- The Washington Times - Thursday, January 7, 2010

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.”

Indebted nations also face the likelihood of rising interest rates this year, which will make it more expensive and difficult to finance their debts, he said.

Even as governments are paying more for their debt, their bloated finances are expected to drive up interest rates across the board, making it more difficult for consumers and businesses to borrow, analysts said.

Growing worries about defaults will force some of the most strapped governments to end aid programs even if it hurts their economies, citizens and financial markets.

“As most governments simply cannot afford another financial crisis, they will attempt” to limit their spending commitments and liabilities in the future, Mr. Cailleteau said. “This could in some cases create disorderly market conditions.”

Greece, Iceland, Ireland and other countries have been struggling with gigantic budget problems and trying to retain the confidence of international investors and markets. Ireland lost its AAA rating as it plunged into a fiscal crisis that drove its debt to 76 percent of economic output. Greece and other countries have faced repeated downgrades as their debts bloated to more than 100 percent of their economic output.

Greece’s problems last month sparked a brief run on the euro and flight to safe-haven Treasuries and the U.S. dollar. Investors who had favored the European currency through much of 2009 suddenly awoke to the numerous fiscal risks plaguing the euro area.

Membership in the European Economic and Monetary Union, with its common currency and respected central bank, protects countries against the worst kinds of financial runs, but it will not by itself help them solve their budget problems, Mr. Cailleteau said.

A country’s history of budget discipline also makes a difference, said Adarsh Sinha, foreign currency analyst at Barclays Capital.

He sees a “sharp difference” between Ireland and Greece, although both countries face deficits in the range of 12.5 percent of economic output this year.

“The Irish government is committed to implementing tough measures, and has done so in the past,” he said. “By contrast, Greece has no history of public finances adjustment and the government has not shown yet a strong commitment to adjustment.”

The budget problems of most of the major developed countries pose a striking contrast with the economies of developing countries such as China and Brazil, which entered the financial crisis flush with surpluses and high savings rates, enabling them to weather the global crisis comparatively well.

While such developing countries in the past often were at the center of global financial crises, today they are on the periphery and reaping the benefits of better financial discipline than their mature counterparts.

Bob Doll, a vice chairman at BlackRock, said the absence of a “debt noose” around the necks of Brazil and China makes those countries attractive places to invest in the next few years.

“The emerging markets also have a much higher savings rate — therefore more flexibility in terms of planning their future,” he told the Reuters news agency summit last month. Also making these countries attractive are large emerging middle classes that will bolster consumption for years to come.

Although the U.S. is saddled with big debts, Mr. Doll said, he still prefers U.S. markets over their Japanese and European counterparts because the U.S. economy appears to be rebounding strongly and its stimulus programs have been the most effective.

“We think that combination of monetary and fiscal policy stimulus far outshines anything done in the rest of the developed world,” he said.

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