Debt Crises and Market Turmoil: Is The World Going Bankrupt?

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The wrangling over raising the US debt ceiling led the country to the edge of a financial disaster, and the deal reached seems like a band-aid on a torn jugular. A total of $2.4 trillion is to be saved over a period of 10 years, but that's not much given the debt today already amounts to a barely imaginable $15 trillion and will probably have reached $20 trillion in a decade.

The US has been living above its means for years. The wars in Afghanistan and elsewhere, the world's most expensive healthcare system, costly stimulus programs -- the US kept on paying for it all with borrowed money. It worked as long as the economy kept on growing and flooded the state coffers with tax revenues. But now those coffers are empty, and the planned spending cuts couldn't come at a worse time.

"The deal's spending cuts increase the odds of a double-dip recession," said Robert Reich, a US economist and former labor secretary during the Clinton administration.

Experts at the International Monetary Fund recently published a study of 170 fiscal policy measures undertaken since 1930 and concluded that state spending cuts dampen economic growth, with every cut amounting to 1 percent of gross domestic product leading to a 0.62 point reduction in growth in the subsequent two years.

The current debt plan envisages cuts amounting to 16 percent of US GDP over the next decade. If the IMF's calculations are correct, the US would inevitably slip into a new recession.

It is imperative that the fiscal problems be addressed. But just like in Europe, the crisis stems largely from a lack of government action and leadership. The political climate in Washington is poisoned, the system isn't working properly and needs to be reformed.

US Heading for 'Banana-Republic Status'

"Our nation isn't facing just a debt crisis; it's facing a democracy crisis," wrote the New York Times.

Nobel Prize-winning economist Paul Krugman wrote the debt deal "will take America a long way down the road to banana-republic status."

America was founded on the principle of the separation of powers and that decisions are reached through consensus. But the new Tea Party radicals in Washington just want power rather than results. For them, compromise has become a dirty word.

In almost half of all US electoral districts, either Republicans or Democrats have clear majorities. That means there's no dialogue between the two fronts. In the primaries, politicians only have to fear internal party critics from the hard left or hard right. And those critics can be very loud.

The result is that ideology overrides pragmatism, even if it means the nation sinks under its fiscal burden and pulls the rest of the world with it.

Given the gridlock in Washington, the Federal Reserve is seen by many as the last savior because it is politically independent and can't be blackmailed by Washington. There are growing calls for the Fed to do what it did three years ago: print money.

Since 2008, the central bank under Ben Bernanke has pumped out 2.5 trillion fresh dollars. That stimulated the economy and could now provide an alternative, albeit crude, way out of the debt crisis. The billions of dollars flushed into the global economy lead to price increases. It is tempting to pay down the debts with the help of inflation.

But the strategy has two dark sides: inflation amounts to a creeping expropriation of ordinary citizens, whose assets gradually lose value. And there is a risk that the US will export inflation to other parts of the world -- to China, for example.

China Faces Slowing Growth and Mounting Inflation

Life is getting more expensive in the country often referred to as the world's factory -- not just for producers, but also for consumers. Chinese consumer prices rose 6.4 percent in June year-on-year, the highest rate in three years. Pork, the most popular food in China, is becoming a luxury -- its price has risen by more than half since June of last year.

The inflation is making people angry. Early last week, around 1,000 taxi drivers went on strike in the eastern city of Hang Zhou to protest against rising fuel prices and traffic congestion.

The unease is being compounded by a deteriorating economic outlook in China's most important export markets -- Europe and the US.

The Chinese probably lost their last illusions about America's economic might when the US raised its debt ceiling yet again to avert insolvency. China has more than a third of its $3.2 trillion foreign currency reserves invested in dollars.

Chinese central bank governor Zhou Xiaochuan urged Washington last week to act responsibly to deal with its debt. The state Xinhua News Agency said the political wrangling in Washington had been a "madcap farce" and it described US debt as a "ticking bomb."

The Chinese economy, the world's second largest, is already at risk of overheating, with dramatic consequences for the world, because it has been the driving force behind global growth. China has been growing at double-digit rates for years -- by 10.3 percent last year alone.

German firms in particular have been benefiting from the huge Chinese market, which is starting to slow. An important sentiment indicator measuring the mood of corporate purchasing managers fell in July. The Shanghai Stock Exchange has been stagnating. And real estate prices fell 13 percent year-on-year in the first half.

