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Today's swollen fiscal deficits and public debts are
fuelling concerns about sovereign risk in many
advanced economies. Traditionally, sovereign risk
has been concentrated in emerging market economies.
After all, in the last decade or so, Russia,
Argentina, and Ecuador defaulted on their public
debts, while Pakistan, Ukraine, and Uruguay
coercively restructured their public debt under the
threat of default.
But, in large part and with a few exceptions in
Central and Eastern Europe, emerging market
economies improved their fiscal performance by
reducing overall deficits, running large primary
surpluses, lowering their stock of public
debt-to-gross domestic product (GDP) ratios, and
reducing the currency and maturity mismatches in
their public debt. As a result, sovereign risk today
is a greater problem in advanced economies than in
most emerging market economies.
Indeed, rating agency downgrades, a widening of
sovereign spreads, and failed public debt auctions
in countries like the United Kingdom, Greece,
Ireland, and Spain provided a stark reminder last
year that unless advanced economies begin to put
their fiscal houses in order, investors, bond market
vigilantes, and rating agencies may turn from friend
to foe.
The severe recession, combined with the financial
crisis during 2008 and 2009, worsened developed
countries' fiscal positions, owing to stimulus
spending, lower tax revenues, and the backstopping
and ring fencing of their financial sectors.
The impact was greater in countries that had a
history of structural fiscal problems, maintained
loose fiscal policies, and ignored fiscal reforms
during the boom years.
In the future, a weak economic recovery and an aging
population are likely to increase the debt burden of
many advanced economies, including the United
States, the UK, Japan, and several eurozone
countries.
More ominously, monetisation of these fiscal
deficits is becoming a pattern in many advanced
economies, as central banks have started to swell
the monetary base via massive purchases of short and
long-term government paper. Eventually, large
monetised fiscal deficits will lead to a fiscal
train wreck and/or a rise in inflation expectations
that could sharply increase long-term government
bond yields and crowd out a tentative and so far
fragile economic recovery.
Fiscal stimulus is a tricky business. Policymakers
are damned if they do and damned if they do not. If
they remove the stimulus too soon by raising taxes,
cutting spending, and mopping up the excess
liquidity, the economy may fall back into recession
and deflation. But if monetised fiscal deficits are
allowed to run, the increase in long-term yields
will put a chokehold on growth.
Countries with weaker initial fiscal positions, such
as Greece, the UK, Ireland, Spain, and Iceland, have
been forced by the market to implement early fiscal
consolidation. While that could be contractionary,
the gain in fiscal policy credibility might prevent
a damaging spike in long-term government bond
yields. So, early fiscal consolidation can be
expansionary in the balance.
For the "Club Med" members of the eurozone, Italy,
Spain, Greece, and Portugal, public debt problems
come on top of a loss of international
competitiveness. These countries had already lost
export market shares to China and other low
value-added and labour-intensive Asian economies.
Then a decade of nominal wage growth that outpaced
productivity gains led to a rise in unit labour
costs, real exchange rate appreciation, and large
current account deficits.
The euro's recent sharp rise has made this
competitiveness problem even more severe, reducing
growth further and making fiscal imbalances even
larger. The question is whether these eurozone
members will be willing to undergo painful fiscal
consolidation and internal real depreciation through
deflation and structural reforms in order to
increase productivity growth and prevent an
Argentine style outcome: exit from the monetary
union, devaluation, and default.
Countries like Latvia and Hungary have shown a
willingness to do so. Whether Greece, Spain, and
other eurozone members will accept such wrenching
adjustments remains to be seen.
The US and Japan might be among the last to face the
wrath of the bond market vigilantes. The dollar is
the main global reserve currency, and foreign
reserve accumulation - mostly US government bills
and bonds - continues at a rapid pace. Japan is a
net creditor and largely finances its debt
domestically.
But investors will become increasingly cautious even
about these countries if the necessary fiscal
consolidation is delayed. The US is a net debtor
with an aging population, unfunded entitlement
spending on social security and healthcare, an
anaemic economic recovery, and risks of continued
monetisation of the fiscal deficit. Japan is aging
even faster, and economic stagnation is reducing
domestic savings, while the public debt is
approaching 200pc of its GDP.
The US also faces political constraints to fiscal
consolidation. Americans are deluding themselves
that they can enjoy European style social spending
while maintaining low tax rates, as under President
Ronald Reagan. At least European voters are willing
to pay higher taxes for their public services.
If US democrats lose in the midterm elections this
November 2010, there is a risk of persistent fiscal
deficits as Republicans veto tax increases while
Democrats veto spending cuts. Monetising the fiscal
deficits would then become the path of least
resistance. Running the printing presses is much
easier than politically painful deficit reduction.
But if the US does use the inflation tax as a way to
reduce the real value of its public debt, the risk
of a disorderly collapse of the US dollar would rise
significantly. The US's foreign creditors would not
accept a sharp reduction in their dollar assets'
real value that debasement of the dollar via
inflation and devaluation would entail. A disorderly
rush to the exit could lead to a dollar collapse, a
spike in long-term interest rates, and a severe
double dip recession. |
