Today's Opinions, Tomorrow's Reality
A Greek Canary in an American Mine
By David G. Young
Washington, DC, December 15, 2009 --
Economists agree that government deficits around the world are unsustainable. The end may be coming sooner than they think.
Just over a year after finance companies were gutted by the mortgage crisis, new tremors are shaking the financial world. Last month, the Emirate of Dubai announced it would be unable to pay interest on $26 billion in debt held by state-owned Dubai World.1 Shortly thereafter, Fitch Ratings downgraded the credit rating of the Greek government to BBB+ with a negative outlook, based on the budget deficit rising sharply to 12.7 percent of GDP this year.2 The government is now struggling to cut spending in order to avoid a debt crisis.
But the potential crisis goes far beyond Greece and Dubai. Around the world, large government deficits are the rule, not the exception. In the major, rich countries in the Organization for Economic Cooperation and Development, government deficits are running at 8.2 percent of GDP this year, with gross debts totaling 90 percent of GDP.3 Even the most fiscally responsible countries like Germany are running mild deficits (3.7 percent of GDP). The more profligate rich countries like Ireland, the United Kingdom, Greece and the United States have pushed deficits to double digit levels.
When discussing government debt, it's easy to get lost in the numbers and miss the bigger picture. When heavily indebted governments continue to run budget deficits, they must constantly and furiously borrow more money to pay for both new deficit spending and to pay the interest on their existing debts. This works fine, so long as there are enough buyers trusting enough to accept a low interest rate. Trouble is, those pesky buyers are beginning to ask a difficult question: How can they be sure that governments will pay them back?
Investors in Greek bonds didn't like the answers they heard. They started demanding more money: 5.5 percent interest for a 10-year bond -- 2.3 percent more than they expected from the biggest European bond market in Germany.4 With the Greek government awash in debt amounting to 113 percent of its GDP 5, higher interest rates make it much more expensive just to keep paying the interest on the existing debt. As more money goes to service old debts, the country's financial situation worsens, further reducing investor confidence and making the problem worse still. Greece faces a classic debt spiral.
Small countries like Greece and Dubai are the most vulnerable to these problems, because they don't have deep pockets. But just because they are the first dominoes to fall doesn't mean they will be the last. The granddaddy of the government bond market, the United States, has raw debt numbers nearly as bad as those of Greece. Its gross debt is 83.9 percent of GDP, it is running an annual deficit of 11.2 percent of GDP6, and its long-term fiscal outlook is every bit as shaky. When U.S. Treasury Secretary Tim Geithner told Chinese economics students in June that Chinese investments in America are "very safe," he was practically laughed off the podium.7
This skepticism has yet to lead to higher interest rates on U.S. government securities (rates are still relatively low at 3.6 percent for a 10-year note8) but it has markedly changed the profile of investors.
China has greatly curtailed purchase of new U.S. bonds. In the six months after the Federal Reserve's March announcement that it planned to print money, China purchased only $30 billion in American debt, compared with $84 billion over the previous six months.9 Despite the Chinese pull-back, the market has remained stable, partly because the Federal Reserve soaked up $300 billion worth of bonds with the money it printed.10
Now that the Federal Reserve has completed these purchases, it is unclear who will be willing to buy the huge quantities of new bonds that America must continue to sell to finance its new and existing debts. Once these investors grow skeptical -- like the Chinese students or the buyers of Greek bonds -- then America will have to pay higher interest rates and pay much, much more to finance its profligate ways. This could very quickly lead to a Greek-like crisis, a devaluation in the dollar and domestic inflation as the Federal Reserve intervenes to keep interest rates low.
The crises in Greece and Dubai are but a warning of bigger problems to come -- they are the canaries in the coal mine of unsustainable government debt. Failures in small countries will sow seeds of doubt for investors in the bond markets of medium sized countries. As investors begin to have doubts there (as is currently happening in Ireland and Britain), the next stop could be big countries like the United States.
Bond market insiders, of course, say this will never happen. Yet mortgage market insiders were once equally confident. It was only six months between the crisis at the relatively small investment bank Bear Stearns before the near collapse of huge insurance giant AIG. Let us hope that America's finances look far better six months in the future.
Related Web Columns:
From America to Zimbabwe, March 24, 2009
1. Washington Post, Abu Dhabi to Give Heavily Indebted Dubai a $10 Billion Lifeline, December 15, 2009
2. Economist, Rate and See, December 10, 2009
3. OECD, Economic Outlook No. 86, November 19, 2009
4. Bloomberg News, German Bonds Rise as Investors Remain Cautious on Greek Bonds, December 14, 2009
5. Reuters, Timeline-Greece's Economic Crisis, December 15, 2009
6. OECD, Ibid.
7. Telegraph, Geithner Insists Chinese Dollar Assets Are Safe, June 1, 2009
8. Associated Press, Treasurys Fall On Inflation Fears, Year-End Sales, December 15, 2009
9. U.S. Treasury Department, Major Foreign Holders of Treasury Securities, Oct. 2008 - Sept. 2009, Dec. 15, 2009
10. Federal Reserve, Factors Affecting Reserve Balances, December 10, 2009