A WORLD OF DEBT:
Every human being on earth currently carries a debt burden of nearly $22,733 on average, if the latest reports are to be believed.
Every child is sharing the same debt burden at birth, as debt growth rates beat the global population growth rate. In fact, debt liabilities are growing faster than GDP expansion rates.
Overall outstanding debt worldwide has more than doubled in the past ten years to $158 trillion (Dh580 trillion) in 2010, up from $78 trillion in 2000, according to a recent report by global consultancy McKinsey.
The global population is currently estimated at 6.95 billion, whereas worldwide gross domestic product (GDP) reached $74.54 trillion last year.
This translates to a per capita GDP of $10,500, which is less than half of the per capita debt burden of $22,733.
In theory, this makes the human population a ‘bankrupt’ race and financially the most dangerously exposed and vulnerable in its history.
If you think this is bad, then wait for the worst news: The debt toll is rising and it will be higher next year.
The global debt trap
The global debt of $158 trillion includes $41.1 trillion incurred by governments worldwide up to last year, accounting for 69 per cent of global GDP. This is expected to rise to $46.12 trillion in 2012, according to the Economist Intelligence Unit (EIU).
“Debt also grew faster than GDP over this period, with the ratio of global debt to world GDP increasing from 218 per cent in 2000 to 266 per cent in 2010,” McKinsey said.
Around $48 trillion of the total debt outstanding was that of governments and financial institutions. In both the US and Western Europe in 2010, the ratio of public debt stood at more than 70 per cent of the GDP, McKinsey said.
“Developed countries may need to undergo years of spending cuts and higher taxes in order to get their fiscal houses in order,” it added.
Many governments in the developed world have resorted to massive stimulus measures to bolster their economies since the 2008 global financial meltdown.
“Public debt outstanding [measured as marketable government debt securities] stood at $41.1 trillion at the end of 2010, an increase of nearly $25 trillion since 2000. This was equivalent to 69 per cent of global GDP, or 23 percentage points higher than in 2000. In just the past two years, public debt has grown by $9.4 trillion — or 13 percentage points of GDP,” McKinsey said.
The government debt worldwide was $31.7 trillion in 2008. Last year alone, government debt accounted for about 80 per cent of the overall growth in total outstanding debt.
World governments owe the money to their own citizens and lenders. The rising total debt is important for two reasons.
First, when debt rises faster than economic output (as it has been doing in recent years), higher government debt implies more state interference in the economy and higher taxes in the future, EIU explains in its global debt clock — which is ticking every second.
“Second, debt must be rolled over at regular intervals. This creates a recurring popularity test for individual governments, rather as reality TV show contestants face a public phone vote every week,” it says.
“Fail that vote, as the Greek government did in early 2010, and the country can be plunged into imminent crisis. So the higher the global government debt total, the greater the risk of fiscal crisis, and the bigger the economic impact such crises will have.”
Greece, Ireland, Portugal, Spain, the UK and the US are caught in a debt trap. For some governments, the only escape is to do the same things that an average household must do when it can’t make ends meet — sell off assets, slash spending, scrape for extra earnings, downsize, and make sacrifices.
They are cutting healthcare and pensions for millions of citizens, laying off hundreds of thousands of government employees, or worse. For others, like the US, the primary response so far has been to run the money printing presses — all with untold consequences.
The national debt of the United States — the world’s biggest economy — reached $14.62 trillion in recent months — close to its GDP.
According to the IMF, US public debt will reach 99 per cent of its $14.65 trillion GDP in 2011 and 103 per cent in 2012.
In the United States, debt per citizen is more than double the global average, standing at $46,884, while its burden per taxpayer has reached a whopping $130,662 — according to US Debt Clock.
Born into debt
“Every American born today owes $46,884 to the federal government the day she or he is born. And we are transferring a tremendous amount of debt to the new generation, much of it owed to overseas creditors who expect to be repaid by our children with interest,” US Senator Mark Kirk said recently.
The latest push to raise America’s debt limit of $14.29 trillion by $2.4 trillion earlier this month that placed the country’s policymakers in direct confrontation with opposition politicians — is another example of how difficult things could become. By August 2, a possible US default was creating a worldwide panic.
But how did all this happen?
The US Treasury has borrowed trillions of dollars over the past decade, much of it from foreign investors, to help finance two long wars, rescue its financial system, and promote economic growth through fiscal stimulus.
“The government must be able to issue new debt as long as it continues to run a budget deficit — the current shortfall is about $125 billion per month,” Jonathan Masters, Associate Staff Writer, of Council on Foreign Relations, says. The debt limit was instituted with the Second Liberty Bond Act of 1917, and Congress has raised the cap 74 times since 1962.
“It took the first 204 years of our nation’s history to accumulate $1 trillion in debt. And now we are doing that every two or three years,” Jim Cooper, US Congressman, said.
The Budget Control Act of 2011 of the US now allows up to a $2.4 trillion rise in the debt ceiling (in three tranches), and immediately institutes ten-year discretionary spending caps totalling nearly $1 trillion.
