Today's swollen fiscal deficits and public debt are fuelling concerns about sovereign risk in advanced economies. Traditionally, sovereign risk has been concentrated in emerging-market economies. After all, in the past decade or so, Russia, Argentina and Ecuador defaulted on their public debts, while Pakistan, Ukraine and Uruguay restructured their public debt under the threat of default.
But, in large part, 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 is now a greater problem in advanced economies than in most emerging-market ones.
Indeed, rating-agency downgrades, a widening of sovereign spreads and failed public-debt auctions in countries such as the United Kingdom, Greece, Ireland and Spain provided a stark reminder last year that, unless advanced economies start to put their fiscal houses in order, investors, bond-market vigilantes and rating agencies may turn from friend to foe. The recession, combined with the financial crisis during 2008-09, worsened developed countries' fiscal positions, owing to stimulus spending, lower tax revenues and backstopping 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. A weak economic recovery and an aging population are likely to increase the debt burden of many advanced economies, including the U.S., the U.K. and Japan.
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 recovery.
Fiscal stimulus is a tricky business. Policy-makers 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 U.K., 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 labour-intensive Asian economies. Then a decade of nominal wage growth that outpaced productivity gains led to a rise in unit labour 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 such as 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 U.S. 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 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 U.S. 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 per cent of GDP.
The U.S. also faces political constraints to fiscal consolidation: Americans are deluding themselves that they can enjoy European-style social spending while maintaining low tax rates. At least European voters are willing to pay higher taxes for their public services.
If America's Democrats lose in November's midterm elections, there's 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 U.S. 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 U.S. 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.
Nouriel Roubini is professor of economics at New York University's Stern School of Business and chairman of Roubini Global Economics.