Monday, May 17, 2010

A synchronized debt cycle among developed economies

Carmen Reinhart and Ken Rogoff have shown that sovereign debt build-up has been a recurrent theme among national economies throughout history. However, "this time may be different" given the appearance (as the graphic below suggests) of a global debt cycle across most developed economies. Or is it?



The graphic above, which maps the medium term deficits as percentage of GDP, excluding interest payments and assuming unemployment drops substantially to full employment, shows that most developed economies will have cyclically adjusted primary deficits. It also claims that the "finances of the advanced economies are in a worse state than at any point since the industrial revolution".

Here are two specific reasons why developed economies have been uniformly piling up debts in this remarkably co-ordinated global debt cycle.

1. Globalization and more importantly, global financial market integration, may have had the effect of dramatically synchronizing individual business cycles of nations or regions, into one big global business cycle. This may have contributed towards a more or less synchronized debt build-up amongst the developed economies.

2. Over the last decade or so, much of the developed world has uniformly experienced an era of remarkably low real interest rates. Both the nominal rates and inflation have remained stable at very low levels. This in turn encouraged economies and businesses to load up on debt.

Given the fact that this debt cycle has coincided with economic weakness in all these economies, even the medium-term prospects of a recovery from this debt spiral (through buoyancy in revenues and a fast enough increase in the GDP) does not look promising. Further, the recession may have ended up amplifying the deficits. As long as interest rates remain low, the debt servicing burdens will remain manageable.

But how long can the markets be kept under the illusion that recovery is round the corner and these economies remain credit-worthy? As the recent events in euro zone shows, one wild enough market destabilizing event is enough to drive up the bond spreads and wreck economies.

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