One of the main reasons for the unemployment problem around the world is excessive debt. Only when we eliminate the underlying source of our problems will we be able to sustainably reduce the unemployment rate. In my last post about debt I talked about mortgage debt. This post is about government debt.

Consider the Greek debt problem. Examples of Greek government largesse are easy to find on the internet. For example, government workers get some of the best benefits anywhere in the world. All are paid in 14 monthly paychecks per year. (the two extra amount to negotiated bonus payments). Some workers can retire with a full pension as early as age 45. Pensions of deceased military officers continue to be paid to their unmarried daughters for life or until she weds. Some union members were once granted free unlimited transportation on the national airline. The state railroad payroll is 4 times larger than total ticket sales. There are many more examples like this.

To finance these generous benefits, and to remain popular, the Greek government had to borrow enormously. When the economic crisis hit in 2008, Greek government debt had already reached 100% of GDP. This year Greece’s total debt is expected to exceed 150% of GDP, which amounts to over $450 billion. And still the Greek government continues to run large budget deficits to fulfill promises that are clearly untenable.

The situation is a mess and the problem just keeps getting pushed further into the future. One necessary outcome is for Greece’s budget to be balanced quickly or even moved into surplus to reduce their enormous debt. However, if this is done too quickly it could cause sharp contractions in economic activity making it even harder to pay down the debt. The Greek people have already risen up riotously this year (and last year) to protest the proposed cuts in government programs or increases in taxes. After all, profligate or not, the Greeks feel entitled to these promises, just like Americans feel entitled to their Social security, Medicare and tax breaks. They are surely not willing to rein in excesses without a fight. Besides what is excess to one person is another person’s monthly paycheck.

Greece’s government doesn’t want to make the needed budgetary changes (no sane politician would!) because the changes are very painful and unpopular. So the only way to continue the largesse, quiet the protests, and move along is to get someone to lend them even more money. But with a CCC bond rating (worse than junk bond status) they can’t borrow on the private market unless the interest rate was extremely high to compensate for the high risk of default. The risk premium on short term Greek bonds currently exceeds 25% and borrowing at that rate would push up their deficits and debt even faster.

In July 2011, for the second time, the EU stepped in to provide up to $160 billion in loans to allow Greece to continue to borrow at relatively low interest rates and with longer maturities. In essence this is like an increase in Greece’s debt ceiling, allowing it to continue running deficits. However, these EU bailouts are funded by the other EU countries. Thus, if Greece can’t repay these loans, the losses will be borne by taxpayers in the other EU countries.

Of course, in accepting these bailouts Greece is required to bring its budget into balance in a reasonable time period. Interestingly Greece has not been doing a very good job at this. In the first half of 2011 – this is after the bailout loans they received last summer – the Greek budget deficit rose 24%. Of course some of this has to do with the fact that the economy is stagnant and unemployment remains above 15%.

So growth is slow to nonexistent, tax revenues are falling, government promises remain generous, and any attempt to reduce spending leads to massive riots in the streets. So why do they keep getting bailed out?

There are several reasons.

First, creditors – that is, the institutions holding the $450 billion in Greek bonds – want to get their money back someday. (Note it is not the bank’s money in jeopardy.. it is depositor’s money .. that’s the people’s money) If Greece defaults then some creditors may not get anything back. Better to get a deal and wait longer than get nothing. Also, defaults can be disorderly as creditors line up trying to squeeze as much value out for themselves as possible. For example, if Greece owes $50 billion but only $25 billion in cash, who gets paid and who doesn’t? Figuring that out can sometimes take years.

The bailouts amount to promises that creditors will get their money back eventually, but will have to wait longer for it. So the bailouts buy time. For Greece though, the bailouts result in forced austerity, especially for those most dependent on government programs or those who pay taxes … which, of course, means pretty much everyone, … hence the riots in the streets!

Actually it is worth noting that another way to solve the problem for Greece is an outright default. If Greece defaulted, they would have to first settle with the creditors to decide who will not be repaid (this is a contentious process) and second balance their budget immediately because no one will lend them money for a long while. Thus the austerity will be even more painful in the short run. If Greece receives bailouts, then the austerity still has to happen, but it will be spread out over a longer period into the future. One question worth considering is whether it is better 1) to suffer a greater austerity quickly, resolve the debt problems (basically determine who is getting money back and who isn’t) and move on with a healthy balance sheet, or, 2) to suffer a longer and milder, though still painful, austerity and hope that the economy can grow and change into a healthy one in the distant future?

Perhaps the bigger problem for the world economy, though, is contagion. Many observers say Greece is small and so the problems there don’t matter much. That’s true, Greece is about the size of Maryland. But Portugal, and Ireland, and Spain and Italy are facing similar problems. If Greece’s problems migrate to these other countries then creditors will worry about the value of their loans to these countries too. And these loans are much bigger.

If Greece defaults, maybe the banking institutions can handle the losses. But what if Portugal, or Ireland, or Spain, decides to default? These could be large enough to force innumerable financial bankruptcies and threaten the entire financial system. Or what about the EU and IMF bailout of Greece? Again the values aren’t that large. But, what if the EU needs to lend money to Portugal, Ireland and Spain to keep them afloat too? (Note: they’ve already begun to do this!) How deeply into debt and how much risk are the Germans, French and other EU members willing to bear?

The essence of the true problem then is that numerous financial institutions around the world have taken deposits from its citizens and have saved the money by lending it to governments. Some of that money is in jeopardy of not being returned in full, but no one knows whose money is most in jeopardy or when those losses will materialize. Add on to this the US debt ceiling debate and the downgrading of US debt by S&P and we have financial institutions around the world questioning the true value of an enormous amount of their outstanding loans. It is worries like these, spread across the globe, that prevents the expansion of credit and the necessary risk taking that inspires economic growth. Sure, lending is occurring, but it is mostly safe and highly secured loans. These can keep the economies of the world running in place, but it is unlikely to fuel the rapid expansion we need to bring unemployment rates down.

If we want to solve the unemployment problem, there is no recourse but to alleviate the debt problems. There remains too much risk and uncertainty about the true value of outstanding loans for the world markets to function effectively. This is a reason why a large stimulus program may not work in this environment. Yes extra government spending can increase demand and create a few jobs for a little while, but this probably won’t speed up the debt restructuring. So if after the demand boost runs out, there remains a large number of underperforming loans, then we will also remain stuck in a stagnant economy. Only now we will be stuck with an even scarier level of government indebtedness that in turn could exacerbate the debt problems.

A useful analogy may be to think of the debt problem described above corresponding to a car that has been downshifted into 2nd gear. A fiscal stimulus represents stepping on the accelerator. Yes, the more we step on the gas (the bigger the stimulus) the faster the car goes, but if we remain in 2nd gear we’re in danger of burning out the engine. We can only return to a comfortable highway speed by upshifting to 3rd or 4th gear, and that requires resolving the debt problem first.