The Journal of The James Madison Institute

Government Defaults in Greece & Puerto Rico: Are We Next? | Dr. Randall G. Holcombe

he Greek government has been on had been fiscally irresponsible, promising the edge of defaulting on its debt their citizens more than they had the since 2010. A Greek default has been ability to finance. They were living beyond Tprevented only by a succession of bailouts their means. from the European Union (EU). The Puerto Despite the U.S. government’s Rican government did default on its debts reliance on deficit finance, it will not find in August 2015 because nobody stepped itself in the same situation of having to up to bail it out. These governments found default, as this article explains in more themselves in financial peril because they detail below. Even so, there are certain

12 | The Journal, Winter 2016 The Journal of The James Madison Institute

hazards that can come with deficit finance countries have run deficits higher than 3 at the federal level. Moreover, some of percent of GDP, the level they agreed upon America’s state and local governments when the eurozone was formed. Greece could find themselves in the situation of and Puerto Rico are different only because having to default on their debts because they have already arrived at the point of of fiscal irresponsibility. A review of the not having sufficient revenues to repay factors that have led Greece and Puerto their debts. Their problems are the result of Rico toward default helps to illustrate what government benefits promised in the past, the risks are closer to home. with the costs of those policies pushed into the future. The Greek and Puerto Rican Fiscal Irresponsibility governments used deficit finance to live The governments of beyond their means. Greece and Puerto The Greek case Rico find themselves in “The financing of is especially tragic financial difficulty now government spending because European because of financial through debt is not politics has stood in irresponsibility in the the way of pushing the past. Government unique to Greece or Greeks to enact fiscally benefits given to citizens Puerto Rico. Deficit responsible policies. The are politically popular, spending has been best policy for everyone but taxes are not, so the norm in the United would have been for politicians, looking States since the 1960s, the EU to let Greece to build political and all of the eurozone default and handle its support, always have own problems in 2010 the incentive to offer countries have run rather than bailing it citizens more benefits, deficits higher than 3 out. While the Greeks without providing a percent of GDP...” were living beyond their sufficient flow of tax means, the message revenue to pay for the bailouts sent to the them. The result is increasingly generous Greek people was that they could continue government benefits paid to citizens, to do so thanks to EU support, rather than financed by government borrowing rather having to cut back to an expenditure level than taxes. Greece and Puerto Rico found at which they could sustain themselves. themselves in the position of having The bailouts occurred because of accumulated so much debt that they could the politics of a united Europe, despite the not pay it back. bailouts being economically unsound. One The financing of government of the political goals of the EU is to create spending through debt is not unique to a more European identity, so that people Greece or Puerto Rico. Deficit spending think of themselves more as European has been the norm in the United States rather than German, French, Spanish, since the 1960s, and all of the eurozone Greek, and so forth. From a political

www.jamesmadison.org | 13 The Journal of The James Madison Institute The Journal of The James Madison Institute

standpoint, the other EU nations would power to create dollars to pay its debts, not be acting European if they turned their but the United States government, whose backs on Greece. European politics led to debt is denominated in dollars, does have the bailouts, not sound economic policy. the power to create dollars, through the The Greeks were borrowing to Federal Reserve Bank, to pay its debts. If provide generous government pensions, the debt of the federal government were a bloated government sector with too to become as unmanageable as the debts many government jobs, and an expansive of Greece and Puerto Rico, the federal welfare state. Because the bailouts signaled government could call on its Federal to the Greeks that they could continue to Reserve Bank to create dollars to pay off its live beyond their means, the result has debts. Indeed, the Federal Reserve Bank has been another half decade in which the financed a large percentage of the deficits Greeks continued to do so using other the federal government has run since the people’s money. Puerto 2008 recession. The Rico, unlike Greece, is U.S. government can not getting a bailout, “While the ability to never run out of dollars, which will force Puerto create money to pay because it can always Rico to budget more create more. responsibly in the its debts insulates the When Greece future. In both cases, U.S. federal government joined the eurozone, reforms will be painful, from the threat of it gave up the ability because spending having to default on its to create its own cutbacks will be debts, money creation money, as did all of the necessary. Everybody brings with it the threat eurozone countries. If benefits when those Greece still had its own reforms are made of inflation.” currency, the drachma, sooner rather than and if it issued bonds later, which is why the denominated in bailouts worked against the long-term drachmas rather than euros, it would interests of the Greeks. have the power to create drachmas to pay off its debts. This is why there has been The United States Does Not Face the some discussion about Greece leaving the Same Risks eurozone and reestablishing the drachma. The United States government does If Greece had its own currency, it could not face the same risks because it has then create all the drachmas it needed to the power to print money to finance its repay its debts and avoid default. Greece deficits. The Greek debt is denominated would not be on the brink of default and in euros, and Puerto Rico’s debt is looking for EU bailouts if it had not joined denominated in dollars. Greece does not the eurozone. have the power to create euros to pay its While the ability to create money debts, and Puerto Rico does not have the to pay its debts insulates the U.S. federal

