Nations in the red threaten stability

The world economic crisis has entered a new stage where the overstretched finances of the United States and other national governments have become the biggest threat to economic stability.

While the prospect of an unprecedented string of U.S. budget deficits exceeding $1 trillion is causing much angst, the problems are even worse for smaller countries such as Greece, Iceland and Ireland, where draconian spending cuts and tax increases are needed to prevent immediate financial crises.

Worries about these smaller European countries have caused tumult in financial markets in the past month and strengthened the U.S. dollar, reflecting investors’ judgment that the U.S. deficit problems are solvable, if difficult, as long as the economy keeps recovering.

Nevertheless, a deficit commission recently warned that the U.S. could start to experience financial difficulties within a couple of years unless it quickly lays out a plan to bring deficits under control. Even strong defenders of the $787 billion stimulus bill and bank bailouts that drove the public debt to nearly $12 trillion say the U.S. may not have the luxury of waiting until a full economic recovery sets in before addressing the debt problem.

“While the measures taken were absolutely necessary, unwinding the stimulus, restoring a sound fiscal regime, undoing the expansion of the Federal Reserve Board’s balance sheet, and reducing government’s involvement in the financial system” should be the first order of business for political leaders, former Treasury Secretary Robert E. Rubin said this week.

“Waiting too long to address them could cause a new crisis,” he said.

Fiscal hawks in Congress are expected to demand a plan for bringing down the debt early this year, when Congress once again must raise the debt limit to accommodate rapidly rising deficits.

While the U.S. faces the prospect of painful spending cuts or tax increases to regain fiscal control, it is not alone. Countries including Japan and Britain last year greatly increased spending. Some even put their sterling credit ratings in jeopardy in an effort to soften the deepest worldwide recession since the 1930s.

“The crisis of public finances that has beset many rich countries is what Moody’s believes will be the final — and disturbingly long-lasting — stage of the crisis,” said Pierre Cailleteau, managing director of Moody’s Global Sovereign Risk Group in London.

Moody’s estimates that government debt worldwide has burgeoned by 45 percent, or $15.3 trillion, since 2007, with 78 percent of that increase in the Group of Seven industrial nations — the U.S., Japan, Germany, France, Britain, Canada and Italy.

Moody’s still gives its top credit rating of AAA to the U.S., along with a few other nations such as Britain, France and Germany, out of the belief that the breadth and diversity of their economies, and long histories of dependable debt repayment, make it likely they will pull through the crisis without missing a payment.

The U.S. is still viewed as the world’s safest place to put money because its economy is the largest and most diversified and because it has been more flexible and resilient in times of crisis than other developed countries where government constraints often prevent companies from paring staff and taking other steps needed to survive a recession.

Despite these solid credentials, the path ahead for the U.S. and other overstretched governments is fraught with risks, Mr. Cailleteau said.

“AAA governments with stretched balance sheets will find themselves under pressure to announce credible fiscal plans and — if markets start losing patience — to start implementing them,” he said. “This will complicate the recovery and test political cohesion.”

Moreover, countries will have to “time the exit perfectly” from fiscal stimulus, he said, so it is “not too quickly or too soon so as to prevent choking off growth; and not too slowly or late so as not to unsettle financial markets.”

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