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Global Economy Warning of an Imminent Stall

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The most likely outcome is a protracted period of low, slow growth. The best case is a slow decline in living standards and wealth as the excesses of the past are paid for.

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The Global Economy's "Stick Shaker Moment"

Powered flight requires air to flow smoothly over the wing at a certain speed. Erratic or slow air flow can cause a plane to stall. Most modern aircraft are fitted with a "stick shaker" -- a mechanical device that rapidly and noisily vibrates the control yoke or "stick" of an aircraft to warn the pilot of an imminent stall.

The global economy, too, needs air flow -- smooth, steady and strong growth. Unfortunately, the global economy's stick shaker is vibrating violently.

The GFC Was Never Really Over


The proximate cause of recent volatility is the continuation of Europe's debt problems. The deeper cause is the realization that future growth will be low and the lack of policy options.

In 2008, panicked governments and central banks injected massive amounts of money into the economy, in the form of government spending, tax concessions, ultra low interest rates and "non-conventional" monetary strategies – code for printing money. The actions did stave off the Great Depression 2.0 temporarily, converting it into a deep recession – the US economy shrank by 8.9% in 2008.

As individuals and companies reduced debt as banks cut off the supply of credit, governments increased their borrowing propping up demand to keep the game going for a little longer. The actions bought time. But policy makers did not use the time to prepare the global economy for an orderly reduction of debt. There was little attempt to address structural problems, such as persistent trade imbalances between China and the US or within Europe or the role of the US dollar as the global reserve currency.

Governments gambled on a return to growth, solving all the problems. That bet has failed.


Patient Zero


Greece was always going to be Patient Zero in the global sovereign crisis, highlighting deep-seated problems in public finances of developed nations. While the deep economic contraction was a factor, government financial problems were structural. Much of the build-up in government debt had taken place before the crisis as a result of spending financed by increased borrowing.

Like individuals and companies, governments did not always use borrowed money for productive purposes, fueling consumption and making poor investments. Realizing that many European governments had too much debt that couldn't be repaid, investors pushed up the cost of borrowing and then cut of access to funding.

Instead of treating the situation as a solvency problem and reducing the debt to sustainable levels, stronger countries within the European Union banded together to lend the distressed countries the money they needed. Within a period of about 12 months, Greece, Ireland and Portugal needed bailouts totaling just under Euro 400 billion. Many European banks, exposed to these borrowers, also lost access to commercial funding becoming reliant on European Central Bank ("ECB") loans. The need to guarantee the weaker countries inevitably increased the liabilities of the stronger countries, weakening them.

Greece, Ireland and Portugal will need debt restructuring. Spain and Italy are now firmly in the sights of markets. The bailout strategy cannot continue without affecting the creditworthiness of France and Germany. In the absence of continuing bailout, the European banking system, including the ECB itself, is vulnerable and will need capital from governments – economic catch 22!

Going Viral

The sovereign debt problem is global. The US, Japan and others also owe more than they can repay.

The recent rating downgrade of the US should not distract from the real issue – the quantum of US government debt and the ongoing ability to finance America. US government debt currently totals over $14 trillion.

Commentator David Rosenberg passionately described the problem:

"In the past three years…we had the U.S. public debt explode by $5 trillion- the country is 244 years old and over one-third of the national debt has been created in just the past three years. Incredible. The U.S. government now spends $1.60 in goods and services for every dollar it is taking in with respect to revenues which is unheard of - this ratio never got much above $1.20, not even during the previous severe economic setbacks in the early 1980s and early 1990s."

America has been able to run large budget and balance of payments deficits because it had no problems in finding investors in US treasury securities because of the special status of the US dollar as global reserve currency. In recent years, the Federal Reserve itself also purchased around 70% of issues, under its quantitative easing programs. As foreign investors, especially China, become increasingly skeptical about the ability of the US to get its economy into order, the ability of America to finance itself is not assured.

Japan's government debt to Gross Domestic Product ("GDP") is over 200%. Tax revenues are less than half its outgoings, the remainder must be borrowed. The world's largest saving pool has allowed Japan to manage till now. An aging population and a related slowing in its saving pool will make it increasingly difficult for Japan to finance itself in the future.

China's headline debt to GDP ratio of 17% (around $1 trillion) is misleading. If local governments, its state controlled banks, state owned enterprise, and other government supported debt are included, then debt levels increase to 60% ($3.5 trillion), compared to America's 93% of GDP. Some commentators argue that China's real level of debt is far higher in reality, well above 100%.

At best, governments will cut spending or raise taxes to stabilize government debt as public-sector solvency becomes the priority. Reduction in government spending will slow growth, making the task of regaining control of government finances more difficult. This may require deeper cuts in governments spending and ever higher taxes, miring the developed world in low growth for a protracted period.

At worst, some governments overwhelmed by their debts will default, causing a major disruption in financial markets, perhaps setting off a deep global recession.
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