x Abu Dhabi, UAESaturday 22 July 2017

A second financial crisis if we don't learn from the last one

US brinkmanship pushes the global economy towards a sovereign debt crisis. And it was all totally unnecessary.

Both the United States and the euro zone seem to be in the grip of a debt crisis that is fast getting out of control. If the debt ceiling is not raised, the US federal government will run out of money and go into default.

Across the Atlantic, the fiscal firestorm that has hit Greece, Ireland and Portugal now threatens to engulf Italy and possibly Spain. Political stalemate in Washington and Brussels is fuelling a sense of panic that will spread to the financial centres of other advanced economies and emerging markets.

Global stock markets are increasingly nervous. In the perpetual struggle between fear and greed, fear got the upper hand last week and investors sought safe options such as commodities or the governments bonds of moderately indebted countries such as Germany. But default in the United States or key euro-zone countries would surely bring about the second economic crash in less than three years.

This is all the more staggering given that this transatlantic debt crisis could have been avoided. The current US stand-off is not just to do with a quirk in the law, requiring congressional approval for the administration to borrow more for programmes that Congress has already mandated.

It is caused by both Republican and Democratic brinkmanship. The Republicans refuse any revenue-generating tax hikes for the wealthy, even though total tax receipts are forecast to be a mere 14.4 per cent of national output in 2011 - compared with 18.2 per cent at the end of Ronald Reagan's term in office in 1988.

For their part, the Democrats rule out cuts to entitlement programmes such as Medicare and Social Security when spending on productive investment is much more pressing in economic terms. Radicalised by the recession, both sides defend sectional interests instead of the public good.

The euro-zone crisis is even more pronounced but no less avoidable. Austerity is strangling structurally weak economies that lack competitiveness and can't devalue their way out of the mess. Perversely, the current strategy is exacerbating the risk of imminent default while subjecting heavily indebted countries to years of deflation and therefore rising debt levels.

The policy of trying to reduce sovereign debt through austerity is backfiring. Greece, Ireland and Portugal are in depression, while the US and UK economies are flat-lining. The proverbial "operation successful, patient dead" seems sadly apposite. Fiat justitia, et pereat mundus - let right be done even if the world perishes - appears to be the motto of the West's deficit hawks. Those who are privately hoping for default must have some apocalyptic death wish.

Crucially, dealing with public deficits and national debt alone won't prevent sovereign default. Unsustainable private and corporate debt levels are just as dangerous. Without radical debt restructuring, another financial meltdown beckons.

Indeed, governments and parliaments across the transatlantic West have failed to address private-sector excesses and systemic market failures. Washington bailed out Wall Street but did not put an end to dangerous financial instruments or the wrong lending practices.

Similarly, the euro-zone governments have let banks off the hook, applying only mild stress tests and failing to recapitalise those that are basically insolvent. The mutual dependence of the private and the public sector is unprecedented. Undercapitalised banks are propping up over-indebted states by buying government bonds. States bail out banks, which raises fiscal deficits and national debt.

As such, the sovereign debt crisis is of a piece with the banking crisis. Both are depressing economic growth. If the recovery in the West continues to falter, the world economy will be in trouble.

There are fundamental problems. The falling value of assets such as property, in which private and corporate wealth is tied up, harms confidence in the US recovery. Euro-zone banks lack equity and are hugely exposed to toxic assets - whether it is US subprime mortgages or housing bubbles in Spain and Ireland that have burst.

What is required is a grand bargain on private, corporate and national debt, beginning with a general restructuring of debt. Short-term debt at extortionate interest rates needs to be converted into longer-term maturity with affordable interest payments. Default doesn't pay, as it causes losses to already under-capitalised banks and shuts governments out of international money markets. It also exacerbates the falling value of assets on which investment and consumption depend.

Debt restructuring has important historical precedents. The post-1945 Bretton Woods system helped various economies to manage war debts and channel funds into reconstruction. Likewise, the Paris Club - an informal gathering of 19 creditor countries that was first convened in 1956 - has since concluded over 400 agreements with about 80 debtor countries on rescheduling debt repayments in order to ease the burden while avoiding default.

The so-called "Brady bonds" of the late 1980s provide another important example. They enabled banks to reduce exposure to highly indebted Latin American countries, while alleviating the unsustainable interest payments on outstanding national obligations. Debt restructuring works for creditors and debtors, as it puts a floor under the value of assets and thereby helps restore growth without which debt reduction is impossible.

In the United States and Europe, the old, tired ideology of statist left and free-market right is trumping the pursuit of the public good. What is required is a genuine "third way" that combines debt restructuring with a new economic policy that abandons the logic of short-term returns that undermines long-term sustainable development. Nothing less than a grand bargain is necessary to starve off default and depression.


Adrian Pabst is lecturer in politics at the University of Kent, UK, and visiting professor at the Institut d'Etudes Politiques de Lille, France