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5 Myths about the European debt crisis

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By Carmen M. Reinhart and Vincent R. Reinhart
Sunday, May 9, 2010

Just when the American economy appeared to be on the mend, a new crisis is stressing global financial markets. Greece's difficulty in financing its bloated budget deficit -- and the prospect that its debt troubles will spread throughout Europe and beyond -- is dominating the news. The euro has shed 12 percent of its value this year, and U.S. stock markets have shuddered in response, with the Dow declining almost 6 percent in the past week alone.

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The authorities have stepped in, with the European Union and the International Monetary Fund putting together a $141 billion rescue plan that compels Athens to swallow some tough austerity measures. Will it work? Or will the problems spread? To answer those questions, it helps to first tackle the myths that have emerged surrounding this latest financial crisis:

1. This is a new type of crisis.

It's easy to imagine that this is a thoroughly 21st-century financial calamity, wrought by modern financial products and a hyper-connected global economy. But in fact, governments have borrowed to live beyond their means -- and have had trouble paying their debts -- for about as long as there have been governments. From the 14th through the 19th centuries, monarchies routinely resorted to debasing their currencies, expropriating private property and defaulting on their debts. And their failure to honor their obligations usually produced severe economic hardship for their populations.

More recently, countries have often defaulted on their debts or been forced to restructure their payments. Some have done it multiple times; for the past 180 years, Greece has been in default about half the time.

As recently as 2001, the government of Argentina ran into funding difficulties. Repeated attempts at fiscal austerity triggered widespread riots. In the end, despite IMF assistance, the authorities could not stanch the fiscal bleeding, and Argentina defaulted on $132 billion of debt obligations, sending its economy into freefall.

2. Small economies such as Greece can't launch major financial turmoil.

Remember Thailand, which has an even smaller gross domestic product than Greece? Thirteen years ago, its financial woes sparked a regional crisis that sent currencies and stock markets plummeting throughout East Asia. South Korea and Thailand narrowly avoided default only through painful new economic policies -- slashing government spending, raising taxes and restructuring private debts-- and international support. By the end of the crisis, Asian economies had contracted by as much as 13 percent.

How do crises spread from one country to another? First, many governments have common lenders, including big international banks and hedge funds. If these institutions suffer large losses in one national market, they often pull back their lending to others.

Second, trouble in one country acts as a wake-up call to investors, who scour their global holdings for similar risks elsewhere. When they look hard enough, they usually find something to worry about, triggering even more funding withdrawals. Greece, Ireland, Portugal and Spain may be miles apart, but to a worried portfolio manager, they look similar: They all have ongoing budget deficits and large private and public debts.

3. Fiscal austerity will solve Europe's debt difficulties.

The need for Greece and other European economies to slash government spending is not some artificial imposition by the IMF or the European Union. Once investors decide that a country living beyond its means will have a hard time meeting its debt obligations, spending cuts become a reality of arithmetic.

But fiscal austerity usually doesn't pay off quickly. A large and sudden contraction in government spending is almost sure to shrink economic activity as well. This means tax collections fall and unemployment and welfare benefits rise, undermining efforts to reduce the deficit. Even if new borrowing is reduced or eliminated, it takes time to whittle down a large debt, and international investors are notoriously impatient.

In recent years, several countries facing market pressures opted for austerity measures and eventually recovered, such as Mexico in 1995, South Korea in 1998, Turkey in 2001 and Brazil in 2002. But they all started with debt burdens significantly lower than Greece's.

Of course, a country such as Greece could seek to negotiate with its creditors to reduce its debt, but that path -- essentially a partial default -- is no panacea. Argentina's economy contracted about 15 percent after its default in 2001, as it was shut out of international markets for a time. When debt dynamics turn as adverse as those in Greece appear to be, authorities have no good options.


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