This question has become one of pretty intense discussion between economists across the world recently. Paul Krugman declared that it isn’t and created some graphs to prove his point. Others declared he misinterpreted the data used for the graphs and used it to prove the opposite case. While Prof Krugman used data to try and prove that the US deficit is reducing and Greek deficit is growing in the coming years, his detractors used the same data to show that despite lower deficits, US Debt/GDP ratio in 2020 will be close to Greece’s today.
The funny thing about numbers is, if one’s smart enough, one can prove almost anything with them. Sadly, the core of the problem isn’t about numbers, its about monetary theory. And by ignoring this, both sides are missing the plot completely.
When Greece adopted the Euro, it chose to give up control of it’s currency. The Euro is now it’s home currency and legal tender for all financial transactions within it’s borders. This includes it’s borrowings. But Greece doesn’t control the quantity of Euro in circulation and cannot create it out of thin air, a privilege reserved only for the European Central Bank. So when it comes to repaying its debt, Greece needs to ensure that it either earns the required amount or borrows it. This was not the case when Greece had its own currency when they could just create it to repay their debt.
The core differentiator between domestic and foreign currency, especially when it comes to borrowings, is the government’s control over the quantity of that currency and not it’s use as legal tender in the country. The test for this differentiator is simple. One only needs to ask whether the government can, even if only as a last resort, create the currency required to repay it’s debt. If it can, all borrowings denominated in that currency are domestic borrowings. Conversely, if it can’t, all borrowings denominated in this currency are external borrowings.
When it comes to choosing between domestic and external borrowing, if such a choice exists, government’s will try and keep external borrowings to a bare minimum to minimize their foreign exchange commitments. But there are nations which either don’t have this choice or don’t need to make it. In the former group are nations which adopted the Euro. They do not have any control over the Euro individually, but have to denominate their borrowings either in Euro or in some foreign currency. In essence. all borrowings for these nations are akin to external borrowings since they cannot unilaterally create the currency needed to repay this debt.
Membership of the latter group; nations which don’t have to make this choice, is restricted to nations having the ability to borrow in their domestic currency from foreigners. Nations like the US do not need to undertake any foreign exchange debt commitments. All their borrowings are denominated in a currency they control completely, and can create and destroy at will. For them all borrowings are akin to domestic borrowings regardless of the nationality of their lenders.
So Greece will default, either now or in some time, because it cannot create Euros out of thin air. But with a similar Debt/GDP ratio, all the US has to do is to create the money required to repay its debt. Whether that’s sensible is another discussion altogether, but in the end, the US has a choice and Greece doesn’t.
And that’s what makes them different, not their numbers.
A version of this post appeared on my Business Standard Blog on May 18, 2010