Greece's Deficits Aren't the Problem, A Lack of Economic Freedom Is

Story Stream
recent articles

Now that Alexis Tsipras' socialist bug has splattered against Angela Merkel's reality windshield, it is timely to look at what the U.S. and Greece have in common. No, it's not "unsustainable deficits and debt." It's the imperative of economic growth.

The conventional wisdom seems to be that a national debt equal to 175% of GDP (which is where Greece is now) is "unsustainable." This is not true. England's debt soared to more than 250% of GDP during the Napoleonic Wars, and yet England (which had a gold-backed pound that was even stronger than the euro) never defaulted.

So, what's the difference between England then and Greece now? Economic growth. It is not Greece's debt that is unsustainable; it is the stagnant Greek economy.

Lenders base their decisions on the future, not the present. Mathematically, lenders lend against the present value of a borrower's future income stream. For a government, this is equal to the present value of the nation's GDP times the "tax take," which is the percent of GDP that the tax system captures. The present value of GDP is, in turn, a function of the expected rate of real economic growth, and the real interest rate at which the government can borrow.

At about 40% of GDP, Greece's tax take is much higher than that of the U.S. federal government, which was 17.5% in FY2014. If we assume that a government can feasibly devote about 5% of its revenue to debt service (i.e., 2.0% of GDP for Greece and 0.9% of GDP for the U.S.), then it is possible to calculate how much debt the financial markets would believe that each government could support.

During the 18 years ending with 2013, Greek real GDP (RGDP) grew at an average annualized rate of 0.52%. U.S. RGDP growth during this period was 2.44%.

If the markets considered Greece to be solvent, it would be able to borrow (in euros) at about the same real interest rate as the U.S. Let's go with the Congressional Budget Office's (CBO's) long-term interest rate assumption, which is 2.7% real.

At 0.52% growth, Greece's debt capacity is about 92% of current GDP. This is why Greece's current debt load of 175% of GDP is unsustainable. This, in turn, is why Greek 10-year bonds are currently trading at a prohibitive 9.43% interest rate.

At 2.44% growth, U.S. debt capacity is 317% of current GDP. This is more than 4 times today's federal debt held by the public, which is about 73% of GDP. This explains why interest rates on Treasury debt are so low. Wall Street is coldly looking at the numbers, and ignoring the chattering classes' weeping and gnashing of teeth regarding our deficits and debt.

When it comes to deficits and debt, economic growth is the only thing that really matters. For example, at 3.00% RGDP growth, America's debt capacity is 5,252% of current GDP. Yes, a mere 0.56 additional percentage points of growth increases the federal government's debt capacity by a factor of more than 16.

If you do the math, you quickly realize that it would be worth incurring whatever additional debt was necessary in the short term in order to fund supply-side tax cuts that would increase our RGDP growth rate to 3.0%. This is the kind of "dynamic scoring" that the CBO should be doing.

So, is there any hope for Greece? Yes and no.

Yes, in the sense that RGDP growth of just over 1.5% would make Greece's current debt of 175% of GDP sustainable. No, in the sense that even this meager growth rate is probably not achievable without transformational supply-side reforms, which are just about the last thing in the world that we can expect from Alexis Tsipras and his merry band of Marxists.

Although Greece is in much worse shape economically than the U.S., both nations need the same supply-side medicine: greater economic freedom, including lower taxes on savings and investment.

What neither country needs is a weak, unstable currency. Economists and pundits seem to like to fantasize about the "benefits" that Greece would get from reintroducing the drachma (which could then be devalued with abandon), but doing this would be nothing short of catastrophic. The Greek economy would go underground, and continue doing business in euros, while real Greek government revenues would plunge toward zero.

In the Heritage Foundation's "2015 Index of Economic Freedom," the U.S. ranks #12, which is embarrassing for the nation whose flag is the symbol of freedom. However, Greece ranks #130, and this explains essentially all of its economic woes.

Both nations would do better, and grow faster, by increasing economic freedom. Unfortunately for Greece, Tsipras is a socialist, and socialists want the exact opposite of economic freedom. Fortunately for the U.S., we have an election coming up in less than two years where (it is hoped) Americans will have the opportunity to vote for greater economic freedom.

Part of economic freedom is low taxes on savings and investment. These taxes hinder economic growth directly, by discouraging capital investment. Using the U.S. as an example, here is how an economy works, mathematically:

$280,000 nonresidential assets  $123,000/year GDP  1 average ($48,000/year) FTE* job

The entire difference between the RGDP growth rates of Greece and the U.S. over the 18 years ending with 2013 can be explained by the difference between their respective levels of nonresidential capital investment.

During this period, U.S. nonresidential investment averaged 16.96% of GDP, and RGDP growth came in at 2.44%. Greece invested 12.48% of GDP and got 0.52% RGDP growth. So, America's incremental 4.48 percentage points of nonresidential investment yielded an additional 1.92 percentage points of RGDP growth, which is exactly what you would expect from the equation above.

When evaluating policy options, every government should be asking itself the following question: "Will this increase private business investment, or reduce it?"

Capital investment-private, market-driven capital investment-is what produces economic growth, and economic growth is what makes problems, including deficits and debt, solvable. Growth is also what creates prosperity for everyone, especially the middle class.

During the 8 years ending in 2013, Greek RGDP contracted at an average annual rate of 3.01%. This bankrupted the Greek government, and drove Greek unemployment up to 26%. In the 8 years between 1961 and 1969, U.S. RGDP grew at 5.01%, and this put men on the moon.

Greece needs to keep the euro, and to bring its economic freedom ranking up to, say, #12. Meanwhile, America should make that slot available for Greece by shooting for #1.

*Full Time Equivalent



Louis Woodhill (, an engineer and software entrepreneur, and a RealClearMarkets contributor.  


Show commentsHide Comments

Related Articles