Global Economic Crisis

It is the rating agency statement heard across the world, like the first cannon ball fired at Fort Sumter. One of the three iconic ratings agencies, Standard & Poor’s, sent panic waves through global financial market when it issued a statement on the U.S. fiscal situation, changing its previous outlook on the U.S. government’s finances from “stable” to “negative.” However one interprets the latest statement from Standard & Poor’s ( and many Washington cheerleaders claim that the statement is meaningless and America will never default on its debts), the reality is quite clear: not even the “late to the party” rating agencies that previously classified subprime mortgage-backed securities as AAA grade investments can ignore any longer the catastrophic fiscal trajectory of the United States.

In its statement, S&P indicates that if the fiscal crisis in the U.S. remain unresolved, within two years U.S. Treasuries will be downgraded. The statement acknowledges that the American political system is totally dysfunctional, and appears unable to craft a viable plan to restore fiscal sanity to America’s out of control federal government budget. Reading between the lines, and adding my own perspective ( see my report “Global Economic Forecast 2010-2015: Recession Into Depression”) it seems increasingly obvious that save for a miracle, the United States is headed for a fiscal train wreck of calamitous proportion, probably sooner rather than later.

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The weakest links in the Eurozone chain are known as the PIIGS. This acronym represents five fiscally vulnerable members of the European monetary union: Portugal, Ireland, Italy, Greece and Spain. Already, two of the five members of this august club have capitulated to the dismal reality of their public finances and are receiving a Eurozone bailout, which comes from a fund consisting of borrowed money, borrowed that is by slightly less indebted Eurozone partners. Now, it would appear, Portugal is likely to be the third affiliate of the PIIGS to get a bailout.  Portugal’s Prime Minister Jose Socrates has resigned after Lisbon’s parliament rejected his proposed austerity package. Socrates claimed that Portugal did not need financial aid, and could resolve its fiscal problems through its own austerity measures. That hope appears now to have been abandoned, and the expectation is that Lisbon will soon come crawling for a bailout, as the spread on its bonds gets ever wider.

Standard & Poor’s, S & P and Fitch have all severely downgraded their ratings on Portuguese government debt. In the meantime, a new government in Ireland is stating that it wants to negotiate a less severe austerity package than the one accepted by the previous Dublin government in exchange for a Eurozone and IMF bailout. As Portugal wobbles, Ireland confounds while continuing to bankrupt its citizens as the price for bailing out its reckless banks. In the meantime, the Greek economy is deflating, making it ever more likely that Athens will eventually default on its public debt. That still leaves the two biggest PIIGS without a bailout.

After Portugal, Spain is the next likely candidate for the bond vigilantes. The most significant problem with Spain is that it is so much larger an economy than the previous candidates for a bailout, it is unlikely that the Eurozone and its already indebted taxpayers could sustain the massive public borrowing required to rescue Madrid from its own fiscal follies.

The sovereign debt crisis in the Eurozone is spinning out of control. And not far behind in entering  this vortex of doom is the United Kingdom, which despite massive public spending cuts retains an unsustainable deficit as its economy contracts. And then there is the United States, with a national debt now virtually at parity with its annual GDP, and projected  to have a record deficit in the current fiscal year, exceeding ten percent of its annual GDP.

In my book, “Global Economic Forecast 2010-2015: Recession Into Depression,” I predict that by 2012 a massive sovereign debt crisis in the major advanced economies will plunge the world into a global economic depression. All the recent developments regarding fiscal issues in the Eurozone, UK and U.S. do not give me any reason to alter my forecast.

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At a conference in Beijing, the International Monetary Fund’s first deputy managing director, John Lipsy, spoke with alarm over his forecast that average public debt to GDP ratios in all advanced economies would exceed 100 percent during 2011. Lipsky and the IMF issued a blunt warning; these ratios, set for continued expansion with public deficits spiraling out of control, are unsustainable and will lead to critical economic consequences. His views were in opposition to those who supported continued government deficits as vital for stimulating advanced economies, which continue to be plagued by low or negative growth.

The IMF official also said that current low interest rates on sovereign debt cannot be sustained for much longer. Higher interest rates are inevitable, Lipsky indicated. The IMF is clearly worried that a sovereign debt crisis of massive proportions is about to metastasize throughout all advanced economies, having already ravaged Greece and Ireland.

