Friday, August 27, 2010

Sovereign Debt Defaults And Financial Oppression

There’s a fascinating article on Morgan Stanley’s Global Economic Forum today, assessing the state of government finances in the West:

Ask Not Whether Governments Will Default, but How
By Arnaud Mares

The sovereign debt crisis is not European: it is global. And it is not over. The European sovereign debt crisis of spring 2010 was a misnomer in more ways than one: there was not one crisis but two. And it will continue well beyond 2010, in our view. The first crisis was, and remains, an institutional crisis of the euro, caused by a flawed multilateral fiscal surveillance framework. Steps have been taken towards a correction of the flaws with a move from peer pressure to peer control of fiscal policy. This is reflected by the acceptance by the Greek, Spanish and Portuguese governments of fiscal measures largely dictated from Berlin and Brussels. The second crisis was, and remains, a sovereign debt crisis: a crisis caused by sovereign balance sheets being overstretched, to the point where insolvency ceases to be merely possible and becomes plausible. This crisis is not limited to the periphery of Europe. It is a global crisis and it is far from over. We take a high-level perspective on the state of government balance sheets and conclude that debt holders have to be prepared to enter an age of ‘financial oppression'.

The basis of his argument is that unfunded future liabilities and ageing populations, on top of the deficits incurred during this recession, make government debt defaults likely. What’s different in this scenario, and what distinguishes the viewpoint of this article from the more incoherent doomsayers, is that the definition of “default” used here is very broad, and not necessarily in a financial sense. From this perspective, Greece has already defaulted – on its pension and retirement promises to its civil service, and in the promised level of services to the rest of its population. While this doesn’t do squat for the current financial situation, this does remove potential future liabilities growth.

Mr Mares also brings up financial “oppression” where governments wield the traditional ways out from under onerous debt burdens, via currency devaluation (external debt) or inflation (internal debt). All avenues are still in play, although I think neither currency adjustments or inflation are likely in the near term – everybody can’t devalue at the same time, and deflation is a bigger threat right now than inflation.

In the Malaysian context, we have a couple of additional ways to reduce the debt burden. First is that we don’t have unfunded future liabilities in terms of over committed pension and healthcare costs for an aging population – Malaysia’s demographics are actually at the other end of the scale, and welfare obligations are as yet very low – so there aren’t any promises to break here. The other way out is of course to grow faster than debt accumulates – again we have an advantage with a relatively young population.

But there is a lesson here for the future – lets not let our zeal for social welfare lead us to overpromise and build a social safety net we can’t afford. The fertility rate in Malaysia is already dropping precipitously, and we’ll be supporting an aging population soon enough. One more argument for cutting consumer subsidies? You bet.

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