The government debt crisis involving Greece, Spain, Portugal and other European countries has been pretty good for the United States. It provided a moral satisfaction, of course, after the world ganged up on Washington in 2008, blaming American overconsumption, excessive borrowing and financial speculation for dragging the rest of the world into the most severe recession since World War II. Now, it has been pay-back time for U.S. economists and government officials, because while the U.S. economy has seen some economic recovery, excessive public sector debt accumulated by fringe euro-zone countries is creating problems for the rest of the world.
There have been substantial tangible benefits as well. The yield on the benchmark Treasury bond, which stood at 4 percent in early April for the first time since September 2008, declined sharply as investors sought protection from financial turmoil in Europe. By mid-June, the 10-year U.S. government bond yielded just 3.25 percent. Lower long-bond yields, and correspondingly lower mortgage rates, have been a blessing for the still-sluggish U.S. real estate market.
A Fly in the Ointment
The only problem has been in the stock market. On Wall Street, there has been little rejoicing over European debt problems. The Dow Jones Industrial Average surrendered the 10,000 level yet again in early June, and in fact gave back all of the gains accumulated since a robust 10 percent rally began in November 2009. Volatility returned with a vengeance, further scaring already scared stock investors.
Over the years, Wall Street has been a far better predictor of future economic trends than any economist. Based on the movements of the Dow in the second quarter, a double-dip global recession looks like a distinct possibility. Moreover, despite recent sharp declines in Treasury yields, there is reason to fear that government debt problems now plaguing weaker euro-zone countries will cross the Atlantic.
Euro-zone debt problems were set into motion by the global economic downturn, but they are inherent in the way the European currency union was set up. The euro-zone has one monetary policy set by the European Central Bank and a variety of fiscal policies set by individual governments. Each government has the sovereign right to run its own budget deficit and finance it with sovereign bonds.
When the euro came into existence in the 1990s, many economists were concerned about this flaw. The currency union united some of the world’s leading industrial economies, such as Germany, Holland and France, with some that should be classified as emerging, such as Greece, Portugal, Ireland and even Spain.
In the past, weaker economies responded to economic pressures by devaluing their currencies. A devaluation curbed consumption of imports and made domestic products more competitive both at home and abroad. The advent of the single currency changed all that. But it opened an opportunity to borrow in euros cheaply and plentifully. For 10 years, investors were willing to lend to Greece on almost the same terms as to Germany. The current crisis broke out when investors suddenly began to differentiate among different European sovereign borrowers. They sold off Greek debt and bought German bonds. As a result, German long bonds yielded 2.7 percent in mid-June, while Greece had to pay over 9 percent on its 10-year bond. The crisis quickly deepened as investors realized that such interest rates will push Greece deeper down the debt hole. Greek government debt, which stood at an already onerous 117 percent of GDP last year, will reach an unsustainable 150 percent in 2011.
No More Deficits
In the United States, the level of economic development also varies greatly from state to state. States along the Eastern and Western seaboard are global leaders in the post-industrial economy, while the formerly industrial Rust Belt and the agricultural Deep South are much poorer. However, states are prohibited from running their own budget deficits, so that the U.S. dollar is backed by a single fiscal policy, matched by a single monetary policy set by the Federal Reserve. Eventually, the euro-zone may also have to impose a requirement on its constituent governments to balance their budgets.
However, this will not happen soon and will require a fundamental reform of the European Union. In the medium term, European governments will try something else: They will slash their budget deficits. Greece and Spain have already adopted major austerity measures, but even stronger economies in the euro-zone, including most importantly Germany and France, have committed themselves to spending cuts.