Nouriel Roubini is still Doctor Doom

The Risky Rich
Nouriel Roubini
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
January 20, 2010

NEW YORK – Today’s swollen fiscal deficits and public debt are fueling concerns about sovereign risk in many advanced economies. Traditionally, sovereign risk has been concentrated in emerging-market economies. After all, in the last decade or so, Russia, Argentina, and Ecuador defaulted on their public debts, while Pakistan, Ukraine, and Uruguay coercively restructured their public debt under the threat of default.

But, in large part – and with a few exceptions in Central and Eastern Europe – emerging-market economies improved their fiscal performance by reducing overall deficits, running large primary surpluses, lowering their stock of public debt-to-GDP ratios, and reducing the currency and maturity mismatches in their public debt. As a result, sovereign risk today is a greater problem in advanced economies than in most emerging-market economies.

Indeed, rating-agency downgrades, a widening of sovereign spreads, and failed public-debt auctions in countries like the United Kingdom, Greece, Ireland, and Spain provided a stark reminder last year that unless advanced economies begin to put their fiscal houses in order, investors, bond-market vigilantes, and rating agencies may turn from friend to foe. The severe recession, combined with the financial crisis during 2008-2009, worsened developed countries’ fiscal positions, owing to stimulus spending, lower tax revenues, and backstopping and ring-fencing of their financial sectors.

The impact was greater in countries that had a history of structural fiscal problems, maintained loose fiscal policies, and ignored fiscal reforms during the boom years. In the future, a weak economic recovery and an aging population are likely to increase the debt burden of many advanced economies, including the United States, the UK, Japan, and several euro-zone countries.

More ominously, monetization of these fiscal deficits is becoming a pattern in many advanced economies, as central banks have started to swell the monetary base via massive purchases of short- and long-term government paper. Eventually, large monetized fiscal deficits will lead to a fiscal train wreck and/or a rise in inflation expectations that could sharply increase long-term government bond yields and crowd out a tentative and so far fragile economic recovery.

Fiscal stimulus is a tricky business. Policymakers are damned if they do and damned if they don’t. If they remove the stimulus too soon by raising taxes, cutting spending, and mopping up the excess liquidity, the economy may fall back into recession and deflation. But if monetized fiscal deficits are allowed to run, the increase in long-term yields will put a chokehold on growth.

Countries with weaker initial fiscal positions – such as Greece, the UK, Ireland, Spain, and Iceland – have been forced by the market to implement early fiscal consolidation. While that could be contractionary, the gain in fiscal-policy credibility might prevent a damaging spike in long-term government-bond yields. So early fiscal consolidation can be expansionary on balance.

For the Club Med members of the euro zone – Italy, Spain, Greece, and Portugal – public-debt problems come on top of a loss of international competitiveness. These countries had already lost export-market shares to China and other low value-added and labor-intensive Asian economies. Then a decade of nominal-wage growth that out-paced productivity gains led to a rise in unit labor costs, real exchange-rate appreciation, and large current-account deficits.

The euro’s recent sharp rise has made this competitiveness problem even more severe, reducing growth further and making fiscal imbalances even larger. So the question is whether these euro-zone members will be willing to undergo painful fiscal consolidation and internal real depreciation through deflation and structural reforms in order to increase productivity growth and prevent an Argentine-style outcome: exit from the monetary union, devaluation, and default. Countries like Latvia and Hungary have shown a willingness to do so. Whether Greece, Spain, and other euro-zone members will accept such wrenching adjustments remains to be seen.

The US and Japan might be among the last to face the wrath of the bond-market vigilantes: the dollar is the main global reserve currency, and foreign-reserve accumulation – mostly US government bills and bonds – continues at a rapid pace. Japan is a net creditor and largely finances its debt domestically.

But investors will become increasingly cautious even about these countries if the necessary fiscal consolidation is delayed. The US is a net debtor with an aging population, unfunded entitlement spending on social security and health care, an anemic economic recovery, and risks of continued monetization of the fiscal deficit. Japan is aging even faster, and economic stagnation is reducing domestic savings, while the public debt is approaching 200% of GDP.

The US also faces political constraints to fiscal consolidation: Americans are deluding themselves that they can enjoy European-style social spending while maintaining low tax rates, as under President Ronald Reagan. At least European voters are willing to pay higher taxes for their public services.

If America’s Democrats lose in the mid-term elections this November, there is a risk of persistent fiscal deficits as Republicans veto tax increases while Democrats veto spending cuts. Monetizing the fiscal deficits would then become the path of least resistance: running the printing presses is much easier than politically painful deficit reduction.

But if the US does use the inflation tax as a way to reduce the real value of its public debt, the risk of a disorderly collapse of the US dollar would rise significantly. America’s foreign creditors would not accept a sharp reduction in their dollar assets’ real value that debasement of the dollar via inflation and devaluation would entail. A disorderly rush to the exit could lead to a dollar collapse, a spike in long-term interest rates, and a severe double dip recession.