Shaky Union

Even though members of the European Union have no control over their domestic monetary policies, their undisciplined domestic fiscal policies can still wreak great havoc for the financial health of the Union.

Greece has become lately the poster child of irresponsible budget managers among EU countries. Its debt is about 125% of its GDP and its annual budget deficit exceeds 12% of its GDP. To finance its debt, Greece has been forced to pay up 4 percentage point yield premium on its 10-year bonds over Germany’s. And the price of debt default insurance premium has quadrupled in February 2010 year over year (BW 2/22/2010).

Greece is not the only EU country that suffers from budget deficits problem. It is only the sickest member of the PIIGS league (Portugal, Ireland, Italy, Greece, and Spain) of spendthrifts. EU members are supposed to limit their annual budget deficits to no more than 3% of their GDP and the national debt/GDP ratio to no more than 60%. The Great Recession has caused many even financially prudent EU members to go over these limits. But Greece’s case is especially egregious because it has been cooking its financial books to game its entry into the EU. (WSJ 3/3/2010).

EU member countries are similar to the states in the US. They cannot control their money supply by varying their interest rates without inviting adverse capital flows and they cannot unilaterally devalue their currencies vis-à-vis non-EU countries. The only way they can affect their trade balance and budget balance is to adjust their factor costs such as reducing their labor costs and adjust their taxes and spending.

Ironically, Greece’s shaky financial status has led to 12% depreciation of the Euro vs the dollar from December 3, 2009 to April 23, 2010, making vacations in Greece that much cheaper for Americans. (http://www.x-rates.com/d/USD/EUR/graph120.html). For a country whose GDP is only about 2% of the EU’ total, such an effect may appear to be outsized. But if Greece’s debt problem leads to a contagion effect on the PIIGS countries, the viability of the euro block might be in jeopardy. As yet, the EU rescue plan and the IMF rescue plan have not quite stabilized the Greek bond market even as the rescue package keeps growing.

During the current Great Recession, American states are also running big budget deficits even though they must by law balance their budgets annually. Arizona, California, New Jersey, and Rhode Island all had projected 2009 budget shortfall of over 10% of the state general fund. (CBPP 12/18/2007). But even the state with the largest budget shortfall, California, had only a deficit/state GDP ratio of less than 2% (seekingalpha.com 2/7/2010). Still many states have accumulated huge unfunded pension and retiree health care liabilities. These liabilities are essentially debts that must be repaid at some points. When they and other general-obligation bonds are fully accounted for, California’s debt/state GDP ratio may well be over 50% (WSJ. 4/27/2010). Not being able to change their interest rates or devalue their currencies unilaterally, American states must also tighten their belts to eliminate their budget shortfalls. One saving grace of the United States compared to the EU is the greater labor and capital mobility across states. But state retrenching will offset whatever stimulating effects of the federal expansionary monetary and fiscal policies.