Financial crises have occurred very often in history. They are caused by unsustainable bubbles that go bust, and from excessive risk-taking and debt-leveraging by the private sector during the bubble. Then in the wake of, and as part of the response to, the economic downturn, government debts and deficits grow to unsustainable levels that can lead to default or inflation if not corrected. The crisis we are going through now follows this pattern.
Today there is a lot of talk about “de-leveraging”, yet the data shows that de-leveraging has barely begun. Debt ratios in the corporate sector as well as households in the US have essentially stabilised at high levels.
At the same time, we are seeing a massive “re-leveraging” of the public sector with budget deficits on the order of 10 per cent of GDP. The IMF and OECD are projecting that the stock of public debt in advanced economies is going to double and reach an average level of 100 per cent of GDP in the coming years.
This is all actually quite typical of what happens in a financial crisis. What explains this re-leveraging? First, “automatic stabilisers” (such as unemployment compensation) came into play during the recession. Second, countercyclical fiscal policies (such as tax cuts and spending increases) have been implemented by government to avoid depression because private demand is collapsing. Third, we have decided to socialise some of the private losses in the financial, corporate and housing sectors and put them on the balance sheet of the government.
So, there is a massive buildup of public debt. And the lesson of history is that unless this buildup of sovereign debt is tackled eventually by raising taxes and controlling spending, then there are only two outcomes: default or high inflation.
Historically, we have seen a series of defaults and sovereign debt crises in both advanced and emerging market economies. If you are a country like the US, the UK or Japan that can monetise its fiscal deficits, then you won’t have a sovereign debt event but high inflation that erodes the value of public debt. Inflation is therefore basically a capital transfer from creditors and savers to borrowers and dissavers, essentially from the private sector to the government.
While the markets these days are worrying about Greece, it is only the tip of the iceberg, or the canary in the coal mine of a much broader range of fiscal crises. Today it is Greece. Tomorrow it will be Spain, Portugal, Ireland and Iceland. Sooner or later Japan and the US will be at the core of the problem, shaking the global economy.
We need to recognize that we are in the next stage of financial crisis. The coming issue is not private-sector liabilities, but public-sector liabilities.
Revived economic growth alone will not generate enough tax revenue to relieve this sovereign debt crisis. Fiscal deficits are huge and structural. They are not due solely to a cyclical downturn in growth but to long-term commitments such as pensions, social security and health care. To avoid default or high inflation, the advanced economies will require some combination of raising revenues through taxes and cutting government spending.
In Europe, where tax rates are already very high, the right adjustment is cutting spending instead of raising taxes further. In the US, the average tax burden as a share of GDP is much lower than in other advanced economies. The right adjustment for the US would be to phase in revenue increases gradually over time so that you don’t kill the recovery while controlling the growth of government spending.
What worries me most is the political gridlock in Washington. While everyone agrees that $10 trillion (Dh36.7 trillion) deficits (by the Obama administration’s own estimates) for the next decade are not sustainable, there is no political will to act. The two parties are completely divided. Effectively, the Republicans are against any form of revenue increases. The Democrats are against spending cuts, especially of entitlements.
If the Republicans take control of the House of Representatives in the next election and refuse any revenue increases while the Democrats veto spending cuts, the path of least resistance will be runaway fiscal deficits which will then be monetised by the Federal Reserve, which has already embarked on this path. In just the last year alone, the Federal Reserve has bought $1.8 trillion of Treasury securities and agency debt, a course that will inevitably lead to high inflation if sustained. It is what is popularly known as printing money.
In Greece (with yields higher than 12 per cent on two-year bonds) or Spain or Portugal, the bond markets are forcing an adjustment. In spite of the recession, the markets are telling them to either straighten out their problems or go bankrupt.
Unfortunately, there is no such adjustment being forced upon Washington at the moment because the bond market has not woken up to the dangers ahead. You can borrow at a zero percentrate on the short end and 3.6 per cent on the long end. As a result, the political system is going to resist fiscal consolidation. This means the risk of something serious happening in the US in the next two or three years is significant.