A tale of two economic crises foretold

Nowadays, American and European policymakers seem to have very different views on many economic policy issues. However, it would seem that they do share one thing in common. They both have learned very little from Greece’s sovereign debt crisis of the past eight years. This is all too likely to produce something else that they might soon have in common: They both will very likely become bogged down with trying to resolve debt crises in small economies – that of Puerto Rico in the case of the Americans and that of Greece, yet again, in the case of the Europeans.

To its credit, the IMF at least seems to have learned from the major mistakes that it made in its initial years of handling the Greek sovereign debt crisis. It now recognizes that it was counterproductive to require excessive budget adjustment of an economy stuck in a currency union without a currency of its own to depreciate to help offset the negative effects on the economy of budget belt-tightening. Far from helping Greece to reduce its debt ratios to a sustainable level, such excessive belt-tightening worsened the Greek situation. It did so by producing the deepest of economic slumps that contributed to both a reduction in Greece’s tax collections and a rise in its debt ratios.

The IMF now admits that were it to have its druthers, it would have handled the sovereign Greek crisis in a very different way. It would have insisted that as a precondition for the IMF bailing Greece out, that country would first have had to secure a major reduction in its debt with private bondholders. Such a debt reduction would have allowed the IMF to design a Greek economic program that would have involved a very much lesser degree of budget adjustment that would not have sunk the Greek economy.

Apparently Greece’s European partners have not learned much from Greece’s dismal economic performance over the past eight years. Whereas the IMF is now insisting on European debt reduction for Greece and noting that the most that can be expected of Greece is a budget surplus, excluding interest payments, of 1.5 percent of GDP, Greece’s European partners remain reluctant to grant Greece debt relief. They are insisting instead that Greece strive to attain a 3.5 percent of GDP primary budget surplus. Nevermind that the Greek economy is in the midst of an economic depression that now exceeds in severity that of the United States in the 1930s. Nevermind too that Greece appears politically to have reached the limits of how much more budget adjustment it can bear.

If Greece’s European partners have learned little from the Greek sovereign debt crisis, the same is certainly true of the oversight board that the U.S. Congress created last year to help resolve Puerto Rico’s economic and financial crisis. Seemingly oblivious to the Greek experience, that board too is demanding excessive budget belt-tightening of the Puerto Rican economy. Indeed, rather than insisting that Puerto Rico’s debt be restructured to a level that might be consistent with a reasonable amount of budget adjustment, the board is suggesting that Puerto Rico should over the next 10 years take revenue and expenditure measures to reduce its budget deficit by around 10 percent of GNP.

If Greece’s experience with budget belt-tightening in a currency union is anything by which to go, the 2-3 percentage points of budget adjustment in each of the next two years, which the oversight board seems to be seeking from the island’s government, is likely to cause the Puerto Rican economy to contract further by between 3 to 4 percent a year over that period. This would be devastating for the Puerto Rican economy, which has already seen its economy shrink by more than 10 percent over past decade and which has seem more than 10 percent of its population move to the mainland in search of better economic opportunity. It is also difficult to see how such a decline in Puerto Rico’s economy would help it service its debt mountain.

By a strange coincidence, it seems all too probable that the Puerto Rican and Greek economic crises might come to a head together later this year. The Puerto Rican crisis could very well do so after May 1 when the current stay on suits by the island’s creditors is due to expire and when the U.S. Congress’ attention is likely to be distracted by other matters of U.S. economic policy. The Greek crisis could do so in July when a large debt payment to its European partners falls due and by which time Greek politics could have taken a turn for the worse.

If this does occur, U.S. Treasury Secretary Steven Mnuchin and German Finance Minister Wolfgang Schauble might find that they can take comfort in one another’s misery.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.