MYTHS ABOUT THE EUROPEAN DEBT CRISIS

May 13, 2010

Greece's debt crisis is neither a new phenomena, nor a uniquely Greek problem, say Vincent Reinhart, a resident scholar at the American Enterprise Institute, and Carmen Reinhart, an economist at the University of Maryland. 

Greece's difficulty in financing its bloated budget deficit has caused a global crisis that has prompted the authorities to step in.  The European Union and the International Monetary Fund have put 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, say Reinhart and Reinhart. 

This is a new type of crisis: 

  • This is not a financial calamity unique to the 21st century alone; governments have borrowed to live beyond their means for about as long as there have been governments.
  • More recently, countries have often defaulted on their debts or been forced to restructure their payments; for the past 180 years, Greece has been in default about half the time. 

Small economies such as Greece cannot launch major financial turmoil: 

  • Thirteen years ago, Thailand, which has an even smaller gross domestic product than Greece, experienced financial woes that sparked a regional crisis and sent currencies and stock markets plummeting throughout East Asia.
  • South Korea and Thailand narrowly avoided default only through painful new economic policies. 

Fiscal austerity will solve Europe's debt difficulties: 

  • 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.  

The euro is to blame for Greece's financial woes: 

  • The immediate reward for Greece becoming a member of the European Union was the ability to borrow money at lower rates.
  • Before it joined the Eurozone, Greece's household debt was only 6 percent of the nation's gross domestic product; by 2009, it was nearly 50 percent of GDP and by the end of 2009, government debt had marched upward to about 115 percent of GDP.
  • In that sense, the euro did pave the way to this crisis.  

Source: Vincent R. Reinhart and Carmen M. Reinhart, "Five Myths about the European Debt Crisis," American Enterprise Institute, May 9, 2010.

For text:

http://www.aei.org/article/102030 

 

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