Research

Budget Banter

This quarterly KnowRisk Commentary gives you two views of government debt. The first is a greatly simplified description of the US budget called Federal Budget 101. This article was recently picked up as a letter to the editor by the Baton Rouge newspaper The Advocate. We have received many positive comments on how clearly this simple example makes the point.

The second article is a more in-depth analysis of the complex budget problems facing Greece. The article is called Greece Fire. We hope you enjoy these articles and find them informative and helpful.

Federal Budget 101

The U.S. Congress sets a federal budget every year in the trillions of dollars. Few people know how much money that is so we created a breakdown of the federal spending in simple terms.

Let’s put the federal budget into perspective. The 2011 Federal Budget analyzed in simple terms:

  • U.S. income: $2,170,000,000,000
  • Federal budget: $3,820,000,000,000
  • New debt: $ 1,650,000,000,000
  • National debt: $14,271,000,000,000
  • Recent budget cut: $ 38,500,000,000 (about 1 percent of the budget)

It helps to think about these numbers in terms that we can relate to. Let’s remove eight zeros from these numbers and pretend this is the household budget for the fictitious Jones family.

  • Total annual income for the Jones family: $21,700
  • Amount of money the Jones family spent: $38,200
  • Amount of new debt added to the credit card: $16,500
  • Outstanding balance on the credit card: $142,710
  • Amount cut from the budget: $385

So in effect last month Congress, or in this example the Jones family, sat down at the kitchen table and agreed to cut $385 from its annual budget. What family would cut $385 of spending in order to solve $16,500 in deficit spending?

It is a start, although hardly a solution.

Now after years of this, the Jones family has $142,710 of debt on its credit card (which is the equivalent of the national debt).
You would think the Jones family would recognize and address this situation, but it does not. Neither does Congress.

The root of the debt problem is that the voters typically do not send people to Congress to save money. They are sent there to bring home the bacon to their own home state.

To effect budget change, we need to change the job description and give Congress new marching orders.

It is awfully hard (but not impossible) to reverse course and tell the government to stop borrowing money from our children and spending it now.

In effect, what we have is a reverse mortgage on the country. The problem is that the voters have become addicted to the money. Moreover, the American voters are still in the denial stage, and do not want to face going into rehab.

Greece Fire

With the backdrop of nearly a decade battling ongoing debt issues, Greece’s risk of default has come to a forefront this past June. Its impact directly affects the Euro and puts Germany and France in the difficult situation of leading a potential bail out. Much of the Greek situation is already priced into the market, but it is worth examining the causes behind the crisis.

In late 2009, Greece found itself with a looming government deficit.    Greece’s debt level could lead to a loss of investor confidence across all the less prosperous European Union countries, namely Portugal, Ireland, Italy, and Spain. Germany and France, seeking to preserve stability with the euro, are now stepping forward to address Greece’s troubles, creating a delicate balancing act.

The upshot of not achieving this delicate balance is a potential destabilizing effect on the whole Eurozone. Moody’s has already downgraded Portugal to junk bond status. A potential bailout of Portugal could lower stock markets in the Eurozone, even if the Greece debt issue is currently priced into the markets. Much of the Eurozone, even the larger economies of Spain and Italy, are starting to feel vulnerable, as their fate to some degree lies in the hands of the rating agencies. As an example, the risk premium for Italian bonds recently went up, as contagion continues in the 17 country Eurozone.

Do not be surprised if the number of member countries in this young European Union experiment increases or decreases over time as the Union settles into a structure and matures. Readers of the Bible will recall that the reformation of the old Roman Empire will have ten members.

In the past two years, Greece benefitted from aid from its more prosperous European Union member countries, while simultaneously exacting austerity measures. The result of Greece’s struggles was higher interest rates for the Greek government and less access to capital, which might have helped catapult the economy.    In April 2010, Greece’s Prime Minister George A. Papandreou formally approached his EU neighbors, requesting a $60 billion bailout plan. Greece’s economy decreased by 6.6 percent in 2010, and estimates from economists expect close to an additional four percent reduction in 2011, according to the New York Times.

In June 2011, Greece suffered from a recession in the wake of a political crisis. While addressing internal turmoil of organized workers protesting, the necessary austerity measures were put in place by the Greek government, in return for a 12 billion euro bail out from EU member countries. Prime Minister Papandreou faces a difficult challenge as he tries to avert bankruptcy of the country while leading a fractious Socialist Party, but he was able to gain enough support to pass the recent austerity plan on June 29th, 2011. The plan follows a previous austerity package put forth in 2010 by Greece. The 2011 austerity plan focused on tax increases, wage reductions, and the privatization of approximately 50 billion Euros in state-held assets.

