THE BEAR'S LAIR Which big country will default first?
By Martin Hutchinson
Of the world's six largest economies, three have budget and public debt
positions that if allowed to fester will push those nations into bankruptcy
(the seventh largest, Italy, also has a budget and debt position that is highly
vulnerable, but its problems appear chronic rather than acute).
Given the proclivities of modern politicians for delaying pain and avoiding
problems, it is likely that festering is just what those positions will do. So
which major country, the United States, Japan or Britain, will default first on
its foreign debt?
The other three of the six top economies, Germany, China and
France, appear to have fewer problems but are not out of the woods entirely.
Germany has substantial public debt because of the costs involved in
integrating the former East Germany, but those costs are now mostly past and
the current government is highly disciplined - thus Germany is now the most
stable major economy. France is less disciplined; its debt level is similar to
that of Germany but its budget deficit is much higher, at around 8% of gross
domestic product (GDP) in 2009, according to The Economist forecasting panel.
However, its problems pale in comparison to those of the deficit-ridden trio.
China has huge amounts of hidden debt in its banking system, which could well
collapse, but its direct public debt is small, as is its budget deficit, so it
is unlikely to enter formal default.
The worst budget balance of the three deficit countries is in Britain, where
the forecast budget deficit for calendar 2009 is a staggering 14.5% of GDP.
Furthermore, the Bank of England has been slightly more irresponsible in its
financing mechanisms than even the Federal Reserve, leaving interest rates
above zero but funding fully one third of public spending through direct money
creation. Governor Mervyn King has a reputation in the world's chancelleries as
a conservative man of economic understanding. He doesn't really deserve it,
having been one of the 364 lunatic economists who signed a round-robin to
Margaret Thatcher in 1981 denouncing her economic policies just as they were on
the point of magnificently working, pulling Britain back from what seemed
inevitable catastrophic decline.
King's quiet manner may be more reassuring to skeptics than the arrogance of
"Helicopter Ben" Bernanke, the US Federal Reserve chairman, but the reality of
his policies is little sounder and the economic situation facing him is
distinctly worse.
Britain has two additional problems not shared by the United States and Japan.
First, its economy is in distinctly worse shape. Growth was negative in the
third quarter of 2009, unlike the modest positive growth in the US and the
sharp uptick in Japan. Moreover, whereas US house prices are now at a
reasonable level, in terms of incomes (albeit still perhaps 10% above their
eventual bottom), Britain's house prices are still grossly inflated, possibly
in London even double their appropriate level in terms of income.
The financial services business in Britain is a larger part of the overall
economy than in the US and the absurd exemption from tax for foreigners has
brought a huge disparity between the few foreigners at the top of the City of
London and the unfortunate locals toiling for mere mortal rewards. A recent
story that the housing market for London homes priced above 5 million British
pounds (US$8.3 million) was being reflated by Goldman Sachs bonuses indicates
the problem, and suggests that the further deflation needed in UK housing will
have a major and unpleasant economic effect.
A second British problem not shared by the US is its excessive reliance on
financial services. As detailed in previous columns, this sector has roughly
doubled in the last 30 years as a share of both British and US GDP. In
addition, the sector's vulnerability to a restoration of a properly tight
monetary policy has been enormously increased through its addiction to trading
revenue. The US has many other ways of making a living if its financial
services sector shrinks, and New York is only a modest part of the overall
economy. Britain is horribly over-dependent on financial services, and the
painful if salutary effects of London costs being pushed down to national
levels by a lengthy recession are less likely to be counterbalanced by
exuberant growth elsewhere.
The other question to be answered for all three countries is that of political
will. If, as is certainly the case in Britain, deficits at the current levels
will lead to default (albeit not for some years since the country's public debt
is still quite low), then to avoid default tough decisions must be taken.
Britain is in poor shape in this respect. Its prime minister, Gordon Brown, is
largely responsible for the underlying budget problem, having overspent when
Chancellor of the Exchequer, or finance minister, during the boom years,
largely on added bureaucracy rather than on anything productive or
value-creating. However, the opposition Conservatives, likely to take power
next spring, are led by a center-leftist with a background in public relations
and no discernable backbone or principles.
Britain has a history of such leaders, which it has managed to survive - the
ineffable Harold Macmillan, in particular, who wanted to abolish the stock
exchange and contemplated nationalizing the banks when they raised interest
rates, was a man of outlook and temperament very similar to David Cameron's.
