With all the attention being focused on whether or not there will be a sustainable recovery in 2010, the potential for a wave of sovereign-debt crises following the wake of the global recession has just recently started to appear on people's radar screens. Yet, such a wave should not be surprising.
As historical research conducted by University of Maryland economist Carmen Reinhart and Harvard University economist Kenneth Rogoff shows, financial crises are usually followed by government-debt crises. This starts as private debt is shifted onto the balance sheet of the government, through bailouts and purchases of toxic debt. The government-debt problem is then made worse as the economic downturn leads to an increase in expenditures in the form of unemployment benefits and stimulus spending, coupled with a decrease in tax revenues.
Not only does this historical trend align with the American experience in the aftermath of the financial crisis, but it is being replicated in Europe and Asia too. It makes us painfully aware of some of the costs of Keynesian fiscal stimulus, and it clearly displays how a short-run fix turns out to be a long-term problem. The Keynesian long run will dawn upon us much sooner than mainstream economists believe.
So far the looming sovereign-debt crisis — i.e., the series of fiscal crises around the world leading to calls for restructuring of public debt and to the potential of outright defaults — has made itself felt most strongly along the periphery of the world economy, not the least along the rim of the European Union. It has been at the forefront of political events in Greece.
CNBC recently published a list of the top ten government-debt issuers most likely to default, that is, countries with the highest sovereign-credit risk. Topping the list is, perhaps not surprisingly, Hugo Chavez's Venezuela. Further down the list we find (in descending order of how likely they are to default), Ukraine, Argentina (where the Kirchner government recently made a move against its own central bank, and is on a fast path toward the third debt crisis in two decades), Pakistan, Latvia, Dubai, Iceland, Lithuania, California (which, alarmingly, has a 19-percent likelihood of defaulting, according to this ranking), and, of course, Greece, which has been at the center of media attention for the last few weeks.
Smells Like Bacon
The Greek debt crisis has led many observers to believe a eurozone-wide contagion is in the making, including all of the PIGS — Portugal, Italy, Greece and Spain — and it could spread to the northwestern periphery as well. As Ian Bremmer and Nouriel Roubini recently commented in the Wall Street Journal:
The current crisis in Greece is only the worst example inside the EU. The PIGS … all boast public debt above or headed for 100% of GDP. Though the PIGS acronym was apparently coined by British bankers, Britain, Ireland and Iceland also smell distinctly of bacon.
So far the two PIGS most afflicted by the European debt crisis, Greece and Spain, blame mysterious foreign conspirators, rather than home-grown macroeconomic mismanagement. Greek Prime Minister George Papandreou expressed the view that the crisis is "an attack on the euro zone by certain other interests, political or financial," whereas the Spanish government has, reportedly, ordered an investigation into the alleged "collusion" between American investors and the media to hurt the Spanish economy — a policy response that was dubbed "Europe's crisis of ideas" in a recent Wall Street Journal commentary.
Along the EU's eastern borders, the Baltic countries were hit hard by the financial crisis and global downturn, as the rapid inflow of "hot money" in the boom years — caused in large part by low interest rates in the eurozone — created a huge potential for currency crises and rising debt in these previously rapidly expanding markets.
In the long run, however, several major economies could see their fiscal position severely weakened as well. And the two countries at the center of the financial meltdown, the United States and the United Kingdom, are anything but immune. According to a recently released Global Sovereign Credit Risk Report, the situation has deteriorated significantly. You can see this deterioration by looking at the market for credit default swaps (CDS), a type of credit insurance on securities like government bonds. The report states that both the United States and the United Kingdom "have been among the worst performing sovereign CDS" in Q4 of 2009 and that "concerns are mounting about the increase of debt to GDP ratios in UK and USA, 97% and 75% respectively."
The weakening of the British fiscal position has triggered a political debate on the urgent need for fiscal consolidation. A group of 20 economists, including Kenneth Rogoff, published a letter in the Sunday Times warning that in "the absence of a credible plan, there is a risk that a loss of confidence in the UK's economic policy framework will contribute to higher long-term interest rates and/or currency instability, which could undermine the recovery."