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Japan, now the third largest economy in the world (China has recently assumed the spot of number two) is continuing to accrue worrying economic metrics.  For the first time in nearly two years, export-dependent Japan incurred a trade deficit. According to Tokyo, the nation incurred a $5.7 billion negative trade balance in January. The trade figures, however, were not the only troubling development on  Japan’s economic front.

Moody’s has just lowered Japan’s debt rating from stable to negative. This comes in the wake of Standard & Poor’s downgrading Japanese public debt from AA to AA-.  Japan has the developed world’s highest  ratio of public debt to GDP, a figure approaching 200 percent. These recent developments portend the growing risk of a sovereign debt crisis confronting Tokyo.  A growing number of investment fund managers are warning that the current trajectory of Japan’s public debt and annual government deficits is unsustainable. Could Japan become the Greece and Ireland of the Far East? These negative metrics, in conjunction with Japan’s aging  and declining population, point to a deepening economic and fiscal crisis for the land of the rising sun.

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As the United States national debt reaches parity with total annual GDP, President Barack Obama continues to preside over a record level of deficit spending by the federal government. He has just sent to Congress a proposed $3.73 trillion budget for FY 2012, while forecasting a record $1.65 trillion deficit for the current fiscal year. Earlier, the Congressional Budget Office projected that the current deficit would reach at least $1.5 trillion. These figures mean that America remains trapped with unsustainable structural mega-deficits,  and that more than 40 percent of everything the U.S. federal government spends is financed with borrowed money.

As I have commented on before, this level of government indebtedness just cannot be sustained, and will lead to catastrophic repercussions. While the politicians in Washington, particularly in the Obama administration, pay lip service to the need to “rein in” this profligate public spending, nobody believes that they are serious. The president’s claim that he “plans” to reduce the deficit cumulatively over ten years by just over a trillion dollars is an utter farce, since even by the most optimistic forecasts this would leave a combined deficit over the decade of more than ten trillion dollars.

The problem, however, is not uniquely one of the Obama administration and the Democratic Party. The Republicans, who left for Obama as an inaugural present in 2009 a first-ever annual deficit to exceed a trillion dollars, are as intellectually bankrupt as are their adversaries on the other side of the aisle. The GOP is equally bereft of ideas on how to control this raging fiscal train wreck, offering little more than worn-out cliches such as reducing taxes, as though that would not further exacerbate the federal government’s structural mega-deficit.

What we are witnessing is not only an economic and fiscal calamity in the making. It is as much a display of political dysfunctionality and moral cowardice as it is of inept fiscal policy. Which leads to the melancholy conclusion that it will not be the political echelon in Washington that ultimately  imposes budgetary discipline on public spending. Increasingly likely is a doomsday scenario, in which the bond vigilantes, well practiced already with their punishing assaults on the credit ratings of Greece, Ireland and now Portugal, unleash the full fury of the market place on Uncle Sam. When that fiscally apocalyptic moment arrives, not even the impressive weight of political inertia that resides in Washington DC will be able to impede a sovereign debt crisis in the United States that will not only cripple the nation’s economy with devastating effect; it will likely dispossess the next generation of Americans  of their future.

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In a recent interview with Bloomberg TV, Dr. Nouriel Roubini, one of the foremost economists monitoring the global financial and economic crisis, warns of  grave dangers facing the public budgetary imbalance of the United States. “The fiscal problem is very serious. The bond vigilantes have not yet woken up in the U.S. in the way they have in the Eurozone. Unless the U.S. addresses this fiscal problem, we’re going to see a train wreck.”

Roubini in the past has supported the vast budget deficits of governments and monetary loosening of central banks as a painful but necessary measure by advanced economies to redress the damage resulting form the financial and economic collapse of 2008. Even then, he warned that there was no free lunch, and that policymakers would have to present a credible plan for withdrawing stimulus and monetary easing and curtailing their levels of public debt. Now, with a full-fledged sovereign debt crisis raging in Europe and the U.S. trapped with a structural mega-deficit, Roubini and other perceptive economists are clearly worried about the unsustainable budgetary imbalance of the U.S. federal government. Indeed, a day of reckoning is coming closer, with no cogent remedies on the horizon. It is becoming far more likely that a fiscal train wreck is a future destination for the U.S. economy, and that future may not be long delayed.

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According to the non-partisan Congressional Budget Office, the annual deficit of the United States federal government will reach $1.5 trillion in 2011, a record amount in nominal terms. More alarmingly, the CBO projection exceeds 10 percent of the U.S. GDP for the first time since the onset of the global financial and economic crisis in 2008.

