The new reality – debt, deficits and sovereign crises

The Dubai and Greek crises have forced investors to pay attention to something long ignored – rising sovereign risk. According to this week’s reports, Dubai is trying to settle debts for 60 cents on the dollar. Meanwhile, there has been no real progress in the unfolding Greek debt crisis.

Given the scale of fiscal deterioration in much of the developed world, the trouble is unlikely to end with Greece. For now, however, this looks like a mainly EU-specific problem.

Germany is, for the moment, unwilling to talk about bailouts, and demands austerity measures from the Greek government. EU finance ministers stated Athens must comply with austerity demands within 30 days or risk losing control over its own tax and spend policies. But the truth is, the EU has no real enforcement mechanism, and Greece knows it.

The Greek government promised to reduce its fiscal deficit to 2.8% of GDP by 2012, and to under 9% by the end of this year. However, the EU authorities are fooling themselves into believing this to be possible – current Greek deficit is 12.7% (and that is only the official figure; Greece has forged data before). Due to both political and economic reasons chances of Greece meeting such targets are near zero. The Greek population is largely against austerity (and keen to express it via crippling strikes and riots), making it highly unlikely that the socialist Papandreou government will be able to enforce any meaningful measures.

Some 95% of Greek debt is held by a number of large European banks, so a Greek default would most likely spark a massive bank crisis in Europe. The contagion would inevitably spread to Portugal, Spain, Italy, Ireland and possibly other countries. But even if Greece is bailed out, it will unlikely meet the conditions that will come attached to a bailout, hence just kicking the problem down the road for another while.

And of course the problem is much larger than just Greece. Fundamentals are very poor across much of the eurozone, meaning that a number of countries could easily follow Greece down.

The root of the problem is the one-size-fits-all monetary policy of the euro. The monetary policy set for the centre (Germany, France) was always going to be inappropriate for the economies of the periphery. Instead of adopting stricter fiscal discipline (since monetary and exchange rate policy was no longer in their control), Greece, Spain, Portugal etc used the extremely low interest rates and high credit rating they gained access to thanks to the EMU to go on a long, wild spending spree. The cheap credit fueled housing bubbles as well as ever growing public sectors and generous welfare systems. It was inevitable that the day of reckoning would come.

Southern Europe’s competitiveness has also declined sharply as these countries joined the eurozone with an exchange rate that overvalued their currencies, raising the cost of labour.

The fiscally precarious states benefited from low rates because, in the eyes of investors, their bonds enjoyed an implicit guarantee of the stronger eurozone members. Once investors finally started paying attention to their fiscal situation, and to the risk of Greece being let to fail, the spreads between German Bunds and Greek bonds have widened considerably, increasing the country’s debt servicing costs.

In a staggering display of self-delusion the Greek prime minister said yesterday that Greece wants to be able to borrow on the same terms as other eurozone countries. I suppose we shouldn’t be surprised at such misguided sense of entitlement; entitlement, after all, is the theme of our times. Papandreou also stated “it is a fallacy to say the Greeks are reckless”. Yes, Greeks indeed are the model of prudence and their current fiscal mess and the fact they have been in default for 105 years out of the last 200 should just be ignored by the markets (or ‘socially useless’ speculators in modern day political speech).

Although distrusting Greece’s willingness and ability to reduce deficit, the markets, for the moment, continue to believe in an eventual bailout. Should it start looking like there will be no such thing after all, the spreads on Greek debt would dramatically expand and most likely push Greece into default.

Yet the fiscally responsible Germans have little appetite for bailing out Greece. A bailout, in their view, would destroy EU’s monetary (and any remaining fiscal) discipline and undermine the credibility of the euro. Not to mention that it would not solve the structural problems facing the eurozone. Since German taxpayers are hardly going to be willing to open their wallets to the profligate states every time there is a crisis, a bailout of Greece may only bring closer an eventual break-up of the EMU.

Having said that, German banks have massive exposure to Spanish, Irish, Italian and, to a lesser extent, Greek and Portuguese debt – to the tune of some 523 billion euros. Germany will undoubtedly take that into consideration when deciding on bailing Greece out or letting it fail.

So what are the options for Greece? The traditional remedy would be currency devaluation, but eurozone members don’t have such luxury. Control over their monetary policy is in the hands of the European Central Bank (ECB).

