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California Dreamin'

Wed, Feb 3 2010, 07:41 GMT
by UniCredit Research

UniCredit Group  |  View company's profile

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At the press conference on Thursday, ECB President Trichet will again be asked about Greece, and he might be tempted to again draw a parallel between Greece and California. He should not. True, California has a much greater weight in the US economy than Greece in the eurozone; and this in turn implies that while Greece suffers from a far higher debt/GDP ratio than California, both are negligible as a fraction of eurozone and US GDP respectively. But that is where the similarities end, and once you consider how current fiscal problems can be addressed, the differences become painfully obvious. In the US, the federal government already plays a dominant role in the economic life of individual states, it can help smooth out gradual adjustments and it has the resources to mount a rescue if needed. In the case of the eurozone, it is far from obvious who can come to the rescue and with what resources—and how the accompanying policy conditionality would be imposed. Eurozone policymakers are clearly struggling on these issues under the nervous watch of markets. Paradoxically, it would be easier for the US to abandon California to its own devices than it would be for the eurozone to abandon Greece: contagion would be far stronger, and the eurozone has no mechanism to deal with it: there is no federal debt, no real sharing of resources. The weakness of centralized eurozone institutions will define the response to the current crisis, and it will play an even greater role in constraining long-term adjustments, which loom large for Greece, other member countries, and the eurozone as a whole; these include the burden of aging populations, but also how to generate growth without recurrent large external imbalances at the single country level. California dreamin’ cannot dispel the Greek nightmare.

Trichet has pointed out that like Greece, California also faces fiscal problems, and that California is a much greater part of the US economy than Greece is of the eurozone; therefore, Greece’s troubles should be of lesser concern to eurozone policymakers than California’s are to the US government. This fits into the ECB’s view that there is no substantial difference between the US and the eurozone: US states share a common currency but still maintain a degree of fiscal autonomy, like eurozone member countries; and the dispersion of growth and inflation rates across eurozone countries is no greater than across US states. The strongest implication of this view is that one should no more be concerned with the external current account balance of Greece or Portugal than with those of Georgia or Pennsylvania. This view is fundamentally misguided.

Let us first look at the Greece vs California comparison in greater detail. The observation about the relative weights in overall eurozone and US GDP is of course correct: Greece accounts for about 2% of eurozone GDP (based on latest Eurostat estimates), whereas California accounts for 13% of US GDP; indeed California is the largest US state in terms of GDP, followed by Texas with a share of about 8 ½ % and New York with a share of about 8%. If it were an independent country, it would rank as the eighth largest economy in the world, somewhat smaller than Italy but larger than Spain, and would enjoy a seat at the G20. It is therefore certainly correct that a downturn in California’s economy would have a greater impact on the US than a Greek recession in the eurozone.

Looking at the fiscal numbers, though, the first impression is that comparing California to Greece is rather unfair. In 2008, the latest year for which official US Census Bureau data are available, California ran a budget deficit of USD46bn, or some 2.5% of California GDP. In the same year, Greece recorded a deficit of 7.7% of GDP, which then went on to an estimated 12.7% of GDP last year. Moreover, California’s debt amounted to a paltry 7% of the state’s GDP at end-2008; in Greece it stood at about 100% of GDP, ready to escalate to over 110% in 2009. On this metric, Greece’s troubles look far more serious. If, however, we take an “implicit bailout assumption” in both cases, the difference vanishes: California’s debt amounts to less than 1% of US GDP, but as Greece is so small its debt amounts to just over 2% of eurozone GDP. So the US could in principle take over California’s liabilities without much of an impact, and the same could the eurozone do with Greece. As we know, however, moral hazard makes that scenario undesirable in both cases.

It is exactly when you consider a possible bailout scenario, however, that the difference starts becoming apparent. First of all, who would come to the rescue, why, and with what funds? In the case of California it would be the Federal government, and for a very obvious reason it already plays a major role. Consider personal income taxes: California, which has one of the highest state taxes in the US, levies up to 10% for the highest income bracket; federal income tax rates range between 10% and 35%. While California, like other US states, does enjoy a degree of fiscal autonomy, it is the Federal government that raises the bulk of the tax intake, and provides the corresponding services. The Federal government was raising about 18% of US GDP in revenues in 2008 (before the recession caused a significant decline in 2009), and it provides a number of key services from national security to social security to Medicare and unemployment insurance; moreover, the Federal government provides transfers to the individual states to help fund education, Medicaid and other programs. It seems obvious that the Federal government would have both the responsibility and the resources to help if needed.

In the case of Greece, as we are seeing, the answer is far from obvious. While the EU provides structural funds under various headings, there is no European Federal government that raises a substantial proportion of revenues and provides key services to the EU population. As a consequence it is not obvious at all how a financial rescue can be organized if needed. A bilateral loan? A multilateral loan? A newly created EU fund? This in turn relates to how the corresponding conditionality would be imposed: would it be a single EU country imposing policy conditionality? It is not clear how the Greek population would react at having key public expenditures and tax decisions imposed from Berlin, for example. Or would the conditionality be imposed at the EU level, and in this case would it need to be formally ratified by all remaining 26 member states?

EU policymakers are currently struggling with these issues as it seems increasingly likely that a rescue operation will be needed. And here there is an apparent paradox: it would be easier for the US to let California default than for the EU to allow Greece to do so—and the reason is contagion. I noted above that a California recession would have a far more damaging direct impact on the US economy than a Greek recession on the eurozone. But if California defaulted, the repercussions on US federal debt would in all likelihood be minimal. US federal debt has vulnerabilities of its own, and these are becoming increasingly obvious with the ongoing deterioration of the federal fiscal accounts—but they are very clearly distinct from those of state debt. There is no federal debt in the eurozone: the eurozone sovereign debt market is a mosaic of national debts that have so far been held closely together by the market’s confidence in the so-called “implicit bailout assumption”, that is the idea that a member countries would be rescued by its peers if needed. Confidence in that assumption is already fraying, and spreads are widening. A sovereign default would shatter it, creating serious funding difficulties for other member countries with weak fiscal balances, and serious tensions in the financial sector. The overall repercussions would be far more severe than a simple Greek recession, and far more severe than a California default.

A currency union does not make a federal state—that is the bottomline and the crux of the problem. It will define the response to the current tensions, and it will play an even more important role in constraining the long-term adjustment needed at the EU and individual country level. Once the current funding difficulties have been surmounted, Greece will still face with a looming aging problem of epic proportions—the European Commission estimates a rise in public expenditures of about 16% of GDP over the next 50 years. Reform of pensions and health care appears inevitable, but to make the overall fiscal adjustment tolerable Greece would need to raise its growth potential, which in turns requires it to recover some of the lost competitiveness (which the IMF estimated at some 20-30% in its latest Staff Report). Greece cannot rely on a currency devaluation, and neither can California, but the latter can rely on transfers from the federal government, and on a degree of labor mobility which within the US is far higher than within the eurozone. Without high labor mobility, strong transfer programs, and a truly unified fiscal authority, external imbalances at the single country level will continue to matter, and to pose a risk to the eurozone’s medium term growth prospects.

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Published on  Wed, Feb 3 2010, 07:49 GMT

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