Long-Run Implications of Fiscal Policy

In 2009 the government of Greece ran into a financial wall. Like most other governments in Europe (and the U.S. government, too), the Greek government was running a large budget deficit, which meant that it needed to keep borrowing more funds, both to cover its expenses and to pay off existing loans as they came due. But governments, like companies or individuals, can only borrow if lenders believe there’s a good chance they are willing or able to repay their debts. By 2009 most investors, having lost confidence in Greece’s financial future, were no longer willing to lend to the Greek government. Those few who were willing to lend demanded very high interest rates to compensate them for the risk of loss.

Figure 13-11 compares interest rates on 10-year bonds issued by the governments of Greece and Germany. At the beginning of 2007, Greece could borrow at almost the same rate as Germany, widely considered a very safe borrower. By the end of 2011, however, Greece had to pay an interest rate around 10 times the rate Germany paid.

Greek and German Long-Term Interest Rates As late as 2008, the government of Greece could borrow at interest rates only slightly higher than those facing Germany, widely considered a very safe borrower. But in early 2009, as it became clear that both Greek debt and Greek deficits were larger than previously reported, investors lost confidence, sending Greek borrowing costs sky-high. Sources: Federal Reserve Bank of St. Louis; OECD “Main Economic Indicators Complete Database.”

Why was Greece having these problems? Largely because investors had become deeply worried about the level of its debt (in part because it became clear that the Greek government had been using creative accounting to hide just how much debt it had already taken on). Government debt is, after all, a promise to make future payments to lenders. By 2009 it seemed likely that the Greek government had already promised more than it could possibly deliver.

The result was that Greece found itself unable to borrow more from private lenders; it received emergency loans from other European nations and the International Monetary Fund, but these loans came with the requirement that the Greek government make severe spending cuts, which wreaked havoc with its economy, imposed severe economic hardship on Greeks, and led to massive social unrest.

The good news is that by mid-2014 Greek borrowing costs had fallen sharply. In part this reflected a growing sense that Greece would stay the course on spending despite the huge suffering. It also, however, reflected the intervention of the European Central Bank, which assured investors that it would do “whatever it takes” to sustain the euro, Europe’s common currency; this move was widely interpreted as a guarantee that, if necessary, it would step in to buy the bonds of Greece and other troubled debtors.

Despite this good news, however, the crisis in Greece and elsewhere made it clear that no discussion of fiscal policy is complete without taking into account the long-run implications of government budget surpluses and deficits, especially the implications for government debt. We now turn to those long-run implications.