The perfect storm that erupted with unanticipated fury on August 1 shook the world. Outcomes had materialised that financial markets wanted to see. Further, if yet insufficient, action was taken on Greece. Agreement was reached in the US Congress on the debt ceiling. As these imminent threats in the EU/US were de-risked, markets realised belatedly that their attention was misplaced. Despite actions taken, debt problems in the EU and the US were so large as to be intractable to resolve, politically or economically. Public understanding of the problems faced in the EU/US, and willingness to accept the adjustments that must occur over the decade to deal with them, were conspicuous by their absence. Political leadership in the EU/US had failed spectacularly to acknowledge or communicate: (a) the size of the problem; (b) the time over which it had been created and exacerbated; and (c) what really needed to be done now. Belated market recognition of the real problems has generated three powerful tailwinds now driving the current storm.
First, markets have realised that EU leaders did not resolve very much. They applied a larger bandage than before to stem the bleeding in Greece. They reduced interest costs in Ireland and Portugal. But markets saw that restructuring the debt of the PIGs on the lines agreed would not enable them to grow out of recession into debt sustainability. In the process, EU leaders opened the door to financial markets perceiving via CDS prices that even greater problems were posed by Italy and Spain. The debt of PIGs is less than 600 billion euros. That of Spain and Italy is over 2.6 trillion euros. PIIGS thus account for 44% of total Eurozone debt of 7.2 trillion euros. So, despite premature self-congratulation, all EU leaders had done was to buy another 3-6 months, but at the cost of making markets aware that the debt problem had migrated to the core and multiplied six-fold.
The Euro Summit of 07/21 spotlighted the EU?s problem as being very large, politically intractable, and economically unmanageable. It underlined the lack of insightful political leadership and the EU?s inability to exercise collective responsibility for a problem that is now regional and core; not national and peripheral. Nor does the EU have institutional structures for swift decision-making, to permit the problem to be dealt with as it should. EU leaders?from Germany and northern Europe?keep failing to see that they need to leap way ahead of market expectations before they trigger an EU-wide debt disaster as markets lose faith in governments. Instead they remain too far behind, dragging their feet in desultory fashion.
If they do not act comprehensively now, Italy and Spain will be pushed to the brink of default within weeks. Whether they are, or are not, bailed out (they may be too big to bail), markets will pick on France, Belgium, the Netherlands and the UK whose debts are all of disconcerting dimensions. The end result will be an unravelling of the Euro, the Eurozone and, possibly, the EU itself. The Eurozone has two choices. It can use this crisis to move faster and further towards effective fiscal union or it can disintegrate at tremendous cost to itself and the world. There is no middle ground.
The EU?s political failure has triggered a value loss of all traded contracts over $3-4 trillion in just 15 days across all markets. It may cost the global banking system a portfolio loss of another $1-2 trillion. That would need to be provided for by banks short of prudential capital. Now flat on their backs, EU banks will go under water, requiring public support, which governments cannot afford. The carnage the EU?s ?leaders? have created defies comprehension. They have revealed themselves as midgets who haven?t a clue what forces they are unleashing or what stakes they are playing for.
The only option that will work now is to use the Eurozone?s collective balance sheet to reverse market psychology convincingly. Eurozone authorities must swap all Eurozone national sovereign bonds for a single Eurobond backed by the full faith and credit of all members. They should stretch maturities and durations of the swapped bonds as far out as they can, depending on the market absorption capacity for long-tenured paper. That may raise borrowing costs marginally (50-60 bps) for the stronger Eurozone members. But it would reduce financing costs for indebted countries by 200-400 bps, thus increasing the chances of achieving debt sustainability. It would avert a collapse of the EU banking system and make a revival of EU growth more likely. That is better than continuing to go down the cul-de-sac that they have driven themselves in.
Second, markets have realised that the US Congress and Administration have bought another 18 months for debt issues in the US to be addressed. But, as in the EU, the ?debt deal? highlights debt unsustainability in the US to be much larger than anyone had appreciated. While Congress and the White House were playing poker with ?down-payments on deficit reduction? ranging between $1.8 trillion to $4 trillion, eventually settling for a compromise of $2.4 trillion, the actual fiscal gap in the US is authoritatively estimated at $211 trillion!
