The Debt Death Trap

NEW YORK – The Greek financial saga is the tip of an iceberg of problems of public-debt sustainability for many advanced economies, and not only the so-called PIIGS (Portugal, Italy, Ireland, Greece, and Spain). Indeed, the OECD now estimates that public debt-to-GDP ratios in advanced economies will rise to an average of around 100% of GDP. The International Monetary Fund has recently put out similar estimates.

Within the PIIGS, the problems are not just excessive public deficits and debt ratios (in different degrees and measures in the five countries). They are also problems of external deficits, loss of competitiveness, and thus of anemic growth.

These are economies that, even a decade ago, were losing market share to China and Asia, owing to their labor-intensive and low value-added exports. After a decade that saw wages grow faster than productivity, unit labor costs (and the real exchange rate based on those costs) appreciated sharply. The ensuing loss of competitiveness manifested itself in large and growing current-account deficits and slowing growth. The final nail in the coffin was the appreciation of the euro between 2002 and 2008.

So, even if Greece and other PIIGS had the political resolve to reduce massively their large fiscal deficits – and that is a big if, given the political resistance to spending cuts and tax increases – fiscal contraction may, at least in the short run, make the current recession worse as higher taxes and lower spending reduce aggregate demand. If GDP falls, achieving a certain deficit and debt target (as a share of GDP) becomes impossible. This, indeed, was the debt death trap that engulfed Argentina between 1998 and 2001.