What Does Cyprus Mean for Us?

The recent events in Cyprus have many in our country debating whether Cyprus and the larger financial problems mean anything for the U.S.  There are two questions that people ask most: 

1.  Will the events in Cyprus affect us?

2.  Can we become like Cyprus if our debt becomes too large?

First, it is important to quickly cover some background on Cyprus and the larger problems in several European countries like Portugal, Italy, Ireland, Greece and Spain (PIIGS).  The bottom line is that all of these countries face growing turmoil due to large debt compared to their GDP.  Their ability to pay back their debt is in serious doubt so other countries are unwilling to loan them more money unless they take steps to curtail their deficits through a combination of spending cuts and tax increases, typically referred to as austerity measures.  For more background on austerity, I refer back to an older post on the topic:  The Myths of Austerity.  The biggest difference between a country like Cyprus and the U.S., and this is important, is that Cyprus does not have a sovereign currency.  They belong to the Eurozone and use the Euro as their currency.  That means they cannot simply print more money to pay off their debt.  Cyprus made headlines recently because of the seizure of portions of private bank accounts to help pay off their debt.

So to answer the first question, can Cyprus affect the U.S, the answer is no in the short term but possibly in the long term.  Cyprus is a tiny country so their economic problems should not directly affect the U.S.  However, the problems in Cyprus and the reaction to the problem of seizing people’s private funds could cause more widespread concern in the PIIGS countries.  If people in those countries believe that their bank accounts could be targeted as well, they could cause a run on the banks and create greater economic problems throughout Europe.  The other short term problem that could happen is if countries throughout Europe decide that the Euro is no longer a viable currency and a nation like Germany, tired of being forced to bail out their Mediterranean neighbors, decides to dissolve the Euro experiment.  Although some feel this is a better option in the long term, the short term chaos would cause problems here in the U.S. since Europe is our largest trading partner.

Now for the second question, can something like Cyprus happen here, the short answer is no but the larger answer is a little less definite.  Remember when I said that we have a sovereign currency.  So technically we can always pay off debt by printing more money.  The problem becomes when we accumulate too much debt and print too much money.  Experts disagree on when that point occurs, but if more currency is put into circulation, eventually the value of all of the currency decreases.  That is inflation.  Now creditors will want more return for their investment because each dollar they receive back is worth less, so the price of borrowing goes up.  Now some argue that despite all the money that the Fed has printed over the last few years that inflation is still low.  They miss the point in two areas.  One, the official inflation rate or Consumer Price Index (CPI) is low because it includes housing rental prices, which have been low due to the crash of the housing market.  With a lot of empty houses due to foreclosure and people underwater and unable to sell their homes, rental prices dropped.  But, think about the things you buy every day like gas and food and you get a sense of real inflation.  Also, higher unemployment rates have kept inflation low because fewer people have money to spend.  However, no one can argue that an almost limitless printing of money will eventually cause inflation.  Without a gold standard to back up our money, the currency gets its value from the full faith and credit of the government.  In other words, creditors have to believe the money has value.  If there is so much of it in circulation, the dollar will lose value, making everything we buy more expensive.

So Cyprus and the events in other European countries are important to watch for a couple of reasons.  One, a larger economic catastrophe in Europe will affect our economy.  Two, the problems countries like Cyprus and Greece have with their debt is actually a better comparison to the issues our states and cities will face due to debt or bankruptcy.  The national debt of Cyprus is about $19 billion.  The debt of California is about 20 times that and like Cyprus, California does not have a sovereign currency.

The Myths of Austerity

If you spend some time on blogs and message boards you see a lot of different reactions to the current discussion in Washington about our debt and deficits.  Inevitably, someone talks about the debt crisis in Europe and the PIIGS countries in particular.  In these discussions, I have seen a few alarming flaws in logic regarding the word austerity that is typical of the reason why we have a difficult time discussing this topic in our country.

Pundits, politicians, experts and everyday people argue whether or not we have a debt problem in this country, and if we do, what is the best way to address it.  Is it increased taxes, decreased spending, or a combination of the two?  This article is not to address those issues.  But what it is important to address are fundamental logic flaws about the concept of austerity in Europe that many people in this country have.  To do so, I will focus on Greece in particular as an example of the worst of the problem.

Greece is in an economic crisis because their debt to GDP ratio became so high that their ability to ever pay back their debt was put in question.  As a result, their bond rates increased making it more difficult for Greece to pay back debt.  In addition, the global market crash in the late 2000s affected Greece’s GDP, making it even more difficult to get their debt under control.  Because the country is part of the EU they do not have the same flexibility with their money that the U.S. does.  But, the fundamental problem for Greece was that their debt to GDP ratio simply became too high.

Now this is where austerity comes in.  Austerity was essentially forced on Greece as a condition to secure loans.  In other words, other countries said we do not want to give you more money until you demonstrate that you are going to take measures to get your debt under control.  So austerity was a result of out of control debt, not the cause of it.  I can’t count how many times recently I have heard people try to state that austerity was the cause of Greece’s problems.  Now, the other problem I see in this country is that many people are trying to equate Congressman Ryan’s recent budget proposal with austerity.  There are several logic flaws with this also.  First, if you try to look at what any U.S. budget proposal is, it is not really spending cuts, it is mainly slowing the rate of spending increases.  In other words, if I gain 3 pounds a year and one year I only gain 2 pounds, I didn’t cut any weight.  I just got heavier a little more slowly that year.  Second, the austerity measures in Greece are a combination of spending cuts, tax increases and other measures such as the privatization of some industries.  So to only equate austerity with spending cuts is not logically valid. In fact, austerity in Europe more closely resembles a balanced approach to deficit reduction, just on steroids.  There is a good link below that covers the austerity measures in more detail.

So what does all this mean?  When discussing our options for the deficit and debt, it is important to not only look to what other countries are doing but to fully understand what they are doing in context.  Austerity did not cause Greece’s debt crisis, over-spending on social programs, and a decrease in revenue due to a lowered GDP and problems with their tax code caused their debt crisis.  Their ability to handle debt differs from the U.S. because they are a member of the Eurozone and not in control of their own currency.  However, what made their debt a crisis was that they let it reach a level that made creditors doubt the country’s ability to pay it back.  Austerity was an attempt to fix the debt crisis and was required as a condition to get access to more money.  Finally, austerity for Greece involves large cuts in spending and large increases in taxes, large compared to what the U.S. is discussing.

 

http://www.bbc.co.uk/news/business-13940431