In terms of external bodies, the IMF gave Greece an infusion of credit on April 11th, 2011, of $15 billion, along with $30 billion from the EU. The fiscal measure passed in June by Greece, which was tied to aid from the IMF, leaves open the possibility of another tranche from the IMF. While these recent measures solve a short term problem, EU member countries anticipate a potential bailout some time in 2012 as it appears Greece’s sources of income from selling government bonds will likely no longer be a tool to raise funding for Greece.

According to the New York Times, Greece’s debt, amounting to more than 150 percent of GDP, puts Papandreou in a tight situation, with limited vehicles at his disposal. The European Central Bank and France have come to a consensus with Germany that rollovers of debt from private banks be voluntarily initiated by the banks themselves. As the largest holders of Greek debt, both France and Germany would find themselves in a very serious quandary if Greece were to default. External pressure includes greater privatization on the part of the Greek government and tougher tax collection. The ongoing goal is for Greece’s economy to develop over time in order to pay back its debt with a longer period to recover.

On July 2nd, 2011, as a start to what appears to require an ongoing bail out strategy to be revisited in September 2011, the 17 EU finance ministers approved a measure to extend an 8.7 billion euro package, as part of a 110 billion euro package put in place in 2010. In addition, the International Monetary Fund will likely move forward with a 3.3 billion euro package. These measures will help to counterbalance the risk of default for Greece and insolvency by late July. The next step is a second issuance of credit to Greece to bolster the economy through 2014. The latest meeting of the euro zone ministers was on July 11th, 2011. Following the meeting, the Eurozone finance ministers announced a number of possible initiatives, including reductions in interest rates and extensions of loan maturities. Another option still on the table is buying back bonds in the secondary market.

The meeting did not give any conclusion to the debate on private sector involvement or how it might tie into the risk of a selective default. Some read this lack of comment as a tacit willingness to accept a selective default if necessary, even though it poses risk of destability to the Eurozone as a whole. Maintaining the selective default as a rating agency decision, rather than actual default, would likely be the key to any acceptance of such a risk.

The Greek economic struggle demonstrates the tenuous nature of constraints created by the euro.    It would be a drastic measure to bring back the drachma, similar to Britain exiting the gold standard in 1931 or Argentina’s actions with its currency board in 2001. Greece is no longer able to devalue its own currency to foster greater competitiveness and must work within the constraints of the ECB. One alternative is an orderly restructuring of Greek debt, which may cause some Greek banks to close, but might not disrupt the current market if it has already priced the risk of default into the market.

Greece’s debt of 340 billion euros alone may not cause a huge resulting impact globally. The potential collapse of the Eurozone, however, if other less prosperous EU states find themselves with mounting pressure to pay back debt or take on higher interest rates, would pose a devastating threat to Europe as a whole. S&P has already cut Greece’s long term rating to CCC, which occurred on June 13th, 2011. Moody’s also cut Portugal’s credit rating to Ba2 on July 5th, signaling the repercussions of loss of investor confidence across EU member states. thS&P actions could lead to a fall in 10 year yields of Treasury bonds, as evidenced by the fall on July 5 .

The Greek crisis, if mishandled, could set off lower confidence in the EU stock markets.    The less prosperous countries could find it harder to sell future debt, raising interest rates.    Germany may lower interest rates in an effort to rescue Greece. Italy, in particular, is finding its stock market hit hard by the uncertainty across the Eurozone. Prior scares where Greece’s situation has put pressure on Italy and Spain, looking at the positive side, have historically proved temporary.

It is a good time to be careful before entering the European markets and take a “wait and see” approach. The worst case scenario could include a credit crunch similar to that which caused Lehman Brothers to fall. That scenario, however, seems unlikely, given both German and French vigilance in addressing actively these bailouts, in addition to efforts by private institutions to restructure Greek debt and possibly Portuguese debt. Investor panic, as a result of any default by Greece, could create a ripple effect with investors pulling out of Portugal, Spain, Greece, and possibly Italy.    The worst case scenario could mean a retreat from liquid assets such as corporate bonds and emerging market stocks, as investors move to cash. Money market mutual funds in the U.S. have particular exposure to private European banks, which are slated to restructure debt voluntarily. Credit default insurance would have repercussions on U.S. insurance firms and U.S. banks. The Euro is now at is its lowest level since March, hurting its purchasing power.    The coinciding dollar rise has put pressure on U.S. energy expenses, as the U.S. experiences a resulting effect. Japan’s stock market has fallen recently amidst the issues of the Eurozone sovereign debt situation combined with the federal deficit of the United States, based on concerns about lack of global economic growth.

China and most of the emerging international market countries continue to grow stronger, and are without the debt problems of the industrialized Western countries. What a change in the global economics we are witnessing in our lifetime.