Why we should care about Greek debt

THE debt crisis in Greece may seem very far away to most Americans. Greece is small — its 2009 GDP of $309 billion makes it only about 2 percent of the size of the U.S. economy — and few Americans hold Greek government bonds.

But the crisis that started in Greece is going to have significant effects on all of us in the United States. It will hurt U.S. exports, raise our interest rates and put our still-fragile economic recovery at risk. Worse still, the contagion effects from Greece's problems threaten another credit crisis. There are things the U.S. must do to minimize these contagion effects. Ultimately, the U.S. response must include measures that make us pay higher taxes and expect less government spending.

How can this be?

The Greek crisis is about government debt, also known as "sovereign debt." After years of excessive government spending, Greece has accumulated debt equal to about 120 percent of its GDP. As confidence in Greece's creditworthiness falls, the country has to pay ever higher interest rates to get investors to hold its bonds.

The collapse of confidence in Greek sovereign debt has spilled over to other European countries with large debt burdens, such as Portugal and Spain. In response, European governments have organized a financial rescue package for Greece and a large loan-guarantee plan for other member states that might run into trouble. In exchange, these countries have implemented dramatic austerity measures, including tax increases and government spending cuts.

The problems in Europe are already causing the euro to fall and the dollar to appreciate. The exchange-rate changes make U.S. goods less competitive. Furthermore, the austerity measures in European countries will reduce their demand for U.S. exports. Thus, U.S. exports will decrease.

Next, interest rates will rise. As government debt loads increase worldwide, borrowing countries must offer higher interest rates to attract investors to hold their bonds. In addition, uncertainty about the sustainability of sovereign debt may lead investors to require an extra interest-rate increase to compensate for the risk of default.

The interest-rate effect will be mitigated somewhat for the U.S. because, in uncertain times, the dollar is a "safe haven." That means global investors perceive the U.S. to be the safest place to invest. So interest rates on U.S. government debt will not rise as much as for other countries. But the increase will still be big enough to raise borrowing costs for households and firms, slowing our economic growth.

A loss of confidence in one country can have dangerous ripple effects through the global financial system. In 2008, when doubt arose about the creditworthiness of banks holding bad housing loans, the banks stopped lending to each other, and the global financial system seized up.

Cross-border holdings of sovereign debt could create a rerun of that credit crisis. The Economist magazine estimates that American banks hold only about $10 billion of Greek government bonds, but eurozone banks may hold as much as $120 billion. In turn, American banks hold claims of more than $1.2 trillion on European banks. If bad Greek debt triggers a loss of confidence in European banks, the domino effect on the U.S. financial system will be large.

Another contagion effect is at work. The European sovereign-debt problems are starting to make observers question the sustainability of the large government debts in countries like Japan and the United States (where government debt is approaching 100 percent of GDP). A collapse of confidence in U.S. government bonds could increase U.S. interest rates enough to throw us back into recession.

What can the United States do? To avoid becoming the next Greece, it is imperative that we get our own fiscal house in order. Sooner or later we need to adopt some combination of higher taxes and reduced government spending. We will all feel the painful results in our pocketbooks and our lifestyles, but we will avert catastrophe.