PIGS in Europe Face Consequences of Budget Failures

Why do we care? Americans have one big reason to worry about these developments. As Niall Ferguson, author of "The Ascent of Money," noted increased fears of default push up real interest rates. That, in turn, drags down economic growth, especially when the private sector is heavily indebted, as is the case in the United States. And higher interest rates would dramatically impact the U.S. budget, possibly pushing payments on the $12 trillion in U.S. debt to a crippling 25 percent of all federal revenue.

As for the four European countries, all of them last year broke the EU's budget rules that call for deficits not to exceed 3 percent of GDP. Portugal's deficit equaled 9.3 percent of gross domestic product, Ireland's deficit was about 12 percent, Greece's was just under 13 percent, and Spain's deficit was 11.4 percent of its GDP in 2009. (These four countries are not alone. The European Commission expects the aggregate budget deficit in the eurozone to climb to nearly 7 percent in 2010, up from just 2 percent in 2008.)

While Ireland, the onetime Celtic Tiger, seems to have averted a crisis by adopting a credible deficit reduction plan, the other three countries, especially Greece, have yet to do so.

Many of Greece's problems are of its own making, shown, for example, by the fact that it recently more than doubled its estimated budget deficit for 2009 and it has tolerated tax evasion and corruption in the public sector. The European statistics office has questioned the quality of its data for years. Greece has failed to take steps to reduce its deficit as EU finance ministers requested last year. In a November report, the European Commission highlighted excessive employee compensation and capital spending as important factors behind Greece's budgetary problems.

With a new government in place since October, the country's credibility may be improving. To help narrow its budget deficit, Greece has proposed freezing civil servant salaries and scaling back allowances, halting recruitment in 2010, and cutting the compensation of chief executives at state-controlled corporations to a maximum of €5,000 ($6,890) a month. Greece plans to increase taxes on fuel, tobacco and alcohol, eliminate certain tax exemptions, provide a tax amnesty to encourage Greeks to return their funds held overseas, and to "crack down" on tax evasion. In response to the spending cuts, the Greek public sector union held a 24-hour strike last Wednesday.

Regardless of whether or not Greece is able to cut its budget deficit by four percentage points this year, as it has promised to do, the Europeans face a dilemma over how to address the country's present fiscal crisis and the possibility that it may not be able to refinance its debt later this spring. Greece could be allowed to default on its debt payments, thus throwing the euro bond market into turmoil. Or, the Europeans, most likely Germany and France, could guarantee that they would not allow Greece to default. In other words, they could bail out the Greeks.

On February 11, the Europeans essentially took the bailout option. To address fears of a potentially disastrous default, the leaders of the 27 EU members meeting in Brussels promised to help Greece by taking "determined and co-ordinated action, if needed, to safeguard stability of the euro area as a whole." The euro area is the 16-member group of EU countries that have adopted the common currency. Although the EU leaders pledged support for Greece, they stopped well short of providing details, or even saying whether they would step in if Greece needs such support.

Even though all 27 EU member states would be hurt by a Greek default, the 16 EU countries that have adopted the euro would be most affected. And, among these 16, France and Germany have the most direct financial exposure to Greece. Thus, to some extent, the other EU countries can act as free riders on Germany and France.

To try to calm the financial markets, which have never dealt with a sovereign default by a member of the eurozone, the EU's permanent president, Belgian Herman Van Rompuy, made it clear that Greece had not requested a bailout. However, much as he would like to help Greece, Von Rompuy's hands are tied. The European Commission, which is the governing body of the European Union, is relatively powerless to help Greece, as the European Union treaty specifically prohibits providing a "bailout" to one of its members. Furthermore, unlike the American central bank, which has authority to rescue failing financial institutions, the European Central Bank has no similar rescue power. Thus, such support must come from Greece's fellow EU members.

French President Nicolas Sarkozy and German Chancellor Angela Merkel, leaders of the two largest EU countries that have adopted the euro, are expected to lead efforts to support Greece, likely in the form of loans or guarantees if Greece is unable to meet its debt payments later this spring. Merkel said that although the EU stands by Greece, Greece must first implement its deficit reduction program.

However, it is important to recognize that Germany and France are not acting solely on Greece's behalf. Both countries have a large exposure to Greece, with French banks holding almost $80 billion of Greek sovereign and financial institution debt and German banks holding about $43 billion of that debt. Other countries also would be hurt by a Greek default. Thus, as was true in the United States when the federal government provided a $700 billion financial rescue package in the fall of 2008 to prevent a global financial crisis, the cross-border ownership of Greek debt and the severe consequences for financial stability if Greece defaulted makes a default highly unlikely.

Despite the low probability that Greece will default -- whether it meets its fiscal obligations on its own or because other EU countries come to its aid -- the financial markets are wary of possible sovereign defaults in other EU countries. Given the integration of global markets, should the Greek contagion spread it it likely that it would cross the Atlantic and infect the United States. All highly leveraged countries are under pressure to meet their debt obligations. Even though there is virtually no possibility that the United States would default on its debt, a default in Greece has potentially important consequences for the U.S. as it struggles to meet its increasing fiscal demands.

The story coming out of Europe has an unfortunate ring to it, as the budgetary problems and the credibility of government fiscal promises are called into question. Years of mismanaged budgets will not be cured overnight. And statements by European countries that "All euro area members must conduct sound national policies in line with the agreed rules" count for little when the markets see that these statements are nothing more than easily broken promises.

Or, as the saying goes, when pigs become too greedy, they get slaughtered.