Published in The Australian (Sydney), 15 July 2011
With the US fiscal crisis nearing a dramatic finale, downgrades of European debt ratings continuing and the euro crisis deteriorating, the global financial crisis has just moved into a new phase.
This may come as a surprise to observers who believed the worst of the GFC was already behind us. And it proves that fundamental problems cannot be solved by treating their symptoms.
After the previous peak in the wake of the Lehman Brothers collapse, political leaders on both sides of the Atlantic had been busy fiddling with effects of the crisis.
Trying to stabilise their ailing economies, they spent billions and trillions on stimulus programs. They provided cash for clunkers, rescued banks and bailed out whole countries. They lowered real interest rates deep into negative territory and, when even that was not enough, they resorted to old-fashioned money-printing advertised as “quantitative easing”. And for a while they even believed that all of this would work.
It was only a matter of time until reality caught up with the rescuers. Excessive levels of public and private debt had been at the root of the crisis, and every single emergency measure only aggravated this problem by adding yet more debt.
In addition, expansionary monetary policy that had fuelled the explosion of debt has become even looser in order not to undermine the recovery.
All the stimulus, bailouts and emergency measures thus shared the same characteristic: they were the equivalent of downing a bottle of whisky because you do not want to endure last night’s hangover. In this way, the day of reckoning had only been delayed but this delay was bought at huge cost.
The result is a massive hangover from the first phase of the GFC that Europe and the US are only beginning to wake up to.
Although relative levels of debt to gross domestic product are comparable in the US and in Europe, and although budget deficits are lower in many euro-zone countries than in the US, the economic problems are more severe on the eastern side of the Atlantic. The reasons for this are structural issues in many European economies combined with the monetary straitjacket of the euro.
The monetary crisis of the euro and the sovereign debt crisis are closely linked. But they are not quite identical because Europe’s addiction to debt precedes monetary union. Besides, sovereign debt problems are not exclusive to just a few peripheral countries or the euro-zone. Even in supposedly healthy economies, financing public expenditure through deficit spending was the norm. The last time Germany recorded a budget surplus was five decades ago.
Sooner or later, it was inevitable a sovereign debt crisis would erupt somewhere in Europe. Europe’s official debt figures could not be taken at face value anyway, as liabilities, particularly in social security systems, had been carefully hidden. As economist Jagadeesh Gokhale calculated in a 2009 report for the US National Centre for Policy Analysis, the EU’s average implicit indebtedness stood at 434 per cent of GDP before the crisis, several times higher than official debt figures.
The Greek crisis, which first erupted in late 2009, was the moment when markets realised the real extent of Europe’s debt problems and were no longer prepared to give Greece credit at interest rates it could afford. Unfortunately, Europe’s political leadership did not draw the correct conclusions from this. Although it was obvious back then that Greece would never be able to repay its debt, EU leaders decided a Greek default would be politically too embarrassing to let it happen. And of course they were afraid that panic might spread to Ireland, Portugal or Italy. So they kept Greece on life support with an extra E110 billion of emergency loans, while establishing a E750bn safety net for the rest of the euro-zone. They also allowed the European Central Bank to purchase Greek treasuries, killing off both the bank’s credibility and independence in one go.
The result of these “rescue measures” is a complete mess. After 1 1/2 years of saving the continent, Europe is a scene of economic devastation. Its central bank is overloaded with toxic papers; Portuguese, Irish and Greek debt is officially rated junk; and markets are seriously wondering whether Italy could be next.
Meanwhile, the euro is at risk of imploding with unforeseeable consequences for Europe’s financial system. The implications would be so severe that last year’s EU banking stress test did not even attempt to model such a doomsday scenario. The European debt crisis alone has the potential to derail the world economy. But it is not the only trouble spot on the world map. The US’s economic recovery is stalling, while the Obama administration is trying to stave off insolvency. Japan, already the most heavily indebted country in the developed world, just had to pass a second emergency budget since the tsunami. Instead of preparing for the aftermath of the next and more severe phase of the global financial crisis, Australia has been wasting its energies.
Domestic debates pale into insignificance in comparison with the financial storm that is brewing on the horizon. Why are we even contemplating new taxes that damage our international competitiveness at a time of the utmost economic uncertainty? Australia may have been an island of tranquillity post Lehman, but for how much longer?