So, the focus on marginal deficit reduction over the next 10 years is inadequate. It does not address the gargantuan problem of future entitlement payments with a worsening demographic profile. These are an even larger problem in the EU and Japan. Such entitlements provide public subsidies for pensions, social security, healthcare, education, housing, childcare, etc. Starting out as safety nets for the poor, these entitlements have grown like Topsy to become steel cages in which the middle class is trapped. It seems beyond present political leadership in the EU/US to convince electorates that all these entitlements must be reduced to avert national bankruptcy.
Third, before markets had time to celebrate the deal passed by Congress on August 1, they were hit by a slew of PMI/ISM data from around the world suggesting that the global recovery is stalling rapidly. The effects of earlier fiscal and monetary stimulus are fading. A new round of stimulus in the US and EU is neither affordable nor financeable. Stimulus is being provided in over-indebted Japan for reconstruction in the aftermath of earthquakes, tsunamis and nuclear meltdowns. Its effect may be felt marginally in 2H-2011 and through 2012. But it will not help global recovery to any degree.
Markets now realise that the stimulus bet taken in 2008-10 has failed to bring the world back to a self-fuelling, self-sustaining, recovery based on a revival of ?natural??rather than artificial?demand. The recession-avoidance strategy for 2011 and beyond is not working. It implies that painful adjustments in household, corporate and government balance sheets slowly taking place must now accelerate. With household balance sheets having to be rebuilt due to over-indebtedness (households in the EU/US have debt of 6-12 times annual income) the emphasis will be on saving rather than consumption.
With reduced demand in developed markets, large companies will hoard cash (Apple has a cash balance of $76 billion, Microsoft $38 billion and GE $26 billion) rather than invest in markets with overcapacity. To the extent they invest, it will be to expand in emerging markets. But these are not yet large enough to pull a faltering world out of recession. Likewise, EU and US governments will have to impose austerity in public expenditure because they are over-borrowed. They cannot afford to raise taxes while entering into another recession or, at best, a prolonged period of stagnation or low growth. Both will worsen their debt problems.
The outlook in the developed world for the coming years is bleak. Whilst the debt problems of the EU and US have been highlighted in the last year, no one is focusing on the worse debt overhang in Japan. In relative terms, it is nearly twice as large as that of the US and 60% larger than Italy?s. That may be because Japan?s debt is financed (almost entirely) internally. The debt of the EU and the US is financed significantly (50+%) by external creditors. The source of financing does not make a mountain of debt any more sustainable in a shrinking economy. Japan has, for the last two decades, been moribund. It has deflation, a no-growth future, and a steadily diminishing population. Is it a precursor of what may happen in the EU and US as well?
Such a scenario is hardly comforting for emerging markets, even those in which uncharitable views run high about the developed world. The EU, the US and Japan have dictated and imposed their will on EMs for too long. Finally they are having a long-delayed come-uppance. But one should be careful about what one wishes for. One might get it. It is a distressing scenario for those emerging countries, and their sovereign wealth funds, that have invested reserves/capital in the public debt of the EU, US and Japan. As their creditworthiness diminishes, reflected in the downgraded ratings of the paper they issue, the status of their currencies (i.e. the EUR, USD and JPY) as the world?s principal reserve currencies comes increasingly into question.
That can only beg the related question of when key emerging markets?especially China and India?will accept the inevitable; i.e. that they must open their capital accounts and make their currencies freely convertible, and freely available, as additional reserve currencies. They must accept, as large trading countries that are significant players in the global economy, that currency markets (along with global capital flows related to trade and investment) rather than their own governments and central banks, must be allowed to determine fairly (rather than manipulate unfairly) the relative prices of their currencies. That would permit adjustments to occur more readily in global external accounts. It would help prevent the further build-up of massive imbalances which, in part, are responsible for the debt problems that have emerged in the EU and the US. It would also make it easier for the developed world to make the unpalatable structural adjustments it must make.
The author is chairman, Oxford International Associates Ltd