“Global Debt Crisis: The World on Stranger Tides”

The financial crisis and the great recession that followed it in 2008 was a culmination of years of overspending and borrowing in major parts of the developed world fueled by the skewed savings and consumption pattern in the world. In order to save their economies Governments all across the world responded with massive stimulus and central banks followed a ultra easy monetary policy. This crisis soon gave away to a sovereign debt crisis. With some countries in European Union periphery almost facing a sovereign debt default which if happened would cause a global contagion and would result in breakup of European Union the way we know it today. Downgrading of US debt ratings by S&P sent a very strong signal that US should get its house in order and even if the status of dollar being a global currency allows it borrow without strings and at a very low cost in the long run there is a fear that dollar would lose its status a global reserve currency status if US does not stabilizes its borrowing. While the emerging economies and commodities due to the QE1 and QE 2 faced massive flows of funds resulting in fears of asset price bubbles. Many emerging economies even placed capital controls in order to regulate the flow of money. We think that it is inevitable that US has to cut down its fiscal deficit but in the short run US should continue with its expansionary fiscal and monetary policy as the US economic recovery is not that solid and there is a real fear of a double dip recession. In Europe we think it is inevitable that the strong economies like France, Finland etc led by Germany have to bail out the troubled European economies if EU has to survive and the question is not if they will but the question is when. Current measures being undertaken by EU are very inadequate and it is only postponing the inevitable. Going forward we will see a  union of monetary as well as fiscal policy as the current system of only a monetary union and fiscal policy being independent of countries clearly unsustainable. We think in the long run the skewed global consumption and savings pattern need to change in order for the global economic growth to be more sustainable.

It has always been the case that capital has flowed from the developed world to the developing world. But things began to change in the late 1990s. The developing economies started running huge surpluses which were channelized to the developed economies mainly the US. This allowed developed countries to run huge deficits mainly the US and at one stage US consumed 90% of world’s savings. This resulted in artificially low borrowing cost for Americans and their counterparts in the developed world. This allowed the Federal Reserve to keep interest rates low for an extended period of time which coupled with lax regulations and financial innovation gave way to massive housing bubble which through securitization and use of derivatives led to Subprime debt being circulated throughout the financial system and throughout geographies in US and Western Europe. When Fed started raising the rates the entire pack of cards began to unravel and after Lehman brothers bankruptcy the world saw a financial crisis of the scale not seen after the great depression. There was a fear the economies in the developed world may go into a depression and in Keynesian wisdom to support the economies, governments across the world unveiled massive stimulus packages along with a very easy monetary policy by central banks. Eventually the entire banking system was bailed by the Government in countries like US, UK and Ireland. In US to fund government bailout the Federal Reserve resorted to a massive programme of buying US treasury bonds called as Quantitative Easing. While Quantitative easing 1 and 2 had mixed results. They clearly could not pump up the economy. All this was funded by borrowing. The US consumer after years of spending beyond its means has started saving. This has result in weak consumption demand which is not helping the economy recover. The Fed in US faces a difficult choice whether to continue with QE  . While as economies around the globe slowed down, countries like Greece, Portugal, Spain and Ireland which had not been fiscally imprudent started facing financial troubles. Years of financial mismanagement and non transparency did not help. Soon the bond markets started reacting to the bad news and yields on sovereign debt of countries facing financial problems started rising. This aggravated the debt problems of these economies. If these countries which shared a common monetary system and a common currency Euro defaulted on their debt it would result in breakup of the monetary union. While markets expected rich countries in EU like France, Finland and the bulwark of EU. Germany  to provide a bailout of their beleaguered European partners which was highly unpopular in these countries where the common man on street was against the idea of providing bailout with tax payers money to fiscally imprudent counterparts in EU. The problem started when in the wake of Lehman Brother Bankruptcy, Angela Merkel, Chancellor of Germany announced that the responsibility of bailing out banks with problem will be dealt by individual countries on their own and it won’t be a joint EU effort. This German procrastination aggravated the Greece and other troubled economies problems and it is today a question about existence of a common monetary union. This signaled the German unwillingness to go all out to support troubled economies with its own funds.  The Germans want Euro to survive but are not ready to bear the cost. While the European central bank started buying bonds of Greece and other troubled countries. This was a stop gap arrangement and it did not result in any substantial fall in yields on these bonds. There is no mechanism in EU for a country to systematically leave the union and any disorderly withdrawal or exit from the union even of an small economy like Greece would precipitate a banking crisis of the scale seen during the Great Depression. Without help from other member nations Greece will be forced to withdraw from the union and it will sound death bell for other countries facing similar problems as the financial markets will increase their borrowing cost by dumping their sovereign bonds. What Europe wants is a strong monetary union coupled with a strong fiscal union.  The global debt crisis according to some commentators has accelerated the process of transition of power to the East specially Asia with China leading the pack. With Asian economies having done reasonably well during the crisis and their banking system looked very robust , China and India became the drivers of global economic recovery. China and US are two ends of the spectrum when we speak of the imbalance in global savings and consumption. Chinese model of economic growth which is highly dependent on US consumption is highly unsustainable and China needs to change to a more balanced domestic consumption driven growth.  “Till when can the world’s biggest debtor be world’s superpower?” the question raised by Larry Summers , former economic advisor to President Bill Clinton. US debt to GDP ratio is expected to touch 100% by 2011. If EU breaks up it will be a catastrophe many times the size which we saw after Lehman Brother Bankruptcy. The global debt crisis has major implications for the global community. The world economic outlook is bleak and if the problems are not addressed we may soon see the global economy again sliding into recession again.

Eurozone crisis: Given the situation half hearted efforts won’t help. While European Financial Stability Fund has been established to deal with solvency issues, its size is too small.  They have fallen short of creating a creating a credible fiscal authority for the Eurozone which is the long term solution to the problem.  If very stringent fiscal austerity measures are imposed on these troubled European economies it will not help them achieve economic growth which is the most important thing required to stabilize their fiscal situation. The cost of bailout has to be borne by Germany and other rich countries in order to save Euro as well as their own banking system which is highly exposed to debt from these countries. Even a partial default or restructuring will make it impossible for other troubled economies to avoid a default as market would dump their bonds resulting in a self fulfilling prophecy. Germany which was the driving force behind the European Union has to take the lead.  German politicians have to make people understand that its in Germany’s long term interest for Euro to survive and they will have to bite the bullet.

US situation: The Federal Reserve should continue its bond buying programme if the yields on US treasury paper shoots up or the economy falters. While in the short run the US economy needs to stimulated with monetary and fiscal measures in the long run US has to cut its fiscal deficit . Its needs to reform the social security schemes or else we can see a serious debt problem in the future.

China: China has to increase its consumption and save less.  It will also allow China to allow Yuan to appreciate which will help in addressing the problem of managing massive  its forex reserves which have already touched 3 trillion dollars.  

The world clearly is on stranger tides and there are no clear answers and some tough policy decisions needs to be taken to address the challenges before the World.  

Abhishek Jain and Chandan Meghwani. This was written for a competition at IIT-M