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Can Greece be more like California?

greecepalm.JPG

Over at VoxEU, Jacques Melitz, a professor of economics at Heriot-Watt University in Edinburgh and a CEPR Research Fellow, argues that the Greece problem is, to a large extent, all in the EU's head. In particular, he says, the European Union has been so committed to the idea that "the Eurozone is founded on fiscal discipline and the Stability and Growth Pact" that we're now in the bizarre position where "the possible default of a country engaged in irresponsible fiscal policy and accounting for only 3% of the Eurozone’s GDP can raise questions about 'saving the euro' and the survival of the entire monetary system."

As comparison, Melitz says, look at California.

In June 2009, the state of California handed employees IOU’s, so-called vouchers, for payment. The incident has not been recognized as a default only because banks have honoured the vouchers thus far; but costlier and incontestable default still lies ahead as a significant probability.

This is reflected in the spreads on the credit default swaps on state bonds and the credit ratings of the bonds. The Californian economy is four times larger relative to the U.S. than the Greek one is relative to the Eurozone. Yet nothing remotely resembling the concern and turmoil in Europe about Greece has occurred in the U.S. regarding California.

Neither California’s recent or prospective future breaches of contract have caused a ripple in the U.S. financial sector, not even the part of it heavily implanted in California. Upon examination, it is difficult to explain this difference without invoking the self-inflicted damage of the doctrine that any default would be anathema for Eurozone.

Melitz suggests that the EU adopt a doctrine saying that "if any individual member government engages in irresponsible fiscal conduct, contrary to the Pact, its taxpayers and the creditors will bear the consequences. The Eurozone will only act to assure the stability of the financial sector in the Eurozone and the lack of any repercussions of undisciplined government spending behaviour on the risk premiums that the rest of the governments in the Eurozone need to pay."

I don't know how that'll actually work in practice, but Melitz is right that the EU needs to seriously rethink the core terms of its union now that Greece's problems have exposed not just the fragility of the pact, but the tensions threatening to tear it apart.

Photo credit: By Pascal Rossignol/Reuters

By Ezra Klein  |  May 3, 2010; 12:50 PM ET
Categories:  Economy  
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Comments

I think it gets more complicated because trade and worker-mobility among the EU members is not as simple as its among US states.

Posted by: jduptonma | May 3, 2010 1:17 PM | Report abuse

California slashed spending and briefly even passed out IOU's to employees in order NOT to default on bonds. I think there is a constitutional mandate in California that debt obligations must supercede everything else. So it is not especially surprising that this has not been a major source of upset in US financial markets.

If my understanding is right, then that seems a very different sort of situation than the European concerns about Greece and the liklihood Greece can repay its debt without substantial restructuring.

Posted by: Patrick_M | May 3, 2010 1:17 PM | Report abuse

Melitz has no idea what he is talking about w/r/t California. Patrick M gets it right that there is absolutely no chance that the state can default, as a constitutional matter they are obligated to pay off debt service before anything but K-12 education. The IOUs are probably something like 97% paid off at this point and haven't been handed out since last summer. We've also handed out IOUs in the recent past, in 1991, without incident. This is a really false comparison.

Posted by: dday212 | May 3, 2010 1:30 PM | Report abuse

Ezra you say "The Eurozone will only act to assure the stability of the financial sector in the Eurozone..." and then you say you do not know how that would work in the practice.

You are right, you indeed do not know.

The problem with banks in Euro is if a bank holds Greece bond which is not backed by ECB, it is to be treated as like any other Private company bond though the purchasing bank bought with AAA rating with full backing of ECB originally. So that bond purchasing bank looses capital and rest of the banks in Europe stop lending money to that bank as a result of inadequate capital. In other words, bonds of Greece, Spain, Italy essentially replace CDOs which in USA exerted enormous pressure on balance sheets of bank.

That is why despite it is a bonanza for folks who gambled on Greece bonds, ECB & EU is guaranteeing full Greece debt for 3 years.