Two things need to be pointed out. The CBO forecast is not a “worst case” scenario but a conservative projection, which may possibly be exceeded. Secondly, this staggering structural mega-deficit follows on the heels of several previous annual U.S. trillion dollar annual deficits, in parallel with similar ratios of government deficit to GDP in many other advanced economies.

The continuing flood of red ink is rapidly hastening a “come to Jesus” moment for many indebted economies, and a catastrophic sovereign debt crisis looks increasingly likely for the United States.

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The massive structural deficit that has overwhelmed California’s legislators is only the most extreme manifestation of a rapidly metastasizing fiscal cancer that is threatening almost all of America’s fifty states with financial insolvency. Illinois and  New York also are in  a fiscal black hole of significant size, however, many small states are in a similar financial jam. The causes are  both recent and longstanding; a convergence of the Great Recession that continues to erode state coffers, and the sustained failure to adequately fund pension programs promised to public employees. The growing danger of  collective state insolvencies is no longer a secret that can be swept under the rug. Witness the front page headline that appeared only days ago in The New York Times, ” State Bankruptcy Option Is Sought.”

As reported in the Times, “ policymakers are working behind the scenes to come up with a way to let states declare bankruptcy and get out from under crushing debts, including the pensions they have promised to retired public workers.” And not just the underfunded state pensions. Bankruptcy, not currently a legal option for state government (though a viable and at times utilized option for counties and municipalities) would allow the virtually insolvent states to inflict a haircut on bondholders. Yet, that option, though on the surface an enticing possibility for desperate state governors and legislators, is a double edged sword. Given how dependent state governments are on the bond market to finance their operations, any hint that bankruptcy might be actively explored by policymakers on the federal level could dry up access to credit for state governments, or at the least drive up yields to a level that guarantees an earlier day of disastrous fiscal reckoning for the states.

In an e-mail exuding panicky agitation,  Bill Lockyer, who serves as California’s Treasurer, stated in response to the New York Times headline story that, “to the folks in Congress cooking this baloney: Don’t bother. States didn’t ask for it. We don’t want it. We don’t need it.”

However, it appears that a growing number of policymakers and politicians on Capitol Hill believe the states do need it. In part, some of the effort stems from Republicans, including possible 2012 presidential hopeful Newt Gingrich.  They believe that creating a legal path to state bankruptcy will punish the labor unions, viewed by the GOP as incorrigibly pro-Democratic. However, there is more to this scenario than party politics.

The fiscal conundrum confronting America’s states is so massive, it is virtually insoluble. States have fiscal restrictions that do not face the federal government; a requirement for a balanced budget, combined with restrictions on taxation, as is the case with California, and no state version of the Federal Reserve to print money or buy up state bonds. The situation is so bad, it threatens to unleash a second financial crisis that would derail even the meager economic recovery the Obama administration claims is underway. This leaves open the possibility of the states coming to Washington for a bailout, presenting the ultimate examples of being “too big to fail.” However, the states are also too big to bail out, which may be the primary driver of the behind-the-scenes exploration by policymakers for a possible structured bankruptcy by the states

What has failed to materialize thus far in these discussion, however, is an even more daunting fiscal challenge facing the federal government. If in fact a scenario was devised that enabled the most financially challenged states to declare bankruptcy and cleanse their balance sheets of obligations to public workers and investors, how much confidence would the bond market retain in the credit worthiness of the U.S. federal government? What is being discussed behind closed doors now in connection with an unsustainable debt burden of the states may be but an interlude before a full-blown sovereign debt crisis strikes directly at Washington, leading to even more apocalyptic reflections by policymakers.

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The savage shooting incident in Arizona over the weekend, in which six people were murdered and many others injured, including a U.S. congresswoman, has brought forth all sorts of political commentary and PR spin in the American media. I don’t wish to add to the partisan debate going on in America over the Tuscon shooting. Instead, I want to point out that the perception of political stability in the U.S. has been the primary factor in enabling Washington to borrow unlimited amounts of credit to finance its profligate budget deficits. It is also a vital factor in enabling the American dollar to hold its value relative to other currencies, despite very weak economic fundamentals.

