Sovereign Debt: Comparing Greece and California

by: Bob McTeer

I’m afraid I’m about to state the obvious again. Most of you already know what I’m about to say, but as I listen to pundits talk about Greece on daytime TV it’s becoming obvious that not everyone does.

The issue is sovereign debt: when is it a problem and when does it become a crisis? The short answer is that too much debt, by definition of “too much,” is always a problem, whether the debt is owed by individuals, corporations, or countries. Focusing on countries only, too much debt becomes a crisis if the debt is payable in a currency other than the debtor’s currency, or if the debtor has no central bank to purchase its debt, i.e. monetize it.

U.S. debt is a problem, but not a crisis. If worse comes to worst, the Treasury (with the help of Congress) could prevail on the Federal Reserve to buy its debt at prices more favorable than those demanded by foreign creditors. If not sterilized, thus neutralizing the impact of the purchases on the money supply, the Fed would be monetizing the debt and a pickup in inflation would be the likely outcome. Indeed, that is what people mean when they refer to “inflating your way out of debt.”

A developing country that cannot issue debt in its own currency, but must issue it in another currency, say U.S. dollars, must earn the dollars necessary to service and redeem the debt through foreign trade (or perhaps temporarily through foreign borrowing to roll the debt over). It does not have the luxury of borrowing from its own central bank to service and redeem the debt.

Since Greece is one of 16 members of the Euro zone, its position is very much like a state in the United States. The European Central Bank is its central bank, but Greece cannot force it to monetize its debt. Likewise, California shares its central bank with 49 other states and cannot force it to buy and monetize its debt. Just as Greece has to earn the Euros it needs, so must California earn the dollars it needs.

Of course, none of this comes as a surprise. Countries knew they were giving up monetary independence when they joined the Eurozone and that monetary policy would be determined by a central bank serving all its members collectively rather than individually. Consequently, these countries cannot indefinitely delay paying the piper – a positive outcome. For individual states, maintaining a balanced budget is likely just as constructive.

Of course, California is a larger percentage of the dollar zone than Greece is of the Euro-zone and is more likely, eventually, to be treated as too big to fail, not by its central bank, but by its federal government. Since the dollar zone has been around a long time and states (except Texas) don’t have the option of dropping out, California will likely have less leverage with its federal government than Greece has with the European Community. So far, the Europeans have been gathering to decide how to help even before Greece has asked for any help. That’s pretty responsive, if you ask me.