Greek Bailout Leaves Larger Issues Unresolved

Published on Think, by Matthew Yglesias, July 21, 2011.

I’m still trying to fully understand what’s happening in the latest European debt plan, but at first glance it seems to be almost entirely besides the point—a plan to address insolvency in Greece at a time when as Megan McArdle says “[t]he spreads on Spanish, Italian, Irish, and Portuguese bonds are not widening because investors think that Greece needs a debt swap, or because the solons of Brussels haven’t made enough announcements about the virtues of budget-cutting.” Right, the spreads on PII[G]S’ bonds are going up because of concerns about those specific countries. An uncontrolled Greek default would make the situation worse, but merely avoiding such a scenario doesn’t address the issues there.

I think it’s worth just plowing straight forward and looking at Italy, the largest and allegedly least-troubled of the PIIGS. This from JP Morgan is very instructive:

view online the chart: too little growth and too much dept make Italy vulnerable … /

… To review, Italy has a lot of debt. That means that Italy pays a lot of money in interest on its debt. But Italy also has what’s called a “primary budget surplus.” That means tax revenues exceed non-interest spending. Normally for a country that borrows in its own currency that’s all the austerity you need. Since your debt is denominated in nominal terms in your own currency, all you need is for your nominal GDP to grow fast enough to ensure that your debt:GDP ratio shrinks. And since shrinking debt:GDP ratio reduces the interest burden on your budget, if you can hold that primary surplus flat soon enough you’ll be making enormous progress. Alternatively, your central bank might be so stingy as to insist on NGDP growing so slowly that your debt:GDP ratio rises despite the primary surplus. That means your interest burden rises and your situation spirals into disaster. Except no country’s central bank would be that insane. If fiscal policymakers deliver the primary surplus, the central bankers can take care of the rest. But Italy’s central bank is located in Frankfurt and doesn’t appear to actually care about Italian conditions. Instead, responding to conditions in Germany, the European Central Bank is setting monetary policy that ensures a rising debt burden for Italy.

That’s a problem for Italy. Indeed, it makes me wonder how Italy can avoid default. And wondering about that is making investors charge a high interest rate for Italy to roll its debts over. Which is making Italy’s debt:GDP ratio even worse. And as best I can tell, today’s announcement doesn’t even gesture at trying to address this, much less the even more acute problems facing Spain, Portugal, and Ireland. It seems to promise that austerity will take care of this. But in the case of Italy, austerity will only slow NGDP growth further. There has to be a commitment that countries engaged in reasonable budgetary practices will enjoy sufficiently rapid growth to manage existing debts. (full text).

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