The most prudent thing for Greece would be to undertake the severe budget cuts necessary to get its fiscal deficit down to 3% of GDP over the next few years. Such extraordinary fiscal tightening would result in a few years of declining GDP and high unemployment. There is not much indication that Greek voters are even remotely considering taking a few years of pain (austerity & recession) for a future gain.

Another option is default, which would reduce the debt burden but also result in a severe and long recession/depression. Government spending would be cut drastically and immediately since Greece wouldn’t be able to borrow for quite some time. Finally, Greece could also decide to leave the eurozone, go back to drachma and, in effect, devalue its debt. It would make the country more competitive. Of course their borrowing costs would also soar. However, this appears to be the least likely path for Greece to take.

Essentially, Greece and the Greek voters should be given two choices: take the pain and make the necessary cuts or leave the EU. This would leave the decision in the hands of the Greek people, avoiding further cries of them being stripped of their sovereignty, and it would ultimately be better for EU’s monetary and fiscal discipline than a bailout and the moral hazards that come with it.

After all, Greece is not eurozone’s only problem. Budget deficits have reached unprecedented proportions in many EU countries. Concerns about the weak fundamentals and the state of public finances in Portugal, Spain, Italy, Ireland, the UK are evident in the financial markets, with rising sovereign bond yields and sliding euro.

Portugal’s and Spain’s external debt position is worse than that of Greece; their household debt is also considerably higher. Spain, apart from a nearly 10% deficit, has unemployment close to 20% and a banking system weighted down by a massive amount of overvalued real estate. Oh, and the socialist Zapatero government is not any more likely to be able and willing to cut spending than the Greeks. Italy’s and Ireland’s external debt obligations as well as GDP and unemployment rates are also worse than those of Greece. So while the markets’ focus is primarily on Greece, contagion is a very real threat. And not even Germany has the finances to bail out the likes of Spain. Given its size, a full blown fiscal crisis (or default) in Spain would most likely be the death of the euro.

The eurozone governments have to borrow approx 2.2 trillion euros from the capital markets this year to finance their budget deficits (Greece needs some 60 billion just to make it through the year); it won’t be an easy task. A wider fiscal crisis in Europe appears increasingly likely.

Yet ballooning national debts, out of control deficits and rising sovereign risks are not just a European issue. Most advanced economies have huge fiscal problems. The IMF projects the G20 government debt/GDP ratio to reach 118% by 2014. This will severely constrain economic growth.

A recent study by Carmen Reinhart and Kenneth Rogoff (‘Growth in a Time of Debt’) found that “the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.”

The following chart shows the public debt to GDP ratios across the world.

(And let’s not forget the true public debt/GDP levels are several times higher then the explicit figures that exclude massive unfunded liabilities for public pensions, healthcare, social security.)

Consider also the high government spending as a percentage of GDP in many advanced economies today, which causes a further drag on growth, and you get a future of slow economic growth and high unemployment. (In Greece, as well as the US, UK and other countries government spending now makes for approx 50% of GDP.)

The fiscal deterioration will become worse still due to the massive demographic challenges in the developed world. The IMF estimates that increased health spending and other costs related to aging population will drive debt to GDP levels of advanced economies up by a further 50% over the next 20 years.

We will therefore see a significantly higher economic growth in low debt, and most likely sluggish growth in high debt economies such as the UK, US, much of the eurozone and Japan. (A strong rise in government bond yields of much of the developed world is also inevitable.)

But it’s not just government debt. There’s too much debt everywhere, including in the private sector (although the private sector has started deleveraging, while the public sector increased leverage). Total debt is highest in Japan at 459% of GDP and the UK at 469% of GDP (or 380% if adjusted to reflect UK’s position as a financial hub). Spain follows in the third place at 342% (in Greece total private-public debt stands at around 225% of GDP).  

Over the next decade sovereign debt crises and defaults seem inevitable. Those countries that can resort to the printing presses will take the path of a massive monetization of debt, hence reducing their debts through severe inflation. That is the most likely outcome in the US and UK. (Clearly, paying our debts back in devalued currency is simply default by another name.)

