economics

February 18, 2010

Lessons for Europe from California

Filed under: Uncategorized — ktetaichinh @ 4:29 am
Tags: , , , ,

The financial aftershocks being felt in Greece will show the EU what ‘union’ really means

Over a year ago, the world economy suffered a massive economic quake – and certain countries have been experiencing aftershocks ever since. Two such aftershocks have grabbed headlines, one recently in Greece and another last summer in California. A comparison of these two events reveals something about the respective features of the west’s two leading capitalist economies, the US and Europe.

The Greek aftershock has roiled the financial markets in recent weeks. With some $25bn worth of loan payments coming due for which Greece will need to refinance, the bond markets became skittish that a Greek default may lead to a wave of other national defaults in Portugal and Spain, and drag down the euro itself (much like Lehman Brothers initiated the global financial industry’s collapse).

But that seems unlikely. Greece’s economy comprises only 2% of the overall European economy – about the same magnitude as Indiana’s in the United States. Greece’s deficit to GDP ratio, while high at about 12.5%, is not that much higher than that of both the US and Japan, around 10.5%. True, Greece has a sizable accumulated debt over many years, estimated at about 110 percent of its GDP, but even the US has a debt to GDP estimated at 94% and projected to break 100% by 2012. And Greece is embedded within the euro zone which actually has a fairly low deficit to GDP ratio by today’s post-collapse standards, only 6%. So there is little doubt that Europe has the capacity to absorb Greece’s troubles. This is a matter of investor confidence, not economic fundamentals.

But California by comparison makes up 14% of the US economy, about the same magnitude as Germany’s economy in Europe, truly “too big to fail.” Yet when California threatened to default on its loan obligations last summer and the governor, Arnold Schwarzenegger, asked for a federal bailout, the Obama administration flatly rejected it. That caused California to have to issue IOUs as a way to pay its bills, and its bond rating plummeted.

California’s situation in some ways is more worrisome than Greece’s. Having a state that is one-seventh of the national economy in dire straits is a threat to the nation’s economic recovery. It is analogous to having Germany struggling instead of Greece, striking at the heart of Europe. California has been shaken by widespread layoffs and furloughs – the city of Los Angeles just laid off 1,000 more workers – and core social programmes have been slashed. Millions of low income children have lost access to meal programmes, and community clinics have been closed. Almost 3 million low income adults have lost important benefits such as dental care, psychological services and mammograms.

In addition, while both California and Greece are in major belt tightening mode, at least in Greece all families and individuals still have access to healthcare and a long menu of other social supports that Europe is known for. In California, even before the crisis millions had no healthcare, and now more have lost their jobs and their health insurance. Unemployment compensation is miserly, as is the overall safety net, which impacts consumer spending and further weakens the economy.

But California and the US do have one advantage over Greece and the European Union. Certainly Europe has the capacity to handle this crisis – its economy is nearly as large as the US and China combined – but that’s only if its big euro zone economies, Germany and France, are willing to lead. While the American federal government is used to playing the role of financial backstop for the states, making loans and other guarantees to weaker EU members is a new role for Germany or France to play.

The Germans and French are about to get a real dose of what “union” means. They didn’t realise that the euro came with a hidden obligation for them to bail out the Greeks and perhaps others during tougher economic times. So far they have agreed to stand behind Greece in return for new restrictions on government spending, but this crisis is going to test their union.

Will this mean the end of the EU, or the euro, as some doom-and-gloomers are predicting? Quite the contrary, says Tommaso Padoa Schioppa, former Italian Minister of Economy and Finance who is considered one of the founders of the euro. He said in a recent interview that the Greece situation “confirms the necessity and role of the euro in a very clear way”. The crisis, he says, will bind the EU closer and ultimately strengthen it as all sides recommit to this union-in-progress. The EU member states have swum too far across that stream to turn back now.

But ironically California’s current plight may serve as a warning to Germany and France. Over the last several decades, California’s once thriving economy served as a kind of backstop for other American states. California has subsidised low population (and often conservative) states by only receiving back about $.80 for every federal tax dollar it sends to Washington DC. Californians have sent tens of billions of dollars to conservative states such as Mississippi, Alaska and North Dakota, which receive about $1.75 for every dollar sent to Washington.

Yet when Governor Schwarzenegger asked the federal government for a return on that long-term support, the White House shut the door and the Republican states long subsidised by California were unsympathetic. Memories are short, as is gratitude. Wouldn’t it be ironic if one day, Germany asked the EU for a helping hand and was told “nein” by its erstwhile beneficiaries?

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