14 | The Journal, Winter 2016 The Journal of The James Madison Institute The Journal of The James Madison Institute

government from the threat of having that the government’s currency loses all its to default on its debts, money creation value. This happened in Zimbabwe, where brings with it the threat of inflation. When inflation peaked at 80 billion percent per governments increase the quantity of month in 2008. The government quit money more rapidly than their economies printing money in 2009, and Zimbabwe are growing, the excess money bids up has been using other countries’ currencies prices. Many countries around the world since. In September 2015 it officially have inflation rates in the double digits, switched its currency to the U.S. dollar. including Venezuela with an annual Greece and Puerto Rico, because they did inflation rate of 68 percent, Ukraine with not have debts denominated in their own an inflation rate of 57 percent, and Iran and currencies, could not print money to repay Russia with inflation rates of 16 percent. their debts, but lacking the ability to do so The United States is not immune to double- has more positives than negatives, since digit inflation rates, having experienced it creates an incentive for governments to inflation rates of 11.3 percent in 1979, 13.5 be more fiscally responsible because they percent in 1980, and 10.3 percent in 1981. cannot inflate away their debts. So, the answer to Greece’s fiscal One of the ideas behind the problems is not to return to the drachma. creation of the eurozone was that because That just substitutes one problem it took away the power of national (inflation) for another (default). Inflating governments to inflate away their debts, away a government’s debts is another way it would push the member countries to for governments to live beyond their means be more fiscally responsible. This has not a little longer, but eventually, without fiscal worked for Greece, at least partly because reforms, inflation can become so rampant the other eurozone countries have shown

Protestors during the 2015 Greek default. (Photo via CNN Money)

www.jamesmadison.org | 15 The Journal of The James Madison Institute The Journal of The James Madison Institute

a willingness to allow Greece to continue to be paid in the future, pushing the costs to live beyond its means. The fact that of those promises forward in time. In the United States cannot find itself in the California, Illinois, and many localities, same position because of its ability to the promises of past politicians are now create money to pay its debts only means coming due, and current governments that excessive deficit finance in the United are fiscally strained as a result. While the States will cause a different set of problems. United States government does not face the In addition to the threat of inflation, threat of default as in Greece and Puerto deficit finance means that an increasing Rico, several state and local governments share of government revenue goes toward do. paying interest on the debt. With today’s artificially low interest rates, the long- What About Florida? run burden of these interest payments is In contrast to the governments in states understated, but when interest rates return such as Illinois and California, Florida’s to their historical norms, the share of the state government has a sustained record budget devoted to paying interest on the of fiscal responsibility, in part because national debt will surge. the state Constitution requires a balanced budget and the maintenance of a “rainy State and Local Governments day” reserve to cover lean years. Florida Several state and local governments find also has a well-deserved reputation as a themselves in a position similar to Greece low tax state, and is among the lowest of and Puerto Rico, because their debts are all states in expenditures per person and denominated in dollars and the states government employees per person. cannot create dollars to pay their debts. Looking at the pension issues that Thus, fiscally irresponsible states such as plague Illinois and California, Florida’s Illinois and California could be pushed state retirement system is about 85 percent into a situation of default. While no states funded, which is not as good as it should have found themselves in default so far, be but ranks Florida among the top states a number of municipalities have been in pension funding. Governor Rick Scott forced into bankruptcy because of debts and many members of the Legislature have they could not repay, including Detroit, pushed for reforms to make the retirement Michigan; San Bernardino, California; system even more fiscally sound, although Stockton California; and Harrisburg, attempts to take action have stalled in the Pennsylvania. Legislature in the past few years. The primary culprit in state and Florida’s record of fiscal prudence local governments is pension benefits goes back two decades. State government that have been promised by governments appropriations were 11.9 percent of Gross that have not set aside sufficient funds to State Product (GSP) in the 1994-95 budget meet those promises. Pension promises year, and have continually declined -- to 9.2 are politically tempting because politicians percent of GSP in the 2013-14 budget year. can offer current workers higher pensions Similarly, state taxes peaked at 7.7 percent

16 | The Journal, Winter 2016 The Journal of The James Madison Institute The Journal of The James Madison Institute

of GSP in the 1992-93 and 1993-94 budget future arrived, they were unable to repay years, and were 6.1 percent of GSP in the their debts. 2013-14 budget year. (Spending is a greater State and local governments face percentage of GSP than taxes because the same risks, if the officials who design much spending is financed through federal their budgets are fiscally irresponsible. grants.) The state has budgeted responsibly Political incentives make it very tempting and cut spending rather than raising taxes to offer constituents benefits now, pushing during economic downturns. the costs of those benefits into the future. In Ironically, the states facing the that context, Floridians should be grateful biggest fiscal challenges are not only among that for two decades our state-level officials the wealthiest states, but also the states with have been fiscally responsible, keeping the highest levels of government spending taxes low, balancing the state budget, and per person. Low incomes or a lack or not accumulating substantial unfunded revenues does not create state budgetary liabilities. Many state governments have problems. Excessive been less than prudent spending, unfunded in their budgeting, so pension liabilities, and “While Florida’s Floridians are fortunate fiscally irresponsible state government that their state government budgeting create them. has a solid record of has been among the most While Florida’s fiscally responsible in the fiscal responsibility, state government has nation. a solid record of fiscal the same is not true At the local level, responsibility, the of many of Florida’s however, budgeting same is not true of local governments.” has not always been as many of Florida’s local responsible as at the state governments. Especially level, so there is the real in the area of unfunded pension liabilities, threat that the problems facing Greece and cities such as Fort Myers, Hollywood, Lake Puerto could create severe fiscal problems Worth, Miami Beach, and Cocoa Beach for some of Florida’s local governments. are among those that have substantial The fiscal problems facing the Greek and unfunded liabilities that threaten their Puerto Rican governments -- seemingly so financial conditions. rare and remote -- are more common and closer to home than they might appear to Fiscal Responsibility Staves Off Debt most Floridians. Default The ultimate cause of the fiscal problems Randall G. Holcombe is the DeVoe Moore facing Greece and Puerto Rico is the Professor of Economics at Florida State past decisions of fiscally irresponsible University and a senior fellow at The James governments to spend more than they were Madison Institute. receiving in revenues, pushing the costs of their spending into the future. When the

www.jamesmadison.org | 17