Tuesday, June 22, 2010

The Debt Trap; No Way Out

Deficit-Spending and Currency Printing are the Roads to Nowhere

On June 5th, G20 finance ministers made a rather remarkable (and perhaps under-reported) decision to drop their support for fiscal stimulus. Concerns over sovereign debts have raised an urgent need for deficit reduction and trump desires to spur false, government-created economic growth.

The G20 (with the notable exception of the US, UK and Japan) no longer believes that deficit spending is sustainable or effective in fostering an economic recovery. The confidence of a dubious bond market will instead take precedence.

This puts the majority of the G20 at odds with the US, UK and Japan, who are going full steam ahead with their efforts to stoke consumer demand.

As if on cue, Japan's central bank announced it will offer financial institutions up to $33 billion in new lending, while also leaving its key rate unchanged at 0.1%. However, Japan already has an abundance of available liquidity. Yet, it hasn't translated into strong credit growth primarily due to sluggish demand.

What this proves is that you can try to entice people to borrow, but you can't force them.

Japan has been faced with economic stagnation for 20 years and the IMF predicts it could grow by an anemic 2% this year and next. Deficit spending hasn't gotten Japan anywhere, except further into debt.

Japan's debt is nearly 230 percent of its GDP, the highest of any industrialized nation. Yet the Bank of Japan will continue its policy of saddling the nation with even more debt.

Faced with the same concerns about slow economic growth, the US government has been underpinning the economy for more than a year through government stimulus.

And the Federal Reserve will continue its program of expanding the money supply, or "quantitative easing" as it likes to call it.

However, despite an $787 billion federal stimulus program and $2.3 trillion in spending by the Fed, in the past year we've only seen an average of 2.38% growth.

But even the Fed can't force open the wallets of Americans, who are paying down debt and saving at a 3.4% rate. That does not bode well for an economy 70% reliant on consumer spending.

It seems that Japan, the US and the UK have not learned anything from the Greek debt crisis. Greece's debt isn't any bigger now than it was a year ago, it's just that everyone is suddenly paying attention. And Greece's prospects continue to go from bad to worse.

Last week, Moody's lowered Greece's bond ratings by four notches, taking it out of investment grade and into speculative 'junk' status.

The US, UK and Japan should take notice. Yet, these nations are being driven by politics, particularly a fear of how voters will react to economic pain. So the elected officials avoid it at all costs.

As a result, each nation continues to try to prime the economic pump through deficit spending and by printing money out of nothing. After all, under our economic system, if you're not growing you're dying. Stasis equals death. This is a dangerous strategy that will result in a debt trap from which there may be no escape, other than currency devaluation.

That will be very uncomfortable to the citizens of these nations. Their governments know this, and they also know the danger of simply printing money — inflation, or even hyperinflation.

But they seem to fear economic stagnation even more. Without government intervention, these economies certainly won't grow, which will increase their debt-to-GDP ratios. The US and UK, in particular (which have much larger external debts than Japan), need to finance their deficits or risk a dramatic rise in interest rates.

That would only make unemployment worse and risk social unrest.

The reality is that there are no easy options, no good choices. These governments are damned if they print money, damned if they continue deficit spending and — at least in the minds of the central bankers and the political leaders — damned if they don't.

They have entered the debt trap, and there is no way out.

At a minimum, there are only painful choices ahead.

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