What is the Deficit Endgame?

No one yet has any idea about when the global financial crisis will end, but one thing is certain:
Government budgets deficits are headed into the stratosphere.

What may happen?

• Although governments may try to cram public debt down the throats of local savers (by using, for example, their rising influence over banks to force them to hold a disproportionate quantity of government paper), they will eventually find themselves having to pay much higher interest rates as well. Within a couple years, interest rates on long-term US Treasury notes could easily rise 3-4%, with interest rates on other governments’ paper rising as much, or more.
• Interest rates will rise to compensate investors both for having to accept a larger share of government bonds in their portfolio and for an increasing risk that governments will be tempted to inflate away the value of their debts, or even default.
  

“In research we have done on the history of financial crisis, we find that public debt typically doubles, even adjusting for inflation, in the three years following a crisis. Many nations, large and small, are now well on the way to meeting this projection.”

Scenario: China
China’s government has clearly indicated that it will use any means necessary to backstop growth In the face of a free fall in exports. How? It has $2 trillion in hard currency reserves to back up their promise.
China’s claim that its GDP grew at a 6% rate, during the end of last year, is suspect. Exports have collapsed throughout Asia, including Korea, Japan, and Singapore. Arguably India, and to a lesser extent Brazil, have been holding out a bit better. But few emerging markets have reached a stage at which they can withstand a sustained collapse in the developed economies, much less serve as substitute engines of global growth.

Scenario: United States of America
US long-term growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution.
President Barack Obama’s new budget calls for a stunning $1.75 trillion deficit in the United States, a multiple of the previous record. Even those countries that are not actively engaged in a fiscal orgy are seeing their surplus collapse and their deficits soar, mainly in the face of falling tax revenues. Income in the US and euro- area both appear to have declined at an annualized rate of roughly 6% in the fourth quarter of 2008; Japan’s GDP fell at perhaps twice that rate.

Scenario: Europe
Countries with European-style growth rates could handle debt obligations of 60% of GDP when interest rates were low. But, with debts in many countries raising to 80% or 90% of GDP, and with today’s low interest rates clearly a temporary phenomenon, trouble is brewing. Many of the countries that are piling on massive quantities of debt to bail out their banks have only tepid medium term growth prospects, raising real questions of solvency and sustainability.
Italy, for example with a debt-to-income ratio already exceeding 100% has been able to manage so far thanks to falling global rates. But as debts mount, and global interest rates rise, investors will become rightly nervous about the risk of debt restructuring. Other countries, such as Ireland, UK, and the US, started with a much stronger fiscal position, but may not be much better off when the smoke clears.

Scenario: India
Prime Minister Manmohan Singh’s tax cuts and extra spending plans will widen the budget deficit to 6 percent of gross domestic product in the year ending March 31 from a target of 2.5 percent. That will force the government to borrow a record 3.62 trillion rupees ($71 billion) next year. Indian government debt is the equivalent of 80 percent of the nation’s GDP.

Exchange rates: A wild card
Exchange rates are another wild card. Asian central banks are still nervously clinging to the dollar. But with the US printing debt and money like it is going out of style, it would appear the euro is set to appreciate against the dollar two or three years down the road.

Outlook

• With the credit crisis still making it difficult for many small and medium-size businesses to obtain even the minimal level of financing necessary to maintain inventories and conduct trade, global GDP is on a precipice in 2009. There is a real possibility that global growth will register its first contraction since World War 2.
• As debt mounts and the recession lingers, we are surely going to see a number of governments trying to lighten their load through financial repression, higher inflation, partial default, or a combinations of all three. Unfortunately, the endgame to the great recession of the 2000’s will not be a pretty picture.
• In all likelihood, as slew of countries will see output declines of 4-5% in 2009, with some having true depression level drops, of 10% or more. Worse yet, unless financial systems spring back, growth could disappoint for years to come, especially in ‘ground zero’ countries such as the US,UK, Ireland and Spain.