The downgrade of Greece is the next phase of the credit crisis. The behavior of governments to use fiscal policy (deficit financing) to help avert financial disasters is now starting to haunt the sovereign issuers. Let's look at the process of government throughout the world during this crisis.
Private borrowers as well as governments were hit hard by the slowdown in the global economy. This was a result of excessive speculation as well as a commodity shock. Defaults started to increase. Banks became more conservative given the risks and tax revenues declined. In an effort to slow this process, governments followed a classic Keynesian combination of loose monetary policy and deficit financing. By front-loading new expenditures with the existing automatic stabilizers the slowdown was arrested. There is no problem with this process. It saves the economy from a steeper downturn. The cost has been a run up in deficits. The problem is pushed into the future. These deficits by themselves would not be significant problem if there were strong sovereign balance sheets. Unfortunately, for many countries this is no the case.
Deficit financing coupled with already high debt /GDP levels means that the ability to pay for this new financing can be called into question. Future tax revenue is related to the future GDP growth. If debt to GDP is greater than 100% and interest rates are higher than growth rates, all incremental tax revenue will have to go to interest payments and not the pay down of principal.
So how do you pay-down the debt burden? You can grow out of the problem which is not possible if you have a slow growth environment. You can increase taxes but there is the side effect of further slowdown in the economy, or you can inflate your way out of the problem. A final solution is a default but we will assume that repudiating debt is a last resort solution.
The problem is that for Greece, as a member of the EU, there is nothing it can do on the monetary policy side to inflate the economy. Greece cannot inflate because the ECB controls monetary policy. In fact, there is a current bias toward raising rates by the ECB.
There is the additional problem that it may not be willing take collateral from with Greek bonds used as collateral if its rating continues to fall. This is not an immediate problem but one that will have to e addressed. It is unlikely that other EU member will be willing to bail-out Greece so there is the added problem that help will not come form their closest friends.
Fitch downgraded Greece to BBB+ with a negative outlook. S&P has Greece on a negative outlook with A- rating. There will be other countries in a similar situation which start to have investors differentiate across sovereign risks. The next phase.
Private borrowers as well as governments were hit hard by the slowdown in the global economy. This was a result of excessive speculation as well as a commodity shock. Defaults started to increase. Banks became more conservative given the risks and tax revenues declined. In an effort to slow this process, governments followed a classic Keynesian combination of loose monetary policy and deficit financing. By front-loading new expenditures with the existing automatic stabilizers the slowdown was arrested. There is no problem with this process. It saves the economy from a steeper downturn. The cost has been a run up in deficits. The problem is pushed into the future. These deficits by themselves would not be significant problem if there were strong sovereign balance sheets. Unfortunately, for many countries this is no the case.
Deficit financing coupled with already high debt /GDP levels means that the ability to pay for this new financing can be called into question. Future tax revenue is related to the future GDP growth. If debt to GDP is greater than 100% and interest rates are higher than growth rates, all incremental tax revenue will have to go to interest payments and not the pay down of principal.
So how do you pay-down the debt burden? You can grow out of the problem which is not possible if you have a slow growth environment. You can increase taxes but there is the side effect of further slowdown in the economy, or you can inflate your way out of the problem. A final solution is a default but we will assume that repudiating debt is a last resort solution.
The problem is that for Greece, as a member of the EU, there is nothing it can do on the monetary policy side to inflate the economy. Greece cannot inflate because the ECB controls monetary policy. In fact, there is a current bias toward raising rates by the ECB.
There is the additional problem that it may not be willing take collateral from with Greek bonds used as collateral if its rating continues to fall. This is not an immediate problem but one that will have to e addressed. It is unlikely that other EU member will be willing to bail-out Greece so there is the added problem that help will not come form their closest friends.
Fitch downgraded Greece to BBB+ with a negative outlook. S&P has Greece on a negative outlook with A- rating. There will be other countries in a similar situation which start to have investors differentiate across sovereign risks. The next phase.
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