The expected slowdown could be interpreted as a sign that China's economic planners are managing to engineer a "soft landing" for the economy. The central bank has raised interest rates five times since October 2010 and ordered banks to boost their loan loss provisions in a bid to stem price pressures. But a weakening construction sector -- a key industry in China -- is likely to pull other sectors like cement manufacturers and steel makers down with it.

China is like a junkie being forced into a rehabilitation program. But the government of Prime Minister Wen Jiabao only has itself to blame. When demand from the US and Europe collapsed during the last financial crisis, his government pumped around 4 trillion yuan (about €450 billion) into the economy, the biggest stimulus package in history, to boost the sale of PCs, television sets and cars. New motorways, airports and train lines were planned. China turned into a gigantic building site.

Local authorities ran up massive debts to stimulate the boom. That has lessened the central government's scope to cool the economy down. If interest rates are raised too sharply, the provinces won' be able to service their debts.

New York economist Nouriel Roubini, who predicted the 2008 financial crisis, fears that China could offload its surplus cement, steel and aluminium on world markets at dumping prices.

German Economic Miracle at Risk

Germany has been enjoying what many have described as a new economic miracle, with 3.6 percent growth in 2010. In the first quarter of 2011, growth even reached 5 percent year-on-year. But with the world economy facing a slowdown, Germany's enormous dependence on exports, the driving force behind its impressive recovery in the last two years, could now spell doom. The US and Italy are among Germany's top five trading partners -- and neither country is likely to provide much impetus for German industry in the foreseeable future.

There is a further danger: the Swiss and Japanese central banks are intervening in markets to stop the appreciation of their currencies which has been putting their exports at risk. If the Americans follow suit, a global race to depreciate national currencies could ensue -- a disastrous form of protectionism.

In its latest "Global Trade Alert," the London-based Center for Economic Policy Research warns that protectionism is on the rise among industrial nations.

The world is closer to an economic crash than at any time since the outbreak of the financial crisis, even though governments are in many respects in a better position than they were in 2008. True, many Western states have amassed gigantic piles of debt. But unlike three years ago, there has been no disorderly insolvency so far that threatens to tear banks into the abyss. On the contrary: Western governments have the means to get to grips with their debt crises.

However, the usual crisis diplomacy with telephone conferences and pledges of "decisive action" won't suffice to calm markets. Effective decisions are needed now, on both sides of the Atlantic.

In the US, the government and opposition must agree on a sustainable plan to reduce the debt -- spending cuts will be as necessary as higher taxes, and politicians must make sure that the measures don't choke off economic growth. That isn't easy but it's not impossible either, as former President Bill Clinton showed in the 1990s. Similar plans are available today. The question is whether the divided political establishment can find the strength to implement them.

A Choice for Euro Zone -- Break Apart or Integrate Much More

And in Europe, governments need to realize that they can't keep on sitting out the euro crisis. The currency bloc will either break apart or its members will move much closer together on fiscal policy. The latter move offers the chance to move ahead with European integration. Here too, the necessary plans are all there -- they just require a plethora of unpopular decisions.

If the euro is to survive, the donor countries will have to shoulder even greater financial risks than they have already. And the debtor nations will have to surrender their sovereignty in budget matters to Brussels bureaucrats for years to come.

The lesson from the latest crisis can be phrased in three words: solid state finances.

It has become evident that debt-to-GDP ratios of 80, 90 or 100 percent will sooner or later cast doubt on a country's creditworthiness. Even supposed paragons of fiscal virtue such as Germany must be careful. The German debt ratio of 83 percent is too high, given the ageing population. Who is supposed to pay down that debt in the future?

Scaling down debt isn't easy, as can be seen in Britain. The government of Prime Minister David Cameron has imposed more rigorous spending cuts than any other traditional industrial nation. The austerity program is coming at a high price. The cuts are hitting domestic demand and have all but wiped out economic growth. Every country that embarks on fiscal cuts faces a similar fate, and it takes years for the measures to bear fruit. States that have restored their budgets to health tend to grow faster than profligate ones.

So the economic prosperity of the West hinges on whether governments are capable of thinking in new dimensions of time. They finally need to start thinking further ahead than the next election.

REPORTED BY ALEXANDER JUNG, CHRISTOPH PAULY, CHRISTIAN REIERMANN, MICHAEL SAUGA, GREGOR PETER SCHMITZ, THOMAS SCHULZ AND WIELAND WAGNER

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• Part 1: Is The World Going Bankrupt?
• Part 2: US At Risk of Double-Dip Recession