Of course the most desirable way to address the budget problems would be by radical spending cuts. The scale of fiscal tightening necessary to return to healthier debt levels would cause a medium-term drag on growth. But not reducing debt will ultimately have much greater consequences.

However, chances we will witness drastic spending cuts in the UK, US and across the eurozone in the next few years are rather slim. The culture of entitlement has made it near impossible to talk about the hard facts. Our political elites will continue to ignore the fact that the bloated welfare states have become unsustainable and we can no longer afford them. The reason is simple – it’s not what the voters want to hear. Instead of acknowledging painful reality and the need to make sacrifices, we prefer to keep kicking the problems into the future. Until the inevitable day of reckoning comes.

Indeed the developments in the US and UK are not at all encouraging.

The Obama administration is determined not to waste a good crisis and continues to focus on a massive expansion of government. Instead of letting the free markets work and acknowledging that it’s the private sector that creates wealth and will be the engine of growth, the political leaders on both sides of the Atlantic show an enormous zeal to meddle in the free markets and reinvent and fix what wasn’t broken.

Redistribution of wealth via tax hikes (as well as introduction of entirely new taxes), a ruinous healthcare reform, expensive energy and climate change legislation, pro-union policies, excessive and ill thought-out regulation… Obama has shown a deep lack of understanding (and indeed contempt) of private business and a determination to socialize the US economy.

And while the productive part of the economy is being hammered, the public sector has been enjoying an unprecedented boom. In 1902 total US government spending was approx 7% of GDP. In 1928 it came to just over 10%; two thirds of that was state and local and just 3% was federal spending (about the same as 150 years earlier, excluding increases during war periods). Government spending has since exploded, making for more than 40% of GDP – two thirds of that being federal expenditure. Public spending increases in 2009 alone came to well over $1 trillion, a rise of more than 20% from 2008.

The UK has fared even worse, with government spending increasing from about 36% of GDP to almost 55%, putting increasing pressure on the dwindling productive segment of the economy.

The following chart from the Wall Street Journal shows the shocking and unsustainable spending explosion. US government spending has grown seven times as much in real terms as median household income over the last 40 years!

And, just as in the UK, employment and compensation in the public sector have continued to increase while the private sector has taken the pain. (Public workers not only enjoy far higher wages than their private sector counterparts but also benefit from extremely generous pensions. These largely unfunded public sector pension liabilities will naturally just serve as further drag on economic growth for many decades to come.)

As the following chart from the Business Insider shows, the US has gone from producing jobs in wealth creating private industries to jobs in the wealth destroying government sector. By the end of 2007 the total number of government jobs exceeded the total number of goods producing jobs.

Indeed, whether we look at the public sector gorging itself at the expense of the private sector, or the widespread culture of entitlement and welfare state (at the expense of the dwindling numbers of hard working taxpayers), this is what has come to characterize our time: enabling the unproductive and lazy to steal from the productive and enterprising. Otherwise called socialism.

So what is being done? Do we see any plans for serious fiscal tightening and debt reduction? Quite the opposite, our leaders seem to be enjoying a rather long vacation from reality.

Obama (and Gordon Brown) have apparently not been listening to Reinhart and Rogoff, or they wouldn’t be attempting to solve our problems by issuing yet more debt.

Perhaps we shouldn’t be too surprised that debt reduction doesn’t seem to be our policy makers’ priority. Indeed, one might think our extreme indebtedness is nothing more than a minor nuisance. Neither our political elites nor the central bankers and leading economists appear to grasp the obvious: that years of cheap, excessive credit and high debt were precisely what got us into trouble. And yet we’re still happily continuing on the same path.

In only three years the Obama administration will have increased the national debt by some $4.35 trillion. (And that excludes the huge deficits of off-budget programs like Medicare, Medicaid, social security.) The budget freeze proposed by the administration for 2011 is projected to save some $15 billion (or about 0.4% of the total budget, a drop in the ocean). Note that it’s merely a budget freeze, not a cut in nominal terms. Worse still, the the vast majority of federal programs (incl. Medicare, Medicaid, social security, military, homeland security etc) are to be exempt from the freeze.

It should be obvious that the US won’t get its debt under control unless it sharply reduces government spending, including on health and pensions that have simply become unaffordable. The US is not much behind Britain and the eurozone when it comes to the horrific shape of public finances. The only advantage, for now, is the dollar’s status as the world’s reserve currency (and of course the country’s control over its own monetary policy).

