How many times have we heard the warning that if the government in Washington doesn’t change its ways, the United States could become another Greece? Three years ago, when the crisis in Greece was just getting underway, I wrote a post making some comparisons between Greek and U.S. fiscal performance, along with a separate slideshow that presented a supporting set of charts.
One key chart showed the two countries’ fiscal balances moving in an ominously parallel pattern that suggested that the United States might be about to follow Greece down the fiscal drain. Here it is:
Last week, a reader who had run across the old slideshow scolded me for having been an alarmist. While the crisis in Greece has morphed from a crisis into a disaster, he pointed out, the U.S. economy has gradually recovered and its fiscal balance has improved markedly. Why? What were the key factors that made the difference?
Greece was in a deeper hole than we thought
One reason that the U.S. has fared better than Greece over the past three years is that in 2009, the Greek economy was in a deeper hole than we thought at the time.
The next chart updates the old one with actual data for 2010 through 2012 and projections for 2013 and 2014. In addition, it shows that the fiscal balances reported three years ago greatly understated the size of the Greek budget deficit from 2006 through 2009. (Revisions to U.S. balances for that period were negligible.)
The Greek budget gap did begin to close after 2010, as did that of the U.S., but by that time, the years of larger deficit had made the Greek net debt burden much larger than it had earlier been thought.
For example, OECD data now show the net debt of the Greek government to have been 101 percent of GDP as of 2009 rather than the 86 percent previously reported. That put it 35 percentage points higher than that of the U.S. rather than just 20 points higher.
The advantages of a sovereign currency
A second reason that the U.S. has fared better than Greece is that we have our own currency, the dollar, whereas Greece is a member of the euro zone. That gives us two advantages…
One is that a country with its own sovereign currency can often count on a depreciation of its exchange rate to boost its competitiveness during an economic downturn. In contrast, the Greek exchange rate is fixed relative to its largest trading partners, which are also members of the euro.
True, the euro can change in value relative to other currencies, but whether it does so depends on policies of the euro zone as a whole, not just those of Greece. The importance of the different currency regimes is apparent when we look at U.S. and Greek real effective exchange rates, or REERs. (The REER, a weighted average of inflation-adjusted exchange rates relative to a country’s trading partners, is a broad measure of international competitiveness.)
Since the dollar peaked in March 2009, its REER has depreciated by 12.7 percent, significantly boosting U.S. exports. By comparison, the Greek REER, tied to the euro, has depreciated by only 5 percent.
The other advantage of having one’s own currency is a lower risk of default. A country with its own currency can never be forced to default on its sovereign bonds. It can, if need be, always issue enough new money to pay off its maturing debt. (For more on this point, see the discussion of equitable solvency in this earlier post.)
The lower risk for a country with a sovereign currency often translates into a lower market interest rate on its bonds. The following chart shows the dramatic divergence of interest rates between U.S. and Greek government bonds.
Interest payments alone eat up a share of the Greek government’s expenditures that is equal to 5.4 percent of GDP, compared with just 1.7 percent in the United States. The lower share of GDP going to interest payments and the greater confidence of international investors has given the United States much more fiscal room to maneuver.
The curse of procyclical fiscal policy
Procyclical fiscal policy is a third factor that accounts for the divergence of the Greek and U.S. economies. Although this policy pathology has afflicted both countries, Greece has had a worse case of it than the U.S.
Ideally, fiscal policy should be countercyclical. Such a policy would provide stimulus in the form of tax cuts or increased spending to soften recessions and speed recoveries, and then move the budget balance toward surplus to prevent overheating during periods of high employment. A procyclical policy does the opposite — it deepens recessions and slows recoveries by tightening during a slump, and then cuts taxes and increases spending when the economy booms.
To tell whether country’s fiscal policy is counter- or procyclical, we need a measure of its policy stance that removes the effect of the business cycle and other transitory factors on the budget balance.
We start by estimating the economy’s potential real output, which is, roughly speaking, the level of its real GDP when the economy is following its long-term growth trend. We define the country’s output gap as the actual level of GDP minus the potential level. When the economy is in recession, the output gap is negative; during a boom it is positive.
Next, we adjust the budget balance to account for the effects of automatic stabilizers, such as income taxes and unemployment benefits, that move the budget toward deficit during recessions and toward surplus during expansions. That gives us the structural budget balance, which is the surplus or deficit that would prevail under given tax and spending laws if the economy were operating with a zero output gap.