If the assassination attempt targeting an American politician at a campaign meeting in Tucson, Arizona is the start of a wave of politically motivated violence throughout the United States, that veneer of perceived political stability will evaporate, leaving in its wake a floodtide of investors and bondholders stampeding for the exists. The Arizona shooting incident may, on top of its political significance,  also be a harbinger of economic and financial aftershocks that could prove a final nail on the coffin of America’s so far unhindered ability to borrow money on the global sovereign debt market.  Those who know the American political scene well realize how polarized the U.S. currently is. That, and the easy access to firearms has always made the potential for politically motivated violence a serious possibility. After this weekend’s tragic melee in Arizona, America’s creditors and purchasers of Treasuries can no longer assume  that America’s political stability will prove impervious to a worsening trend of political polarization.

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When  the Obama Administration assumed office in early January 2009, the President’s chosen Secretary of the Treasury, Timothy Geithner, was already on record as estimating that the United States banking sector was in such dire straits resulting from the global financial and economic crisis triggered by the collapse of leading investment banks on Wall Street, it would require $2 trillion in government bailouts to repair the damage. However, once in power, President Obama and Secretary Geithner were reluctant to ask American taxpayers for another handout for Wall Street after the highly unpopular $700 billion TARP bailout. Their response was to rig a series of so-called banking stress tests,  which were completed in the spring of 2009. Only months after the near implosion of the global financial system, Geithner’s stress tests supposedly showed that the U.S. banks were in such excellent shape, only a handful required a measly $75 billion in recapitalization, a sum that could be easily raised through private investors. Never mind that Geithner’s stress tests  incorporated “worst case” unemployment rates that were already eclipsed by the summer of 2009 and other less-than-rigid assumptions. The market seemed to be charmed by Geithner’s charade, attested to by rising equity values of financial firms. Now the Europeans hope they can pull off the same performance.

With much fanfare, the Committee of European Banking Supervisors has announced the results of their own engineered bank stress tests, involving 91 banking institutions in 20 European countries. The architects of this banking Eurofest knew they could not show that all 91 had “passed” the stress tests, as this would simply not be credible even to the most gullible. For that reason, seven banks were selected as sacrificial lambs, and revealed as having failed the stress test, including five relatively minor Spanish banks, as well as the much larger state-owned German property and municipal funding specialist, Hypo Real Estate. This latter financial institution was so heavily weighted with toxic real estate assets, providing it with a passing grade would clearly have given the game away. However, despite the not unclever manipulation engaged in by the Committee of European Banking Supervisors, a growing number of observers and investors have begun to see through this farcical exercise.

Consider this; how valid can a stress test of European banks saturated with government bonds and other long-term public debt instruments really be if the supposed “worst case scenario” envisions no possibility of sovereign debt default in Europe? Only months after Greece was on the verge of public debt default without a massive Eurozone financial bailout, in turn funded by European countries that are themselves becoming increasingly mired in a profound sovereign debt crisis? Neither did the tests consider the possibility of a real estate or commodities crash, despite warnings that, among other dire possibilities, a global commercial real estate crash is increasingly likely.

The authors of this banking stress test would have one believe that not a single UK bank is in danger from worsening economic developments, despite a warning issued by analysts at the Royal Bank of Scotland to senior British policymakers in January 2009, entitled “Living on a Prayer,” which stated that almost the entire banking sector of the United Kingdom was “ technically insolvent.”

In February 2009, the European Union’s own executive branch, the European Commission, issued a confidential report, subsequently leaked to the British newspaper, The Daily Telegraph, which warned that European banks collectively held as much as 18.6 trillion euros in toxic assets. In the past 18 months we have witnessed a massive expansion of public debt  across Europe to fund economic stimulus programs, which has produced at best anaemic or stagnant growth figures, at the price of catastrophic levels of sovereign debt, prompting these same countries to now reverse fiscal policy and revert to budget trimming austerity measures. The likely outcome is clear; a double-dip recession in Europe, in conjunction with a lack of financial capacity by European taxpayers to again bail out their banking system to the same profligate degree that was undertaken after the collapse of Lehman Brothers.

As with Timothy Geithner, the architects of the European banking stress tests hope that  investors and the general public will believe their farce, based on totally unrealistic and overly-optimistic scenarios. In the case of Europe, the fervent desire is that the banks which are rightfully worried about counterparty risk will jettison their well-founded anxieties, and resume interbank-lending and credit flows at pre-crisis levels. However, as the American experience reveals, a banking stress test based on public relations requirements rather than realistic financial and economic modeling may boost the stock price of major banks, justifying  massive bonus payments to banking executives. However, as a solution for the continuing credit crunch and economic turmoil, it is no more than a tragic-comedic farce designed by committee.

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