Greek Apples Californian Oranges

In the midst of their sovereign debt crisis, Europeans seem to be taking comfort in California's budget travails. For one, ECB President Jean Claude Trichet recently suggested that while Europe had its Greece, the United States had an even larger Californian problem. Sadly, this comparison reflects a basic lack of appreciation of the fundamental ways in which the Californian situation differs from that of Greece. In particular, it glosses over the fact that, unlike Greece's real threat to the continuation of the Euro in its present form, California does not pose a similar threat to the US dollar.

There can be no gainsaying that California is presently confronting an extremely troubling budget situation. Plagued by political gridlock and constrained by a variety of popularly approved Budget Propositions that highly limit the room for corrective budget action, California is having extreme difficulty in balancing its current budget as it is legally obliged to do. As if to underline these difficulties, last year the Californian government was forced to issue IOUs to pay for income tax refunds.

While California certainly has budget problems that should not be minimized, they pale in comparison to those of Greece. Whereas California's budget deficit presently amounts to less than 2 percent of its US$ 2 trillion economy, Greece's budget deficit has now reached a staggering 12 ¾ percent of its US$300 billion economy. This difference must make one think that the eventual correction of the Californian budget deficit would have around one fifth of the negative impact on its economy as the necessary correction of the Greek budget deficit would have on the Greek economy.

At under US$200 billion, California's state debt is less than half that of Greece despite the fact that its economy is almost seven times the size of the Greek economy.

More concretely, whereas one would expect that the 10 percentage point of GDP correction in the Greek budget deficit would cause Greece's economy to contract by anywhere between 10 to 15 percent, California's quest for budget balance could be effected with a decline of between 2 to 3 percent in the Californian economy.

Even more striking than the relative difference between the Californian and the Greek budget deficit situations is the difference between their relative public debt positions. At under US$200 billion, California's state debt is less than half that of Greece despite the fact that its economy is almost seven times the size of the Greek economy. Put differently, California's state debt only amounts to around 8 percent of its product whereas, despite the Maastricht criteria's 60 percent of GDP public debt limit, Greece's public debt is already in excess of 110 percent of GDP.

The difference in the relative sizes of their public debt would suggest that any eventual Greek sovereign debt default would directly have around twice the negative impact on the European economy as would any equivalent Californian debt default have on the US economy. Worse still for the European economy is the likelihood that a Greek default would trigger an eventual sovereign debt default in Spain, whose economy is five times the size of the Greek economy and which has around US$1 trillion in public debt.

Perhaps the most fundamental difference between the Californian and Greek economic situations relates to the relative competitive position of the two economies. As part of a country that is characterized by a high degree of wage flexibility and labor mobility, California's wage and price structure is broadly in line with that of the rest of the United States. By contrast, over the past decade, Greek wage and price inflation has been consistently above that of its European partners. As a result, the IMF now estimates that Greece has lost around 30 percent in relative unit labor cost competitiveness. And this loss of competitiveness is now contributing to an external current account deficit in Greece well into the double digits in relation to GDP.

Stuck in a Euro-zone straightjacket that precludes devaluation, the correction of Greece's massive loss in international competitiveness will necessarily require a prolonged period of deflation that could involve a 20 percentage point absolute decline in Greek wages and prices. Such deflation would substantially increase Greece's already heavy public debt burden. It would also materially complicate Greece's prospects for correcting its large budget deficit by seriously eroding the Greek tax base.

Even were California's economic and budget difficulties not different from those of Greece, it is difficult to see why California's present misfortune has any bearing on the likelihood that Greece will be forced to default or to leave the Euro-zone. Europe would be better served if its policymakers were to harp less on California and to think more about the consequences of Greece eventually being forced out of the Euro.

Desmond Lachman is a resident fellow at AEI.

Photo Credit: iStockphoto/DNY59

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About the Author

 

Desmond
Lachman
  • Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund's (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.
  • Phone: 202-862-5844
    Email: dlachman@aei.org
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    Name: Emma Bennett
    Phone: 202.862.5862
    Email: emma.bennett@aei.org

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