Macmillan was notoriously prone to soft options that postponed economic
problems, firing his entire Treasury team in pursuit of soft options in 1958
and leaving behind an appalling legacy of inflationary bubble on his retirement
in 1963. If Cameron is truly like Macmillan, his government's response to
economic and financial disaster will be one of wriggle rather than
confrontation.
With neither party providing solutions to an economic crisis, the British
public is likely to discover that, unlike in the crisis of 1976, no solutions
will be found. Default (doubtless disguised as with Argentina as
"renegotiation") would in that case inevitably follow.
The United States is in somewhat better shape than Britain. Its deficit is
somewhat lower, at 11.9% of GDP in calendar 2009, although its debt level is
higher if you include the direct debt of mortgage guarantors Fannie Mae and
Freddie Mac, as you should. It also has lower overall levels of public
spending, although spending is rising rapidly. Furthermore, it has a much more
diverse economy and a healthier real estate market, so that further likely
downturns in California and Manhattan real estate and the financial services
sector can be easily overcome.
US pundits like to whine about the impending deficits in social security and
healthcare, but the former is easily overcome by adjusting the retirement age
while the latter could be greatly mitigated by simple cost-containment
measures, such as limiting trial lawyer depredations, making the state pay for
the "emergency room" mandate to treat the indigent and allowing interstate
competition for health insurance. All those changes would be politically
difficult, but they are clearly visible and involve no damaging cuts in vital
services, unlike the changes that would probably be necessary in Britain.
The other US advantage is political: it has an alternative to overspending.
Last Tuesday's election results were a useful shot across the bows of the
overspending consensus that had developed in both the George W Bush and Barack
Obama administrations (as well as among the barons of Congress) since 2007.
Whereas voter concern about spiraling deficits and public spending has no
satisfactory outlet in Britain, it can now express itself clearly in the US,
producing either a sharp change of policy by the current administration and
Congress or a change of administration in 2012. Since the likelihood of a
reversal of policy towards sound budgetary management is greater in the US than
in Britain, the probability of eventual default is less.
Japan has already had its change of government, throwing out the faction of the
Liberal Democrat Party (LDP) that regarded politics as the art of creating
pointless infrastructure. Unfortunately, the Japanese electorate, faced in
August with a no-good-choices problem similar to that of US voters last year
and British voters next spring, replaced a long-serving overspending government
with another committed to a different set of spending priorities rather than to
ending the spending itself. The Democratic Party of Japan (DPJ) has cut back
sharply on the infrastructure "stimulus" but is showing signs of replacing it
with social spending. It is also committed to economically dozy policies such
as reversing postal privatization, organized with such great political effort
by prime minister Junichiro Koizumi in 2005.
Japan does however have a couple of advantages that may enable it to avoid
default. First, its public debt carries very low interest rates, mostly below
2% per annum, and is owned almost entirely by its own citizens. What's more,
state-owned entities such as the now un-privatized Postal Bank lend vast
amounts of money to the government, acting as conduits to the less efficient
bits of the public sector in the same way as do China's state-owned banks. This
is appallingly bad for the efficiency of the economy and for living standards,
but it postpones default and makes it less likely.
Second, it's not inevitable that the LDP's wasteful infrastructure spending
will simply be replaced by wasteful social spending. Finance Minister Hirohisa
Fujii is reputed to be a budgetary hard-liner. Further, at least part of the
DPJ's spending will take the form of handouts to families with children. That
may increase domestic consumption compared with exports and thereby better
balance the Japanese economy, increasing its growth potential marginally.
Nevertheless, since Japan's public debt is currently around 200% of GDP, Japan
is much closer to the default precipice than either the US or Britain. Thus,
while the better structure of Japan's economy and its debt make Japan's
probability of default lower than Britain's, it's likely that if both countries
defaulted, Japan would do so first.
We have not experienced a debt default by a major economy since the 1930s. That
three such defaults are currently conceivable indicates both the severity of
the current downturn and the wrong-headedness of the policies taken to address
it. If it happens, a major sovereign debt default of this kind will cause the
seizure of global capital markets, prolonging downturn for a decade or more.
We'd all better hope the urge for fiscal responsibility hits London, Washington
and Tokyo pretty damn soon.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-09 David W Tice & Associates.)
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