Fifth, the socialization of private losses and debt implies a sharp rise in public debt burdens. In the U.S. alone, the CBO estimates that the public debt-to-GDP ratio will rise from 40% to 80%, or about $9 trillion. If long-term rates then increase to 5%, the resulting increase in the interest rate bill alone would be about $450 billion, or 3% of GDP.
The fiscal primary surplus will have to be permanently increased by 3% of GDP (via an increase in taxes or cuts in government spending) to prevent an unsustainable Ponzi increase in the stock of public debt as a share of GDP. The burden of trillions of dollars of additional public debt in the advanced economies will be a medium-term drag on growth. High debt levels may be financed only with default (an option that advanced economies have not followed in recent decades), a capital levy on wealth, and use of the inflation tax to wipe out the real value of public debt--or a painful increase in regular taxes, or reduction in government spending.Rising government debt ratios will eventually lead to increases of real interest rates that may crowd out private spending and may even lead to a sovereign refinancing/default risk. Indeed, sovereign risk that was until recently limited to emerging-market economies is now on the rise in advanced economies, especially those in the Eurozone.
If one rules out defaults and the inflation tax as options--since their costs in advanced economies would be serious--a painful process of increases in taxes and reduction in government spending may reduce the rate of economic growth over the medium term (2010 and beyond). Such fiscal adjustment may be necessary to ensure medium-term debt sustainability, but its immediate effect would lead to a reduction in private and public aggregate demand. So it will be a drag on economic growth over the medium term.
Sixth, the massive monetization of fiscal deficits that has been pursued by central banks this year is not yet inflationary, as there are massive deflationary forces at work in the world. But if central banks don't find a clear exit strategy from very easy monetary policies that have led to the doubling or tripling of the monetary base in the U.S. alone, eventually inflation and/or another dangerous asset and credit bubble will ensue when the global economy gets out of this severe recession. And some of the recent rise in equity, commodity and other risky asset prices is already clearly liquidity driven, rather than being fully justified by the improving economic fundamentals.
Inflation may indeed become the path of least resistance for policymakers, as it is easier to run the printing presses and cause inflation than it is to implement politically difficult tax increases or spending cuts. But inflation is not a cheap solution to high public debt and the debt-deflation problems of the private sector. If central banks were to allow the inflation genie out of the bottle, at some point a painful Volcker-style recessionary disinflation policy would have to be implemented to break the back of inflation expectations.
Seventh, employment is still sharply falling in the U.S. and other economies. According to the OECD, the unemployment rate in advanced economies will be close to 10% by 2010. And low medium-term growth will only lead to a slowly falling unemployment rate once the recession is over. Years of high and rising unemployment rates have corrosive effects on growth. Chronically unemployed workers lose skills and human capital, and they become less employable.
High unemployment rates are associated with lower incomes, lower consumption spending and thus lower growth. The ability of households to service their high debts is corroded by high unemployment rates and sluggish income growth. Default rates and recovery rates on a variety of bank assets--mortgages, credit cards, student and auto loans--are highly correlated to the unemployment rate. And the pressures that globalization, technology and trade are putting on real wages will remain a challenge.
Eighth, for the last decade the U.S. and a few other deficit countries have been the consumers of first and last resort, spending more than their income and running large current-account deficits. Meanwhile, China, Germany, Japan, most of Asia and most emerging markets (with the exception of emerging Europe) have been the producers of first and last resort, spending less than their income, running large current-account surpluses, and thus relying on the demand of deficit countries for their growth. But this system of imbalances is now challenged, as the consumers in the deficit countries need to consume and import less. And for deficit countries to be able to go back to their potential growth while domestic demand is falling relative to GDP, they will need net exports to improve over time.
The resulting reduction of global current-account imbalances implies that the current-account deficits of the overspending countries will lead to a reduction of the current-account surpluses in the over-saving countries. But if net exports shrink in surplus countries, they can go back to their potential growth rate only if domestic demand rises faster than GDP. But if it does not, the resulting lack of global aggregate demand relative to supply will lead to a weaker recovery of global growth.
Ninth, while the rising role of government is necessary to prevent severe recession from spiraling into near-depression, mistaken public policies may lead to sub-par growth for years to come. Think of trade protectionism and its potential costs; think of financial protectionism and its likely restrictions to foreign direct investment. Think of rising public debts and deficits leading to higher real rates and the need to raise distortionary taxes to avoid debt-sustainability problems. Think of the effect that greater necessary regulation and supervision of financial institutions will have on credit growth, which will remain limited for a long time. Think of the greater degree of government intervention in economic affairs and the risk that this intervention will distort private-sector development and growth.
Tenth, there is a real risk that we may also observe a significant fall in potential growth in advanced economies. This could be the result of several factors: first, of demographic trends, such as aging. Second, of a reduction in the rate of human capital accumulation as long-term unemployed workers lose skills, younger unemployed workers do not acquire on-the-job training and there is lower investment in education and training. Third, several years of sub-par capital expenditure and capital accumulation will reduce trend productivity growth. Fourth, the crowding-out effect on the private sector of public-sector deficit and rising real interest rates on public debt will imply less growth. Fifth, a lot of the growth of the last decade in deficit countries was artificial and driven by excessive borrowing, leveraging and overspending.
In conclusion, several medium-term yellow weeds may constrain the ability of the global economy to return to sustained high growth. Unless structural weaknesses are resolved, the global economy may grow in 2010-11 at a rate well below its potential--and even experience a reduction of its potential growth.
p/s photo: Francine Roosenda