Tuesday, January 11, 2011

Lessons from Greece

This was originally posted April 30, 2010 on the Japan and Economics blog. I've moved the blogs that focus primarily on the US economy here, to better unify the content.
The following was written with the financial end of the auto industry in mind. But I fear it's rather more general than that.
The US faces its own Olympic hurdles, ones likely far higher than those faced by the government in Athens. But the hurdles are much the same: a political economy where the lines of central versus local government do not mesh well. The European Union has known from the beginning that it would face tensions between local macroeconomic performance and the common monetary policy that comes with a common currency. Hence it placed requirements that potential new members meet debt and inflation restrictions before joining the Euro zone. Those were applied with a wink and a nod, and with hindsight poorer countries inevitably faced inflation as the convergence of salaries in the service sector raised costs for agriculture and manufacturing, which faced trade competition. Furthermore, no mechanism was put in place to handle the sort of crises facing the southern fringe of the EU. With little in the way of a central government and no substantial central taxing ability, such rules probably could not have been put in place. But the EU now faces a high hurdle, and it's not clear that the members of that clumsy, cobbled-together semi-polity can jump very high, or even at the same time.
We have California, and Illinois and other states that face fiscal problems as grave as those of Greece. We had the recent spectacle of Arnold Schwartzenegger begging and pleading for mercy from bondholders, and somehow managing to float billions of short-term debt – at a substantial premium. No one was so foolish as to try to sell long-term bonds. But California is fundamentally broken, with the ability to put propositions on the ballot making any shift on the revenue side unlikely in the extreme, while basic public services collapse. Our most populous state has one of the worst performing set of school systems in the nation, something that should have the rest of us frightened. While further cuts will (must?!) be made in the short term, given the lack of cash, doing so is surely being penny-wise and pound-foolish.
So in due course California's debt will become unmarketable, and the economy will collapse. Unlike Greece, California is large – were it its own country, it would rank in the world's top 10. And if California goes, then surely we would see contagion, as panic would spread to the holders of the debt of other highly leveraged states, counties and cities.
The Federal Reserve holds no sway in those markets. Under our Federal system, it's not clear what could be done by Washington – unlike with the financial system, it would be unconstitutional to ask for a quid-pro-quo (though the courts might finesse the issue by taking a few years to get around to a ruling). And the screams of "bailout" would be loud, perhaps overwhelming. After all, Californians know their fiscal system is broken but have been – let's be frank – too cheap to levy the modest taxes on themselves that would be needed to set things aright. Unfortunately the same can be said of a host of entities across the US – we have something like 17,000 governmental issuers of debt, from the legislature in Sacramento down to local water and school systems.
The banking and shadow banking systems may have returned to a semblance of normalcy. But to think we are out of the woods is hubris, and we're bigger and taller than Greece. Tragedy makes good theater, if you are in the audience. However, we won't be spectators, we won't even be actors. We'll be victims. Is your balance sheet ready?
Mike Smitka

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