I do not envy our Greek socialist friends. They got elected because the previous conservative government was catastrophically incompetent, but the mess they now have to sort out is worse than the wildest imaginations could have predicted. This is not just a local problem. The fate of the euro, and therefore of Europe, hangs in balance. What the Greek government does will decide the future of European social democracy for years to come.
The Euro Area’s Achilles’ heal are buoyant deficits. The European Commission expects new government borrowing in 2010 to be 6.9% for the Euro Area, 14.7% in Ireland, 12.2% in Greece, 9.3% in Spain, and 8.7% in Portugal. In Sarkozy’s France it is 7.7%. Outside Euroland the UK is expected to run negative balances of 12.9%, Latvia of 12.3% and the USA of 13%. By contrast, for Germany the expected deficit is only 4.6% and in Austria or the Netherlands the figures are similar. According to these estimates, only Bulgaria will fulfill the famous Maastricht criteria of 3%. Not surprisingly, the Greek debt to GDP ratio, which was 95% only 3 years ago, will shoot up to 125%, the highest level in the European Union and more than double of what the Treaty requests. No wonder, financial markets are in turmoil. If unchecked, they could bring down the whole edifice of the European construction.
Remedying this situation will be very, very painful. Why should Socialist governments care and execute the hidden needs of financial markets? There are many reasons for Socialists pursuing orderly fiscal policies, but we can concentrate on two strong arguments: preserving government’s capacity to act and social justice motives.
Modern social democracy has learned to accept and live with markets. This includes, of course, financial markets, for they are an efficient instrument to allocate resources to private goods, provided the proper regulatory framework is in place. In a social market economy, the government provides public goods in accordance with voters’ preferences and in many European member states these resources are close to one half of all goods and services produced. These public purchases are financed overwhelmingly by taxes of all kinds and, to a small part, by public borrowing.
When the government borrows, it issues debt titles (i.e. bonds), which are bought by private savers, maybe by households, but most importantly by institutions which manage individuals’ savings and retirement. Of course, economic freedom means, they will only buy these securities if they will get a return that is comparable to what they could get elsewhere and if they are reasonably sure that the government will honour its commitments in the future.
This is Greece’s trouble: many people doubt that the Greek government will still be able to serve its debt in the future, if it continues borrowing at the present rate. The higher the debt ratio rises, the heavier will be the debt service, i.e. the interest and repayment on the outstanding debt, today. Now, what would happen, if the Greek government failed to pay its debt?
Many media speculate that it could mean the exit from the euro. Wrong. Monetary union is defined by the fact that commercial banks can always obtain the liquidity they need from the central bank. Leaving the so-called ‘discount window’ open, i.e. allowing banks to get all the money they demand, is a prerequisite for the stability of any monetary system. During the financial crisis we have seen the European Central Bank doing a superb job in preventing a meltdown. Thus, even if the Greek government would have to suspend its interest payments, Greek and other banks would continue to have access to the ECB and get the money they need. Firms will continue to borrow from banks. Only those individuals and institutions that hold Greek bonds would be short of money. This could be bad for some banks with substantial amounts of Greek government assets in their portfolio and they may need help, but there is no reason for the whole country to leave the Euro Area. If anything, the incentives to stay are stronger than before.
The problem is rather that the Greek government would cease to exist as an economic actor. Insolvency means it cannot pay for the public goods that citizens desire. Without financial means, governments are powerless. The proper way for social democratic policies is therefore to pay for desirable social goods out of taxes rather than by borrowing money. It is a matter of honesty, of transparency, and of democracy. For only if people know that they can and how much they need to pay for their public goods will they be able to make collective choices in accordance to their preferences. Thus, balancing budgets is a necessary requirement for governments to pursue the policies their voters want them to implement.
However, there is political danger from populist agitation claiming that sticking to ‘the rule of Maastricht’ is responsible for social destruction and poverty. Of course, in a crisis, public deficits help stabilise output and employment. No social democratic government would refuse to stabilise the economy. But even this common-sensical policy is disputed by conservatives, who accuse governments of burdening future generations. The two arguments together make for an explosive cocktail.
This leads us to the second argument. It is about social justice. Many media and politicians claim that one must reduce budget deficits because going into debt now creates a burden for future generations. This is simply nonsense. When a government borrows today, it issues a bond that is repaid with interest in the future. The debt service on this bond will require taxing people in the future. That is true. But a bond issued now is bought by some more or less wealthy savers, who refrain from consuming today, so that they get income in the future. Hence, the taxes raised by future governments to repay debt are income for future bond owners. There is no burden on future generations, for the next generation consists of wealthy bond owners and of a broad public that is obliged to pay taxes. Therefore, government debt does not create intergenerational injustice.
So where is the problem? Unfairness is generated, in the present and in the future, because public debt is paid for by taxing people in general, while the income derived from the debt service only benefits the small group of wealth owners, who were able to save and buy government bonds. Public debt redistributes from the many to the few, but it does not create merry times for our generation and hard times for the young. The larger the size of public debt relative to GDP is, the worse the income distortion will become.
This is where the Greek problem becomes urgent again. Greek tax payers will have to pay 5.6% of GDP to cover the interest on government debt in 2010. In Italy, the debt/GDP ratio is 120%, and the interest payment is 4.7%, while in Germany and Spain, with debt ratios of 76% and 66% respectively, the burden is only 3% and 2%.
The moral of the story is, of course, that socialists know better how to handle public finances than conservatives and liberals. Because they know of the value of good government, they are willing to pay for it. They do not shrink the public sector by undermining public finance as liberals all to often do. But convincing voters of fiscal rectitude is a tough job ahead for the Greek government, as it is for all social democrats. Their success will determine whether Europe will be captured by conservative populists or realise a fairer and more social Europe.