In the beginning of May, after assuming as Britain's Secretary of the Treasury, Liberal-Democrat David Laws received a curious note from his predecessor, Labor's Liam Byrne. "Dear Secretary," said the note, "the money's gone. Good Luck! Sincerely, Liam." Despite the slightly joking tone, Byrne's message is uncomfortably precise. The country has no money - at all. With a budget deficit that could reach 12% of GDP in 2010, the United Kingdom is experiencing a situation of penury of the likes not seen in quite some time. Risk classification agencies have already warned that lowering Britain's debt rating, something unheard of a few years ago, is increasingly more probable. But, more than summarize Britain's situation, Byrne and his note help summarize the situation of the planet's major economic powers. Today, the chronic lack of money is a much disseminated evil among the world's richest nations. A team of researchers from Citigroup recently studied the history of global finance from the Industrial Revolution to today. The conclusion is quite frightening. Except for those periods of world war, never has so much been owed, and worse, never has global debt grown so out of control.
Countries deep in the red are walking a fine line that separates creditor trust from fear of possible non-payment. Just give the impression you are stepping on the wrong side of the line, and that's it: you have the ingredients for a debt crisis. It is a well-known and recurring script. From 1800 until today, there have been more than 300 sovereign defaults, and the fear of history repeating itself - this time with rich nations in the role of villains - has given rise to the crisis of the past few weeks. On May 9, the European Union and IMF announced the biggest bailout plan in history, a huge 1 trillion dollar package aimed at eliminating default risks by the most problematic countries in the Euro zone.
As per the agreement, hugely indebted Greece will get 140 billion dollars. In exchange, it agrees to put its house in order, cut costs and increase income. The rest of the money will be available to mitigate possible problems of other Euro zone members. The biggest candidates are Portugal, Ireland, Italy and Spain, a group that, with Greece, was given the not very nice nickname of Piigs. The European package was initially received with relief. On May 10, stock exchanges around the world rebounded. But the very next day, distrust was even greater. By the closing of this edition of EXAME, the Dow Jones Index of the New York Stock Exchange had accumulated a 10% drop in May. Market value of Brazil's main companies fell almost 200 billion reais in the month.
The very poor reaction by the financial market showed the debt crisis will not be solved by a snap of fingers, all night meetings or bags full of money. Fiscal adjustments the size European countries are beginning to make now take at least five years to yield results - and there is always the risk of not yielding the desired effect. Look at Greece, for example. The country agreed to cut its deficit by 10% of GDP by 2014. If put into effect, it will be the most Draconian fiscal adjustment ever, because, even if everything works, Greece will finish the period owing even more than today - which led to an increase in bets the country will end up renegotiating its debt. The Greek crisis becomes even more complex because it takes place in the Euro zone. Countries in similar situations normally opt to depreciate their currency to stimulate the economy during the cost cutting season. Revenues grow and the adjustment ends up being less painful. Since Greece cannot do that, the process has no palliative agents. It can only cut, suffer and see what happens. "Greece has no money. Period," says economist John Cochrane of the University of Chicago. "The problem only gets worse as you delay the solution." In face of the improbability for a happy ending to this story, countries like Portugal and Spain have been contaminated, precisely what the package intended to avoid. Thus, the Euro took a nose dive into an existential crisis. In 2010, the currency has depreciated nearly 15% compared to the dollar.
The world in the red and the current crisis are direct consequences of the 2008 financial panic - and the recession that followed. Countries like the United States and United Kingdom have spent hundreds of billions of dollars to save banks in crisis, and then to jump start the economy with stimulus packages. This socialization of losses has transferred private sector risk to the public sector. And in this case, risk means debt. Before the crisis, the ratio between wealthy country debt and GDP was 73% - high, but far from dramatic (see map on page 22). But, in the following years, these countries took on record deficits. For example, in the United States, it exceeded 1 trillion dollars per year from 2008 to today. The result is out there, a debt that in 2011 will exceed 100% of GDP in the group of the richest countries in the world. Actually, that was a predictable consequence. According to a study by economists Kenneth Rogoff and Carmen Reinhart, banking crises increase public debt in affected countries by 86%. And defaults normally follow. Countries like Spain and Ireland depend on real estate tax revenues, which were experiencing an already well-known bubble. After it popped, the governments found themselves with very high debt and little money to pay.
Although the financial market is not in as desperate a situation as in September 2008, when the American investment bank Lehman Brothers collapsed, today's crisis has something that makes it more difficult to solve than the previous one. In 2008, the American economic team formed a sort of committee to save the planet, and in a rather second class way, ended up restoring investor trust. Starting in March 2009, with the realization that American banks were reasonably healthy after government intervention, the financial market forgot all about the issue and stock exchanges began to rise non-stop.
Everything is more complicated when it comes to sovereign crises. Now we will go through what American journalist James Surowiecki has coined the "Era of political risk", where the most important economic decisions will be made by governments and not companies and consumers. In moments of economic stability, for example, investors strive to anticipate whether Petrobras' profit will be more or less than expected. In crises caused by excess debt, the most important is to project what will happen with governments, which are often in fragile situations. Since this is almost impossible, the risk of shocks increases. Starting now, this uncertainty will be served at breakfast to investors around the world. Did the Greek government withstand the jolt? Is the German voter willing to take money from his pocket to save countries in trouble? Will American Congress attack the deficit? Is the British coalition strong enough?
