In recent weeks, the European Union, especially the 16 countries that share the euro as their currency, has been shaken by a fiscal policy crisis in Greece.
Greece has the worst fiscal policy position of any EU country, with net government debt of more than 100 percent of GDP and a budget deficit of more than 12 percent of GDP. Official euro area fiscal policy rules mandate a debt ratio of no more than 60 percent, and a deficit of no more than 3 percent.
After last year's elections, fear that the Greek government was unable to manage its finances frightened lenders. By February, they were willing to roll over Greek government debt only at punitively high interest rates, more than 3 percentage points higher than those paid by countries like Germany and the United States.
Faced with this kind of crisis, a government has only three options: default on its debt; pay its bills with newly issued money (even at the risk of runaway inflation); or implement harsh fiscal reforms. As a member of the euro area, Greece lacks an independent central bank, so the option of monetization is technically impossible. As a member of the European Union, default was unthinkable. In the end, Greece was pressured by its neighbors into painful tax increases and spending cuts, at the cost of strikes and violence in the streets.
How does the fiscal situation of Greece compare with that of the United States? Side-by-side comparisons of Greek and US data show some sobering parallels. Neither country took advantage of the boom years of the mid-2000s to put its fiscal house in order. During the crisis, the US deficit has risen as high as that of Greece, and the US national debt is fast approaching the 100 percent level that Greece has already breached.
The bottom line: The middle of a recession is the worst time to carry out painful tax increases and spending cuts. However, that is exactly what countries are forced to do if they do not make timely reforms during years of prosperity. The United States still has a strong credit rating, at least for the time being, so it has escaped a Greek-style budget emergency during the current recession. Unfortunately, projections by the U.S. Congressional Budget Office show no sign on the horizon of needed reforms. If business-as-usual continues in Washington, a crisis is only a matter of time.
Follow this link to download a free set of PowerPoint slides with a discussion of the Greek budget crisis, including graphs with side-by-side comparisons of Greek and US data. If you find this material useful in your courses, please post a comment or send me an e-mail.