The top chart shows the spread on 5-year Credit Default Swaps on Greek government bonds. Spreads have shot up to over 400 bps on fears that Greece's federal deficit is spiraling out of control (with a deficit of about 12% of GDP) with no fix in sight. Similar fears have surfaced in Portugal, with spreads today reaching 230 bps, Italy (153 bps), Ireland (172 bps), and Spain (170 bps), thus giving rise to the new acronym for fiscally challenged countries: PIIGS.
(Truth be told, the US should be included in the group of PIIGS, since an objective analysis of Obama's 2011 budget implies deficits of 10% of GDP or thereabouts for at least the next several years.)
For purposes of comparison, the second chart above shows the spread on generic 5-year Credit Default Swaps on speculative grade (junk) bonds. For all the fears of a Greek default, Greek government bonds are still trading better than junk bonds, and their spreads are still far below the worst we saw for junk bonds about a year ago. In other words, while the situation does look troubling, we are still far from standing on the edge of an abyss. Nevertheless, European sovereign debt risk has managed to infect the U.S. market, helping send stocks down 3% or so today. For further purposes of comparison, the following chart compares the performance of the German DAX index and the S&P 500, with the DAX priced in dollars. Both markets appear to be moving in lockstep of late, with German stocks made more volatile by swings in the dollar's value.
The problem of Greek deficits is multifaceted. On the one hand, the EU doesn't want any of its members to run large deficits, for fear that it could bring down the Euro. Greece has no authority to print Euros, so if it can't pay its debts it must default, and that could send shockwaves through the other PIIGS and destroy confidence in everything. This might result in great pressure on other EU member countries to effectively bail out the PIIGS, but no one is enamored of that solution. On the other hand, Greece's options appear limited, since it has a socialist government that loves to spend and wants to tax the rich to pay for it. This isn't exactly working out, and the economy is struggling and supposedly very vulnerable to any attempts to cut spending or raise taxes. (If this sounds familiar to US citizens, it should be.)
I'm having trouble with the idea that all of this represents an intractable and grave problem. Why are people so quick to assume that government spending can never be cut? That any attempts to reduce fiscal deficits via spending reductions will cause grave harm to economies? In my view, the deficits are big and awful already, and that is a major problem already. Big deficits imply expanding government intervention in the economy, the risk of major increases in tax burdens, and a less efficient and slower growing economy going forward. Increasing fiscal deficits is only stimulative if they are used to finance a significant and productive cut in taxes; otherwise, higher deficits, especially when they get to 10% of GDP or more, are bad (just look at what they have done to Japan). I believe it is never a bad thing to do the right thing; if higher deficits are bad, then lower deficits are good. Cut the spending, and watch the private sector take off; that's the best way to fix these economies.
The real problem faced by the PIIGS and by the U.S. is political in nature, not economic. The party in power never seems to want to cut spending, but ultimately that is the only solution. The spending is unproductive to begin with, so eliminating it should be a net benefit. It probably requires a near-crisis to cause such a sea-change in fiscal policy, but by the looks of things we are well on the way, both here in the U.S. (with the rise of the Tea Party), and in Europe (thanks to the discipline of the bond market).
Source: The Real Problem with PIIGS Debt