The fear is back, in the stock exchanges and in the capitals of the industrial nations. There are growing signs everywhere of a new financial crisis, and the political leaders of the West are looking helpless and out of their depth.
The United States is struggling with an enormous budget deficit. And the euro zone's central bankers and government leaders can't find a strategy to end the permanent malaise of their single currency. The White House has achieved little more than to buy some time with a new debt compromise reached after theatrical political squabbling between Democrats and Republicans. Last Friday night, rating agency Standard & Poor's lowered its rating for the US from AAA to AA+.
Muddling through, postponing, playing down -- the motto of the crisis managers on both sides of the Atlantic has sent alarm bells ringing in stock markets. Britain's Economist magazine is warning of a double-dip recession in the US, a second downturn just three years after the last one. Many economists have been pointing out that last week's panic resembled the fear that swept financial markets after the collapse of US investment bank Lehman Brothers in September 2008.
Then as now, banks stopped lending each money. Then as now, banks' cash deposits at the central bank doubled within days. The European Central Bank reacted by assuring banks of unlimited liquidity in the coming months. It was an emergency measure that led to short-term relief but sparked anxious questions among bankers and stock market players. How long can the central bank keep up its market-soothing liquidity operations before it finally loses its credibility, the most important asset of a central bank? Is the financial crisis about to escalate? And will the world then be bankrupt?
It was less than three years ago that the global economy inched towards the abyss after the US real estate bubble burst. In order to save their over-indebted banks and insurance companies, Western governments borrowed huge sums of money themselves. They nationalized banks and implemented vast stimulus programs, while central banks flooded the economy with cheap money.
As former German Finance Minister Peer Steinbrück put it, "fire was fought with fire."
That helped to prevent a global economic crisis of the kind that brought the world to a standstill in the 1930s. But it also set ablaze the headquarters of the world's economic fire-fighters. Who will save the saviors? That question was already being asked back in 2008, and it has gained urgency now that government debt mountains are higher than ever.
Crisis Management Obstructed by Politics
The scale of new borrowing is less of a problem than the inability of governments to find a credible strategy for reducing their debts. In the US, the government and opposition have been locked in a dispute over whether the deficit should be removed through tax hikes or cuts in social spending. In Europe, the solvent governments of the northern countries are refusing to underwrite the debt of the struggling Mediterranean countries.
The West faces a dual crisis that has engulfed its most important political leaders. President Barack Obama has failed to mend a gaping rift in US society and to outmaneuver the conservative Tea Party rebels. In Europe, it has become more evident with each European Union summit that German Chancellor Angela Merkel, rather than being in control of the crisis, is being driven along by it.
The West hasn't been this weak since World War II, and never before has a crisis paralyzed Europe, America and Japan at the same time. The problems of the leading industrial nations aren't just sapping the political influence of the so-called Free World, they are also threatening the global economy.
There are growing fears in the US that the debt woes could drive up inflation to new record levels. In Europe, the future of the single currency is at risk.
Merkel can't avoid the key decision much longer: either the euro zone will be converted into a close fiscal union with financial transfers and commonly issued Eurobonds, or Europe's most indebted nations will have to leave the currency union -- with unforeseeable consequences for the remaining members.
The longer the Western debt crises smolder on, the darker the outlook for the global economy. Because the US economy is collapsing, American consumers are buying fewer goods from China and India. And because investors are piling out of euro and dollar investments, supposed islands of stability are starting to look shaky as well. In recent weeks, the Swiss franc and the Brazilian real have appreciated so strongly that exporters in those countries have been virtually unable to sell their products abroad.
Global Downtrend Feared
And so the world is at risk of sliding into a downward spiral. The debt crises are weakening economic growth, and the declining momentum in turn is making it even harder to escape the debt crisis.
Italian bank UniCredit has predicted a "synchronous downtrend in the US, Latin America, Asia and Europe." A downtrend that would also engulf the economy that has so far been getting through the crisis better than most others: Germany.
If the vicious cycle is to be broken, the governments in Europe and the US must take action now, united and coordinated. No less than the world's economic stability is at stake. But so far, that particular risk doesn't seem to feature prominently in the concerns of the world's crisis managers.
Jean-Claude Juncker, Luxembourg's prime minister and president of the euro group of euro-zone finance ministers, is a veteran of EU policymaking. After the July 21 special EU summit in Brussels, he declared that the euro crisis had been sorted out, and that the second Greek bailout agreed to that day was "the last package." The triumph lasted barely 14 days. The crisis started worsening again last week. Financial markets have set their sights on Spain and Italy, two economies that are too big to be dismissed as peripheral problems like Greece, Ireland or Portugal.
The risk premiums on the government debt of the two countries rose to risky levels last week. Italian and Spanish bond yields were four percentage points above comparable German debt, seen as the benchmark of stability.
That makes borrowing more expensive, and governments simply can't afford such rates in times like these. When Ireland's interest rates reached similar levels last autumn, its neighbours urged the country to seek a bailout from the €440 billion ($625 billion) EU emergency rescue fund, the European Financial Stability Facility (EFSF).
Pledges Don't Calm Markets for Long
But Italy and Spain are too big. It has once again become clear that the euro was launched as a fair-weather currency. And that the euro zone's rescue mechanisms, despite all the additions and improvements, remain little more than inadequate, stopgap measures.
Once again, government leaders are falling behind the financial markets and economic realities in a race that will determine the fate of the euro. It is particularly worrying that their announcements and pledges appear to have an ever decreasing shelf-life.
Last year, when they rushed to the aid of Greece and set up a rescue fund for the high-debt nations on the edge of the currency bloc, they managed to calm markets for a few months. But since then, the breathing space following EU announcements has been whittled down to weeks, even days.
Europe's rescue efforts are not just behind the curve. The measures they end up taking turn out to be insufficient. "Too late and too little," said former EU Commissioner Günter Verheugen, referring to the failure of EU leaders to secure a long-term solution for their ailing currency.
Merkel opposes increasing the volume of the rescue fund. "Every increase would only be an invitation to speculators to go on finding out how much more the euro zone is ready to give," said one German government expert.
Berlin Officials Say EU Fund Can't Save Italy -- Even if It's Trebled
Officials in Berlin say the fund could cope with a bailout of Spain but wouldn't be able to handle Italy even if its resources were trebled. Worse, that assessment also applies to the permanent European Stability Mechanism (ESM) that is due to replace the EFSF in 2013. This admission is unlikely to strengthen confidence in the euro.
"You can't bail out an economy like Italy," said one high-ranking government official. The financial requirement would be too huge. Italy's EU partners couldn't even provide a guarantee for the country's government debt, currently totalling €1.8 trillion, as some economists have proposed.
The alternative is simple: Eurobonds. But at present, German officials are only mentioning that possibility in whispers. The common issuance of government debt is still a taboo in top government circles -- for the time being.
The German government fears that such bonds would entail major disadvantages for Europe's largest economy. The yield on them would be higher than on current German sovereign bonds, because the euro zone as a whole wouldn't be as creditworthy as Germany is on its own. If the interest rates on Eurobonds were just one percentage point higher than German government bonds, it would cost the German government an additional €20 billion per year in the medium term.
That is why Merkel and Finance Minister Wolfgang Schäuble are insisting that Italy find its own way out of the crisis by cutting government spending and enacting reform. But Berlin is under pressure, not just from the other EU member states, but from Washington. The US is pushing Germany to agree to Eurobonds. Obama is calculating that if Europe gets to grips with its crisis, his own fight to cut US debts will become easier.
US At Risk of Double-Dip Recession
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