The collapse of the Euro, defaults and a new wave of European banks going broke are some of the cataclysmic scenarios envisioned by the pessimists for the coming chapters of the European debt crisis. But even the most probable and benign scenarios will represent a step backward for the current rebound of the global economy. Over the past few weeks, several European countries announced they will begin cost cutting to reduce financial market fears. According to the Fitch risk classification agency, it will be the biggest fiscal adjustment program in history. France, the second largest economy in the European Union, intends to cut its public deficit from today's 8% to 3% in 2013. The new British government will cut 8.6 billion dollars in expenses by the end of the year. Portugal and Spain, the most threatened countries, also announced a series of sacrifices. The truth is these cuts come at the worst possible time - in the middle of an already fragile economic recovery. An example: Spain has a 20% unemployment rate, very high even for European standards.
Budget cuts at a moment like this are a necessary response to the current crisis, but they will mean less growth for Europe and the rest of the world. "This is the biggest threat to the rebound," says George Magnus, head economist at the Swiss bank UBS. "But the countries have no alternative. If they do nothing, investors will charge increasingly higher interest rates to finance their debts, which will also hamper growth." Even if the problem is restricted to Europe, there is significant risk of damage. Brazil has a lot to lose in this scenario. Europe represents 22% of our exports - sales of Brazilian chicken to the European Union, for example, have already fallen 15% in 2010. If the continent goes into recession again due to budget cuts, numbers like these could get even worse.
If it is any consolation, the world's fiscal situation has been worse. At the end of World War II, American debt almost reached 120% of GDP. In the United Kingdom, it approached 250%. The panorama improved drastically soon after. "When the war ended, there was no more reason to accumulate debt," says Steven Hess, analyst at the Moody's risk classification agency. And, as a stimulus, the West began a wave of economic expansion led by the baby boomer generation. Growth helped reduce the burden of debt. The bad news is that in today's case, the tendency is the opposite. Baby boomers are retiring, which will multiply age-related expenses like public pensions and health plans. One way out to avoid a complete collapse in accounts is to have workers remain active longer. In the 19th Century, when Otto von Bismarck created government retirement, the minimum age for obtaining a pension was 70 - and life expectancy was 45. With the increase in life expectancy seen in the 20th Century, the math just wasn't there. Countries like Greece, United Kingdom and Spain have already announced they will raise retirement age. The British plan to raise the minimum age to 68 by 2046. Today it is 60 for women and 65 for men.
Although the current crisis is concentrated in Europe, the American fiscal situation may become an even more serious problem in coming years. The combination of rescue packages, economic stimuli and recession has positioned American public debt at a level considered unsustainable by Congress - over the next ten years, the federal deficit rise to 9 trillion dollars. Numbers like these stir up investors and analysts. According to a report by Deutsche Bank, what we see in Greece is a "dress rehearsal" for an inevitable American debt crisis. "American debt is as safe a port as Pearl Harbor in 1941," wrote British historian Niall Ferguson. In ten years, interest payments will be responsible for 20% of the American budget. For critics like Ferguson, this situation will force the government to print money, an old recipe for arousing inflation. That will scare off investors, fearful of seeing the value of their assets diminish at the speed of a probably depreciating dollar - then definitely leading to a global uproar. But, on the other side of the debate, we have economists like Paul Krugman, for whom current concern with the deficit is exaggerated and the American economic recovery will end up mitigating the impact of debt accumulation. It won't take long for us to find out who is right - American debt will exceed 100% of GDP next year.
For emerging countries, the current debt crisis is seasoned with a dash of irony. Until a few years ago, threats of default and fiscal adjustment programs were considered Third World problems. Brazil, which defaulted on foreign debt in 1987 during José Sarney's government, went through five programs with the IMF since then. Argentina had the honor of the largest sovereign default in history in 2001. But today, the emerging countries are doing well, and the rich, poorly. This difference is changing the perception of what is considered a safe investment. Pimco, of California, one of the biggest fund managers in the world, ranks Spanish debt securities as "risky" and Brazilian securities as "stable". "Emerging countries learned from previous crises," says American economist Nouriel Roubini (read interview on page 34). "Many, like Brazil, obtained consecutive primary surpluses, brutally reduced foreign debt and today find themselves in much better shape than rich countries." According to data from Citigroup, the debt-GDP ratio of the 20 biggest emerging countries should remain stable at 40% over the next four years. In the 20 richest countries, it will go from the current 80% to 120% - while the economy in emerging nations will continue growing at an accelerated pace, the rich will grow less as they struggle with their fiscal challenges.
But few errors could be as serious for emerging countries, especially Brazil, as to treat this current difference with haughtiness and a touch of triumphalism. Unfortunately, that seems to be Brazil's case. The government stepped on the accelerator in the middle of the 2008 crisis. The crisis passed, the country is growing at China's rate and the foot is still on the accelerator. Some recent data is a call for concern. The government increased public debt 6%, 74.2 billion reais, to capitalize BNDES. Congress, heading the opposite direction as the rest of the world, approved the end of the social security factor, creating an incentive for early retirement (the government is studying a veto of the measure). And more, over the past 12 months, the primary surplus has been 1.9% of GDP, less than half what was obtained five years ago. "The lesson for Brazil is that the winds have changed. European countries that experienced a period of euphoria in the recent past did not save when they should have," says economist Fabio Giambiagi, of the BNDES. Although in a better situation than the rich countries and having obtained the long yearned for investment grade two years ago, Brazil still has a high debt, calculated at 70% of GDP by Fitch. It is not a good thing to go overboard. "Expectations can change at any moment," says John Cochrane, of the University of Chicago. "And before you know it, you've become Greece." The golden age experienced by Brazil' economy may even create the feeling in some that this time will be different, and that destined to grow non-stop over coming decades, the country does not need to worry about controlling expenses. But the current crisis among rich nations once again helps demonstrate that ageless truth: it is never different.
Report by Fabiane Stefano