But that doesn’t change the basic fact – you cannot spend your way out of a fiscal crisis. The current path is unsustainable. The Obama prescription of more debt, more spending and more taxes is a triple ticket to ruin, plain and simple.

But, it would be unfair to focus solely on the US, for here in Britain we are in an even greater mess.

The UK has not only the world’s highest total debt/GDP (along with Japan) but also one of the worst budget deficits at 12.6% of GDP. (According to OECD, only Iceland and Greece have higher deficits, at 15.7% and 12.7%, respectively. The UK is expected to post a 12.8-13% deficit this year, overtaking Greece.)

The speed of the debt run-up has been nothing short of alarming. Unsurprisingly, Britain is already paying higher interest rates to borrow than Spain or Italy. While the yields on gilts have recently risen significantly, they are heading far higher – as soon as the markets start taking a look at other basket-case economies aside of Greece. The pound has fallen by some 25% vs the dollar, and has much further to go unless the markets start seeing some credible solutions from Britain.

Yet there is no political will to face the excessive debt, no meaningful plans for deficit reduction. Gordon Brown’s government has rejected any idea of implementing spending cuts in 2010/2011. And the opposition? David Cameron said spending cuts during the early part of a Conservative government wouldn’t be ‘particularly extensive’.

Government spending has exploded over the 13 years of Labour governments and is now completely out of control. But one would look in vain for austerity measures and severe fiscal tightening, not just from Labour, but also from the (so-called) Conservatives.

The micro-cuts that both the government and the Tories are proposing will not even make a dent in the monstrous amount of public spending. The pledges to ring-fence all main areas of spending, including the wasteful, bureaucratic and inefficient NHS, instantly expose any deficit reduction plans as lacking of credibility.

What remains are tax raises. As if Gordon Brown’s hike of higher earner income tax from 40% to 50% (or 62% once national insurance contributions are added on) wasn’t bad enough, further tax increases are likely on the way. All that (along with the insanity of the additional 50% bonus tax) will only achieve one thing – further damage to the dwindling private sector already suffocated by a gargantuan web of high taxes, red tape, hostile regulation and uncertain political environment.

From Labour’s point of view, there is no harm in further undermining the only economically productive part of the economy. Expansion of government and redistribution of wealth are the objectives. What Brown and Obama have in common is their disdain for and antagonism toward anyone earning (or striving to earn) a decent income, and the desire to redistribute from the hard working and productive to the idle and unproductive.

It matters little which party wins the upcoming general elections; all three of the country’s main political parties have fully embraced ‘progressive’ (read socialist) ideas. A Tory victory may be slightly less disastrous than another Labour term, but nothing that the party is offering will set Britain onto the right path.

And the people have only themselves to blame. Thanks to the vast expansion of government too many millions are now enjoying an idle life of welfare-dependency. Add the millions more in public sector jobs with their high wages and appallingly generous pensions, and it is little wonder that politicians are unwilling to do anything that would anger the majority of the voters.

We have become a society with an overwhelming sense of entitlement – at the expense of those who still believe in self-reliance and hard work, only to see their wealth stolen by the parasites. This unsustainable situation will inevitably blow up, and deservedly so. Only then will a new cycle be able to start. And perhaps, just perhaps, we will even witness a return to common sense one day – as in smaller government, less interference in the free markets and the productive sector, less dependency and more self-reliance.

But in the meantime, as public debt is becoming a crushing burden on most developed economies, the only thing that appears certain is a widespread sovereign debt crisis (and defaults) a few years from now.

Tags: budget deficit, debt/GDP, deficit reduction, demographic challenges, entitlement, expansion of government, fiscal deficit, Gordon Brown, government spending, Greece, monetization of debt, Obama, Papandreou, public sector jobs, redistribution of wealth, Reinhart and Rogoff, socialism, sovereign debt crisis, spending cuts, total debt/GDP, welfare dependency, welfare state

This entry was posted on February 20, 2010 at February 20, 2010 and is filed under Economy, Featured, News, Politics & Society. You can follow any responses to this entry through the RSS 2.0 feed.