Responding to the arguments made by Rogoff and his cosignatories, another group of economists, including the famous Keynes biographer Lord Skidelsky and US economists Brad DeLong and Joseph Stiglitz, published a letter in the Financial Times. They support the decision of the British finance minister, Alistair Darling (Labour) to delay spending cuts until 2011. The letter argues that the "first priority must be to restore growth."
However, by tightening its fiscal policy too late, the government could make things much worse. Public borrowing, needed to finance the unprecedented peacetime deficit, will crowd out private investment, making an economic recovery even harder, thereby further weakening the country's fiscal position. This will in turn put pressure on the central bank to "accommodate" public borrowing (i.e., bond issuing) by printing more money. This is one reason why the pound is weakening.
On the suspicion of further depreciation of the pound, foreign holders of British debt will demand even higher yields, pushing long-term funding costs higher, thereby making the debt burden harder to service as interest payments shoot up. This is, in other words, a recipe for fiscal disaster unless drastic measures are taken in the near future.
The outlook for America doesn't look too promising either, as the Obama spending spree has led to a record $1.6 trillion deficit and a 2011 budget proposal that would push the US debt-to-GDP ratio to 77 percent. According to IMF estimates, the debt-to-GDP ratios of the United States and the United Kingdom could reach 100 percent by 2014.
This out-of-control debt spiral is threatening the US credit rating, as reflected in the official bond ratings by agencies such as Standard and Poor's, Fitch, and Moody's. The latter recently released a warning that the triple-A sovereign-credit rating of the United States could be downgraded:
Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the triple A government bond rating.
Both scenarios — increased budget discipline and stronger-than-expected growth — however, seem rather unlikely. Even though Obama recently announced his desire for a three-year freeze of discretionary spending, this will only come after a further spending spree and it will ignore the unsustainable growth of entitlements and military spending.
As for the growth projections, again Reinhart and Rogoff warn us: history shows that high levels of public debt are usually accompanied by low growth rates. The Obama growth projections are most likely too optimistic, largely because of a fake recovery based on short-run monetary and fiscal fixes, which do not address the underlying problems of the economy's need to structurally adjust to a postcrisis reality.
A Vicious Cycle
The misalignment of deficits and a growing national debt burden on the one hand, and lower than expected growth rates on the other, could lead into a vicious cycle, whereby investors become ever more reluctant to put their money into US treasuries — up till now seen as "safe havens" in the global economy. This would push bond yields up, creating even more fiscal pressure, as the cost of servicing debt would be higher. This would make bond holders even more reluctant to invest further in treasuries, and so on.
So far, the US government's ability to raise debt has been helped along by the bad news coming out of Europe. As financial historian Niall Ferguson explains: "The worse things get in the Euro-zone, the more the US dollar rallies as nervous investors park their cash in the 'safe haven' of American government debt." The same thing happened during the Great Panic in the fall of 2008, as investors rushed into dollars, i.e., US government securities, since they are usually looked upon as a "safe haven" when things get even worse in other developed countries.
The ability to fund the growing national debt has also, of course, been helped along by the "generosity" of the Chinese government, which has invested heavily in US government securities during the last decade, thereby funding large chunks of the annual deficits needed to finance soaring healthcare costs and two expensive foreign wars, not to speak of the explosion in public debt during Obama's first year. However, the Chinese are growing more and more reluctant to put their surplus export revenues into US debt. Not only are they diversifying their portfolio of foreign securities, thereby reducing the purchases of US government debt, they have actually started to sell off some of their currently held securities.
Last month, the US treasury department announced that "foreign demand for US Treasury securities fell by a record amount in December as China purged some of its holdings of government debt." Furthermore, this "shift in demand comes as countries retreat from the 'flight to safety' strategy they embarked on upon during the worst of the global economic crisis and could mean the US will have to pay more to service its debt interest."
