The Mother of All Debt Crises



The global economic meltdown is bad news for Indian exporters but the fuel import bill could see significant savings thanks to cheaper oil

Nitin Desai

Another headache The impact of downgrading the US debt will resonate beyond the stock market
Another headache The impact of downgrading the US debt will resonate beyond the stock market
Photo: AFP

“What is safe if Rome perishes?”
Saint Jerome

THE NORTH Atlantic economy of US, Canada and Europe is in a state of crisis. The downgrade of US debt and heightened uncertainties about the solvency of some Eurozone governments is the sixth in a sequence of global debt crises that started with the Latin America in the early 1980s. But this is the mother of all such crises as it involves two key international currencies and financial assets held by central bankers and, directly or indirectly, by savers the world over.

The immediate consequence of the crisis, as always, is the sharp fall in stock markets the world over and the usual newspaper stories about the billions wiped out from the wealth of some country or individual. What we ought to talk about are the persistent imbalances in the global economy that have led to this crisis and their long-term impact.

What is the problem in the United States?
In the short term, the US economy needs a growth stimulus because the 2008 mortgage debt crisis led to a much more persistent weakness in demand than anticipated. Households held back spending as they tried to rebuild their solvency. Faced by this weakness in demand growth, corporations held back on investment spending. In this situation it is truly perverse to impose short-term spending cuts amounting to a government demand reduction of about 2 percent, which is what the Obama-Congress debt deal does.

In the medium term, the US budget needs a major rebalancing exercise as entitlement spending on Medicare and pensions escalates and worsens the deficit. In fact, Standard & Poor downgraded US sovereign debt because of their assessment that this medium-term worsening could lead to US government debt reaching 85 percent of GDP. Yet the Obama-Congress debt deal fails altogether to address this medium-term challenge.

Frankly, the US Congress has descended to a new depth of irresponsibility and this political failure should be sufficient for a measure of caution on the future of the dollar. How long will the world repose confidence in a currency buffeted by such political storms? What if China, which holds $1.2 trillion of dollar treasury bills, decides to cash out?

And what about Europe?
The situation in Europe is as bad. When the euro was established as a new currency at the turn of the millennium, there were many who argued that a single currency was not viable without a single fiscal policy. Otherwise an individual government of a country with a weak economy could happily overspend, issue euro-denominated sovereign debt and count on the major euro countries like Germany and France to bail it out. This is more or less what happened with Greece, Portugal and Ireland. But now the crisis of confidence involves two big economies, Italy and Spain, and the rescue options are much more painful.

In a way, the failure here too is political. European unification has been based on the double-think that national sovereignty and regional integration can be made compatible. This has led to an unwieldy institutional structure of coordination and decision- making that ensures that mandates for effective action come months after they are needed. We are seeing this now in the delays in the expansion of the Stabilisation Fund that is necessary to protect the sovereign debt of Spain and Italy. In the world of finance, where funds move quite literally at the speed of light, this tardiness is suicide.

What are the global imbalances that have led to this pretty pass?
The most important imbalance is in the strange economic relationship between the US and China. The US runs a huge budget and this overspending leads to a balance of payment deficit that reflects massive low-cost imports from China that help to keep inflation at bay and large investments by US companies in China to make this possible. China, in turn holds on to its accumulating dollars, which amounts to lending them back to the US. This strange relationship allowed the US government to postpone fiscal adjustments to balance spending and revenue and thereby brought about the derating crisis that is upon us.

Another more subtle imbalance is in the European Union, which provides a non-discriminating home for a hugely successful German economy, moderately viable economies in other parts of the Eurozone in North Europe and substantially profligate economies, mainly in Southern Europe. When good apples and bad apples are all packed together, then sooner or later the whole basket turns rotten.

How will these upheavals affect us in India?
The global crisis will mean slower growth, perhaps even a recession in the North Atlantic economy that still accounts for two-thirds or more of global consumer demand. This will affect India’s exports, which have been booming of late. The silver lining may be the possible fall in commodity prices because of slower growth in the rich economies and perhaps also in China whose growth depends heavily on these markets. A $10 fall in the per barrel crude price can save us $8 billion and insulate us partially from a reduction in capital inflows. But the real problem is that all this will come at a time when the domestic environment for growth is not very favourable.

India’s problems are local, not global — and that, curiously, is some reason for hope

The finance minster and others have argued that the India growth story is intact. This is questionable. The high growth that we have seen since 2004 has been driven by a phenomenal growth in corporate profits, savings and investment. This growth has ground to a halt and the mood in the corporate sector is quite pessimistic. Investments are held up partly by regulatory bottlenecks but also by a growing sense of uncertainty about the short and medium-term growth environment. We are going to see more of this unless the government comes up with some spectacularly exciting reform announcements.

Inflation is the other problem and seems to be the government’s priority at the moment. The RBI’s aggressive interest rate policy addresses demand pressures leading to inflation. But is that the problem right now? Profit margins in the corporate sector are under pressure, suggesting that cost increases can no longer be passed on to consumers.

Food inflation and the impact of international commodity price increases are clearly supply-side factors and the latter is already showing signs of abating. If that is the case, then the RBI’s aggressive interest rate policy may do little to control inflation and simply add to the pressures that are holding back domestic investment.

Our problems are local, not global — and that, curiously, is some reason for hope.

What could be the long-term impact?
The long-term consequences are uncertain. The North Atlantic economy runs the risk of being caught in a catatonic coma by politics driven by right-wing zealots and a dysfunctional financial system that requires strong public intervention. Something similar happened to Japan when it was hit by its own financial crisis some 20 years ago.

The developing world, India included, will be able to grow into prosperity even with a stagnant West. They already account for half of the global accumulation of productive assets, three quarters of the steel consumption, half the car sales and more than three-quarters of the mobile phone connections added. They will depend less on the West and more on each other’s market. A buoyant economy will provide the room for creativity that will close the technology gap.

So even if Rome perishes, we will survive.

Nitin Desai is Former Chief Economic Adviser, Finance Ministry.


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