If the 1980s was the decade of the third-world debt crisis, could the current decade be described by future economic historians as the decade of the first-world sovereign debt crisis? Quite possible, of course, given the problems being witnessed by some eurozone countries (Greece, Ireland, Portugal, Spain?). And, across the Atlantic, the situation does not look any better if the late 2010 “deal” between the Democratic President and the Republican leadership is any indication. The Republicans won the mid-term election with a hawkish stance on the budget deficit. The first thing they did on winning was to get a two-year continuation of a tax-cut for the rich which would cost something like $850 billion. In return, the Democrats got what they were after: a continuation of unemployment benefits beyond the existing time limit, necessitated by the continued near-double digit unemployment. It is not left for us, the poor third-world commentators, to understand the ways of the Americans to cut budget deficits, or, indeed, the ways of the financial market that charges a higher credit spread on the German sovereign debt compared to the US sovereign debt (“too big to fail”?). Or, is this phenomenon merely another manifestation of the the financial market’s US-centric biases? To be sure, there would be analysts who would give an extremely plausible rationale for the lower US spreads. The fact is that the US public debt and fiscal adjustment are major challenges for policy makers. The dilemmas are reflected in the way the high-profile debt reduction panel appointed by US President Barack Obama failed to agree on recommendations.
Historically, there have been two ways of solving a sovereign debt problem. One, fast growth and, two, currency debasement (that is, high inflation). Neither seems to be on the cards so far as most of the first-world countries are concerned. And, in the US the debt problem extends not only to states like California, but a very large number of municipalities — the aggregate outstanding municipal debt is estimated at $2 trillion, and yield spreads have been widening since investors perceive a greater credit risk. Another debt bomb that could explode in a not-so-robust economic recovery is the commercial real estate sector.
Turning to the prospects of global inflation, there are signs that it could pick up. Bond yields in the US have gone up to some extent, although the headline inflation number is still pretty benign. This is not surprising — the index looks at the past while, at least in theory, markets are supposed to factor in expectations about the future in current prices. The fact is that commodity prices have increased sharply since mid-2010 — for example, prices of precious metals, base metals, agricultural commodities (FAO’s food price index is up 50 per cent over the last two years) and, more recently, crude oil. There are, perhaps, two different drivers that flare up commodity prices. One, rising demand in emerging markets, which continue to grow much faster than the first world. Two, the emergence of commodities as a new “asset class”. This would surely exacerbate cyclicality.
Product inflation may also pick up. One of the reasons for the relatively benign inflation over the last couple of decades in much of the first world has been China’s prices. And, this could be in for a change. Two factors that will put an upward pressure on Chinese product prices are: sharp increases in wages and a gradual appreciation of the yuan in nominal terms. In theory, this should help reduce global imbalances. In my view, this is unlikely since the major deficit Anglo-Saxon economies have progressively de-industrialised themselves. (To be sure, these developments may help other emerging markets’ competitiveness.) Overall, however, inflation in the first world is unlikely to go to levels that would make any significant impact on debt as a percentage of nominal GDP. Macroeconomic policy makers have learnt much more about bringing inflation down than pushing it up — look at the experience of Japan.
What about the growth outlook? The US stock market is back to the pre-Lehman collapse levels. There are other indications that economic growth could pick up in 2011, but unemployment seems to be an increasingly intractable problem. Analysts have been suggesting that a GDP growth of 2.5 per cent a year is needed merely to keep the unemployment level stable. The big question is, what will happen to economic recovery once the monetary and fiscal stimuli are withdrawn? The picture is not any rosier in Europe, with the exception of Germany. But the problems of some of the eurozone countries would continue to hobble the European recovery. The Chinese central bank is increasingly becoming the lender of last resort for many European governments. And, it remains the largest holder of US sovereign debt.
The big worry for the global picture is the possibility of tensions over exchange rates (particularly of the Chinese yuan) and political pressures for trade protectionist measures. In times of difficulties, it is always tempting to blame the nasty, crafty foreigner for one’s own woes.