Eurozone — the trouble zone
“In recent months the major areas of uncertainty for the global economy have revolved around the crisis in the Eurozone, the future path of monetary and fiscal policy in the United States, and the fight against inflation in emerging markets,” says Ira Kalish, Director of Global Economics, Deloitte Research. “Failure to resolve these issues will have a negative impact on global growth and stability.”
In its report, Deloitte Research says, despite the problems in the housing market and sovereign debt in Europe, the case for growth in the United States seems to be more compelling at the moment.
“As for Europe, recovery will depend on implementing a permanent solution to the debt crisis. Lowering inflation and steadily increasing average earnings will be key to recovery in the United Kingdom,” it says.
The authorities in Europe and the US must focus on radical structural reform that brings hope to the markets that the debt situation is being seriously tackled, feels Gary Dugan, chief investment officer for Private Banking at Emirates NBD.
“Investors now recognise the Eurozone is at the epicentre of the world’s fears. As the dust settles on problems in the United States [at least for the moment] investors have come to recognise the Eurozone as the weakest link in the global economy,” Dugan says.
“Whilst the United States faces its own problems as an integrated economy it has the ability to address its problems far quicker than the Eurozone. In Europe it is incumbent upon each government to address its problems separately with only mild pressure from the European Central Bank [ECB] or the European parliament.
“Rules that were in place about how much debt a country can have and how much of a budget deficit any country can run in any one particular year have largely been ignored and now lack credibility.”
None of the rules are working anymore, it seems. In fact, the rules of managing economies have changed drastically. Where this will land the human race — no one knows, including bankers and economists.
Market volatility
The last two weeks have been a rollercoaster ride in the markets. Already concerned about signs of economic weakness, investors have reacted dramatically to the dysfunction in Brussels, Frankfurt and Washington.
European policymakers have responded to their crisis with a series of indecisive measures, including a counter-intuitive tightening of monetary policy by the European Central Bank, said a Bank of America Merill Lynch report.
“Apparently, we are told, raising interest rates can control inflation without hurting growth or financial markets.
“Closer to home, fiscal authorities have bombarded the markets with a quadraphonic message of hopelessness: 1. The US has a huge fiscal problem, 2. They are too dysfunctional to deal with it, 3. Threatening to default on the debt is an acceptable form of negotiation, and 4. We will continue to tighten policy regardless of how the economy is doing,” it said.
“Unfortunately, this leaves the Fed in a familiar spot, cleaning up everyone else’s mess. Back in 2008, the Fed was left to deal with the emerging financial crisis, while the ECB hiked rates and Congress refused to take any action, until the stock market was in full collapse.”
Ben Bernanke, Chairman of the US Federal Reserve, has pointed out that monetary policy cannot solve all of the world’s problems.
Moreover, each new round of unconventional policy is likely to have a smaller effect than the last.
“This is particularly the case when the Fed faces a bevy of dissent from both inside and outside the Committee,” Ethan S. Harris, Economist at BofA Merill Lynch, said.
Nonetheless, the Fed is not impotent.
However, there are two reasons for concern. First, a number of sectors have yet to recover from the previous crisis. Banks have rebuilt their capital and are in better shape. However, both the housing sector and state and local governments are quite vulnerable. If the economy does go back into recession, it could reignite the negative feedback loop between employment, home prices and mortgage delinquencies, BofA economists argue.
Hope against hope
The best case for a recovery is that the market panic stops and some of the recent shocks fade. Oil prices have already come off their highs and Japanese supply chains are recovering from the impact of the recent earthquake and tsunami. Moreover, while the Fed has no room to cut interest rates, the ECB and most emerging market central banks have room to ease, it says.
“Europe could take the big step of fiscal integration and centralised debt financing—this is the natural end game for the union. Over the longer term, we could see a pickup in foreign investment, a re-opening of immigration to skilled workers and a productivity boom triggered by technological innovation,” it says.
While risks are skewed to the downside, the economy will continue to recover slowly.
“The recovery will likely come in fits and starts, and we should not be surprised if there are more dead spots that may feel like a recession.
“We learned from historical episodes that the healing process from a balance sheet recession is slow and often bumpy,” Harris says.
How and why did the world get into this huge ‘trap’?
To begin with, it is the advanced or developed industrialised countries that have a huge and unsustainable debt problem, says Dr Nasser Saidi, chief economist of Dubai International Financial Centre (DIFC).
By contrast, emerging market economies (with few exceptions) have healthy national balance sheets, strong macro-economic conditions and sound fiscal policies.
The OECD forecasts that advanced economies — without major corrective changes in fiscal policies — will have debt to GDP ratios in excess of 115 per cent by 2015.
What led to this growing debt problem?
“We need to distinguish between secular, trend factors that underlie government budget deficits and debt accumulation from cyclical factors and the results of interventionist government policies,” says Dr Saidi.
The trend factors are related to the demographics of ageing populations in advanced economies (Japan, Europe and to a lesser extent the US) and the role of entitlement and health policies: social security, national health programmes (Medicare, Medicaid).
