No one yet has any real idea about when the global financial crisis will end, but one thing is certain: Government budget deficits are headed into the stratosphere. In the coming years, investors will need to be persuaded to hold mountains of new debt.
Although governments may try to cram public debt down the throats of local savers (by using, for example, rising influence over banks to force them to hold a disproportionate quantity of government paper), they eventually will find themselves having to pay much higher interest rates as well. Within a couple of years, interest rates on long-term U.S. Treasury notes could easily rise 3 per cent to 4 per cent, with interest rates on other governments' paper rising as much, or more.
Interest rates will increase to compensate investors for having to accept a larger share of government bonds in their portfolio, and for an increasing risk that governments will be tempted to inflate away the value of their debts, or even default.
In research that Carmen Reinhart and I have done on the history of financial crises, we find that public debt typically doubles, even adjusting for inflation, in the three years following a crisis. Many nations, large and small, now are well on the way to meeting this projection.
China's government has clearly indicated it will use any means necessary to backstop growth in the face of a free fall in exports. The Chinese have $2-trillion in hard currency reserves to back up their promise. President Barack Obama's new budget calls for a stunning $1.75-trillion deficit in the United States, a multiple of the previous record. Even countries not actively engaged in a fiscal orgy are seeing their surpluses collapse and deficits soar, mainly in the face of falling tax revenues.
Indeed, few governments have submitted remotely realistic budget projections, typically relying on overly rosy economic scenarios.
Unfortunately, in 2009, the global economy will not be a bed of roses.
Income in the U.S. and the eurozone both appear to have declined at an annualized rate of roughly 6 per cent in the fourth quarter of 2008; Japan's GDP fell at perhaps twice that rate.
China's claim that its GDP grew at a rate of 6 per cent during the end of last year is suspect. Exports have collapsed throughout Asia, including South Korea, Japan and Singapore. Arguably, India and, to a lesser extent, Brazil have been doing a bit better. But few emerging markets have reached a stage at which they can withstand a sustained collapse in the developed economies, much less serve as substitute engines of global growth.
With the credit crisis still making it difficult for many small-and medium-sized businesses to obtain even the minimal level of financing necessary to maintain inventories and conduct trade, global GDP is on a precipice in 2009. A real possibility exists that global growth will register its first contraction since the Second World War.
In all likelihood, a slew of countries will see output declines of 4 per cent to 5 per cent in 2009, with some having true depression-level drops of 10 per cent or more.
Worse, unless financial systems spring back, growth could disappoint for years to come, especially in “ground zero” countries such as the United States, Britain, Ireland and Spain. U.S. long-term growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution.
Countries with European-style growth rates could handle debt obligations of 60 per cent of GDP when interest rates were low. But with debts in many countries rising to 80 per cent or 90 per cent of GDP, and with today's low interest rates clearly a temporary phenomenon, trouble is brewing.
Many of the countries that are piling on massive quantities of debt to bail out their banks have only tepid medium-term growth prospects, raising real questions of solvency and sustainability. Italy, for example, with a debt-to-income ratio already exceeding 100 per cent, has been able to manage so far thanks to falling global rates. But as debts mount and global interest rates rise, investors will become rightly nervous about the risk of debt restructuring. Other countries, such as Ireland, Britain and the U.S., started with a much stronger fiscal position but may not be much better off when the smoke clears.
Exchange rates are another wild card. Asian central banks are still nervously clinging to the dollar. But with the U.S. printing debt and money like it is going out of style, it would appear the euro is set to appreciate against the dollar two or three years down the road – if the euro is still around, that is.
As debt mounts and the recession lingers, we are surely going to see a number of governments trying to lighten their load through financial repression, higher inflation, partial default, or a combination of all three. Unfortunately, the endgame to the great recession of the early 2000s will not be a pretty picture.
Source : www.theglobeandmail.com