How Greece’s Problems Affect Us
A lot of people don’t even know that Greece’s debt is a problem that is threatening to bring down the European Union. And of those that have heard about, few realize its significance and potential impact on the US. John Mauldin has done a fine job explaining that in his most recent newsletter. It’s written as a letter to his kids explaining how the current economic situation affects them.
Why is Greece important? Because so much of their debt is on the books of European banks. Hundreds of billions of dollars worth. And just a few years ago this seemed like a good thing. The rating agencies made Greek debt AAA, and banks could use massive leverage (almost 40 times in some European banks) and buy these bonds and make good money in the process. (Don’t ask Dad why people still trust rating agencies. Some things just can’t be explained.)
Except, now that Greek debt is risky. Today, it appears there will be some kind of bailout for Greece. But that is just a band-aid on a very serious wound. The crisis will not go away. It will come back, unless the Greeks willingly go into their own Great Depression by slashing their spending and raising taxes to a level that no one in the US could even contemplate. What is being demanded of them is really bad for them, but they did it to themselves.
But those European banks? When that debt goes bad, and it will, they will react to each other just like they did in 2008. Trust will evaporate. Will taxpayers shoulder the burden? Maybe, maybe not. It will be a huge crisis. There are other countries in Europe, like Spain and Portugal, that are almost as bad as Greece. Great Britain is not too far behind.
The European economy is as large as that of the US. We feel it when they go into recessions, for many of our largest companies make a lot of money in Europe. A crisis will also make the euro go down, which reduces corporate profits and makes it harder for us to sell our products into Europe, not to mention compete with European companies for global trade. And that means we all buy less from China, which means they will buy less of our bonds, and on and on go the connections. And it will all make it much harder to start new companies, which are the source of real growth in jobs.
And then in January of 2011 we are going to have the largest tax increase in US history. The research shows that tax increases have a negative 3-times effect on GDP, or the growth of the economy. As I will show in a letter in a few weeks, I think it is likely that the level of tax increases, when combined with the increase in state and local taxes (or the reductions in spending), will be enough to throw us back into recession, even without problems coming from Europe. (And no, Melissa, that is not some Republican research conspiracy. The research was done by Christina Romer, who is Obama’s chairperson of the Joint Council of Economic Advisors.)
And sadly, that means even higher unemployment. It means sales at the bar where you work, Melissa, will fall farther as more of your friends lose jobs. And commissions at the electronics store where you work, Chad, will be even lower than the miserable level they’re at now. And Henry, it means the hours you work at UPS will be even more difficult to come by. You are smart to be looking for more part-time work. Abbi and Amanda? People may eat out a little less, and your fellow workers will all want more hours. And Trey? Greece has little to do with the fact that you do not do your homework on time.
And this next time, we won’t be able to fight the recession with even greater debt and lower interest rates, as we did this last time. Rates are as low as they can go, and this week the bond market is showing that it does not like the massive borrowing the US is engaged in. It is worried about the possibility of “Greece R Us.”
Bond markets require confidence above all else. If Greece defaults, then how far away is Spain or Japan? What makes the US so different, if we do not control our debt? As Reinhart and Rogoff show, when confidence goes, the end is very near. And it always comes faster than anyone expects.
The good news? We will get through this. We pulled through some rough times as a nation in the ’70s. No one, in 2020, is going to want to go back to the good old days of 2010, as the amazing innovations in medicine and other technologies will have made life so much better. You guys are going to live a very long time (and I hope I get a few extra years to enjoy those grandkids as well!). In 1975 we did not know where the new jobs would come from. It was fairly bleak. But the jobs did come, as they will once again.
At least there is some good news in the end!
The underlying issue is the size of the country’s debt. At some point, either it becomes too big to service, or creditors get cold feet about the ability to service the debt and demand repayment – usually at the worst possible time. This is what happened to Iceland. They defaulted on $50 Billion euros of debt, not a large amount by US standards, but 488% of their GDP and a huge amount to their tiny population of less than 350,000. Greece, Portugual, Spain, Ireland and the UK are all in a similar situation.
Even the US isn’t too far behind. Currently our debt is nearly 400% of our GDP. At what point do our creditors stop lending us money?
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April 2nd, 2010 at 1:59 am
Hey LOD, it’s been awhile since I posted. Hope you’re doing well with your MBA program.
Regarding your hypothesis on US defaulting on its debt, it’s been discussed ad nauseum by other financial experts as well as some MSM coverages. I have my own theory to debunk the hypothesis on why US will not default on its debt (not yet for at least in the next several decades).
First of all, US sells its debt obligation through Treasury auctions. If the auctions failed to have 100% asking, the Fed (which is different from the Treasury Department) buys the leftover Treasurys through the method of the printing press (electronically or paper). Therefore, there is no possible way that the auctions will completely fail since the Fed can act as a direct and total buyer of the Treasurys if no one else in the world is willing to touch them.
You might say to yourself, “This is stupid. Why do we have Treasurys in the first place? Why don’t we just as the Fed to print out a bunch of USD to cover our yearly budget deficits?” Well, you have to keep in mind that the Federal Reserve acts as an independent Central Bank outside the jurisdiction of the US Government (well, not completely independent but I’m not going into this). No one, and I do mean NO ONE, is entitled to print US Dollar EXCEPT the Federal Reserve. Therefore, the Fed has the power to control the USD money supply (all those M1, M2, etc that a lot of financial analysts are talking about) in this world.
The only way USG can operate year in and year out is for it to sell debt to finance its budget should it collects less (IRS) than it spends. Shoot, Clinton had it good for one year when IRS was able to collect more than what USG was spending (not sure if we had a bunch of Treasury auctions that year though…I’m not gonna bother checking). Treasurys are the only way for the USG to have an accounting liability (similar to that of public traded companies that have corporate bonds) for it to operate because, as I mentioned already, the Fed is an *independent* Central Bank and, although has the ability to print USD, will NOT print USD simply because USG fails to curb its appetite on spending.
Now, let’s come up with the worst case scenario of everyone, including foreign Central Banks, dumping Treasurys. What would happen? Well, the last entity in this world that would pick up all the Treasurys out there is the Fed and so the Fed will have to redeem all those Treasurys with, you guessed it, USD. Would that crash USD and makes it worthless. Theoretically, it will, but that’s not the point of this discussion. At least we can conclude from my statement above that those that sold Treasurys will get their money back in USD. That, to me, is not default.
April 2nd, 2010 at 8:28 am
Hi Chris,
you’re quite right. Technically the US cannot default because it can pay everyone back in USD. However, since USG needs to borrow money to fund it debt obligations, there may come a point where no one will buy treasuries leading to 15-20% interest rates or severe devaluation of the currency. While its not the same, in my mind the effect to the average American is pretty much the same.
April 15th, 2010 at 1:02 pm
I have to ask, what is the source of that GDP vs Debt graph? Last I checked, US GDP was $14T and total US federal debt was $12T, not even 100% of GDP..
April 15th, 2010 at 2:15 pm
It includes unfunded obligations like Social Security and Medicare. The graph cites Bureau of Economic Analysis and Federal Reserve as sources. Check out this link for more info: http://research.stlouisfed.org/fred2/
May 7th, 2010 at 7:15 pm
Greece and Spain won’t pay back. The only thing Germans can do is:
REPOSES 170 Leopard 2AEX Battle Tanks from Greece, and 190 Leopard 2A6E Battle Tanks from Spain.
U.S.A must REPOSES 170 F-16 Jet Fighters from Greece, … the rest is gone with the wind …forever …
Greece must stop paying lucrative pensions with borrowed money, reform the free health care system, and cut down, 4 times the military budged.