The ageing population that characterises Japan, Europe and the US has contributed to the current situation in two ways.
First of all, an uneven growth of working-age and retirement-age population means that a decreasing number of tax-payers have to provide the financial resources for an increasing number of people that become eligible for old-age pensions, he explains.
“There is large transfer of resources from the young to the elderly causing the generation that is entering the job market now to finance not only their own future retirement, but also of their parents. Rather than increase the taxation burden [considered high already in Europe] politicians have taken the easy way out: increased borrowing,” he says.
“The political cycle in advanced economies is heavily biased towards running deficits and increasing debt. The related issue is that people are living longer: life expectancy in the advanced economies has increased from an average 71 years in 1970 to 78 years in 2009. This results in higher public [and private] spending on health and medical as well as other entitlements and growing budget deficits.”
The cyclical factors relate to the impact of the Great Contraction and the Great Financial Crisis. Recessions typically lead to increased government spending through the operation of automatic fiscal stabilisers (e.g. unemployment benefits) while tax revenues decline as a result of lower income; the result is higher deficit spending and debt accumulation.
This expected deficit increasing cyclical effect was exacerbated by unprecedented fiscal stimulus, bail-outs of banks and financial institutions and the ‘socialisation’ of private debt, when governments and central banks took over liabilities from insolvent banks and financial institutions and other sectors (e.g. car industry).
“In the US the situation was aggravated by loose monetary and fiscal policies after 2001, leading to both public and private sector dissaving and reversing a string of government budget surpluses from 1998 to 2001 [with a peak in 2000 when the surplus amounted to $236 billion (Dh866.8 billion],” Dr Saidi argues.
“A policy of low interest rates encouraged private sector dissaving and greater household indebtedness [mortgages in particular], while military spending surged in association with wars in Iraq and Afghanistan.
“The US moved from being a net capital exporter to a capital importer, absorbing some two thirds of global saving over the period 2004-2006, resulting in the ‘global imbalance’.”
What is the way out?
There is no easy way out.
Advanced economies will require deep and sweeping reforms to their taxation systems and to their entitlement programmes. Fiscal sustainability requires higher tax rates and the countering of demographic pressures, Dr Saidi says.
“The choices are stark and limited: retirement ages need to be gradually extended to 70 or higher, given increased life expectancy; this should be accompanied by a reduction in the size and coverage of entitlement programmes,” he says.
For the US, the long term fiscal sustainability menu will need to include a major reduction in military expenditures and agricultural subsidies. For Europe, dealing with the demographics will also entail loosening of the strict emigration policies in place now: Europe has to draw on the relatively young populations of the Southern Mediterranean in order to pay for its pensions.
None of the above choices are politi cally palatable and we should not expect governments to willingly take hard choices.
“The lessons from history are clear: faced with large debt burdens, governments are unlikely to substantially increase taxation or effect permanent reductions in spending; they are more likely to default or reduce the real value of their obligations through inflation,” he says.
To convince their creditors and financial markets, governments will need to invest in credible institutions. Increasingly, governments are turning towards setting up of independent fiscal advisory councils and the adoption of fiscal rules.
“Such fiscal councils should also be adopting new and different ways of looking at governments fiscal accounts. We should move toward ‘generational accounting’ systems: a method for estimating the economic impact of fiscal policy on different generations — including future ones.
“The idea is to evaluate the intergenerational effects of alternative government fiscal policies,” he says.
But Saidi says to keep the economic growth momentum, governments are forced to spend, rather than repay debts.
Modern political systems — in advanced economies predominantly — have a built-in bias to deficit spending. Most spending once instituted is difficult to roll back and raising taxes is not a vote getter, he explained.
“This is exacerbated by the political cycle and short-time horizon of governments and elected politicians: if you are elected for three to four years or you are a government with a short expected lifetime, you will tend to spend, not tax in order to get re-elected or to pass the consequences of your fiscal follies to subsequent governments,” he says.
Income disparity
Of the global population, nearly half or 3.25 billion earn less than $2 (Dh7.3) a day, whereas the number of millionaires has obly crossed ten million — reflecting a widening wealth gap that could threaten social stability.
According to the latest World Wealth Report by Merill Lynch and Capgemini, the population of global high networth individuals (HNWI) increased 8.3 per cent last year to 10.9 million and HNWI financial wealth grew 9.7 per cent to reach $42.7 trillion. The global population of Ultra-HNWIs grew by 10.2 per cent in 2010 and its wealth by 11.5 per cent.
“In its beginnings, the credit system sneaks in as a modest helper of accumulation and draws by invisible threads the money resources scattered all over the surface of society into the hands of individual or associated capitalists.
“But soon it becomes a new and formidable weapon in the competitive struggle, and finally it transforms itself into an immense social mechanism for the centralisation of capital.”
However, the rising debt toll is becoming the single biggest headache for governments and economists worldwide and is gradually reaching a point where no one can protect humans from ‘insolvency’. The Arab spring is a reminder of how things can flare up if not dealt with properly.
Zerodha (Trading Account)
RHP
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