The grim story of fiscal crises afflicting major economies is something that should not be taken lightly. Furthermore, it could happen sooner than most people think if the governments of the US and other debt-ridden countries don't get their fiscal houses in order. Ferguson recently warned that a "Greek crisis is coming to America," stating that the US fiscal outlook is not sustainable in the long run.
A Tricky Balancing Act
The above story shows just how precarious the "rescue" programs by the United States and other industrial countries have been in achieving actual, sound economic recovery. Surging debt will create conditions that make it harder for the economy to grow. At the same time, monetary and fiscal stimulus on a level never seen before in peacetime needs to be unwound through monetary and fiscal exit strategies. So far, the proposed exits in the United States — Obama's budget forecast and Bernanke's announced exit measures — don't even come close to tackling the immense troubles ahead.
The exit strategies come with several pitfalls. Not the least is that, if enacted too soon, they could set off another downturn, and if enacted too late, they would lead to ever more unmanageable debt burdens, fiscal crises, and low growth. This is the precarious position in which the economy will find itself when put on short-term life-support by the government; economic expectations get intimately tied to government actions. This creates a lose-lose situation in which, whatever the government does, the likelihood of another economic crisis increases by the day.
The managing director of the International Monetary Fund, Dominic Strauss-Kahn, said at the recently held World Economic Forum in Davos, Switzerland, "If we exit too late … it's a waste of resources, it's bad policy, it's increasing public debt, we should avoid this … But if you exit too early, then the risks are much bigger" as this could lead to a "double dip" recession.
Strauss-Khan has been a leading advocate for massive fiscal stimulus, launching this idea at the World Economic Forum two years ago. However, recent developments have clearly demonstrated that, to quote Niall Ferguson, "there is no such thing as a Keynesian free lunch." In his view, the effects of the stimulus have been much more moderate than expected, and "explosions of public debt incur bills that fall due much sooner than we expect."
In other words, the day of reckoning is already upon us, at least for the PIGS, and it is moving closer by the day for the United States and the United Kingdom.
If, on the other side, the authorities of major economies decide to start tightening both fiscal and monetary policy, this could very well trigger a new downturn, the much-dreaded double dip. And if that happens, policymakers have exhausted most of their tools besides monetizing public debt through the central bank's printing press. To do so would be to follow the path of countries like Argentina and Weimar Germany. This is a scenario that should be avoided at all costs.
A Fake Recovery
Most of the measures initiated in response to the crisis, such as the Fed creating a floor for housing prices through its purchase of $1.25 trillion in toxic mortgage-backed securities and agency debt (i.e., Fannie Mae and Freddie Mac bonds), have at best only delayed inevitable corrections. This program is supposed to end in March of this year, and others have already been terminated or are about to be phased out. Several market participants suspect the Fed will extend its mortgage-market support program at the first sign of trouble, though, and Obama is pushing for a new fiscal stimulus. But these measures would just continue to push the readjustment of the economy forward in time, prolonging the economic woes of the country.
Michael Pomerleano, visiting scholar at the Asian Development Bank Institute, makes the case for letting markets correct themselves, when he says that the "nationalisation of private debt injects considerable inefficiency into the economic system, inhibiting Schumpeter's process of Creative Destruction that is essential in a market economy and needed to maintain the private sector."
We have seen this all before. In the 1990s, the Japanese government socialized private losses through a massive transfer of private debt to the national balance sheet. This happened in the wake of the Japanese asset bubble — another boom fuelled by a tidal wave of easy money from the central bank — and led to a decade of slow growth and a lack of restructuring of the economy. Whether or not the US economy is "turning Japanese" is still an open question, but is becoming ever more likely as fake fixes are delaying painful economic adjustments. Christopher Wood made the following observation in the Wall Street Journal:
With the U.S. government stepping in to keep markets from clearing, today's U.S. economy in many ways resembles the post-bubble Japanese economy of the 1990s. Ultra-loose monetary policy and low demand for credit, combined with high unemployment and consumer deleveraging, could lead to a prolonged slump.
As the ominous example of Japan shows us, soaring debt levels (resulting from fiscal stimulus and low growth) and financial forbearance (socializing private losses) is not a recipe for economic success.
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