appreciate against the Euro as markets would become increasingly concerned about Europe's economic growth prospects and about the possibility of an eventual break-up of the Euro-zone. This would put US exporters at a competitive disadvantage with respect to Europe. Over the past year, the Euro has already depreciated from US$ 1.60 to its present level of US$1.25.
A recession in Europe would further diminish demand for US exports by reducing the buying power of an important US trade partner.
A further deepening in the European crisis is very likely to result in increased risk aversion in global financial markets and renewed declines in global equity markets especially given the high interconnectedness of the world financial system. This would appreciably increase borrowing costs and reduce credit availability for both US households and corporations at a time when the US economic recovery appears to be rather fragile.
12. The one silver lining of the Euro-zone crisis is that it is considerably reducing inflationary pressures in the United States. It is doing so through a strengthening of the US dollar and through a considerable correction in international commodity prices in general and in oil prices in particular. This should allow the Federal Reserve to maintain its highly accommodative monetary policy stance without the risk of igniting inflation.
Figure 1: Greece's budget deficit shows only short periods of improvement
Figure 2: Real effective exchange rates
Figure 3: Key Economic Indicators of Club Med Countries
Figure 4: Outstanding claims of German, French, Swiss and U.K. banks
Figure 5: European Bank Exposure to Club-Med countries and Ireland