The rich economies seem to be slouching towards a full-blown fiscal crisis, as the costs of the huge bank bailouts and economic stimulus programmes since 2008 have upset government balance sheets in the West. Is the world economy getting dangerously close to another Lehman moment, some three years after the spectacular collapse of the Wall Street bank led to the biggest economic crisis in modern times? A debt crisis in Europe could unsettle financial markets all over again.
The fiscal mess is evident. In Europe, embattled countries such as Ireland, Greece and Portugal have already been downgraded to junk status by the major credit rating agencies. In the US, political brinkmanship over raising the federal debt limit could force the government to default on its commitments after 2 August; Moody’s and Standard and Poor’s have threatened to take the US off its triple-A list in case the political gridlock is not broken. Meanwhile, Japan is facing its own, albeit less dangerous, budget impasse, as opponents pile up pressure on Prime Minister Naoto Kan.
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An apocalyptic Lehman-style moment seems unlikely right now, because US legislators will likely come to some sort of a deal that will allow the federal government to resume borrowing, while Europe has invested too much in the integration project to let things collapse in the first episode of stress. There is nothing like the threat of a meltdown to get various interest groups to come together to save their skins. The financial markets seem worried rather than panicky, though many global investment banks have been putting out sombre reports on the dangers posed by the sovereign debt crisis.
The low probability of a spectacular bust in the coming months is a cause for temporary relief rather than a sign that the structural crisis in government finances in the US, Europe and Japan will soon come to an end. The rest of the world should worry in case some of the biggest economies in the world slide into economic inertia, even if they do not default on their debts.
It is interesting to see that the biggest budgetary stress is no longer in Asia and Latin America. Fourteen of the top 21 economies in America and Europe, plus Japan, have fiscal deficits in excess of 3% of gross domestic product (GDP). In contrast, only five of the top 21 economies in Asia, Latin America, Africa and Oceania have crossed this threshold. (India is one of the five, and a high fiscal deficit combined with a high current account deficit makes us particularly vulnerable in case we see a European country default any time soon.)
Levels of public debt are also uncomfortably high in most rich economies. In a recent note, Deutsche Bank warned: “Never before in observable economic history have so many countries had so much combined government and financial debt. Many, many countries have defaulted through history with much lower debt.”
Economists Carmen Reinhart and Kenneth Rogoff have shown in their research that large financial crises are usually followed by an explosion in public debt, as money is spent to bail out banks and support aggregate demand during the downturn and early recovery.
Countries can escape a crippling debt crisis through four options: high nominal GDP growth through either a robust economy recovery or high inflation, restructuring debts by forcing lenders to take losses, or pushing through policies that allow the government to compulsorily capture a part of domestic savings to finance the deficits.
None of these four options seems realistic right now: the economic recovery in the West is anaemic; inflation is low; fiscal austerity could lead to a double-dip recession; the resurgent power of the finance industry makes debt restructuring a tough proposition; and financial repression could be unpopular.
The problem can remain on slow burn for a long time. Japan has shown that nearly two decades of high fiscal deficits and rising public debt can be funded if local savers continue to buy government debt in what can be called voluntary financial repression. However, the US and Europe may be less lucky. Their domestic savings rates are relatively modest. Foreign savings will be needed to buy their government debt, which means less capital could be available for countries such as India in the coming years.
There is another effect that should be tracked. A fundamental rule of debt sustainability is that nominal GDP growth should be higher than the interest rates on public debt. The current mess means that Western central banks have an incentive to maintain loose monetary policies and keep interest rates low, even if these policies impose huge costs on economies in our part of the world through inflows of speculative capital and high commodity prices.
The current sea of red ink could be far from transitory—which means that the world economy has a long battle ahead.
Niranjan Rajadhyaksha is executive editor of Mint. Comments are welcome at firstname.lastname@example.org