Government debt is emerging as perhaps the biggest risk to the global recovery.
This point was driven home yesterday as a group that speaks for the financial elite and one of the United States' most respected economists warned that fiscal policy could upend the recovery.
The World Economic Forum, which hosts the annual Davos gathering of international business and government leaders in the Swiss Alps, put extra emphasis on "fiscal crises" in its annual report on global economic risks, released yesterday in London.
Observing that government debt in many advanced economies has been higher only during periods of war, the forum added its voice to the chorus expressing worry that politicians in the U.S. and elsewhere lack the resolve to deal with the problem by cutting spending and raising taxes. The issue - at least from the perspective of most economists - is maintaining investor confidence.
The world's biggest economies went deep into the red last year while bailing out the financial system and pumping billions into the economy, a concerted effort that avoided economic catastrophe.
Now, governments are under pressure to convince investors they are committed to paying the bills for that rescue, or risk a flight of the private capital they desperately need to put the world economy back on a secure footing. Such an exodus would cause bond yields to rise, which would be a significant headwind to growth.
Martin Feldstein, the Harvard University economist who was in the running to replace Alan Greenspan as the chairman of the Federal Reserve, is prominent among those who think governments are doing too little to satisfy investors, especially in the U.S.
"I don't think the Obama administration is doing anything to reduce that risk," Mr. Feldstein said in an interview with Reuters yesterday in Beijing. "They need to bring back a greater sense of confidence that the fiscal situation will not get out of control."
Mr. Feldstein said there is a "significant" risk that debt concerns could arrest the U.S. recovery. The world's largest economy expanded in the third quarter of 2009 after contracting for four consecutive quarters, according to government figures.
The U.S. budget deficit is $1.4-trillion (U.S.), the widest since the Second World War. The country's debt is on track to rise to more than 93 per cent of the economy, from about 62 per cent in 2007, according to the International Monetary Fund.
President Barack Obama, who will release his budget for the 2011 fiscal year next month, says he is serious about reining in the deficit. The announcement yesterday that Mr. Obama will seek to recoup about $90-billion (U.S.) over about 10 years through a tax on financial firms with more than $50-billion in assets was motivated in part by the recognition that the government needs to raise revenue.
Yet it's open for debate whether a tax on the institutions popularized as the villains of the financial crisis is the kind of political will investors are seeking. Many investors and economists say it will take a credible fiscal plan, complete with real spending constraint to prove the administration is serious and evidence Congress will go along with the austerity measures.
The same goes for the rest of the developed world governments, where big economies such as Britain, Japan and Spain are among those at risk of fiscal crises of their own.
"Sooner or later, one of these large governments is going to cause some things that we don't want to hear about," said Adrian Mastracci, a portfolio manager at KCM Wealth Management in Vancouver. "The political risk, the borrowing, it's all a worry for the long-term health of the economy."
The struggles of debt-laden Greece demonstrate the threat to the wider economy. The euro, of which Greece is a member, fell yesterday after European Central Bank President Jean-Claude Trichet said in Frankfurt that Greece would be granted no favours. The premium investors demand to buy Greek 2-year notes over comparable German debt rose to 234 basis points, the widest since Dec. 21.
"In response to the financial crisis, many countries are at risk of overextending unsustainable levels of debt, which, in turn, will exert strong upwards pressure on real interest rates," the forum said in its report. "In the final instance, unsustainable debt levels could lead to full-fledged sovereign debt crises."
