Bad Government Credit Puts World Economy in Peril

Over the past 5-6 years Europe’s welfare states have been trying to defend their big spending programs with increased borrowing. America has been doing the same, only over a much longer period of time. Instead of scaling back spending and reforming away their fiscally unsustainable welfare states, countries like Greece, Spain, Italy, Portugal and the United States have kept on spending even as they ran out of taxpayers’ money. Believing their credit lines were infinite, lawmakers on both sides of the Atlantic thought they had found the perfect formula: spend today and let the grand kids borrow to pay the bill.

That is not working anymore. Several European countries have already been downgraded – Greek treasury bonds are virtually of junk bond quality, Spain is paying in excess of seven percent interest to sell any treasuries – and America has suffered its first-ever downgrade. It is slowly dawning on legislators all over the industrialized world that their spend-as-you-go policies are coming home to roost. Fitch Ratings, a financial analysis corporation, has published an excellent report on the negative trend in government credit rating (free membership required). Their three main findings:

The return of financial tensions in Q212, private-sector deleveraging, sizeable fiscal austerity measures in several member states and declining confidence are weighing heavily on shortterm growth. Risks are skewed to the downside.

This means that anyone who has any money to invest will be holding on to that cash much harder than the economy needs. As economist Paul Davidson put it: “in times of uncertainty, he who hesitates is saved to make a decision another day”. This means less investments, but also less consumer spending. Both these variables will have a dampening effect on macroeconomic activity, especially in Europe but also here in the United States.

The weak US recovery reflects the gradual rebalancing of the  economy, such as the unwinding of excessive household debt and the housing market correction, rather than a permanent downshift in the growth rate of the economy. Risks include uncertainty regarding fiscal policy and the diminished capacity for significant fiscal and monetary policy stimulus.

In other words, the federal government is running out of credit. Its ability to spend obliviously is rapidly weakening. The only other immediate revenue alternative, tax increases, is a toxic proposition for two reasons: this is an election year, and higher taxes always have a negative impact on economic activity. The only remaining option is to cut spending.

The universe of highest grade ratings continues to shrink, with all eight global sectors experiencing reductions since the end of 2010. The sharpest decline occurred in international public finance, where eurozone sovereign downgrades had a negative knock-on effect and the high-grade rating segment halved to 26%. For other sectors, the reduction was in the single-digit percentage point range.

This is a very interesting and important observation. For at least the past century, government treasury bonds have been considered the safest investment opportunity out there. This has been true especially for European and American treasury bonds. As the welfare-state crisis advances like a fiscal bonfire across the European continent, U.S. Congress is absolutely deadlocked over the federal deficit and what to do about it. Having been downgraded already once, America cannot afford another downgrading.

Neither can the world’s banks. They are the ones who have to take the beating when government bonds are downgraded. That automatically exposes them to higher risk, in times when safe-haven private-sector investments are few and far between. Fitch Ratings hint at the profound nature of this problem: as the universe of prime-credit borrowers on the world’s financial markets shrinks, more and more liquidity will be sitting like dead weight in the world’s banking system. As banks find themselves with more and more liquidity on hand, and less and less earnings, they will be pushed toward a disastrous point where there is nowhere to go.

Unless banks can start making money in a safe, low-risk fashion, they will not help pull us out of the deep recession. They have been deprived of some of the opportunity to make money safely by fiscally reckless governments, out to protect their pet political projects: the welfare states.

There is no easy way out of this crisis. The only solution is a tough one: do away with the welfare state, liberate the private sector of stifling regulations and burdensome taxes – and let people go about their business as they see fit. That way, and that way only, can we revive the global economy. Until we do that, though, we will edge closer and closer to a very dangerous global economic crisis.