Eurozone Crisis for Dummies

Uncertainty about the Greek economy and whether Greece will be able to continue using the Euro as its currency have caused stock market gyrations lately. Why?

First, what is the basic problem in Greece? In its simplest form, the problem in Greece is too much government debt. Too much debt, as in there are significant doubts about whether Greece can ever repay it. You can argue about why Greece has too much debt: too much spending, too little taxes, or some combination, but it is important to keep in mind the basic problem is too much debt and doubts about Greece’s ability to repay it.

So what are possible solutions? Well, what if you were in a similar situation? What if you had so much debt there were doubts you could repay it? You could do several things:

  1. You could cut your spending, and use the extra cash flow to start paying down your debt to more controllable levels.
  2. You could increase your income by getting an additional job, getting a raise, or switching to a higher paying job and use the increased income to pay down your debt.
  3. You could declare bankruptcy to restructure your debts to a level you could actually repay.

None of these options is pleasant and not all of them may be available in every situation. Increasing income is particularly difficult, so most people focus more on reducing spending when they realize they have a debt problem. If they do not realize they have a problem they continue piling up debt until bankruptcy is their only choice.

Countries have these same options, plus some others. They can cut spending, increase income, and declare bankruptcy. These actions embody fiscal policy. In addition, most countries can control the available supply of money in their country. By making money more or less available, countries generally try to keep a stable level of growth so business is able to flourish but inflation does not get too large. This is monetary policy.

Using each of these actions to get out of debt like Greece has leads to problems:

  1. Reducing spending can be difficult for people who depend on government spending. In the current Eurozone crisis, this is called “austerity.”
  2. Increasing income is mainly done through increasing taxes, which has the effect of depressing business activity leading over time to reductions in tax income. (To me, this is what actually should be called austerity.)
  3. Declaring bankruptcy makes it difficult to borrow money for an extended period of time, so it leads to a time when balanced spending (through actions 1 and 2 above) is required, not optional.
  4. Debt levels can be reduced through monetary policy by inflating the money supply. This provides more money to repay the debts and causes inflation so future debt payments are paid with devalued currency, which effectively lowers the amount of the debt.

Politically, option 4 is the obvious choice. Cutting spending and increasing taxes are politically unpopular, so most governments have difficulty doing them. (In the U.S. what we call cutting spending is actually just reducing the rate of increase in spending. It never actually goes down.) Bankruptcy is a drastic solution, and it just leads to more of 1 and 2.

So inflating the money supply is the politically easy way to go. Constituents don’t really notice it at first, and when they do politicians can blame it on businesses raising prices. Win-win! This is the traditional way for governments to get out of sticky debt situations. Unfortunately for ordinary citizens, particularly those on fixed incomes, this causes a reduction in income. Your fixed income buys less because everything costs more. Sorry, but the government has to repay its debts somehow.

And unfortunately for Greece, because of its membership in the Eurozone it does not have independent control of its monetary policy so it cannot inflate its way out of its current debt situation. This is why Greece leaving the Eurzone is being considered. Once it is back to having its own currency, Greece can inflate its way out of its debt. Good for the Greek government, but bad for Greek citizens as they deal with rapidly rising prices.

But Eurozone countries say they support Greece, and there is support for providing more loans to Greece. Does this make sense? Let’s go back to our comparison of the options available to an individual. If you have too much debt and someone tells you the solution is to provide you with more debt, would you believe them? A lot of people do believe things like this, and it never ends well.

The hope is that providing more loans to Greece will give it more time to cut spending and increase taxes. Since Greece is not the only country in the Eurozone to have government debt problems, this will also give other countries (Spain, Italy, Portugal, Ireland) time to get a better handle on their own debt problems before the shock of a Greek bankruptcy or departure from the Euro causes them additional problems.

The Greek people do not appear willing to go along with either decreased government spending or increased taxes. Therefore, Greece is on the path for either bankruptcy or leaving the Euro and inflating its currency. More loans will only delay the inevitable and make the problems worse in the meantime.

Look for Greece to leave the Euro at some point this year as its options run out. Politically, it is the easiest solution for them. The next question is whether it will end there, or if Greece will be the first domino that triggers a succession of countries departing from the Euro.

(Note: This post is a result of traveling the last two weeks and getting a steady dose of CNN International, which reports the same shallow overview of events over and over and over again. And the news always seems to be framed in the context politicians prefer, e.g. calling reducing the rate of increase in government spending “austerity.” I feel much better after writing this and getting out my frustrations!)

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