We then remove interest payments from the expenditure side of the budget to get structural primary balance. If we make one more adjustment, by removing the effects of one-off budget measures like privatization revenues and tax amnesties, we get the underlying primary balance…
Changes in the underlying primary balance give the most accurate picture of changes in budget policy. A countercyclical fiscal policy would moderate the business cycle by moving the underlying primary balance toward deficit during recessions and toward surplus as the economy approaches the peak of the business cycle. A procyclical policy, in contrast, would amplify the business cycle by tightening the underling primary balance when the economy is in a slump and relaxing policy when it is in a boom.
A look at the following chart shows that fiscal policy in both Greece and the U.S. has been procyclical over the past decade. (To facilitate comparability, the chart uses OECD data for both countries.)
The chart shows that the U.S. maintained a positive output gap for a full ten years, from 1998 through 2007, including the brief recession of 2001. Fiscal policy was, on balance, procyclical during that decade, which began with an underlying primary surplus of 3 percent of GDP and ended with an underlying primary deficit of -1.9 percent.
Well-known factors contributing to the 4.9 percent swing toward deficit included across-the-board tax cuts, increased defense spending, and the expansion of Medicare drug coverage.
Next came a brief but forceful episode of countercyclical policy in 2008 through 2010. It began with the Bush administration’s tax rebates in the spring of 2008 and continued with the Obama administration’s fiscal stimulus package, which passed Congress in February 2009…
The combined stimulus measures probably reduced the severity of the recession, but they were followed by a very gradual recovery. One reason for the slow recovery is that fiscal policy soon turned procyclical again. By 2012, the expiration of stimulus spending, followed by assorted program cuts and tax increases, had substantially reduced the underlying primary deficit. The trend toward tighter fiscal policy is forecast to continue through 2013 and 2014.
Even so, the underlying deficit in the United States has not moved all the way back to surplus. On balance, although the fiscal consolidation after 2011 has undoubtedly slowed the recovery, it has not yet brought it to a halt.
The pattern of generally procyclical policy in Greece was been similar, but even more pronounced. From 2002 through 2007, the Greek economy boomed, with the output gap swinging from -1.2 percent to +7.4 percent. During this period, fiscal policy was strongly expansionary. The underlying primary balance moved from +0.8 percent to -5.8 percent.
During the next two years, as Greek GDP began to contract, the government tried to counter the trend with still more expansionary policy. The underlying primary deficit increased to -10.3 percent of GDP. Then things fell apart.
An election in October 2009 brought a change of government. The new Prime Minister, George Papandreou, was forced to admit that Greece had been reporting false economic statistics to the EU. The estimated 2009 deficit would be not 3.7 percent of GDP but 12.5 percent.
Under tremendous pressure, the government undertook an emergency austerity program that raised taxes and slashed spending. The petrol bombs and police batons flew thick and fast, but by 2011, the underlying primary balance was back in surplus. It has continued to rise, and is expected to reach 6.5 percent of GDP in 2013.
Not surprisingly, such a strongly procyclical fiscal policy has pushed the real economy into free fall. The output gap for 2013 is forecast to be -17.5 percent of GDP. Despite the huge underlying primary surplus, with the economy in such a deep recession and with interest rates eating up more than 5 percent of GDP, the current budget deficit for 2013 is expected to be 5.6 percent of GDP…
What lessons for the United States?
If the Greek and U.S. governments were students in my fiscal policy class, I would give the former an “F” and the latter no better than a “C-.” Both countries have conducted systematically procyclical policies. By running underlying primary deficits during the boom years of the early 2000s, both entered the global financial crisis with insufficient fiscal space to conduct an adequate countercyclical response.
Greece deserves a failing grade for policies that were even more irresponsibly populist than those of the United States and for making matters worse with outright falsification of its economic statistics. The country is paying a heavy price for its transgressions. The price is made all the heavier by its membership in the euro area, which has forced the government into partial default on its debt and deprived it of the safety valve of devaluation.
By comparison, U.S. fiscal policy perhaps deserves a passing mark, but only barely. Yes, the U.S. economy has outperformed Greece, but at least in part, that is due to the additional degrees of freedom it gains from having its own sovereign currency rather than to any great wisdom of policymakers in Washington. Despite their advantages, for a combination of political and economic reasons, they appear committed to a policy of fiscal austerity in the face of a persistent negative output gap.
The only real policy debate, at present, seems to be whether austerity should include a mix of tax increases and spending cuts, or spending cuts alone.
Don’t Miss Ed Dolan’s “Quantitative Easing: Your Ultimate Cheat Sheet to the Monetary Policy“.