European Central Bank president Jean-Claude Trichet never comments on what he calls "market behaviour" but it appears he knows a thing or two about market psychology. At a press conference in early December in Frankfurt, shortly after Ireland's bailout and in the thick of a run on Portuguese bonds, he in effect cried "foul!" The euro zone's public finances, he said, are in "much better shape than other big advanced economies."
He rolled out some figures. The euro zone's collective budget deficit, as a per cent of gross domestic product (GDP), will fall from 6.3 per cent in 2010 to 4.6 in 2011. The equivalent 2011 figures for the United States and Japan are 8.9 per cent and 6.4 per cent.
The message: If you think we have debt problems, look across the Atlantic or the Pacific, where budget deficits are out of control, relatively speaking.
Was one of the world's most powerful central bankers trying to deflect attention from the euro zone's debt woes? Or was he predicting a global debt crisis? Perhaps both. So far the debt collapses in Greece and Ireland, and sinking bond prices in Portugal, Spain and Italy, have dominated the debt crisis headlines. But that could easily change in 2011. If it does, Mr. Trichet will be able to take some of the credit, or blame, depending on your point of view.
Indeed, the global debt crisis may have already started. In the first half of December, bond yields of the peripheral euro zone countries - Portugal among them - fell, partly because of aggressive ECB bond buying, while yields on American and Japanese sovereign debt went in the opposite direction. Yields on the U.S. bonds hit a two-year high on Dec. 7 and Dec. 8, with 10-year Treasuries reaching 3.33 per cent at one point, up from 2.94 per cent. Bond investors were reacting to the extension of the Bush tax cuts, including the payroll tax holiday, which is expected to boost growth at the expense of slathering an extra $1-trillion (U.S.) onto the already burgeoning U.S. deficit over the next two years.
Certainly the view within the 16-country euro zone (soon to be 17, with the addition of Estonia) is that Greece, which took a €110-billion ($146-billion) bailout in May from the European Union and the International Monetary Fund, and Ireland, which took €85-billion in December, were merely the start of a far more dangerous debt problem, one that may become global as tepid growth, high unemployment, waning tax revenues and the cost of bank rescues and stimulus programs drive up deficits and debt loads. A member of the ECB's executive board, who did not want to be identified, called the euro zone's debt problems a "wake-up call for politicians everywhere," adding that "this is a global problem."
Others agree. In their 2011 outlook, Morgan Stanley economists said: "We continue to think that a spreading of the sovereign debt crisis constitutes the main downside risk to our otherwise constructive global outlook." Citigroup had a similar view.
Greece and Ireland account for a mere 5 per cent of the euro zone's economic output and look at the damage this un-dynamic duo inflicted on Europe. The euro plunged in the spring, yields rose throughout the euro zone, two bailouts were launched and confidence cracked in the great euro project. Since Greece buried its snout in the bailout trough, there have been endless predictions from economists and investors that the common currency, only 12 years old, might not survive its teenage years.
Now imagine the damage a debt crisis in the United States and Japan could cause. The two biggies are often cited as debt victims in the making. Developing countries, because of their high growth rates and young populations, are unlikely to get hit, economists say.
The United States and Japan are vulnerable because investors are not convinced that either country is serious about tackling its budget deficit and public debt load. With a debt-to-GDP ratio of 200 per cent, Japan is already the world's most indebted country and could see its debt rise to an extraordinary 250 per cent by 2015, according to the IMF.
So far, Japan's perennially high debts have not caused financing turmoil. But it may be playing a risky game. The government has enough cash flow to service is debts. Whether it will down the road, as growth wanes and the ratio of the working-to-retired population drops relentlessly, is an open question.
Japan's GDP growth is estimated at a healthy 3.5 per cent in 2010, but is expected to fall to less than half that in 2011, then rise marginally a year later to 1.7 per cent. In its autumn economic forecast, the European Commission said investors could "lose confidence in [Japan's]long-term fiscal sustainability" if long-term interest rates were to rise suddenly.
In the United States, the public debt load, at 60 per cent of GDP, is rising as deficits explode. Under current policy, including the extension of the Bush tax cuts, the debt is forecast to reach 100 per cent shortly after 2020, according to the U.S. Congressional Budget Office. Traditionally, rising American debt loads have not troubled economists, because of the country's flexible work force, vast intellectual capital and ability to use innovation to reinvent its economy to create new wealth and jobs.
This recovery, such as it is, may be different. Unemployment in the United States, at 9.6 per cent in 2010, is forecast to remain stubbornly high for at least the next two years. Spiralling health care costs, an ugly housing market, weak GDP growth and widening deficits at the state level are making the American debt hole deeper.
At the moment, the United States government can borrow 10-year money at the bargain rate of 3.4 per cent. Americans would be wrong to think that investors won't eventually punish them for the government's rising debt load in the absence of compelling growth. Nor should they assume a debt crisis will come with ample warning. Ireland's debt problems, though well-known since 2009, were largely and mysteriously ignored until November, when bond yields soared. Less than a month later, Ireland required a bailout.
Eric Reguly