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The Bigger They Are, the Harder They Fall

Investors all over the world are enthusiastic about company earnings, driving stock prices close to their 2007 highs. But are the earnings sustainable taking into account the real situation of the world economy, where the fiscal deficits of most western economies have reached unprecedented levels?

Some think that the recession is over and although the economies are not at their best, the world economy is recovering and the problems are manageable. Others believe that we are only at the beginning of a situation that will end up badly when another financial meltdown pushes the global economy into a Great Depression.

Fiscal budget deficits were not really considered as a large problem by investors and economists before the recent financial crisis, because the sizes of the deficits were in general not very high and interest rates were low.

Today, deficits in many countries have reached record levels due to lower federal revenue from the slower economic activity and significantly higher spending from various government attempts to preserve jobs and to finance the increased unemployment. The result is that most countries are piling up debt. Fast. What used to be an exception by unimportant economies has now become a global phenomenon.

A year ago, Greece encountered acute fiscal problems that led to the creation of EU help mechanisms for the weaker euro-zone economies that were encountering deficits above 10% of the GDP and parallel debt rates close to, or above 100% of GDP. The speculation of which member state would be next to apply for help led to a rally of the US dollar against the euro, as nervous investors sought a safe haven in the American government debt, obviously believing that the weak countries fiscal problems would spread all over Europe.

So far Greece, Ireland and Portugal have been bailed out with the condition that they reduce their deficits from about 10% to around 3% of GDP within a few years only and also gradually reduce their debt to 60% of GDP within a 20 year period. Other countries in the euro-zone, such as Spain, Belgium and Italy also face similar sovereign debt problems. A future bailout of those countries could lead to severe difficulties for the EU to manage the situation, since the amounts required in these cases are much higher compared to the smaller economies already bailed out.

The European approach of dealing with the deficits has been to take measures that gradually reduce the deficits and debt levels without ending the fragile recovery while in the US there is no credible plan to bring the budget deficits under control during the coming years.

The fiscal position of the US federal government (not to mention many states) is very similar to the troubled economies in Europe that has been forced to seek help. The gross federal debt is close to 100% of GDP and the federal deficit is around 10% of GDP. Yes, such a large budget deficit is understandable and acceptable as a short term result of a large financial crisis but the economy has to get back on track as soon as possible. That goes for Greece as well as for the US. The problem is the same. Only the absolute size of the problem differs.

Who is going to finance the US federal fiscal deficit of over $1.5 trillion, considering that the Chinese have been sharply reducing their purchases of Treasuries the past years, the Japanese have their own enormous and increasing deficit to finance, the oil producing Arab countries will be forced to distribute more wealth to their citizens in order to calm them down and the more wealthy Europeans have their own weaklings to take care of.

Although there are not yet any fears expressed about a US default, a clear depreciation of the US dollar against all other major currencies has been noted so far this year, despite the major ongoing geopolitical developments that historically always led to a stronger dollar. This is a clear warning sign that leads us to ask the question. Is US government debt not considered to be a safe haven anymore?

With the Fed soon terminating quantitative easing, that will lead to a slowdown in economic activity and hence an inevitable deterioration of the US deficit, one can only hope for the politicians to be responsible by making the necessary but politically painful adjustments in the budget, starting today. Unfortunately that is not very likely with presidential elections coming up next year.

So far, the Obama administration is relaying on the assumption that yearly real GDP growth for the coming five years will be around 3-3.5% with inflation averaging 1.5%, figuring that deficits will recede as the economy recovers and that the problem should be dealt with when the US and the world economy is in a better shape.

That is a very dangerous assumption and there is absolutely no guarantee that things will happen the way they expect it. Looking at past recessions, it is not all that unusual (8 out of 11 times) for there to be positive GDP quarters in the midst of an ongoing recession. Soaring oil prices and Japans problems following the recent natural disasters could easily cause an economic deterioration of the fragile recovery. Or it could be something else. There is always something else.

At some point the credit rating of the US has to be lowered from today’s triple A, otherwise the impartiality and objectivity of the credit rating agencies will be seriously questioned.

And so the show called “the negative spiral” begins. Higher interest rates, lower growth, higher unemployment and even higher deficits. We have seen the same show in Greece, so we already know the ending. The big difference is that the US economy has the size and the capacity to drag the whole world economy down the drain.

So, I wonder. Will the fiscal crisis that was born in Greece, also the birthplace of western civilization, end up with a funeral of capitalism, in the US?

Source by John Vout


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