Again the issue does not stop there. Unless ECB & EU put solution for Spain, Portugal and other weaker members in one go and then start applying stricter norms; market gets an opportunity to play with fire - try to call the ECB/IMF bluff on Spain, Portugal, etc. That is where I regard current Greece bailout by EU as 'half smart'.

If you want to do the bail out - do it for entire Europe (even if it is at the cost of One Trillion Dollars) and then start treating Greece as California. Anything in between - turkey is still half cooked.

Posted by: umesh409 | May 3, 2010 1:39 PM | Report abuse

This post seems to be a trial baloon...or a trap.

"Why so much had-wringing about Greece? CA is so many times more important and just as bankrupt but you don't hear anyone over here caterwauling about their ability to pay their debts! Hell, the taxpayers will pick up the tab!"

You agree with that, Ezra?

"Metz suggests..." but you are not suggesting anything of the sort, are you? It's getting hard to tell.

Regards.

Posted by: luko | May 3, 2010 1:55 PM | Report abuse

The comments to this piece are useful. I don't think the spot-comparison of Greece to California is particularly accurate; however, there are parallels in the future of both states.

This will be a great story to follow, as it will give insight into the differences between the organization of the EU and the US and may perhaps (perhaps) guide US leaders to avoid the mistakes of the EU and its states. The outlook is not all that rosy for either union.

Posted by: rmgregory | May 3, 2010 2:18 PM | Report abuse

The two situations are in no way comparable. The problem for CA was that they had not passed a budget within the statutory time limit and could not borrow more money as a consequence. As soon as the budget passed, they could borrow short-term to meet commitments. CA has serious budget problems that were exacerbated by Schwarzenegger's cancelling of the car tax increase when he took office. But the annual charade about IOUs is because of the failure to pass a budget on time, and that is a result of the 2/3rds requirement and the refusal of GOP legislators to vote for anything with tax increases in it.

Posted by: Mimikatz | May 3, 2010 5:04 PM | Report abuse

Mimikatz - California had shortfall of $20B or more per year. I do not believe new car tax would have brought that much.

In any case, increasing State Government revenue is not the solution for CA problems. Bloated State bureaucracy is definitely one problem which that much State Auditor says. Even without head count reduction, if State of California avoided egregious overtime payment rules, State and local bodies will save $1 to 3 Billion.

Prop 13 is another reason. But you cannot also change that in one go. Diluting Prop 13, if that is what State accepts (and there are no signs of that), will have to played out over a decade or so as home buying calculations of folks do not get totally whacked.

And then the third thing - entitlement rationalization.

All these things will still not fill the gap of $20B or so per year for last 2 years. But chances are that reforms along these lines can at least make the state finances sustainable.

I have been living in the State for last 12 years and I do think we have reached a tipping point in terms of Taxes. There is no much room to grow these taxes, be it Car Tax or any new Tax.

Posted by: umesh409 | May 3, 2010 7:48 PM | Report abuse

People always say, we need to declare our commitment to discipline in a crises, as if it's a magical statement. In fact it's a completely empty declaration. We can show discipline before a crises by creating sane regulations.

Posted by: theamazingjex | May 3, 2010 10:17 PM | Report abuse

The stability of the US system over EU has two major components.

#1 Labor Mobility. There isn't a lot the EU can do about this because of cultural barriers, although they could probably incentivize this behavior using some sort of subsidy.

#2 Fiscal transfers by the Federal Government. The Greek bailout is a stabilizing fiscal transfer. It would certainly be better if the EU had a more continuous policy along these lines and more automatic stabilizers rather than this manual klugey policy, but the Greek bailout is the right sort of policy.

I suspect this crisis will ultimately bring about a more integrated EU rather than a disintegrating one. There is no question that they have the resources to pull through, and it sets precedent for a stronger Federal Government. To analogize, the EU is the Articles of Confederation and the Greek crisis might very well be Shays' Rebellion.

Posted by: zosima | May 4, 2010 12:12 AM | Report abuse

CA state employees continued to get paid their regular paychecks during last summer's IOU episode:

http://www.sco.ca.gov/eo_news_registeredwarrants.html

Posted by: eduardom | May 4, 2010 10:31 AM | Report abuse

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