Lighting the Global Debt Fuse

In a recent commentary I discussed the pending sovereign debt crisis gripping several countries around the world. Unprecedented peace time fiscal stimulus have given rise to rapidly accumulating government debt, thus weakening the fiscal position of several European countries, including the United Kingdom. A similar development is taking place here. This shows just how precarious the “rescue” programs by the United States and other industrial countries have been in achieving actual, sound economic recovery:

Surging debt will create conditions that make it harder for the economy to grow. At the same time, monetary and fiscal stimulus on a level never seen before in peacetime needs to be unwound through monetary and fiscal exit strategies. So far, the proposed exits in the United States — Obama’s budget forecast and Bernanke’s announced exit measures — don’t even come close to tackling the immense troubles ahead.

The exit strategies come with several pitfalls. Not the least is that, if enacted too soon, they could set off another downturn, and if enacted too late, they would lead to ever more unmanageable debt burdens, fiscal crises, and low growth. This is the precarious position in which the economy will find itself when put on short-term life-support by the government; economic expectations get intimately tied to government actions. This creates a lose-lose situation in which, whatever the government does, the likelihood of another economic crisis increases by the day.

The managing director of the International Monetary Fund, Dominic Strauss-Kahn, said at the recently held World Economic Forum in Davos, Switzerland, “If we exit too late … it’s a waste of resources, it’s bad policy, it’s increasing public debt, we should avoid this … But if you exit too early, then the risks are much bigger” as this could lead to a “double dip” recession.

Strauss-Khan has been a leading advocate for massive fiscal stimulus, launching this idea at the World Economic Forum two years ago. However, recent developments have clearly demonstrated that, to quote Niall Ferguson, “there is no such thing as a Keynesian free lunch.” In his view, the effects of the stimulus have been much more moderate than expected, and “explosions of public debt incur bills that fall due much sooner than we expect.”

In other words, the day of reckoning is already upon us, at least for the PIGS, and it is moving closer by the day for the United States and the United Kingdom.

If, on the other side, the authorities of major economies decide to start tightening both fiscal and monetary policy, this could very well trigger a new downturn, the much-dreaded double dip. And if that happens, policymakers have exhausted most of their tools besides monetizing public debt through the central bank’s printing press. To do so would be to follow the path of countries like Argentina and Weimar Germany. This is a scenario that should be avoided at all costs.

Read the full story here.